Macroscope | Government debt will test euro zone solidarity

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 US$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 per cent 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 per cent -- 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 euro zone 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 eurozone 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 per cent of GDP, budget deficit at 3 per cent of GDP, and inflation -- were the price Germany extracted for sacrificing the deutsche mark at the altar of European integration. They have always been honoured 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.