If you had a hundred euros to lend this week, and you wanted a nice safe borrower,

the bond market would suggest you lend it to L’Oréal… rather than the French Republic.

Or to Air Liquide, a company whose main product is, broadly speaking, air. There is also LVMH,

or Sanofi, or (according to the credit strategists at Barclays) a fairly wide

selection of triple-B rated companies - the bottom rung of what the rating agencies call

investment grade. All of them can now borrow money more cheaply than France.

So can Italy… and so can Greece. Which is a bit embarrassing,

as French officials have spent the past fortnight reassuring everyone that France is not Greece.

Bloomberg calculates that about 215 billion euros of French high-grade corporate bonds (or 38% of

the market) now trade at lower yields than French government debt of a similar maturity. At the

start of the year it was just 12 billion euros. Now, in theory, a government is the safest

borrower in its own country. If things go wrong, it can always raise taxes or print more money.

L’Oréal can’t do either of those things… it has no legal way of sending armed police to your

house to collect seventy euros for moisturizer. France, as it happens, can’t print money either.

It handed that job over to the European Central Bank in 1999, which we’ll come back to later. But

it can still raise taxes, so investors have always given it the benefit of the doubt. Over the last

few weeks, they’ve been rethinking that. French ten-year borrowing costs came within

a whisker of 5% last week, the highest rate in almost a quarter of a century. The spread

over German Bunds, which is how bond traders measure how nervous they are about a country,

briefly topped one and a half percentage points, the widest it has been since 2011. In eurozone

seating-plan terms, France has been moved from the top table to the one near the bathroom.

While this has been going on, high school students across France have spent the past

few weeks blockading their schools in protest at teacher shortages, overcrowded classrooms,

and buildings that are falling apart. Most of the marches have been peaceful - but some have not.

A few entrance halls have been set on fire, and more than six thousand people have been arrested,

most of them teenagers. Setting fire to your school in protest at the condition of school

buildings is a bold negotiating strategy… though I suppose it does strengthen the case

for renovation. The students would like more money spent on schools. The bond market would like less

money spent on everything. The French government is standing in between them, holding a budget.

During the euro crisis, the bond market’s troublemakers traveled as a group: the PIIGS,

which were Portugal, Ireland, Italy, Greece, and Spain. This time, as Lionel Laurent pointed out

in Bloomberg this week, France has been given an acronym all of its own. FROGS – which stands

for French Oversized Government and Social Security. It was coined by a Paris research

firm called Rexecode, so at least the insult was made in France. I think it’s OK if they say it

themselves… I’m not sure if I’m allowed to say it. I’ll credit Rexecode every time, just to be safe.

As an Irishman, I take a strong interest in this sort of thing. I helped put the

“I” in PIIGS (well, my country did… I mostly just watched the bond yields), so I’d like to formally

welcome France to the club. The membership fee is about ten years of austerity, and

the troika will soon be in touch. So, before I dig into how France is

going to handle its new membership, let me tell you about this week’s

video sponsor, Incogni. [Sponsor clip] So, to understand why the French bond market

is on fire, it helps to look at why everyone else’s bond market is also smoking slightly.

For most of the last decade, borrowing money was close to free, and governments (understandably)

took full advantage of the offer. Today, according to The Economist - the median ten-year government

bond in the rich world yields about 4%, the highest in more than fifteen years. America’s

ten-year yield topped 5.3% this week, and Japan’s crossed 3% for the first time since 1996.

There are a few reasons for this. The first is AI. Goldman Sachs expects the five biggest

hyperscalers, Alphabet, Amazon, Meta, Microsoft, and Oracle, to spend around $800 billion on

capital investment this year and $1.2 trillion next year, which would be more than 3% of

America’s GDP. At first they paid for their data centers out of their own cash flow. Now they’re

borrowing. They’ve issued $230 billion of bonds so far this year, which is double last year’s total.

That money comes out of the same global pool of savings that governments borrow from,

and the AI companies are not very price-sensitive borrowers. The FT reports that they see building

data centers as an existential necessity, and an extra percentage point or two of

interest as a detail. The Economist says the hyperscalers now account for nearly 10% of new

euro-denominated bonds sold by non-financial companies, and that some European firms

avoid issuing debt on the same days they do. The second reason is the war in Iran. Crude oil

is about 40% more expensive than it was before the war started. This has kept inflation high

and pushed central banks into raising rates rather than cutting them. The Federal Reserve

raised rates in September for the first time since 2023, and the ECB has raised twice since June.

Now, when borrowing costs go up, every indebted government gets tested. The arithmetic goes like

this. If your economy grows faster than the interest rate on your debt,

the debt shrinks as a share of national income over time, as long as you aren’t

borrowing too much on top. If the interest rate is higher than your growth rate, the debt grows

relative to the economy, unless you raise taxes or cut spending. Economists call this “r minus

g,” which is about as exciting as it sounds. Some countries are getting through the test for

now, each for their own reasons. America runs a deficit of about 6% of GDP, which The Economist

describes as unsustainable, but it issues the world’s reserve currency, its economy is growing

at over 3% a year, and investors still seem happy to lend to it. Japan’s net debt is 134% of GDP

(its gross debt is a lot higher than that), but inflation has risen alongside interest rates,

so in real terms the debt is shrinking, and most of it is owed to the Japanese.

Britain’s thirty-year gilt yield is above 6%, the highest since 1998,

but Britain already had its bond market revolt in 2022, when Liz Truss’s unfunded tax cuts

were outlasted by a lettuce. British politicians have been nervous of the gilt market ever since.

And then there’s France. It doesn’t issue a reserve currency, it isn’t having an AI boom,

it imports most of its oil and gas, and it hasn’t had its Liz Truss moment… yet. As The Economist

points out, French borrowing costs were about two percentage points above nominal GDP growth in the

second quarter, the widest gap in the rich world, and the gap has widened since. On those numbers,

unless something changes, French debt keeps growing faster than the French economy.

So, how hard is the arithmetic? Well, back in May, the French government asked four

independent economists to work out where the country’s public finances were heading. Their

report came out in July, and it said that based on current policies, the deficit would rise to 6.8%

of GDP by 2030, that debt would pass 130% of GDP, and that the interest bill would grow by

about 10 billion euros a year. They also noted that the interest bill was already approaching

the budget of the entire Ministry of Education – and we’ll come back to that in a moment.

To stabilize the debt, the economists argued that France would need to make savings worth about 125

billion euros a year by 2032. That calculation assumed France’s ten-year borrowing rate,

which was 3.7% at the time, would drift down to 3.3% as the bond market rewarded the government

for behaving responsibly. That rate has recently risen to about 4.9%. The report came out in July,

which in bond market terms makes it a historical document. Ben Hall at the FT

reckons that the amount that needs to be saved per year has already gone up to 140 billion euros.

Against that, Prime Minister Sébastien Lecornu’s 2027 budget proposes 43 billion euros of spending

cuts and tax rises. For one year, that is a big number. The problem is that something like it has

to happen again, and stick, every year until 2032, and Lecornu doesn’t have a majority in

parliament. ING’s economists say that even if his plan passes in full, it won’t stabilize the debt.

Part of the problem, according to the commission, is that the French state has come

to see itself as the “insurer of last resort” for every crisis. When something goes wrong,

the state steps in to protect household incomes and company balance sheets, and the emergency

measures tend to stay in place long after the emergency has passed. The report calls this a

ratchet effect. In insurance terms, the French state writes a policy for every disaster and

never lets one expire. This month, the queue of claimants includes students, farmers, fishermen,

truckers, construction companies, and nurses. Normally, a government that spends too much can

raise taxes. But France’s tax take is already at 44% of GDP, compared to an OECD average of 34%,

and the commission says that it is the highest in the eurozone. The economists warn that the

public’s “consent to taxation” is weakening, because people feel they are paying more and

more for public services that are getting worse. People will put up with Scandinavian

tax rates if they get Scandinavian schools. They get less enthusiastic when the roof is leaking.

Which leaves the option of spending cuts. Almost a quarter of public spending in France goes on

pensions. And French workers retire earlier, on more generous terms, than in most rich countries.

While pensions aren’t legally untouchable, they are politically radioactive. Lecornu’s

budget proposes freezing the most generous state pensions, and the opposition parties are already

lining up against it. Defense spending, meanwhile, is the one area that has been ring-fenced.

Now, back to the schools. The protests started in the middle of September at a lycée in Créteil,

just outside Paris, over long school days, crumbling buildings, and teacher shortages.

The Economist reports that spending per secondary pupil has been flat in real terms for a decade.

Two weeks into the protests, the government published its budget, which cuts 1,588 teaching

posts, on the grounds that pupil numbers are falling. As timing goes, that could have been

better. One university student summed it up to The Economist: “The budget for the

army is increasing, but not for education.” One student union reckons the students’ demands

would cost about 10 billion euros. Lecornu has promised measures that are “concrete,

swift, hence, funded”… which he’ll announce at the end of the month.

So, the government is stuck. Every euro it tries to save brings someone new out onto the streets,

and every year it doesn’t save anything, the interest bill goes up by another ten billion.

Which raises the difficult question… If France is in this much trouble,

how is Italy, a country with more debt than France, able to borrow more cheaply?

To answer that, we need to go back to our official league table of borrowers that

the bond market currently considers safer than the French Republic.

Greece has been on it since the end of 2024. Italy joined last year. Emmanuel Moulin,

the governor of the Banque de France, told the FT this week that France is not Greece,

which is true… they are entirely different countries – but Greece does borrow more cheaply.

Italy is maybe more of a puzzle. The Economist puts Italy’s net debt at almost 130% of GDP,

while France’s total debt is just under 120%. Normally, if you owe more than someone else

relative to your income, you’d expect to be the one paying the higher interest rate.

You might think the bond market is rewarding Italy for some newfound

culture of enthusiastic tax compliance, but that doesn’t seem to be the case either.

The FT reported this week that an estimated 60,000 cars and motorbikes, mostly in and around Naples,

are registered in Poland. Their Italian owners transfer their ownership to Polish

shell companies, with the promise of saving about 70% on road tax and insurance. Naples has some of

the highest car insurance premiums in Italy, and the road tax on a Fiat Panda is around 130

to 140 euros a year. According to the Polish car insurers’ agency, most of these vehicles

“have never been on the roads of Poland.” There are other benefits too. Parking tickets

and speeding fines get sent to the shell company in Poland, where, as the same agency put it,

“everything vanishes into thin air.” The Italian and Polish police are both aware of this. In

March, police in Warsaw arrested seven people for producing registration papers for more than

a thousand five hundred vehicles, with the help of what investigators described as corrupt local

officials. All of the cars had passed Polish technical inspections… which was impressive,

as none of them had ever been to Poland. With an election coming in 2027, Giorgia

Meloni’s government has come up with a solution. It’s suspending the road tax on small and midsized

cars for a year, which will leave about 2.4 billion euros with Italian motorists rather

than the Italian treasury. This is possibly the most effective anti-evasion policy ever

devised… it’s impossible to dodge a tax that doesn’t exist. For now, the hole in the budget

will be filled with money left over from Italy’s EU-funded Covid recovery plan. Francesco Galietti

of the consultancy Policy Sonar described it to the FT as “giving some sugar to voters.” So,

Italy is not exactly Switzerland. But it still borrows more cheaply than France.

Different governments take different approaches to raising revenue. While France is searching

down the back of every radiator in the country for taxable euros, other countries are more

relaxed about it. In 2016, the European Commission ordered Ireland (founding member of the PIIGS) to

collect 13 billion euros in back taxes from Apple. The Irish government spent the next

eight years in the European courts, arguing that it didn’t want the money… which is a position

that would be hard to explain to a French finance minister. Ireland finally lost that case in 2024,

and roughly 14 billion euros, including interest, was handed over. Having 14 billion euros deposited

in your bank account against your will is a heavy cross to bear, but as an Irishman,

I can tell you we accepted it with great dignity. So, anyhow… back to the bond market.

If bond yields were a reward for paying your road tax, Italy would not be beating France.

Growth and political stability matter too, of course. But the biggest difference between

the two countries comes down to one line in their accounts: the primary balance.

The primary balance is a government’s budget before interest. You take everything the state

collects in taxes, subtract everything it spends on running the country, the schools,

the pensions, the hospitals, and the army, and you ignore the interest on its debt.

Italy runs a primary surplus. It collects more than it spends on everything (if you exclude

interest), and it has done that in most years since the early 1990s. It learned the hard way,

in the 1992 currency crisis and again during the euro crisis, but it learned. Its overall deficit,

interest included, is expected to fall below 3% of GDP this year.

France runs a primary deficit of 2.9% of GDP. So even if France had no debt at all,

and paid no interest to anyone, it would still be borrowing to keep the lights on. It has run

a primary deficit every year since 2002, and it hasn’t balanced its overall budget since 1974.

Italy has its own risks. It has an election in 2027, it has populists of its own,

and its deficit is expected to tick back up next year as it spends more on defense

and on cushioning the energy shock. But the bond market has made a fairly practical calculation.

Italy has already had its crisis, and has shown that it can run a surplus. France hasn’t… and,

as the past three weeks have shown, the political cost of even talking about an adjustment is high.

So, what does the French political class plan to do about all of this? The short answer is:

quite a lot, and not all of it adds up. Let’s start with the government. Emmanuel Macron

came to power in 2017 promising business-friendly reforms that would boost growth and fix the public

finances. Over his nine years in office, the national debt has grown by more than a trillion

euros, a lot of it spent protecting households and businesses from the pandemic and the energy

crisis. Since the 2024 snap election left France with a hung parliament, budget negotiations have

cost two prime ministers their jobs. The current one, Sébastien Lecornu, is trying to pass his 43

billion euro package without a majority, and lawmakers are expected to rewrite much of it.

Then there’s the opposition, which is preparing for next April’s presidential election.

Leading the polls is Marine Le Pen of the National Rally, whose party has long championed generous

state spending. On Tuesday, she announced that she is now a champion of fiscal discipline.

She wants a constitutional “golden rule” capping debt at 60% of GDP and cutting the deficit by

half a percentage point a year, backed by a package of savings worth 140 billion euros by

2032. Which is exactly the number Ben Hall at the FT came up with a few days earlier.

The bond market liked it, and French ten-year yields fell by 0.12 percentage points that day.

Economists were less convinced, as the plan also includes cutting VAT on energy and food,

and lowering the retirement age from 62 to 60 for people who started work young. Olivier Blanchard,

the former chief economist of the IMF, told The Economist: “Unfortunately, now that she has shown

where she intends to find the money, there is zero credibility to her promise.” The finance minister,

Roland Lescure, said he had “the impression that she has converted to fiscal discipline.”

On the left, Jean-Luc Mélenchon, who is second in the polls, has a more direct solution. According

to the FT, he has suggested that the French bonds held by the central bank could simply

be thrown “into the fire.” I suppose a bond fire would at least help with energy costs…

The formal version, from his party, is to convert about 488 billion euros of French bonds held by

the Eurosystem into perpetual, zero-coupon debt, which France would never repay and

never pay interest on. Daire MacFadden at the FT’s Unhedged newsletter, who used to work at

the Bank of England and the European Central Bank, pointed out the problem: the central bank created

reserves to buy those bonds, and it still has to pay interest on those reserves to the banks.

Canceling the bonds just moves the cost to the central bank, while the bond market watches a G7

government default on its own central bank. France does have some history here. In 1789,

Louis the Sixteenth ran out of money, couldn’t get anyone to agree to new taxes, and called the

Estates-General to sort it out. Things escalated from there. By 1797, with the king long since

executed, the Directory carried out what became known as the “bankruptcy of the two-thirds,”

writing off two-thirds of the national debt. This solved the interest problem… The regime

that did it lasted two more years before Napoleon took over. So, by French standards, the current

budget negotiations are going reasonably well. With six months to go before the election,

the bond market is looking at three main options: a minority government that may not be able to pass

its budget, a frontrunner promising an earlier retirement age funded by spending discipline,

and her nearest rival proposing to settle the national accounts with a bonfire. You

can sort of understand why investors want to be paid more to lend to France than to Germany.

Meanwhile, the frontrunner has already asked the European Central Bank to step

in and “lighten the heavy interest burden,” as soon as France “takes back control” of

its finances. Which brings us to Frankfurt. So, why can’t the ECB just step in and fix this?

Well, according to Morningstar, Jörg Krämer, the chief economist at Commerzbank,

sees four steps the ECB could take if things get worse. Step one is to sound less keen on raising

interest rates. Step two is verbal intervention, where central bankers solemnly declare that they

are ready to use their emergency tools. Step three is to stop shrinking the ECB’s balance

sheet and start reinvesting maturing bonds, with the reinvestments tilted toward France. And step

four is to press the big red button and activate the Transmission Protection Instrument, or TPI.

The TPI was created in 2022 to let the ECB buy a country’s bonds, with no size limit set in

advance, when market moves are “unwarranted” and “disorderly.” It has never been used. The

slight catch is the eligibility criteria. To qualify, a country is supposed to be following

sound and sustainable fiscal policies, and France is currently under the EU’s excessive

deficit procedure. According to Krämer, that doesn’t automatically rule France out,

but it doesn’t help. Now, just to be clear, the ECB isn’t going to let France collapse.

But the TPI is an emergency rescue tool designed mainly for countries that don’t need rescuing.

Using it on a government with a 5.4% deficit that may not be able to pass

its budget would not go down well in Berlin. Christine Lagarde has been here before. In March

2020, she told a press conference that the ECB was “not here to close spreads.” Italian

borrowing costs jumped immediately, and she spent the rest of the day walking the comment back.

Then there’s inflation. With the war in Iran keeping energy prices high, the ECB has raised

rates twice this year, and markets still see a good chance of another hike by December.

Every hike makes France’s debt more expensive. Lagarde has started telling European lawmakers

that higher bond yields will slow the economy, which is a polite way of saying that the bond

market is now doing some of her job for her. As The Economist notes, all of this sets up a

game of chicken. Countries are supposed to fix their budgets before the ECB buys

their bonds. But the European Union can’t really survive without France, so if a populist French

president refused to cut spending and dared the ECB to let French bonds collapse, The Economist

reckons the president would probably win. Greece tried this in 2015. The ECB capped

emergency funding to Greek banks, the banks closed for three weeks, and Greece gave in. But, as we’ve

been told repeatedly, France is not Greece. So, where does all of this leave France?

Lionel Laurent at Bloomberg described the situation as less like Liz Truss’s sudden

blowup and more like “a slow squeeze.” And that seems to me like the right diagnosis.

France does have some real protections. French officials point to high household savings,

reliable tax collection, and a stable banking system. But their biggest protection is a

shared currency - the euro, and this is where that decision from 1999 comes in.

As The Economist points out, French governments are still haunted by memories of May 1968, when

students and workers shut the country down with a general strike. The government settled it with

a deal that raised the minimum wage by about a third. Money quickly started leaving the country,

and the Banque de France spent much of its reserves defending the franc. De Gaulle refused

to devalue at the time, but a few months after he left office in 1969, the franc was devalued by

about 11%. When a country has its own currency, that’s where the pressure shows up first,

and it tends to show up all at once. Today, the euro protects France from

a currency run, so the pressure arrives more slowly: a spread over Germany that

keeps creeping wider, an interest bill that eats a little more of the budget every year,

and a steady turnover of prime ministers. For now, the bond market is waiting.

Parliament will spend the next couple of months deciding how much of Lecornu’s 43 billion euro

package it’s willing to keep. Moody’s is due to review France’s credit rating later this month.

And on October 29th, the ECB meets to decide what to do about interest rates.

If nothing changes, the arithmetic the economists laid out in July will keep

running in the background. The debt will keep growing, and the interest bill will keep rising

by about ten billion euros a year… and that’s using July’s interest rates. Meanwhile, the bond

market will keep updating its league table. If you liked this video, you should watch my

video on Scott Bessent’s war on prices next. Don’t forget to check out this week’s sponsor, Incogni,

using the link in the description. See you in the next video, bye.