France Is Living Fat and Giving the Finger to Germany

For the last two years, bond investors have turned a blind eye to the deep-seated problems of the eurozone, from the threat of outright deflation to the failure to build a proper political and fiscal union. Much of the credit for the resilience of Europe’s debt markets goes to European Central Bank (ECB) President Mario Draghi. His pledge in July 2012 to do "whatever it takes" to save the euro dramatically improved investor sentiment towards the bloc after four years when the currency’s dissolution seemed plausible if not imminent.

Yet over the past several months, the failings of what remains an ill-managed currency union have become much more apparent. The eurozone’s economic recovery has stalled. The ECB’s policies, like cutting interest rates to a record low and trying to encourage lending to small- and medium-sized firms, are proving ineffective in countering the threat of Japanese-style deflation. European stock markets have been in free-fall due to fears of continuing stagnation, dragging other markets down with them. Perhaps most worryingly, the bloc’s two most important members are at daggers drawn over economic policy.

France, the eurozone’s second-largest economy and a founding member of the European Union (EU), is at the forefront of a campaign to ease Europe’s stringent fiscal rules. Made more stringent in 2012 at the request of Germany, the rules require all members of the EU to keep their budget deficits below 3 percent of GDP — even during severe economic downturns like that of the last few years. France’s plea for greater leniency over fiscal targets — which is supported by Italy, the eurozone’s third-largest economy, and has even found a sympathetic ear in Draghi — is strongly opposed by Germany, the eurozone’s biggest economy, its chief paymaster, and the bloc’s staunchest proponent of austerity.

In German eyes, it isn’t just southern Europe’s commitment to reform that is in doubt, as was the case in the early years of the eurozone crisis. Instead, the biggest fear in Berlin is Paris’s reluctance to undertake the reforms being demanded of it. That poses the biggest challenge to Europe’s single-currency area.

Until several months ago, France had at least paid lip service to the need for fiscal consolidation. These days it doesn’t even bother: In its budget proposal for next year, published last week, the Socialist government of President François Hollande pushed back its already twice-delayed deficit target of 3 percent of GDP from 2015 to 2017. This year’s deficit, moreover, is expected to reach 4.4 percent of GDP, even higher than last year’s 4.3 percent.

What’s more, the government is unapologetic. French Finance Minister Michel Sapin has not only made it clear that his government "rejects austerity," he has called on Germany to abandon its focus on deficit reduction and support a growth-friendly economic agenda featuring a significant increase in investment.

France’s determination to force a change in eurozone policy is not surprising. Its economy is expected to grow a paltry 0.4 percent this year, having posted practically no growth in 2012 and 2013. By contrast, Spain — which, unlike France, was forced to introduce major reforms during the crisis — has returned with a 1.3 percent growth following contraction last year. Even Greece, which has suffered a savage recession over the last several years, shrinking 0.9 percent last year alone, is expected to grow faster than France this year.

If France had been under pressure from bond markets to take on necessary reforms, it too might be back into positive-growth territory now. But instead Paris chose to "muddle through" the crisis, leaving France in the disastrous position it finds itself in now. This reversal of fortunes within the eurozone is raising the stakes in the standoff between France and Germany.

In Berlin’s eyes, as well as those of the European Commission in Brussels, which is responsible for vetting EU members’ budgets, France is now paying the price for having consistently failed to carry out much-needed reforms, from public expenditure reform to liberalizing the labor code. With French government debt now surpassing 2 trillion euros, or some 95 percent of GDP (up from 83 percent in 2010), and public expenditure amounting to a whopping 56 percent of GDP (one of the highest shares in the world), France is in no position to plead for leniency, let alone demand a fiscal stimulus.

Paris, on the other hand, is warning of the dire consequences of imposing excessive austerity at a time when the recovery in the eurozone has been snuffed out. The government’s 2015 budget already includes 21 billion euros in spending cuts, with the axe falling on parts of France’s sacrosanct welfare state. More austerity could tip the economy into recession and play into the hands of Marine Le Pen, the increasingly popular leader of France’s far-right National Front party who, according to a recent poll, would beat Hollande, the most unpopular French head of state since World War II, in a second-round runoff for the presidency.

A showdown with Brussels looms. The European Commission has already let France off the hook for missing its fiscal targets for the last three years. But the commission is now seriously considering rejecting the government’s budget, which needs to be submitted to Brussels by Oct. 15 for approval. If the two sides are unable to agree on deeper spending cuts, or at least additional structural reforms in return for a slower pace of fiscal tightening, France could face financial sanctions, including a fine of up to 0.2 percent of GDP.

Investors, however, appear unperturbed. The yield on France’s 10-year government bond currently stands around 1.2 percent — an historic low — and is down 1.3 percent (or 130 basis points) since the beginning of this year and, even more surprisingly, is only 30 basis points above the yield on benchmark German 10-year debt.

Financial markets perceive the creditworthiness of France and Germany as more or less the same, despite the fact that Germany’s more competitive, export-oriented economy has long been viewed as a model for the rest of Europe while France is now perceived as the weakest link in the eurozone. This is mainly because of the idiosyncrasies of the French government bond market, one of the largest in the world, whose investor base is predominantly foreign. France’s deep, liquid, and relatively safe debt market is the most popular alternative to pricier German bonds, allowing France to remain extremely resilient to financial instability.

Germany cannot force France to reform, but the bond markets may be able to. So far there are no signs of this happening. Yet France is sailing close to the wind: The eurozone’s second-largest economy has been mired in stagnation for the last three years; it lacks the political will to embrace reform. The question is how long Germany will tolerate a reform-shy France and, more importantly, how long France’s own bond market will remain resilient. Time might be running out.