I have been warning for over a year that a new debt crisis in Europe is inevitable. Since the last crisis in 2009-2011, the big-spending, highly taxed welfare states that populate the continent have made no efforts to alter their structural imbalances between government outlays and tax revenue.
Therefore, nobody should have been surprised when our own Hélène de Lauzun recently reported:
Bad news for the French economy: Fitch has just downgraded France from AA to AA-. Although Fitch is the only rating agency to have lowered its rating for the moment, the signal sent is nevertheless very negative for the French government.
It is bad news indeed. Not only is France now the poster child of European credit downgrades, but President Emmanuel Macron and Prime Minister Élisabeth Borne will now gradually lose the ability to run the country’s finances. The downgrade, namely, is a blow where it really hurts: the credit rating is a core ingredient when investors decide what country to trust with their money. Sovereign debt, i.e., government-issued debt securities, has historically served as the low-risk anchor in investor portfolios. When a government—like the French—over-indulges in debt and becomes less reliable as a credit anchor, investors will start looking elsewhere for a more reliable place to put their money.
If market distrust becomes strong enough, investors will dump the troubled sovereign debt like a cheap suit. France is not there yet and will not reach that point for a long time. A downgrade from AA to AA- still keeps French treasury securities in the investor-grade category, i.e., debt you can generally trust.
The question is how the French government responds to this downgrade. If it responds responsibly, it can turn this negative experience into a fiscal turning point and a turn-around moment for the ailing French economy. If, on the other hand, Macron and Borne decide that Fitch’s analysts are wrong, and continue with business as usual, then their country will inevitably be hurled into a downward spiral of credit downgrades, skyrocketing interest rates, and galloping budget deficits.
In other words, France is at a fork in the road, where her political leaders have shrinking maneuverability, where they are running out of time, and where they cannot afford to repeat the mistakes of the past.
The window of opportunity to save France from more downgrades is in part decided by how investors in the sovereign-debt market respond to Fitch’s decision. They are not likely to pull money out of French sovereign debt simply because of Fitch’s downgrade, but they are more likely to take their new investments elsewhere. Furthermore, even a mild redirection of new investment money could grow into a major headache for Macron. As de Lauzun mentions, S&P Global Ratings (previously known as Standard & Poor’s) are scheduled to re-evaluate France next month. They put the country on a negative outlook back in December, which means that unless they find good reasons not to, they will follow Fitch and kick Macron’s government a notch down the credit ladder.
At this point, it will not be long before the French government will have to raise interest rates to encourage investors to not sell their treasury securities. Once this happens, the window of opportunity to stave off a major fiscal crisis begins to close; while the immediate financial repercussions for the French government will be limited, the investment community will gradually seize de facto control over French fiscal policy.
To be blunt, the real information value in France’s credit downgrade is that the political leadership in Paris now must make fiscal reforms its highest priority. Whatever Macron and Borne have had in mind for other policy areas should be put on the back burner.
If they do the right kind of reforms, they can escape further downgrades. If, on the other hand, they choose the same type of reforms that Greece, Italy, Spain, and others did in 2009-2014, the French government will rapidly lose control of the situation.
Again, it is important to note that one credit downgrade is not a disaster, and a country can sustain itself even if it takes a few more hits from the rating agencies. France did suffer downgrades in the last crisis, but they never set off a runaway situation like in Greece or Italy. S&P took France down from AAA in 2010 to AA negative in 2014; Moody’s did the same—from Aaa stable in 2010 to Aa1 negative in 2012.
Subsequently, both S&P and Moody’s upgraded France again. Fitch, on the other hand, has exhibited more concern about the fiscal policy coming out of Paris. They put France on AAA negative watch in 2011, took its rating down to AA+ stable in 2013, added a negative watch in October 2014, and downgraded it to AA two months later.
While the other two agencies upgraded France again, Fitch refused to do so. In 2020, they put France on a negative watch. That is where the French government has been until they were now ratcheted down to AA-.
Without the proper response from Paris, anything can happen. It sounds like a worn-out internet meme to refer back to Greece, but given the catastrophic consequences they suffered, every political leader of an indebted, modern welfare state must learn that lesson.
Before 2009, Greece was doing well in the evaluations by all three major rating agencies. However, once the country lost control of its finances, it started going downhill in its credit ratings. All three major rating agencies issued multiple downgrades in a short period of time:
- S&P downgraded Greece from A in January 2009 to BBB+ with a “negative watch” in December of that same year;
- Moody’s had Greece at A1 with a positive outlook in January of ’09 and at A2 negative in December;
- Fitch, having made a minor downward adjustment of Greece in 2008, from A positive to A stable, rapidly lowered their ratings in 2009; by December, Athens was rated BBB+ with a negative outlook.
It did not stop there. Greece kept falling, having its debt moved from investment grade to so-called speculative grade. This was a big step with bad consequences for the ability of the government to borrow money. In early 2012, Greek sovereign debt was ranked C by Fitch and C negative by Moody’s. S&P placed the country in the “selective default” category, which meant Greece as a debtor was teetering on the edge of its grave.
It is worth remembering the reasons why Greece suffered this credit disaster. The immediate reason was the partial default on their debt that the European Union, the European Central Bank, and the International Monetary Fund had negotiated. The government in Athens unilaterally wrote off one-quarter of its debt.
As of today, it is inconceivable that France could end up in such a catastrophic position. However, the path from Paris to Athens is just that: a path, a continuum without any apparent cut-off points. Once a government puts itself at the starting point of that road, it has no room for fiscal policy mistakes, or else the jurisdiction to design credit-saving policies will gradually move away from Paris and into the hands of the rating agencies and the investors who trust their judgment.
Before we get to the conditions on which credit-saving policies can be designed, it is worth noting that Greece is not the only country that serves as a cautionary tale from the last fiscal crisis. Spain was in almost as bad shape as Greece in the early 2010s and has struggled incredibly to recover since then.
Just like Greece, Spanish credit ratings plummeted after 2009. From that year to 2012, S & P took the Spanish government down from AAA to BBB- with a negative outlook. From 2010 to 2012, Moody’s downgraded Spain from Aaa to Baa3 negative, while Fitch lowered its Spanish AAA rating to AA+ in 2009, and all the way down to BBB negative in 2012.
The critical mistake in both Athens and Madrid was to rely on quick-fix policy measures to end the credit pain. These are policies that immediately (by fiscal policy standards) reduce the budget deficit. Both governments hoped that rapid improvements in their budgets would reduce worries among investors and credit analysts. However, that is not what happened: In Greece, the legislature passed over a dozen austerity packages, leaving its government-dependent population with social-benefit programs that had been reduced by 50-90%.
As a result, the Greek leadership found itself fighting a tidal wave of voter frustration and political polarization.
Meanwhile, the budget crisis kept getting worse. The reason is built into the very quick-fix programs they decided to rely on. Also known as austerity programs, these packages of spending cuts and tax hikes were designed to take effect as quickly as the legislative process allowed. This often meant a few weeks or months, yielding immediate increases in tax revenue and almost as quick savings on the spending side.
From a strictly fiscal viewpoint, austerity was a success.
The problems with such austerity measures always show up a bit later, in the next 6-12 months. By then, consumers, workers, and entrepreneurs have adjusted their spending, their work hours, and their investments and employment plans to the higher taxes and lower government-spending levels.
At this point, macroeconomic activity declines, wages and salaries drop, and, with them, consumer spending and employment.
With less economic activity, tax revenue falls as well, just as prescribed by the so-called paradox of thrift. The initial gains that government made in terms of more revenue and less spending gradually erode and reopen the budget deficit.
When faced with persistent budget problems, the Greek government doubled down on its quick-fix austerity policies. The effect was the same, over and over again.
The result was brutal. In five years, one-quarter of the Greek economy was wiped out. It was not until the lawmakers in Athens abandoned the quick-fix approach that they brought the country’s disastrous economic implosion to a halt.
The Greek lesson, therefore, is that fiscal reforms that aim to reduce a budget deficit must be long-term in nature. For every measure that takes more money out of the economy—by spending cuts or tax hikes—there must be one policy reform that encourages more economic activity.
One good way of achieving the latter is to implement deregulations in key sectors of the economy. Regulations are costly: a good rule of thumb from the economics literature is that for every €1 we pay in taxes, we lose €0.50 worth of economic activity to regulations. Therefore, if the French government is going to cut spending, it would be well advised to expand regulatory freedom in the economy, and to do so in tandem with the spending cuts.
Environmental regulations are often mentioned as particularly onerous, and it would be a blessing for France if the government would dare to roll back ‘green tape’ in the economy. Another idea with potentially significant economic impact would be to deregulate the French labor market. According to the Index of Economic Freedom, published annually by the Heritage Foundation, the French labor market is more heavily regulated than that of 66 other countries. French workers are onerously stifled in their freedom to choose when to work, where, how, and for what compensation.
It would not be difficult to find paths to deregulation. France could simply adjust its labor market laws and regulations to what they have on Spain, which is ranked 47th, 19 spots above France. Other interesting sources of inspiration are Denmark (29th), Italy (12th), and Austria, which ranks second in the world in labor freedom.
As for spending cuts, the key point is the same as for regulations: to permanently reduce the presence of government in the economy. This is difficult to achieve, as Macron’s pension reform efforts indicated, but given what is at stake—with the shadow of the Greek disaster lurking in the background—for the French political leadership, it would constitute a dereliction of duty to not at least try the same kind of structural reforms to other government programs.
