French president Macron threw down the electoral gauntlet to what looks like a large majority of voters who seem to prefer the extreme right or left to his centrist coalition. He hopes the French will, after “voting with their heart” on the first round on June 30, “vote with their wallet” on the second, decisive, round on July 7. The choice is between the simplistic and populist policies offered by Marine Le Pen’s rightwing Rassemblement National (RN) and Jean-Luc Melenchon’s New Popular Front (NPF) of the left; and the pragmatic, centrist policies of Macron since he was first elected president in 2017.

Both the RN and NPF offer tax cuts and spending increases that would boost France’s current budget deficit, already 5.6% of GDP, further above the Euro zone’s 3% target. Over the years, France, a cornerstone of the European Union, has wangled a sweetheart budgetary privilege for its excessive deficits from the European Commission despite misgivings from its austerian EU partners. This has caused serious tensions with Germany, the EU’s other cornerstone country, especially when Berlin operated under a “schwarze null” no-deficit policy.

France’s exorbitant deficit privilege appears even more anomalous since the Euro crisis of 2011-12 led to emergency measures for Euro zone countries in fiscal trouble. But France was never forced to toe the fiscal line. It would be even more ironic if France, a key part of the Euro system, required emergency financing under other Euro zone mechanisms designed to help countries in budgetary difficulty. France’s errant fiscal position also jeopardizes a new and unique Euro zone joint-borrowing facility adopted during the Covid pandemic and which the euro countries share responsibility.

Bond market vigilantes are reacting negatively to the risks associated with the programs and probable behavior of France’s New Popular Front on the left and Le Pen’s French-style MAGAs on the right. The yield spread between France’s ten-year OAT bond over its German counterpart oscillated in a tight range between 45 and 55 bps over past years. But when Macron threw down the gauntlet, the spread rose to 79 bps at Friday’ close (June 21), confirming market worries about France.

Despite the deficit, France is unlikely to submit quickly to the north European “austerians” who want Paris to reduce its deficit from today’s 5.6% of GDP towards the EU’s 3.0% target. The European Commission cited Paris last week for its failure to adopt policies to reduce the deficit.

The EC imposed painful austerity policies on Spain, Ireland, Greece, and Cyprus during the 2011-2012 Euro crisis, producing dramatic improvement despite political protests. The Greek government today pays 362 bps to borrow ten-year money, Italy 394, and France 320 (since Macron’s call for elections) compared with Germany which pays 240 bps.

The French pain threshold is very low, as we saw when Macron tried to raise the tax on diesel fuel, triggering serious nationwide rioting by the “gilets jaunes” (they torched our BNP bank office). Remember, too, repeated massive “touche pas ma retraite !” demonstrations against raising the retirement age from 62 to 64.

French government spends about 55% of GDP, one of the highest ratios among developed countries. More than half of that is for “social protection” programs which few French voters are prepared to give up. An austerity policy imposed by Brussels that involves reducing that social spending would undoubtedly lead to very disruptive demonstrations.

In a financial crisis, the ECB could buy French OAT government bonds in unlimited amounts to limit the rise in French borrowing costs and damage to the economy. But that would mean reversing the ECB’s current tight monetary policy aimed at slowing inflation while reducing its balance sheet of € 6.5 trillion. (The Fed is also reducing its own balance sheet of $7.3 tn for the same reasons.) Markets would take a very dim view of the ECB appearing to perpetuate bad French policies.

The stakes are also very high for the world financial system. Euro-denominated debt of EU countries totaled $14 tn at end-2023 and the euro accounts for 21% of central banks’ FX reserves. Any significant threat to the world’s second reserve currency (after the USD) would trigger a global financial crisis.

If France triggered a euro crisis, Europe’s equity and bond markets would be roiled, causing international investors to transfer capital into the USD which would appreciate drastically against all major currencies. The weakened euro would worsen European inflation, slow consumption, and paralyze capital spending. Currently persistent slow economic growth and low productivity would worsen, perhaps causing Europe to fall into recession.

Ironically, capital flows into the USD would increase foreign financing of our twin deficits (BOP and budget), easing pressure on the Treasury which is forced by Congressional inaction to finance a federal deficit forecast to be close to $2 tn, close to 7% of GDP, this year. While easing U.S. interest rates, the foreign capital inflow would not necessarily stimulate the U.S. economy if international financial turmoil caused currently over-valued equities to correct and investors shifted to safer Treasury debt.

European Union could be at risk since both Melenchon and Le Pen are viscerally anti-EU and anti-EUR, which they blame for constraints on domestic policies. Will Marine Le Pen’s efforts to seduce Georgia Meloni, Italy’s far right PM, into joining the far-right coalition in the European Parliament ? If that happens, the EP could become another structural obstacle to the functioning of the EU.

The EU’s normal legislative procedure puts Parliament on an equal footing with the Council of EU ministers since it must approve EU directives (laws). Special legislative procedures apply, however, in specific cases such as taxation and defense, where Parliament has only a consultative role or must give only an advisory opinion.

If the Parliament refuses to approve a directive, or give an advisory opinion, the Commission’s proposal cannot become law. If Parliament were to be ruled by a majority controlled by Le Pen and Meloni, the work of the Commission and EU Council of Ministers could be severely restricted.

Such problems lead some observers of Europe, including this writer, to hope Macron wins his bet that the French will vote with their wallet rather than their heart-felt irritation.

J.Paul Horne

International Economist