DIVERGING DEFICITS COULD FRACTURE THE EUROZONE / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( RECOMMENDED READING )

Diverging deficits could fracture the eurozone

By Wolfgang Münchau

Published: October 4 2009 21:09

On one level, I am quite optimistic that Germany’s new centre-right government can deliver. When the coalition agreement is finalised early next month, we might actually see some tax cuts and structural reforms. I would also expect progress on sorting out the banking sector. This is the minimum needed to ensure a reasonable pace of economic recovery.

I am almost despairing, however, about what is happening at the eurozone level. Here, I fear that the new coalition may not make much difference to the quality of economic governance. The departure of Peer Steinbrück, the outgoing Social Democratic finance minister, will improve Germany’s financial diplomacy, no matter who replaces him. But in the end, I only expect improvement in style, not substance.

The underlying problem is a policy divergence between France, Spain, Italy, Portugal and Greece on one side, and Germany, Finland, Austria, and the Netherlands on the other. The policy divide between France and Germany is the most damaging. Paris dropped a bombshell last week when it said it no longer aimed to reduce the French budget deficit to under 3 per cent of gross domestic product by 2012. This is the limit set by the Maastricht treaty. Even on optimistic growth assumptions, France will not hit the target until 2015 at the earliest. By then the country’s debt-to-GDP ratio will have reached more than 90 per cent.

This means that France has effectively given up on policy co-ordination within the eurozone, a decision President Nicolas Sarkozy will almost certainly regret one day. I would also expect the debt-to-GDP ratio of Spain to head into the same neighbourhood. Since it would be unwise to hope for much in terms of deficit reduction from Silvio Berlusconi’s government in Italy, we are likely to end up with debt-to-GDP ratios in three of the four large eurozone economies settling at levels close to 100 per cent.

Germany, by contrast, has committed itself to the virtuous path. The previous coalition changed the constitution so that the federal deficit cannot exceed 0.35 per cent of GDP over the economic cycle. The new cap will take effect in 2016, but getting there will require fiscal consolidation. This deficit target implies a debt-to-GDP ratio of about 10 per cent in the long run. The fiscal divergence inside the eurozone will then become intolerable.

Of course, the new coalition might cut taxes by more than it does spending. But this would have to be reversed later. A unilateral tax cut, welcome as it is, will not correct the divergence problem in the eurozone. This requires co-ordination.

It always takes two to diverge. France and Germany are both guilty of flouting the single most important economic policy rule of the Maastricht treaty. By this I do not mean the infamous 3 per cent deficit cap, but the clause that says member states should treat economic policy as a common concern. Germany ignored this principle when it unilaterally changed the constitution. France is ignoring it now. We should not be surprised to hear that at last week’s informal meeting of European finance ministers, there was no consensus, and much confusion, about crisis exit strategies.

The eurozone has been here before: in 2003, the original stability and growth pact collapsed as France and Germany jointly allowed narrow national interests to prevail. They managed to turn the corner with a new, more flexible pact. It is the only mechanism of co-ordination there is and it not likely to survive near double-digit deficits.

What are the long-term consequences of sustained divergence? First, interest rates will almost certainly be higher than they would be otherwise. Second, France will use tax cuts to strengthen the economy’s supply side, which in an out-of-control monetary union can give rise to a race of competitive real devaluations. Third, the perception of sovereign default risk within the eurozone will rise dramatically.

Within 10 years, I would expect people to start making the case that Germany would be better off outside the eurozone. I am not predicting that Germany will actually go down that route. Politics may well prevent it. But a monetary union would be extremely ill-advised to allow such a situation to arise in the first place.

Neither France nor Germany wants this to happen, of course, but that does not stop both countries adopting policies that could produce such a calamity. Relations between Mr Sarkozy and Germany’s Angela Merkel are awful. Do not expect this conflict to be settled over a glass of wine. Nor should we expect a change of leadership in either country. Ms Merkel is secure for at least another four years and Mr Sarkozy has a good chance of re-election in 2012.

Both Ms Merkel and Mr Sarkozy should have a strategy to co-ordinate their agendas and link them with those of others in the eurozone. I just cannot see that happening.

The writer’s new book The Meltdown Years was published last week by McGraw Hill in the US

Copyright The Financial Times Limited 2009.