Christine Lagarde's Impossible Challenge

If Federal Reserve Chair Kevin Warsh thinks he has a difficult inflation challenge with Trump breathing down his neck for lower interest rates, he should spare a thought for Christine Lagarde, the president of the European Central Bank (ECB). Not only does she have an inflation challenge and a eurozone economy that is being hit by several external shocks. She will also soon need to bail out the French economy, which seems to be on the cusp of a full-blown government bond market crisis. It is far from clear how the ECB will manage to square the circle of bringing down inflation with higher interest rates while at the same time being forced to engage in some sort of quantitative easing to prop up the French government bond market.

Unlike the Federal Reserve, which has a dual mandate, the ECB has a single policy mandate to contain headline inflation to 2 percent. Lately, the ECB has not been doing well on that charge largely due to a sharp increase in energy prices in the wake of the US-Iran war. Inflation has been above the ECB's target for the past 21 months and has now climbed to 3.8 percent. To address its inflation problem, during the summer the ECB raised interest rates twice to its present level of 2.5 percent and has intimated that it will not hesitate to raise interest rates further if inflation does not begin declining.

While inflation has been rising, France appears to be on the cusp of a full-blown government bond market crisis due to the parlous state of its public finances and its political dysfunction. France's budget deficit has widened to around 5.5 percent of GDP while its public debt-to-GDP ratio has risen to 119 percent, or to a level reminiscent of that of Greece on the eve of its 2010 sovereign debt crisis. Six prime ministers under Emmanuel Macron's presidency have failed to get restrictive budgets through a very divided National Assembly, and it is highly improbable that anything serious will be done about France's public finances in the run-up to the country's April presidential election.

Markets have taken note of France's unsustainable public finances and its dysfunctional politics. Since the start of the year, France's 10-year bond yield has surged from 3.5 percent to its present level of 4.9 percent. That has increased the spread between French and German 10-year government bond yields to 1.4 percent, or to its highest level since the 2010 eurozone debt crisis.

Two factors heighten the chances that France's debt crisis will deepen in the months immediately ahead. The first is the unhelpful statements being made by the two leading candidates to be the next French president. Marine Le Pen, who is favored to win the presidency, talks of wanting to reduce the retirement age from 64 to 62. Meanwhile, Jean-Luc Melenchon, the far-left politician who is likely to make it to the second round, proposes canceling the roughly 18 percent of the national debt being held by the French central bank.

The second factor clouding the French bond market outlook is the multiple shocks now hitting the already sclerotic French economy. Those include high energy prices, rising interest rates, domestic political unrest, and an onslaught of Chinese imports. Those factors could tip the French economy into recession, thereby worsening an already troubling budget situation.

All of this puts the ECB in a difficult position. While in principle the ECB can bail out France by buying an unlimited amount of French government bonds through its Transmission Protection Instrument, it can only do so if France has a credible macroeconomic adjustment program in place. That would seem to be unlikely anytime soon in France's present domestic political context. The ECB would also need the support of Germany, its largest shareholder. That might be a difficult ask with the far-right Alternative for Germany party on the march. Yet another headache for the ECB is that it might find that bailing out France with some sort of quantitative easing would conflict with its efforts to reduce inflation with higher interest rates.

It would be an understatement to say that if France does have a full-blown government bond market crisis, there will be serious spillover effects to the world economy and its financial system. In 2010, the Greek sovereign debt crisis shook the world economy. How much more so would a debt crisis in France, Europe's second largest economy and a country with a debt level many times the size of that of Greece?

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