Monday, April 23, 2012

France can't afford Francois Hollande

The people of France will choose their next president on May 12th. 

While presidential elections are always important in France (because the right/left policy divide is so pronounced), this time it is particularly consequential. France will be choosing between market credibility and “social justice”. 

Sarkozy, on the right, represents the policy of fiscal austerity and bond market credibility, while Hollande offers greater social welfare spending and confiscatory taxes on “the rich”. There is nothing new about such a debate, and normally this election would be business as usual.

But it isn’t business as usual, because of France’s decision in 1999 to ditch the franc and adopt a foreign currency, the euro. France has committed what economists call “original sin”: she has financed her national debt in foreign currency. Like a Latin American country in 1982 or an Asian country in 1997, she has placed herself at the mercy of foreign creditors.

France sacrificed her monetary sovereignty to get greater European unity. Now, instead of worrying about the external price of the franc, she must worry about the attractiveness of her debt to eurobond investors. A weak currency is a problem; unmarketable debt is a catastrophe.

If, in the midst of the euro crisis, the people of France demonstrate that they prefer more social welfare to bond market credibility, they will soon have neither. The consensus view among the punditocracy is that either candidate will have to pursue austerity and that, should Hollande take a step down the socialist road, the markets will push him back.

But markets have memories, and once a new yield plateau is set for French bonds, it could prove quite difficult to convince the market that France = Germany as a credit. Should the people elect Hollande, at this conjuncture in history, no rational investor would ever again view France as the same as Germany. (Even the German socialists are austere.)

So, as a thought experiment, let’s think about what it would mean for the world if France became a “story credit”, a name that appeals to some investors’ tastes but not others. First of all, it would be bad news for the rest of Club Med, since they are even worse credits. It would make it harder for Portugal, Spain and Italy to market their debt. it would probably force Europe and the IMF to rescue Portugal and Spain. No one can rescue Italy (too big), and the cost of rescuing the entire Club Med (France, Italy, Spain and Portugal) staggers the mind.

There is only one way to avoid a Second Great Depression, and that is for each member of Club Med to do its part in building bond market confidence, and for the ECB to do its part as the lender of last resort. At present, the signals coming from the borrowers are mixed, and the ECB continues to engage in metaphysical debates about its mandate. Germany and the Bundesbank continue to insist upon austerity from all eurozone members.

We are looking at a multi-piece orchestra in which each player must be flawless. For France, of all European countries, to be the one that blows the false note, would be a very negative event. We’ll know in a couple of weeks.