Will France be the next domino to fall in the eurozone debt crisis?

While other nations within the eurozone are doing their best to back away from the fiscal cliff, France is accelerating towards it. As a result it’s looking more and more likely that France will be the next domino to fall in this on-going crisis.

If France doesn’t alter course it could quickly find itself in the same position as Greece and Spain, i.e. unable to fund its profligate lifestyle, and this would surely be the decisive blow that breaks the eurozone apart.

Is France the next Greece?

The charts below shows the Bank for International Settlements (BIS) public debt projections for France, Greece, Spain and Italy. What’s striking is that the debt outlook for France is significantly worse than that of Spain or Italy, and in fact, is much more closely aligned with that of Greece.

As the BIS points out, “The results plotted as the red line show that, in the baseline scenario, debt/GDP ratios rise rapidly in the next decade… As is clear from the slope of the line, without a change in policy, the path is unsustainable.”

Public debt/GDP projections

Eurozone Public debt to GDP projections

Source: The Future of Public Debt, Prospects and Implications, BIS Working Paper 300, March 2010. Note that the BIS figures use gross rather than net public debt.

The BIS concludes that these nation’s deficits will rise precipitously unless they change their fiscal policy, or cut age-related spending, and even then, “Only in Italy do these policy settings keep the primary deficits relatively well contained”.

Seeing that the status quo is untenable, countries are embarking on fiscal consolidation plans”, say the BIS. Apart, that is, from France, which is continuing full steam ahead towards a fiscal cliff.

Since being elected President of France on 6 May 2012, Francois Hollande has reduced the pension age from 62 to 60 and increased the minimum wage by 2%. Both of these are excellent things to do if you can afford to do them, but France cannot.

Mr Hollande’s solution to his nations’ massive debt time-bomb is to increase taxes on the rich. To that end, he has increased the nations’ wealth-tax, which affects those people worth more than €1.3 million, such that the wealthiest households, banks and big businesses will have to pay an additional €7.2 billion in tax. In addition to this one off levy, Mr Hollande also plans to introduce a 75% tax rate for those earning more than €1 million.

France has also just enacted a new tax which affects second homes owned by foreigners. The new tax raises the levy on the sale of second homes from 19% to 34.5%, and the same 15.5% “social charge” will be added to rental income, raising the rate from 20% to 35.5%.

As we have pointed out before, higher taxes don’t lead to higher government revenue. Instead these measures are likely to result in businesses, and wealthy individuals relocating to other countries such as Switzerland or the UK. In fact, there is already evidence that this is happening.

Mr Hollande’s short-sighted policies are likely to mean that France will run into trouble all the more quickly. As BCA (Bank Credit Analyst) put it recently, “France is currently headed toward mild recession and according to our Global Investment Strategy service, there is a non-trivial risk that if the French recession turns out worse than ’mild’, then its debt problem will be in the spotlight, creating intense pressures in the French bond market.”

The bottom line

Sooner or later, thanks to its unsustainable debt burden, the bond markets will strip France of its safe haven status and throw it into the crisis spotlight. When that happens I expect eurozone leaders to embark on more massive money printing in a last ditch attempt to prevent the breakup of the euro.

I think Albert Edwards, co-head of Global Strategy at Société Générale Cross Asset Research, had it right last month when he said, We are merely seeing the early sweet breeze of a QE hurricane that must be enacted to bail out bankrupt governments.”

Ultimately I believe that their efforts will fail, the eurozone will breakup, and the number of nations sharing the single currency will shrink from seventeen to around ten. This will leave a smaller but stronger euro currency block which is likely to include Germany, Finland, Austria, Luxembourg, Slovakia and Slovenia.

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