Angela Merkel will carry on as German chancellor, but has emerged weakened from the September 24 German parliamentary election. Has this outcome undermined the prospect for deepening Europe's economic and monetary union (EMU)? Compromises on euro area reform have clearly become more difficult, and the political opportunity created by the election of Emmanuel Macron to the French presidency may have been squandered. But there is a possible solution.
Macron's election had created hope for a Franco-German bargain on the future of the euro. The French government is now pushing meaningful domestic economic reforms—reforms that in Germany are viewed as long overdue. This gives him the credibility to ask Germany to cooperate on reforms that would create more risk sharing across euro area countries. And indeed, just prior to the French election, Merkel appeared to be open to some of Macron's key ideas, such as a eurozone budget. While both leaders clearly interpreted these ideas differently, Merkel's willingness to use the term "eurozone budget"—viewed with much skepticism in Germany—was a good sign.
Merkel's political space to seek a Franco-German compromise on the euro has now narrowed, for two reasons. One is the fact that the Social Democrats, currently in coalition with Merkel, have ruled themselves out as a future coalition partner after a poor electoral result. This deals a strong hand to the Free Democratic Party (FDP), without whom Merkel cannot form a government. Although traditionally pro-EU, the FDP's electoral campaign took a hard line on euro issues—accusing the European Central Bank's public sector asset purchases of creating moral hazard, rejecting European deposit insurance, demanding that Greece be "escorted out of the Eurozone," and calling for automatic sanctions for countries violating EU fiscal rules. On election night, party chairman Christian Lindner said that there should be "no new funds for automatic transfers" in the euro area, and called a euro area budget along the lines proposed by the French "unimaginable" and "a red line."
How much these views will determine future coalition policies is a matter for negotiation, and the presence of the euro-friendly Green party in the coalition may prevent some "red lines" from making it into the formal coalition agreement that the parties need to negotiate in the coming months. But the election has created an additional problem that runs deeper than coalition politics: the strong electoral showing of the right-wing Alliance for Germany (AfD), Germany's anti-euro party and now the third strongest political force in parliament. The sense in Merkel's Christian Democratic Union and its Bavarian sister party, the Christian Social Union, is that they cannot afford to lose any more voters to the AfD and must fight to get them back. The scope for undercutting the AfD on its most successful campaign issue—immigration—is limited: Seeing the writing on the wall, Merkel has already tried hard to reduce refugee inflows (successfully), get tough on security, and accelerate deportations (less successfully). This leaves the second hot button issue that the AfD has successfully exploited: rejection of euro area policies and institutions that can potentially lead to transfers across countries, such as the institutions that the French would like to see.
If there is a way to recover the momentum on euro area reform, it will have to address what has irritated German voters more than anything: the seemingly repeated violation of the European Union's "no-bailout rule." Regardless of whether the letter of the law was respected or not (no legal challenge has succeeded so far), it is true that over the years short-term loans at high interest rates mutated into increasingly long-term loans at almost no interest rates. The volume of outstanding euro area loans to Greece has continuously risen. And it is clear at this point that some of these loans will need to be written off—at least in net present value terms. Greece is too indebted to repay in full and on time, and pretending that it is not simply postpones the day of reckoning—and likely increases the final bill to the euro area taxpayer.
Merkel can cut through the Gordian knot of euro area reform politics by asking Macron to support reforms that would make the no-bailout rule credible in the eyes of the skeptics. In exchange, Merkel should support more risk sharing in the euro area through common fiscal instruments, European deposit insurance, and/or other steps supporting stable financial integration. This may sound like a contradiction, but it is not. A credible no-bailout rule does not preclude risk sharing; it only precludes systematic transfers in one direction. And it creates market-based incentives to run responsible fiscal policies, a prerequisite for successful risk sharing.
There are practical ways of making the no-bailout rule work. Most importantly, sovereign debt restructuring must become a viable option for countries whose debts are unsustainable (an option that the FDP has also called for—on this point, it is right). This requires reducing the exposures of banks to their own sovereigns, a situation that guarantees a sovereign problem will instantly become a financial sector problem—and hence engulf the entire economy. Managing down sovereign exposures without triggering a financial crisis is tricky, but it can be done, as I argued in a May 2017 paper.
Pushing for more risk sharing while restoring the credibility of the no-bailout rule would hence be a matter of both good politics as well as good policy. This is why my PIIE colleague Nicolas Véron and I propose a Franco-German bargain along these lines in an op-ed coauthored with a dozen colleagues from both France and Germany. Merkel has the power to create such a bargain, by taking the euro-critical German bull—and its main obsession, the no-bailout rule—by the horns. But she will need Macron's cooperation to succeed.
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