Emmanuel Macron's Projected Win in France Offers a Reprieve for the Euro

By Greg IpFeaturesDow Jones Newswires

Emmanuel Macron should thank the euro. While there were a lot of things French voters didn't like about Marine Le Pen, leader of the National Front, perhaps foremost was her promise to ditch the common currency and bring back the franc, with the implicit threat of inflation and devaluation.

Yet there is an irony to this. While Ms. Le Pen never offered a plausible path out of the euro and the European Union, her critique of both was sound. The rigidity of the euro coupled with strict budget rules enforced by Brussels impose one-size-fits all macroeconomic policy on every country in the union no matter how divergent its circumstances. That planted the seeds of the last crisis and could create the conditions for another.

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The eurozone today remains fragile, like a building constructed on an earthquake fault. Ms. Le Pen's solution, to simply tear it down, was brutal. But it was no less logical than the status quo, which amounts to hoping another earthquake doesn't happen. Mr. Macron's plan is to reinforce it against future earthquakes by deepening its governance and economic ties. Yet that risks inflaming the grievances that sustain nationalist movements like Ms. Le Pen's.

The low inflation and steady growth of the euro's early years masked growing imbalances. Until 2000, French and German labor costs largely tracked each other. But with the introduction of the euro and German labor market reforms, French costs began to rise much more sharply, and those in Spain, Italy, Portugal and Greece even more so. The result was a large and growing trade imbalance in Germany's favor which its neighbors couldn't cure through the usual mechanism, devaluation.

The public and private debts taken on to finance those trade deficits proved unsupportable, yet member countries' central banks could no longer act as lender of last resort to guarantee that governments and their biggest banks wouldn't default. The euro crisis was the result.

The acute phase of the crisis subsided once the European Central Bank decided it would act as lender of last resort to its members. Since then, a moderate recovery has ensued. Trade imbalances have also closed sharply; the current account, which includes trade and investment income, is in surplus in Spain, Ireland and Italy and the deficits of Greece and Portugal have narrowed dramatically. Only in France has the deficit deepened. Germany's surplus has grown, though largely with the rest of the world rather than Europe.

But those imbalances have been replaced by others. Unemployment has fallen to historic lows in Germany yet remains in double digits throughout the southern periphery and in France. Government debt has fallen steadily in Germany thanks to balanced budgets while rising relentlessly elsewhere. It has stabilized at more than 100% in Italy and around 100% in Spain. It is just below 100% in France, and still climbing. It isn't a stretch to think that a few years from now the ECB will be raising interest rates because Germany is overheating. Yet those same rates saddle its highly indebted and still moribund neighbors with snowballing interest costs that must be met with another dose of austerity.

That probably won't produce another sovereign debt crisis. The ECB will remain lender of last resort, a EUR500 billion European Stability Mechanism now exists to bail out indebted governments and banks, and a more independent regionwide bank supervisor ensures banks are better insulated from their governments' troubles. This "makes potentially a huge difference," says Nicolas Veron, an expert on the eurozone at Bruegel, a Brussels-based think tank. Even a severe fiscal crisis will be "much more manageable."

But flaws will persist: the failure of the eurozone's underlying economies to converge and their inability to calibrate macroeconomic policy to their own needs.

Mr. Macron, the projected winner of the French election, would address the euro's flaws by deepening its governance and creating a common budget that can stimulate growth as needed via infrastructure spending financed by Eurobonds. His approach would also stop members such as Germany from using fiscal policies, such as tax changes, that hurt their neighbors. At the same time, he will try to complete the work he began under departing president François Hollande: injecting more flexibility into France's labor market. In theory, this will allow French unemployment to fall and productivity to catch up to Germany's, closing the competitiveness gap.

But labor reform is deeply unpopular in France. Moreover, Ms. Le Pen struck a chord with working class voters by linking France's industrial decline to the impositions of the European Union: free trade, immigration and prohibitions on government intervention. In an interview with Foreign Affairs last year she blamed French unemployment on "completely free trade, which puts us in an unfair competition with countries that engage in social and environmental dumping, leaving us with no means of protecting ourselves and our strategic companies."

Mr. Macron has five years to prove her wrong by overhauling both the French labor market and the EU. If he fails, voters at the next election may find Ms. Le Pen's siren song of nationalism irresistible.

Write to Greg Ip at greg.ip@wsj.com

(END) Dow Jones Newswires

May 07, 2017 14:41 ET (18:41 GMT)