Home pressures may prove more telling on Merkel, Schäuble and Co

As Michael Noonan unveiled the budget in Dublin on Tuesday, another, but not unconnected, debate was taking place in Luxembourg.

With euro zone countries due to submit their draft budgetary plans to the European Commission for scrutiny this week, finance ministers gathered for two days of meetings.

The economic mood has darkened in Europe in recent months, with fears that the euro zone economy could be tilting again towards recession. The latest signs of trouble have come from Germany.

This week, the euro zone’s largest economy cut its growth forecasts to 1.2 per cent for this year and next, down from previous estimates of 1.8 per cent and 2 per cent. The export-focused economy is being hit by low demand from other euro zone countries as well as the impact of Russian sanctions.

The slowdown in Germany is evident elsewhere. Figures on Monday showed that euro zone industrial production fell more than expected in August, with Germany registering the steepest fall. Meanwhile the euro zone's second and third largest economies, France and Italy, are struggling to rein in dangerous deficit and debt levels.

In the immediate term, the focus is on France and Italy’s 2015 budgets in light of this week’s deadline to submit budgetary plans to Brussels. France’s confirmation two weeks ago that it will miss its deficit target by a further two years has elicited a furious response from Brussels.

Italy's finance minister Pier Padoan insisted on Tuesday that Italy would meet its 3 per cent deficit target. While technically this is the case, the real dispute with both countries centres around the "structural" budget deficit – ie when a budget deficit persists for some time. Italy has agreed to a "structural effort" of 0.1 per cent, with the European Commission pushing for 0.25 per cent. Similarly France is under pressure to increase its structural effort next year, from the 0.2 per cent figure touted by it, to something closer to the 0.8 per cent demanded by the European Commission.

The outcome of the dispute between the European Commission and two of the largest euro zone economies is highly significant politically. With memories of German and French defiance of the Stability and Growth Pact rules in the early days of the single currency still fresh, the commission cannot be seen to allow larger countries to break the fiscal rules when smaller countries, including Ireland, have made painful structural adjustments. EU commissioner-designate Jyrki Katainen insisted at this week's euro group meeting that all member states would be treated "fairly and equally".

But at the same time France and Italy’s plea for more flexibility in the implementation of the rules is gaining ground as the situation deteriorates. Germany is finding itself increasingly isolated in its opposition to flexibility.

With a summit of EU leaders a week away, efforts are being made to secure a compromise with France and Italy on their draft budgetary plans; technically the European Commission has two weeks in which to return budgetary plans to national capitals for changes.

Behind-the-scenes negotiations are now taking place between Paris, Rome, Brussels and Berlin to try to reach a compromise.

The controversy over France’s and Italy’s budgets also feeds into the broader debate about an investment strategy for Europe.

Incoming commission president Jean-Claude Juncker has been sounding out senior figures from the European Stability Mechanis, European Central Bank and European Investment Bank, about how to fund his €300 billion investment plan, though details of a package is unlikely to emerge until the end of the year.

To date, Germany has shown no sign that it is prepared to temper its opposition to additional government spending. German finance minister Wolfgang Schäuble said last week at the International Monetary Fund in Washington that “writing cheques” for the euro zone was not the solution to the economic problems.

Similarly, Berlin opposes any efforts by the ECB to kick start the economy, believing it is beyond the bank’s mandate. Just this week, the European Court of Justice began its hearing into a German court’s ruling earlier this year which questioned the legality of the ECB’s Outright Monetary Transactions, programme, the bond-buying scheme widely credited with soothing the euro zone debt crisis.

But Germany’s insistence that the answer to Europe’s economic problems lies with structural reforms at a national level could be facing its toughest challenge yet, as it faces the prospect of recession at home. Political pressure from other countries might not be enough to sway Merkel and Schäuble; the weakening of their own economic model might just be.