The French and German governments met together in Freiburg (Germany) today to discuss whether the euro zone countries should issue government bonds that they all back collectively. They also met to discuss whether the financial rescue fund created to save Greece and Ireland should be fortified with more cash as financial markets turn on Portugal. It is now clear that neither of these things will happen. For the moment.
The Paris-Berlin agreement comes a week before meetings with all EU member states on how to respond to the reality that they have now woken up to: that financial markets are far from finished with attacking euro zone countries.
Countries that are on the front lines of the speculative war on the euro have been understandably receptive to the idea of the new euro zone bonds. They would provide a source of cash that their more prosperous neighbours would likely end up paying for, given the disastrous nature of their own public finances. Germany and a host of other countries have been understandably relectant to commit to such a move. They understand well enough that the euro zone bonds would reduce pressure on the front line states to retrench their finances and lead effectively to fiscal transfers from northern to southern Europe. It is what some German politicians and most German economists feared would happen before the euro was created. That is why Germany insisted on the Stability and Growth Pact and the Excessive Deficit Procedure in 1995. Southern European governments would be institutionally and politically obligated to rein in their borrowing to prevent the question of bailouts from arising in the first place.
It is still possible that countries like Germany will give in to political pressue to save their southern neighbours, but blocking the euro zone bonds will ensure that they are not automatically obligated to do so, and that the pressure to cave in to southern European demands remains contained. Even a common euro zone bond would have to be underpinned by political agreements by the principal member states. The incentive structure, however, makes it difficult for a country like Germany to insist on placing conditions on other member states in return for saying yes. One would think that a bankrupt country with its back to the wall would be compliant with the demands of its saviours, but there is no reason to assume this.
For this reason, if Germany and its allies feel the need to assist the countries on the front line of this war, they will prefer to do this with the tools they have just agreed to rather than the bond proposal. The European Financial Stability Facility (EFSF) allows the donor countries more opportunity to retain the upper hand in negotiations. Governments that need the aid are failures and must submit to political demands, at least from a German perspective. The Germans have just come around to understanding that the EFSF should be allowed to exist in perpetuity, rather than until 2013. They are not willing to enlarge the amount of money it contains, and came to the talks in Freiburg insisting they would not budge on this demand. This ensures that pressure on applicant countries remains high. This runs the risk of the funds being insufficient, however.
Unlike their demand for automatic sanctions on countries that violate EMU's budget rules, Germany got its way this time. France chose to side with Berlin's demand to place increased pressure on southern Europe. Why is this consistent with France's previous position on automatic sanctions, which was to block them? Whilst the German camp and southern Europe lined up on opposite sides of this issue over the past two weeks, France remained uncommitted and sided with Germany in the end.
Those who saw Paris as the defender of southern Europe fail to appreciate the interest that France has in the policies and institutions of a strong currency. It has a history dating back to the mid-1980s of promoting a strong currency, le franc fort, as a central component of its economic strategy for competitiveness and development. The political establishment in France is only too aware that Germany has achieved good results with its conservative policies during tough economic times.
And yet, this policy of the strong currency is sometimes at odds with the impulses that pervade French politics to ensure public intervention in economic affairs for the greater public good. This is the impulse that stood behind the French demand during the EMU negotiations for a measure of political discretion and control of economic affairs in an economic government for Europe.
The consequence of this is that whilst the German-led camp and southern Europe are very stable in their preferences and more or less balance each other out, France remains ambivalent and capable of swinging either way. Germany may have become the most powerful country in Europe in terms of resources and willpower, but it can't get its way without the help of France.
In this situation, France is not able to decide outcomes alone, but it is the fulcrum of Europe. When the inevitable fights over how to respond to an attack on Portugal, Spain or Italy erupt, France's position will likely tilt the European response in the direction it chooses.
That is power too.
A New Mankiw Publication
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