I never expected a message of austerity to emerge from the Palace of Versailles, where Nicolas Sarkozy, France’s president, spoke last week to outline his economic strategy for the rest of his term. He left no doubt that he is not prepared to follow Angela Merkel, Germany’s chancellor, in the direction of a balanced budget. Instead, he distinguished between “good” and “bad” government deficits, went on to explain that a good deficit is cyclical, a bad deficit structural, and then produced yet another category: a temporary deficit that would be brought down through higher economic growth in the future.
In theory, this is all fine. In practice we have reason to doubt whether he will make an earnest effort to get rid of the deficits, good or bad. One can have endless debates about the relative benefits of Germany’s legalistic approach or Mr Sarkozy’s alternative version. Whatever side of the debate you support, you will probably agree that it is not a good idea for the two largest members of the eurozone to move in opposite directions.
In fact, it could prove highly destabilising to the eurozone. Germany, as I argued last week, is heading in the direction of a zero level of government debt in the long run as a consequence of a new constitutional balanced-budget law. It is perhaps not intuitive that a balanced budget, pursued indefinitely, would eventually lead to a complete eradication of public debt. But this is what will happen.
In fact, Germany’s new law imposes an upper deficit ceiling of 0.35 per cent of gross domestic product over the economic cycle. But remember this is a ceiling. There is no floor. If the cyclically adjusted deficit came in exactly at that ceiling, year after year, and assuming a nominal rate of output growth of 4 per cent, this would stabilise Germany’s debt-to-GDP ratio at just under 10 per cent. So if this constitutional law sticks, Germany’s debt-to-GDP ratio will settle somewhere between zero and 10 per cent in the long run.
Now, Germany is a country with a large current account surplus, or excess of domestic savings over domestic investments – 6.6 per cent of GDP in 2008 and 7.6 per cent the year before. It is no surprise therefore that German banks have been hit so heavily by the securitisation crisis. They had to channel masses of surplus savings abroad. In the event, they bought US subprime mortgages and their derivative products.
They will not repeat the same mistake, but they will still be facing a problem. If Germany’s national debt converges towards zero, Germany’s surplus savers will have to invest huge amounts of their savings outside the country, since the supply of German government bonds will diminish over time as the outstanding stock of debt is depleted.
Now this is where Mr Sarkozy’s bad deficits come in. Most German savers, especially pension funds, will want to invest in euro-denominated government debt, which, for practical purposes in this scenario, means French debt, because no other domestic European bond market is sufficiently large and mature. As a result France may enjoy a version of America’s exorbitant privilege.
If Germany unilaterally goes down the road of deficit reduction, and if France unilaterally goes the opposite way, the result will be a serious imbalance. France will find it progressively easy to finance its public sector deficit, as German savers have no choice but to buy French debt instruments. They will get trapped in French debt, just as the Chinese got trapped in US debt.
This means that Germany will suffer two successive blows. The first is a sacrifice of economic growth as a result of the pro-cyclical policies needed to do away with the deficits for ever. We got a taste of that last week, when Klaus Zimmermann, president of the German Institute for Economic Research, advocated an increase in value added tax from 19 to 25 per cent. Such action would obviously be disastrous for economic growth. It would throw Germany into a full-scale depression. But he is right in a narrow technical sense. If Germany is hell-bent on eliminating its structural deficit by 2016, some drastic measures are inevitable. Ms Merkel has said she will not raise VAT, but she will either have to raise other taxes or cut spending. Politically, the first will be easier than the second.
Once budgetary balance is achieved, at huge economic cost, German savers will then suffer the second blow in the form of poor returns on investment, as their surplus savings will be financing Mr Sarkozy’s good, bad and ugly economic policies.
How long can this go on? Imbalances can last a long time, but they do not last for ever. Something will have to give. It could be that future generations of German politicians find ingenious ways around the balanced budget law. Or that they find a two-thirds majority to overturn it. Or that Mr Sarkozy or his successors follow Germany into a future of austerity. But as long as one of those three events fails to happen, Germany may discover that unilateral fiscal rigour in a monetary union could prove extremely costly.
For the sustainability of the euro, you surely do not want to get into a position where a large member state has a rational economic reason to quit. So if Germany and France really do what they both promise, you may as well start the egg timer.
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