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Oct 8, 2014 | 09:00 GMT

7 mins read

France and Italy Threaten Germany's Plan for the European Economy

France and Italy Threaten Germany's European System
(PHILIPPE HUGUEN/AFP/Getty Images)
Summary

The European crisis continues to expand from the Continent's periphery to its core, escalating frictions between Germany, France and Italy. Over the past five years, Germany has used the European crisis to carefully introduce controls on the fiscal systems of EU member states. Now that the fear of a debt crisis is somewhat assuaged, however, France and Italy are challenging Germany's leadership in Europe and questioning the European Union's deficit and debt targets. In the short term an agreement seems likely, but it will only create more problems down the road.

European leaders spent most of 2013 saying that the worst part of the European crisis was over and that growth would return to the Continent in 2014. But not only did the crisis continue this year, it also focused increasingly on the three largest economies of the eurozone. Ironically, bailout countries such as Ireland, Portugal, Greece and Spain were relatively calm in 2014, while Germany, France and Italy were at the heart of a political and economic crisis that has slowly been expanding from Europe's fringes to its core.

Between 2010 and 2012, all eyes were on the European periphery. Emergency summits were held and extraordinary measures were taken to prevent Greece from leaving the eurozone, Portugal from defaulting on its debt and Spain's banks from collapsing — some of which did, but in a controlled way. Bailouts were distributed, promises of intervention on debt markets were made and economic reforms were requested. As a result, talk of a "Grexit" came to nothing, unemployment declined in Portugal, and Spain will experience timid economic growth this year. But the European periphery continues to struggle. Half the stores in Athens' main shopping streets are closed, many Portuguese live on poor salaries and more than half of Spanish job seekers cannot find one.

While crises in the European periphery are serious, nothing jeopardizes the survival of the continental bloc as much as a crisis in its political core. The governments of Ireland, Portugal and Greece demanded fundamental changes to the European Union but understood their marginal role in continental decision-making. Many countries ultimately complied with Brussels' demands in order to secure concessions, knowing full well that were they not to honor some of their promises in return, the impact would be minimal. France, Italy and, for different reasons, Germany do not have the same luxury. The final quarter of 2014 will be a key juncture for the European Union and could lead to additional problems through 2015 and beyond.

Deficits, Treaties and Exemptions

The second half of October will further test the credibility of the European Union. Member states have to present their budgets for 2015 by Oct. 15. After that, the European Commission has roughly a month to assess them and ask member states to make changes in compliance with European fiscal and debt targets. Member states that fail to follow Brussels' recommendations could be fined up to 0.2 percent of gross domestic product — though the final decision on sanctions requires a European Council vote. The budgetary process will be particularly contentious for France, which plans not to meet its general budget deficit targets until 2017. Italy also faces problems because it is unlikely to meet its structural deficit targets until a similar date.

General Government Deficit, 2004-2013

The European Union, and Germany in particular, finds itself in a dilemma. Since the crisis began, Berlin has been carefully building a system to force countries to be more fiscally responsible. When the fiscal compact treaty (a key piece of this structure) was signed in 2012, the fear of a eurozone collapse was so strong that Germany was able to make certain demands. The treaty establishes strict targets when it comes to debt and deficit, giving the European Commission additional powers to oversee national budgets, a process that began in late 2011 with legislation know as the "two-pack." France is presently challenging the system, while Italy is directly ignoring it. To some extent, the European Union is a victim of its own success: The promise of intervention on debt markets by the European Central Bank has created an artificial environment where countries no longer feel market pressure, thereby reducing the pressure to apply reforms.

Now, Germany faces the possibility that the system it so carefully built will collapse. The fiscal compact treaty establishes that, under "exceptional circumstances," countries could decide not to abide by EU targets. This exemption clause has allowed France and Italy to argue that such circumstances are indeed occurring, therefore each country needs more time to meet the EU targets. German Chancellor Angela Merkel's government believes that Europe's current problems began a decade ago, when Germany and France were allowed to miss EU fiscal targets. While conservative sectors continue to pressure Berlin not to give in to Paris and Rome's demands, Merkel also understands that pursuing a hard line against France and Italy could radicalize anti-German postures in these countries as well.

Obstacles to Possible Solutions

The German government must deal with this dilemma even as it faces economic trouble at home. On Aug. 7, Germany's statistics office announced that industrial production was down by 4 percent month-on-month in August, including a decline of 8.8 percent in the production of capital goods. Seasonal factors partly explain the downturn — school holidays began later than usual, leading to a particularly slow August — but it is also connected to declining activity in two of Germany's main trade partners, France and Italy. The eurozone helps the German economy because it includes some of the country's main export destinations, but Berlin needs to ensure that its partners experience enough economic growth to be regular consumers of German products.

France and Italy have problems of their own. The French government is extremely unpopular, and internal dissent is threatening Prime Minister Manuel Valls' ruling Socialist Party. French President Francois Hollande is dealing with the continued growth in popularity of the anti-euro National Front, which a few weeks ago got its first-ever seats in the Senate. Italian Prime Minister Matteo Renzi is under similar pressure from the left wing of his Democratic Party to tone down some of its proposals to reform labor legislation. Unlike Hollande, Renzi is not currently dealing with a cohesive anti-EU front. With little prospect of economic growth in the next couple of years, however, there is certainly room for anti-European sentiments to grow in Italy.

The various problems facing Germany, Italy and France in fact increase the likelihood of a temporary solution to the budget issue. In late October, the European Commission will likely ask France (and potentially Italy) to enact budget reforms. At the same time, Brussels will probably grant Paris and Rome the extra time they demand. France and Italy will probably accept some of the commission's proposals because they are not interested in a direct clash with Brussels. The current transition in the European Commission will help this compromise because neither the outgoing commission nor the incoming commission will have enough political power to fight Paris and Rome at the same time.

In the long run, this agreement will only generate additional problems for Europe. Conservative and Euroskeptical sectors in Germany will see any solution that lets France and Italy off the hook as a confirmation of their criticism of Mediterranean Europe and the eurocrats in Brussels. It is this sentiment that keeps pushing Berlin to adopt a tougher stance against fiscally irresponsible European countries. In the meantime, the governments in France, Italy and other countries will push for new concessions, including more expansionary policies by the European Central Bank and the abolition of the fiscal compact treaty. The economic and financial crisis will continue to hurt France, Italy and, to a lesser extent, Germany. Simultaneously, the combination of internal and external pressures will continue to divide these countries. As a result, the dispute over national budgets for 2015 will create solutions for today's problems in Europe that ultimately generate additional problems in the future.

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