Simon Nixon / Dec 2024
Photo: Shutterstock
In bringing down Michel Barnier's government, Marine le Pen and the French left are betting that a political crisis won't become a financial crisis. But it may not stay that way for long.
So Michel Barnier has become the shortest serving prime minister in modern French history following a vote of no confidence in the French parliament. At least he has the consolation of having lasted longer than Liz Truss. And unlike the former British prime minister, he can take satisfaction from the fact that his defenestration following parliament’s rejection of his 2025 budget makes him a martyr to fiscal responsibility rather than a global laughing stock ousted for budgetary recklessness. The big question is what on earth Barnier’s opponents think they are doing and whether France’s Liz Truss moment lies ahead.
Until a few days ago, the conventional wisdom in the markets was that Barnier would ultimately get his budget on the basis that Marine Le Pen, the leader of the National Rally, would not want to be blamed for causing a crisis when she is trying to present herself as a responsible politician. After all, why not let the unpopular minority government take responsibility for a budgetary tightening that needs to happen anyway? Yet not even €10 billion of last minute concessions from a €60 billion budget was enough to sway her. It seems that any association with the budget was too much to bear when all the left-wing parties, including the supposedly centrist Socialist Party, were determined to vote it down.
Le Pen, along with the rest of Barnier’s opponents, have clearly calculated that while this is a political crisis, it is not a financial crisis. To be fair, that may be a reasonable bet. The yield on 10-year French government bonds may be 0.8 percentage points higher than that on German equivalents, which is the highest spread since 2012, but that is still well below their eurozone crisis era peak, let along the crisis spreads on southern European bonds. Besides, thanks to recent European Central Bank interest rate cuts, French borrowing costs are actually lower today than they were when Emmanuel Macron called parliamentary elections in July. Another cut is expected in December.
Why have French government bonds not sold off more as a result of the political brinkmanship? And what might lead to a deeper financial crisis?
One reason that the market has not moved much this week is that traders are already short and there has been no new economic data, which is what tends to drive prices, one broker tells me. Besides, although Barnier has been rejected, we still don’t know how the current drama will play out. The true budget deadline is December 31, so there is still for a new prime minister to pass a version of Barnier’s budget. Alternatively, the 2024 budget to be rolled over. That would freeze tax allowances and spending levels which in theory could lead to a similar squeeze to Barnier’s budget as a result of fiscal drag.
A second reason is that while traders may be betting against French govenment bonds, domestic institutions are still buying, which helps keep a lid on prices. That’s a big difference from the global financial crisis when banks in Spain and Portugal were too weighed down by credit losses to help their sovereigns. What’s more, most government bonds are held at historic cost, rather than marked to market, so there is no risk of falls in values hitting their capital ratios. Instead, the extra yield can make for a profitable trade for local banks given that they have access to cheap funding, while reducing the risk of a domestic financial crisis that would wreak havoc on their own businesses.
But the third and possibly most important reason is that if French government bond yields rose too high, the European Central Bank has the option of stepping into the market to buy the bonds and drive yields down. No one knows for sure how the ECB’s Transmission Protection Instrument, which it first announced in 2022 and which is designed to ensure that borrowing costs do not vary too widely across the eurozone and therefore undermine its monetary policy, will work in practice in terms of when and under what conditions it will be activated. The rules allow the ECB some discretion. But if you are a hedge fund with a big open short position, it could be a very costly mistake if you guess wrong.
Nonetheless, the French political class would be foolish to count on the ECB to shield them from the consequences of their decisions if they cannot agree a budget. The Barnier budget was supposed to reduce France’s deficit from 6.1 percent to 5 percent as part of a four year process agreed with the European Commission to bring it back to 3 percent, the limit under eurozone rules. Yet even before Barnier made his concessions to Le Pen, most economists expected a deficit next year of closer to 5.5 percent. And few believe that if the 2024 budget is rolled over that parliamentarians will be able to resist pressure to upgrade spending on pensions and welfare. Plus the political uncertainty is bound to be a drag on growth. A deficit closer to this year’s level would be realistic.
Under those circumstances, it is very hard to see how the ECB could possibly intervene to support French bonds. It would make a mockery of the eurozone’s fiscal rules. When southern European countries faced a financial crisis, they were forced to accept bailout programmes and crushing austerity. Were France to be spared similar treatment while making no attempt to reduce its deficit, it would signal to the rest of the eurozone - and more powerfully to the markets - that all discipline had evaporated and that the ECB could be counted on to print money to finance deficits. The euro’s credibility would be destroyed.
That is surely not going to happen. The ECB could intervene to keep a lid on the borrowing costs of other eurozone countries affected by the turmoil in France. Indeed, that explains why there has been little evidence of any contagion so far. But France should expect to be left to the mercy of the markets. The fiscal adjustment that they were asked to deliver at one percent of GDP was large but not unprecedented and far less than what was demanded of southern Europe a decade ago. What does it say about the French political system that it is seemingly incapable of delivering even one year of a four year effort?
One way or another, sooner or later, the French political class will need to face up to its responsibilities. What’s more, the longer it leaves it, the harder the task will be, as higher interest rates feed through to higher interest costs and a weaker economy. Already the French savings rate is hitting levels last seen in the 1970s and consumer sentiment has slumped, even as the outgoing government had been counting on higher consumer spending to drive stronger growth. Goldman Sachs calculates that France will ultimately need to reduce the primary deficit ( pre-interest costs) from 4 percent to zero simply to stabilise the debt ratio.
Yet its hard to see any political clarity emerging before the 2027 presidential election - and perhaps not even then if the second round is a choice between Le Pen and Jean-Luc Melanchon, the far left populist. But even they will not be able to avoid doing what they refused to do this week. The markets will see to that.
Simon Nixon writes the Wealth of Nations newsletter on Substack
