No sugar for Merkozy's medicine

Angela Merkel and Nicolas Sarkozy are urgently seeking an economic boost that will encourage the rest of the eurozone to accept their rescue plan. But it appears the policy cupboard is bare.

As European economic activity grinds to a halt, German Chancellor Angela Merkel and French President Nicolas Sarkozy will meet later today to discuss new measures to boost growth and jobs in the region.

The meeting is a crucial one for Sarkozy, who faces a tough test in May’s presidential election against a backdrop of rising unemployment and a stalled economy. The latest opinion poll published in the French weekly Journal du Dimanche shows that the Socialist candidate, Franois Hollande, still commands a solid lead, even though support for Sarkozy is rising.

The opinion poll showed that Hollande would pick up 28 per cent of votes cast in the first round of voting, ahead of Sarkozy in second place, with 26 per cent. But in the second round, Hollande would win 54 per cent of the vote (down 2 per cent since the previous poll in mid-December) compared with Sarkozy’s 46 per cent (2 per cent higher than in the previous poll).

But even Merkel appears to have realised that some move to boost jobs is necessary if European countries are to swallow the tough new budgetary rules and sanctions that European leaders agreed to adopt last December.

While the exact details of the new treaty have yet to be hammered out, it is clear that this rigid fiscal tightening will force eurozone countries – particularly the vulnerable peripheral economies – into a vicious downward economic spiral. Although all 17 leaders have agreed to the plan in principle, the agreement has yet to be ratified by all national parliaments.

Merkel and Sarkozy (or Merkozy as they’ve been dubbed) are undoubtedly worried that there’ll be resistance to the tough new budgetary regime in some countries, and that some parliaments may even dig their heels in and refuse to ratify the new treaty.

If investors start to fret that some countries could choose to quit the eurozone rather than sign up to measures that will almost certainly plunge their countries into deep recession, this will trigger a fresh outbreak of market turbulence. At the first sign of resistance, investors will start dumping the bonds of countries seen at risk of leaving, which will push their borrowing costs even higher.

As a result, the two are desperate to find some way to boost economic activity and jobs. But unfortunately for Merkozy, the policy cupboard is largely bare. Governments and central banks have four tools to boost economic activity – increasing government spending, cutting interest rates, boosting the money supply and cutting exchange rates.

But under the new Merkozy rules, eurozone countries will not be able to fall back on government stimulus packages to get their economies moving. Instead, economic activity will contract sharply as governments embark on a draconian tightening of budgetary policy aimed at eliminating budget deficits that range between 2 per cent and 12 per cent of GDP.

At the same time, Merkozy won’t be able to rely on lower interest rates to boost economic activity. The European Central Bank has already cut interest rates back to their previous historic low of 1 per cent.

And even though European banks can borrow unlimited amounts of money at 1 per cent, they remain extremely reluctant to lend because they’re worried that they won’t be repaid. As a result, European credit markets remain largely frozen, because the key issue remains the banks’ unwillingness to lend, rather than the cost of money. And banks are only likely to become even more reluctant to lend as the eurozone slides further into recession.

Meanwhile, the ECB appears hopelessly divided on the issue of whether it should start buying huge amounts of bonds of peripheral countries, such as Spain and Italy, in order to push their interest rates lower. While some ECB board members are in favour of the ECB printing money to buy bonds, the powerful Bundesbank chief Jens Weidmann continues to broadcast his opposition.

It’s possible that the ECB is delaying its decision to embark on a major bond-buying spree until it is confident that countries such as Italy and Spain will implement the tough budgetary measures they’ve promised. The fear is that if the ECB maintains its tough stance for too long, it will only exacerbate the region’s financial crisis.

As a result, Merkozy’s only hope is that a weaker euro will boost eurozone exports, which will boost economic activity in the region. The good news for them is that the euro is likely to continue to weaken while investors fear that peripheral economies, struggling with large budget deficits and swollen trade deficits, will ultimately choose to quit the eurozone rather than swallow the bitter Merkozy medicine. The bad news is once the weak economies have exited, the euro is likely to strengthen again, and will increasingly come to resemble the old Deutschemark.

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