Daily: On France as the time bomb at the heart of Europe

Note: this daily will not have links as I am still on holiday. But, I will begin to post more in the coming week and resume a normal posting schedule next week.

Yesterday, Moody’s Investors Service finally downgraded the sovereign credit ratings for France from AAA. This was a long time coming because France’s sovereign fundamentals are no better than Spain’s and Spain is in the midst of a severe crisis. Look at the euro nations with the largest deterioration in their fiscal situation and France stands out with Slovakia as having the highest deficit of the non-crisis eurozone countries.

There are two ways to look at this. First, it could well be that the euro crisis is not just about debt and deficits since only Spain and Italy have been in the hot seat. That is the conclusion I have drawn. But, then to the degree that debt and deficits are indeed the problem, France will eventually be pushed into crisis. And that’s  what has a lot of people worried about the sovereign debt crisis.

I provocatively titled a post “Why France will be forced out of the eurozone last November, based on the work of Simon Tilford and Philip Whyte at the Centre for European Reform. Let me riff off of that post here to give a bit more color to what’s going on. If you are asking why the euro zone is in crisis and why France is a problem, here’s what the Centre had to say about the origins of the crisis:

The short answer is that the introduction of the euro spurred the emergence of enormous macroeconomic imbalances that were unsustainable, and that the eurozone has proved institutionally ill-equipped to tackle. North European policy-makers have been reluctant to accept this interpretation. For them, the crisis is not one of the eurozone itself, but of individual behaviour within it. If the eurozone is in difficulty, it is because of a few ‘bad apples’ in its ranks. In this interpretation, neither the design of the eurozone nor the behaviour of the ‘virtuous’ in the core were at fault.


The North European interpretation is by no means all wrong (no serious observer disputes that Greece grossly mismanaged its public finances). But it is damagingly partial and self-serving. It skates over the contribution played by the euro’s introduction to the rise of indebtedness in the periphery; it wrongly assigns all the blame for peripheral indebtedness to government profligacy; it makes no mention of the far from innocent role played by creditor countries in the run-up to the crisis; and it does not acknowledge how the it was wasted (perhaps unsurprisingly).

It is wrong, however, to blame government profligacy for the rise in peripheral indebtedness: Greece is the only country where this holds true. In Ireland and Spain, it was the private sector (particularly banks and households) that was to blame. Indeed, in 2007, the Spanish and Irish governments looked more virtuous than Germany’s: they had never broken the fiscal rules, had lower levels of public debt and ran budget surpluses.


The current crisis, then, is not simply a tale of fiscal irresponsibility and lost competitiveness in the eurozone’s geographical periphery. It is also about the unsustainable macroeconomic imbalances to which the launch of the euro contributed (in creditor and debtor countries); about the epic misallocation of capital by excessively leveraged absence of fiscal integration has exacerbated financial vulnerabilities and made the crisis harder to resolve.


On current policy trends, a wave of sovereign defaults and bank failures are unavoidable. Much of the currency union faces depression and deflation. The ECB and EFSF will not keep a lid on bond yields, with the result that countries will face unsustainably high borrowing costs and eventually default. This, in turn, will cripple these countries’ banking sectors, but they will be unable to raise the funds needed to recapitalise them. Stuck in a vicious deflationary circle, unable to borrow on affordable terms, and subject to quixotic and counter-productive fiscal and other rules for what support they do get from the EFSF and ECB, political support for continued membership will drain away.

Faced with a choice between permanent slump and rising debt burdens (as economic contraction and deflation leads to inexorable increases in debt), countries will elect to quit the currency union. At least that route will allow them to print money, recapitalise their banks and escape deflation. Once Spain or Italy opts for this, an unravelling of the eurozone will be unstoppable. Investors will not believe that France could continue to participate in a core euro: the country has weak public finances and a sizeable external deficit.

I agree with this. Now, the text was written before the ECB decided to go all-in, do, as Mario Draghi put it, “whatever it takes” to save the euro. But the outlines are still the same: the crisis is about an unsustainable macro balance in a fixed currency zone with the only policy solution on the table acting to worsen the deflationary forces inherent in this situation. It is a disaster. So, regardless of how Moody’s spins why it is downgrading France, we should see France as a problem because it would be the next domino to fall in the euro experiment. And that is one domino to many. The whole thing would collapse.

The Economist aptly had France on its cover this week as the cover story in a post calling France “the time-bomb at the heart of Europe“.

The threat of the euro’s collapse has abated for the moment, but putting the single currency right will involve years of pain. The pressure for reform and budget cuts is fiercest in Greece, Portugal, Spain and Italy, which all saw mass strikes and clashes with police this week (see article). But ahead looms a bigger problem that could dwarf any of these: France.

The country has always been at the heart of the euro, as of the European Union. President François Mitterrand argued for the single currency because he hoped to bolster French influence in an EU that would otherwise fall under the sway of a unified Germany. France has gained from the euro: it is borrowing at record low rates and has avoided the troubles of the Mediterranean. Yet even before May, when François Hollande became the country’s first Socialist president since Mitterrand, France had ceded leadership in the euro crisis to Germany. And now its economy looks increasingly vulnerable as well.


France still has many strengths, but its weaknesses have been laid bare by the euro crisis. For years it has been losing competitiveness to Germany and the trend has accelerated as the Germans have cut costs and pushed through big reforms. Without the option of currency devaluation, France has resorted to public spending and debt. Even as other EU countries have curbed the reach of the state, it has grown in France to consume almost 57% of GDP, the highest share in the euro zone. Because of the failure to balance a single budget since 1981, public debt has risen from 22% of GDP then to over 90% now.

This is a big problem. Question: can France get away with continued high deficits when Spain and Italy are cutting? The 2013 French budget is not very austere and we have already identified France as one of two non-periphery states with a remarkable deterioration in its fiscal outlook. Meanwhile Hollande is adding to future fiscal promises by lowering the retirement age to 62. How is that going to work for France, a currency user in a fixed exchange rate environment? It’s not. There’s no printing press to bail the French out. France is where the music stops.

Further reading: So much to do, so little time, The Economist

Update: below is the Economist’s video on the French situation which I think gets at the heart of the issue well.

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