Can financial markets put pressure on a powerful country like France, the world’s eighth-largest economy? It is better not to test it. The UK has found that out several times.
An analysis by Institut Montaigne found that promises made before the election by the leftist New Popular Front would increase France’s annual budget spending by €95 billion and the state finance deficit by 3.6 percent of GDP. Implementing the right-wing National Rally’s plans would increase the deficit by about €48 billion – which equals 2 percent of GDP. President Emmanuel Macron’s party also made pre-election promises. They will cost an additional €15 billion, equaling 0.6 percent of GDP.
Far-left leader Jean-Luc Mélenchon has announced that he will implement his entire program without compromise when he wins the presidential election and appoints his own government. The National Rally, a far-right party, is more cautious. Before the election, the party’s prime ministerial candidate, Jordan Bardella, said he would finance his program by cutting spending, encouraging legal and illegal immigration, and closing some tax loopholes. He also promised an audit of public finances to get an idea of the real situation.
This situation is well known to President Macron. France’s public debt is about €3 trillion, or more than 110 percent of GDP, and this year’s deficit of €154 billion – 5.5 percent of GDP. The average French citizen does not understand the relationship of these abstract numbers to concrete numbers – the balance of their bank account and the monthly income credited to that account.
Instead, financiers employed by funds and investment banks, such as Rothschild & Cie Banque, where Emmanuel Macron worked for four years, understand this perfectly. About half of French debt is held by foreign investors. The share has shrunk since 2010, but domestic debt holders – French banks, insurance companies, pension funds – are also not holding it altruistically. They treat it as a deposit on which they make money and give it to customers. These institutions are referred to by the common term “financial markets.”
Even before the election, the French government pledged to the European Commission that it would reduce the deficit to below 3 percent by 2027. Experts doubted whether this was realistic, and after the elections, doubts intensified. Like Poland and five other countries, France has been placed under the excessive deficit procedure. It is possible to negotiate with the European Commission. For years, it tolerated the build-up of public debt in France.
However, it is impossible to negotiate with the financial markets. On May 31, Standard & Poor’s downgraded France’s rating from “AA” to “AA-.” For financial markets, this is a signal that the credibility of the debtor French government has declined, which has translated into yields on French government bonds. It currently stands at 3.13 percent (10-year bonds) and has risen by more than 0.6 percentage points since the beginning of the year. This means that the government has to pay a higher percentage of the debt it takes on.
Two Lessons from the UK
Can financial markets put pressure on a powerful country like France, the world’s eighth-largest economy? It is better not to test it. The UK has found that out several times.
In 1979, the European Exchange Rate Mechanism (ERM) was created in the European Economic Community, the predecessor of the European Union. ERM countries were required to maintain fixed exchange rates against the Deutsche Mark. They could fluctuate no more than 6 percent.
The UK joined the ERM in October 1990 and for the first few years, it profited from it. But in 1992, the UK was hit by a recession. There was a perception among analysts that the British pound was heavily overvalued. The financial markets also recognized this, where George Soros’ Quantum Fund was a big player. From the beginning of August 1992, he began to play for a decline in the pound, conducting so-called short selling. On Wednesday, September 16, the pound exchange rate came within a hair’s breadth of the lower limit of the range set by the ERM.
The Bank of England began buying pounds, but investors from around the world rushed to sell pounds, following in the footsteps of the Soros fund. British authorities spent £27 billion buying up the country’s currency, but the defense yielded nothing. The GBP’s exchange rate fell one day by 25 percent against the USD and by 15 percent against the Deutsche mark. The UK has decided to leave the ERM. This story is familiar to all professionals employed by banks and funds. Its moral is clear – financial markets are not worth fighting.
Financial markets admonished the UK for a second time in September 2022. A few weeks earlier, Liz Truss had become prime minister, trying unsuccessfully to emulate her great predecessor Margaret Thatcher, without considering the country’s dire financial situation. On September 23, Chancellor of the Exchequer Kwasi Kwarteng unveiled a “mini-budget” that included a package of tax cuts that shocked financial markets. The tax cuts were expected to cost the Treasury some £161 billion over five years, while additional spending worth £60 billion was announced to offset rising energy costs. The pound fell below $1.11 for the first time since 1985, and five-year Treasury bonds, known as gilts, saw their biggest-ever daily drop in value.
Truss tried to back out of these announcements by resigning Kwarteng, but confidence was not restored. She herself resigned on October 25, making history as Britain’s shortest-serving prime minister.
Erdogan’s Failed Experiment
However, financial markets are more likely to discipline the governments of less-developed countries, such as Turkey, which are trying to deal with constraints by deviating from standard macroeconomic policies. Turkey has maintained a fairly rapid growth rate for more than 30 years, averaging more than 4.5 percent per year, but periods of rapid growth are punctuated by financial crises and subsequent periods of recession. The reasons have always been similar – lack of confidence in the stability of Turkish finances and the Turkish state.
In 2003, the Justice and Development Party (AKP) won the parliamentary elections, and its chairman Recep Tayyip Erdogan became prime minister. The AKP won elections several more times, and in 2014, Erdogan became President and changed the country’s political system through a referendum. As a result, he gained near absolute power, giving him the right to, among other things, dismiss and appoint the governor of the Central Bank of the Republic of Turkey.
He eagerly exercised this right. Since 2016, the bank has been headed by six successive CEOs, none of whom have completed their terms. Erdogan demanded contradictory things from them – that they keep interest rates low and the Turkish lira currency stable. The President called for lower interest rates, describing high rates as “the mother and father of all evil.” He claimed that they were the cause of inflation and that lowering them would stabilize prices and strengthen growth. When this theory didn’t work, he sacked the bank’s President and appointed another. Financial markets reacted to this with a flight from the lira, whose exchange rate fell continuously.
When Erdogan won the presidential election in August 2014, the lira was worth $0.46. It is currently worth $0.03. The depreciation of money caused investors to shun Turkey and its foreign exchange reserves to melt away. The President hoped to supplement them with loans from oil Arab countries, but these were desperate steps. Erdogan gave in when inflation exceeded 80 percent last year. He asked Mehmet Simsek to take over as Treasury and Finance Minister. Simsek was in charge of the economy in Erdogan’s first government. As finance minister, he formulated fiscal policies that helped Turkey recover from the 2008 global financial crisis.
He is now also trying to restore stability in the economy by introducing stricter fiscal policies. The Central Bank raised the benchmark rate from 8.5 percent to 50 percent.
On July 19, Moody’s credit rating agency raised Turkey’s credit rating for the first time in more than a decade. The rating on long-term foreign currency and Turkish lira debt rose two notches from the previous “B3″ to “B1″. In addition, the agency gave the rating a positive outlook, indicating the possibility of a further upgrade.
Moody’s justified its decision on the grounds that Turkish monetary policy has returned to the path of traditional orthodox monetary policy, which has led to a decline in inflation and a rapid increase in the central bank’s foreign exchange reserves. The rating agency indicated that confidence in the policies of the Central Bank of the Republic of Turkey has increased significantly. According to Istanbul-based consulting firm Bürümcekçi Research and Consultancy, fund managers have invested some $24 billion in Turkish lira-denominated assets since October 2023. Foreign exchange reserves have, therefore, increased.
Turkey is not a particular example of irresponsible economic policy. Many countries have gone bankrupt through irresponsible policies, driving their inhabitants into abject poverty.
France Is in Danger of Falling into Debt Spiral
Can Mélenchon or Marine Le Pen disregard the financial markets if they win the presidential election and assume full power in France? This is possible, especially in the case of the leader of the Left Party.
Let’s try to imagine such a scenario: after winning the presidential election, Mélenchon would dissolve the National Assembly, and after snap elections, a leftist government would gain a majority in parliament. So, the government is delivering on its promises: lowering the retirement age, raising the minimum wage, freezing energy and food prices, and increasing welfare benefits. The budget deficit is rising from today’s 5.5 percent to 9.0 percent of GDP, and the government, to finance spending, as well as rollover debt previously incurred, needs to borrow about €400 billion a year on the financial markets.
A few years ago, the government was selling bonds with an interest rate of 1-2 percent, but they have just come due. Thus, it has to sell new bonds, so much so that financial markets will be ready to buy them if their interest rate is 5 – 7 percent.
This year, debt service is expected to cost €52.2 billion, according to the French government. The increase in bond yields and interest rates on new bonds will cause the cost of servicing “Mélenchon’s debt” to exceed €100 billion already in the first year of his rule, and to rise rapidly in subsequent years. Debt will also grow, with levels approaching those of Italy. The government will thus fall into a debt spiral, which will grow because the cost of servicing it will exceed the state’s capacity. It is as if we are paying off debt on a payment card by incurring debt on another card.
In July 2012, when Italian government bond yields exceeded 6 percent, and investors wondered when the government would announce a suspension of repayments or ask for international help, European Central Bank President Mario Draghi said he would “do whatever it takes to save the eurozone.” This calmed financial markets, and yields began to fall. But financiers demanded the dismissal of Silvio Berlusconi’s irresponsible government and its replacement by Mario Monti’s technocratic government.
Arguably, the financial crisis following Mélenchon’s populist actions would have forced the ECB to help France, but aid even to such an important country would not have been unconditional. The situation would end up like in Italy.
Written by Witold Gadomski – Polish journalist, “Gazeta Wyborcza” columnist
The article is part of the Economic Freedom Foundation’s series “Through the Eyes of a Liberal” and was also published on Wyborcza.pl.
