Eurozone Watch

This is the second part of our Eurozone Watch outlook on 2007. We discuss the impact of major political events in EMU member countries and assess potential developments in EMU economic governance in the next twelve months. Read our outlook on the EMU's economic developments in 2007 here.

Will the French Presidential elections have an impact on EMU economic governance in 2007?  

No. From today's point of view, either the PS candidate Ségolène Royal or the likely UMP candidate Nicolas Sarkozy is going to be the next French President elected on May 2007. Despite their recurrent calls for some "gouvernement économique", neither is going to make a constructive contribution to the debate on the future of EMU in 2007. Neither of them has ample EU-policy experience nor a consistent positioning on EMU governance or economic policy (although unemployment, growth and social inequality will be decisive issues in the election). Both have recently made it into the news with populist ECB criticism, if at all, their impact on the EMU governance debate is likely to be negative.

Front National leader Jean-Marie Le Pen has not lost support among voters since the last presidential elections in 2002, when he made it into the second round. However, votes may be less dispersed among competing candidates especially on the left, which lowers his chances to repeat this success. Although Le Pen is unlikely to gain largely over 20% of the votes in the first or second round of the Presidential elections, his nationalist, xenophobic and hard-line security proposals have considerable influence on the positioning of the leading candidates Royal and Sarkozy. The public climate in France is characterised by a loss of confidence in the political elites and by a growing receptivity to "France first" rhetoric and protectionist policy reflexes which are used to cover up the need for a profound reform debate on the French economic, social and political model.

Will Germany use its EU presidency to improve eurozone governance?

Not if everything runs as planned. The German government has chosen not to put EMU governance on the EU-Presidential programme. This choice can be explained by the concern not to interfere with the Eurogroup's Presidency, a lack of interest in this topic, and the dominance of other issues on an already highly charged EU agenda. However, Germany heading both the EU and the G8 in 2007 may very well come into a position in which it has to deal with EMU economic governance - for instance if the euro's exchange rate against the dollar increases sharply and exchange rate intervention becomes an issue.
 
Will the European Commission increase its role in EMU governance?

No, despite maintained efforts. In 2007, the Commission will for the second time deliver its annual report on the Eurozone. In the preparation of the Broad Economic Policy Guidelines, the overarching tool for national economic policy coordination in the EU, it will pay special attention to Eurozone issues. The Commission will continue to support the work of the Eurogroup by its reports, analyses and presence in the meeting, and will nourish the debate on economics and economic governance through meetings, public conferences and research and publication activities.

Politically, despite these efforts, its political influence will not grow. The Eurogroup's Presidency, gone into its second two-year period with Jean-Claude Juncker as its President, is the more potential Agenda setter. If the much needed debate on the legitimacy of economic governance in the EMU continues to gain ground in 2007, the European Commission will have increasing problems in influencing the EU and EMU economic policy agendas.

Will the change of Prime Minister in the UK have any consequences for the UK's perspective to enter EMU?

No. The current Prime Minister Tony Blair is likely to hand over the stick to Gordon Brown in June 2007. The current Chancellor of the Exchequer (serving since 1997) has ample experience in economic policy coordination processes as a member of the Ecofin Council. However, he is known to be a euro-scepticist and has clashed publicly over this issue with fellow members of the UK government in recent years (e.g. with Blair, Jack Straw and others). Brown invented the "Five Economic Tests", a political tool to "measure" the Pros and Cons of British entry in EMU. Given his previous political statements, it is unlikely that Britain under the Premiership of Gordon Brown moves any closer to an entry into the Eurozone - unless fierce tensions on foreign exchange markets put the Pound under such a pressure that the membership of the world's second largest reserve currency and financial market becomes an interesting alternative from the UK's point of view.

Will 2007 bring further decisions on enlargement of the Eurozone?

Most likely, Cyprus and Malta will get their go-ahead with regard of joining EMU, making their accession on January 1, 2008 possible and taking the number of EMU members to 15. The Baltic countries will be again prohibited from entering the euro-area. The EU commission will again quote excessive inflation which is boosted by a booming economy, the increase of indirect taxes and lagged gas price rises (in absence of any significant fall in oil prices, inflation is set to be above 4 percent for all of the Baltic countries).

Will the German government implement reforms relevant to the Eurozone?

After the cut in payroll taxes effective on January 1, 2007, little legislation to affect the cost competitiveness of Germany (and therefore the relative competitive position of the rest of EMU) is to be expected in 2007. Major elements of the health reform will most likely be put on hold until 2009 and even then, the reform will only have modest consequences for labour costs. The rest of the union, however, should watch the German corporate tax reform to take effect on January 1, 2008. With lowering nominal corporate tax rates as well as lowering taxes on interest and dividend income, Germany will enter the race towards lower tax rates, increasing the pressure on other large countries such as Italy and France.

Can the Prodi government rely on more political stability than 2006 to bring forward reforms?

No. The year 2007 started with unexpectedly good news for the Prodi government: The public deficit shrunk to 35.2 bn € in 2006, well below the initially expected 47.7 bn € announced in September 2006. Italy may hence meet the Stability and Growth Pact deficit limit of 3 per cent. However, Prodi and his finance minister Padoa-Schioppa have no reason to lay back after this success. For the year 2007, they face a packed reform agenda, the most delicate of which is the pension reform. Further, the centre-left government attempts to continue opening up the highly protected and regulated services sector. Tensions around the budget 2006, which was almost torn apart in autumn last year due to struggles in the centre-left coalition and brutal attacks by the Berlusconi-lead opposition, give some idea what may come up in Italy in 2007. The government is fragile and only based on a slim parliamentary majority. The centre-left coalition gets into regular clashes with both the employers associations, and even more so with the trade unions. The attempt to further deregulate the services sector (which would be an important step forward from an EMU perspective) is likely to bring anti-liberalisation demonstrations to Italy's streets. The smaller leftist partners in the governmental coalition may again put pressure on the government which may destabilise it so far that the nine-party-coalition breaks apart. This political climate and Prodi's political weakness will cause problems for his attempt to increase political stability by pushing the larger left parties towards a merger into a new centre-left "Partito Democratico" by the end of 2007/the beginning of 2008.

Read our assessment on the Italian economy in our Economics Outlook 2007.