Are we heading toward a financial crisis?

The yield on France’s 10-year government bonds has risen to 4.9 percent. Rising government bond yields reflect diminishing trust in public finances, with France emerging as the greatest concern. Investors are demanding greater compensation for the risk of lending to the French government. This risk premium makes debt servicing more expensive, while issuing new debt to finance the government’s excessive spending becomes increasingly difficult. France is not alone in heading in this direction. In the business world, borrowers in this position would be candidates for junk status.

The eurozone faced a sovereign debt crisis in 2012, with Greece at its center. Germany played a leading role in the bailout, while the European Central Bank also provided support. A domino effect threatened to spread the crisis. In July that year, then-ECB President Mario Draghi famously pledged to do “whatever it takes” to preserve the euro. This signaled a willingness to rescue eurozone countries, in effect breaching the principles on which the ECB was founded.

France’s economy and debt are many times larger than Greece’s, making a rescue far more difficult.

Prince Michael of Liechtenstein

 

The intervention helped contain the crisis and may have been justified in the short term. But it also opened the door to moral hazard, weakening governments’ incentives to maintain fiscal discipline. As the saying goes in crime stories: “Only the first murder is difficult; then it becomes a habit.”

We now face a similar situation, but public debt has risen drastically since 2012. France’s economy and debt are many times larger than Greece’s, making a rescue far more difficult. Other European countries are unable to come to its aid.

In 2022, the ECB introduced the Transmission Protection Instrument, or TPI, which has yet to be used. It allows the bank to buy government bonds on the secondary market to counter unwarranted increases in borrowing costs. For France, higher yields make additional borrowing extremely expensive. The instrument could offer relief, but it is intended to address increases in yields that are not justified by a country’s economic fundamentals.

Unfortunately, France’s fiscal problems are precisely what is driving concern. Under those conditions, using the TPI to support France would be difficult to reconcile with its rules. Nevertheless, ways will probably be found to meet France’s financing needs, even at the expense of fundamental eurozone and European Union rules. Over time, this would further weaken the euro system. The can is simply kicked down the road.

And the problem extends well beyond France.