The French Political Crisis That's Turning Into a Debt Crisis

Shahin Vallée · German Council on Foreign Relations (DGAP)Bearish

Chinese competition in aircraft could eventually produce an A320 equivalent and hurt Airbus and France.

Aeronautics is a very important French export and one where China is not yet competing. The speaker's worry is that China may eventually be able to build the equivalent of an Airbus A320, and that would be very damaging for Europe and France. He flags this as the main industrial risk for France, even though the auto sector is currently the centre of the trade fight. No timeline or numbers are given.

“but where it might, you know, the days where the Chinese can produce the equivalent of an Airbus A320 are going to be dark days for Europe and for France”at 46:06

Shahin Vallée · German Council on Foreign Relations (DGAP)

Centrists are collapsing, so France's 2027 elections leave fiscal policy harder to set than today.

The budget announced was roughly in line with expectations and perhaps slightly better, so fiscal news is not the trigger; the change is perceived political risk. Centrist candidates have fallen in first-round polls and now lose in hypothetical runoffs to Marine Le Pen, so the likely runoff is Le Pen versus Jean-Luc Mélenchon. Le Pen could win the presidency but struggle to win a majority in the general election a month later, especially against a strong far-left opponent. Markets had assumed a credible fiscal adjustment by 2027 under a president and parliament able to pass it. Vallée thinks France may now be worse placed to decide fiscal policy after the elections than it is today, since Macron has lacked a majority since 2024.

“I think they're worried about French debt not because there is anything new about fiscal policy... I think what has changed in the last few weeks is the perception of the political risk”at 9:08

Shahin Vallée · German Council on Foreign Relations (DGAP)

A Le Pen-led France would likely be more antagonistic to the EU than Meloni's Italy.

Far-right parties across Europe have mostly stopped opposing the euro and the EU, so the difference lies in France's position. Unlike Italy, which was a net recipient of about 300 billion euros from the recovery and resilience facility, France is a net contributor to the EU budget. That gives a Le Pen government leverage to pick a fight over the EU budget, which is being negotiated now. Vallée argues that Meloni had no such leverage when she took power. He adds that France under Le Pen would have much more difficulty building a governing coalition than Meloni did.

“Le Pen would be in a different position than Meloni because France is a net contributor to the EU budget, and so Le Pen could pick up a fight with the EU on the EU budget”at 13:26

Shahin Vallée · German Council on Foreign Relations (DGAP)

Mélenchon's idea to cancel Banque de France-held debt is provocative and would unsettle markets, not help.

About 20% of French public debt is owed to the Banque de France, which holds it from ECB asset purchases during the euro crisis and COVID. Mélenchon said he would cancel it, first 'throw it to the fire' and later put it 'in the freezer', meaning the ECB would roll it indefinitely. That would cut financing costs at the margin. Vallée thinks he proposed it to be provocative and did not see it would heighten debt sustainability concerns. The ECB governor, Emmanuel Moulin, said it would violate European treaties and warned France could be strangled by its debt. Mélenchon reacted angrily and threatened the governor with a high treason trial. Vallée sees a Varoufakis parallel: Mélenchon could gain political credit by standing against markets, but the policy is unrealistic.

“So he's put this on the table, I think deliberately to be provocative, not realizing I think that this would excite even more market concerns around debt sustainability”at 27:12

Shahin Vallée · German Council on Foreign Relations (DGAP)

Le Pen's new constitutional fiscal rule is too bold to be credible without concrete reform steps.

Le Pen proposed putting a fiscal rule in the constitution that requires bringing the deficit to a debt-stabilising level, roughly halving it almost immediately. Until debt returns to 60% of GDP, it would require at least 0.5% of GDP in annual adjustment. Budgets that break the rule would be blocked by the constitutional court, and exceptions need a three-fifths parliamentary majority and are limited to two years. Vallée says this sets the bar above Germany's debt brake. But she has not put forward the policies to deliver it, such as pension reform, and her commitment to social spending conflicts with it. Vallée argues the tension cannot survive: she will have to disappoint markets by admitting she cannot deliver, or disappoint her electorate by raising the pension age.

“Where I see a bit of cognitive dissonance is that she's saying that and on the other hand she hasn't really put the policies that would deliver that kind of fiscal adjustment”at 21:45

Shahin Vallée · German Council on Foreign Relations (DGAP)

Euro area is more robust to crises after ESM, banking union and central bank backstop additions.

The euro crisis ended without an explicit 'whatever it takes' pledge, but the architecture changed. The ESM was created as a lender to governments that agree to adjustment programmes, similar to the IMF. Banking union added a single bank supervisor and resolution authority to break the bank-sovereign doom loop. The euro area also implicitly accepted that the central bank could act as lender of last resort in a crisis. Vallée argues that together these left the euro area better buttressed and more robust to crises. That is why the ECB does not need to repeat magic words to cap spreads now.

“I think what we left Europe with or the Euro Area with at the time is the impression that we had solidified, we had kind of buttressed the architecture of the Euro Area and that now we are more robust to crises, which I think is true.”at 37:56

Shahin Vallée · German Council on Foreign Relations (DGAP)

Tools to resolve France's debt crisis exist, but none can happen before the French elections.

The circuit breakers need two steps. First, a national fiscal consensus, for example a cross-party expert process that agrees a debt rule for the next decade, as Germany did with its fiscal rule commission. Second, an ECB intervention, either an ESM-style program with OMT or the new Transmission Protection Instrument (TPI). The TPI can be activated without a program but only if the country is deemed compliant with EU fiscal rules, which in turn requires a credible medium-term adjustment. So the building blocks are within reach, but the speaker sees no catalyst to get them in place before the French elections.

“I struggle to see how they happen on this side of the French elections.”at 49:12

Shahin Vallée · German Council on Foreign Relations (DGAP)

French banks have little sovereign exposure and no active doom loop with French OAT debt.

French banks hold less government debt than Italian or Spanish banks, so they could raise their sovereign exposure meaningfully and still be within what Italian or Spanish banks hold. That gives roughly 300 to 400 billion of room to stabilise the market, enough to return to their 2011-2012 peak exposure. The 2011 French bank squeeze was not a sovereign doom loop. It was a scramble for dollars, as US money market funds stopped financing European and French banks. Vallée says he is less worried about a sovereign-bank doom loop now than ten or fifteen years ago.

“So I don't think we're in a situation where there is a very active doom loop between the French OAT exposure and the French banks.”at 31:13

Shahin Vallée · German Council on Foreign Relations (DGAP)

ECB is unlikely to backstop French debt without credible French fiscal consolidation, and Germany's politics block a free backstop.

ECB backstop tools (OMT, originally tied to an ESM program) were conditional on a country committing to fiscal adjustment. The ECB would have the power to stabilise French debt quickly, but France shows no sign of a sound fiscal path, so the ECB is unlikely to step in. Politically, a German chancellor giving France a free backstop would carry a severe domestic cost, because it would boost the AfD (described as 'IFD' in the transcript, a party founded as anti-euro that is now focused on immigration). Countries that went through tough adjustment in the euro area would also see the exception as unfair, so the intra-European political bind is hard to resolve.

“The problem we have today is that, you know, we have no signs that France is prepared to deliver on a sound fiscal path, and I think as a result of that, it's very unlikely that the ECB can step in.”at 38:49

Shahin Vallée · German Council on Foreign Relations (DGAP)

Consolidating French public finances requires restoring some form of wealth tax; abolishing it was a mistake.

Macron's 2017 abolition of the wealth tax was a mistake, both symbolically and economically, because it made the tax system less progressive. It also led to Macron being painted as 'president of the rich', which undermined his reform efforts, including a pension reform he was never able to pass. The speaker expects France to at least return to the 2017 wealth tax and probably go further, since the wealth tax is an inevitable part of the fiscal adjustment, alongside pension reform on the spending side. He doubts France will go as far as Gabriel Zucman's aggressive proposal, and notes even Mélenchon has not fully embraced it.

“I think that was a mistake and indeed I think now there is no way of consolidating public finances without restoring some form of a wealth tax.”at 43:10

Shahin Vallée · German Council on Foreign Relations (DGAP)

France is much less exposed than Germany to the Chinese export surge, since deindustrialisation has largely already happened.

French policy circles have pushed Germany to treat the second China shock as a real issue, and a Franco-German non-paper and a recent trade-commissioner deal with China show Europe is more willing to use trade defence tools. Economically, though, France is much less exposed than Germany. France has already largely deindustrialised and is mainly a service-based economy, while Germany's deindustrialisation is still under way. The speaker calls it a fight France has already lost in part, while noting autos, the centre of the current fight, is not a central concern for France.

“economically speaking I would say France is a lot less exposed than Germany is. To some extent de industrialization has occurred in France already, it is occurring now in Germany”at 45:26