Merkel and Hollande Clash Over Eurobonds

Germany's Angela Merkel and France's Francois Hollande are having their first fight. Merkel and Hollande presented a smiling, united front when they had dinner together in Berlin on the evening that Hollande was sworn in as president of France. Now pressure is mounting and there are fewer smiles.

The Paris-based OECD (Organization for Economic Cooperation and Development) is forecasting a contraction of 0.1 percent for the eurozone economy in 2012. At the same time the United States is expected to grow 2.4 percent and Japan's economy will expand by 2 percent. This imbalance has put pressure on Merkel and Hollande to resolve Europe's problems, in particular from American President Barack Obama. But internal battle lines prevent the odd couple from agreeing on how to proceed.

The EU is commonly described as having a "core" consisting of France, Germany, Italy and Spain. The other members constitute the "periphery". However, heavy sovereign debt, weak banking systems, and large trade deficits have cast doubt on Spain and Italy. In recent years, EU policy-making has been headed up by Germany and France.

During the presidency of Nicholas Sarkozy, France was largely in agreement with German Chancellor Angela Merkel that strict fiscal discipline was the way to go. However, newly elected Francois Hollande does not agree. He has joined the many countries on the EU periphery who are calling for more growth and less austerity. Indeed, with the May meeting of the Group of 8 at Camp David, and the convening of the European Commission in Brussels almost immediately after, the French president is leading the charge, and he and Merkel are sounding less friendly.

At issue is how much austerity, and how much growth? Since the French election, Merkel has signaled a softening of her anti-spending stance, possibly by allowing the European Central Bank to adopt looser policies. But she has taken a hard line when it comes to the issuance of government bonds guaranteed by all 17 members. According to Merkel and her CDU party, in a few years, the overall indebtedness of the region would reach crisis levels, and the smaller peripheral countries would pull Germany down with them.

Germany has a lot at stake. It is the only remaining EU country with a triple-A bond rating and is the largest economy in the region. Like all of the other members, it is under close international scrutiny though, and is nowhere near large enough to bail out the whole EU. By itself it can not even bail out the increasingly shaky Spanish banks.

Germany's only pro-austerity EU allies are the Netherlands, Austria and Finland. France, and Italy, in addition to the remaining peripheral members, all favor the issuance of Eurobonds, and sooner rather than later. At the recent OECD meeting, its chief economist, Pier Carlo Padoan said that Eurobonds must be issued quickly to help recapitalize banking systems in the fragile peripheral countries.

Greece is widely viewed as a lost cause in that it is quickly running out of money and may have to exit the European Union. The private sector has been quietly preparing for that eventuality with extensive discounting, and some economists believe that once out of the eurozone, Greece's debt workout might be manageable. Of course, that does not take into account the increased hardship for Greek voters, which makes the advent of a frightening political reaction almost certain.

Spain is a different matter, because it is larger than Greece. In addition to major problems in its banks, Spain faces high unemployment and huge trade imbalances. Its sovereign debt has reached crisis proportions, and continued deterioration would pose a real threat to Germany, France and Italy. The core countries must find a way to stabilize Spain or risk the economic failure of the entire eurozone. There seems to be no way out short of massive restructuring.

Proponents of Eurobonds maintain that they will bolster the competitiveness of the fragile peripheral countries. That, they say, is what's mainly holding back growth. The smaller countries cannot supply goods at a competitive price, nor can they compensate by devaluing or adjusting their currencies as long as they're bound to the euro. With Eurobonds, the inflation imbalance between the core countries and the smaller ones can be addressed and the internal competitiveness gap can be narrowed. Smaller countries will be able to produce goods at reasonable prices. However, it is widely believed that structural reforms will also be needed in the periphery.

It's difficult to see how to get started without coordinated European fiscal policy and a common banking authority with real teeth. For these to be achieved the leaders of the two largest countries must find a way to work in tandem, all the while keeping the voters back home happy.

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