How the next eurozone crisis happens French collapse is contagious

France is in the grip of social breakdown, with financial chaos looming. The urgent question now is: could it spread? A leading expert on Europe and its discontents, Wolfgang Münchau explores how the next debt crisis might start — and how it could both destroy the eurozone and scar Britain’s economy. 

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“The Irish say they are not Greece. The Portuguese say they are not Irish. The Spanish finance minister said last week that Spain is not Portugal.” I wrote these words in the Financial Times over 15 years ago, as the eurozone sovereign-debt crisis raged. Fast forward to today, and the big news is that Belgians are not French. Expect, soon enough, to hear that Italians are not Belgian. With all eyes currently on France, on the violence, the protests, and the rising possibility of a genuine financial crisis, the key question now is how such a crisis might spread.

The first eurozone country in the firing line today is Belgium. Like the French, the Belgians allowed their budget deficit to rise, and the national debt to soar. To be fair, the country’s leaders are aware of the risks. To quote Bart De Wever, Belgium’s prime minister and one of Europe’s smarter leaders: “We absolutely must distance ourselves from the French situation to prevent it from spreading to us.” He might as well be telling us that “Belgians are not French”.

In the event, I worry De Wever will have less control over the situation than he thinks. That’s partly because Belgium’s debt-to-GDP ratio — at 108% — is so high. But also because the other two countries in the danger zone are France and Italy: respectively the EU’s second and third-largest economies, and two of the most indebted countries in the bloc.

Just recall that France is in its current mess because of Emmanuel Macron. Who could have predicted that his decade-long presidency would end with his country in flames, and with a financial crisis looming? Yet the policies Macron pursued earlier in his tenure nonetheless led him here. The austerity imposed by his government bred more violence, while cuts in public investment deterred private investors.

Looking at the presidential candidates in France today ahead of the election next April, I struggle to see how the country will end up with a government that succeeds in doing all of the following: bringing the budget deficit under control; avoiding social unrest; complying with European rules; and staying in the eurozone. Something has to give here.

Nobody, not even leading French candidate Marine Le Pen, wants to quit the eurozone. Nor, for that matter, does Jean-Luc Mélenchon. If you thought Brexit was disruptive, a euro exit would be on a different order of magnitude. Yet what many Europeans, including politicians, don’t understand is the relationship between debt and membership of the eurozone. Put simply: you can’t default on your debt and expect to keep the euro. Debt serves as collateral for the money the banking system gets from the ECB. If a country defaults on its debt, the banking system inevitably freezes up.

Given these fundamentals, how might a eurozone crisis actually play out? Le Pen, even more likely to win the presidency now that Paris is burning, is probably crucial here. One option is that, notwithstanding her rhetorical largesse on the campaign trail, she decides to impose austerity once in the Élysée. Her popularity ratings would soon slump, and would likely not recover. You might think this is totally irrational, but we saw this pattern repeat itself over and over again during the eurozone crisis.

Alternatively, Le Pen might conclude that France cannot service its debt if interest rates stay high. She could therefore ask the European Central Bank for a bailout. If the ECB refused — helping France would drive inflation up for everyone — a President Le Pen might instruct her finance minister to default on a payment to bondholders.

In the short-term, at least, there are advantages to such an approach. First, it would free Le Pen up to default on more foreign debtors. That, in turn, could allow her to impose less austerity than she might otherwise have had to. France also would benefit from lower debt-servicing costs, and a more competitive exchange rate, making French companies more competitive against the rest of the world. And perhaps most importantly, France will have its own central bank, one able to set interest rates suited to the country’s economy, and which could be relied upon to act as a backstop in a crisis.

All the same, France defaulting on its debt would likely lead to a French exit from the euro. Should we ever get to this point, the ensuing financial crisis would dwarf everything we have ever experienced. Financial institutions would fail all over the world. For its part, the eurozone might not survive, as other countries default on their debts and crash out in turn. Ironically, one of the European countries most affected in this scenario would be the UK. Despite not being a member of the EU, let alone the eurozone, Britain’s capital market would be deeply vulnerable to chaos across the Channel.

You might well wonder why anyone in their right mind would choose this scenario. The problem is that we’d only get to the implosion of the European financial system after several other things happened first. No one would choose it from a menu.

I’m not saying that there’s no way out. But none of the alternatives are obvious or easy. Leaving the eurozone might well end up being the easiest option, especially if you don’t care about the consequences for the rest of the world.

Having spent a good part of my career writing about the eurozone’s financial crisis, and its ongoing economic decline, I concluded that the one big mistake the EU committed was to choose a monetary union without installing the necessary political infrastructure first: a fiscal union, a single capital market, and a single sovereign debt instrument. The introduction of the euro was the crowning achievement of Europe’s political integration in the Eighties and Nineties. Then it stopped.

This is not an argument about the pros and cons of European integration as such. If you oppose political integration, you should not join the euro. The UK’s opposition to the euro was internally coherent. Poland is an example of a country that would not dream of leaving the EU, but it, too, chose not to join the euro. But what we’ve learned in the last 15 years is that if you join a single currency, you don’t want to stop there; you must go all the way. This is where the bloc went wrong. A half-way house of an unfinished monetary union is unsustainable. By unsustainable, I don’t mean bad. Just that either it’ll be made sustainable — or it’ll end.

Some people argue that political integration may yet happen. I fear this is wishful thinking. The politics of the EU has been moving away from political integration for quite some time; the euro crisis was probably the last moment when a fiscal union could have been realistically agreed. Back then, the far-Right was not yet a political force in most countries, while Germany’s economy was strong enough to theoretically accept a closer union. The fact that, even then, Angela Merkel said nein is telling — certainly, in its newly weakened state, none of Germany’s bickering political parties even mention EU integration today.

Superficially, the euro crisis ended when the ECB supported national bond markets through quantitative easing. But the underlying problem of economic divergence between member states was never really resolved, even as the solutions were only designed for small economies. So, if you tell me that France is not Greece, I’d happily agree — except to add that it’s worse.