September 28, 2014 / 8:49 AM / 3 years ago

Europe's German growth locomotive on strike

PARIS (Reuters) - Europe’s growth locomotive is on strike.

A huge euro logo is pictured next to the headquarters of the European Central Bank (ECB) before the bank's monthly news conference in Frankfurt August 7, 2014. The European Central Bank left interest rates unchanged on Thursday, holding off fresh policy action as it prepares to launch fresh funding for banks next month that it hopes will lift inflation from rock-bottom levels. REUTERS/Ralph Orlowski (GERMANY - Tags: BUSINESS POLITICS) - RTR41KE0

With the euro zone economy stuck in a rut despite European Central Bank efforts to pump money into the system, pressure is mounting for Germany to use its healthy budget position to boost public investment, stimulate demand and spur growth.

The answer from Chancellor Angela Merkel so far is an adamant “nein”, spelled out firmly to visiting French Prime Minister Manuel Valls last week.

If her refusal is final, rather than a tactic to extract more reforms from European partners, it could dash the prospects of a three-way grand bargain sketched by ECB President Mario Draghi to revive the European economy.

That could tip the euro zone back into another recession, worsen unemployment and fuel political radicalism.

The International Monetary Fund, the ECB, the European Commission, the United States and euro zone partners are all pleading with Berlin to use what economists call its “fiscal space” to stimulate the economy through tax cuts and investment in aging road, rail, energy and telecommunications networks.

German officials acknowledge privately that the country has an investment gap, both public and private. It spends less than half as much of its economic output - just 1.6 percent - on public investment as France or Sweden, less even than Greece.

Yet the government is determined to stick to its balanced budget strategy, moving faster into surplus than planned, even though its own economy shows signs of slipping into the stagnation already gripping France and Italy.

There are political, cultural and economic reasons for the refusal to loosen the purse-strings when most economists think Germany could afford to do so.

Berlin makes three main arguments:

1) Germany is determined to set an example by meeting its fiscal targets and running the first balanced federal budget since 1969 with no borrowing. The credibility of the euro zone depends on governments sticking to their commitments.

2) Germany has less fiscal space than outsiders understand because it has an aging, shrinking population and needs to run surpluses to meet future pension and healthcare liabilities.

3) The euro zone’s economic problem is largely one of supply rather than demand. Structural reforms of labor markets, legal systems, pensions and welfare to improve competitiveness are the only way to achieve a sustainable recovery. More public spending financed by debt would ease the pressure to make those changes.

Finance Minister Wolfgang Schaeuble spelled out a stonewall response in presenting the 2015 budget to parliament on Sept. 9: “We must not allow ourselves to entertain the illusion that we can solve our problems using more and more public funds and ever higher deficits.”

Behind such public arguments, Merkel has a strong political motive for sticking to her course.

The balanced budget is written into her conservatives’ coalition pact with the Social Democrats (SPD). Any departure from it could fuel support for the right-wing anti-euro Alliance for Germany, which made big gains in state elections this month.

As so often since the start of the euro zone crisis in 2010, domestic politics is tugging Merkel in one direction and European responsibility in another.

Her usual tactic is to hang tough until others have made as many concessions as possible, then give as little ground as necessary at the last minute when Europe is on the brink.

It’s easy to imagine a trade-off now between more French and Italian reform, a German fiscal stimulus, more European public investment with new EU financial instruments leveraging joint borrowing with private sector money, and an expansion of the ECB’s easy money policies.

Olli Rehn, who was vice-president for economic and monetary affairs in the European Commission until July, calls for just such a pact to avert deflation in an article to be published in the policy journal Europe’s World in October. (www.europesworld.org)

“If Germany can lift domestic demand and investment while France and Italy are embracing reforms to their labor markets, business environments and pension systems in support of their economic and industrial competitiveness, they will together do a great service to the entire euro zone,” said Rehn, now a member of the European Parliament.

A German stimulus could also help bring down the euro’s real exchange rate and make southern euro zone countries’ exports more competitive, he argued.

“The key actors - Italy and France, the ECB and Germany – need to work out the details of such a pact this autumn and then agree on it at the European Council in December.”

German leaders are not monolithic in rejecting the notion.

Deputy Labor Minister Joerg Asmussen, a Social Democrat, signed a joint article with ECB Executive Board member Benoit Coeure this month urging Berlin to use its “budgetary room for maneuver” to support investment and cut taxes on workers’ pay.

French politicians believe Vice-Chancellor Sigmar Gabriel, economy minister and SPD leader, is broadly sympathetic to their cause, despite his commitment to the balanced budget.

“This debate exists within the German government because Gabriel is a supporter of this new European investment policy,” said Philip Cordery, national secretary for European affairs in the ruling French Socialist Party.

However Paris and Berlin seem to be talking past each other.

German officials fear President Francois Hollande is too weak politically to push through far-reaching reforms to France’s protective labor laws and generous social benefits, or to take a serious axe to bloated public spending. A strike by Air France pilots that forced the airline to scrap plans for a low-cost European subsidiary highlights resistance to change.

They are only slightly more optimistic about Italian Prime Minister Matteo Renzi’s drive to loosen labor law, shake up the judicial system and streamline politics and state administration despite entrenched resistance from unions and politicians.

If Germany won’t fire up its investment engine and France won’t risk major reforms, it will be left to the ECB to carry the whole burden of refloating the economy.

Even if Draghi were able to overcome German opposition to the central bank printing money to buy government bonds, he told EU lawmakers last week that monetary policy alone cannot have a meaningful effect without structural reforms.

Writing by Paul Taylor; editing by Tom Pfeiffer

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