France’s finances and politics are in turmoil. President Emmanuel Macron has just appointed a new prime minister — the fourth person to hold the job in the past 12 months. The deficit is out of control. Borrowing costs are rising. And parliament can’t muster a majority to tackle spending.
It’s a serious comedown for a major industrial power that has the second-largest economy in Europe.
Here’s how France found itself in this state of affairs:
First the pandemic, then an energy crisis
France last balanced its budget in 1973, and maintained a generous welfare state with strong worker protections. That worked for years so long as solid economic growth swept tax revenue into government coffers and kept deficits from getting out of hand. First as economy minister and then from 2017 as president, Macron took steps to improve growth and state finances, cutting taxes and spending and raising the retirement age from 62 to 64.
Accumulated debt was high — over 90% of annual gross domestic product from 2008 on — but manageable due to steady growth, near-zero interest rates for much of the past decade, and France’s solid credit rating that let it borrow on favorable terms.
Then came the pandemic, followed by an energy crisis after Russia cut off most natural gas supplies over its 2022 invasion of Ukraine. The government spent heavily on subsidies to keep businesses afloat and shield consumers from higher gas and electric bills. At the same time, a global shift occurred in interest rates, sending them suddenly higher.
Almost overnight, the pile of accumulated debt jumped: from 98% of GDP in pre-pandemic year 2019 to 114% in 2020, where it has stayed. The annual deficit last year ballooned beyond forecasts to 5.8%, well above the 3% limit under European Union rules.
France is hardly alone in loading up on debt in recent years. Its debt pile is smaller than Greece’s, which is 152% of GDP, and Italy’s, which is 138%. It’s also lower than the U.S.’s 119%. France, however, lacks the U.S. advantage of having the world’s dominant reserve currency which supports Washington’s ability to borrow, while Greece has been running budget surpluses after being bailed out and Italy reduced its deficit last year. Greek 10-year bonds now yield 3.3%, indicating the market views them as less risky than France’s.
Macron’s election call was a self-inflicted wound
Macron called new elections last year after his pro-European party took a beating in elections for the European parliament from Marine Le Pen’s anti-immigration, nationalist party. The new French parliament wound up sharply divided, with a leftist coalition facing off against Le Pen’s party and with centrists in between. There’s been no functioning majority — except to say “no” to austerity and topple Prime Ministers Gabriel Attal, Michel Barnier and Francois Bayrou in quick succession.
France has both high government spending and high taxes
Taxes in France are 43.8% of GDP, the highest in the EU. Spending is also high. The money goes for pensions, civil servant salaries, and recently increased defense spending due to the perceived threat from an increasingly aggressive Russia.
With interest rates much higher these days, interest costs have reached 67 billion euros a year, money that is not available for spending on schools, pensions or heath care. And high taxes leave less room for increases without hurting growth.
With a deficit that big, France will have to enact some mix of tax increases and spending cuts equal to around 5% of gross domestic product over the next several years, according to economist Zsolt Darvas, senior fellow at the Bruegel think tank in Brussels. That’s doable — Greece did even more after its debt crisis in 2010-2015 — but a heavy lift for any government.
And it’s not happening yet. The National Assembly balked at Bayrou’s plan to start putting finances on a sustainable path by eliminating two public holidays and cutting 44 billion euros ($55.4 billion) in spending, toppling him in a confidence vote and leaving investors wondering when exactly legislators would confront the deficit. Macron named Sebastien Lecornu as Bayrou’s successor on Tuesday.
France isn’t in a financial crisis. Yet
When governments spend more than they take in in taxes, they fill the gap, or annual deficit, by selling bonds to investors. When the debts come due, governments pay them off by selling new bonds, which usually works fine — so long as bond investors are confident that the government is managing its finances well.
That confidence has been eroded by the deadlock in parliament. As a result, markets are demanding higher interest rates on French borrowing to compensate them for the additional risk that the political logjam will continue, the deficit will remain high, and the bonds will fall in value or — still very unlikely — that France might not pay at all.
The outside scenario France must avoid is a death spiral in which investor doubts push borrowing costs higher, and high borrowing costs increase the deficit and fuel more investor doubts in a self-reinforcing doom loop, like the one that sank Greece and threatened Italy in the early 2010s.
“A genuine financial crisis with a self-reinforcing doom loop … remains quite unlikely for the time being,” said Holger Schmieding, chief economist at Berenberg bank. “Of course, we cannot rule it out completely.”
If legislators “continue to reject common sense and insist on unfinanceable demands, the risk could rise,” he said.
His base case is: France “continues to muddle through” with mediocre growth, somewhat higher borrowing costs and a small deficit reduction.
France will have to fix this on its own.
In a case of extreme and unwarranted market panic that threatens France’s ability to borrow, the European Central Bank could intervene by buying French bonds and driving down the government’s borrowing costs to sustainable levels. But the ECB reserves such aid for countries pursuing “sound and sustainable” policies, meaning the central bank won’t bail out politicians who refuse to act.
The same applies to the eurozone bailout fund, the European Stability Mechanism, and the International Monetary Fund. Help from them imposes even stricter conditions on spending and policy, and France would still have to make the fiscal adjustment anyway.
Economist Darvas said there’s no rescue program that would spare France having to bite the bullet. “It’s very hard to imagine that France, such a big and proud country, would go cap in hand to the ESM and possibly the IMF,” Darvas said. “So again we come back to the same position… that in whatever world, France will have to do the fiscal adjustment.”
