12/12/2024
Source
By Desmond Lachman
It would never be a good time for France to have a governability crisis. However, it is a particularly bad time for it to have one when the country’s public debt is on a clearly unsustainable path and when president-elect Trump is threatening to impose a 10–20 percent tariff on US imports from Europe. This set of circumstances will pose major challenges to the European Central Bank (ECB) next year if it is to avoid another round of the Eurozone crisis centered this time on a country many times the size of that of Greece.
President Emanuel Macron’s rash decision in June to call a snap parliamentary election has led to a situation where his party has lost control of parliament and where last week his prime minister was forced out of office over a proposed austerity budget. This now leaves France without a government for at least a month or two. It also raises serious questions in the markets as to whether France has the political will to engage in budget belt-tightening to regain control over its public finances.
One measure of the seriousness of France’s budget troubles is the fact that its budget deficit has ballooned to over six percent of GDP. Another is that its public debt to GDP ratio has risen to over 110 percent or to a level more than 20 percentage points higher than that which prevailed during the Eurozone sovereign debt crisis. With French economic growth hovering at around one percent, there is little prospect that France can grow its way out of its debt problem.
The markets have taken note of the dangerous state of France’s public finances. The spread between the yields on French and German government bonds have jumped to their widest level since the 2012 Eurozone debt crisis. As a result, the French government is having to pay similar yields to those of the Greek government.
Beyond revealing the French government’s inability to engage in budget belt-tightening, the current crisis is exposing a basic flaw in the Euro’s structure that was first noted by American economists like Milton Friedman and Martin Feldstein at the time of the Euro’s 1999 launch. Stuck within a Euro straitjacket, France cannot engage in monetary policy loosening or currency depreciation to stimulate its export sector. This leaves it with no policy offset to the contractionary effect on aggregate demand of budget belt-tightening. This means that even if France had the political willingness to take corrective budget measures, it would risk causing a recession as occurred to a number of countries during the 2012 Eurozone debt crisis. Needless to add, punitive import tariffs by the United States would complicate an already difficult French economic situation.
Strictly speaking, the Treaty of Lisbon prohibits the ECB from financing a member country’s budget deficit by buying its bonds. However, France being the Eurozone’s second largest economy is far too big for the ECB to allow it to fail. This makes it likely that the ECB will be forced to use an untested lending facility that it has on its books from the last Eurozone sovereign debt crisis to keep France afloat.
Any ECB bailout of France will face legal challenges and cause a political backlash in Germany. This makes it likely that the ECB will only come to France’s rescue in the event that market conditions become disorderly and French government bond yields spike to high levels. It is also likely that as the price for any bailout, the ECB will require France to sign up to an IMF-style economic program to correct its public finances.
Before imposing punitive tariffs on imports from Europe, the incoming Trump administration might want to recall how the Greek debt crisis roiled US and world financial markets. It also might want to consider that the French crisis is playing out at a time that all is not well with the world economy. The Chinese economy is struggling in the wake of the bursting of its housing market bubble and the German economy is struggling and having governability problems of its own. Maybe if it takes these factors into consideration, the incoming administration might refrain from resorting to a destructive trade policy that could bring foreign economic and financial market troubles to our shores.