Who will suffer most from Standard and Poors European sovereign-debt downgrades of January 13? Not France, though it lost its triple-A rating. Not Italy, whose rating dropped to BBB+, out of respectable A status. Rather, it will be Germany. The continents powerhouse guarded its sterling rating, but Chancellor Angela Merkel will find it lonely at the top.
S&P slashed not just France and Italy, but seven other European nations, including Austria, Portugal, and Spain. Only Germany—plus Finland, Luxembourg, and the Netherlands—held on to top-grade status. Germany even won some praise from the ratings analysts. They said the nations AAA rating reflects the governments track record of prudent fiscal policies and expenditure discipline.
Conventional wisdom holds that S&Ps verdict on Frances high government debt and labor-market stagnation is a blow for, well, the French. The French certainly arent happy about it, and last month, government officials argued that Britain, not France, should see a ratings cut. French central-bank head Christan Noyer pointed out that the U.K. has greater deficits, as much debt, more inflation, and less growth. Prime Minister François Fillon said, our British friends are even more indebted than we are and have a higher deficit, but the ratings agencies do not seem to notice this. The verdict must sting for President Nicolas Sarkozy, who faces reelection in four months.
Yet the sting carries more venomous potential in Germany. For two years, since Greeces finances started to disintegrate in 2010, its been Germany and France against everyone else. At summit after summit, Merkel and Sarkozy—or Merkozy, as the media have branded them—stood fast in their orthodoxy. Theyve said that countries such as Greece cannot default on their high levels of debt, at least not unless their lenders volunteer for such an event (which they havent). Theyve said that Europe cannot brook any inflation, though inflation would lower the debt burden by letting countries pay back borrowed money in cheaper euros. And theyve continued to maintain that it would be unthinkable to allow a country to leave the eurozone to inflate its currency. At the same time, Germany and France have been parsimonious with bailout money. They insist that only immediate fiscal rectitude—tax hikes and public spending cuts—can save struggling nations.
Now Germany and France wont stand so close together. France has less to lose, no matter what happens next. If France can still borrow cheaply despite the downgrade, as it did yesterday, it will learn that the price for straying from orthodoxy isnt all that high. If France cannot borrow so cheaply as time passes, it may discover that it has more sympathy with Europes weak countries, including Italy and Spain. The French, whether under Sarkozy or his successor, may not like markets—as imperfectly represented by S&P— forcing them to make pension and other reforms any more than the Italians and Greeks have. France may balk at what those markets want rather than continuing to act with Germany as the Continental co-enforcer.
Such a scenario is more likely in light of what S&P had to say about the German-French strategy of cutting everything now and asking questions later—namely, that it isnt working. A reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers rising concerns about job security and disposable incomes, eroding national tax revenues, the S&P analysts observed. Albeit obliquely, they noted further that the years-long dithering over potential solutions isnt helping.
It will dawn on France that Germanys insistence upon the impossible—no more big bailouts, yet no inflation and no defaults—isnt hurting Germany but is hurting France. France soon may want to end the uncertainty, even if it means Europe must do things that are actually possible, but unpalatable: allowing Greece and others, for instance, to default on their debt, regardless of lenders wishes; avoiding defaults by allowing inflation; or watching nations leave the euro currency so that they can achieve that inflation themselves.
If Germany wants to avoid these outcomes, it may find that it has to pay for it. Germans would have to transfer money to other nations with few austerity strings attached. That would be expensive, and not just politically. As S&P notes, Germany could lose its own AAA rating if its debt goes to 100 percent of its annual economic output—and its already 80 percent of the way there. With a GDP of $3.4 trillion, another half-trillion worth of bailouts for countries such as Italy and Spain would inch it closer. Long stagnation in Europe, caused in part by continued delays on the debt crisis, would do the rest. Tiny Finland and Luxembourg wont carry the burden.
S&P, then, has isolated Germany in a gilded cage—and given France a neighborly reminder that the escape door is unlocked. For Germany, its not fiscal, financial, monetary, or economic issues that will define the new year, but a question of psychology: Will it choose to escape its confinement by abandoning the impossible?