European Debt Is on a Dangerous Path. It’s Not Just France.

european debt is on a dangerous path. it’s not just france.

About the author: Desmond Lachman is a senior fellow at the American Enterprise Institute. He was previously a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

French president Emmanuel Macron shocked markets earlier this month by calling for a snap legislative election after his party’s defeat in European parliamentary elections. His gamble could result in a win for the country’s far right party— a significant political upheaval. This instability raises risks of a French debt crisis. Other countries in Europe, most notably Italy, are also flashing warning signals at a particularly bad time for the global economy.

Debt is putting an economic strain on Europe. Italy, the third-largest euro zone member country, finds itself on an unsustainable public debt path. To have France, the second-largest, also on such a path looks plainly dangerous for the euro’s future. Especially since the European Central Bank is no longer buying its member countries’ bonds on the massive scale that it was doing after the Covid-induced recession.

Until recently, Italy was generally regarded as the euro’s weak link. Not only was its public debt to GDP ratio well above its level at the time of the 2010 euro zone debt crisis, there was also little prospect that it could get its debt ratio on a declining path. In addition to having an economy that grows at a snail’s pace, last year Italy ran a budget deficit of over 7% of GDP. That combination of low growth and a relatively high budget deficit must be expected to keep Italy’s public debt at a dangerously high level indefinitely. It’s little wonder that the IMF is warning Italy that its high budget deficits could erode investor confidence.

Over the past few years, Italy’s budget vulnerability has been masked by massive ECB bond purchases under its various bond buying programs. However, those programs have been terminated as part of the ECB’s effort to regain inflation control. This raises serious questions as to how and at what price the Italian government will be able to finance its very large gross borrowing needs in the period ahead.

In 2015, Greece’s debt problems shook world financial markets. We have to wonder how much more markets would be shaken if debt problems were to surface in Italy, which has an economy some ten times the size of Greece. This makes it all the more inopportune that President Macron’s call for snap elections at the end of this month is now also focusing the market’s attention on France’s precarious public finances.

Even before Macron’s risky decision to go to the polls, rating agencies were expressing concern about France’s debt trajectory. In particular they noted that on present policies its public debt to GDP ratio could reach almost 115% by 2027.

Unfortunately, France’s public finances could become more worrisome after the election if President Macron’s party loses control of the National Assembly. That would be particularly the case if Marine Le Pen’s National Rally Party was to repeat its electoral success in the recent European Union election. While the National Rally Party has not set out its policy proposals in detail, its goals include slashing taxes on fuel and energy, increasing public spending, and lowering the retirement age to 60. That hardly bodes well for France’s ability to restore public debt sustainability.

Even in a benign political setting, experience with budget belt-tightening during the 2010 euro zone debt crisis suggests that France and Italy will have difficulty in restoring public debt sustainability in their euro straitjackets. Not having an independent monetary and exchange rate policy of their own, those countries would not be able to use exchange rate depreciation as a means to boost exports as an offset to reduced domestic demand from budget belt-tightening. This could make budget belt-tightening counterproductive in that it could trigger an economic recession that in turn would reduce the tax base.

All of this casts a dark cloud over the world economic recovery in the year ahead. The last thing that the world economy needs is a stuttering euro zone economy at a time when China is grappling with the bursting of its housing and credit market bubbles, the U.S. economy is being challenged by a slow-motion commercial property trainwreck, and Japan’s currency is being heavily weighed down by its poor public finances.

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