Nine questions about what to expect from Sarkozy's trip to Brussels next week

Good ideas often get destroyed by bad advocates. Economic policy co-ordination in the euro area is a good idea in principle, but only it it's done right. What Sarkozy is planning to propose at Monday's Ecofin is economic policy co-ordination of the wrong variety. The good news is that he will probably fail to achieve anything. The bad news is that this will leave a bad all around, especially in France. Here is a list of nine questions and questions.

 

 

1. What will Sarkozy tell finance ministers?

 

First of all, he will defend his new medium-term budget plan, under which France will postpone the year of a balanced budget from 2010 to 2012. This postponement is not in itself a problem - Germany is not going to do it until 2011. The problem is that France postpones all the painful adjustment efforts after the year 2010. If, as is not unlikely, these years mark the beginning of an economic downturn, this adjustment process will almost certainly be delayed once again. It does not really matter which year countries choose when to balance their budgets. It is far more important that countries start doing the right thing right away. This means meeting the agreed target under the new revised stability and growth pact, which foresee a reduction in the structural deficit by 0.5pp each year until balance is reached. In Italy, the structural deficit will fall next year, though not by sufficient amount. In France it will actually increase.

 

 

2. What is the likely reaction?

 

The European Commission has already criticised these plans as being inconsistent with the stability and growth pact. We would expect other countries to join in the criticism, though finance ministers may be careful to openly criticise Mr Sarkozy on Monday. He is, after all, a head of state. But it is fairly likely that France may once again come under an excessive deficit procedure if it persists with its plans.

 

 

3. What else is going to propose?

 

Sarkozy is going to propose more policy co-ordination, by which he primarily means a political process to influence the exchange rate, the only large macro variable, which is still up for grabs, and where there is ambiguity under the European treaties about who is in charge. The EU presently operates under a gentlemen's agreement that leaves the ECB in charge, but Sarkozy is going to challenge this. He claims - falsely - that the euro area is the only large economy where the exchange rate has not been put at the service of economic growth. He also wrongly blames the euro's exchange rate for unemployment and de-industrialisation.

 

 

4. Is there going to be support for this initiative?

 

Having just told ministers that he intends to break the revised stability and growth pact, Sarkozy is an extremely weak position to propose any form of policy co-ordination. It would have been far easier to propose them from a position of moral high ground. In any case, it takes a qualified majority in the Ecofin to do anything. As things stand at the moment, Sarkozy is not even close to a simple majority.

 

 

5. Is there any way the Ecofin might try to accommodate Sarkozy?

 

Yes, it is quite possible that ministers will set up a study group with the task to report on improved policy co-ordination. Everybody would probably agree to this, especially if asked by a head of state. But don't kid yourself: the only purpose of such a group would be to defuse Sarkozy's proposals.

 

 

6. Is there any merit whatsoever in a greater political influence on the exchange-rate?

 

Yes, but that depends on how it is done. The ECB is right in its argument that its exclusive focus on price stability - as set out in European law - does not allow for a parallel exchange rate target. But that does not mean that any exchange rate policy is in breach of European law. If, for example, the Ecofin were to signal that it would like the euro's bilateral exchange rate with the dollar to trade at below $1.35 for the next year, this would hardly impede the ECB's inflation target, especially since current monetary policy is predicated on the assumption of some degree of exchange rate stability. There is a question of how effectively such an exchange rate policy might be. But in principle, no harm is done if elected politicians to provide such direction. Even in Germany, pre-1999, exchange rate policy was the prerogative of the finance minister, not the Bundesbank.

 

The problem with the Sarkozy proposal is the built-in hostility towards the ECB. This is the ultimate reason why they will fail. The ECB has already cried foul, and expect more claims that Sarkozy threatens to undermines price stability. That alone means that such a policy cannot be implemented.

 

 

7. What does Germany think?

 

Honestly, we don't know, but we can guess. Angela Merkel has let it be known that she is now too comfortable with Sarkozy. She has rejected any attempts by him to dilute the goal of price stability from the Treaty (apart from "free and undistorted competition"), and she is a firm supporter of central bank independence. She and her advisers are not keen on an exchange-rate policy, or another the ECB will openly reject. But if pressed by Sarkozy, Merkel would probably also agree to study this question in great detail. But as of now, there is little prospect that she would accept it.

 

 

8. What would constitute good policy co-ordination?

 

Beyond ensuring that the revised stability pact works, the single most important measure the euro area could conceivable undertake right now is to appoint a single representative in international institutions such as the IMF, the World Bank, and for bilateral economic policy, for example vis-a-vis China. The second best thing would be to consider proposals for greater risk sharing between member states (for example a common unemployment insurance, or some form of income transfer mechanism), and greater risk sharing through financial markets, and the third best thing would be to co-ordinate structural reforms.

 

 

9. Is there any chance of this being implemented?

 

Probably not. The first of these is essentially by France, the euro area country least prone to abandon its national representation in international institution, something from which the French elites draw much of their power. Economists have long proposed ideas such as fiscal federalism in the euro area, but this has been staunchly and successfully resisted by Germany, which is also one of the biggest obstacles to the EU's attempt to integration and liberalise financial markets. On structural reform, there is at least now a vigorous exchange of view in the euro group about individual countries experience with specific policies, such as Germany's labour market reforms, or the recent VAT increase. This is, however, not co-ordination.

 

 

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