Will she come to his rescue?

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Growing Government Debt Will Test Euro-Zone Solidarity

Jean-Michel Paul is founder and Chief Executive of Acheron Capital in London.
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The German chancellor and the French president stood side by side last Wednesday to address the European Parliament. But beneath that show of solidarity lies a story of two diverging economies at the heart of the euro zone. 

At the time the euro was born, Germany's economy -- bearing close to $2 trillion in reunification costs -- looked not too dissimilar to France's. Today, however, the gap between the two countries is the widest since the reunification. Not only is the debt-to-gross-domestic-product ratio of France and Germany the widest in 20 years, but -- more importantly in a currency union without a federal state -- the latter has a huge and increasing current surplus, while the former is in deficit.

This is not surprising. Germany, while benefiting greatly from the opened markets of its fixed exchange rate partners, undertook a series of reforms to improve its economic position. France was not only unable to reform but indulged in the 35-hour workweek. If we were still living under the European Monetary System that predated the euro, France would simply have had to devalue, as it did many times before the euro. Under the euro, helped by its trade surplus, Germany kept a tighter budget, while the French state kept spending an ever-higher percentage of its GDP in repeated attempts to support its faltering economy. As a result, its debt is now close to the symbolic 100 percent of GDP level, not accounting for unfunded pension liabilities, and the rating agencies have stripped it of its AAA rating and continue to downgrade it. The European Commission, in its last assessment, speaks of France facing "high sustainability risk" in the medium term.

This is not just a French problem though; it's a euro-zone one. According to Eurostat, in the first quarter of 2015, the euro-zone debt-to-GDP ratio was 92.9 percent -- the highest it has been since the creation of the euro. Never has the zone been so far away from its own Maastricht fiscal sustainability criteria. Huge differences between countries exist, but the only country of the original 12 euro-zone members still respecting the debt and deficit levels is tiny Luxembourg. What does this say for the future of the euro?

By 2014, after the financial crisis, only five of the 19 eurozone countries (Luxembourg, Slovakia and the Baltic countries) were compliant with the Maastricht fiscal sustainability criteria. In truth, it's a select club anywhere: Looking at the OECD economies today, only a handful would make the grade. They tend to be well-run smaller states with a propensity toward external trade surplus. During the financial crisis, in the absence of fiscal support from a federal Europe, one euro-zone country after another fell short of the criteria. There was good reason for this: Global fiscal stimulus was much-needed and could not have been achieved by the United States alone. But the debt has consequences Europe has not yet faced.

The criteria themselves -- in particular, limits on debt at 60 percent of GDP, budget deficit at 3 percent of GDP, and inflation -- were the price Germany extracted for sacrificing the deutsche mark at the altar of European integration. They have always been honored more in the breach. In the years leading up to the euro's introduction, European finance ministers launched an accounts-fudging exercise that would have made Enron's chief executive officer blush. Greece may have been in a category of its own, but the competition was fierce. France raided its telecoms pension fund and Belgium the cash of its public companies on New Year's Eve, while Italy entered into large derivatives trades.

The goal was to gain entry into the promised euro zone, where lower interest rates would solve fiscal problems for ever after. European authorities ignored the fudges, while Germany was deeply absorbed by its reunification.

Symbolically, the euro notes were themselves a fudge of sorts, too. The historic-looking windows and bridges on euro notes are fictional; member states could not reach an agreement on which actual historical monuments to feature on their currency, so they made them up. The European monetary union's most potent daily symbol is in fact a stark reminder of the lack of a commonly accepted cultural and historical reference.

There is more than symbolism at stake here, though. The European Central Bank purchase of government bonds won't be able to keep the rates of affected countries stable forever. To correct for a fixed exchange rate framework with its main trading partner, these countries desperately need to lower their cost base relative to Germany -- that is, to internally deflate. But this is politically untenable at a time of already-severe social discontent. Large transfers from the European Commission or Germany are also unthinkable. Not only is there no mechanism in place to achieve this rebalancing, but if France is too big to fail, it is also too big to be bailed out. It's hard to see a way out. It is therefore little surprise that France was one of the staunchest supporters of the Greek bailout; it may well be next in line. (This would seem to be the opinion of Greece's former finance minister, Yanis Varoufakis.)

Bismarck did not need the Maastricht criteria to impose the deutsche mark. Helmut Kohl did not hesitate, despite the costs, to offer the deutsche mark to East Germany. Sustainable monetary unions are not based on technical criteria that states will try to fudge or circumvent, no matter how well or badly designed. They work either by dint of the economic hegemony of a dominant partner, or through a sense of common identity.

How much debt the euro zone can handle (Japan manages with 250 percent of GDP) is a question on which we can only speculate. But if one needs a test to know if the EMU will survive the inescapable forthcoming adjustments, a simpler and more relevant question might be whether today's ECB can print banknotes bearing real historical symbols that the people of Europe can relate to.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Jean-Michel Paul at JPaul@acheroncapital.com

To contact the editor responsible for this story:
Therese Raphael at traphael4@bloomberg.net