The dangerous game between European leaders and bond markets is entering a brutal new phase, with investors dumping Italian and Spanish bonds, while fears spread to triple-A rated countries such as France, Austria, Finland and the Netherlands.

Bond markets scored a victory in the recent political changes in Italy and Greece. It was pressure from the bond markets, rather than voter outrage or convincing plans from opposition parties, that caused European leaders to lose confidence in the Italian and Greek leaders and led to the resignations of Silvio Berlusconi in Italy, and George Papandreou in Greece.

In their place we now have two highly trained economists: Mario Monti in Italy and Lucas Papademos in Greece. Both men obtained their PhDs in economics from elite US universities and both are determined to implement tough austerity programs — slashing government spending, raising taxes and pushing through major labour market reforms.

But the bond markets are becoming increasingly worried that budget-cutting measures won’t work, particularly as Europe seems set to plunge into recession. As a result, investors are putting increasing pressure on the European Central Bank to step up its purchases of bonds issued by debt-strapped eurozone countries.

And markets have been quick to show their displeasure with what they see as the ECB’s recalcitrance. Jens Weidmann, who heads Germany’s powerful Bundesbank, again has stressed that the ECB would not be a lender of last resort to debt-strapped eurozone countries. “The co-option of monetary policy for fiscal needs must come to an end,” he said in a speech on Monday. “The pressure on the ECB as the only reputed institution that can act has increased with every failure by governments to solve the crisis, [which] lessens the imperative [on leaders] to implement the necessary measures.”

Weidmann’s words helped trigger a fresh wave of selling of eurozone bonds. The yield on Italian 10-year bonds again soared above the critical 7% level overnight. (When their borrowing costs hit this level, Greece, Ireland and Portugal were all forced to seek bailout packages.) Spain, meanwhile, saw the yields on its 10-year bonds jump by 23 basis points to 6.27%.

The debt crisis is increasingly infecting countries such as France and Belgium. Worries about the heavy exposure of French banks to debt-laden eurozone countries pushed 10-year French bond yields up 23 basis points overnight to 3.62%, a record 188 basis point spread over comparable German bunds.

And, in a worrying new development, even fiscally sound eurozone countries such as the Netherlands, Austria and Finland, which were previously considered to be absolutely “safe”, are seeing increases in their borrowing costs as investors worry that their economies will be hit by Europe’s austerity drive.

About three-quarters of Europe’s fund managers now believe the region is headed for a recession in the next 12 months. After all, many of the region’s major economies — Spain, Italy and France along with Portugal, Ireland and Greece — are now embracing similar budget cutting measures. These involve reducing the number of public servants and cutting their wages, introducing pension reforms, reducing health insurance costs, and selling off government assets.

But the reforms are going beyond simple budget cuts. Greek and Spanish employers can fire workers more easily, and get rid of collective agreements, and the new Italian government is being urged to introduce similar measures. Overnight, French President Nicolas Sarkozy announced a review of the funding of the country’s social welfare system, arguing that it has led to onerous labour costs that hurt France’s ability to compete internationally.

European leaders are deeply aware that these savage cuts in government spending will likely trigger a recession on the continent. They know that countries in the eurozone are important markets for each other. With so much of the region now engaged in austerity programs, they know that countries with dwindling domestic demand won’t be able to compensate by boosting their exports.

But European leaders appear determined to take advantage of the present debt crisis. Under the cover of austerity programs, they want to dismantle the extensive and expensive social security system that Europe introduced after the Second World War in order to make old Europe more competitive with the United States and developing countries, such as China. They want to boost European productivity by deregulating labour markets and increasing the ability of employers to sack workers.

Of course, European leaders recognise that they have little choice but to pursue these programs if they are to secure the long-term economic survival of the eurozone. The problem is that their long-term plans are increasingly being derailed by skittish bond markets.

*This article was originally published at Business Spectator