If, as opinion polls suggest, the French Socialist Party’s presidential candidate, Francois Hollande, ousts Nicolas Sarkozy in elections this spring, the euro area may be in for a new wave of instability with far-reaching consequences for financial markets and the euro system itself.

The elections are, of course, important above all for France. But they can also be seen as a referendum on the German approach to redesigning Europe’s single currency. This is an approach that Sarkozy has supported, but that Hollande is targeting for attack in his election campaign. Small wonder then that German Chancellor Angela Merkel has offered to campaign on Sarkozy’s behalf.

If the mechanics and details of the so-called fiscal compact for Europe are the “breaking news” here, the real substance of the euro debate concerns the sensitive issues of sovereignty and national self-determination that a well-founded common-currency design has to invoke. It is these that ultimately will determine if and how European integration will evolve.

We already saw a skirmish in this underlying debate when it was revealed that in negotiations over the fiscal compact, Germany proposed to put a European commissioner in charge of Greece’s budgetary policy. This was instantly ruled out by Greek Finance Minister Evangelos Venizelos, as well as by European Commission officials, and we can assume the proposal won’t resurface. But, the German attempt reflected a truth: If European leaders are serious about fiscal and political integration, then a key component is the transfer of budgetary sovereignty to European institutions.

Enter Hollande

Enter Francois Hollande. On the campaign trail, Hollande has articulated everything that is wrong with, or missing from, “Merkozy’s” current approach to integration. This approach has led to the fiscal compact, which in reality is less a path to real fiscal integration than a dusted-off and beefed-up Stability and Growth Pact, the agreement that was supposed to keep euro-area deficits in check but was never enforced. Hollande has said he wants to renegotiate the compact, which he has called a “betrayal of French sovereignty and democracy.”

Hollande has come out in favor of a series of key goals that even euro skeptics would concede are essential to the integrity and survival of the euro area. These include a strong and specific emphasis on measures to spur economic growth, both nationally and at the level of European institutions; a more activist policy by the European Central Bank with regard to sovereign-bond purchases; a well-resourced bailout fund or firewall; and, significantly, joint and severally issued euro-area bonds.

If elected to office, it’s possible that Hollande might not be as assertive in pursuing some of these goals, while the threat to renegotiate the compact might evolve into a program to amend and enhance it. However, what is striking about Hollande’s declared platform is that he is backing concrete proposals to make a fiscal union work that Germany, for the most part, implacably opposes. Think about it.

You have to have economic growth to change the perception about sovereign solvency. This requires not a one-sided adjustment in the form of relentless austerity in debtor states, but a symmetric arrangement that involves creditors, too -- primarily Germany. You cannot solve structural external imbalances successfully unless creditors also take some of the responsibility for growth and changes, including higher inflation rates in their own economies.

Shielding Sovereigns

To shield nations, such as Italy, that are still solvent but face liquidity problems, and to fund euro imbalances while economic adjustment is proceeding, you need a big enough firewall plus the year-to-year bridging finance that only the ECB can provide. And no fiscal integration makes sense unless you put in place a commitment to, and timetable for, euro-area bonds, so that all sovereigns stand behind one another and no sovereign instruments are distinguishable according to country or national credit rating.

So, could Francois Hollande become the French president who stands up to Angela Merkel and says the current goal of a Teutonic-style euro area is a path to a permanent austerity zone, laid with land mines of social unrest? Italian Prime Minister Mario Monti, who has won back respect for his country in Europe’s political and economic circles, has already told the German leader something similar. But if the leader of France -- the euro’s second-biggest economy -- were on board, he could act as a lightning rod for rising European opposition to the German approach to integration. If that happens, the future of fiscal integration in the euro zone may be called into question again.

The immediate issue would be how the ECB might respond if it felt the momentum behind the fiscal compact was stalling or that it was hostage to new divisions. It seems most unlikely that the Governing Council would continue to deploy financial largess, as it does now.

More than that, how would Germany react? Especially in view of the recovery in poll ratings that Merkel and her party have seen lately? Remember, Germany’s national self-determination and sovereignty also are at stake. The country’s opposition to many of the things that Hollande and others favor, in particular the creation of euro-area bonds, is based on Germany’s refusal to hand the Bundestag’s budgetary sovereignty to a European institution on a continuing basis, at least until such time as the fiscal compact is cast in stone and functioning as Germany desires.

Bridge Too Far

The surrender of sovereignty to achieve full fiscal union is as much a bridge too far for Germany as handing over budgetary control to external forces is for Greece. This is not about pro- or anti-Europe posturing, but about national and sovereign interests that conflict in a politically integrated euro area.

Germany wants a federal Europe, built around a rules-based fiscal Ordnung, or discipline, which would be enforced by supranational institutions, such as the European Commission and the European Court of Justice. Officials in Berlin want to see this new order firmly established before considering bigger concessions over their nation’s fiscal sovereignty. France prefers that power reside in the European Council, which collects the heads of state of the member countries. Louis XIV’s dictum “L’etat, c’est moi” is anything but an abstract concept to this day in the Fifth Republic. Hollande would like to see Germany make concessions on its fiscal sovereignty upfront.

Those tensions suggest the French elections may prove to be the catalyst for a further bout of jitters in Europe.

(George Magnus is a senior economic adviser at UBS AG. The opinions expressed are his own.)

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To contact the writer of this article: George Magnus at george.magnus@ubs.com

To contact the editor responsible for this article: Marc Champion at mchampion7@bloomberg.net