The director of the Bruegel think tank in Brussels once asked what would happen if a eurozone state ever attempted a variant of Trussonomics without protecting its own sovereign central bank and policy instruments. We may find out as soon as the first round of the French elections this Sunday.
Jeromin Zettelmeyer said the Truss-Kwarteng incident in the UK was humiliating but was corrected quickly with no lasting damage. "The UK's political and economic institutions absorbed the shock. Now think of something like this in the eurozone with, say, a populist right-wing party in France trying to pull a Liz Truss. The consequences would be disastrous," he warned.
This is a pertinent question because the eurozone's structure makes it almost impossible to react to a political crisis with speed and clarity. The risk is equally great if the left-wing Front Populaire wins with plans to roll back Emmanuel Macron's reforms and push through the first radical spending program ever attempted by a major eurozone state.
The European Central Bank (ECB) will likely stabilize the French bond markets and stem contagion to the Club Med bloc before matters escape control. However, legal constraints will prevent the ECB from acting quickly enough to avoid prolonged turmoil that could endanger the fragile economic recovery.
This is not a repeat of the euro debt crisis of 2010-2012, which was the consequence of launching a monetary union without a functioning lender-of-last-resort. The ECB has since acquired powers to act as a backstop for the debt markets in an emergency. But that alone does not resolve the underlying issues.
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The unfolding events in France expose the persistent flaws of the incomplete euro project. They revive the poisonous internal politics that have long plagued monetary union, pitting fiscally conservative northern creditors against more indebted southern states with conflicting economic philosophies.
"The Germans were deeply concerned about Macron even before this snap election, and the situation is now dire," said David Marsh, chairman of the Official Monetary and Financial Institutions Forum and author of books on the Bundesbank and the euro.
"They fear being caught in a pincer movement by the French and the Italians. They believe the debtor states are taking advantage of the creditor countries," he said.
The two German members of the ECB Governing Council know that any decision to bail out a French government openly defying EU budget rules would be challenged in the German constitutional court. This would further reinforce the view within the German ordoliberal establishment that the euro project has gone astray. "The bar for ECB intervention is high," said Davide Oneglia from TS Lombard.
Mr. Oneglia stated that France is not facing a debt crisis per se. The growth rate of nominal GDP exceeds the debt interest rate costs, thus avoiding a self-reinforcing debt spiral. However, France has let matters deteriorate, lulled by its "exorbitant privilege" as a core member of the Economic and Monetary Union (EMU).
"Absent a catalyst, markets can overlook certain facts for a prolonged period. For years, France has managed to borrow at virtually the same cost as Germany, while running much larger deficits and accumulating enormous leverage in the corporate sector," he said.
What markets can no longer ignore is the drastic divergence in debt between the two anchor economies of the euro. In the 1990s, the public debt ratios of Germany and France were similar. Today, Germany's debt stands at 64% of GDP and declining, while France's is at 111% and rising. This is unsustainable for the monetary union.
French private and corporate debt is also extreme, and some of this represents a contingent liability for the state. Data from the Bank for International Settlements show that total "core" debt is 320% of GDP in France, 235% in Italy, and 180% in Germany.
"France has always been able to get away with it because it is France," said Bernard Connolly, a renowned Wicksellian economist and author of "You Always Hurt The One You Love: Central Banks and the Murder of Capitalism."
"But Germany is no longer inclined to let France get away with it. The differences are becoming too great to smooth over, and we are moving closer to the point where the Germans give up on monetary union," he added.
When Mr. Macron first took power in 2017, he touted a "grand bargain" with Berlin: he would reform France and make it fit for the euro; Germany would agree to fiscal union, the critical step needed to stabilize the eurozone. His gamble seemed to succeed when Angela Merkel accepted joint debt issuance for the EU's €800bn (£676bn) Recovery Fund. However, that was a one-off scheme, carefully ring-fenced in law. "People thought it was the start of Eurobonds. It was really the death of euro bonds," said Yanis Varoufkis, who had his own experiences with Germany during the Athens Spring.
Berlin has since resisted all attempts to perpetuate the fund or to issue joint debt for energy and defense. "Fiscal integration is a super-tough nut to crack in Europe because it is intrinsically linked to national sovereignty and democracy," said Bruegel's Mr. Zettelmeyer.
"We thought for a moment that it was some kind of 'Hamilton moment' but it was not. We will probably never get to the minimum economic constitution required for the euro to deliver stability and prosperity," he said.
If there was any doubt a year ago, there is none now. Mr. Macron's snap election has guaranteed that Germany, the Netherlands, and the fiscally conservative countries will not share their credit card with the Latin bloc in the foreseeable future. They will not agree to an EU treasury with federal tax-raising powers. The euro will remain an orphan currency.
The euro may limp on for years because the trauma of breaking it up is too awful to contemplate. But what is the purpose of a monetary union that will never be placed on a viable footing?
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