One of the most striking features of current European politics is the complete detachment of policy making from reality. This detachment stretches from elected officials into the hallways of appointed Eurocrats.
On the policy side, the reality-last approach to policy making is eminently represented by the crop of politicians trying to figure out how to run France. While they are engaged in the political equivalent of debating adverbs, the French economy took another hit last week:
Credit ratings agency Moody’s unexpectedly downgraded France’s rating on Friday, adding pressure on the country’s new prime minister to corral divided lawmakers into backing his effort to rein in the strained public finances.
The only surprising part of this Reuters report is that they refer to the credit downgrade as “unexpected.” Back in May 2023, with reference to Fitch downgrading France’s credit rating, I explained:
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.
The only part of my prediction that has not yet materialized is the rapid rise in interest rates. Let me get back to that in a moment.
In June this year, when France—just as I predicted—got another credit downgrade, I foresaw that “we have good reasons to expect further downgrades in the future.” In October, Fitch, Scope, and Moody’s all downgraded their ratings or outlooks for France; now Moody’s has gone one step further, giving France the lowest rating a country can get before it loses its high-grade investment status.
The painful truth in this is that we are now at the point that I highlighted in May last year, namely where the French government will have to start paying higher interest rates to attract investors to its sovereign debt. The dysfunctional government in Paris is already paying a premium compared to the German government: according to Trading Economics, French 10-year bonds currently pay 3.03% per year, compared to 2.23% for a German equivalent.
This may not seem like a meaningful difference, but it is. In the first two quarters of this year, the French government ran deficits of, respectively, €49 billion and €48.4 billion. A sale of sovereign debt of that amount comes with a significant cost upgrade for Paris compared to what the government in Berlin would have to put up; if we assume that the 10-year bond rates represent the average interest rates across all government bond maturities (a reasonable assumption), then
- If the French government wanted to borrow €48.4 billion at 3.03%—its current rate—it would have to pay €1.45 billion per year in interest;
- If the French government could borrow the same amount at the ‘German’ interest rate of 2.23%, it would have to pay only €1.07 billion per year.
The difference in interest cost is €384 million per year—and let us not forget that this is for just one-quarter of government borrowing. If we scale up the €48.4 billion deficit to a full year, the French government’s cost for borrowing money due directly to their higher interest rate amounts to €1.5 billion per year.
This is the amount of money they will have to spend just because of their less-than-stellar credit rating.
We are now talking about money that will directly impact government spending programs. As an example of what this means, using Eurostat’s numbers from 2022, the €1.5 billion premium over the ‘German’ interest rate equals up to 9% of the national government’s health spending.
That share is lower now, of course, as spending has increased, but it gives us an idea of just how costly the higher interest rate is without having to delve into the current budget debate.
Since the French political leadership is more concerned with keeping Marine LePen out of any position of influence than with saving the nation’s economy, my predictions from May last year and from June this year are unchanged: more downgrades will come. With at least one agency, Moody’s, having France on the verge of falling into a lower overall rating category, the borrowing costs for the French government will now tick up faster, and with bigger jumps each time it happens.
If left to fend for itself, the French government would rapidly lose control over the situation. But fortunately for them, the European Central Bank is poised to come to their rescue. In a speech on December 16th, ECB President Christine Lagarde proclaimed:
[We] previously said that “we will keep policy rates sufficiently restrictive for as long as necessary”. … With the disinflation process well on track, and downside risks to growth, this bias in our communication is no longer warranted. … We no longer aim for “sufficiently restrictive” policy, but rather intend to deliver an “appropriate” policy stance.
This means, plainly, that the ECB is no longer concerned with high inflation; it believes that inflation will be low so that the central bank does not have to bring it down—in other words, raise interest rates. On the contrary, Lagarde’s speech is one big hint that the ECB will do exactly what I just last week recommended them not to do, namely cut interest rates further. As I explained then, inflation is not at all back to the ECB’s target level; quite the contrary, inflation in the euro zone has been ticking up again in recent months.
Given the overall weak European economy, the euro zone should be at price stability, with some countries even experiencing some minor deflation. But this is not happening; of the 20 EU member states that had reported inflation as of December 13th, five had an inflation rate above 3.5%. The euro zone as a whole is trending up again to 2.5%.
Christine Lagarde and the ECB’s other monetary policymakers know all this. They know very well that the microeconomic foundations of price stability simply do not work as they used to. But, again, this is of no consequence to the ECB; the highest priority now seems to be to get interest rates down so that member states like France can run budget deficits without skyrocketing interest costs.
In doing this, the ECB is playing with fire. They are perpetuating fiscally reckless behavior at the euro zone’s member state level while running the apparent risk of reigniting inflation. I really don’t want to make this prediction, but one year from now, the ECB will probably have returned to buying government debt to prevent a fiscal meltdown across the euro zone.
