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Politics may trigger shift in European economic policy

November 18, 2016 9:54 AM EST

The headquarters of the European Central Bank (ECB) are illuminated with a giant euro sign at the start of the "Luminale, light and building" event in Frankfurt, Germany, March 12, 2016. EUTERS/Kai Pfaffenbach/File Photo

By Noah Barkin

BERLIN (Reuters) - Slowly but surely, the economic policy tide in Europe is turning, and it may only be a matter of time before Germany is swept up.

By adding its voice this week to the long list of institutions pressing Germany to spend more, the European Commission left Berlin looking more isolated and out-of-step than at any time since the outbreak of the global financial crisis nearly a decade ago.

Predictably, the Commission's call for a "significantly more positive fiscal stance" in the euro area was shot down by Finance Minister Wolfgang Schaeuble and the conservative media establishment in Germany.

On Friday, Schaeuble accused the Commission of overstepping its mandate and urged it to focus its energies on enforcing the EU's fiscal rules.

But by this time next year, the episode may be looked back upon as the first step toward a broader change in Europe's economic approach, away from the austerity-first stance pushed successfully by Berlin for many years.

This could be fueled by a range of factors: the pressures arising from Donald Trump's victory in the U.S. election and the arrival of new governments in France and Germany in 2017.

"We expect that the German position will gradually lose influence," Marco Protopapa of JPMorgan said this week.

Trump's win is especially significant. On the one hand, it is likely to increase pressure on Germany to spend more public money on defense and security.

On the other, it sends a powerful signal to the German political establishment about the dangers of ignoring an increasingly frustrated underclass, buffeted by the forces of globalization, that has shown a readiness to vent its anger at the ballot box.

GRAND BARGAIN

The looming French election will be crucial. Center-right frontrunner Alain Juppe, and his top conservative rivals Francois Fillon and Nicolas Sarkozy, are all promising radical economic reform if they are elected in May of next year.

That could open the door to the sort of "grand bargain", or reforms-for-stimulus compromise between France and Germany, that has been talked about for years but was impossible with a weak, unpopular Francois Hollande in the Elysee and the French economy languishing.

"We are very much in the grand bargain game," an adviser to Juppe told Reuters.

The real game changer could be the German election in the autumn of next year and the fate of Schaeuble, the personification of Germany's rule-based restrictive approach to fiscal policy.

The most likely outcome of that vote looks like another "grand coalition" between Chancellor Angela Merkel's conservatives and the center-left Social Democrats (SPD).

Schaeuble, 74, has already said that he plans to run for a seat in the Bundestag again, a signal to many that he would like to continue to play an important role in the next cabinet.

But the SPD, which would probably have first choice of ministries in such a constellation, could claim the finance ministry this time around, as they did in 2005 in Merkel's first term. That would push Schaeuble into another ministry, blunting his role as a guardian of fiscal rectitude.

One senior official who served in both grand coalitions said the lessons of the past years would push Merkel's next coalition partner to take the finance ministry instead of the foreign ministry, the traditional first choice.

"Regardless of who that partner is, everyone has understood that the finance ministry has a great deal more value than the foreign ministry," the official said.

FROM WITHIN

Christian Odendahl, chief economist at the Centre for European Reform, said the European Commission's call for more spending was unlikely to sway Germany.

"The change needs to come from within," he said. But Odendahl does believe that a more vigorous debate is developing within Germany over the wisdom of Schaeuble's "Schwarze Null", or balanced budget, policies.

A poll for public broadcaster ARD in September showed that 58 percent of Germans favored spending additional tax revenues on infrastructure investments, compared with 22 percent who prefer debt reduction and 16 percent who want tax cuts.

"If you had a different finance minister or if the political case for a topic-based fiscal expansion grew, then you could see a shift," he said, citing the messages from Trump's election. "Merkel is far too pragmatic and political to make the Schwarze Null a priority when there are other problems to address."

A more expansive German fiscal policy after the election may help pave the way for a tightening of monetary policy, a step Schaeuble himself has called for.

The European Central Bank (ECB), which meets next month to decide on whether to extend its quantitative easing (QE), or bond-buying program, has been looking for ways out of its ultra-loose stance. It too has called on Germany to grab the stimulus baton.

Marcel Fratzscher, who runs the Berlin-based DIW economic institute and is a former senior official at the ECB, says the pressure is building on Berlin to shift its stance.

His worry is that the ruling parties may end up wasting the fiscal wiggle room they have by making lavish promises to pensioners in the coming election campaign.

"I think there will be a further shift, even if Schaeuble stays. If the United States ratchets up spending and this is successful then it would be a signal," he said. "My worry is that it could come too late, that the government will have used its fiscal space for pension increases and tax reductions."

(Editing by Hugh Lawson)



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