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The Price of the Pact: What Will a European Economic Government Entail?

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German Chancellor Angela Merkel and French President Nicolas Sarkozy want to create a European economic government. The idea sounds good, but it is unclear exactly what it means. If the proposal is serious, it will lead to significant changes -- especially for Germany.

European Council President Herman Van Rompuy (left) is tipped to head the European economic government proposed on Tuesday by French President Nicolas Sarkozy (C) and German Chancellor Angela Merkel. Zoom
DPA

European Council President Herman Van Rompuy (left) is tipped to head the European economic government proposed on Tuesday by French President Nicolas Sarkozy (C) and German Chancellor Angela Merkel.

The words sound mighty enough: A "true economic government" will be created to coordinate economic and finance policies in the euro zone in future to make the currency union more resistant to crises. That's what German Chancellor Angela Merkel and French President Nicolas Sarkozy agreed to at their summit on Tuesday afternoon. But neither leader offered much more than that during their joint press conference, and they left completely open precisely what this economic government is meant to do.

That's little wonder, either. After all, the term "economic government" can be interpreted in different ways. The French have been using it for years to describe government intervention in the economy through, for example, state holdings in important companies. But the German chancellor appears to have an altogether different understanding of the term. "The member states of the euro zone need to ensure, with a greater degree of commitment, that they adhere to the existing Stability and Growth Pact," Merkel said after her meeting with the French president.

In fact, Tuesday's agreement does seem to largely take into account German concerns over stability. The proposal calls for the 17 euro-zone member states to anchor balanced-budget provisions into their constitutions, and to take account of European Commission concerns when setting their national budget plans. Of course, the idea isn't entirely new. Already back in March, the euro-zone states agreed to the so-called "Euro Plus Pact," which would lead to closer coordination of budget, tax and social policies -- albeit non-binding.

Jean-Claude Juncker Would Be Stripped of Power

"Up until now, the term had been a pretty empty one," said Henrik Enderlein, professor of political economy at the Hertie School of Governance in Berlin. He said it was now a task for the euro-zone countries to fill the term with meaning. "What is needed is a change in mentality. The governments have to see that they can no longer create national economic policies, but rather only European ones in the future."

Enderlein said he could imagine a kind of European finance minister who would monitor and coordinate the policies of euro-zone states. "There has to be someone who tells the individual governments: What you are doing right now is damaging to the euro zone. Unfortunately, an institution like that doesn't exist yet."

Until now, the Euro Group has been in charge of coordinating economic policy among the 17 euro nations and checking whether they are adhering to the Stability Pact. It consists of the finance ministers of the euro countries as well as representatives of the European Commission and the European Central Bank. Its chairman is the prime minister of Luxembourg, Jean-Claude Juncker.

According to the plans presented on Tuesday by Merkel and Sarkozy, the future economic government would comprise the 17 heads of government and would meet twice a year. It is set to be chaired by Herman Van Rompuy, the current president of the European Council. "The proposal for an economic government is an attempt to sideline Jean-Claude Juncker," says Enderlein. "That is a pretty open snub."

Germany Must Strengthen Domestic Consumer Demand

The new economic government will have to do more than the Euro Group did, analysts believe -- and more than Merkel has indicated so far. "It wouldn't be much if a European economic government only watched out for stronger budget discipline," says Gustav Horn, director of the IMK economic institute, which has links with German trade unions. "This is really about imbalances in the current accounts."

The imbalances are regarded as one of the main reasons for the crisis. Countries like Germany have run very high trade surpluses for years, while other countries like Greece, Portugal or Spain are less internationally competitive and import far more than they export. If they had their own currencies, they could even out these differences through interest rate policies and currency fluctuations. But in a monetary union, such imbalances aren't tenable in the long run.

That would be a job for the economic government, says Horn. "Countries with current account deficits would have to commit themselves to a more restrictive fiscal policy." That means they would have to cut government spending, raise taxes or limit wage increases. "How the countries do that should be left up to them."

But countries with surpluses, like Germany, would also have to adjust their policies. Horn says these countries would have to strengthen their domestic demand through higher wages or benefits, or via tax cuts.

If Merkel and Sarkozy are serious about an economic government, they will have to sign up to something else too. "In the medium term in a common economic area, one will have to levy joint taxes and have a significant common budget," says Enderlein.

France and Germany have made a start: They plan to harmonize their corporate taxes and introduce a pan-European tax on financial transactions. But that can only be the first step on the road to an economic government.

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