France is pushing its luck. The country has long enjoyed an “exorbitant privilege” within the EU, able to borrow at rock-bottom German rates because it is deemed to be the twin-anchor of the European project.
Markets assume that the EU institutions will always coddle France whatever it does. We may soon find out whether this is a political narrative beyond its sell-by date.
There is a high likelihood that the Barnier government will collapse over the next month without passing a budget, unable to rein in runaway fiscal deficits that subvert the cohesion of monetary union.
“The governability of France is being called into question more than I have ever seen in my lifetime,” said Moritz Kraemer, ex-head of sovereign ratings at Standard & Poor’s.
The risk spread of 10-year French bonds over German Bunds spiked to 83 points on Tuesday, the highest since the eurozone bond crisis in 2012, though that metric does not fully capture the underlying gravity of events.
“The markets are waiting for a credible response but nobody can see where it is going to come from and there doesn’t seem to be any sense of urgency,” said Mr Kraemer, now chief economist at the German Landesbank LBBW.
“The French are playing with fire. Nobody in the markets still thinks that France is still part of the eurozone core. These spreads are a loud and clear warning,” he said.
His words have weight. S&P will decide on Friday whether to downgrade French debt yet further, after cutting the rating to AA- in May.
France is not at any imminent risk of a Greek default crisis, any more than Britain was at risk during the Truss mini-storm. But it is moving into the grey zone.
Mr Kraemer said the European Central Bank may ultimately be forced to intervene, invoking its untested “spread protection tool” (TPI) to buy French debt on the open market. “This could only go on for a couple of months; then there would have to be a proper adjustment,” he said.
This would require combined action by the International Monetary Fund and EU’s bail-out fund (ESM), together imposing the IMF’s usual medicine of spending cuts, tax rises, and harsh reform – if they could even handle a big beast with €3.3 trillion (£2.8 trillion) of public debt.
“It would be really brutal upfront austerity. The politics would be absolutely toxic because the ECB’s president is a former French finance minister,” he said.
Any use of the rescue machinery would require the assent of the German Bundestag, the Dutch Tweede Kamer and the northern creditor states. It is hard to imagine a more explosive political showdown.
The chances that the current French parliament would agree to draconian terms is close to zero. Two prickly animals hold the balance of power: the Left-wing Popular Front, and the Right-wing National Rally. Both defend France’s sacred – and unaffordable – welfare model.
The EU’s Mercosur trade treaty with Latin America adds another stick of political dynamite to the mix. If this treaty is imposed on France against its vehement protest – as seems likely – it risks an emotional rupture between the French people and the EU power structure.
For now there seems to be a widespread assumption that the ECB will suppress French bond yields as it did for Italy over the years. As cynics say, isn’t that why Emmanuel Macron pushed so hard to secure the top job for France’s Christine Lagarde?
But the institution can no longer mop up Club Med debt with no questions asked under the cover of quantitative easing. Post-Covid inflation has made this patently illegal. Any attempt to do so at scale would lead to a knife-fight within the governing council.
The French government understands the risks as the budget deficit hits 6.1pc of GDP this year and heads for structurally higher levels through the 2020s. “If we don’t act, the mechanical dynamic of public spending could push it to 7pc in 2025,” said Laurent Saint-Martin, the budget minister.
Premier Michel Barnier wants fiscal tightening of €60bn – in reality nearer €45bn – in mixed cuts and taxes, warning of a debt trap as interest service costs spiral higher. “Retrenchment is unavoidable, otherwise we are heading straight into a financial crisis,” he said last month.
Yet he cannot even count on the parties of his own loose coalition. His finance minister – a Macron loyalist – has publicly rebuked him for trying to raise taxes. Other Macronistes are acting as if they are in opposition. Party discipline has disintegrated.
The National Assembly has become a seething hotbed of self-promoting potentates pursuing their own power plays. It is an unedifying spectacle.
The government survives on the sufferance of National Rally’s Marine Le Pen, poetic justice after an election manipulated to deprive her 11m voters of genuine franchise.
As Henry Samuel reports from our Paris bureau, Le Pen is threatening to plant the “kiss of death” on the hapless coalition by joining the Left in a vote of no confidence triggered by attempts to force through the budget by decree power.
She has imposed a “red line” over the cost of living. The real reason is that 73pc of her party’s supporters want rid of Mr Barnier, one of the last great gentlemen of modern politics.
Professor Thomas Mayer, ex-chief economist at Deutsche Bank and author of Europe’s Unfinished Currency, said the political foundations of monetary union are coming apart. “The eurozone core is melting down. Markets can see that public finances are out of control and that France is moving into the Italian camp,” he said.
The German economic establishment is splitting into two camps as it watches the soap opera unfold. “The orthodox view is that Germany must stick to sound finances even if it becomes the sole anchor of the euro. At least we will still have a halfway respectable currency,” he said.
“The second view you are hearing more and more is that if others don’t bother, why should we? To hell with it, let’s just get rid of our debt-brake, and if the euro goes down the drain, that’s just too bad. The coalition imploded over this,” said Prof Mayer, now director of the Flossbach von Storch Research Institute.
“What you are seeing in the bond markets is that investors are beginning to doubt whether the German debt-brake will continue,” he said. Danish yields are now 20 points below German yields even though the krone is pegged to the euro. This is unprecedented.
Prof Mayer said the EU had turned into a bureaucratic leviathan that posed an increasing threat to Germany’s fundamental interests.
“Our government is going to have to confront the European Commission head on. It is imposing more and more directives on everything. It is impinging on personal freedoms, on production, on supply chains. It’s simply horrific,” he said.
“I don’t know how long Scandinavians will go along with it, or the Netherlands: they can all see the writing on the wall,” he said.
One thing is absolutely clear: President Macron’s “grand bargain” with Berlin has failed. He came to power in 2017 pledging to restore fiscal probity and make France fit for the euro. This would supposedly unlock German assent for a “Hamiltonian” leap forward: joint debt issuance and a muscular EU treasury with borrowing powers.
“It is dead in the water. There is no realistic constellation of political parties in Germany that would agree to it,” said Mr Kraemer.
France will probably muddle through and avert a full-blown financial crisis for now. But the larger damage is done.
There will be no fiscal union after all. Without that the euro is a chronically unstable construction on borrowed time.
France is playing with fire: an IMF bailout is no longer unthinkable
The collapse of the European project’s twin-anchor threatens dramatic consequences for the Continent