Thoughts about the French Election

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If the first quarter was about absorption of the ECB's LTRO, the second quarter will be about politics. This weekend's first round of the French presidential election kicks of the quarter that will include:

* Greek national elections, where polls warn that the current coalition government may not be returned, increasing the uncertainty.

* Italian municipal elections which will be, at least in part, a referendum on Monti, who has seen his support wane since the labor reform was unveiled.

* Two German state elections, which may see the FDP further marginalized, making a grand coalition next year more likely.

* Irish referendum on the fiscal compact. Due to qualified majority procedures, an Irish rejection would not prevent the adoption of the fiscal compact, but would jeopardize Irish access to the ESM, should it be needed.

* After the second round of the French presidential election in early May, there is the parliamentary election in June.

The first round of the French elections looks to be a dead heat between Sarkozy and the Socialist Party's Hollande. The two of them together are polling about 55% of the vote. Another 30% or so appears to be also nearly evenly split between Le Pen on the right and Melenchon on the left. That is almost a third of French voters may cast their vote in the first round to candidates that would prefer to drop out of EMU. The remaining votes are divided by a handful of parties.

Most polls have consistently pointed to an eventual Hollande victory in the second round. The wagers at Intrade give Hollande almost a 79% chance of victory.

That said, within the collective memory of current market participants, the French votes have surprised on occasion. Many will recall the "petite oui" by which French voters support EMU with the slimmest of majorities, or the presidential election in 2002 when Jean-Marie Le Pen knocked the Socialist Prime Minister Jospin out in the first round. This forced many on the center-left to support Chirac over Le Pen and ironically Chirac has caused a bit a stir suggesting he may vote for Hollande over Sarkozy.

It is particularly difficult to know from either Hollande or Sarkozy what are political rhetoric and electioneering and what are true commitments. While this distinction is important, it may be over shadowed by even larger considerations.

Monetary Union sits on two pillars, we are told, Germany and France. The financial crisis, however, has torn the veneer off facade of parity. France is not Germany's equal. The whole "Merkozy" rhetoric obscures this point and the German and French relationship will likely be significantly different going forward regardless of who wins the French presidential contest.

It is understandably why a Hollande victory would put off Merkel who had earlier considered campaigning for Sarkozy. However, Sarkozy has increasing taken to campaigning against Germany as he fights for his political future.

To some extent, the fundamental problems that greater monetary experiment is having can be traced to France's weakness. For example, France understood that it alone could not harness Germany to Europe. This is part of the reason France campaigned for a broad membership to EMU from the start.

France has been too weak to offer a counterweight to Germany's austerity drive. The effort to have a growth pact alongside the austerity pact has largely been taken up by Italy and, arguably to a lesser extent by Spain.

At the end of the day, France appears to have more in common with the Mediterranean members of the euro zone than the Northern core. It runs a persistent trade and current account deficit. Its unit labor costs have risen relative to Germany. If the older European Exchange Rate Mechanism was still operative, France might be tempted to devalue to restore competitiveness.

Given the state of the French economy, easier monetary policy is desirable. A weaker euro is desirable. For Germany and several other core members, ECB policy to too accommodative and the euro is too weak. Whereas Merkel talks about the need for greater political union, Sarkozy and Hollande strike nationalistic chords.

France is paying 127 bp more than Germany to borrow on 10-year bonds. This is in the upper end the premium that France has had to pay under EMU. The premium had reached almost 200 bp in mid-November last year, before the LTROs and the liberalization of the criteria of acceptable collateral. The premium had fallen to less than 90 bp in early February amid the LTRO euphoria. From the start of the crisis through the middle of last year, the premium investors demanded was no more than 60 bp and mostly between 20 and 40 bp.

While the center-right parties of Europe, which currently dominate member governments, have shown a willingness to cooperate, the center-left parties experience no such thing. The German SPD, arguably the natural allies of the French Socialists, has distanced itself from Hollande as well. They are not interested in re-negotiating the fiscal compact or lowering retirement ages.

The SPD, much to the chagrin of Merkel who may have to accept it as her coalition partner next year on a national level, advocates a joint European bond. The French left have not embraced this very enthusiastically. For his part, Sarkozy seems more interested in changing ECB policy than a joint bond.

The economic crisis in Europe will have profound political changes in Europe and the French election may prove to be the catalyst. Regardless of the outcome of the French presidential elections, the relationship between France and Germany is going to change. There may be more political space created by the scope for policy arbitrage between France and Germany, the once-heralded twin pillars of Europe.

Hollerkle will not simply replace Merkozy, but Europe is on the cusp of potentially significant political realignment.