In announcing the projected budget surplus of $1.5 billion for 2012-13, Treasurer Wayne Swan made the proud boast that “not even a sovereign debt crisis in Europe or unprecedented natural disasters here at home could deny Australia this substantial achievement.” As Bill Clinton might say, it all depends on what you mean by “could”. Certainly, these adverse developments haven’t prevented the announcement of the surplus. But there is every reason to think that the crisis in Europe might prevent the promised surplus from being delivered.

A string of electoral revolts have closed off any prospect of success for the policies of austerity under which European governments were supposed to cut their way back to budget balance. These policies were imposed by the European Central Bank and the IMF, in return for limited assistance with the sovereign debt problems arising from the Global Financial Crisis in 2008, and were supported by most of the governments of Northern Europe.

The strongest political support came from “Merkozy”, the alliance of German Chancellor Angela Merkel and French President Nicolas Sarkozy. Although not in the eurozone, and therefore not subject to the constrictive monetary regime of the ECB, the Conservative-led government in the UK has pursued almost identical policies.

A couple of months ago, when the budget was still in the final planning stages, it looked as if austerity might just succeed. The ECB, while resolute in its refusal to buy European government bonds on any substantial scale, had channeled more than a trillion euros through the banks, hoping to achieve the same expansionary outcome. And 25 European countries had signed the European Fiscal Compact committing them to a policy of balanced budgets, to be achieved primarily through cuts in expenditure.

In both electoral and economic terms, that policy is now a shambles. The voters have thrown out the French and Greek governments and the Dutch government has collapsed after failing to pass austerity measures in parliament. Local elections in the UK and Italy have also produced huge swings against the architects of austerity. Even in Germany, Merkel’s party suffered a crushing defeat in a state election at the weekend, and may well face more to come. In this electoral landscape, the commitments made in the Fiscal Compact are effectively null and void, whatever Merkel may say about its being non-negotiable.

The economic news has been equally grim. According to the advocates of austerity, cuts in public expenditure were supposed to make room for private expansion. Instead, Europe is sliding back into recession. Even Germany, where relatively strong economic performance has made for a good deal of complacency, not to say schadenfreude about the problems of its European partners, looks set to record its second successive quarter of negative GDP growth — the most commonly used criterion for a recession.

Austerity is doomed to fail, but there are two radically different ways in which this failure could play out, with very different implications for Australia. If Merkel and the ECB hold their line, Greece will almost certainly default on its debt, and probably abandon the euro. That will threaten a chain reaction, in which Spain, Italy and Portugal follow suit, producing a financial crisis at least as severe as that of 2008-09. In these circumstances, the forecasts in the budget papers will be rendered irrelevant.

The alternative is that the ECB (presumably with German acquiescence) blinks, abandoning its 2% inflation target, and printing trillions of euros to buy European government bonds.  That would have less immediate consequences for the Australian economy, but it would represent a comprehensive failure of the system of monetary policy pursued by all major developed countries, including Australia, for the last two or three decades.

The best outcome for monetary policy, a shift to targeting nominal GDP rather than inflation, would also necessitate a return to active fiscal policy. That would be consistent with the Labor government’s approach in responding to the GFC, but not with the pre-crisis orthodoxy of budget paper 1, which states:

“The return to surplus also recognises that fiscal policy should be set in a medium-term framework. In normal circumstances monetary policy should play the primary role in managing demand to keep the economy growing at close to capacity consistent with achieving its medium-term inflation target.”

Swan continued: “The deficit years of the global recession are behind us. The surplus years are here.”

Judging by recent developments abroad, this statement could turn out to be as ill-judged as Paul Keating’s famous boast about the 1988-89 budget that “this is the one that brings home the bacon”.

*Professor John Quiggin is a Federation Fellow in economics and political science at the University of Queensland and the author of Zombie Economics: How dead ideas still walk among us