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After socialist victory, panic in Paris?

May 7, 2012: 9:11 AM ET

New French President Francois Hollande will certainly give German Chancellor Angela Merkel a headache. But Germany's power over Europe remains relatively unchallenged.

By Katherine Ryder, contributor

francois_hollandeFORTUNE -- "Merkozy" is what the press dubbed the symbolic marriage of fortune between German Chancellor Angela Merkel and French President Nicolas Sarkozy, describing their efforts to hold Europe together through economic crisis. Now a new portmanteau has been coined, mashing the names -- and pessimistically describing the relationship -- between Merkel and France's new socialist president, Francois Hollande, as "Merde."

On May 15th, when Hollande is inaugurated, he will be only the second socialist to run the country since World War II. His promises are bold and disruptive -- including restoring France's budget by taxing the rich and reducing unemployment by hiring more government workers. This deeply worries the 48% of the French voters who cast a ballot for Sarkozy, or those who protested both candidates by refusing to vote at all. Markets, by contrast, seemed more troubled by Hollande's plans on another front -- his promises to lead a "New Europe." "Germany doesn't decide for all of Europe," Hollande proclaimed on the campaign trail. A major element of his campaign narrative has been to fight against German austerity on behalf of Europe's beleaguered economies. He has even asserted that his first French presidential trip will be to Berlin, to "renegotiate" the fiscal compact that took "Merkozy" so long to pass.

Merkel, who offered to help Sarkozy campaign to avoid this uncomfortable meeting, will have her hands full over the next few months. Hollande knows he has a lot to prove. But what he's about to learn is that no matter his posturing, Germany still holds much of the power. Germany's economy remains significantly healthier than France's, and Merkel's approval ratings are high. Though her austerity programs are now in question, she's been quick to shift her own rhetoric to a "growth compact." Some flexibility with respect to austerity may actually be healthy for Europe -- certain countries, like Spain, have economic woes driven more by housing prices than national debt, and could desperately used a shift in focus toward growth. At the same time, however, some form of budget discipline appears to be the only sane path forward if the European experiment is to succeed. Politically, that's an easy stand to take for Merkel. It will be harder for Hollande.

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Hollande's hair may yet go whiter than Barack Obama's as he begins to collect experience in France's national government. First, though he promised that France will hit the 3% deficit target in the EU's fiscal compact in 2013 and will achieve a balanced budget by 2017, he hasn't explained how he will do this. Meanwhile, France's public debt, the amount of money borrowed by the French government to pay its bills, is projected to reach 90% of GDP by 2013. This is the year that Hollande says France will return to strong growth. But particularly with the U.K. and Spain in a double-dip recession, most economic forecasts aren't as rosy as Hollande's.

Locked into the euro alongside Germany, Hollande's main goal, if he wants to lead Europe and preserve the best parts of France's social model, should be to increase French competitiveness. Again, he has yet to lay out a specific plan. Although worker productivity is similar in Germany and France, the French export market is among the weakest in Europe. Further, France's generous welfare state has led to a dysfunctional labor market, where excessive protection by labor unions and state laws make it hard for incompetent workers to be fired -- and mean that even those who are fired wind up getting paid off handsomely by either their company, the state, or in some cases both. Hollande's idea to rollback the retirement age to 60, after Sarkozy pushed it to 62 in one of his only meaningful attempts at structural reform, seems wildly out of touch.

Despite Hollande's ambiguous and, in some cases, dubious plans for managing the French economy, he was elected not just as an anti-Sarkozy vote, but because he talks a lot about European growth. In some ways, his timing couldn't be better. When the eurozone crisis broke last fall, the Franco-German crisis response was to push through an austerity package; but spending cuts have further undermined growth in several European economies, prompting a clamor for a more stimulative approach. Hollande hopes to seize the moment and frame himself as a champion of growth. He has three ideas for how to do this, one of which -- tapping the funds of the European Investment Bank to promote growth -- is supported almost unanimously by EU leaders, including those in Germany.

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Hollande's other two ideas are more unpalatable to Germany. First, he wants to create Eurobonds, "not to pool debts but to finance industrial infrastructure projects." Merkel's problem with this is that if all national debt becomes eurozone debt, Germany will essentially pay in a more direct way for Greek and Spanish economic woes. Most observers agree that this is what ultimately needs to happen if the European Union achieves its goal of becoming more than just a currency union. The question is not if, but when. No German politician, including Merkel, who faces reelection in 2013, wants to talk about the subject without other fiscal checks and balances in place. But additional fiscal checks seem increasingly unlikely, given nationalistic sentiments rising across Europe. So while Hollande might be able to put positive pressure on Merkel to be more aggressive in figuring out the various avenues with which to pursue Eurobonds (already think tanks and central banks are putting forth proposals), he can't create them alone. Merkel, with Germany's deep pockets, still holds all the cards.

Hollande also wants the ECB to go beyond lending to banks, as it did last winter, and to lend directly to governments. The goal, similar to that of the Eurobonds, would be to ease the debt burdens of sick European economies. The danger is that such a move would inevitably force politics onto the ECB. In various speeches, ECB board members fall back on the idea that EU legislation clearly rules out the ECB's bailout of governments. But as Europe's weak markets have shown, the ECB's bank bailouts haven't addressed the structural economic problems behind the eurozone crisis. Though Europe's leaders could revise the ECB's mandate, as Hollande desires, the world has watched Germany skitter around this option -- in large part due to its own domestic political concerns that remain fully relevant today.

In the beginning of his presidency, Hollande will be determined to "save face," which will likely lead to a lot of hot rhetoric -- and he may yet block Germany's pick to lead the group that runs the currency union, German Finance Minister Wolfgang Schaeuble. But markets should also be reassured on a few counts. First, after Greece's recent election, which resulted in more anti-European politicians, Merkel and Hollande are at least on the same side of the broader European debate. Second, Hollande will have his hands full at home -- with the rise of the anti-immigrant extreme right, and high unemployment, particularly among France's youth, and with a business community vigorously opposed to more debt downgrades. This crowded agenda will continuously divert him from picking unnecessary fights with Merkel. At best, Hollande's opposition to German austerity could even be channeled into productive compromises, with Germany still having the upper hand.

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