Currency war likely between Germany, France

So here’s the good news. The overhyped threat of “currency wars” is off the table for the time being after G-7 officials said they won’t censure Japan over Prime Minister Shinzo Abe’s go-for-growth strategy built around looser credit policy and a weaker yen.

The bad news is that, if a currency war does break out, it’s most likely to be between France and Germany.

French President François Hollande has set the stage, with a Gallic mix of pragmatism and panache, by admitting there’s little chance for France to meet its growth and budget-deficit targets this year.

At the same time, he’s made clear — in a move soundly rebuffed by the Berlin government, the European Central Bank and the Bundesbank — that the euro’s EURUSD +0.01%  heady rise on the foreign exchanges needs to be brought under control.

The issues of growth and the exchange rate are linked. Germany is projected to exceed France’s economic growth in 2013 for what will be the seventh year out of the last eight, It ran a current-account surplus of 6% of gross domestic product last year against a deficit of 2% for France.

So the Germans can live with a euro above $1.30 (or maybe even $1.40) much easier than their western neighbors.

On the budgetary front, Jörg Asmussen, the former German finance ministry state secretary who is now Germany’s man on the ECB’s six-member executive board, fired a warning shot last week by calling on France to stick to its plan to bring the budget deficit down to 3% of GDP. 

Only six weeks ago, Pierre Moscovici, the French finance minister, solemnly pledged in a German newspaper article that 2013 would be a “milestone” and a “year of progress” in which France would meet the 3% goal.

Lower economic growth after the poor showing for the fourth quarter of 2012 — when the euro area contracted 0.6% after a 0.1% fall in GDP Q3 — has put paid to French hopes,

France needn’t fear direct European repercussions, Paris will face merely a polite rap across the knuckles. Olli Rehn, the EU’s monetary commissioner, carefully signaled last week that countries such as France and Spain may be given an extra year — until 2014 — to meet their deficit targets if they can prove that they are making efforts in structural reforms.

Psychologically and politically, though, the implications are more severe. The episode badly weakens France’s negotiating hand as the euro area heads for a choppy period in which the period of financial market stability wrought by the ECB’s bond-buying pledge last summer may be coming to an end. Optimists such as Jacek Rostowski, the Polish finance minister, who bravely said in London last week that the euro crisis is “effectively over,” are in the minority.

If Greece, Cyprus, Italy and Spain again make negative headlines in the next few months, it will be much more difficult for France and Germany to muster a common position on economic rigor in all these countries now that Paris and Berlin are far apart in other elements of policy.

The French government is likely to draw encouragement from Japan. Abe has had some early successes in his campaign to clip the wings of the Bank of Japan to steer the Japanese economy out of years of deflation.

Yet Germany’s euro negotiating line may get tougher, not more generous, as we approach the federal elections in September. Chancellor Angela Merkel’s personal lead in the opinion polls looks far less likely than many had earlier predicted to give her Christian Democrat party the power to lead a new government this autumn. 

Commentators and market analysts should heed one salient fact.

If the Social Democrats and their Green former coalition partners do manage to return to power in Germany after September, they may be slightly more accommodative on Europe than the present Berlin government. 

But Merkel’s Christian Democrats and their current coalition partner, the Free Democrats, will be far more rigorous on euro bailouts than the present SPD-led opposition — so, overall, Germany’s hard-line position on the euro will likely get more stringent over the next 12 months. 

In its almost ritualistically uncompromising stance on the euro, the Frankfurt-based Bundesbank has been a lonely voice on the European stage in the past two years. But now, just as other central banks like the Bank of Japan are starting to lose their autonomy, the Bundesbank may be coming back into vogue. 

Probably it was a mistake to think that more than one big central bank in the world could ever be properly independent. As George Orwell might have put it, all central banks are independent, but some are more independent than others. The Bundesbank, as ever, will be the last institution standing firm. 

There may be less of a gap between euro policies in Frankfurt and Berlin in the next 12 months than over the past year. And, for governments that miss their targets in Europe, this could spell troubling times ahead. 

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