Analysis: Merkel's 'fiscal union' drive faces major hurdles
LOS CABOS, Mexico
LOS CABOS, Mexico (Reuters) - In the mid-1990s, Helmut Kohl was asked how he ever hoped to convince Germans to give up the deutsche mark for a nebulous new currency that was later dubbed the euro.
"It will happen," the chancellor shot back. "The Germans accept strong leadership."
Nearly two decades later it has fallen to Kohl's former protégé, Angela Merkel, to put her own neck on the line and persuade skeptical Germans - and her euro zone partners - that more, not less, Europe is the answer to the deep crisis afflicting the single currency.
At a G20 summit in the Mexican resort of Los Cabos this week, Merkel worked to get U.S. President Barack Obama and others behind her push to move toward a so-called fiscal union in Europe, where member states would cede unprecedented power over budget policy to a central authority in Brussels.
Her hope is that by committing to a big leap forward in political and economic integration, Europe can correct the mistakes of the euro's founders like Kohl and convince markets of its resolve to keep the currency.
"These steps will show the world that Europe and the European project are irreversible," European Commission President Jose Manuel Barroso said in Los Cabos.
He is one of four top EU officials who have been tasked with making proposals at a summit of EU leaders in late June on how to achieve a fiscal union in Europe.
But in the run-up to that summit and in the months that follow, Merkel faces a daunting set of obstacles that could disrupt her plans.
First, she must make up for lost time in explaining her vision to citizens at home and in the wider bloc who have grown skeptical about the benefits of the euro and European Union as the crisis has deepened, pushing up unemployment and plunging economies across Europe into recession.
"The strongest argument against re-inventing Europe is that a majority don't want it," German daily newspaper Sueddeutsche Zeitung said in a weekend editorial.
Despite littering her speeches with references to "political union" in past months, Merkel has yet to spell out how this would really look and how fast it can happen. Europe is not a passion for her, as it was for Kohl, compounding her challenge in selling the grand plan.
Merkel must also cope with the high expectations of G20 partners like the United States, which have only reluctantly embraced closer European integration as a solution to the crisis after she had shot down their push for more radical short-term steps, like joint euro zone bonds and cross-border bank deposit guarantees.
German officials in Los Cabos told reporters that Washington understood that Merkel's push for a fiscal union was an "evolutionary" and not a "revolutionary" process.
But they also conceded that pressure was rising to deliver a big statement at their June 28-29 summit, no matter how difficult or unrealistic that might be.
"We know the expectations for the EU summit are high," a Merkel aide said. "We need to deliver something. But in reality many countries have still not come to grips with the idea of moving towards greater fiscal integration. It's going to be very hard to deliver the big announcement."
The biggest obstacle, besides her domestic audience, could be Francois Hollande, the new French president with whom she has yet to develop a close rapport.
A protégé of Jacques Delors - like Kohl, one of the fathers of the euro - Hollande has not tipped his hand yet on whether he is prepared to abandon decades of Gaullist opposition to transferring powers to Brussels and embrace Merkel's plan.
A resounding victory by his Socialists in a parliamentary election on Sunday has strengthened Hollande's hand and, German officials hope, given him more flexibility to meet Merkel halfway.
To help convince him, they can point to a series of concessions by Berlin over the past months that have gone some way toward meeting Hollande's demands that stricken euro members be given more relief.
Germany announced earlier this month it was prepared to grant Spain an extra year to reach its deficit reduction targets, and also showed flexibility in allowing EU aid to flow directly to Spanish banks without the country having to submit to a full economic adjustment program.
German officials have broken a postwar taboo by signaling tolerance for price rises at home and supporting inflation-busting wage deals in the manufacturing and public sectors.
Some saw the language of the G20 communiqué in Los Cabos as another sign of Berlin's newfound readiness to compromise. In it, European countries acknowledged that they were considering moving toward a so-called banking union, with bank resolution tools and an integrated deposit guarantee scheme that Germany has until now been cool on.
Whether these steps will help convince Germany's partners will become clear in the buildup to the EU summit. Merkel is due to travel to Rome on Friday to meet with Hollande, Spain's Mariano Rajoy and Italy's Mario Monti.
An even bigger issue is whether a long-term plan for closer integration - which would presumably include central budget controls, harmonized taxes, coordinated labor policies and a more powerful European Parliament - has any chance of calming markets.
Although Europe dodged a bullet in Sunday's Greek election, which gave pro-bailout parties a parliamentary majority, and it convinced Madrid to seek a bailout for its banks a week earlier, Spanish borrowing costs remain worryingly high, and the risk still exists that Italy could fall victim to contagion.
Bailing out the euro zone's third- and fourth-biggest economies is not an option. That is why officials are quietly preparing to use the tools already at their disposal to protect Italy and Spain.
In Los Cabos, Monti put forward the idea of using the bloc's dual rescue funds - the European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM) - to buy the bonds of weakened euro zone members on the open market.
Merkel has signaled in private that this is a step she would be ready to accept if the crisis deepens, although Berlin gave no assurances to Monti at the G20 summit, officials said.
If EU leaders are able to send a convincing message on fiscal union at their summit at the end of the month, the European Central Bank could also step in to limit short-term turmoil with a third round of cheap long-term loans to banks - also known as LTROs - or a cut in interest rates.
"A successful exit from the euro area crisis will require both a road map to a fiscal and banking union and a much larger ECB balance sheet," JPMorgan economist David Mackie said. "But while what is needed seems increasingly clear, the risk is that policymakers continue to move incrementally."
That, Mackie said, will mean "a lot more market stress and a lot less economic growth" along the way.
(Editing by Lisa Von Ahn)