Expansionary fiscal policies and rising interest payments on government debt are pushing long-term yields higher across the European Union, with significant political and economic implications.
What is occurring in France is likely a preview of coming attractions across the G-7 and potentially the United States.
The dislocation is best illustrated by the blowout in Franco-German yields to 159 basis points on Oct. 21.
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That spread would not be out of the question in a developing market, but it is highly unusual in the world’s seventh-largest economy with a gross domestic product of $3.6 trillion.
It’s happening because investors have reassessed the risk of holding French debt, pushing up the term premium as its sovereign debt approaches 120% of GDP. That repricing will increase the cost of capital in France and quite possibly the European Union.
Executives at small or medium-sized firms may not think that the turmoil in global debt markets is of immediate concern to them, but it is.
That’s because the new regime of higher inflation and interest rates since the pandemic is only going to continue, as investors attach higher risk premia to the debt of developed economies, especially France.
The arrival of the new regime was originally a response to the resurgence of growth after the pandemic and the ability to support non-zero interest rates. But now it is a function of rising government debt without the means or intention to pay it off.
Where does this all lead? Higher inflation and interest rates, most likely followed by fiscal consolidation. But it won’t be easy.
The increase in public debt
France was accumulating debt at a moderate pace after the financial crisis and the European debt crisis.
But now its debt has exceeded 100% of its yearly GDP output, a level that the International Monetary Fund anticipates will grow.
The initial fiscal restraint of French President Emmanuel Macron’s early years has faded. Fiscal discourse among the major parties, until recently, can best be characterized as populist, with high levels of spending.
Global investors view the policies as profligate and part of the reason why France stands on the precipice of a fiscal crisis.
Yield spreads
Add France’s recent turmoil onto its rising debt and the result is a yield spread blowout between French OATS paying 5.01% and safer German Bunds paying 3.42%.
The investment community is requiring additional compensation for the risk of holding French debt.
Blast from the past
It has been a little less than two decades since the financial crisis and the European debt crisis pushed the eurozone to near collapse as the smaller economies of the European Union groaned under excessive debt.
But now, it is not Portugal, Italy, Ireland, Greece and Spain that are the target of global investors. Rather, it is the developed economies like France, UK, Germany and the U.S. that are flashing warning signs.
The spread between French and German 10-year debt is approaching peak levels of that European debt crisis.
During that period of stress, contagion from the southern European periphery spilled over into the other economies, which made it difficult for those economies to refinance their debt without the intervention of the International Monetary Fund, the European Central Bank and the European Financial Stability Facility. The relief was granted in exchange for strict fiscal austerity.
Today, though, these same institutions are not prepared to bail out France as the political parties continue to embrace expansionary fiscal policies.
The result will be continued volatility until the French election next April offers some kind of clarity on policy.
What can be done?
There are five basic options to reduce government debt and drive yields lower.
- Fiscal consolidation
- Running the economy hot
- Financial repression
- Debt cancellation
- Default/restructuring
Fiscal consolidation
Over the past four decades, some developed economies have put their fiscal paths on more sustainable footing, which led to lower yields. The U.S. in the 1990s and Italy over the past two decades are two examples.
We would anticipate that once the fad of populist economics fades, fiscal consolidation is the end point absent a fiscal crisis.
But it is hard to envision right now. In France, economic populism is the defining feature of both the left and the right. Global bond investors as a result are demanding higher payments for holding its debt, which only pushes up the cost of capital for businesses and consumers.
Running the economy hot
Inflating away debt was part of the post World War II economic environment as price controls were gently removed. The U.S. Consumer Price Index peaked at 19.7% in March 1947 before declining to an average of 7.5% from 1946 to 1949.
The dynamic since the pandemic is not dissimilar. Inflation peaked at 9.1% in June 2022 but has averaged 4.1% since then. At the same time, GDP growth has averaged 2.9%, which is well above the 1.8% long-term trend.
Under such a policy framework, inflation pushed down real rates which erodes the real value of existing debt. It is a far more subtle way of restructuring government debt without the upheaval that accompanies debt restructuring and defaults.
But given the monetary constraint faced by Paris—the ECB sets monetary policy not the French Central Bank—this option is a nonstarter. Excessive expansionary fiscal policy would just make the situation on yields worse and result in a greater crisis.
Financial repression
Large-scale asset purchases by central banks were a primary response of major economies following the financial crisis and the pandemic.
The goal was to keep nominal rates lower than market-derived levels and to drive down debt servicing costs.
The policy of pressuring government funds to below market rates was a form of financial repression for savers and financial institutions that could not benefit from market prices.
Higher interest rates make it difficult for governments to continue serving past debt. Central banks may purchase government debt to drives down yields (prices move higher), but that disadvantages savers who miss out on higher yields.
The Federal Reserve’s balance sheet expanded to a peak of $8.9 trillion in April 2022 and 36.8% of GDP in December 2021. The European Central Bank peaked at 68% of eurozone GDP in December 2021 and $8.8 trillion in June 2022.
Right now, the ECB is not predisposed to to purchase French-issued debt to drive down yields.
Until the long Japanese economic malaise of recent decades took hold, financial repression was primarily observed in emerging market countries.
Other policies such as interest rate caps, capital controls, elevated reserve requirements, and strict government control over the banking system often accompany policy frameworks organized around financial repression.
Debt cancellation
Debt cancellation occurs when a government refuses to pay back its creditors. Under such circumstances, the courts may invoke legal arguments which are distinct from default. But the result is that the state declares itself simply unable to pay.
I tend to think about this option as another form of monetization of existing debt, which typically involves high inflation, and the state renouncing some portion, or maybe all, of its debt.
That would be followed by writing down equity to negative value by the central bank, which then typically makes reserves used to purchase debt permanent. In that case, devastating inflation follows.
Think of debt cancellation as another form of monetary financing.
Default/restructuring
The most complex form of repudiating government debt involves default and restructuring.
We adopt an elastic definition of default as a policy that imposes losses on creditors that is voluntary. That can involve partial or complete default.
A narrower definition—failure to pay debts beyond a specifically defined grace period—can be considered that is typically organized around credit default swaps and insurance in case of such exigent circumstances.
Restructurings, however, involve debt rescheduling that traditionally involves extending maturities or reducing coupons while maintaining the face value of debt, or outright debt reduction that involves reduction in the face value.
While there are other arrangements like pre-emptive restructurings and post-default restructurings that we will not get into here, the point is that once an economy has been found to have debt that cannot be repaid, a combination of default and restructuring typically follows.
This has often taken place in developing economies in Asia, Africa and Latin America.
France is now being discussed in terms along those mentioned above. One gets the sense that it will require a more pronounced period of financial stress before two things happen.
First, the French political authority negotiates a mutually agreed upon period of fiscal consolidation.
Second, the risk of contagion spilling over into other eurozone nations compels France to use its Transmission Protection Instrument, which allows the European Central Bank to buy sovereign debt to counter “unwarranted and disorderly market dynamics.” But because France is non-compliant with EU rules, such a move is not warranted.
Still, it would not take much imagination for the ECB to adopt an elastic definition of unwarranted and disorderly market dynamics to initiate this kind of action.
The takeaway
It does not help that one of the major candidates standing for election in France has proposed canceling the 18% of French debt that it owes to its central bank. That sort of economic populism is why such policy frameworks of both the right and left always result in financial turmoil.
Currently the risk of contagion is slowly rising but not yet a cause of the ECB to use its TPI to being purchasing French debt to relieve the current period of financial stress.
Yet, the global bound rout that continues is now part of a broader financial conversation among international investors as to the direction of fiscal policies among governments that run large primary budget deficits and are on what look increasingly like unsustainable fiscal paths.
Perhaps American fiscal policymakers will pay close attention to what is occurring in France and take steps to avoid such an outcome in the near to medium term.
We are not holding our breath on that one.
