Lagarde will need to manage expectations carefully, HSBC economist Fabio Balboni warned, since ruling cuts out completely could drive up borrowing costs across the eurozone, including in France.
“Many countries in Europe face tough fiscal challenges, especially France,” Balboni said. “They simply can’t afford” to spend more money just on interest payments.
The situation Balboni describes is something economists call “fiscal dominance,” which occurs when the central bank is forced to keep interest rates low so governments can continue to borrow. Such intervention generally leads to higher inflation in short order.
It was debt problems, more than anything else, that brought down France’s government on Monday, after Prime Minister François Bayrou failed to garner enough support for €44 billion in proposed budget cuts for next year. But after initially taking fright when Bayrou called his fateful vote of confidence, investors have largely held their nerve.
The spread between French and German 10-year bond yields, a bellwether of market stress, is now at 0.82 percentage points, the widest it’s been all year. But it continues to resemble a slow puncture more than a blow-up. That’s partly because President Emmanuel Macron, who has appointed yet another centrist prime minister, is still trying to build consensus around a deficit reduction plan, rather than call new elections.
C’est la vie
It has been a humbling summer for France, which has always benchmarked its economic and financial strength against Germany. But as its politics have become increasingly paralyzed and its debts have mounted, markets have come to see it more as a peer of Italy. For the first time this century, Paris’ borrowing costs surpassed those of Rome on Tuesday, albeit only briefly and due to a technical quirk. But the fear is that a growing public debt burden — which stands at over €3.35 trillion — will make the country increasingly vulnerable to a financial crisis.