France, whose public finances have become unsustainable and whose politics have become dysfunctional, could pose an existential threat to the Euro. Being the Eurozone’s second-largest economy and being many times the size of Greece, France is too big to fail if the Euro is to survive. However, by the same token, it is far too big to bail, at least without IMF-like conditions being attached to such lending.
According to the IMF, France’s budget deficit is likely to remain at around six percent of GDP for as far as the eye can see. That is set to take the country’s public debt to GDP ratio to a Greek-like 128 percent by 2030. With taxes and public spending as high as 51 percent and 57 percent of GDP, respectively, France has little real option but to cut public spending if it is to regain public debt sustainability.
One reason to doubt that France will be able to rebalance its budget is that there is no political appetite for doing so. Both France’s far-left and far-right parties, which dominate the French National Assembly following the last French election, are opposed to budget belt-tightening. Underlining this point is the fact that President Macron has gone through four prime ministers over the last 20 months. All those prime ministers fell when they failed to get their budget belt-tightening budgets through the National Assembly.
Earlier this month, Macron named Sebastien Lecornu, a long-time loyalist, to serve as his new prime minister. Judging by the decidedly cool reception this appointment got from the far right and far left, there is little prospect that he will fare any better than his predecessors in making the much-needed corrections to the French budget. There also appears to be little prospect that the Assembly’s composition will change very much in the event of a new election.
The other reason to doubt that the budget deficit will be corrected is that France is stuck in a Euro straitjacket. That straitjacket precludes France from using exchange rate depreciation or monetary policy loosening as an offset to the contractionary effect of budget belt tightening. Worse yet, France will have to engage in budget belt-tightening at a time when the Euro has appreciated strongly and when France will have to cope with higher US import tariffs. This implies that even if France had the political will to correct its budget deficit, trying to do so would likely precipitate a French economic recession. Indeed, that was the experience of a number of countries during the 2010 Eurozone sovereign debt crisis. By eroding the tax base, a recession would highly complicate the attainment of the goal of getting the budget back into balance.
The precarious state of France’s public finances has not gone unnoticed by the rating agencies or the markets. The Fitch rating agency recently downgraded France to AA-, while Standard and Poor’s has put France on a negative outlook for its AA- rating. Meanwhile, French bond yields have now risen to levels similar to that of Italy, the Eurozone’s erstwhile enfant terrible, and the French bond spread with respect to Germany has risen to over 80 basis points or to its highest level since the 2010 Eurozone debt crisis.
In the period ahead, with a six percent of GDP budget deficit and large debt rollovers to make, the French government will have very high borrowing needs that investors will be reluctant to meet at current French government bond yields. With the far-right on the march in Germany, it is wishful thinking to believe that France will be bailed out by a large Eurobond issuance. The country’s only real hope is that it will be bailed out by the European Central Bank, which fortunately now has the tools to do so. However, given the large amount of French government bonds that the European Central Bank (ECB) would be required to buy, it is unlikely that the ECB would do so without attaching IMF-type conditionality to those loans. Currently, that would be anathema to France’s political class.
All of this makes it difficult to see how France will avoid an economic crisis next year. This raises a fundamental question for world financial markets. If in 2010, a Greek debt crisis roiled world financial markets, why will the same not occur over the coming year if we do have a debt crisis in France, a country whose economy is many times the size of that of Greece?