Analysis: French downgrade puts onus on Germany

[January 17, 2012]  BRUSSELS (AP) -- One of the defining images of Europe's two-year-old debt crisis is that of the French and German leaders, side by side on a podium presenting their latest strategy for the continent.

But the underlying message of this image -- former foes presenting a united front as the 17 countries that use the euro face their biggest crisis since World War II -- may now be under threat.

Standard & Poor's downgrade last Friday of France's creditworthiness to AA+ leaves Germany as the only large eurozone economy with a AAA-rating, making it the one country that will have to shoulder the currency union's rescue efforts.

France was the only top-rated country that at least behind the scenes had lobbied for more expansionary policies in the face of a threatening recession. Its fall from the AAA club leaves it up to Luxembourg, Finland or the Netherlands -- three other fiscal hard-liners -- to challenge Germany.

Of those four, Germany is by far the largest. Its euro211 billion ($267.32 billion) contribution to the eurozone rescue fund is more than three times those of the other three combined, moving it into an odd position of dominance.

However, S&P's knockdown could just as easily force the region's biggest economy into even closer European integration as it could create a new moment for German influence on the continent.

At first glance, France's downgrade upgrades the German push for budget cuts and tax increases -- the very strategy that S&P criticized.

"We believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating," S&P analysts wrote in their reasoning for the downgrades of France and eight other eurozone countries. Rising unemployment and uncertainty among consumers, they argued, has hurt both tax revenue and growth.

The reaction to the downgrades on Friday was swift -- and suggested leaders may not even have read the analysts' report. Over the weekend, French Premier Francois Fillon, Italian Prime Minister Mario Monti and Spanish Premier Mariano Rajoy all vowed to cut deficits, and adopt more austerity measures should they prove necessary.

The downgrade "certainly reinforces the relative weakness of France to Germany in the current context," said Simon Tilford, chief economist at the Centre for European Reform in London.

"However, what it also does," Tilford continued, "it isolates Germany."

With every drop in the creditworthiness of its large euro partners, Germany finds itself in a lonelier position. And the further the crisis moves from small peripheral states like Greece or Portugal, to core countries like Italy and France, the more vulnerable it becomes.

Any increase of the eurozone's bailout fund, which is underpinned by the guarantees of the AAA countries, would primarily come out of German pockets. The main risk of a more expansionary European Central Bank, would have to be borne by the Bundesbank. Eurobonds, where debt would be backed by all eurozone countries and is seen by many in Europe as the final solution to the crisis, would automatically mean higher funding costs for Berlin.

But the alternative, a breakup of the euro, would be much more expensive than closer integration, analysts warn. The German economy depends on exports to the rest of Europe and the world, and the eurozone's weaker members have depressed the value of the euro and helped make Germany goods more competitive.

"If the eurozone were to break up, it would be one of the hardest-hit economies in the end," Tilford said.

Whether Berlin will come to that conclusion, and then push it past a skeptical electorate, is another question, one that may ultimately decide the future of the currency union.

Some argue a weakening of Paris, which has traditionally been a fierce defender of national sovereignty, may even help moving to toward closer economic and fiscal union in Europe.

"Pressure on France will increase and that will help find more European solutions," said Zsolt Darvas, a research fellow of Brussels-based think tank Bruegel. "My understanding is that Germany will be more open to a higher level of fiscal integration."

That could lead the way to a more powerful European Commission, pan-European taxes, and once the risk of overspending governments has been mitigated, Eurobonds.

That moment is still far away, and for Tilford, and many others, that interpretation is overly optimistic. But without a similar step, they concede, it's hard to see how the eurozone can emerge from the crisis.

As for the Franco-German news conferences, that image is likely to stay, if only because Germany, for historical reasons, cannot afford to be seen as the dominant force in Europe.

"I don't think the Germans can afford to allow this front to disappear," said Tilford.

[Associated Press; By GABRIELE STEINHAUSER]

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