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France May be the Domino that Causes the Euro to Collapse

Commentators are wringing their hands again, worried the troubles in Spain could cause the whole euro project to collapse.

As a result, all eyes are now on Spanish 10-year debt yields, which went above 6% last week as the threat of euro-chaos returned.

But it's not Spain the markets should be worried about.

The reality is that Spain is not in too bad a shape and that a rescue would be affordable for the European Central Bank even if it was needed.

The real tottering European domino to worry about is France.

After all, it would be impossible for the remaining solvent members of the EU to bail out France if it began to fall.

The larger reality is that France's fiscal position is considerably worse than Spain's.

The country's debt-to-GDP ratio was 85% at the end of 2011, while Spain's was only 66%. What's more, France's public spending is 56% of GDP, according to the Heritage Foundation, compared to Spain's 45% of GDP.

Spain's current government has also instituted a stiff austerity program, mostly comprised of cuts in public spending, which will reduce its deficit below France's by 2013.

Meanwhile, France's austerity has so far consisted almost entirely of tax increases on the rich -not actual spending cuts.

Spending cuts, especially from governments which are overspending, may well stimulate GDP because they free resources for the more productive private sector, whereas tax increases generally worsen recession.

French Elections Hold the Key to the Euro

Whether or not France brings down the euro hinges on the outcome of its upcoming presidential election, set for two rounds April 22 and May 6.

France's current position is very confused, to say the least. No fewer than five candidates have a chance to make it into the two-candidate runoff.

The incumbent, Nicolas Sarkozy, is currently running slightly behind the mainstream socialist Francois Hollande, but three other candidates potentially could knock one or the other of the front-runners out of the second round.

They are Marine LePen, a nationalist; Francois Bayrou, a moderate; and Jean-Luc Melanchon, an extreme leftist.

Presumably if any of those three made it to the second round, they would be beaten by the remaining major party candidate, as was LePen's father by Jacques Chirac in 2002.

But it has to be said that electoral prognostication is exceptionally difficult.

If Sarkozy or Bayrou win, nothing much changes; France remains committed to the current consensus Eurozone policies and the Eurozone probably "muddles through."

But if one of the other three wins, there is going to be a big problem for the European Union (EU).

LePen would be anathema to the EU leadership, so even if she committed to continue austere fiscal policies, the markets would probably react badly.

As for a Hollande or Melanchon victory, the commitment to government austerity is just not there. In the current nervous state of the markets, France's budget deficit could become impossible to finance.

Hollande, for example, wants to reverse Sarkozy's earlier raising of France's pension age, while also pushing the top income tax rate to 75%.

An election win by Hollande or (very unlikely) Melanchon would simultaneously weaken the credibility of France's own austerity program and weaken the Eurozone coalition that has imposed austerity on Greece, Portugal, Ireland, Italy and Spain.

That would almost certainly cause markets to attack French government bonds, as well as stepping up the attack on Spanish, and probably Italian, government bonds.

The reality is that a France managed by an anti-austerity leftist, even a moderate one, is simply too far from Germany and Scandinavia in its fiscal management and economic outlook to remain part of the same currency zone.

And even if Germany and Scandinavia wanted France to remain part of the euro, they don't have the resources to bail France out.

Hence a Hollande victory at France's election May 6–currently believed to be at least a 50-50 probability–would almost certainly mean the end of the struggle to hold the euro together, and its collapse in failure.

Questions About France, Italy, Spain and the Euro

France, Italy and Spain – unlike Greece – do have ample resources with which to support their government bond markets, provided they control their own currencies.

Since most of their obligations are denominated in euros, their debt/GDP ratios would rise, but probably only by 15-20% since a devaluation of that level would be sufficient to make them export powerhouses.

Thus in principle a break-up of the euro need not lead to a world banking collapse, since the value of French, Spanish and Italian government debt would remain solid.

However, all three countries would have questions about their future.

In France's case, the commitment of the new government to controlling public spending would be questionable.

In Spain, the current government's position would be weakened. What's more, there would be a further round of banking trouble, as home mortgages denominated in euros would be secured only against houses valued in new pesetas.

In Italy, the Monti government, imposed by the EU, would doubtless fall, bringing political uncertainty and further aggression by the country's powerful unions.

And even if everything turned out to be okay in the end (except in Greece) the uncertainty would roil world markets, including in the United States.

For investors, that means it may pay to keep our heads down until the French election results are known.

While everybody is watching Spain, it is France that could topple.

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Join the conversation. Click here to jump to comments…

  1. Harmen de Bondt | April 18, 2012

    again lovely and interesting to read,… there is not much wrong in what you write,..only the story is not complete,… I agree that all countries have debts which they can not effort to have. Not on either side of the Atlantic Ocean,… And that will cause a huge fall back in almost everybody's living standard,… of on average 25%, then we must really start cutting government spending now. And to avoid that wages needs to go down… to keep the spending on a certain level,… we must all work 4-8 hours per week extra for the same wage. If we delay the steps we need to make the fallback will more likely be 35% AND then we must at least work 8-12 hours per week extra for the same wage. This will really happen, nothing else, do not expect a soft landing. The government debts in the USA are not healthier than in the average Euro country. One day (not too long from now) investors will realize that the USA can not refinance its debts at the same conditions and that is the moment that it is toooo late. Actually it is too late already.

    • Werner | April 18, 2012

      Your scenario looks pretty realistic and may work in the US, where I believe citizens will face reality. I have much more doubt about the majority of French to live up to that effort, the Trade Union's nuisance is just too big to implement real austerity in France. At least tha'ts how I see it.

  2. Werner | April 18, 2012

    In the past 40 years, France has run one single budget surplus and that must have been under prime Minister Raymond Barre.
    They ran a deficit ever since, whether it was under a right wing or left wing president. Just remember the FFR's breakdown after the Mitterand election. France had to introduce a sort of foreign exchange control, authorisin its citizens to take along no more than the equivalent of something like 2500 FFR, in fact by far insufficient for any decent vacation.
    France needs to be profoundly reformed (labour, public services etc.), but that wont go through with the present Unions.
    My guess is that the next person to really manage France sits at the helm of the IMF and France will compulsorily be reformed from outside, since it cannot be reformed within.
    For years I have professed to my friends that France, who was a big leader in the inception of the Euro, will be at the helm of breaking it up. I reckon I'll have some 6 months to wait to see the confirmation or denial of my opinion. Meanwhile I am afraid that social unrest will become widespread.
    Living in Switzerland, being called on travelling pretty often in France, I shall in no way rely on public transport and make sure my gas tank is near full so as to make it back to my basis!

  3. J. James Herschling | April 18, 2012

    75% tax rate in France? Why even try to be successful in that country? Keynesian economics do not work. Never have, never will. This is a perfect example of that.

  4. eric taylor | April 18, 2012

    You can't say that the Europeans have not copied our supply side, raise the government debt for 30
    years by giving the money back to the rich; but even still, the Europeans have modernized their
    infrastructures in the doing, an run their debt up in moderation, in most countries. Pity Japan,
    which has debt off the charts due to their brand of crony capitalism, who can understand
    whether or not their small cap stocks are the cheapest in the world, when they could easily
    fall into depression along with the U.S. should we fall? The world is a complicated patchwork
    quilt of various types of mixed economies, requiring considerable analysis before investing
    with great confidence. Keep up the good work in spite of the criticisms unwound by the readers.

  5. Robert in Canada | April 18, 2012

    In spite of the absolute proof that left wing policies lead to social and economic ruin, a lot of people support left wing politicians.

    They just refuse to accept that failed states like USSR, Greece, Spain, Italy, Argentina, Cuba, Venezuela, Zimbabwe, etc. became basket cases due to left wing policies.

    • Harmen de Bondt | April 20, 2012

      Dear Robert,.. i see you refer to Venezuala and Zimbabwe,…2 years ago, on this site i did mention that Zimbabwe is the number one in printing money,.. and that the USA is the runner up in doing so. And is closing the gap. Capitalism also means do not spend more money then you make in the long run. We should use our brains.
      And again we all should work more hours for our money to sustains the same level of our living standard. And we, rich people should pay more tax, and governments should cut spending at the same time, big time. Otherwise our national debts will push us back, at least 50 years.

  6. don larson | April 20, 2012


    Can agree with you theoretically – – it all makes sense normally. But this World-Wide Deep Recession is anything but normal.

    Here's the Wild Card: The Euro Zone is China's number one overseas market. The U.S., is number
    two. Right or wrong, it is my belief that China will come to rescue, with a bailout.

    China must keep it's production engine roaring. If you look at the history of China, the Masses can turn on a dime. It's not unreasonable to say, that perhaps China fears Social Unrest, as much as it does the U.S. Military.

    That's all; but what do I know?!


  7. Dom | April 20, 2012

    Intersting analysis, but I have to wonder…if France is in such dire straights, why hasn't the attack on their debt already begun? The market typically tries to be forward looking and right now their 10 bonds are yielding about 3%, vs the more precipitous 6% for Spain. Just my thoughts…

  8. Myron Martin | April 26, 2012

    What I find interesting in the comments is the acknowledgment that there is to much debt, political inertia, conflicting interests with the remedies being working longer hours for the same money, cutting back money printing etc.

    What everybody seems to miss is the simple fact that all the evidence points to the foundation of our problems being a flawed monetary system. Everyone seems to ASS-U-ME that our present fractional reserve fiat monetary system is the only way that things can be done. Surely it is simple mathematics that as long as we bring our currency into existence as DEBT, that must be repaid with interest, we are only "piling our debt problem higher and deeper' (PHD) and maybe that is the foundational problem, PHD's who failed mathematics designed the system.

    These idiots can do all the bailing out and money printing they want, but it SOLVES NOTHING, it just re-arranges the deck chairs on the Titanic. The "SYSTEM" is going down, it just becomes a question of the trigger and the timing that causes the technocrats to lose control. It is time to put this corrupt, unworkable system out of its misery and return to honest and sound money on a world scale.

  9. stephan black | May 3, 2012

    i agree france could be the domino that collapses the whole euro construct…..but i believe the real trigger will be french banks…i believe their balance sheets are works of fiction…remember dexia…. are credit agricole and bnp-paribas…the new dexias….?…markets are not rational…if deficits and national debt were the only factors to determine risk….japan should have been already vaporized….

  10. WORMSER | May 4, 2012

    In France it is not a so-called right of left wing policy that will change the Eurozone situation, but the status of BCE, presently leading the all system to collapse . When the BCE status possibly allows her to lend directly to the states, the short term needs will be met.

    In the past economic history ,an austerity policy has never led any country to recovery . It only works when growth is around !

    Have a nice week-end .

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