The French have finally made it!

 

With trade-wars, market volatility and Stormy Daniels Russian diplomats dominating the headlines this week, you would be excused for missing the week’s good news: France has managed to bring its government deficit back below 3%! On the back of better than expected tax receipts, France’s public deficit shrank to 2.6% as a percentage of GDP in 2017, which means that – with the exception of Spain – all of the major Eurozone members managed to comply with the deficit rule of the Growth and Stability Pact in 2017.

Finally!

Capture

Source: Bloomberg & Robeco

 

Whether this 3% norm is a good thing or a bad thing has been a question of debate in recent years. There are many people who claim that the growth performance of the European economy since 2009 would have been much improved if only governments had been able to spend more. According to these speculators, the 3% target was chosen completely at random and would offer limited added value in the long run. With bond yields at record lows – suggesting that governments could finance projects almost at zero costs – why not lend and spend more, so it was argued. Opponents pointed out that while issuing more debt might be cost-free at the time, what if you had to refinance that debt, say, ten years down the line? With the cost of ageing forecast to swell in the future, now was the time to be vigilant on deficits!

 

Missing the point

As interesting as this discussion may be, it sort of misses the broader idea of setting certain uniform limits within a single currency market. The whole purpose of the limit – whatever its level – is to prevent too much divergence in the financial stability of the various member states. The example of Greece clearly shows what can happen when the financial position of a single country is spiraling out of control: immense pressures within the single currency zone which can ultimately rock the very system to its core. As long as all the governments more or less follow the same deficit path and as long as nominal growth is more or less equal, in the longer run the debt (accumulation of all past deficits) will ultimately converge, leading to stability within the group.

With this in mind, our reason to cheer soon evaporates, as this week’s chart clearly illustrates. Since the introduction of the euro back in 1999, France has only managed to reach the target 6 times (out of 19), with an average budget deficit for this period of 3.5%. The last time France actually made the magic 3% mark was 10 years ago… The difference with its neighbor Germany is pretty notable: whereas both countries used to have comparable levels of deficit, since 2007 the gap has gradually widened . Germany has been running a budget surplus for the past four years now.

 

The divergence between the French and German deficit is pretty notable…

deficit

Source: Bloomberg & Robeco

 

If you are not impressed by these numbers, let me show you a third chart. This one shows the development of debt to GDP in the two countries over time. The green bars show the development of the differential of debt to GDP in France in excess of that in Germany.

 

…with pretty dire consequences for debt divergence

debt

Source: Bloomberg & Robeco

 

Back in 2010, the debt to GDP in both countries stood at roughly 81%, with only a marginal difference of 0.7% points between them. In just seven years, this gap has widened to 33.3% points! Germany’s strict budgetary policy has brought the debt to GDP ratio back to 65% of GDP – still above the 60% debt to GDP stability pact target – while French debt to GDP has climbed to 98% in the same time frame.

 

All in all, whether France has managed to make the 3% mark is not the main issue at play here. A more important observation is the substantial debt divergence between the two largest economies of the Eurozone, a fact that should be seen as a huge warning sign for the future of this economic region.

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