European stocks are down and peripheral bond yields up as austerity continues to undermine the continent’s economy, writes MoneyShow.com senior editor Igor Greenwald.

Well, that didn’t take long. A couple of days into the new year, Spanish and Italian stocks are down 2% and dimming risk appetite around the globe.

Big Italian lender UniCredit had to discount its equity 43% to raise €7.5 billion from skeptical investors. Denmark’s Vestas, the world’s top maker of wind turbines, fell even more after cutting its outlook for the second time in two months as European customers postponed orders.

French hearing-aid maker Audika is also generating static, after warning that the “very unfavorable” economic outlook has dampened sales.

And no wonder, since the German and French political elites appear to have gone irretrievably deaf. German leadership has exhorted the nation to lead by example in adopting austerity, the polar opposite of the economic spur the continent badly needs.

The French are seeking German advice on pinching worker income to avoid mass layoffs. Both are still banking on “labor-market reforms” to see Italy through, reforms that would take years to pay off even if they were the answer, which they aren’t.

Edward Hugh explains in excruciating detail why that’s so. Italy’s real problem is that it’s become 30% less competitive against Germany since entering the Eurozone. Given this obstacle to investment and growth, prying open the Italian professions is akin to trying to bail the Titanic.

Unlike Germany and Japan, rapidly aging Italy is no exporting powerhouse, and can’t prop itself up that way. Even if it manages to refinance the mountain of debt coming due over the next three months on acceptable terms, the budget cuts implemented by Mario Monti’s technocrats figure to sink the economy soon thereafter, jeopardizing revenue collections.
Yields on shorter-term Italian debt have fallen steadily, as banks deploy the nearly free money lent to them recently by the European Central Bank. But ten-year Italian bonds have found noticeably fewer takers, and their yields continue to hover near 7%.

Spanish bond yields have also started creeping up after plunging in anticipation of the ECB largesse. Spain’s newly elected conservative government last week revised the forecast 2011 budget deficit from 6% to 8% of GDP, setting the stage for more painful cuts. Whether and when austerity will ever lead to growth is anyone’s guess.

Until Europe reverses course and figures out that shrinkage will not restore the ability of Spain and Italy to compete and grow, it’s hard to be optimistic no matter how many euros the ECB throws at the problem. The ECB’s interventions have bought time, but right now that time is being used counterproductively.

And that makes European bank stocks attractive shorts despite the market drubbing they’ve already suffered. Things can, and will, get worse. Shares of Deutsche Bank (DB) and Banco Santander (STD), down roughly by a third in six months, are likely to get significantly cheaper.