Hollande's troubling memo to Merkel

German Chancellor Angela Merkel probably had an anxious sleep on Sunday night as she pondered how the day’s political developments could derail her plans to use tough austerity measures to salvage Europe.

Her first challenge is how to manage France’s newly elected president, the Socialist Franois Hollande, who wants to renegotiate Europe’s ‘fiscal pact’, which emphasises budgetary discipline, so that it puts more emphasis on economic growth. Hollande is planning to send out a "memorandum” to European leaders today that will outline several new initiatives to stimulate growth, including plans to beef up the European Investment Bank and create 'eurobonds' to finance industrial and infrastructure projects.

Still, Merkel was prepared for Hollande’s victory. When she telephoned him on Sunday night to congratulate him on his victory, it’s likely that she intimated that she was prepared to make certain compromises that would allow the powerful Franco-German partnership to continue.

Although she’s adamantly refusing to renegotiate the fiscal pact, Merkel is happy to use some of the money that is left over in the eurozone’s first bailout fund to boost the EIB’s capital by €10 billion. She’s also prepared to give her blessing to the idea of 'project bonds' to raise money for industrial and infrastructure projects, provided that the bulk of the money comes from the private sector. (Merkel is extremely keen to ensure that Berlin isn’t left to pick up the tab for Hollande’s new growth initiatives.)

Hollande, she figures, will be keenly tempted by her offer. Even though he declared during the election campaign that his "true adversary” was the world of finance, France’s new president will be eager to not upset financial markets, which would push up the interest bill on France’s hefty debt.

What’s more, she knows that, despite his feisty campaign pledges, Hollande enjoys a reputation for flexibility and pragmatism, so much so that the French have nicknamed him "Flanby”, after a type of wobbly caramel pudding.

All the same, Merkel knows this will likely be a temporary patch over the Franco-German relationship. She knows that her counter-proposals are very modest, and will do little to rescue Europe’s recession-ravaged economy. Merkel is deeply afraid that, very soon, Paris will revert to its previous demands for extra funding to combat the region’s growing economic crisis – either by issuing eurobonds or by giving the eurozone bailout fund a banking licence. Both of these ideas are anathema to Berlin.

Still, if the news from France was disappointing, the news from Greece was disastrous.

Sunday’s general election witnessed a surge in support for extreme parties of the left and the right, as Greek voters took their revenge on Greece’s two mainstream parties – the centre-right New Democracy and the socialist Pasok party. The two parties, which picked up a combined 77 per cent of the vote in the last election in 2009, are being blamed for the country’s dire economic plight.

Instead, Greek voters flocked to fringe parties, most of which reject the country’s painful austerity program. Greece’s radical left party, Syriza, saw its share of the vote more than triple, and looks set to become the second-largest party in the new Greek parliament. Exit polls suggest that Syriza – which has rejected the country’s bailout program as "barbarous” – picked up between 15-17 per cent of the vote, putting it ahead of Pasok (with around 14 per cent of the vote), and only slightly behind New Democracy around 20 per cent. Meanwhile the far-right, anti-immigrant Golden Dawn party, picked up between 6-8 per cent of the vote, and will enter Greece’s parliament for the first time.

Merkel knows that the dismal results for New Democracy and Pasok – both of which supported Greece’s second €130 billion bailout – will struggle to form a stable coalition government capable of implementing stringent budget cuts and tough reforms that Athens agreed to in exchange for additional funding.

As a result, Greece looks set for a protracted political instability as fragile coalition governments collapse under the weight of a deteriorating economy and mounting public anger, while the prospect of Greece quitting the eurozone grows ever more likely.