Will France Torpedo The Euro?

Chirac wins concessions from Kohl that threaten EMU

A year ago, French President Jacques Chirac paid a less-than-cordial visit to German Chancellor Helmut Kohl in Bonn. Under pressure from special-interest groups at home, Chirac had been wavering in his commitment to the reforms needed to whip the French budget into shape for European Monetary Union, the Continent's highest economic priority. Kohl read Chirac the riot act, and voila! When Chirac flew back to Paris, he unveiled a radical change in policy, designed to meet German standards for budget-cutting and forging a single currency.

This fall's visit could not have been more different. On Dec. 9., Chirac traveled to Nuremberg's sparkling Christmas market. His government had just suspended privatizations in the defense and banking sectors and had caved in on fatter retirement benefits for striking truckers. Did he get another Kohl lecture? Not at all. In fact, it was Chirac who laid down the law to his German counterpart. His message: For EMU to become reality, Germany will have to accept less stringent rules, and perhaps a weaker currency, to accommodate France's economic problems.

The sudden role reversal hangs menacingly over the European Union as it enters 1997--a pivotal year in its march toward the single currency planned for 1999. French politicians are so insecure about their crumbling popularity that they may hold the whole single-currency process hostage to their bad economy. And that could make Kohl, who has made monetary union his personal priority, vulnerable to a voter revolt in Germany against a weaker new currency. The two countries "are not at all on the same wavelength about monetary union," says Thomas Mayer, an economist with Goldman Sachs & Co. in Frankfurt.

As the leaders ended their Nuremberg powwow, they served up the usual platitudes about European integration--even though the agenda has lost the support of most French and Germans. They vowed to resolve their differences before the European Union summit in Dublin on Dec. 14. The main Continental divide: the shape of a "stability pact" that would impose fines and other penalties on EMU countries that don't stick with the tough fiscal policies needed to keep the single currency strong.

But the fact that Kohl and Chirac couldn't cut a deal in Nuremberg signals that a final pact won't be reached in Dublin either. More ominous, Chirac has already hinted that he wants to offset the power of the new European Central Bank with a government body that could soften monetary policy. A central bank "needs a political counterpart," he asserted in Nuremberg. To Germans, politicizing monetary policy is heresy. The reason the mark is so strong and inflation so tame, they believe, is that their Bundesbank is fiercely independent from political influence.

Realistically, no one ever expected Germany to be able to call all the shots on monetary union. But lately, France has thrown its weight around to an alarming extent. Much against their will, German officials accepted French plans to include a one-time $7 billion windfall from France Telecom's privatization in budget receipts for next year, thereby helping France get closer to the deficit criteria for joining EMU. Then, when Spain and Italy resisted stiff German rules for a stability pact, French officials pointedly didn't speak up for Germany.

In perhaps the most stunning challenge to Germany's vision of a strong single currency, members of the French central bank's monetary committee joined former President Valery Giscard d'Estaing in questioning the importance of linking the values of the mark and the franc. That linkage is the EMU's cornerstone. In the face of unemployment edging up toward 13%, the French are desperate to spur growth with a weaker franc that would keep exports booming.

ON EDGE. As France's malaise has deepened in recent weeks, Bundesbank President Hans Tietmeyer has uncharacteristically sought to appease French officials by talking up the dollar against the mark and franc. Although a stronger dollar helps German exports as well as French ones, Tietmeyer's straying from the strong-mark line put many investors on edge. "When a Bundesbank president talks the currency down, you can be sure there's nobody else in Germany who's going to go out and support it," warns Mayer.

France's economic doldrums are likely to keep such pressures intense. Its gross domestic product could grow by 2.4% next year, but the jobless rate won't improve much. And a terrorist bombing in Paris in early December could put a damper on the Christmas retail season.

That makes Chirac and his Prime Minister, Alain Juppe, prime targets for voter pressure that Morgan Stanley & Co. economist Eric Chaney calls "a creeping kind of blackmail." In response to widespread strikes and unrest, French politicians are blaming everything from exchange rates to foreign investors for the structural problems that keep unemployment high. What they're not doing is doling out the necessary fiscal medicine.

BAD HABITS. If there's no progress on growth and unemployment, "the politicians' instinct for survival may lead to agonizing reappraisals" of support for monetary union and belt-tightening, says Dominique Moisi, deputy director of the French Institute on International Relations. Some members of Chirac's party have even hinted that they might call for a public referendum on constitutional changes needed for monetary convergence with the rest of the EU. That would be a surefire loser.

France's buckling to union demands doesn't make it any easier for Germany to tackle its own labor costs. In mid-December, German bank employers joined steel-industry counterparts in disabling a law designed to cut rich sick-pay benefits. If France doesn't draw the line with its public-sector workers, the German government will find it harder to defend increases in the retirement age and other labor cost-cutting.

Even if France's bad fiscal habits don't spread, they could send financial markets into turmoil. If there are signs that the Euro, as the new currency will be called, will be less stable than the German mark, bond traders will once again load up on German debt and dump everything else. That would cause the mark to soar and boost interest rates outside of Germany.

Besides rocking European bond and currency markets, Chirac's insistence on softer terms for EMU might pressure Kohl to draw a line in the sand. The German Chancellor must ultimately decide whether monetary union is worth risking the value of German voters' savings. Some Europe watchers have even begun to speculate that Chirac and Kohl may deliberately be building toward an impasse on monetary union that will let them both save political face at home while seeming to work hard at negotiating. If that's the case, they're doing everything right.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE