French Finances Are in Finer Fettle Than Feared

It is hard to make sweeping statements about a region as vast as Europe, but it seems two things must always be true. One, Europe must always have a proverbial “sick man” whose economy is supposedly a drag. Two, Europe must always have a deficit problem child. A decade ago, the eurozone’s troubled southern periphery donned these dubious distinctions. Now, the roles have reversed. Germany, that old economic stalwart, routinely gets the sick man nod. And now France is in the debt hawks’ sights, with EU punishment and austerity supposedly looming. But as in most developed nations with supposedly too-high debt, this is a political issue—not an economic and market one.

France’s sins are procedural: Its debt, currently about 110% of GDP, exceeds the EU’s maximum (60%), while its deficit (5.5% of GDP) exceeds the 3.0% cap.^[i] The EU suspended its budget disciplinary process in 2020 so that national governments could throw money at COVID lockdowns, but it came back this year. In June, the European Commission revealed its deficit naughty list, demanding France and six other smaller nations get their budgets in order within four to seven years. The “or else” here, illogically, is a fine.

At the time, France was neck-deep in a snap election campaign, so debt stuff kinda went on the back burner. But now it is front-burnered: New Prime Minister Michel Barnier, taking a page from new UK Chancellor Rachel Reeves’ book, announced he looked at the public finances and found them “very serious,” far worse than he expected, while the country’s official budget police (the Court of Auditors) announced it will take €110 billion worth of budget cuts to reach EU limits.^[ii] Now Barnier is threatening to reverse a number of President Emmanuel Macron’s tax cuts, crossing a red line Macron drew mere weeks ago.

It all sounds so serious! Only, the market doesn’t seem to agree with the popular political view of France as a debt crisis in waiting. As we write, 10-year French OATs, which is the actual abbreviation for their treasury bonds, yield just 2.98%.^[iii] Headlines made a lot of this figure briefly exceeding Spain’s 10-year yield for the first time since 2008 on Tuesday. But politicians and EU bureaucrats haven’t been injecting fear into the marketplace for Spanish bonds. Moreover, that is an arbitrary comparison, playing off memories of Spain’s debt problems during the eurozone’s crisis. The reality is their debt loads basically match these days, and both have growing economies and manageable debt service costs. Why shouldn’t their debt costs be similar?

We think a different comparison sheds more light. If French debt were in a truly bad spot, markets would indeed show it with high and rising borrowing costs. But the reference point wouldn’t be Spain, a country with similar fundamentals and matching currency risks. It would be the world’s preferred fixed income benchmark: the 10-year US Treasury. It currently yields 3.79%.^[iv] If French bonds yield less than the world’s most liquid, stable and trusted bonds, then where is the problem?

For all the attention the comparisons of debt and deficits to GDP get, those aren’t the measures that matter. They are apples and oranges. GDP is the flow of all economic activity in a given year. Debt is an accumulated stock. The deficit is an accounting entry. Three. Different. Things. You don’t pay debt with annual economic activity. Nor does economic activity finance the deficit. What really matters is interest payments—the cost of servicing debt—and how that compares to government revenues. As long as debt interest doesn’t hog a huge share of tax revenues, then public finances are in fine shape. France’s central government interest costs were 9.9% of tax revenues last year.^[v] This is up from 6.6% in 2020, but it is below the entirety of 1992 – 2015. (It is also down a smidge from 2022.)^[vi] If France’s finances didn’t implode when interest gobbled nearly 14% of revenue in 2011 and 2012, then why would they suddenly do so now?

This is why we call this a political issue. EU debt limits are a political construct, designed to mollify Germany and other Northern European nations that were concerned about entering a political and economic union with nations they viewed as more spendthrift. The limits are arbitrary. They are also, remarkably, unenforced. We have lost count of how many nations have entered the EU’s excessive deficit procedure and been at risk of that very bad fine over the past 20 years. But no nation has ever actually been fined. Maybe Eurocrats know, even if they don’t admit, that making a nation with financial problems pay a fine as punishment for debt would be self-defeating. Or maybe it is all a big shell game. Either way, absent enforcement, this is all just political theater.

There is also a lot of theater within France, amid worries that its divided, gridlocked legislature won’t be able to pass the tax hikes and spending cuts supposedly needed to get debt in check. Perhaps. But we also aren’t totally sure draconian austerity is necessary. Look at France’s own history. In 2009, central government interest costs hit a whopping 13.4% of revenue for a simple reason: The recession that accompanied the global financial crisis reduced the tax base, knocking revenues.^[vii] Interest payments actually went down that year. In 2010, costs slipped to 12.5% of tax revenue—despite slightly higher absolute interest payments—because a recovering economy helped tax revenues rebound.^[viii] Now, as then, economic growth can be the French Treasury’s best friend, helping improve the debt situation even if politicians do nothing.

We do see some implications for stocks, but not the ones you might think. While US and global markets—and several European nations—are back at all-time highs after the summertime pullback, French stocks are taking the long way. With the summer’s snap election in the rearview and the new government in place, falling uncertainty should be helping lift French stocks. But all this austerity chatter counters that, to a degree, by raising uncertainty. UK stocks, currently beset by matching budget uncertainty, are in a similar boat. We doubt sentiment stays stuck for long, as uncertainty should fall as the governments release their fiscal plans, but it may take a little more time.