Hollande sets France and Germany on collision course

Austerity strategy poised on a knife-edge as Socialists look set to storm the Elysée Palace

Angela Merkel's agenda of forcing through austerity programmes from Athens to Dublin faced its toughest test yet with the success of François Hollande in the first round of French presidential elections.

Shares across the eurozone fell sharply yesterday, followed by Wall Street, as investors digested the political news from Paris. Dismal economic news from the eurozone added to the uncertainty. Michael Hewson, an economist at CMC Markets, declared that victory for Mr Hollande would be "Europe's worst nightmare".

The euro also fell amid concerns that the consensus, formed largely byMs Merkel and Nicolas Sarkozy, that cutting budget deficits should be the main goal of European governments was on the brink of collapse. The fall was exacerbated by the demise of the Dutch government amid failure to agree on budget cuts.

Centre-right Ms Merkel attempted to put a brave face on Mr Sarkozy's waning powers, with her spokesman declaring: "The Chancellor continues to support President Sarkozy."

While austerity has pushed down German borrowing costs, other countries have seen themselves punished by the financial markets. French10-year debt is now trading at yields of more than 3 per cent, compared with Germany's 1.6 per cent and Britain's2.1 per cent.

Mr Hollande believes too much emphasis is being placed on budget cuts, and not enough on measures for growth. Yesterday he declared that if he became President, it would be "the end of imposing austerity everywhere, austerity that brought desperation to people throughout Europe".

Mr Hollande is also keen for the role of the European Central Bank to be extended beyond just demanding austerity to include a remit of spurring growth, which could involve more exposure for German taxpayers to potential funding of the eurozone's weaker nations.

Mr Hollande plans to balance the French budget a year later than Mr Sarkozy, by 2017. Some economists point out that even this delayed timetable would still be remarkable in a country which has not had a balanced budget since 1979.

As the main plank of Mr Hollande's fightback against the Merkel mantra of austerity, he wants to renegotiate the Treaty on Stability, Co-ordination and Governance.

Those in the Merkel camp point out parallels with the former Prime Minister Lionel Jospin, whose finance minister at the time, Dominique Strauss-Kahn, renegotiated a similar "stability pact" with more focus on unemployment and growth in 1997. However, with the absence of German backing, France was unable to secure funding from the markets and the proposals largely foundered.

The downbeat data on the eurozone came from the research company Markit, whose survey found that the eurozone economy fell at its fastest rate for five months.

Stock markets in France, Germany, Spain and the UK fell between 1.8 per cent and 3 per cent.

Can "Mollande" work together?

What happens when Merkozy becomes Mollande? This key question is now exercising the minds of financial markets and political pundits as President Nicholas Sarkozy's grip on the Élysée Palace is weakened – perhaps fatally – by the Socialist challenger François Hollande.

Mr Sarkozy's relationship with the German Chancellor, Angela Merkel, has been tense at times, but by and large the two have been a formidable tag-team, bullying and cajoling by turns their European colleagues and driving through the so-called "fiscal compact" last December.

This mandates strict caps on government spending and borrowing, with deficits capped at 0.5 per cent of GDP, and it is here where Mr Hollande could find an early chill in his relations with Germany.

Citigroup's Jurgen Michels said: "Hollande confirmed that he would block the ratification of the Fiscal Compact Treaty if the proposal did not contain measures for growth. His argument is that Europe is suffering from a 'deficit of economic dynamism'."

Grant Lewis, the head of research at Daiwa Capital Markets Europe, said that on the big question of how the two would work together in a crisis like a Spanish bailout, the simple answer was that they would have little choice. He said: "You have to pull out all the stops no matter who you're working with."

Russell Lynch