The French budget crisis

The latest growth figures show a weak Euro-area economy, with Germany stagnant, France at an annual gross domestic product (GDP) growth of 1%, Ireland negative and Italy at 0.6%.

The forward-looking purchasing managers index (PMIs) for the European Union (EU) reveals a weak position. In November, the composite fell to 48.1 from 50, with manufacturing down at 45.1 and services moving to a negative 49.2. A PMI reading under 50 represents a contraction while a reading at 50 indicates no change. The further away from 50, the greater the level of change.

These downwards moves were led by France and Germany. France is seeing a decline in services after the summer Olympics boost to activity. The big uncertainties over trying to pass a French budget and the large borrowing requirement are worrying markets.

Germany is seeing the consequences of weaker industrial activity – and the threat of job losses flow through to the service sector. In a unitary state, you would expect some combination of fiscal and monetary stimulus to be considered. Where an independent central bank still faced inflationary issues, as in the US in 2023, there was still a fiscal boost. The EU is more circumscribed by its rules-based system embedded in the treaty that governs them.

The European Central Bank

The European Central Bank (ECB) is seen by the markets as the best hope of coming to the rescue. They have started their reductions in intertest rates and are widely expected to deliver more. The central bank did a great deal over the pandemic period with its quantitative easing policy. It now holds €4.341 trillion of government bonds from the Eurozone countries for monetary purposes. It is running these off as the bonds mature.

The ECB is keen to influence government bond interest rates throughout the zone and wishes to avoid a big difference between the borrowing costs of the lower indebted countries such as Germany and the higher indebted countries like Italy and Greece. It accepts there will be some difference of borrowing cost because it does not guarantee the debts and wants there to be some market signal to highly borrowed countries to borrow less.

After a first wobble by ECB resident Christine Lagarde, the central bank has managed to keep spreads between Eurozone countries within a reasonable band, by setting out that it would intervene to stop an extreme widening between the highest and lowest country interest rates. In recent days, French bond yields have risen. This reflects the difficulties in passing a budget that might start to tackle excessive borrowings. The ECB will need to manage this stress.

The EU is itself becoming a larger borrower, issuing bonds to help pay for the Covid recovery costs and the funding for the green transition. A member of the ECB board has recently commented on this development: “What we want to have is a minimum of EU-level bonds and also national bonds of as high a quality as possible”. He shies away from any discussion of superior quality for EU bonds and adds they do not “pretend that Europe is going to move towards a federal model like that of the USA” where federal debt dominates and is more widely acceptable than individual state debt.

In the EU, state debt enjoys the sovereign quality of being backed by the tax revenue of the country. Individual member states do not enjoy the sovereign power for the central bank to create money to repay state debt if necessary.

The ECB performs a very important role in the Euro system of commercial banks and the settlement of government and private sector transactions. The ECB runs a system of Target 2 balances, allowing individual countries to borrow to cover shortfalls and to deposit to hold surpluses. This was originally designed to deal with day-by-day fluctuations but has become an important part of the system.

Germany currently lends the ECB €1,073bn, whilst Italy borrows €446bn and Spain €446bn. This is all at zero interest rates and has become a longer-term part of the system adjusting to different levels of economic performance between members. It is a kind of concealed regional policy.

The ECB’s recent report on the Euro-area says that “financial stability vulnerabilities remain elevated”. It draws attention to fragile and low growth, trade uncertainties, high valuations and risk concentrations. It queries the sustainability of some government bond financing, given low revenues, poor growth and rising spending.

The EU will always stress the need of individual member states to be able to service their own debts. They emphasise that their individual central banks must control their own balance sheets and look to the government of the member state to put in capital if needed, even though they are agents of the ECB for monetary policy and need to carry out ECB instructions.

The member states

The prevalence of proportional representation systems of voting has encouraged a wide choice of political parties in many countries, making it very difficult for any one party to win a majority and to implement its manifesto programme.

The lack of clarity over whether EU or national actions are having most impact on the results of policy also makes it more difficult for voters to see their votes translated into actions they support. There has been widespread unhappiness about low growth, recent high inflation, and the difficulty of providing for a large number of new migrants. As a result, we have seen waves of challenger parties emerge in Greece, Spain, Netherlands, Germany, France and others bringing about the temporary or permanent eclipse of the old Christian Democrat centre right parties and old Social Democrat centre left parties.

More people vote for parties that could shock the system. Increasingly they want much lower rates of migration. Those to the left want higher levels of public spending and those to the right want lower taxes. None of them campaign for the lower deficits that EU prudence and sometimes markets seek.

The German election is heading for a bad result for the three coalition parties of the last government. Whilst the Christian Democratic Union (CDU) and their Bavarian sister party should be top of the poll, they are unlikely to win a majority. Coalition building could be difficult as the CDU are unlikely to want to govern with the AFD as partners.

In France an early election produced a three-way split in the National Assembly and no ability to form a government that can reliably win votes in the Parliament. The budget remans a big hurdle, with the €60bn of spending cuts and tax rises unpalatable to both left and right in the National Assembly. Even that degree of austerity will leave France well short of hitting the 3% budget deficit target the EU sets out in the Treaty.

The states all want to spend more and are not keen to raise taxes which are already very high compared to the US. The EU is taking a leisurely approach to enforcing the excessive deficits procedure, though is now reviewing the worst cases and trying to get them to take action.

It means there is little scope for reflationary action via any intended fiscal expansion, as most are under orders to rein in spending and or put up taxes. Germany could expand its deficit under EU rules but has its own tougher budget controls that parliament would have to amend to allow a reflationary budget. The CDU has said it might consider relaxing the control for suitable investment expenditure but not for current spending.

There will be pressures for more defence spending by the EU countries given the perceived threats from the China/Russia bloc and as a result of the election of President Trump. Somehow budgets will need to accommodate this spending pressure on top of all the others.

Tariffs and Trump

We now know that China, Mexico and Canada are the top targets for US tariffs and for use of tariffs as a weapon to force policy change. The EU is not popular with Mr Trump as they have been critical of him and are planning defences against his policies. He still thinks some European NATO members do not contribute enough and will be expecting the EU to shoulder more of the burden of European defence.

Mr Trump is well disposed towards Brexit and friendly with Nigel Farage, the leader of the challenger Reform party in the UK. Mr Trump might compound the difficulties of the European car industry with a tariff on their car exports and other items, leading to retaliatory tariffs against the US by the EU. Both sides will suffer from such a development.

Conclusion

The EU cannot afford fiscal stimulus and, in leading cases like France, is seeking a fiscal contraction. The ECB can – and will – cut rates more and could ease the rate of run off of the extraordinary measures to boost liquidity through bond purchase and lending to commercial banks.

Politics will revolve more around cutting back on high levels of migration and on responding to Chinese competition and US pressure for tariff increases. Overall, the background points to sluggish growth next year after a pause in growth in Germany and some others this year.