Merlin Weekly Macro: France’s fiscal woes expose Eurozone faultlines

France: “Another one bites the dust”

As the soothsayer’s poking of the chicken’s entrails foretold, French Prime Minister Beyrou was duly evicted from office in the recent no-confidence vote concerning his proposals to restore fiscal stability.  It would have been far more surprising had he won and survived.  Now tasking Beyrou’s successor with not only forming a group of ministers with whom to work but creating a government which can govern, President Macron has passed the poisoned chalice to a centrist and fellow Renaissance Party hack, former Defence Minister Sebastien Lecornu.  Bonne chance, mon brave! Extrapolating history, he too will be no more than a memory in less than a year.  By the time Macron leaves office in 2027, France may have had one if not two further hapless holders, what would be the eighth and ninth with the title of prime minister in Macron’s presidency, in office but most certainly not in power. 

Imagine France as an economic and political battleship.  In its present condition it is a derelict.  The admiral is isolated on his bridge; the new captain knows that virtually all his own predecessors have been thrown overboard; the crew is divided and mutinous; the ship itself is engineless and rudderless and leaking through every joint and rivet in its hull; safe harbour is way beyond the horizon.  In the Good Old Days familiar to those of us of a generation brought up on conventional economic theory, such political turmoil, economic prolapse and fiscal dysfunction would have led to a full-blown financial crisis: investors would have run a mile from French bonds, the currency would have been dumped like so much toxic waste, there would have been a run on the banks and social breakdown and rioting on the streets.  The International Monetary Fund would be stepping in to take control and restore order.

Certainly, there is a pronounced air of despondency and frustration.  Unrest too as principally left-wing activists including students, teachers and the Gilets Jaunes demonstrate under the banner of “BLOCK EVERYTHING!”.  But the evidence of financial panic or distress, either domestically or internationally, is simply not there.  At 3.44% the yield on the French government 10-year bond has barely shifted and the risk premium over its benchmark German counterpart is a mere 77 basis points (0.77 of a percentage point; 100bp = 1 percentage point), and remarkably constant.  Admittedly, France has the new embarrassment of trading either at par with or a yield premium to what used to be regarded as fellow fiscally incontinent “Club Med” peers in the eurozone (Italy 3.47%; Spain 3.22%; Greece 3.35%) but these countries, plus Portugal (3.06%), have been on a demonstrable path towards instilling fiscal discipline even if the job is not yet complete.  Not so France where there is no question of completing the job: the intractable problem is establishing a consensus even to get it started.

French bonds: understanding the illusion of stability

The question is why? Why are investors relatively relaxed about what by rights should be a moment of incipient panic as France heads for the rocks, especially given its position as a G7 economy and the second largest in the eurozone.  We described last week that it falls into the category of “too big to fail” and so it will not be allowed to.  And the principal reason is precisely because it is not only in the eurozone but is one of its cornerstone members.  If France fails, so does the eurozone and with it its central currency and the national bond markets of 20 countries in aggregate accounting for 14% of global GDP.  The euro is the second most traded currency on the planet, second only to the dollar, and it is one of only five accorded membership of the collective Special Drawing Rights group of reserve currencies (the dollar, renminbi, sterling, the yen and the euro itself) which together are the pitprops underpinning the global financial and settlements systems.  The knock-on effects would be catastrophic.

Usually in circumstances such as this, the sharks who are the speculators are circling, ready to assault the foundering unfortunate, making a killing as they wreak their own brand of mayhem from falling prices.  Without wishing to tempt fate, even those who use sophisticated practices and instruments to benefit from shorting and arbitraging by deliberately dislocating markets and creating instability, know that the stakes are ridiculously high.  But they are also aware that following a not dissimilar episode with Italy a couple of years ago, after being caught flat-footed and off balance the European Central Bank recovered its composure and immediately put in place emergency stabilising mechanisms to prevent differential national yields between eurozone members’ bonds and those of Germany ballooning beyond what was deemed a critical maximum tipping point of 150bp.  Instituting this “anti-fragmentation policy” termed Transmission Protection Instruments (TPIs), the ECB would simultaneously deploy quantitative tightening and quantitative easing, in the former case selling the bonds of financially secure countries (predominantly Germany, but also including Holland) to drive their yields up, and buying the bonds of the ones under threat (i.e.  Italy at the time, France now etc) to keep their yields down.  The resulting differential (or “spread” in the market lingo) could be kept within reasonable safety limits.  While respecting the need for stability in the common interest, nevertheless such policies adopted by the ECB raised political hackles in Germany that, yet again, Germany was having to bear the brunt through higher government borrowing costs imposed by the independent, unelected central bank, to maintain financial stability among neighbours whose governments were either fiscally illiterate or persistently incontinent.

Shaky foundations

Mechanically, whether as a warning to speculators not to bother taking on the ECB, or in practice as a means of achieving financial stability, it has worked.  But what it has also done is to expose the gaping structural weakness in the foundations of the eurozone and indeed the broader European Union: it is simply neither a competent nor coherent economic or financial system.

It might have monetary union to the extent that 20 countries are bound by a single currency (and therefore exchange rate and interest rate), but there it ends.  There is no fiscal union to complement monetary union: instead, 20 countries pursue their own individual fiscal and social policies while having zero control over their interest rate, and each has lost the natural safety valve of its own exchange rate when national current accounts (the differential between imports and exports) are out of equilibrium.  Further, the necessity for TPIs is a tacit admission of this structural weakness and the fact that differential bond purchasing and selling tactics are required to manage national yield spreads to hold the whole together explodes the myth of universally applied monetary union.  TPIs would not be necessary were there debt union (the eurozone has neither a central treasury nor a conventional budget as normal sovereign countries do, so has no centralised debt issuing authority).  But debt union logically requires fiscal union, and in a democratic system fiscal union is unthinkable without political union. Political union is underwritten by the fundamental principle of “No Taxation Without Representation”, i.e.  the full, direct enfranchisement of the electorate and the ability to vote out unpopular governments (enfranchisement of course has the advantage of conferring the legitimacy and authority of a popular mandate to the winning party or coalition, though the UK is doing a good job of disproving the point).

The prospect of European political union is vanishingly small.  Popular support for the European Dream peaked on the formation of the euro a quarter century ago and has receded ever since.  The pressures created by immigration, the threat from Russia, economic inequality and the reactions to Europe’s loss of influence have only added to political division, populism and polarisation.

An accidental monster

No sane person would invent what today exists as the eurozone from scratch and think it complete.  It was never intended as such.  Lack of leadership never got it off first base let alone achieving the original political aim of full integration and the creation of a single European state.

What has emerged is Frankenstein masquerading as a fully-formed human: it has some of the appearance of a homogenous, sentient entity, but is in fact no more than bits and bobs bolted and stitched together with copious sticking plasters stuck over the many gaps and rough patches.  It cannot go back: economically and financially it cannot and must not disintegrate in a disorderly fashion; equally it finds itself in the position that the next logical step, full integration, is impossible.  Introvert by circumstance but struggling to find its place in the world with delusions of being a global superpower to rank alongside the US and China as an equal, today it finds itself like an adolescent orphan. Trump detests it and gives it no more attention than an afterthought; Putin has nothing but contempt for it; China sees it as weak but occasionally pathetically useful when it comes bearing ingratiating gifts of capital and investment and has no time for its platitudes about the Chinese Communist Party needing to conform to western values and European norms for human rights.

But needing to do something to demonstrate progress and self-justification, its natural tendency while holding itself together, is centralisation of control.  The main preoccupations of which are the removal of internal competition through regulation, and as a defensive measure to safeguard jobs and industry the promotion of EU protection mechanisms against international competition.  Centralisation is an evolving process, perceptibly encroaching on national sovereignties including but not restricted to: defence procurement; pan-EU policies on the path to carbon net-zero; pharma regulation and procurement; tax harmonisation; and the biggest of all, through the closed shop of the customs union, total responsibility for negotiating trade terms and treaties with EU counterparties.

How not to win friends and influence people

Today, another is looming, as one headline put it a new “Brussels Land Grab”.  That it was the Eurosceptic Daily Telegraph does not alter the facts: taxation has so far strictly been the domain of national governments and their domestic electorates; however, the European Commission is now seeking tax-raising powers of its own as its sphere of operations expands and the need for a budget to fund them becomes a necessity.  Under the existing financial framework, the annual membership contributions from the wealthy countries are insufficient to cover the grants and subsidies to the poorer ones, especially given that national domestic budgets are under pressure during this prolonged period of economic under-performance and near-stagnation.

Preparing its next Multi-Annual Financial Framework expenditure programme spanning 2028-34, the Commission has plans to nearly double expenditure over the period from €1.2 trillion in the current period to €2 trillion.  Given that most of the big EU economies fail the most basic financial tests for the maintenance of the Bloc’s stability (the main limits of which are annual budget deficits of no more than 3% of GDP and government borrowings not to exceed 60% of GDP, the strictness of which has already had to be relaxed to averages over a period because of the extent of persistent delinquency and Brussels’ inability to bring offenders to heel), forcing more financial burden by way of contributions to Brussels on to such countries is both self-defeating and hypocritical.

The alternative is simple: raise what is needed through additional corporation taxes on “large companies” (defined as those with more than €100m of gross revenue) operating in the EU; Commission President Ursula von der Leyen also proposes additional pan-European sectoral taxes and levies, including on proceeds from trading emissions credits and revenues associated with vaping products.

If the EU is seeking foreign inward investment, levying new access taxes on companies simply for the privilege of operating in the EU is most certainly the wrong way of going about it.

Sceptics within the Bloc suspect this as representing the thin end of the wedge towards progressive centralised tax policies which one day might include direct taxation on individuals.  All in a good cause, of course.

Exceeding her mandate

Von der Leyen is playing with fire unless fundamental governance reform is in the offing too.  Today, constitutionally the Commission (the executive/civil service) derives its authority from the Council of Ministers with policies sanctioned by the European Parliament.  The reality is that through increasingly centralised policy-making, the powers and influence of the Council are being gradually but perceptibly eroded by the unelected Commission (the Commission President is ostensibly “elected”; in practice the eventual appointment is a political mash-up, a compromise among national leaders from a pre-determined list of candidates amid much horse-trading about who is the is the most amenable or more accurately the least objectionable to the majority) while Parliament is so divorced from the electorate and structurally inferior to both the Commission and the European Court of Justice as to be little more than a rubber-stamping forum and talking-shop.  Without governance reform, the electorate becomes increasingly detached and irrelevant.

Pondering the medium-term horizon

We must all be grateful that, like Italy and Greece before it (and many painful lessons were learned in both cases), a financial melt-down has been averted in the French crisis.  But we must also recognise that the risks of a systemic failure remain while the eurozone lacks structural integrity and, that in the absence of a homogenous system combining monetary and fiscal union, achieving a confident, match-fit, competitive economy with enduring growth and improving prosperity is an uphill struggle.  The longer-term political consequences, and by extension the unpredictability of investment risks, are obvious.       

Perhaps the greatest test is yet to come.  Towards the end of the decade, contemplate the possibility (and increasing probability) of a far-right deeply Eurosceptic National Rally government in France; in Germany a far-right dominated coalition led by the equally Eurosceptic Alternative fur Deutschland, or just as risky, a weak coalition from which the AfD has been deliberately excluded despite winning the popular mandate; and cheerfully pouring petrol on fiery waters from the sidelines, a Farage-led Reform government in the UK.  Whatever your own political opinions and proclivities, from an investment risk standpoint one to ponder.

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