France and the other big problem: the debt
The French government has to pay an interest rate of almost 5% to borrow for a 10-year term, more than Italy or Greece. The difference with what Germany pays, the risk premium, has climbed to 1.5 percentage points, more than double that in the case of Spain. Some investors fear that the situation could spiral out of control. How did we get here? Is the fear of a French debt crisis realistic? Could it drag down other countries in the euro zone like in 2012?
Interest rates have risen everywhere, not just in France, due to the increase in inflation and the response of central banks. In France, however, the increase has been more intense due to its fiscal situation and political instability. The combination of public deficits exceeding 5% of GDP for four years and poor economic growth (this year it is expected not to reach 0.5%) has raised public debt to nearly 120% of GDP. The upward trajectory of the debt is more worrying than the 120% level, which is not prudent but is lower than in Italy or Greece. Markets tend to be more lenient with a highly indebted country that controls its debt trajectory than with a less indebted country but without a credible plan to stabilize it.
To stabilize debt and begin to lower it, France must reduce its public deficit in a sustained manner. The problem is that the government does not have a sufficient majority to take the necessary measures. Social unrest makes it even more difficult. And the presidential elections scheduled for next spring add uncertainty. It is unknown who will win or if a stable government will emerge from it.
Is a French debt crisis, therefore, likely? I do not think so: today, a debt crisis remains a risk, but it is not the central scenario. The situation is difficult to manage, but the adjustment needed to stabilize debt in the medium term is not exaggerated: reducing the deficit by half a percentage point of GDP per year could be sufficient. France will have to choose between increasing an already very high tax burden (52.4% of GDP) and moderating spending (57.7% of GDP) that clearly exceeds the euro zone average. Fortunately, despite the difficulties it is going through, it is not an economy in free fall where revenue is declining, which would make it more difficult to achieve a deficit reduction. There is also a certain consensus among the majority of political forces on the need to put public finances in order, even if, until now, they have not agreed on how to do it due to electoral tactics or ideological reasons. And debt restructuring or abandoning the euro are not part of the central French political debate.
Although there is no debt crisis, there could still be more turbulence than what we have seen so far. Investors are scrutinizing what is happening in France. Any data, news, or statement will be examined based on what it indicates about the country's ability to stabilize debt. If the economy falls into recession, social tension worsens, or candidates with the possibility of forming a government do not clearly enough convey a minimum commitment to fiscal discipline, the risk premium may still grow further. In other countries, we have seen that, sometimes, the situation must worsen before improving. Faced with the possibility of a more serious crisis, which would have an enormous economic cost, it seems reasonable to think that policymakers will do what is necessary to avoid it.
Regarding the risk of contagion to other countries, today there are mechanisms that help to prevent it. The European Central Bank can buy debt from a country that is affected by a loss of confidence that has more to do with the situation in France than with the situation in the country itself. The current situation is very different from that of 2012, when these mechanisms did not exist and doubts about the survival of the euro were much more intense. However, it is necessary for the country in question to meet certain criteria regarding fiscal sustainability and the absence of serious macroeconomic imbalances. The ECB has room for discretion to assess these criteria, and I think that, if the case arises, it would not be excessively picky. In any case, Spain meets these criteria and faces the current situation from a more solid position than in other episodes of turbulence – this does not prevent the need to continue reducing public debt. The lesson from France is clear: markets can ignore more or less weak public finances for years, but when the environment changes, they stop looking at the average and start looking for the exceptions. The best time to correct imbalances is before becoming one of these exceptions.
