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France’s finance minister sends tremors through European capitals with a defiant warning that his country would no longer try to meet deficit targets

German GDP contracted 0.2pc, is France once again stuck at zero and Italy is already in a triple-dip recession Photo: Alamy

Eurozone strategy is in tatters after economic recovery ground to a halt across the region and France demanded a radical shift in policy, warning that austerity overkill is driving Europe into a depression.

Growth slumped to zero in the second quarter, with Germany contracting by 0.2pc and France once again stuck at zero. Italy is already in a triple-dip recession.

Yields on 10-year German Bunds fell below 1pc for the first time in history, beneath levels seen during the most extreme episodes of deflation in the 19th century. French yields also touch record lows. Much of the eurozone is replicating the pattern seen in Japan as it slid into a deflation trap in the late 1990s.

It is unclear whether tumbling yields are primarily a warning signal of stagnation ahead or a bet by investors that the European Central Bank will soon be forced to launch quantitative easing, buying government bonds across the board.

Michel Sapin, France’s finance minister, sent tremors through European capitals with a defiant warning that his country would no longer try to meet its deficit targets and would not inflict further damage on its economy by tightening into the downturn. “I refuse to raise taxes to close any budget gaps,” he said.

“What is absolutely necessary is to adjust the pace of deficit reduction to the exceptional situation we are in today. Growth is too weak in Europe and inflation is too low. We must therefore stop reinforcing the causes of this depression,” he told RTL television.

“We must face the figures in front of us with realism. The truth is that, contrary to the forecasts of the International Monetary Fund and the [European] Commission, growth has broken down, both in France and in Europe.”

He halved his French growth forecast to 0.5pc this year and to little more than 1pc next year, too weak to stop unemployment hitting fresh highs. The IMF has already warned that there will be no job growth until 2016.

Germany has so far refused to yield any ground on austerity policies but is increasingly vulnerable. Revised data show that the economy has been far weaker than thought over the past two years, falling into a significant double-dip recession last year. Professor Paul De Grauwe, from the London School of Economics, said: “They are victims of their own folly. Germany needs massive investment in its energy sector and it should be doing it now while it can borrow for almost nothing.”

Mr De Grauwe said EMU elites have misdiagnosed the cause of Europe’s intractable slump, blaming it on lack of reform when it is in reality a “demand crisis” made worse by a debt purge since the financial crisis. “They are doing everything they can to stop recovery taking off, so they should not be surprised if there is, in fact, no take-off,” he said.

“It is balanced-budget fundamentalism and it has become religious. We know from the 1930s that if everybody is trying to pay off debt and the government then deleverages at the same time, the result is a downward spiral. The rigidities in the European economy have absolutely nothing to do with the problem we face today.”

Many German economists said one-off factors explained the “sudden stop” in the second quarter but Berlin’s Institute for Economic Research (DIW) warned that deeper forces may be at work, with a risk of recession as Germany suffers the blowback effects from sanctions against Russia. “The economy may shrink again in the third quarter,” it said.

Sigmar Gabriel, Germany’s vice-chancellor, blamed the slowdown on “geopolitical risks in eastern Europe and the Near East”.

The contraction of world trade over the early summer has undoubtedly played a role since Germany is highly-geared to global exports.

The signs of a policy revolt in France could prove a turning point in Europe. Mr Sapin said his country would miss its deficit target this year but not try to make up the ground because the shortfall was caused by the deflationary conditions in Europe. He pledged to cut the deficit at an “appropriate pace” but would not go further. It is likely to exceed 4pc of GDP.

President Francois Hollande has so far gone along with EMU austerity demands, imposing severe fiscal tightening in his first two years in office, even though the ECB refused to offset the effect with monetary stimulus.

The result has been a permanent slump, with industrial output down 14pc from its peak. Mr Hollande has suffered a collapse in his approval ratings and faces a mutiny by the Left-wing of his own Socialist Party. There is increasing speculation over whether he may be forced to resign before the end of his term in 2017.

However, Mr Hollande is known for pirouettes that come to little. It is too early to tell whether he is willing to form a “Latin alliance” with Italy to force a change in policy, launching what amounts to a rebellion against German policy doctrines. Any such demarche would risk a dangerous rupture with Berlin.

The collapse of economic recovery in Europe leaves the ECB in a delicate position. Mario Draghi, the bank’s president, offered no clues earlier this month on when the ECB might finally resort to QE, insisting that it will wait to gauge the full effects of its negative deposit rate and the result of new loans to banks (TLTROs) in September and December.

This delays any likely QE until next Spring, yet it is far from clear whether the TLTROs will make much difference. They involve exchange of collateral and are merely asset swaps. Banks are in any case shrinking their lending to meet new capital ratios. The IMF said QE is a far more powerful instrument.

“The ECB will do as little as possible in the hope that something will come along to save them, and the euro will weaken,” Gabriel Stein, from Oxford Economics, said. “They are desperate not to do QE.”