An end to cut, cut, cut? Merkel and Sarkozy agree to focus on growth.

After months of focusing on fiscal discipline in the eurozone, pushing indebted countries to cut their spending, the leaders of France and Germany are turning their attention to growth. The change in tack has been heralded as the right move – albeit a late and probably insufficient one. 

In a meeting today in Berlin, German Chancellor Angela Merkel and French President Nicolas Sarkozy said that boosting economic growth should be a priority in Europe’s efforts to overcome the sovereign debt crisis. 

Addressing the press after the meeting, Mr. Sarkozy said that he had agreed with Chancellor Merkel that while they needed to keep working on reducing deficits in the eurozone, their focus should be on growth, employment, and efficiency of European economies.  

“Finally they are talking growth now,” says Charlie Parker, investment editor with the London-based financial publication Citywire. “That’s good for the medium term, but what they – and Germany in particular – need to do straight away is start spending.” Mr. Parker argues that only government expenditure can prevent European economies from sliding into recession, thus aggravating the debt crisis.

When Europe wound down for the holiday season after a final emergency summit in Brussels last month, political leaders left the table with a general plan to fight the crisis by introducing a tighter fiscal regime for the eurozone, but they did not agree on details. 

As a result, the new year starts with the same old problems: Greece is facing the threat of a default, Italy and Spain (the third and fourth largest eurozone economies, respectively) are struggling to implement tough austerity programs in order to regain investor confidence, and European banks remain at risk of bankruptcy due to unrecoverable loans. 

Up until now, Merkel, supported by German Finance Minister Wolfgang Schäuble, opposed growth plans – even though Germany, with its massive export surplus, could have afforded stimulus programs demanded by, among others, US President Barack Obama. Instead the German government asked its indebted southern neighbors to cut back their public spending, streamline their bureaucracies, dispose of state assets, and collect taxes. 

Merkel was anxious to avoid the impression German money was being used to prop up European economies who spent beyond their means, but analysts and politicians have for some time argued that imposing austerity programs on struggling economies like Greece was a sure way to drive them into default. Former German Chancellor Helmut Schmidt told a recent meeting of German business leaders that "no other developed country with a debt rate like Greece's has ever been able to solve its problems through austerity." What these countries needed, Schmidt said, was investment in jobs and infrastructure. 

Before today's meeting, Sarkozy announced that France would go ahead with the introduction of a so-called financial transaction tax, a levy on share trading which is supported by Germany and a number of other European countries, but strongly opposed by Britain and the US, who fear such a tax could damage their financial sectors. Germany has argued that the tax should be introduced in a harmonized move across Europe.

Sarkozy’s foray is seen by many as an attempt to raise his profile ahead of French presidential elections in April.

“It looks like a courageous move,” says Rupertus Rothenhäuser of  Maquarie Group, a fund management service in Frankfurt. “But a financial transaction tax will damage markets and banks in France.”

Monday’s talks in Berlin were meant to start preparations for yet another EU summit at the end of January. Merkel and Sarkozy intend to have a treaty on the creation of a fiscal union signed by March 1. The agreement on such a union, reached at a Brussels summit in December, envisages a system in which eurozone member states adhere to certain budgetary targets controlled and enforced by a central authority.

But creating this union will take months, if not years. Meanwhile Italy and Spain both face a number of bond auctions in the coming weeks, and uncertainty about the future of the eurozone will drive up the borrowing costs for these countries. 

“Europe needs the fiscal union, no doubt,” says Norbert Walter, former chief economist with Deutsche Bank. “The European Central Bank cannot for ever save Europe by buying bonds of ailing economies. But I don’t think the financial markets will give the eurozone much time. Certainly not until March.”