A make-or-break week: Can Sarkozy and Merkel save the euro?

Despite happy appearances, the two leaders disagree the way out of the Eurozone crisis. AAP

What could be a decisive week for Europe and its common currency has begun, with the announcement of a package of fiscal austerity measures in Italy.

Markets, European partners, and – perhaps above all – Italian citizens had been waiting for these measures since November 16, when Prime Minister Mario Monti was appointed by the President of the Republic to head a technical government. Speculation and rumours over the past few days indicated that the package would essentially consist of an increase in income and consumption taxes, with only mild expenditure cuts. This in turn raised concerns among most economists and observers because such a package would be largely inadequate to address the fundamental causes of the Italian crisis.

In fact, the measures announced at a press conference on Sunday differ from what was anticipated, at least to some degree. The austerity package does include more taxes: the value added tax rate will be increased by 2% in the second half of 2012, a tax on housing property is reintroduced just a few years after its abolition, new taxes on luxury goods (luxury cars, boats, and airplanes) and a one-off tax of 1.5% on repatriated financial capital are also introduced, and the excise on fuel consumption is further increased. Even though there are no changes in household income tax rates at national level, the package allows for a marginal increase in the maximum household income tax rate of the regions.

An increase in taxes is unescapable in a context where stabilising the public finance is a priority. Some of these taxes will inevitably have a contractionary effect on consumption. In this respect, the increase in the value added tax might be particularly hard on poorer households as this type of tax is generally regressive.

Italian PM Mario Monti delivered a tough austerity plan. AAP

Yet, the package is not just about taxing more. It includes a set of tax incentives to stimulate entrepreneurial investments and measures to put to use about 40 billion euros already committed to finance investment in public infrastructures. With this package the government also makes some attempt at reducing the cost of the public administration, by reducing the number of members of several public authorities, and the political system, with a reduction in the numbers of members elected to province-level assemblies and the elimination of province-level cabinets. Finally, the government has included a much-needed reform of the pension system in order to make it more sustainable in the long-term.

Overall, the announced measures are expected to lead to an overall extra-revenues and savings of about 30 billion euros. This is certainly a welcomed outcome. Nevertheless, in itself it might not be enough to ease the pressure on the Italian debt. For one thing, more ambitious expenditure cuts could be envisaged in the public sector.

For another thing, markets must be convinced that the debt to GDP ratio is going to decrease steadily. But this in turn requires the GDP to start growing significantly faster than what has happened in the last decade or so. For this to happen, various structural interventions are needed. These include reforms of labour market legislation, of the bureaucracy and public administration, and of the justice system – as well as liberalisation to promote competition in various sectors of economic activity. The government must be therefore complement the austerity package with concrete steps towards the introduction and implementation of such interventions.

But the Italian austerity package is not the only event of this action-packed week. The leaders of Germany and France, Angela Merkel and Nicholas Sarkozy, have begun talks in Paris ahead of the European Council meeting on Friday.

The success of the European Council and, ultimately, the future of Europe critically hinges on the ability of France and Germany to find common ground on both the short term measures to address the crisis and the long term reform of the European treaties.

There are indeed significant differences in the positions of Merkel and Sarkozy. Merkel is anchored to a rather conservative view of the role of the European Central Bank (ECB) and she has more than once ruled out the use of jointly issued euro bond and the possibility for the ECB to act as the lender of last resort. In this respect, she might have probably failed to recognise that by undertaking large-scale purchases of bonds of solvent countries (like Italy), the ECB would not fail its mandate and compromise its independence, but rather take a course of action in line with its primary objective of price stability.

Sarkozy, instead, is uncomfortable with Merkel’s idea to establish tougher, automatic sanctions for countries that do not meet the fiscal rules. He seems to favour emergency action such as the Eurobonds or the use of ECB as lender of last resort.

In fact, these differences might be less profound than what appears at first sight. The Italian austerity package might be signalling the strong commitment of the Italian government towards the consolidation of its fiscal stance. This in turn might convince Merkel to soften her position on the role of the ECB. Moreover, both leaders seem to agree on the need for further economic integration, most notably for a form of fiscal integration that matches the existing monetary integration arrangements.

The key difficulty here is that deeper fiscal integration can occur only if countries are willing to surrender a consistent portion of their sovereignty to supranational authorities. But in a context where most citizens are, erroneously, convinced that the euro is to be blamed for the current crisis, national government will have hard time in selling the idea of giving up sovereignty to their voters.