Chief Economist's Corner: Europe’s new sick man

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I am thoroughly enjoying the fifth and final season of the fantastic Babylon Berlin, which has just premiered on German television. And as I watch it, it is difficult not to draw parallels with today’s political polarisation.

Not because I fear that history as such is repeating itself. Interwar Germany was burdened by defeat in the First World War, war reparations, hyperinflation and, later, the Great Depression. Thankfully, that is not where we are today. But in many places, the economy is stagnating, the cost of living is rising, public finances are under pressure, and voters are losing faith in the political system’s ability to deliver progress. In such a situation, compromises become harder and political extremes grow stronger.

This is the reality of Europe today, which at the same time must find its place in a new world order in which security policy and economic policy are increasingly intertwined.

Much would be easier if growth were stronger. As things stand, Europe continues to fall further behind the United States and China in productivity, innovation and investment. This was also a central message of the Draghi report, published just over two years ago, whose recommendations have still only been translated into action to a limited extent.

Nowhere are the problems more evident than in France, which risks taking over the unflattering role of Europe’s sick man. Growth is weak, productivity performance is disappointing, industry has lost importance, and for many years the government has spent more than it takes in. In fact, France has not recorded a public-sector budget surplus since 1974, and debt has exceeded 110 per cent of GDP. That illustrates just how structural the problem is.

The combination of high debt, low growth and rising interest rates is a particularly toxic cocktail that can quickly trigger concerns about long-term debt sustainability. The reaction of financial markets says it all. In a short period of time, the yield on a 10-year French government bond has risen to 5 per cent. That is higher than the Italian yield and almost 2 percentage points above the equivalent Danish government bond yield.

At a time when interest payments are swallowing an ever larger share of the budget, while new political priorities are pressing their claims, debt dynamics risk taking on a life of their own. France also needs to spend more on defence, the green transition and an ageing population. In its latest special report on the French economy, the OECD also concludes that significant fiscal tightening and far-reaching structural reforms, including to the pension system, are needed if debt is to be stabilised.

Neither is an obvious vote-winner in an election year. At the same time, any solution will remain difficult if growth stays weak. The country needs higher productivity, more investment and greater innovation if it is to avoid stagnation and an outright debt crisis.

But before it gets that far, it is also worth remembering that France is a systemically important country, simply too large and too important for the euro area for other countries to stand idly by if confidence in its ability to service its debt seriously begins to erode. In such a scenario, the pressure on the European Central Bank, the ECB, to intervene would be enormous. It could, for example, launch a new programme of purchases of French government bonds to push yields down.

But it must be stressed that, in reality, the ECB can only buy the French time to generate productivity growth or build political majorities for unpopular policy decisions. And I must admit that I am not particularly optimistic on that front.

And if we return for a moment to Babylon Berlin, this is no longer about hyperinflation, stock market crashes and depression. Today’s problem is rather the interplay between economic stagnation, growing inequality and political polarisation. In many ways, France’s dilemma is a concentrated version of the massive challenges facing the old continent. Perhaps, in the end, we really do need a small miracle.