Merlin Weekly Macro: In France, Germany - debt rises, government falls

And lo! It came to pass, that in the third month of its incarnation, the French government did fall. As the prophets of politics (including us) foretold, Michel Barnier’s administration skewered itself on the first hurdle. Resorting to Article 49.3 of the French constitution to ram through legislation (in this case his budget) by the expedient of bypassing parliament, Barnier risked a vote of no confidence. He lost.

Macron: hoisted on his own petard

The French constitution says that there can be no new parliamentary election until 12 months have elapsed from the previous one. President Macron is now in the invidious position of having to find yet another prime minister who can command the confidence of a deeply fractured parliament in which the real power lies to the poles of the far right and the far left, to neither of which he wants to cede control, while also having to deliver a budget that complies with Brussels’ rules on deficits and debt reduction. It took him three months and several discarded candidates eventually to end up with Barnier; successive candidates in Barnier’s wake will have even less authority given everyone is very well aware that a) whoever is appointed is there because of who he/she is not, rather than who they are, i.e. they are a compromise candidate; and b) they are demonstrably not first choice. Weep not for the hapless Macron: this is a problem entirely of his own making. He did not have to go to the polls in June after the European elections; he chose to, spontaneously. In an act of folie de grandeur laced with political bravado and arrogance, he gambled on a knock-out blow against Marine Le Pen. He lost too.

Two imploded governments, one common detonation: deficits

In September, before Olaf Scholz’s Traffic Light Coalition collapsed, we raised the question: “Should we be worried about German politics?” The answer is yes. But we should be worried more about the political instability in France. Both Germany and France are in a mess. At least a political way forward is visible in Germany if the centre-right CDU can garner sufficient support that with a partner in government it can command effective leadership with a solid centre of gravity and begin rebuilding economic, industrial and social confidence. According to Politico, the CDU has a strong lead in the polls (32%) over its nearest rival, the far right AfD (18%) followed by Scholz’s centre left Social Democrats (15%). The centrist parties will be taking some comfort that, splitting the German nationalist vote, the hard-left ultra-nationalist BSW has lost momentum. Much can change between now and February 23^rd, but the polls indicate that BSW popularity possibly peaked in the September State elections in Brandenburg, Thuringia and Saxony; nationwide, it is the Greens who are the principal beneficiaries.

France is in a different predicament. It is in constitutional limbo until June 2025 and unless Macron resigns as President. If polarisation has been a feature of German politics, at least there is still a robust centre ground. Polarisation is pronounced in France but, in contrast with Germany, the traditional centre-ground parties which governed the Fifth Republic for seven decades have all but lost their constituency in less than the most recent decade. Seeing a way through the political limbo in France is difficult.

While there are many causes behind the polarisation of politics on the Continent (migration, cost of living, Ukraine, climate change, the populist backlash against elitism and the establishment etc), what is common and specific to the final collapse of both the German and French governments in short order is crystal clear and can be summed up in one word: deficits.

Continental fiscal crises: compare and contrast

‘Old-fashioned’ industries based on hydrocarbons (vehicles, plastics, chemicals) have been the powerhouses of the German economic revival and its long-time momentum since the Second World War, notably with the strength in exports and a consistent positive balance of trade. It was an enviable, seemingly unassailable and enduring position conferring significant international political leverage and influence. However, today they have all the hallmarks and perceptions (rightly or wrongly) of incipient redundancy. For Olaf Scholz, the irreconcilable and insuperable political conundrum was how to match the expectations of public sector expenditure, including committing €100 billion extra to defence spending on top of its support for Ukraine, with an economy which has not only stagnated but is in a period of pronounced insecurity, against the strict legal requirement to remain within the limit of an annual deficit no greater than 0.3% of GDP (gross domestic product). The author’s granny, a Wise Woman, had a favourite saying: “it’s like trying to fit a quart into a pint pot” It won’t go. Scholz found that out the hard way.

The irreconcilable political positions even within government, let alone between the government and the opposition, were whether or not to change the law and allow more freedom to have larger planned deficits. Is it acceptable to allow debt to grow both in nominal terms and as a percentage of GDP? Or with Germany’s moment of fiscal paralysis in the Global Financial Crisis still too painfully fresh in its collective memory, should it be sticking rigidly to its guns on it being illegal for the government to present a budget which in essence does not balance the books between income and expenditure? It will be up to a new government either to develop a more radical means of fiscal reform and economic regeneration, or to move the legal goalposts on redefining the boundaries of deficits and debt. Both routes are painful: the former risks a punch-up with the electorate, the latter risks the same with the courts and the bond markets. It is a familiar story.

France faces a different problem. More than a fifth of the workforce is employed by the government. It has highly restrictive employment laws (France is one of the strictest adherents to the EU Working Time Directive: it explains why the BBC had to take so many flagship presenting teams to the Olympics this year because normal scheduling would have put individuals and the Corporation at risk of being in breach of the law for working too many hours), and its generous benefits and early retirement pensions structures are incompatible with the realities of international competitiveness and demographic change. It is already nursing a deficit of 5.5% which under its own steam is heading towards 6% and double the maximum allowed under the EU’s fiscal stability mechanism. At 115% of GDP, the government debt is also nearly double the 60% maximum allowed by Brussels.

Macron rammed through entirely sensible and necessary pension reforms for which the electorate was unprepared and uncomprehending; Barnier tried the same with benefits reform with the same result. Both represent a failure of leadership in making the case that France cannot continue living beyond its means in perpetuity without significant consequences.

The politics of deficits

We have talked on many occasions about how western debt is the elephant in the room. The elephant is now firmly out in the open. It is on the loose, trampling the crops and cannot be ignored. It has just sat upon and squashed the governments of the two biggest economies in Europe. But of course you know and I know that debt itself is not the problem; debt is the symptom. Governments are the root cause of the problem when they fail to make hard choices about deficits (it is why we identified ‘deficits’ and not ‘debt’ as the cause of Germany and France’s governments’ demise). Governments make the decisions about how much income to raise, how much to spend and, where there is a deficit, how the gap will be plugged, either by higher taxation or by borrowing more. Debt is merely what accumulates when the gap is enduring; it simply compounds when despite interest rates being high, governments insist on maintaining or even increasing other areas of day-to-day expenditure while the cost of funding an increasing debt pile is also rising.

There are no innocent bystanders

Which makes it even more curious that in all this, the gap (in market lingo, the ‘spread’) between German government bond yields¹ and those of the French has been relatively stable at little more than three-quarters of a point throughout this prolonged period of political turmoil, and particularly given the cause. Today French 10-year government bond yields are 2.87% versus German Bunds yielding 2.11%. While the yields of both countries’ bonds have been volatile, the spread has been remarkably constant, and certainly well within the two-point limit beyond which the red lights start flashing and the klaxons blaring in the bond markets that a potential systemic melt-down is on the cards.

There are only two conclusions to draw from this: 1) markets reckon that without a working government, economically France cannot do much more harm to itself than it already has done and therefore does not pose a systemic risk to the eurozone financial system; 2) that even if there were a significant threat to European monetary stability, the authorities would step in with egregious dollops of QE (quantitative easing)² and a sharp reduction in interest rates to maintain confidence, followed by the imposition of a financial troika comprising the IMF (International Monetary Fund), the ECB (European Central Bank) and the European Commission such as managed the fiscal affairs of Greece a decade ago. The medicine worked with Greece whose benefits, pensions and working practices have undergone a Damascene conversion including raising the pensions age and moving to a six-day working week.

It is that reform which is key. Merely pumping liquidity into the markets and slashing interest rates every time something goes wrong is little more than applying sticking plaster to a haemorrhage. The fundamental need is to address government spending. We entirely justifiably blame governments for the wrong choices they make. But the central banks are much to blame, as are the markets. It was the ECB in particular which adopted the deliberate strategy of using QE and negative deposit rates to try and stimulate growth and to combat deflation. It did not work (what economists defined as “the failure of the transmission mechanism”).

Liquidity failed to percolate through to the real economy. The economic benefits were non-existent, indeed worse, the consequences were positively damaging: the creation of the zombie economy with falling real wages, a collapse in productivity and lower average growth rates as frictional inefficiencies mounted and became embedded; governments knowing that they could keep producing deficits with virtual impunity which the markets would fund because the central bank was the permanent back-stop. Negative yields, already irrational where the lender pays the borrower to assume more debt, required the Law of the Greater Fool to be applied for bond investors to be able to make a profit (with yields and prices moving in opposite directions, an even lower negative yield was the only means of making a return on the ‘investment’). It was all deeply damaging. Remember that negative interest rates and negative bond yields explicitly encouraged egregious spending and borrowing: they both actively prompted borrowers to increase their loans by paying them to borrow more.

By keeping that yield spread a constant as at present, markets are effectively saying that France is not their problem, they are innocent bystanders, mere agents in a system whose outputs they evaluate and assess and they adjust and react accordingly. Surely as the providers of capital, that is an abrogation of both responsibility and culpability. One to ponder over the festive period.

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions. 

Sources

¹A bond’s yield is the rate of interest or income it pays, usually expressed as a percentage. For a government issuing a sovereign bond, the yield is the amount it must pay to the buyer of the bond.

²Quantitative easing is a policy of central banks intended to increase the money supply and support lending and investment, by purchasing securities such as bonds in the open market.