Sarkozy jeopardises the future of the euro area

By: Wolfgang Münchau

An important aspect of France’s leap back into economic nationalism has not yet attracted sufficient attention. I would expect serious political tensions to emerge inside the eurozone – especially between France and Germany. One should remember that the euro would not exist today if during the 1990s these two countries had not papered over their philosophical differences over the right conduct of monetary and fiscal policy. These old disagreements may be about to flare up again.

Just look at what has been happening in Berlin and Paris. This week, the German cabinet will pass the 2008 budget and present a new medium-term financial plan. News reports suggest it plans to cut the federal government’s 2008 borrowing requirement to about €12.5bn ($17bn) thanks to massive tax windfalls – almost half as much as previously planned. Germany is as serious about deficit reduction as the Clinton administration was in 1993.

 

France is going the opposite way. True, we do not yet know all the details of President Nicolas Sarkozy’s economic agenda. But we know he did not have a balanced budget in mind when he promised a “fiscal shock”. Instead, he plans a yet unspecified increase in the deficit, possibly above the Maastricht treaty’s ceiling of 3 per cent of gross domestic product, partly to buy off the opposition to his reforms and to cushion their impact.

But it is far from clear Mr Sarkozy’s reforms will have that effect. A government can argue legitimately that it should be able to raise the deficit to implement economic reforms designed to raise potential output. All we know is that the new administration is ready to implement tax cuts that will raise the deficit and it no longer adheres to the revised stability and growth pact’s goal to eliminate the structural deficit in the medium term.

In 2006, a year in which the euro area recovery was well under way, France had a budget deficit of 2.5 per cent, compared with Germany’s 1.7 per cent. The difference is not large, but the gap is likely to increase substantially over the next three years under current budgetary plans. In the hypothetical scenario of a subsequent economic downturn Germany will almost certainly be able to keep its deficit below 3 per cent of GDP, while France may be heading towards a substantially higher number. Even though the reformed stability and growth pact is more flexible than the original version, neither the European Commission nor Germany would accept a deviation on such a scale. Worse still, under such a hypothetical circumstance, German politicians and economists might well start to question whether monetary union with France was still in Germany’s best economic interest. This has not happened so far because the fiscal position of France and Germany moved very much in parallel during the euro’s first eight years.

Another source of conflict is Mr Sarkozy’s repeated threat of a co-ordinated policy to drive down the euro’s external exchange rate. I assume a new exchange-rate strategy is what Mr Sarkozy has in mind as he plans to set out his vision for greater economic policy co-ordination within the eurozone at the next Ecofin meeting in Brussels. I am not sure how Angela Merkel, the German chancellor, will react to this. But when Mr Sarkozy attacked the European Central Bank during his election campaign, Ms Merkel immediately paid a visit to Frankfurt to demonstrate her commitment to the central bank’s independence and the goal of price stability.

Mr Sarkozy’s criticism consists of two components. The first is that politicians, not central bankers, should be in charge of exchange rate policy, as is the case in the US and most other countries, including Germany before 1999. The second component is that the euro’s exchange rate should be actively managed to be competitive, in others words deliberately kept from appreciating above a certain threshold. I doubt that Ms Merkel and her economic advisers are keen on any of this.

The re-emergence of a very old Franco-German disagreement over the conduct of economic policy will almost inevitably refocus the debate about the long-term sustainability of the euro. There are already significant tensions in the system. Nouriel Roubini, professor of international economics at New York University*, has listed those divergences: “asymmetric shocks, asset bubbles caused by common monetary policy, labour market rigidities, lack of adjustment of real exchange rates, limited role of risk insurance through financial channels, lack of risk sharing via federal fiscal policies” are the most important, along with insufficient structural reforms.

Mike Wickens**, professor of economics at the University of York, has found that there is a built-in tendency in the eurozone for national price levels to diverge – due in part to the problems just mentioned. In the long run this would suggest that monetary union is not sustainable. Fiscal transfers, improved real adjustment, risk sharing and risk insurance would possibly help to overcome this problem, but all require a political consensus that is currently absent. In fact, Mr Sarkozy’s economic nationalism is more likely to increase the divergences within the eurozone, make them more persistent, and may even risk the long-term viability of monetary union.

* www.rgemonitor.com/blog/roubini/ 201452/ ** Is the Euro Sustainable? CEPR Discussion paper, DP 6337

Send your comments to munchau(at)eurointelligence.com

Copyright The Financial Times Limited 2007

---