Policy-makers and market participants can see much potential for financial crisis in France – and little for durable calm. An ugly mixture of a grid-locked parliament, populist ascendancy on left and right, unsustainable debt and deficits, and a certain national pride could set the stage for a serious French market upset which spills into the broader euro area and the international monetary system.
Observers also point to reasons not to panic, including the term structure of French sovereign debt, and its balanced capital account. Yet financial market pressure on France to rectify its budget, before or after the presidential election in April 2027, could quickly become a broader problem for its neighbours.
The ECB is understandably keeping quiet about the possibility of deploying its so far unused 2022 ‘transmission protection instrument’ to help reduce French government bond (OAT) ‘spreads’ over German Bunds. Soundings with market participants and officials indicate that OAT spreads to Bunds would need to be roughly double current levels – in other words, above 250 to 300 basis points, if not more – before European institutions including the European Central Bank felt the need to act.
French sovereign bond auctions are not currently disorderly. New OATs requiring yields of 8% or more might galvanise bipartisan remedial action in France. Observers note that Italy’s populist-led government under Giorgia Meloni maintains fiscal rules that help it gain access to considerable Next Generation European Union funds. External obligations may provide the justification France needs to restore fiscal sustainability.
‘We are France’
Any solution to the threat of a full-blown France-centred euro crisis must consider the unwritten rules of French exceptionalism. The practical repercussions were summed up in 2016 by Jean-Claude Juncker, Ursula von der Leyen’s predecessor as European Commission president. The EU gave France leeway on fiscal rules, he said, ‘because it is France.’
Financial market participants recognise that the ‘We are France’ notion will dangerously impede the conditionality that would allow other European countries and the ECB to wield ‘conditionality’ over French fiscal and economic policies in return for EU financial support.
At the same time, central bankers recognise that it will be hard to target only ‘unwarranted’ collateral damage in other indebted EMU members (OIEMs) under the TPI. Sooner or later, if French turbulence leads to contagion elsewhere in economic and monetary union, the ECB will get drawn into the political fray – an outcome it is eager to avoid. The euro area has acquired a much more resilient internal structure since invention of the (again, unused) ‘outright monetary transactions’ mechanism under Mario Draghi, ECB president, in 2012. But EMU remains vulnerable to political shocks. A Draghi-style ‘whatever it takes’ initiative is no longer feasible nor appropriate.
The danger is that, amid the fracas of the forthcoming presidential and legislative elections in France, the euro could suffer a disorderly decline in confidence on world financial markets. This could compound energy price-induced inflation, fundamentally damage ECB credibility and lead to a systemic flare-up on world markets which could even – in an extreme case – claim the single currency as its victim. As a guide to what may happen next, here are five scenarios for the next few months.
Scenario I: VIGILANCE – ‘Say nothing, do nothing’. No TPI use. Benign outcome. 40% probability.
Bond market spreads widen for both France and OIECs, but remain below 250 to 300 basis points for France, so there is no call to activate TPI. The ECB continues to repeat that it is showing ‘vigilance’ in monitoring the position and affirms this is a French budgetary problem to be resolved by French politicians and not central banks. The government of Sébastien Lecornu makes progress in finalising a 2027 budget limiting the deficit to around 5% of gross domestic product. President Emmanuel Macron orchestrates messages of solidarity from other EU leaders. French protests die down. Contagion effects are muted – partly because OIECs, who are alive to the risks, continue to display ‘resilience’ and communicate budgetary prudence.
Marine Le Pen delivers further responsible messages on fiscal policy. European Council members communicate willingness to do business with Le Pen, despite her anti-European domestic messaging. The general rise in longer term interest rates across the euro area exerts a tightening effect on monetary conditions. Together with peace overtures over the Middle East and Ukraine conflicts after the 3 November US midterm elections, this produces a calming effect on financial markets. With political uncertainty and lower levels of activity raising the threat of a euro area growth slowdown or even recession in 2027, underlying inflation pressure falls, lowering the ECB’s wish to raise rates at its 16-17 December meeting. It rejects calls to slow down the steady reduction of its balance sheet under ‘passive’ quantitative tightening. The ‘say nothing, do nothing’ scenario, most favoured by the ECB, is the most likely outcome – but not the only one.
Scenario II: ACTIVISM – ‘Do nothing’ doesn’t work. Von der Leyen and Merz take lead. TPI deployed but in relatively small amounts. Benign outcome. 30% probability.
Fresh street protests, further rise in the French bond spread to over 300 basis points, accompanied by signs of OIEC contagion, lead to calls from inside France and outside France for TPI enactment. Discreet soundings on the ECB governing council, orchestrated by Christine Lagarde, outgoing ECB president, and Emmanuel Moulin, the new, politically skilled governor of Banque de France, conclude that the spread rise for France is ‘warranted’ by lack of progress in producing a sustainable path to budgetary rectitude, whereas in the case of the OIECs, it is not. The ECB, however, concludes that singling out France as the sole EMU member not benefitting from TPI protection would stigmatise and destabilise France and undermine the entire euro area. Markets increasingly focus on fiscal arithmetic: the currently discussed 2027 budget even if passed by parliament, would lead to a higher debt-to-GDP ratio next year, and a further €20bn interest bill compared to 2026 (up to over €90bn from €70bn). So even a ‘muddle through’ scenario lowers fiscal space next year, assuming yields settle at current levels.
Von der Leyen and German Chancellor Friedrich Merz, coordinating with Lagarde and key GC members, led by Deutsche Bundesbank’s Joachim Nagel, engineer a statement of intent from Macron and Lecornu pledging additional firm budgetary action as soon as political uncertainty dissipates.
Thanks to discreet Franco-German political intervention, Le Pen agrees to back a plan for ECB endorsement of France’s aim for sustainable public finances, perhaps channelled through the European Stability Mechanism to avoid perceptions of the central bank setting fiscal policy. The Commission opens the way for TPI deployment, stating that French corrective action is aligned with the EU’s ‘excessive deficit procedure’. It is awarding France more time to achieve agreed cuts in deficits and debt. The ECB governing council declares that it is allowing French political leaders ‘breathing space to create an appropriate environment’ for policies producing ‘necessary budgetary consolidation and a diminution of social tensions’. Display of European solidarity calms the bond markets. Only limited TPI intervention needed. Spreads – although still elevated – return to below-crisis levels after only modest bond-buying. An additional stabilising factor: Merz’s rescue action, coordinated with von der Leyen, modestly improves the lacklustre domestic standing of Merz and his CDU/CSU centre-right political grouping.
Scenario III: CONFRONTATION – Full-scale TPI activation. Attempted deployment of OMT. French counter-reaction. Destabilising outcome. 15% probability.
Amid further escalation of political tension and street protests in France – and failure of Scenario II actions to produce durable calm – a further increase in spreads alarms the ECB, with a self-generating downward spiral in financial markets. The period directly before the French election incentivises anti-European rhetoric and limits the sitting government’s mandate for major policy actions. The ECB’s effectiveness is hampered by leadership changes. It appoints a TPI crisis committee made up of board members and leading GC members – including Nagel and Moulin – to speed up its reaction function. Klaas Knot, previous president of De Nederlandsche Bank, Pablo Hernández de Cos, managing director of Bank for International Settlements, and François Villeroy de Galhau, former governor of the Banque de France, provide behind-the-scenes advice.
Weekly ECB balance sheet data reveal that TPI purchases are rising for OIECs Italy, Spain, Portugal but not for France. Conservative economic groupings – including, ominously the Alternative for Germany (AfD), currently leading German opinion polls – voice strong opposition to TPI purchases and apply for an injunction to stop it at the Constitutional Court in Karlsruhe. This is supported by CDU/CSU representatives.
The ECB GC states that – in spite of modest previous TPI purchases – France no longer qualifies for TPI protection. Media leaks suggest that, unless the Paris government makes further progress on stabilising the budget for 2027 and beyond, the ECB is proposing that France apply for assistance under the 2012 OMT mechanism. This would require a programme of fiscal discipline imposed by the ESM. But it would open the possibility of a large pre-emptive ESM credit line.
Following the leak, Le Pen denounces any recourse to the ESM, declaring that this is inconsistent with French sovereignty. Jean-Luc Mélenchon, leader of far-left opposing party France Unbowed (LFI), issues a similar statement. The spread widens to 400 basis points. The deadlock continues, risking market disorder. This raises the possibility of extraordinary political intervention or possible emergency action such as controls on French credit and capital movements.
Scenario IV: POLITICISATION – AfD enters the fray. Franco-German political stakes rise further. Destabilising outcome. 12% probability.
The ECB concedes that the French debt problem cannot be ring-fenced. Even though TPI allows ECB to buy debt of ‘innocent bystanders’, in practice it is politically unthinkable not to include French debt. Populists of the left and right calculate that inaction prompting contagion might be the easiest way to trigger TPI without much conditionality. The TPI is activated after further rises in spreads. The GC decides a ‘temporary’ cessation of balance sheet reduction through passive QT. But substantial TPI purchases and QT suspension are of limited value. Initial spread reversal proves transitory. Funds flow into German bond markets. German politicians hail the Bund as ‘Europe’s true safe asset’. Market unease generates a sharp inflation-generating euro decline against the dollar, yen and sterling. Inflationary pressure is further stoked by a fresh rise in oil prices and lack of progress towards ending the Middle East and Ukrainian conflicts.
ECB effectiveness is hampered by legal and political constraints in Germany. Media attention focuses on a further rise in the Target-2 imbalances, again making headlines in the German press after a five-year lull. The ECB claims it is remaining on an underlying tightening course. Financial market commentators and newspaper columnists claim that TPI purchase have politicised the ECB and undermined its vaunted independence. They point out that bond-purchasing counters the ECB’s interest-tightening action.
Stepping up its political and legal campaign against the TPI, the AfD emphasises its policy, set out in detail in its 2025 general election programme, for a break-up of EMU and a return to the D-mark backed by the Bundesbank’s gold. In response to internal and external criticism, the ECB stops TPI purchases – leading to a further upsurge of spreads.
Le Pen, Mélenchon and other French opposition groups denounce ECB inaction, claiming Lagarde, in her final weeks at the ECB, and Macron are working together to undermine the opposition ahead of the April presidential elections. If this is Macron’s plan, it backfires. Le Pen gains fresh ground in opinion polls. Ominously German Bunds come under attack after market speculation hardens on a possible German bail-out action to support its western neighbour – an outcome that would undermine Germany’s own strong fiscal position.
Scenario V: NEW BACKSTOP – TPI abandoned. Perceived as unsuitable for France. ECB, backed by the International Monetary Fund and other institutions, invents a new instrument – Systemic Market Facility – to provide a ‘market mechanism’ for safeguarding France and the international system. Short-term stabilising outcome soon fades, leading to greater destabilisation. 3% probability.
‘Renomination risk’ rises again on capitals markets – without a dominant Mario Draghi-like figure to quell it. European media starts to focus on a ‘worst-case’ outcome, claiming that overbearing French institutionalism and an intractable Le Pen government-in-waiting resisting conditionality are making the new European sovereign crisis unmanageable. This could lead to a collapse in the euro exchange rate, exacerbating inflation and paving the way to the break-up of Europe’s proudest and hardest-won achievement – the single currency. Worse, it could widen the dislocation to the entire international system.
The ECB, IMF, European Commission and European Stability Mechanism join forces to examine a new backstop facility that recognises the systematic importance of the euro area turbulence. In a formal statement, the four bodies declare the ‘existential importance’ of maintaining monetary union and announce they are investigating with the French government possible introduction of temporary restriction on capital movement plus a substantial credit line for France under the auspices of the IMF and ESM. This would require eventual adherence to an IMF/ESM-approved programme to be agreed after the French presidential and legislative elections. The statement outlines principal features of an SMF under which the ECB and ESM would jointly purchase substantial French bonds in quantities ‘deemed fit’ by euro area finance ministers and the governing council.
Stabilising intervention is intended to be reversed (though reflow of bonds back to the market) once financial conditions stabilise. However, market calm soon fades. The scheme meets fierce opposition from French opposition parties, AfD and Merz’s CDU/CSU. Financial markets focus again on a principal theme that has been evident since the start. France’s government and political system hold the key to stabilising the French position within EMU. If France proves incapable of fulfilling the task, then the ‘unthinkable’ outcome of euro break-up once espoused by Le Pen – still the formally endorsed by the AfD – becomes a real possibility.
David Marsh is Chairman of OMFIF, John Orchard is Chairman of the Digital Monetary Institute at OMFIF and Mahmood Pradhan is Non-Resident Fellow at Bruegel.
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