With Greece's second bailout seemingly in the bag at last, Spain is shaping up as the next big test of whether euro zone policymakers can keep striking the right balance between carrot and stick to reconcile the very different interests of lenders, debtors and markets.
Fine-tuning incentives and getting policy sequencing right is key to tackling the euro zone's debt and banking crisis.
Imposing losses on Greek bondholders before erecting a firewall to shield other vulnerable sovereigns was an example of how not to do it. The ensuing collapse in peripheral bond markets last autumn brought the euro to the brink.
The choreography has since improved. The European Central Bank's (ECB) provision of 1 trillion euros of cheap three-year loans has bought invaluable policy time by virtually eliminating the risk of a catastrophic bank failure.
Yet the crisis is mutating, not receding.
In defiantly rejecting Spain's 2012 budget deficit target agreed with the European Commission, new Prime Minister Mariano Rajoy is challenging the trade-off underpinning the management of the crisis: EU paymaster Germany and other northern creditors will stand ready to finance southern debtors as long as the latter embrace austerity to reduce their debt and deficits.
We are entering a more political phase of the crisis in which issues of national sovereignty, fiscal surveillance and competitiveness vis-à-vis Germany are coming to the fore, said Nicholas Spiro of Spiro Sovereign Strategy in London.
If Spain is given the leeway it seeks, it will effectively be driving a coach and horses through the euro zone's new German-inspired fiscal regime, he said.
WATCHING FOR PRECEDENTS
Soon after signing up for the new pact, Rajoy, without informing other euro area leaders, raised his deficit target to 5.8 percent from the agreed 4.4 percent, arguing that the books his government had inherited were worse than thought.
The Netherlands, debating what to do about its own overshooting deficit, will watch with interest the politicking over Rajoy's gambit. So too will France, where Francois Hollande, the socialist party's presidential candidate, wants to rework the fiscal compact to put the emphasis on growth if he wins the forthcoming election.
And then there is Greece, which on Thursday was on the verge of concluding a bond swap with private creditors that is key to unlocking a 130 billion euro rescue.
In return for the financial lifeline, Athens has committed itself to further austerity that is likely to prolong and deepen a recession already in its fifth year. Greece, too, is due to hold elections within weeks.
If the Spanish can tell the Commission to ‘go hang', why on earth shouldn't the Greeks? asked Jamie Dannhauser with Lombard Street Research, an economics consultancy in London.
Dannhauser said Spain's fiscal numbers simply did not add up. Madrid, he said, was proposing to slash real government spending this year by an unprecedented 11.5 percent.
If undertaken, this alone should cause a drop in GDP far bigger than the 1.7 percent that the government currently estimates, he said.
If that were to make it impossible to hit the goal of lowering the 2012 deficit to 3 percent of GDP, Dannhauser asked, would Rajoy plough on regardless or snub the Germans?
Paola Subacchi, head of international economics at Chatham House, a think tank in London, said she saw no way out of the impasse for countries like Spain, which has an unemployment rate of 23.3 percent, the highest in the euro area, and yet is being pressed to cut more.
It is very difficult to give another dose of very bitter medicine to public opinion in these countries, she said.
Advocates of relating periphery economies forget that governments adopt tough reforms only when all other options have been exhausted, according to Jacob Funk Kirkegaard with the Peterson Institute of International Economics in Washington.
That was a lesson the ECB learned last summer when then Italian Prime Minister Silvio Berlusconi reneged on promised reforms once the ECB started to buy Italian bonds on the secondary market, easing the pressure on Rome.
Italy, under Berlusconi's successor, Mario Monti, and Spain are now embarking on vital structural reforms.
Getting the incentives right also means creating 'policy space' for well-meaning states that fall short of their deficit targets. To that end, the new treaty envisages dispensations for countries that have a persistently large output gap and are undertaking structural reforms, Kirkegaard said.
As such, it was virtually inconceivable that the Commission would punish Spain. If they do that, they have learned nothing, he said.
The good news is that policymakers are learning.
After markets rebelled at the thought that forcing losses on Greek bondholders would set a precedent for other heavily indebted sovereigns, German Chancellor Angela Merkel and French President Nicolas Sarkozy performed a U-turn and said Greece would be a one-off case.
Berlin had got the sequencing wrong by proposing a private-sector haircut before a firewall was in place to prevent contagion, Kirkegaard said. Governments, especially Germany, have also gained a greater understanding of how markets work and the need to communicate with them.
They clearly are getting better at calibrating incentives. The quality of the policymaking has improved, he said.
Some still fret, though, about the sequencing of the policy mix. For a start, in removing the risk of a bank funding crisis, has the ECB produced a sense of complacency that emboldens governments like Rajoy's to relax its budget discipline?
Andrew Benito, an economist with Goldman Sachs in London, said a roadmap towards a resolution of the sovereign debt crisis was emerging.
But the various components of that resolution, which involve actions at the national and European levels, are not in sync in terms of timing, he said in a note to clients. This carried risks, even if Spain's announcement of less ambitious fiscal targets was not, by itself, a sign of complacency.
In a similar vein, Raghuram Rajan, a former chief economist at the International Monetary Fund, said politicians in the course of the euro drama had obtained a mandate to take bolder action only when the markets had brought home the cost of doing nothing.
While the ECB has bought the euro zone some time, the calming effect on markets may be a mixed blessing. Have Europeans seen enough of the abyss to tolerate stronger action by their leaders? If not, markets might have to deteriorate further to make possible a comprehensive resolution to the euro zone crisis, he wrote in a recent Project Syndicate article.
(Editing by Mike Peacock)