Will France’s political crisis ignite the eurozone debt crisis?

Political Instability and Economic Concerns in France

The recent collapse of the French government, due to its inability to pass austerity measures through parliament, has raised concerns about the growing debt of the EU’s second-largest economy. This situation is causing fears that the country’s financial stability might be slipping out of control.

Sebastien Lecornu, who had been serving as the prime minister for less than a month, resigned on Monday (October 6), just 14 hours after announcing a largely unchanged cabinet. Following his resignation, Lecornu accepted a request from President Emmanuel Macron to work on a plan for “stability for the country” by Wednesday evening. This unexpected turn of events marked a day of political upheaval, with stock markets in Paris experiencing sharp declines due to worries over the political parties’ ability to address the nation’s economic challenges.

If Lecornu fails in his new task, one possible outcome could be fresh legislative elections called by Macron.

France’s huge sovereign debt remains a significant issue, with politicians unable to reach an agreement on how to manage it. As a result, the yield on France’s benchmark OATS government bonds has risen more sharply than other eurozone bond yields. A further sign of investor confidence being shaken is the fact that OATS now trade at a slightly higher spread than Italy’s BTP government bonds for the first time since the euro’s launch in 1999.

Investors are also punishing French stocks, with the CAC 40 index lagging behind the rest of Europe by approximately 14% since the beginning of last year.

France’s Debt Situation

In absolute terms, no EU country holds more consolidated national debt than France. The country’s sovereign debt has climbed to around €3.35 trillion ($3.9 trillion) — about 113% of gross domestic product (GDP), with projections indicating it could rise to 125% by 2030.

France’s debt-to-GDP ratio is so high that only Greece and Italy surpass it within the European Union. With a budget deficit of 5.4% to 5.8% this year, Paris also runs the largest budget shortfall in the 27-nation EU. To meet the EU’s target of reducing the deficit to 3%, drastic savings are necessary. However, current cuts are politically unfeasible, leading to higher risk premiums on French bonds. While German bonds carry an interest rate of about 2.7%, the French government needs to pay close to 3.5% interest for its debt.

Concerns About the Euro

Should we worry about the stability of the single European currency, the euro, if the finances of France slip out of control? Friedrich Heinemann, an economist with the ZEW Leibniz Center for European Economic Research in Mannheim, Germany, believes we should be worried. Although he is not concerned about a new short-term debt crisis in the coming months, he emphasizes the need to ask where this is heading if a big country like France, which has seen a steadily rising debt ratio in recent years, now faces further political destabilization.

Other major economies are also racking up historically high debt and must raise billions on capital markets. This fall, for example, Germany, Japan, and the US will need to issue new government bonds to finance their spending — a key reason global bond markets remain under pressure.

The only reason the markets aren’t even more nervous — meaning the spreads on French bonds aren’t rising further — is the hope that the European Central Bank (ECB) will step in and buy French bonds to stabilize the market. However, Heinemann thinks this hope could be misplaced, as the ECB must be careful not to undermine its credibility.

European Commission and ECB Under Pressure

France now spends €67 billion annually just on interest payments. It is under pressure because it has committed to gradually reducing its deficit in line with EU rules. Heinemann also lays part of the blame on the steps of the European Commission because it “helped create this mess.” He states that the Commission turned a blind eye to France’s issues, driven by political compromises to avoid strengthening populists.

Heinemann points out that France has already used up much of its fiscal space, while Germany is in a much better position with plenty of room for maneuver.

Stalled Reforms and Political Dilemma

According to Heinemann, France, like Germany, urgently needs major welfare reforms and spending cuts. The alternative would be higher taxes in a country that already imposes heavy tax burdens on both citizens and businesses. Therefore, Heinemann is skeptical that French politics can deliver a cross-party consensus on debt reduction.

“With populists on both the left and right gaining ground, I don’t see that happening. The center is shrinking. That’s why I’m pessimistic about France and don’t see a solution,” he said.

Risks to Other European Markets

For Andrew Kenningham, chief European economist at London-based Capital Economics, the risks to other European markets remain manageable for now. He notes that so far, the problems seem largely confined to France itself, as long as the scale of the French issue doesn’t grow too big. However, he warns of scenarios where France’s crisis could escalate significantly, raising the risk of contagion.

“After all, France is the eurozone’s second-largest economy, with deep trade and financial ties to its neighbors, and it is also a leading EU political power,” Kenningham noted. He adds that a crisis in France could therefore put the very viability of the European project into question.

Bad Timing for a Political Crisis

France’s turmoil comes at a time when the EU is locked in conflict with the United States over trade policy, including higher taxes on US tech giants proposed by France. It’s poor timing for the EU to appear weakened by the political deadlock in France.

For Heinemann, many political actors in France are “Trumpists at heart,” especially on the left and right of the political spectrum. He warns that they could increase pressure on the European Commission to retaliate against Trump’s tariffs with European tariffs, which would “raise the risk of a real trade war” and worsen the country’s debt crisis even further.