The conservative government in Madrid is starting to back away from austerity. And Paris is next, writes MoneyShow.com senior editor Igor Greenwald.

In Europe’s Bizarro political economy, weakened by two years of policies that have throttled growth and undermined the financial system they were designed to save, the worse things get at this point, the better.

Not better yet for 10.7% of Europeans unemployed, the highest jobless rate in 15 years.

Not better soon for the bond investors waiting to get paid out of shrinking government revenues.

But better for everyone in the longer run, as the doctrine of austerity delivers the predictably poor results and is discredited. The deeper the hole, the louder the voices demanding that governments stop digging.

Politicians are catching on. Unquestioning acceptance of instructions to cut, cut, and then cut some more, so evident last year, is all but gone, replaced by equivocation and in some cases open rebellion. With livelihoods and political careers on the line, there’s a growing realization that austerity is a dead end in a time of hardship for most of the world’s advanced economies.

Last week, the government of Spain told the European budget police that its former 2012 deficit targets were no longer achievable, just like the 2011 figures it had tried to hit.

Not that the conservative government has failed to make the promised cuts—elected on the platform of austerity, it had gone about the chore with surprising zeal in the face of 23% unemployment. But revenue has continuously fallen short of estimates, as an economy saddled with a burst real-estate bubble and deep cuts in government spending slowly submerges.

Spain will now aim to run a 2012 budget deficit of 5.8% of GDP, well above the old 4.4% target. In 2011, the gap was 8.5%, instead of the projected 6%. But Madrid still signed the new European treaty prohibiting the sort of deficits it has been running, because even though the economy is now expected to shrink for most of this year, the budget deficit is to miraculously fall to 3% in 2013.

The Spanish prime minister wasn’t in the mood to explain himself to European colleagues just yet, beyond describing the new target as a “sovereign decision made by Spaniards.”

Meanwhile, French President Nicolas Sarkozy, who’s staked his candidacy on austerity and the calls to adopt German discipline and flexibility, finds himself trailing in the polls ahead of a two-round election in April and May. Under Sarkozy, taxes have gone up on everything from restaurant meals to cigarettes, booze, and soft drinks, alongside unemployment.

The frontrunner, Socialist François Hollande, has already said that Europe’s budget pact must be renegotiated to support growth. If he prevails, he’s likely to challenge German Chancellor Angela Merkel, who is openly backing Sarkozy.

France’s budget for the current year was developed in August under assumption that the economy would grow almost 2% this year. By November, that had dropped to 1%. Now the economy is expected to flatline during the first quarter, and after that your guess is probably better than the French government’s.

The AAA credit rating is gone, and one of the two remaining A’s could bolt at any time. French voters are so unenthused by austerity that Sarkozy has changed the subject to immigrant-bashing as his last, best hope.

Merkel remains very popular in Germany, and austerity is still in vogue throughout northern Europe, where its effects have been masked by private-sector growth. Dutch, Finnish, Austrian, and German voters remain under the misimpression that the Greek bailout actually helps Greeks, rather than the French and German banks.

But even Germany will soon feel the effect of a recession plaguing its closest trading partners. Already, factory orders are on the wane, and exports are sure to follow.

And yet Merkel and her clueless finance minister, Wolfgang Schauble, have now decided that to defend austerity effectively, they must practice it more vigorously, at the precise time when their allies desperately need Germans to lift spending to offset their own cuts. This will help to depress German exports that much sooner.

When that happens, and the German jobless rate starts heading up, Merkel’s popularity could fade. Her insistence on austerity might wane at the same time. Europe can hardly wait.