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'Merkozy' Should Focus on Putting Out Euro Fire: Analysts

French President Nicolas Sarkozy and German Chancellor Angela Merkel – dubbed "Merkozy" by the press — will meet in Berlin on Monday and their talks are likely to focus on enforcing budget discipline in the 17-member euro area in order to fend off a crisis that threatens to engulf even the currency bloc's strongest members.

French President Nicolas Sarkozy welcomes German Chancellor Angela Merkel prior to a working lunch at the Elysee Palace in Paris.
Eric Feferberg | AFP | Getty Images
French President Nicolas Sarkozy welcomes German Chancellor Angela Merkel prior to a working lunch at the Elysee Palace in Paris.

But creating a stronger currency union that's able to withstand market pressures will take time, and the two leaders should concentrate on putting out the immediate fire first, by finding ways to boost growth and by making sure countries will not default, analysts told CNBC.com.

"For me, two things are important: safety for larger euro zone countries such as Italy – meaning a larger bailout fund or more aggressive European Central Bank – and solving economic problems – how to kick-start growth," Martin van Vliet, a euro zone analyst with ING, said in an interview.

"A lot of analysts highlighted the fact that if everybody in Europe tightens their belts, you have a [negative] effect on the economy, apart from the fact that confidence was hit by the crisis and the lack of policy response."

Even before the European Economic and Monetary Union was launched in 1999, many critics said that without fiscal union – a common budget and common taxes – the euro zone would run into trouble, because the economies that form the euro zone are too different.

With investors sending yields for the euro zone's periphery countries to record highs on fears that some of its members will not be able to pay back their huge debts – even after bailouts by the International Monetary Fund and the European Union – calls for fiscal union to stabilize the common currency have intensified.

"Where in the world do we have a successful currency union? America. That's why we need European taxation," Bob Parker, a senior adviser to Credit Suisse, told CNBC.com.

According to Parker, there are three stages that need to be covered to reach a fiscal union, and the euro zone is — after a crucial meeting of heads of states back in December when 26 European Union members decided to bring more discipline to budgets – now only at stage one.

"Stage one is the easy part, where you go back to the Maastricht limits and tell countries they can't have a deficit higher than 3 percent [of gross domestic product]," Parker said.

Why the Euro 'Failed'

The Treaty of Maastricht, signed in 1992 by the then members of the European Union and adopted by new members since then, stipulates that countries must keep their budget deficits below 3 percent of GDP and their public debt under 60 percent of GDP.

However, all but a few euro zone members have breached the Treaty since the creation of the euro 13 years ago, with debt and deficits in countries like Greece, Ireland, Spain, Italy and Portugal cited as the main reasons for current market jitters.

"Why has the euro zone failed? Because the Maastricht limits were not enforced, not policed," Parker said.

He said stage two in bringing fiscal union would be a framework for common income and corporate tax across the euro zone and stage three, actual European taxation.

"Is there political will to get to stage two and stage three? I think there's a long way [to go]," Parker said.

Analysts and market participants agree that, down the line, fiscal union is what is needed for the euro zone to survive and they say Merkel is pushing the idea because she needs to persuade her taxpayers they need to save countries on the euro zone's periphery.

But political leaders must sort out more pressing problems first.

Janet Henry, an economist at HSBC, said a long-term roadmap for "genuine fiscal union with eventual common bond issuance," a larger expansion of the ECB's balance sheet and steps by export-oriented countries to do more to boost domestic demand are the "comprehensive" solution to the crisis.

"The economy probably moved into recession towards the end of 2011 and any contraction is forecast to deepen in early 2012," Henry wrote in a market note.

HSBC is forecasting a 1 percent fall in euro zone GDP, with bigger falls in some of the countries at the heart of the crisis such as Italy and Spain.

'Turbulent' Political Landscape

A weak economy will pose political risks as well, according to Goldman Sachs economists, who see turbulence ahead.

"The combination of weaker growth and public sector shrinkage is also likely to keep the political landscape in many euro zone countries turbulent, particularly with elections ahead in France, Greece, Slovakia and Finland," they wrote in a market note.

"So our expectation is still that the European growth and market picture will worsen before any more sustainable resolution is achieved," they added.

Spain is an example of a country where a weak economy caused it to miss deficit reduction targets, van Vliet pointed out.

"What next? Do they stick to the target for this year, meaning more austerity, or will they relax the budget deficit target?" he said.

Spain's new center-right government said at the end of December that the public deficit for 2011 would come in at 8 percent of GDP compared with the official target of 6 percent. The government announced tax hikes and wage freezes designed to try to rein it in .

Other countries have announced fresh austerity measures, with Greek Prime Minister Lucas Papademos warning trade unions that if the country doesn't successfully complete talks for a second bailout with the European Commission, International Monetary Fund and the European Central Bank, it risks defaulting on its debt in March.

Spending cuts cannot be avoided in southern Europe, but policymakers need to think of "more realistic" fiscal consolidation, van Vliet said.

"Surely they must understand that if now they implement more austerity measures, because of the weaker economic backdrop, we can enter a vicious circle," he said. "Look at what's going on in Greece; it's spinning out of control there because the economy continues to deteriorate."

More fiscal integration — leading ultimately to fiscal union — is likely to take decades, with a complicated political process needed to approve changes, analysts said.

"[Fiscal union] doesn't help in solving the current crisis," van Vliet said, but added: "If European countries are serious about integration, it may lift sentiment because it shows politicians are willing to keep it all together."

Contact Europe: Economy

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