A Perfect French Debt Storm

Ahead of next May's French presidential election, France, the Eurozone's second largest economy, appears to be heading towards a sovereign debt crisis. At a time when its public debt is already on a clearly unsustainable path, the French economy is being hit by an Iran-induced energy price shock, rising European Central bank interest rates, a slowing European economy, and heightened political uncertainty about France's political willingness to deal with its public finance problem. Having a public debt many times the size of that of Greece, a French sovereign debt crisis must be expected to have adverse spillover effects to the rest of an over-indebted world economy.

Even before the US-Israel and Iran war, France's public finances were on a clearly unsustainable path. Years of deficit spending had raised France's public debt to around 125 percent of GDP or to a level approaching that of Italy and Greece. At the same time, political dysfunctionality as underlined by a highly polarized National Assembly, prevented the country from making a meaningful dent in its 5 percent of GDP budget deficit.

As we learned in the 2010 Eurozone sovereign debt crisis, high public debt levels and large budget deficits make Eurozone member countries especially susceptible to sovereign debt crises. This is because being stuck in a Euro straitjacket, those countries do not have an independent monetary and exchange rate policy. This means that unlike say the United States, a country like France cannot resort to interest rate cuts or to exchange depreciation as an offset to the contractionary effects on aggregate demand of budget belt-tightening. Attempting to reduce the budget deficit through fiscal austerity in a Euro straitjacket could be counterproductive in that it could precipitate an economic recession.

In France's straightened budget circumstances, the last thing that it needs is an energy price shock, higher ECB interest rates, and Eurozone stagflation. Such a combination would slow the French economy making revenue collections more difficult. It would also increase pressure for energy subsidies and raise the cost of debt servicing. Yet, that is what France now has to deal with in the wake of the Iran induced energy price shock.

French gasoline prices have increased by around 20 percent and its natural gas prices have increased by over 25 percent. Meanwhile, the ECB has been forced to raise interest rates by 25 basis points to deal with a Eurozone inflation rate that has ticked up to 3.2 percent or to well above the ECB's 2 percent inflation target. The ECB has done so even at a time when the Eurozone economy has been slowing. At the same time, the 10-year French government bond yield has increased to 3.65 percent or to a level last reached during the 2010 Eurozone sovereign debt crisis.

Heightening the chances of a French sovereign debt crisis next year is the apparent lack of political will to rein in the deficit especially ahead of next year's presidential election. Last year, the 2026 budget was only passed after two non-confidence votes and after the government had to resort to a special constitutional power. Ahead of next year's presidential election, it is bound to become all the more difficult for the government to rein in the budget deficit. Meanwhile, France's 2027 presidential race looks bleak from a fiscal perspective.

Marine Le Penn's far-right Rassemblement National (RN), which is well ahead in the polls, is proposing company tax cuts and potentially reversing pension reforms — popular measures that would add to the debt rather than reduce it. Meanwhile, Jean-Luc Mélenchon National Popular Front (NPF), which is RN's main challenger, is even more expansionary. The NPF is proposing an estimated €150-180 billion in additional spending to be funded by optimistic assumptions about growth and wealth taxes that independent economists largely dismiss.

All of this should raise concerns about potential spillover effects next year from a French sovereign debt crisis to the rest of the world economy for two reasons. The first is that in absolute terms France's debt is over seven times as large as that of Greece. If in 2010, the Greek sovereign debt market crisis shook the global economy, how much more so would a debt crisis in a very much more indebted France.

The second is that a French debt crisis would be occurring at a time when a number of other major countries, including the United States, Japan, the United Kingdom, and Italy all seem to be on sustainable debt paths. In much the same way as the 1998 Thai devaluation triggered the Asian currency crisis, a French debt crisis could be the trigger that causes a global sovereign debt crisis.

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