Euro’s Reputation Damaged – Conflicts over Fiscal Policy Expected

In the second round of the French parliamentary elections yesterday, the leftist New Popular Front (NFP) alliance emerged as the strongest force, Emmanuel Macron’s liberal government alliance came in second, and the far-right National Rally (RN) came in third.

Friedrich Heinemann, head of the ZEW Research Unit “Corporate Taxation and Public Finance” and professor at Heidelberg University, has commented on this matter:

“The outcome of the French election has damaged the euro’s reputation, despite damage control in the second-round ballot. Europe is heading towards very serious conflicts and decisions on fiscal policy with uncertain outcomes.

Although there is relief that a government majority of the xenophobic and nationalist RN was prevented, the parliamentary seats have shifted to the extremes of the political spectrum. For now, this polarised parliament still faces a reform-oriented and pro-European president, whose options are now significantly limited.

This election result in the second largest Member State will further limit the EU’s problem-solving capacity. The NFP, which now claims the right to govern, stands for a reversal of Macron’s reform course. It wants to further increase the already high French minimum wage, cap the price of essential goods and energy, scrap Macron’s pension and labour market reforms, and raise taxes on companies and the wealthy. The NFP is critical of the central integration project of a market-oriented internal market and pursues a decidedly protectionist course at Europe’s borders, rejecting the principles of free trade. It not only opposes new free trade agreements but also wants to end existing ones.

The result will have very tangible consequences for the next EU financial framework. An ambitious expansion of the EU budget now stands little chance, given the Franco-German disagreement on the direction of the integration project.

New EU debt is also likely to be off the table. Financial solidarity during COVID-19 was justified because the pandemic and its financial consequences were an unforeseen external event. However, the French election result represents a looming departure from France’s previous economic and European policy of fiscal responsibility. The expected further deterioration of French public finances would be clearly self-inflicted. It is hard to imagine that a German government would back the financial policy of a fiscally populist France through higher German EU guarantees without voter backlash.

The European Commission and the ECB now face pressing questions about France’s already critically high deficits: they should be increasing the pressure on Paris to reduce deficits. However, France is considered a clear case of ‘too big to fail’. A French debt crisis would trigger a global financial crisis and could destroy the euro. So even a left-populist fiscal policy in Paris can ultimately hope for tolerance from the Commission and financial backing from the ECB. The Commission and the ECB now have to contend with the accusation that their lax and politicised interpretation of the Stability Pact and interest rate guarantees for high-debt states have encouraged the election of populists at both ends of the spectrum. It would also play into the hands of populists of all stripes if the EU institutions, which have previously allowed a euro-friendly government to violate stability rules, now deny the same to a new democratically legitimised government.”