Walking through the charming cobblestoned streets of the Old City in Tallinn in Estonia, it is hard to figure out that this is part of a European economy in crisis. The street cafes and curio shops are bustling with tourists, mostly from other northern European countries; gorgeous young women dressed in the latest fashions walk smartly towards their destinations; the restaurants and malls are full of people consuming; and there are few if any overt signs of increased unemployment or poverty or even more material insecurity.

Yet this probably shows how appearances can deceive, and especially deceive the casual visitor. The centre of Tallinn does indeed suggest what the financial press and the Estonian government are at pains to reiterate: that Estonia is one of the economic “success stories” of the European periphery. This is a country that went through the hoops of very deflationary macroeconomic policies for several years in return for the privilege of joining the eurozone. This goal was achieved early this year.

In fact, the apparent success has been achieved at the cost of significant (and potentially increasing) material pain for the bulk of the population. Severe budget cuts cut public services, further increased unemployment and hit poorer sections hardest. It is estimated that GDP, which fell by 15 per cent in 2009 and grew only a little last year from the low base, will take until 2014 to recover to the level of 2007, before the financial crisis. Real wages have been falling continuously for several years now, in an internal devaluation that reduces the living standards of the “lucky” ones who do manage to retain their jobs. So the picture provided by the apparently bustling activity in the centre of Tallinn is at best a partial one, which does not take into account that economic deterioration tat is actually being felt by most of the population.

But Estonia is the success story! In other “peripheral” economies, of course, the situation is even direr. Countries like Ireland, Greece, Portugal and now Spain are in the throes of a seemingly endless process of trying to deal with private bond markets that simply do not believe that the governments will repay their existing debts in full.

This creates a crazy downward spiral. The problem is this: the more the financial markets hammer the government bond markets, the more ths governments of Greece and Spain are forced to announce and try to implement severe austerity packages that entail large cuts in public expenditure with adverse effects on employment and output. So they keep announcing budget cuts that involve declining spending on crucial things like schools and hospitals and significant effective wage cuts for public sector employment.

Quite apart from the public discontent that this involves, this strategy is macro-economically stupid. The multiplier effects of these moves are obviously negative, and so the economy tanks. This makes it much harder for all the private borrowers – large and small firms, household enterprises, individuals who have taken credit to buy homes or purchase consumer durables, credit card holders, and so on – to repay their debt, because their incomes also collapse.

So the economy gets into a vicious downward spiral, in which even previously solvent and liquid borrowers become progressively less liquid and end in insolvency. This is part of the bust phase of a classic credit cycle. The difference here is that it is being helped along by governments who seem to be powerless to confront the workings of private bond markets.

The peculiar thing is that this path of fiscal austerity and all the associated economic pain is being chosen not only by countries with obvious repayment difficulties, but all over Europe. In the midst of a fragile and easily reversible recovery after a very severe recession, governments across Europe – in both deficit and surplus countries - are announcing fiscal austerity packages that are all but guaranteed to prolong recession or at the very least, damage the prospects of recovery especially in employment.

While the government bond market is the focus of the current crisis, and the talk is all about the possibility of sovereign default, in fact the lending of banks to these countries is dominated by private debt. Lending to government accounts for less than one-fifth of the total exposure of banks to these countries. The so-called “bailouts” that are being provided by the European Centrl Bank and the IMF to the countries n trouble are in reality bailouts for the banks (mostly from Germany, France, the Netherlands and UK) that have lent to these countries. It is the unwillingness of finance capital to acccept a reduction in the value of these debts that is at the bottom of the current crisis and the current strategy.

This is a strategy that is bound to fail, for the reason explained above. So why on earth are so many European governments rushing to engage in what is so blatantly a self-destructive economic path? Partly this reflects the continued political power of finance in most countries. But it also reveals the misplaced but unfortunately common belief in each country that it can somehow export its way out of trouble. The general presumption is that external markets will provide the dynamism required to generate growth in these economies.

It takes only a little intelligence to realise that the fallacy of composition must operate in such a scenario. In other words, obviously, all countries or regions of the world cannot rely on net exports to make their own economies grow, especially if they are intent on suppressing domestic wages and demand to make their own economy more “competitive”. The recent Trade and Development Report 2010 from UNCTAD also shows clearly how the idea that the so-called emerging markets (like China, Russia, India and Brazil) can provide anything like an equivalent market in the global economy is simply nonsensical given current economic sizes and growth patterns. In any case, these countries are also still obsessed with exports as the engine of growth!

The current economic strategy that is now common in Europe is both economically wrong-headed and socially unjust, but its reversal essentially depends upon political pressure. This may not occur quickly in a country like Estonia, with its burden of Soviet history. But elsewhere in Europe the signs are that the worms are finally turning.

In Spain, over the last few days, thousands of students, young people and others have occupied the mains squares in all the major cities and towns, to protest against these policies ahead of the local elections to be held on Monday 23 May. Spain is a country with 45 per cent youth unemployment – that is nearly half the young population – so it is even surprising that such protests did not occur earlier. In Britain the student protests against rising charges for higher education were temporarily quelled and the population was sought to be distracted by circuses like the Royal Wedding, but all accounts suggests that the unrest is simmering just below the surface. In Italy, the party of Silvio Berlusconi has received a huge drubbing in the recent local elections.

So Europe may have seemed like a continent of lemmings rushing into economic destruction because of the inability to reduce the power of finance capital, but things may be changing. Definitely, even in Europe, we are going to witness interesting times.