Trading French Reform for German Investment: A Win-Win for Berlin and the Eurozone
As the summer winds down in Europe, for the first time in recent memory it is the French who should have something to cheer about and the Germans who could be excused for feeling gloomy. In Paris, French President Hollande has purged the cabinet of its left-wing members, placing the government firmly in the grip of moderate Prime Minister Manuel Valls and finally creating the right conditions for long-needed economic reforms. Meanwhile, the headlines in Berlin are about the surprising drop in economic growth in the third quarter of 2014, while France at least managed to avoid going into negative territory by posting zero growth.
France’s Hollande needs to be rewarded for his courage to face down the left-wing elements in his own party – no mean feat in a parliament where his Socialists and allies have only a slim majority and any rebellion within the ranks could mean policy paralysis for at least the next two years. Hollande must be able to show reluctant ideologues on the left that his reshuffle is not just a further concession to austerity policies but instead a break with the past and the start of a new pro-growth agenda across the Eurozone.
How to do this? Some observers have mooted the quid pro quo of a relaxation of the strict EU rules that impose a maximum 3 percent for budget deficits in return for a French commitment to structural reforms of the economy, like eliminating the 35-hour work week, lifting protections for established but inefficient firms, and liberalizing labor markets. France needs to move urgently on reform, and it is true that a somewhat looser fiscal stance would temporarily be helpful since structural changes to promote growth in the long term can actually suppress growth in the short term.
But it is not France that would benefit most from a different approach to rules about budget deficits but rather Germany. There are several oft-mentioned factors holding back growth in Europe: structural rigidities in several countries, troubles in Europe’s banking sector, and an insufficiently activist monetary policy from the European Central Bank. To this list should be added the so-called “debt brake” written into the German constitution.
This rule, which dates from 2009, requires the German federal government to maintain a structural budget deficit of no more than 0.35 percent by 2016 – in other words almost ten times more restrictive than the level prescribed for the Eurozone as a whole. Although there is some wiggle room to deal with downturns, the fact remains that this rule not only slams the break on fiscal misbehavior, but also creates a permanent deterrent to borrowing for investments in things like education and infrastructure whose long-term payoff in growth would more than compensate for any short-term increase in the deficit. And there is ample evidence from, for example, the state of German roads and bridges that German public investment is not keeping pace. More German investment would not only serve the Eurozone but be in the interest of Germany itself.
Greater government spending could also lead to more investment at home by German firms, both by creating increased short-term domestic demand from consumers and by providing confidence to companies that the public goods that are a prerequisite for sustainable economic growth will be there when they need them. Such increased outlays by firms should — in a virtuous circle — lead to greater German imports of products from the indebted Eurozone countries, increasing economic growth there.
The positive psychological effect in France of increased German government investment would arguably be much stronger than any short-term easing of the EU-wide deficit rules. Much of the political tension in the Eurozone since the onset of the financial crisis can be traced to the fact that the adjustment process has been seen as a one-way street. The weaker economies have engaged in austerity policies and, to some degree (witness Spain) politically challenging structural reforms, but these efforts have not been mirrored in the stronger economies by policies aimed at easing either fiscal or trade surpluses. To the contrary, Germany enacted the debt brake in 2009 in part to set an example for the indebted countries, when what was needed was to avoid policies at home that would reinforce the deflationary effects of budget tightening elsewhere.
Now is the time for a new grand bargain between France and Germany: pro-growth reforms from Paris in return for easing the debt brake, or if that is politically unrealistic then increasing government investment from Berlin at least until the debt rule comes into force in 2016. With a more symmetrical approach to recovery from the lingering effects of the financial crisis, France and Germany would become partners in adjustment, setting the groundwork for a return to the kind of cooperation that has traditionally been the force behind the EU’s progress in the past.
Only such a combination of policies would provide the political cover French President Hollande needs to be successful with his reformist agenda – and to ensure the long-term growth that both France and Germany need and that would help the increasingly brittle Eurozone to stick together.