The theatrical resignation threat by Manuel Valls, the French prime minister, combined with deep European anxiety about deflation, suggest that the euro crisis may be coming back. But a crisis is often an opportunity, and this is the hope now beginning to excite markets in the eurozone.
Investors and business leaders are asking themselves three questions: Will European governments and the ECB recognise the unexpected weakness of the eurozone as an opportunity to change course? If they do, will they know how to grasp it? Will they be allowed to do what is necessary by the true economic sovereign of Europe, German Angela Merkel?
First, the opportunity. Europe still has a chance to save itself from a Japanese-style lost decade of stagnation and deflation. And this may be a last chance, because a lost decade in Europe could produce some very un-Japanese social rebellions and political upheavals. Europe lacks Japan?s social consensus, national unity and financial cohesion. It is far from clear that Europe could survive 10 years of recession without the eurozone breaking up and even perhaps the EU.
Second, what must Europe do to save itself from stagnation and disintegration? The obvious answer is to follow something similar to the ?three arrows? programme popularised (though not genuinely implemented) by Japan?s PM, Shinzo Abe. Abe?s ?three arrows? were: aggressive monetary stimulus; fiscal easing requiring suspension of deficit and debt targets, and structural reforms to correct long-term weaknesses in both supply and demand.
Judging by ECB Chairman Mario Draghi?s speech at Jackson Hole, all three of these policies are becoming feasible. The central bank is hinting at more growth-oriented monetary policy, the European Commission seems willing to interpret its fiscal rules more flexibly, and national governments are promising to undertake more structural reforms.
The problem is that all these hints and promises are hedged with too many conditions, uncertainties and caveats. Even if the ECB decides to experiment with US, British and Japanese-style QE, its record suggests that it will probably do too little, too late?just enough to prevent a collapse of the euro but not enough to pull the European economy out of its slump.
The prospects for fiscal and structural reforms are more discouraging, judging by the political upheaval in France. President Francois Hollande responded to his PM?s resignation threat by sacking Arnaud Montebourg, the left-wing economy minister, along with several allies. But Montebourg was calling for budget flexibility and fiscal reflation, policies very similar to those suggested by Draghi. And Montebourg rightly stressed the importance of ?sequencing? monetary, fiscal and structural reforms correctly, a fair point also made by Draghi and before him by Christine Lagarde, head of the IMF. What matters is not just the policies that governments and central banks implement, but the order in which they do so.
Misguided sequencing has arguably been a root cause of European?s economic malaise. Monetary expansion, for example, is much more effective if it is combined with fiscal stimulus, either through temporary tax cuts or injections of public spending. But if monetary expansion is contradicted by premature fiscal consolidation, both policies can be doomed to failure.
Structural reforms are very slow to act and cannot generate growth in the short-term. They should thus be viewed as complementary to macroeconomic policy, not as a pre-condition for monetary and fiscal expansion. Major reductions in public spending, which reduce growth in the short term even though they may increase long-run efficiency, should come at the end of the reform process, instead of being ?front-loaded? ahead of tax cuts, as the European Commission and the German government tend to demand.
For all these reasons, and many others, scepticism is certainly justified about Europe?s willingness to pull itself out of stagnation. That raises the third and most important issue: Will Merkel allow Europe to save itself?
To judge by Merkel?s public statements, the answer is ?no.? The German government refuses to discuss any loosening of EU budget rules. Nor does it accept the economic logic of sequencing espoused by IMF, the US, Japan, China and every other major economy. But is that really her position?and even if it is, can she sustain it much longer?
With the German economy weakening due to the recession in France and southern Europe, as well as sanctions against Russia, Merkel is becoming less adamant about imposing German ideas. The pressure for change coming from France, Italy and Spain is growing as Hollande, Matteo Renzi and Mariano Rajoy all face challenges to their leadership. The rebellion against Hollande could be a useful cautionary tale for Merkel. If she remains obstinate, she could lose her allies and face some hostility from openly anti-German politicians such as Marine Le Pen, Montebourg and Silvio Berlusconi.
It is quite possible that the political upheaval in France was coordinated, at least informally, by Hollande and Merkel. Let us assume that Hollande and Merkel finally recognise that fiscal and monetary reflation are necessary for Europe. For Merkel, this would be a very difficult concession since she has vehemently opposed any loosening of EU budgetary targets and expressed deep reservations about monetary ?experiments? such as QE. To avoid losing face, she would require a diversionary tactic. Montebourg?s demand for fiscal reflation, which he combined with an attack on Merkel?s domination of European economic policy, provided a perfect distraction.
By sacking Montebourg, Hollande was able to signal that he would accept German economic dominance and abide by EU fiscal rules. Having done this favour for Merkel, he could then go ahead and discretely break the rules. It is a measure of the EU?s political and economic dysfunctions that such twisted Machiavellian logic now offers Europe its best hope.
