FRANKFURT, Germany, July 13 (UPI) -- The European Central Bank might by headed by a Frenchman, Jean-Claude Trichet, who used to run the Banque de France, but its headquarters is in Frankfurt, and its soul and its policies continue to be profoundly German.
This matters because one of the more serious disputes now affecting the European economies is the divergence between French policy, which fears unemployment and wants more stimulus, and Germany's even greater fear of inflation. That in turn means Germany thinks there has been quite enough stimulus and deficit spending and expansion of the money supply, and it is time to think about financial restraint.
The ECB's latest report comes down squarely on the German side, arguing that the current stagnation in prices is only temporary and that inflation is going to be the main concern in the future. As a result, it urges governments to start planning their exit strategies from the current burst of spending.
"A return to sound, sustainable public finances, thus strengthening overall macroeconomic stability, must be ensured. Against this background, euro area governments should prepare and communicate ambitious and realistic fiscal exit and consolidation strategies," the central bank's monthly report says. "Many of the policy measures taken in recent months with a view to supporting specific segments of the economy should be phased out in a timely manner."
But French President Nicolas Sarkozy is determined to press ahead with an expansion program to create more jobs. He is launching a massive "emprunt," a national loan, and has named two former prime ministers to come up with ideas on how best to invest the money. One, Michel Rocard, is a Socialist, and the other, Alain Juppe, is a conservative, but both men believe in long-term public investment projects and are enthusiastic about their mandate to determine France's industrial strategy over the next 20 years.
"We cannot afford to have low growth rates over many years," Sarkozy said last week during the G8 summit in L'Aquila, Italy. "Of course we have to combat indebtedness and we have to try and restrain deficit, but we will only achieve that if we restore growth -- and if we restore our economies to health. That is self evident."
But Sarkozy also stressed, and this is why the policy divergence between France and Germany is so important, that "we need a much stronger economic coordination and strategy in Europe and for Europe."
That co-ordination will be much harder to achieve with Paris and Berlin pulling in opposite directions. But the two countries are in somewhat different situations. The German economy, Europe's largest, is expected to shrink 6.2 percent this year, according to the latest forecast from the International Monetary Fund, with a further but smaller contraction of 1 percent or less next year. France by contrast is expected to shrink 3 percent this year and expand 0.4 percent next year, says the IMF. Both forecasts are unchanged from April.
But Europe as a whole is in trouble and likely to stay there well into next year. The IMF predicts that Italy's economy will shrink by more than 5 percent this year and stagnate next year. Overall, the 16 countries in the eurozone (sharing the single European currency) will contract 0.3 percent in 2010, while the Unites States, Canada, Britain and Japan will all return to growth next year.
Some of Germany's top economists think their own government is being too cautious and needs to look to Gustav Horn, head of the IMK Institute, who has warned against reading too much into the first signs of green shoots, like the 3.7 percent increase in German industrial production in May. Horn last week urged the German government to remember what happened in Japan in the early 1990s, when the government cut the fiscal stimulus after the first signs of recovery. Germany could go the same way into prolonged stagnation, he argued, forecasting that the economy would shrink 6.5 percent this year and 0.5 percent next year.
The core problem in Europe, as in the United States, is that even if the economy stabilizes and industrial production starts to rise again, unemployment is likely to keep on rising well into next year, reducing consumption and cutting the scope for growth.
"Activity is projected to strengthen more slowly than elsewhere," the IMF's latest report noted of Europe. "Much of the adjustment in the labor market still lies ahead. Rising unemployment will weigh on consumption," it added.
Unemployment rose to 9.5 percent in April from 9.3 percent in March, according to European Commission statistics, and German forecasters expect their unemployment numbers to exceed 5 million by the end of this year, the worst figures in more than 50 years.
For the European Central Bank, the answer is clear. Its latest report says, "Labor market reforms need to facilitate appropriate wage-setting and labor mobility across sectors and regions."
That means pay cuts, or at least no pay rises, and a liberalization of German labor laws to make it easier to hire and fire. But for the German government, which faces a general election in September, that is politically highly dangerous, even if the current uneasy coalition of Social Democrats and Christian Democrats could agree to such reforms. And if the Germans themselves cannot agree, there is even less chance of Paris and Berlin agreeing.