Eurozone Watch

The Greek case is moving markets – and minds. Over the last few weeks, for instance the German government including Angela Merkel has become a strong proponent of economic policy coordination in the Eurozone. Not only financial markets are nervous these days. Politicians and high officials in particular in the Eurozone are stressed, not only because they wish for nothing less than bailing out Greece, but because they fear contagion to other Euro states such as Spain or Ireland if markets get even more nervous.

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Fourth part of our series on the winners and losers of the current crisis

Before the financial crisis struck, the German finance minister Peer Steinbrück had a very ambitious goal. He wanted to enter history books as the finance minister who managed to oversee the first federal budget in Germany without new borrowings in a generation.

This dream is now shattered. As the Financial Times Deutschland pointedly remarked a few weeks back, Mr. Steinbrück is now entering history books as the finance minister who has overseen the largest federal budget deficit ever: With the government's stimulus package of about €50bn, the German government is now set to borrow as much as never before in euro terms.

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Two important political developments in the EMU surfaced on the ECB's tenth anniversary celebrations. Firstly, the EMU's fiscal policy coordination mechanisms are more in flux and under pressure than the EMU institutions would like to have the public believe since the reform of the Stability and Growth Pact. And secondly, the issue of lower than expected economic convergence within the Eurozone is receiving more and more attention: pro-longued business cyclces and cyclical divergence are now longer issues reserved for the macro-economic academic debate but are increasingly picked up by policy makers.

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Over the past week, the German economy has shown first real signs of an economic slow-down. Data from the labour market has been much less upbeat than before. Yesterday, also manufacturing orders took a hit, pointing to a further growth moderation starting in the second quarter of 2008. The strong euro and the investment backlash from the tax reform enacted on January 1 of this year are finally felt in the economy.

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The French Finance Minister Christine Lagarde last week announced that Paris would use its Presidency of the European Council starting on July 1, 2008 to push for a common corporate tax base. Despite its looks, this is yet not another brand new initiative by Nicolas Sarkozy – in addition to the other French EU Presidency priorities in the fields of European Security and Defence, Environment/Climate Change, Energy, Immigration and the Union for the Mediterranean.

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Roughly ten days ago, I discussed the differences in the policy debates concerning fiscal stimulus on both sides of the Atlantic in this blog, stating that there is an enormous intellectual gap between the European and US debates. While US economists are becoming increasingly comfortable with using discretionary fiscal policies to stabilize the economic cycle, German and European economist are still opposing this idea for fundamental ideological reasons. Some readers, including Daniel Gros, have claimed that the divide is mainly a result of a more sound situation in EMU which still seems to be far away from recession.

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Over the past weeks, the economic environment has significantly clouded on both sides of the Atlantic. In the US, odds have risen substantially that the economy will slip into recession. At the same time, the European economy has also developed signs of weekness: Consumption seems to have flat in EMU at the end of 2007 with GDP growth dropping significantly from the still robust paste of the past summer. Odds are that at least some of the EMU economies might come close to stagnation in the first half of 2008. Any large unexpected shock might now be enough for Europe to follow the US into a recession.

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We have just published an article in the German weekly DIE ZEIT calling for a reform of European budgetary rules in order to limit the national governments' pro-cyclical fiscal policies.

We start from the observation that fiscal policy once again is turning pro-cyclical in a number of European countries. Germany is cutting corporate taxes and increasing discretionary spending at a moment when the economy is growing with rates close to 3 percent (see our post here). France's new president Nicolas Sarkozy is cutting income taxes for home buyers and overtime payment in a boom, providing an ill-timed boost to the economy (see post here) and the Italian government has just increased their deficit target from 2.3 to 2.5 percent of GDP inspite of strong tax revenues (the money supposedly will go into more social spending).

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Tonight, Nicolas Sarkozy will be the first President of a member state ever to attend a Eurogroup meeting. The European press these last days devoted ample space to this unusual event. By the pure announcement of his visit to the EMU finance ministers, Sarkozy has already achieved two things: He again made it into the top news with his very own EU-activism – and he revealed how unprepared the other EMU leaders are to discuss the future of the Eurozone.

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This week, the German government has been debating its budget for 2008. While everyone in the grand coalition seems to be content that finance minister Peer Steinbrück has managed to increase spending, cut taxes and cut the deficit at the same time, there are signs that the government is repeating the mistakes of the red-green government: As I argue in today’s Financial Times Deutschland (full German text here), fiscal policy is turning pro-cyclical once again.

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