For France, Brexit Is Not Primarily About Britain

by: Tokyo Picker

France has consistently been the most rigid of the EU27 with regard to Brexit.

France's attitude is not driven by any animus toward the UK.

Macron is clearly focused on the long-term risk to the French economy created by its membership of the Eurozone.

It is very easy for Americans to view Brexit from a British perspective. Our (approximately) common language makes British media very accessible. The events in the British parliament are dramatic and can be watched on YouTube. Our President (and his family) are getting involved in the process. And the acerbic Nigel Farage, the most important British politician since (at least) Margaret Thatcher, has become a widely known celebrity on both sides of the Atlantic.

Furthermore, it is difficult for most observers on this side of the Atlantic to disentangle the divergent interests of views of the other 27 members of the European Union, only one of which communicates primarily in English. However, throughout the Brexit process, one nation has taken on the role of leader of the EU27 with regard to the Brexit process - France (EWQ). This week revealed the policy behind the positions that France has taken.

For many observers, the position that France has taken (and which has been faithfully reflected by Michel Barnier, the EU27's designated negotiator versus the UK, and a career French/EU politician) has been unexpectedly rigid and hostile to the UK - early British aspirations of a smooth exit and a friendly trade deal were crushed by the EU27's exploitation of the UK's three irreconcilable promises.

  1. The UK government promised Ireland and the EU that there would be no imposition of a border between Northern Ireland (still part of the UK) and the Republic of Ireland - thus effectively binding Northern Ireland into the EU customs union and possibly the EU single market.
  2. The UK government promised Northern Irish unionists (on whom the current minority UK government depends for its survival) that Northern Ireland will be treated exactly the same as the rest of the UK - when combined with the first promise, this would bind the UK into the EU customs union and the EU single market.
  3. The UK government promised the British people and the British parliament that the UK would leave the EU customs union and the EU single market.

The withdrawal agreement negotiated by the British government, but decisively rejected by the British parliament, honors the first two promises, but therefore cannot honor the third, and that is the cause of the current political strife in London.

So why are the EU27, and in particular the French, being so rigid?

It's all about the Euro: Emil

If we look at the direct consequences of Brexit to France, they would be bad for France - loss of markets, supply chain disruptions, transportation delays. However, they pale into insignificance when compared to the problems created by the Eurozone (EZU). The UK is not a member of the Eurozone, but France is. For the purpose of this article, I think it is useful to divide the Eurozone into 4 categories - the Strong - Austria (EWO), Finland (EFNL), Luxembourg, and the Netherlands (EWN); the Weak - Cyprus, Greece (GREK), Ireland (EIRL), Italy (EWI), Portugal (PGAL) and Spain (EWP); the In-Betweeners - Belgium (EWK), Estonia, France, Latvia, Lithuania, Malta, Slovakia and Slovenia; and Germany (EWG), which is, of course, sui generis.

Before discussing the current problems with the Euro, it is useful to look back to the origins of the Euro problem and to compare it to the US dollar. The US dollar has not suffered greatly, if at all, from the bankruptcy or default of even substantial sub-division within our polity. Think of the bankruptcies of Orange County and Detroit, the near-bankruptcy of New York City and the quasi-bankruptcy of Puerto Rico. Even the almost inevitable defaults of Illinois and of Chicago are unlikely to substantially affect the currency or to cause a general loss of confidence in the national economy. This is because all sophisticated investors understand that neither the US government nor the Federal Reserve are obligated to stand behind those troubled entities (they may choose to, but they do not have to, and, historically, they have not). This is not the case with the Euro.

As the Euro and the European Central Bank came into being in the 1990s, the Kohl and Mitterrand administrations attempted to assuage the concerns of (primarily) Dutch and German monetary technocrats about the risks of sharing a currency with debt-ridden Italy and Belgium by putting mechanisms into the Maastricht Treaty and its derivative Stability and Growth Pact ("SGP"), which sought to restrain over-borrowing by member nations and thus reduce the likelihood that Eurozone countries would be required to bail each other out. However, the fact that both France and Germany breached the SGP within a few years of its implementation, and the political decisions to require the ECB to treat the obligations of all member governments equally, regardless of creditworthiness and/or Maastricht compliance led international banks (and particularly European banks) to lend to all Eurozone public sector entities on the assumption that their creditworthiness was little worse than that of Germany. They were supported in this assumption by member states' adoption of the Target 2 monetary transfer system. A full discussion of Target 2 is beyond the scope of this article (see here for a brief description from the Bundesbank). Suffice it to say that Target 2 is a clearing system that never actually clears, and which allows the Eurozone central banks of importing countries to run up large debts to the Eurozone central banks of exporting countries. The latest data (available here) shows that the system's largest creditor is the Bundesbank, which is owed about €866 billion, and the latest debtors are the Bank of Italy (€480 billion) and the Bank of Spain (€400 billion). The large Target 2 balances act (and have acted since the creation of the Eurozone) as a reassurance to the banks who lend to weaker Eurozone governments that the central banks of the stronger governments are in the same boat as they are, and can be relied upon to take over the oars when approaching icebergs.

We all know the consequences of the Eurozone's lack of clarity and political ineptitude. The unintended entwinement of the Eurozone's balance sheets, governmental and banking, led to the crisis of 2009-2012. The damage to the European banking sector, the chronic unemployment, the impoverishment of the weaker countries, and the loss of confidence in political institutions have transformed Europe over the last 10 years. The Eurozone leaders believe that to allow a member country to fail would be economically catastrophic, and they have developed a policy framework to avoid such a situation. This consists of three main elements - (A) ECB monetary laxity; (B) the takeover of Greece, Italian and Cypriot fiscal policy by Berlin & Brussels; and (C) the acceptance that there must be some subsidy to the Weak countries from the other groups (albeit in ways which are not too offensive to the electorates of Germany and of the Strong countries which will have to pay most of those subsidies).

The consequences of the Euro crisis are still plaguing European politicians today, as their electorates tire of constant austerity and lack of opportunity, and their banking sectors suffer through a long, slow recovery. But is there light at the end of the tunnel? If you are President Emil Macron, sitting in the Elysee Palace today, you might very well think so. Some of the Weak countries are looking substantially better - Ireland, Portugal and Spain may not be out of the woods, but the trees have certainly thinned substantially. Even Greece has improved slightly. Italy, which was teetering on the brink of an exasperated rupture with the Eurozone, has pulled back due to sustained pressure from France, Germany and the Strong countries. With patience and consistent policies from their stronger neighbors, the Weak countries may slowly be able to repair the balance sheets of their governments and banks and put the Eurozone back onto a path of sustained growth.

You can check out any time you like, but you can never leave

And there is the greatest problem for and the greatest fear for France. In a monetary union between economies of different strengths, it is much easier to leave through the top than from the bottom. For example, should Germany choose to leave the Euro and reestablish its own currency, it would face a number of problems - writing off the Target 2 balance, recapitalizing banks for depreciated Eurozone assets, a worsening of the terms of trade - but these would not be existential problems. The markets would not lose confidence in Germany or its currency, there would not be shortages of crucial imports, and there would not be hyperinflation. In all likelihood, the new German currency would appreciate against the Euro. None of this would be true for Italy (let alone Greece or Cyprus) should they choose to leave.

The Strong countries are in much the same situation as Germany. France, however, is not. Her economy is considerably weaker, with a chronic debt/deficit problem, stubbornly high (although improving) unemployment, rigid labor markets, violent civil discord arising from her austerity policies and an over-regulated statist economy.

France debt to GDP France: Debt to GDP - source trading

It is very unlikely that the markets would look favorably on a French abandonment of the Euro. However, the Euro is not all bad for France - she gains monetary stability, access to and integration with the northern European economies and low borrowing rates. The Eurozone is, for France, a Hotel California - "this could be heaven or this could be hell... but you can never leave".

The Nightmare Scenario

France cannot abandon the Euro at this stage, but Germany and the Strong countries can (excluding Luxembourg, for reasons too detailed to explain here). This is the nightmare for France. She would be left with the Weak countries and some of the In-Betweeners (others are closely linked to the Strong economies and will likely follow them). The consequences would be devastating. France's banking sector would be once again in crisis. Monetary stability and low borrowing rates would be a thing of the past. External funding would dry up. France's Hotel California would quickly become a Roach Motel. This is the scenario which France must avoid at all costs. To analyze how likely it is, it is useful to consider Germany and the Strong countries separately.

Germany is by far the strongest and most important country in the Eurozone and in the EU. Its economic strength gives it great freedom of action. However, its economic strength is balanced by political weakness and hesitancy. For historical reasons, Germany takes leadership in Europe reluctantly and delicately. It does not wish to be seen as a bully or as a disruptor. There is substantial opposition to the Euro in Germany and the main opposition party - the AfD is in favor of leaving the Euro.

AfD Manifesto - Euro

Source: AfD Manifesto 2017

However, this is still far from a majority opinion in Germany. The AfD received only 12.6% of the vote in the election it fought on that manifesto (it is the main opposition because the two largest parties are in coalition), and no other major party currently supports withdrawal from the Euro. It seems unlikely that Germany will lead any exit from the Euro.

The Strong countries (again, excluding Luxembourg) are a different matter. Each has a strong, populist party with strong reservations about the Euro - the Finns Party, the Austrian Freedom Party and, perhaps currently most importantly, the fast-growing Forum for Democracy in the Netherlands. Each of these parties has a strongly anti-EU/Euro stance and each of them are considerably more important than AfD in their respective countries. The Freedom Party came a close second in the Austrian 2017 election and is in the governing coalition. The Finns Party also came second in the 2015 election and were, until a recent split, in the governing coalition. Most worrying for France, the Forum for Democracy recently won Dutch provincial elections and is expected to become the largest party in the Dutch Senate. While most educated observers would agree that it is unlikely that any of these parties will become strong enough to take their respective countries out of the EU or the Euro, most educated observers also agreed that the British would never vote for Brexit. France cannot afford to take the risk.

And that brings us back to Brexit

France cannot allow Britain to have a Brexit which can be viewed as a positive example by the Strong countries of the Eurozone. Even before the Brexit referendum, when a Yes vote was almost universally agreed to be unlikely, French and EU officials felt it necessary to give a stern warning to the UK, making it clear that Brexit would have painful consequences. That attitude has guided their negotiating position throughout the Brexit process.

Now President Macron has decided to make France's view absolutely clear. While giving the British a much shorter extension than they had requested, he then gave a press conference to describe the situation as a "political lesson" for us all. He went on to say, no doubt with a Dutch audience particularly in mind, "The British people are our friends. I am not overjoyed about any hardship they are about to face. But I hope they see the difference between what they were promised by Brexiteers, and reality." As Jean-Marc Huissoud, a professor in international relations at the Grenoble School of Management in France, opined following the press conference, "France's position is to dissuade any other country from trying to leave the Union".

For France, Brexit is not about the British, it's about the precedent. Leaving the EU or the Euro or both must be shown to be so unpleasant that no other country will ever attempt it.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.