Europe’s New Power Couple May Not Be That Powerful

The German and Italian leaders share an appreciation of market reforms but disagree on monetary policy.

French president Nicolas Sarkozy’s election defeat on Sunday robbed German chancellor Angela Merkel of one of her key allies in combatting the European debt crisis. Italian prime minister Mario Monti may be the next best thing for her.

Monti suggested last Wednesday that he could help France and Germany find “a new equilibrium” after Sundays’ election. “We have become more pressing and, I hope, more persuasive in a European context,” he said.

The former European commissioner took charge of Italy’s technocratic cabinet in December of last year and pushed for austerity measures and market reforms to balance his nation’s budget and make its economy more competitive relative to other members of the eurozone. His very appointment came after Merkel and Sarkozy had publicly questioned Prime Minister Silvio Berlusconi’s ability to save Italy from a debt crisis.

France’s new president, the socialist François Hollande, is far more critical of the sort of austerity measures that are championed by Germany than his predecessor was.

Sarkozy said in January that he wanted the French to be more like Germans — work harder while enjoying fewer benefits. Hollande insists that the emphasis should be less on cuts, rather on “growth,” which means: more room for fiscal stimulus and increased European financing for regions that have been hit hardest by the recession.

The socialist leader does believe there is something to be learned from France’s neighbor. “In Germany, they make room for social partners, unlike in France.” What he doesn’t mention is that Germany’s trade unions accepted cuts in wages and working hours to preserve employment whereas France’s call a strike whenever layoffs loom. Nor does he seem to recognize France’s 34.4 percent corporate tax rate as an impediment. In Germany, the rate is 15.8 percent.

In the context of Europe’s sovereign debt crises, Hollande’s call to “renegotiate” the European fiscal compact that was signed in December and capped deficits at 3 percent of gross domestic product at the risk of a fine, is Berlin’s main worry. The Germans may not find a better partner in Monti though.

Merkel praised the economic reforms that were enacted by the Italian prime minister in January — “they will improve Italy’s economic perspective,” she said — and Monti has had kind words for the chancellor’s iron will to rein in deficits. “Germany for a long time has offered to every European country concrete proof of how public budget discipline and an economy founded on market principles are the best recipe for growth.” He just doesn’t want to follow the German model too closely.

When it comes to central bank financing of government debt, Monti, like Hollande, would like to see more “flexibility” from Frankfurt. The European Central Bank there created €1 trillion out of thin air last year to prop up European banks. Much of that money didn’t go toward financing private businesses. Rather, it was largely spent strengthening banks’ balance sheets and invested in government bonds.

The ECB printed several hundreds of billions more to buy Italian and Spanish debt itself to stop their interest rates from rising to unsustainable levels which would have raised the specter of both countries defaulting and plunging the currency union in an even deeper crisis.

The unprecedented bond buying operation was regarded warily in Germany where it is believed that the central bank’s mission should be to tame inflation, not finance governments’ deficit spending, even indirectly.

The ECB’s balance sheet grew from some €700 billion in 1999 to €2 trillion in 2010. Then, in 2011, the aforementioned €1 trillion was added. As a result, the money supply in the eurozone has expanded by 50 percent more than its economy in the last fifteen years.

The Germans are very anxious about this development. Besides driving up inflation, they’re afraid that it will remove the incentive on the part of heavily indebted eurozone nations to rein in government spending and liberalize their economies. “It’s important that we get away from the idea that it always costs money to get economic growth,” Merkel told the Hamburger Abendblatt on Tuesday.

Hollande evidently doesn’t share her concern but it’s not at all clear if Monti does.