Eurozone split - Europe's central drama

http://www.bbc.co.uk/news/world-europe-29518717

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On Wednesday Europe's leaders will gather in Milan for their on-off-on-again summit on jobs and growth.

Expectations are low. The meeting is very much the idea of the Italian Prime Minister, Matteo Renzi, wanting to demonstrate to a domestic audience that he is at the forefront of the struggle to cut Europe's unemployment numbers.

Even as the leaders discuss how to boost growth, what will be impossible to disguise are the deep divisions within the eurozone - and that is Europe's central drama this autumn.

Germany has proudly announced that it is running a balanced budget. In contrast France and Italy are not just struggling with their budgets; they are threatening to flout the EU's budget rules. "France makes its own rules," says its Prime Minister Manuel Valls. The European Commission may well challenge that assertion.

Let's take the case of Italy. It has torn up its own forecasts. Growth this year will be -0.3%, compared with a predicted figure of 0.8%. Growth next year will be a tepid 0.6%.

Italy's level of industrial production has fallen by a quarter in the past six years. Unemployment remains stubbornly high at near 12%. Its budget deficit is increasing, although the government says it will stay under 3%.

Labour market reforms

Matteo Renzi argues that in these "exceptional circumstances" the rules need much greater flexibility. Growth, not fiscal consolidation, should be the priority. So, in exchange for adopting crucial reforms he wants a less strict interpretation of the budget rules.

To coincide with the summit Mr Renzi is pushing through the centre-piece of his reform programme, the Jobs Act.

Most controversially the new law would weaken Article 18, under which workers unfairly dismissed get their jobs back. Mr Renzi's ministers believe it discourages hiring and contributes to over-use of temporary contracts. He is determined to have the measure agreed to coincide with the summit, even if it means using a confidence vote to get it through.

The Germans are wary. They are less interested in the announcement of reforms than in their implementation. There are many details about this Jobs Act which are unclear and it is unlikely to pass through parliament until well into next year.

But the German economy itself is weakening. Factory orders in August collapsed at the fastest rate in five years. Growth this year will be 1.5%, but lower than forecast.

Visitors to Berlin will know that the government there is not just worried about being buffeted by international events like sanctions against Russia but by the health of both Italy and the eurozone's second largest economy, France.

France will not meet its budget target. The deficit remains at 4.3% and is way off target. It will remain that way for at least the next two years. The French are cutting spending, but not as fast as some elsewhere in Europe would like.

German caution

French defiance also comes with a warning. Prime Minister Valls, in London on Monday, said that austerity (he used the word "adjustment") had been "brutal" and it had turned millions of people against Europe. Growth in France is 0.5% and the priority in Paris is growth.

Together France and Italy are appealing for flexibility in the interpretation of the budget rules. Italy would like a multi-billion European growth fund. Both countries would like to see Germany boost spending on infrastructure and reduce its surplus. They believe making austerity the priority has done lasting damage and has stretched the social fabric in Europe.

The Germans - and Finance Minister Wolfgang Schaeuble in particular - point to Spain and Ireland as examples of countries that embraced labour market reforms much earlier and are already reaping the reward. They doubt Italian resolve and believe the first two years of the Hollande administration in France have been wasted.

That is the central political battle. In a way that was never intended, the most influential player on the stage is the European Central Bank. It is already running various stimulus programmes, including the purchase of asset-backed securities.

Interest rates are at a record low and banks are charged for parking their cash at the ECB overnight. If the risks of deflation continue to grow then the expectation is for full-scale quantitative easing later this year.

In the meantime the lower euro is helping Europe's exports. In many places, Italy included, it is exports that are driving what growth there is.

So, although in Milan there will be discussion of youth guarantee schemes etc, all eyes and ears will be on what can be learned about the central economic drama between Germany, on the one hand, and France and Italy.