Full analysis of the joint Sarkozy-Merkel letter for the Eurozone

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Image Source: French Presidency

From the official website of the French Presidency we get the following joint letter by French President Sarkozy and German Chancellor Merkel. I shall be analyzing the letter point by point to see what will the Franco-German axis demand in the future meetings of European leaders (and what they demand is usually what happens, which makes the understanding of this letter ever more important).

Note: The text that appears in blockquotes (area with different background color and a border on the left side) is extracted from the joint letter. The rest is mine.

On the third paragraph (the first two are general introductory remarks) we get the following:

… the European Union and the Member States of the euro area have introduced decisive reforms to stabilize the economic and monetary union.

The reformed Stability and Growth Pact, the new excessive imbalances procedure and the Euro Plus Pact will reinforce the economic and fiscal coordination and surveillance in the euro area and ensure that any deviation from the objectives set by these instruments are recognized and addressed at an early stage. This policy of prevention will be key to the medium- and long-term stability of the euro area.

The above-mentioned strengthening of the various pacts, fails to understand a couple of profound issues. First that the crisis was not caused because these were not strictly enforced on member-states – the crisis is systemic and is caused because of the structural flaws of the euro, the ill regulated banking system and the consistent under-investment in the periphery. These were the cracks of the system that allowed for the financial crisis to evolve into such a serious crisis that threatens the existence of the euro. The second issue is that the Stability and Growth Pact no matter how effectively is enforced, will still be the source of divergences, since it is contradicting in nature and paradoxically is a pact that prevents growth and therefore causes instability. The point is not to cling to the same failing policies that allowed the crisis to threaten the Euro, but to introduce new truly decisive measures that will (a) fundamentally revise the architecture of the Euro, (b) that will mobilize the European Investment Bank within the framework of a redesign of the SGP, in order to produce real growth and true stability, not nominal growth figures and shaky economies.

Moving on to the next paragraph:

At the same time, by establishing the European Financial Stability Facility (EFSF) and, from mid-2013, the European Stability Mechanism (ESM), we have created the instruments to enable targeted intervention if indispensable to safeguard the stability of the euro area as a whole – always subject to adequate conditionality. Member States which benefit from the EFSF undertake considerable efforts to tackle the causes of the crisis – principally excessive public debt and a lack of competitiveness – effectively</p> The creation of the temporary EFSF that will soon be substituted by the permanent ESM was indeed a step forward. It will be an even bigger step if this mechanism evolves into a much needed overseer and recapitalizer of the euro banking system (which by the way needs to be unified). However the current structure of the EFSF and the one that was agreed upon on the July 21 Euro Summit, which still awaits for ratification from national parliaments (see my full Analysis of the outcomes of the EU summit) are based upon a highly toxic founding stone, which can be the Achilles heel of the efforts to save the euro with all its members. Currently hardly-pressed governments, whose economies are going through a serious recession and who have imposed austerity measures to reduce their spending are called to contribute to a common fund to bail out other countries. So these hardly-pressed countries come to the point where they adopt strict austerity measures to put their finances under control at the expense of shrinking their economy and at the same time are called to increase their spending for the sake of saving another country. Hence austerity diminishes their economy and the EFSF further worsens their fiscal position. This means that interest rate spreads over government bonds increase, since everyone in the market realizes the inviability of the system. We currently see this in the plan that was decided on the July 21 EU summit, where countries that face serious problems in their economy, such as Cyprus, Spain and Italy are asked to contribute to a second bailout to Greece. The EFSF failed to grasp the dangers of indirectly mutualizing the system’s debt and how that would reinforce the dynamic of contagion.

Next paragraph of the letter:

All the Member States of the euro area have committed themselves to swiftly reducing their deficits, achieving balanced budgets in the medium term and implementing the structural reforms required to enhance the competitiveness of their economies on a sustainable basis.</p> All states need to consolidate their finances and to cut inefficient spending in order to improve their competitiveness (by the way the word “competitiveness” is misleading and vague, something that can be discussed in another article). The problem with the above statement is in the “sustainable basis” of the fiscal consolidation policies. Have a look at how Greece is falling into a deeper recession, how it came to the need of a second bailout, since the first round of “fiscal consolidation” was not that “sustainable” after all and how its economy is diminishing with no prospect for growth for the next decade at least. As for the Greek sovereign debt, it will increase not decrease as some are made to believe.

Moving to the next important point:

Regular meetings of the euro area Heads of State and Government: these meetings will be convened twice a year and when necessary in extraordinary session to act as the cornerstone of the enhanced economic governance of the euro area. They would in particular check the proper implementation of the Stability and Growth Pact by euro Member States, discuss the problems facing individual Member States of the euro area and take the requisite fundamental decisions on averting crisis. These summits will also assess the evolution of competitiveness in the euro area and define the main orientations of the economic policy in the euro area to promote sustainable growth, foster competitiveness and prevent the build up of imbalances.</p> The regularity of the meetings is completely irrelevant to the structural problems of the euro. So far there have been many meetings and summit after summit European leaders have been kicking the can down the road, with ad hoc, half-measures that fail to address the root of the problem.

Next from the letter:

The EFSF/ESM missions have been extended by the decisions taken on July 21st. Its effectiveness will be improved and its flexibility increased subject to appropriate conditionalities. To fulfill its new role, the ESM should be equiped with new analytical capacities in particular as regards debt and capital markets analysis to complement the analysis and recommendations provided by European Commission, the European Central Bank and the International Monetary Fund.</p> Currently the European Central Bank is fighting a war it cannot win on the markets where it tries to “save” Italy and Spain. Once the “flexibility” of the EFSF/ESM is ratified by national parliaments, this “war of attrition” will be carried out by the EFSF/ESM, which has limited resources, dubious credibility and toxic foundations.

After that we have a series of “commandements” the essence of which I have covered above, except the following:

In line with the Euro Plus Pact, euro area Member’s States should take all the necessary measures to improve competitiveness, foster employment, ensure stability of the euro area as a whole and deepen economic integration. In particular, further progress should be made on tax policy coordination to support fiscal consolidation and economic growth. Member states should commit to finalize the negotiation on the Commission’s proposal on “a common consolidated corporate tax base” before end 2012. Euro area member states should be ready to consider enhanced cooperation for further progress on tax coordination. Euro area member states should enhance their cooperation to avoid harmful tax practices and fight against fraud and tax evasion.</p> What does a common corporate tax have to do with events and with “competitiveness” and “stability”? Forcing states to revise their corporate tax regime, means that Ireland, Cyprus, Malta and others will prefer to live without the euro rather than abandon their favorable tax regimes, which allows them to be to some extend competitive and stable. The differences in the tax rates, cover the gap in the differences in capacity to grow. A single corporate tax will simply doom the periphery and any other country that wishes to gain a comparative advantage in order to be able to grow.

What follows in the letter is mere concluding remarks. So this is my analysis of the joint letter of French President Sarkozy and German Chancellor Merkel. The two leaders are stuck in the same policies that have allowed the crisis to spiral, that have failed to contain contagion and that have created a euro of two speeds. Moreover they focused more on the future upon a false ceteris paribus assumption.

Economic governance needs to be enhanced and further integration needs to be achieved, but these will be done in a very different manner than what the Franco-German axis wants. Most of the rhetoric of the two leaders will be fundamentally revised by market pressures and events in the real world that are far detached from the world Mr.Sarkozy and Ms.Merkel currently visualize.