France's game with fire

Hardly anyone doubts that Prime Minister François Bayrou will lose the vote of confidence in the French parliament on Monday (September 8). He lacks a majority for his plans to tackle French national debt through budget cuts .

What happens next is anyone's guess. Whether there will be new elections, as demanded by the right-wing Rassemblement National party, or whether President Emmanuel Macron can install a new minority government is the political dimension of the crisis. The economic consequences are about money and France's gigantic mountain of debt. In absolute terms, no EU country is as heavily indebted as the country led by President Emmanuel Macron . National debt has now grown to over €3.35 trillion, equivalent to approximately 114 percent of gross domestic product (GDP). And the debt ratio continues to rise: Experts have projected that it could climb to more than 125 percent of GDP by 2030.

Debt king of the EU

France's debt is so high that it is surpassed only by Greece and Italy in the EU. With a deficit of 5.4 to 5.8 percent of GDP, the government in Paris is also responsible for the highest budget deficit in the EU.

To achieve the EU-compliant deficit target of three percent, significant savings are necessary. And because this cannot be implemented politically, the financial markets are reacting with risk premiums on French government bonds. In some cases, the premium (the so-called spread) paid was higher than it was last seen more than 16 years ago compared to German government bonds, which are considered particularly safe. This means that German government bonds with a ten-year maturity only pay around 2.7 percent interest, while French bonds pay around 3.5 percent.

So, should we be worried about the euro if the finances of the EU's second-largest economy spiral out of control? "Yes, we should be worried. The eurozone is unstable at this point," says Friedrich Heinemann in an interview with DW.

"I'm not worried about a new debt crisis in the coming months. But one must, of course, ask where this will lead if a large country like France, which has already had a steadily rising debt ratio in recent years, now becomes further politically destabilized," emphasizes the economist from the Mannheim-based ZEW, the Leibniz Centre for European Economic Research.

Many other countries are also taking on historically high levels of debt and are having to raise billions on the capital markets. This fall, other major economies such as Germany , Japan , and the USA are issuing bonds, which is another reason why the bond markets are extremely tense.

"The fact that the bond markets aren't even more nervous, meaning that interest rate spreads for France aren't rising even further, is primarily due to the hope that the European Central Bank will then undoubtedly buy French government bonds to stabilize the situation," explains Heinemann. "But this hope could be misleading, because the ECB must be careful not to damage its credibility in this area."

It's a familiar problem: Whenever austerity measures or reforms are called for, both left and right parties in France raise a fuss and mobilize their supporters. Unions have already called for a general strike on September 10, two days after the vote of no confidence in parliament. Memories of the Yellow Vests that paralyzed France in the fall of 2018 are reviving. The trigger back then: the increase in taxes on diesel and gasoline, with which President Macron wanted to advance the green transformation .

EU Commission and ECB in a dilemma

"The European Commission is partly responsible for the problem. It has repeatedly turned a blind eye to France, sometimes both. These were political compromises out of concern that otherwise the populists would be given a boost," says economist Heinemann.

France already has to raise €67 billion a year just to cover its interest payments – money that's lacking elsewhere. And the country is under pressure because it has committed to the EU to gradually reduce its high deficit. However, the agreement with the EU has a catch: It was agreed upon with François Bayrou, the current head of government without a majority.

"Now we have the problem: France has already used up a large part of its fiscal space. Germany is in a much better situation and still has plenty of room to maneuver. France, on the other hand, does not," says Heinemann.

Huge reform backlog

Just like Germany, France needs comprehensive welfare state reforms and must reduce government spending. The alternative would be tax increases – in a country that already imposes very high taxes on its citizens and companies, Heinemann said.

Looking at politics in France, he is skeptical that there will be a cross-party consensus on debt reduction and government spending: "Because the populists on the left and right of the spectrum are gaining ground now, I don't see that happening. I don't see any learning effect there; the center, on the other hand, is shrinking. Therefore, I am pessimistic in the case of France and don't see a solution."

For Andrew Kenningham, chief European economist at London-based research firm Capital Economics, the risks to the financial markets are (still) manageable. "For now, the problems appear largely confined to France itself, at least assuming the scale of the French problem doesn't become too large."

However, there are plausible scenarios in which a much larger crisis could occur in France, increasing the risk of the crisis spreading. "After all, France is the second-largest economy in the Eurozone, with significant trade and financial ties to its neighbors, and is politically a leading EU power," Kenningham emphasizes. A crisis in France could therefore call into question the viability of the entire "European project."

"We don't think a crisis of this magnitude is on the cards for the next one to two years. But if it were to happen, contagion could become a much bigger risk—one that the ECB would have to address."

Not a good omen for trade dispute with the USA

The crisis in France comes at an inopportune time, as the EU's trade talks with the US are still not fully concluded For example, when it comes to the taxation of US tech companies by individual countries like France. It's pretty bad timing that the EU is weakening itself at this very moment because of its second-largest economy, which has become virtually ungovernable.

"France already has protectionist tendencies, both on the right and left of the spectrum. Many people are basically in complete agreement with Trump on trade policy," Heinemann emphasizes. Many think: We need more protection, higher tariffs, we should seal off the European market, and ideally France, even more."

For Heinemann, many actors in France are outright Trumpists, especially on the political left and right. "They could increase the pressure on the EU Commission and respond to Trump's tariffs with European tariffs," the Mannheim-based economist points out. "Then the risk of a full-blown trade war grows."