Will Hollande victory influence euro zone crisis for better or worse?

The victory of Francois Hollande in the May 6th election for the French presidency is bound to have consequences for the previous approach, led by Germany and the European Commission, to resolving the euro zone’s crisis. For Germany it has been primarily a sovereign debt crisis and this is reflected in the treaty on Stability, Co-ordination and Governance that has been signed by all euro zone participants. For Germany tackling the sovereign debt crisis is a pre-condition for reviving growth together with structural economic reforms to foster business and employment growth. For M Hollande and for many others lack of growth is itself a large part of the crisis. The different viewpoints reflect both a tradition of fiscal and monetary orthodoxy in Germany and the fact that the German economy is in fact growing well and unemployment there is at its lowest for 15 years. President Sarkozy has tried to push for policy to be more growth-oriented amongst other demands but the imperative of maintaining unity with Germany—a key to French policy for many decades—meant that he had to give way.

M Hollande has the advantage of not being associated with the existing policy which in most of the euro zone appears not to be working; the French economy is stagnant with unemployment rising and much worse situations exist in the more vulnerable countries, particularly Spain, Portugal and Greece. If M Hollande does win, the result will be a major democratic indication of a desire for a change of policy coming from a country which, for the last 60 years, has played a decisive role in promoting European integration.

The German government will therefore be under strong  pressure to make changes to the austerity policy that it (and other creditor governments) are effectively imposing on the rest of the euro zone. Much of German popular opinion, particular that supporting the parties at present forming the German coalition, is in favour of fiscal and monetary orthodoxy so it is not surprising that the German chancellor, Angela Merkel, has already indication strong reistance to any concessions but a factor operating in the other direction is that the opposition Social Democrats are themselves calling for a more growth-oriented policy.

However, an even more difficult obstacle to a more growth oriented euro zone policy is the financial markets. Governments can only run an expansionary fiscal policy if the extra borrowing required can be obtained at reasonable interest rates from investors. Two major euro zone countries, Spain and Italy, are struggling to keep the confidence of financial markets so as to fund their needs. A factor which may now influence financial markets is that, since fiscal austerity exacerbates declines in economic activity, it will thereby push down tax revenue and so offset part of the improvement to government deficits that should normally result from fiscal austerity. It has even been argued that in an extreme case, which could include Spain in 2012, the economic impact of pursuing a harsher fiscal policy may actually drive down economic activity so much as to actually increase the budget deficit. The European Commission has in the situation conceded a slightly less severe target for Spain in its 2012 budget but the policy of expenditure cuts and tax rises will remain in place with the aim of reducing the general government deficit from 8.5% in 2011 to 5.8% in 2012.  But a halt to fiscal austerity would lose the confidence of investors so Spain and other countries will remain bound by the vicious circle of the need to reduce deficits at a time of economic recession, so exacerbating the recession and in turn reducing revenue.

The victory of the French Socialist, M Hollande, indicates a desire for a change in the imposition of austerity as the prime and almost only policy instrument of euro zone policy makers in response to the area’s financial and economic crisis. The trouble is likely to prove to be that the alternative options are very limited. One thing that could be done is to change the name of the treaty to Treaty for Responsibility, Governance and Growth as demanded by M Hollande, rather than Stability, Coordination and Governance. Some clauses of the treaty might also be changed but it is likely that such clauses will be those of a general rather than specific type.  Germany and other creditor countries will not concede on the key requirements for structural general government balances by 2017 or a compulsory reduction of debt  of countries with debts over 60% of GDP of a twentieth per year.  They regard a commitment to longer term fiscal stability as key to financial market confidence and nothing has happened to suggest that this view might be wrong.

Not only M Hollande but also President Sarkozy have called for a change in the statutes of the European Central Bank so that it balances the requirement of price stability with that of maintaining economic activity and employment as is the case for the US central bank. Such a change would in principle be desirable but it will face intense resistance from the forces of the establishment in Germany particularly the Bundesbank which only agreed to participate in monetary union on the basis that the new European Central Bank should have the same objectives that the Bundesbank—an organization seen as underpinning German prosperity and financial stability for 60 years—had had since its foundation. In any case the ECB has by no means in practice been only concerned with price stability. Despite inflation running above target, ECB interest rates are now almost as low as possible and a massive €1trn has in the last six months been been provided in 3 year loans at low interest to euro zone banks, supplementing the provision of shorter term finance since September 2007. In addition, the ECB has made highly controversial purchases of government bonds, against strong opposition from German members of the ECB board. Angela Merkel has already gone a long way by conceding that ECB independence requires not just independence in the face of political pressures from weaker countries wanting monetary easing but also independence from Germany which may have qualms that some ECB policies are too accommodating.

There is a possibility that Germany might be persuaded to agree a more symmetrical policy towards the resolution of foreign economic imbalances. Germany has in recent years been running large external surpluses while France and Italy have been running moderate deficits, while Spain, Portugal and Greece have had much larger deficits. Even though several years of cutting domestic demand has reduced the deficits of the latter three countries, they remain substantial and need to go into surplus if their overall debt is to be reduced. The deficits of these countries are the counterparts of surpluses of other countries, including China and oil exporting countries, but also Germany. If countries in deficit are to reduce their deficits those in surplus must reduce their surpluses. So far Germany has insisted that the main responsibility for adjustment lies with the deficit countries. In a world economic system based on competition Germany is not likely to be willing to reduce its competititiveness which would affect its ability to compete outside the euro zone and EU as well as inside. Nor is Germany likely to give up its hard won success in bringing down its own government deficit following years of overspending to finance German unification. It would however be reasonable to ask Germany to adopt policies to encourage household spending rather than saving, such as encouraging increased home ownership –which is very low compared to most other EU countries. Higher home ownership would be likely to increase spending both on homes and their contents, and also more generally, given that a home as an asset can substitute for financial assets.

More can also be done through the EU budget complemented by financing from the European Investment Bank (and its subsidiary the European Investment Fund). The EU budget is modest but still plays a significant role in Greece and Portugal and the poorer regions of Spain. The focus of the EU budget should be shifted from infrastructure, which is generally now good in most parts of the euro zone, to promoting business formation and development which if successful would generate more durable growth. This of course should be combined with the removal of bureaucratic obstacles to business formation and the removal of labour market regulation which inhibits employment growth by small to medium businesses. But this kind of deregulation on its own may not suffice in a depressed economy to stimulate growth. If successful cases of business expansion especially in the hardest hit countries and regions were given publicity they could act as examples of a positive nature to counteract the negative economic and social impact of austerity. Because of underspending so far in the 2007-13 budgetary framework period there could be scope to boost spending though the Commission would have to be persuasive and show that spending was likely to be better managed. This would require an increase in the annual budget and the Commission has indeed requested a 6.8% increase in budget funding for 2013. The case for a strong increase in funding for promoting growth in the hardest hit countries should be made, but the Commission should balance this by being willing to make cuts elsewhere in the EU budget, particularly on administration.

The Hollande victory includes risks. In theory his French deficit reduction targets are similar to those of President Sarkozy’s government but as he has made commitments to increase expenditure on education there will be doubts as to whether his tax increase proposals will raise sufficient money to make the deficit reduction targets credible. On the other hand, the Hollande victory brings hope of a shift of emphasis towards stimulating economic activity in France and elsewhere. Whether such a shift can be converted to better economic outcomes remains to be seen.

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