European markets have to adjust to new political and bond market realities

As President Macron is left looking for allies, the ECB looks for unity on Southern state borrowing.

| 7 min read

Last week President Macron's Ensemble parties lost 102 seats in the French Parliament and slipped into being the largest minority party.

The big winners in the election were the left alliance called the New Ecological and Social Popular Union, or NUPES, which gained 131 seats, and National Rally, Madame Le Pen's party with 89. The Republicans, the old centre-right party of France slumped to 7% in the poll and to 61 seats in a 577-seat chamber.

Consequences for Europe

A disconsolate Prime Minister is left looking for allies amongst the less committed newly-elected MPs, seeking those with pro-EU views and a willingness to compromise with Ensemble. The government may decide it has to live from vote to vote as a minority government, seeking allies issue by issue for the things it wishes or needs to do. It may find some MPs or small parties willing to consider a more formal arrangement. The first response of NUPES, National Rally and the Republicans is they wish to be in opposition, united only by their dislike of President Macron's approach.

This has immediate consequences both for the government of France and for the wider Europe. It seems unlikely now President Macron can carry out much of his change programme, which was to include raising the pension age from 62 to 65, continuing with more market-oriented reforms, trimming welfare and cutting some taxes. He will be diverted more to foreign policy and to his role as European statesman. Here he will have more freedom of manoeuvre than on domestic, economic and social policy.

There is considerable disillusion with national politics in France, with 53% not voting in the recent Parliamentary election.

If it becomes impossible to get through budgets and other necessities he may end up calling a new election, though to do so he would need to see some change of mood towards his plans. There is considerable disillusion with national politics in France, with 53% not voting in the recent Parliamentary election. Almost half of those who did turn out voted for an anti-establishment left alliance that wants to go much further and faster with green policies and extra public spending, or an anti-establishment right-wing party that wants to limit immigration and be tougher on law and order. These trends are a bit of a worry for the EU, as they represent an outbreak of a more nationalist approach to policy making over a range of issues.

Merkel's crown untouched

Mrs Merkel's crown as unelected political head of the EU has still not been fully grasped by either President Macron or Chancellor Scholz of Germany. The EU always felt it could turn to Mrs Merkel when it was divided or unsure and get her to chair a meeting to find a compromise and to speak for the European view that emerged. Chancellor Scholz presides over a difficult three-party coalition where there is often an unsureness of view over important matters of the day. The Free Democrats are more market-oriented and the Greens are wedded to a tougher approach to net zero. He does not seem as willing as Mrs Merkel to assume the most senior unofficial role in the EU.

President Macron who is trying to be the voice for a more interventionist EU in the wider world, seeking to develop a more muscular foreign policy, has had a setback without the support of a majority in the French Parliament. He now has to listen more to voices who are not so keen on compliant membership of the economic and social parts of the EU dossiers.

Southern state borrowing causes worries

The EU's main worries lie again in the south. The European Central Bank (ECB) has gone away to work out a better answer to the question of how can they keep the costs of state borrowing by Greece, Italy, Portugal and Spain down without violating the rule that they should not directly finance a member state government nor give it a subsidy or bailout to assist.

They accept there will be divergences between the Greek and German cost of borrowing, given different views of credit worthiness, amounts of debt advanced and the growth of the underlying economy and tax base. The ECB has implied it will use some of the money it receives in repayments for maturing bonds it owns to buy more Greek and Italian debt to keep the price up a bit. The EU as a whole needs to review how much money it can borrow on its own covenant to transfer more cash to the deficit-ridden south. The main programmes to date are geared to major investment in a carbon-free future and favour Italy and Greece given their financing needs.

If the ECB is serious about narrowing the gap between the costs of government borrowing for Greece and Italy compared to Germany, it may need to consider selling some of the lower interest rate country bonds it owns and buying more of the southern states' debts. That would skew the liquidity, applying more of a squeeze to the surplus countries and offering a looser policy for the deficit countries.

8% inflation and favoured support for Greece and Italy were not in the script Germany wanted.

This will not please Germans who hold to the traditional view of the Euro. When it was set up, a reluctant Germany agreed on the basis that each member state would be responsible for its own budgets and borrowings and would pay a market rate of interest based on its individual credit worthiness. Germany was also reassured the ECB would exert a tough central discipline against inflation. Both these promises have been scaled back by the events of the last few years. 8% inflation and favoured support for Greece and Italy were not in the script Germany wanted.

Chancellor Scholz will live with this and accept it is part of the price of trying to bring about greater European unification. Others in Germany will be looking to see if there can be further legal challenges to easy money and support for deficit countries, forcing the ECB to proceed carefully. The ECB will have plenty of legal advice itself and look to the ultimate support of the European Court of Justice, a Court which buys into the mission of ever greater union.

Lawyers on both sides will be out to interpret Articles 123 and 125 of the Treaty of the functioning of the EU about monetary financing in ways that help their case. These arguments add to the uncertainties that worry investors in the Euro area, as it struggles to adapt to the need for higher interest rates.

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European markets have to adjust to new political and bond market realities

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