Arrogant Germany and fearful France tearing euro apart

By Ambrose Evans-Pritchard
The Telegraph, London
Monday, July 15, 2007

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/07/16/ccview...

It's back to Verdun. France and Germany can no longer share a currency, or an aviation industry for that matter. Reverting to historical patterns of behaviour, they are each embarking on policies that must lead to bitter conflict and endanger monetary union.

French president Nicolas Sarkozy is at root an anti-globalist, champion of a weak euro in a trade bloc shielded by "Community Preference". He is letting rip on fiscal policy, gutting the EU's revamped spending rules.

German Chancellor Angela Merkel -- a Baltic PhD physicist and daughter of a Lutheran pastor -- is the white angel of orthodoxy. She will sooner break EMU than allow a resurgent Germany to succumb to wage and price inflation.

advertisementThe culture clash was masked in the euro's early -- aberrant -- years, when Germany was battling slump, and France had not yet tipped into obvious decline.

The cycles have now reversed as the Teutonic Tiger roars back, able to cope with a doubling of interest rates and a euro surge to all-time highs of $1.38 against the dollar and Y168 against the yen.

By screwing down wages, Deutschland AG has deflated costs since 1995 by 20 percent against France, 30 percent against Spain, and 40 percent against Italy.

Germany is now seizing market share across southern Europe, without reciprocating. Total imports fell by E2.2 billion in May. This is not a case of German recovery lifting Club Med. It is a beggar-thy-neighbour squeeze. Germany's trade surplus was E17.5 billion in May alone. France had a deficit of E3 billion.

German finance minister Peer Steinbrück mischievously professed last week to "love the strong euro." He may regret his flippant words as Germany reaps the political whirlwind of its newfound conceit.

How quickly Berlin forgets that the European Central Bank held rates at 2 percent until December 2005 to prop up Germany, damning Club Med to deadly bubbles.

Far be it from me to defend Mr Sarkozy -- Europe's Putin, naively mis-described as a free-marketeer by City economists who should know better -- but he is right that ultimate power over the euro's exchange rate rests with politicians.

The ECB's claim to sole authority is a breach of treaty law, albeit one that Germany has chosen to endorse. It is the sort of monetary putsch that enrages Europe's civic Left, and explains why French voters rejected the EU constitution.

Article 111 of the Nice Treaty states that the Council (politicians) may set fixed exchange rates (by unanimous vote), and formulate "general orientations" (by majority vote). In other words, they may compel the ECB to change course on interest rates. Yes, this requires an enabling proposal from the Commission, but would Brussels ever dare to prevent a vote desired by half of Europe?

This is no longer academic as the euro hits levels that threaten to suffocate France, Spain, Italy, Portugal, and Greece.

The delayed effects will strike at the worst time, just as the housing booms unwind and as higher rates deliver their final kick. A triple whammy in 2008.

Airbus chief Louis Gallois said a rate above $1.35 means death for European aviation. "If there is a prolonged slippage in the dollar much beyond that, then we need to ask ourselves if we can still build airplanes in Europe," he said.

Will Mr Sarkozy let this happen? "We have not created the world's number two currency so that we can no longer build a single aircraft on European soil," he said.

"Mr Sarkozy was rebuffed in Brussels last week, but his is a work in progress. His rebel ideas are a tad premature, and Club Med's elites have yet to understand the gravity of their plight.

Undaunted, he has ordered his team to draw up plans for "implementing an exchange rate policy." Allies will come later: Italy and Spain, already muttering about the "'euro forte/fuerte."

As an insurance, he is pushing through an $11 billion "fiscal shock" to cushion the 2008 downturn -- and Brussels be damned. Mortgage payments will become tax-deductable. House prices will now start rising again after sliding this Spring.

Little noticed, two conferences lately have fretted over the euro-zone's dangerous splits: one at Dresdner Kleinwort and second at the Stiftung Wissenschaft in Berlin.

Leo Doyle, Dresdner's Europe economist, said the euro looks fine until you lift the hood to inspect the engine. "Under the surface, some countries' deficits are getting bigger and bigger, and Germany is taking market share at a dramatic pace," he said.

Spain is the first candidate for crisis, blighted by an ECB-created property bubble, and a corporate financing gap of 10 percent of GDP. "The risk is that Spain will tip over the interest rates rise, and it will find it very difficult to claw its way back out again," said the bank.

Spain cannot copy Germany's hard labour methods. It is nigh impossible to deflate against a low inflation country, without mass defaults and civic revolt.

The Berlin papers are worth reading. "There was a broad consensus among the participants that some of the divergences in EMU might indeed be economically harmful or even politically dangerous. This is a shift in perceptions," commented Eurozone Watch. The experts know. The markets have yet to twig.

Leuven University's Professor Paul de Grauwe explained why the euro had become unworkable. "The fact that large areas of economic policy remain in national hands creates asymmetric shocks. National wage policies lead to divergent trends: this in turn leads to a vicious circle in which each country tries to recover its competitive position by wage cuts, leading to a deflationary spiral," he said.

"There can be little doubt: without further steps towards political union, the eurozone has little chance of survival," he said.

Undeniably true, but haven't Europe's tribes made it clear that they do not want a superstate?

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