French President Francois Hollande holds all the cards.
FORTUNE — France’s Socialist Party could be setting the country up to become the next major victim of the European financial crisis. A landslide victory for the party, called PS, in this week’s parliamentary elections gives the leftist political party virtually total control of the French government. With no check to the PS’s power, the party will be free to implement a number of programs that will increase the country’s burgeoning debt load, making it a target for the bond market vigilantes.
But instead of rolling back prudent reforms and spending more money, the PS, with its commanding majority and enormous political capital, has a golden opportunity to push for a much closer political and economic union for the eurozone. Such a change would go further to mending France’s withered economy than any of the regressive policies currently under consideration.
The champagne flowed at the PS headquarters on Monday morning as the party won 314 seats in the 577-seat French parliament. The victory gives the PS total control of the upper and lower houses of the National Assembly, which hands the head of the PS and the country’s newly elected President, Francois Hollande, the power to push through laws without the need to compromise with the conservative UMP party, which picked up just 209 seats. The resounding victory was better than expected as it meant that the PS wouldn’t even have to form a coalition with other leftist parties to control the legislative branch of government, essentially giving it total control of the country.
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The PS is wasting no time in getting down to work. The parliament has been called into an extraordinary session for a month to start the process of “rebuilding” the French economy. With 10% unemployment and zero GDP growth expected for 2012, things aren’t pretty in the Hexagone these days. The country is facing a 5% budget deficit this year, which will increase the nation’s already high debt to GDP ratio to well above 90%. And even scarier, the French mega banks, which have made billions of euros of loans to governments and consumers across the eurozone, are exposed to a mind-blowing $2.7 trillion in debt, which is pretty much equal to the nation’s GDP.
Looking at those numbers it is no wonder why France is viewed by many on Wall Street and the City of London as being a financial ticking time bomb. The PS wants to quietly disarm the bomb before it goes off through a number of initiatives, which they believe will stimulate economic growth. But while the PS has good intention, it looks like it is getting ready to snip the wrong wire.
The PS campaigned on a populist platform where it promised to tame the country’s rising debt load, while stimulating economic growth. The party plans on achieving these two normally conflicting goals primarily through tax hikes. Hollande campaigned in April on the promise of raising the nation’s top tax bracket to 75% and closing a number of tax loopholes, which his office claims could bring in 10 billion euros to the national treasury, narrowing the 5% budget deficit to a more manageable level. There is also talk of instituting a 3% dividend tax, a 15% special tax on banks and energy companies, as well as a small transaction tax on all financial deals. In addition, there is also talk of increasing the nations VAT tax rate, which will have a negative impact on consumer spending.
Increasing taxes at a time when there is zero economic growth is truly a bad idea. If anything, Hollande should be talking about lowering taxes on businesses and the like, not raising them. To make matters worse, the PS wants to roll back some prudent reforms that were instituted by the previous government. At the top of that list is the move to lower the national retirement age from 62 back to 60. This is an all-around bad idea as it not only cuts productivity, but also tacks billions of euros on to the national debt, wiping out any potential gains expected through the tax hikes.
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The PS has also talked about engaging in several rounds of deficit spending, whereby the government would sell a large amount of debt to fund a number of grand projects across France. The hope is that these large infrastructure projects will help jumpstart the nation’s moribund economy. But while deficit spending can be successful in helping to pull a nation out of recession, the effects are usually temporary. Without a major change in the direction of the economy, France is doomed to fall back right where it started after all the grand projects are complete.
Political philosophies aside, the inescapable conclusion from all of this taxing and spending is a temporary, if not permanent, increase in the nation’s debt load. This is a very dangerous gamble for France given how sensitive the market has become to countries tacking on more debt. After all, France just recently lost its coveted triple-A credit rating and is on a negative credit watch by the rating agencies. If it looks like the country is not being serious about slashing its debt load, then its credit rating will fall even further, which will kick up borrowing costs. Soon the bond market will begin to question the solvency of the French government and will demand a higher yield to hold French debt. This negative feedback loop will ultimately send bond yields to an unsustainably high level, forcing France to either default on its debt or seek a crippling and humiliating bailout.
But there is a glimmer of hope that the PS will not take France down. France’s Prime Minister Jean-Marc Ayrault announced this week that he would be delaying the government’s policy agenda until after a critical eurozone conference scheduled for the end of this month. At the conference, there will be talk about reforming bank rules, creating a national bank regulator, pooling national debts, issuing a common debt instrument and, most importantly, taking the first steps to a closer fiscal and political union.
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It is here where France has the chance to truly make its mark on history. Unlike the rest of the eurozone member states, France has a government that can truly speak with one voice. Whatever France supports at the conference will remain as such as there would be no need to discuss the situation or vote on anything with opposition groups.
The benefits of integrating far exceed any kind of reform that the PS has on its economic agenda. Germany has said quietly it would agree to France’s desire for a common debt instrument if participating eurozone members would be willing to give up some sovereign and fiscal power to a central European authority, which would naturally be dominated by Germany. This would allow France to use the credit rating of other, stronger eurozone members to fund its stimulus package without putting its future domestic funding needs in jeopardy. It would also put the green light on a 120 billion euro stimulus package that Hollande hopes would fund some of the grand projects in France.
Hollande would be wise to tone down the socialist agenda as soon as he can so he can do what is needed to further integrate France into a tighter political and fiscal union with its neighbors. It will take a bold and self-assured leader to agree to give up political and economic control for a greater good. Let’s hope that Hollande can deliver.
