Franco – German Divergence

By Marc Chandler

The European debt crisis is straining the Paris-Berlin axis, the pillar of EMU. French banks are heavily exposed to Italian debt, with some estimates putting public and private sector exposure at more than $400 bln at the end of H1 (without taking into account insurance, hedges, etc). The French government is not in nearly as good a fiscal position as Germany. The French 10-year premium over Germany stands at a record 145 bp today. It finished last year near 40 bp.

The economic divergence is even more stark than the financial divergence. Earlier this week France announced its second austerity package in three months. It will boost its savings by 7 bln euros next year and 11 bln euros in 2013. The two austerity packages will cumulatively boost savings by 113 bln by 2016.

Perhaps overshadowed by the high drama in Greek and Italian politics, many observers appear to have missed the fact that German government has endorsed income tax cuts for lower and middle class earnings. The tax cuts are estimated to be worth about 6 bln euro. The tax cuts make for good politics and good economics. The tax cut may help solidify Merkel’s coalition and strengthen its position ahead of the 2013 elections. In economic terms, its fiscal position had just improved by 55 bln euros, due to the exaggerated loss of Hypo Real Estate and the economy appears to have slowed down dramatically in H2 and there is some risk of a quarter or two of negative growth.

Moreover, if the deficit countries are boosting savings, the surplus countries need to increase their stimulus. Otherwise, the imbalance will drive the world economy down. The 6 bln euro tax cut is too small to really correct the imbalance. It does not even offset the French tightening, let alone the others in the euro zone or the EU. Merkel has also switched to now support a hike in the minimum wage. But here too the measures are too small to offset the contractionary impulse.

The austerity package that French Prime Minister Fillon pushed through is interesting and perhaps the US Super Committee may find instructive (an update will follow shortly). The 65 bln euro package includes accelerating the increase in the retirement age to 62 from 60 in 2017 (4.4 bln euro savings), increase income taxes, corporate taxes, inheritance and dividend taxes (20.5 bln in savings), central government spending cuts on health care and welfare benefits (23.6 bln savings), reduce tax breaks and boosting the lower VAT to 7% from 5.5% (savings 16.5 bln).