France’s budget bombshell is a wake-up call for Europe as it veers toward bankruptcy

French Prime Minister François Bayrou’s budget bombshell on Tuesday wasn’t just a wake-up call for France.

Rather, it was the clearest and most pressing evidence yet that an aging and increasingly  impotent Europe is heading for bankruptcy unless it embraces major change: digitization, decarbonization and defense all need to be financed, against a backdrop of demographic decline. But it has little or no room for maneuver, due to two more ‘D’s — debt and deficits.

And while Bayrou’s presentation, featuring spending cuts, tax increases and even the scrapping of two public holidays, conveyed the impossibility of carrying on with business as usual, the reactions to it only showed how hard changing course will be.

“This government prefers to attack the French people, workers and pensioners, rather than hunt waste,” far-right leader Marine Le Pen said via social media, vowing to bring down Bayrou’s minority government if he sticks to the plans.

France isn’t alone in its predicament. Bayrou is only one of a handful of instinctively centrist prime ministers in the region to find themselves boxed in by the extremes of left and right: only last week, across the Channel, U.K. Prime Minister Keir Starmer was forced by a backbench revolt of his own MPs to abandon welfare cuts he deemed necessary. And while many euro area countries have made progress in closing their budget gaps since the end of the pandemic, the International Monetary Fund expects the bloc’s aggregate budget deficit to widen to 3.3 percent of gross domestic product by the end of the decade, pushing gross public debt up to 93 percent of GDP.

Having escaped the bailout discipline of the euro sovereign debt crisis a decade ago, France’s finances are in a worse state than any other major economy in the region.  Ratings agencies routinely point to its worsening debt trajectory. The deficit reached nearly 9 percent of GDP in 2020 and hasn’t been below the EU’s 3 percent target since 2019. Even under Bayrou’s projections, it won’t get back there until 2029.

And the cost of servicing that debt cannot help but grow in the next couple of years, as governments around Europe refinance at much higher interest rates the money that they borrowed for next to nothing between 2014 and 2022.

But other capitals are having to grapple with many of the same pressures that are troubling Paris — especially when it comes to demographics and the fateful decline in the ratio of workers to pensioners: Germany’s central bank estimates that the workforce will start shrinking in absolute terms, just as Chancellor Friedrich Merz’s huge debt-funded spending plans kick in.

A report earlier this month by the Organisation for Economic Co-operation and Development (OECD) found that overall social spending linked to demographics will raise public spending by some 3 percentage points of GDP within 25 years.

“This will leave increasingly little fiscal space for benefits targeted at mitigating poverty, insuring against income shocks, and supporting labour-market reallocation,” the OECD warned.

In many cases, the most pressing issue is the cost of the state pension system: the U.K.’s Office for Budget Responsibility said this month that by the early 2070s, it will be consuming 7.7 percent of GDP, up from 5 percent today (and only 2 percent back in 1950). More broadly, the European Commission’s last effort at quantifying the problem in 2021 said the overall cost of ageing — including pension, health and care costs — will rise from 24 percent of GDP in 2019 to 25.9 percent by 2070.

Army dreamers vs. bond vigilantes

And at the same time as solving that problem, governments also have to finance a huge upgrade to Europe’s rusty armed forces, to deal with the renewed threat from the east. So far, Germany, the U.K. and France have all accepted they will need to shell out handsomely for that, but Spanish Prime Minister Pedro Sanchez has balked at the challenge.

Credit agency KBRA estimates that the new pledge by NATO states to raise defense spending will widen government deficits in the EU by between 1.3-2.8 percent of GDP, depending on how quickly and on what the money is spent.

“I think the market is much more sensitive now to fiscal policy and the fiscal trajectory of sovereign debt and deficits,” said Ken Egan, senior director for sovereign debt at the rating agency.

That’s particularly true of the U.K., where a combination of high inflation and a concentration of debt in the hands of flighty finance industry investors, like hedge funds, has made the country more exposed to jumps in borrowing costs. The yield on the U.K.’s 30-year debt has pushed well above the level seen in 2022, when then-prime minister Liz Truss’s disastrous “mini-budget” roiled markets. That “suggests that investors remain concerned about the inability to reduce deficits and the debt,” said Guillermo Felices, global investment strategist at asset management firm PGIM Fixed Income.

Dancing to a global tune

But investors in U.K. and French bonds have been sensitized to the issues by other, external, factors, at play over which they have no control. In the U.S., President Donald Trump’s “Big Beautiful Bill” which is projected by the Committee for a Responsible Federal Budget to add over $4 trillion to government debt over the next 10 years.  Concerns are also growing about Japan, where rising inflation has forced the central bank to ease up on printing money to buy an endless stream of government bonds.

The U.S. is still running a deficit over 6 percent of GDP this year, despite having effectively full employment. It’s spending over $1 trillion a year on interest costs alone, more than it spends on defense. As Trump has spread uncertainty through global markets, investors have demanded an ever-higher premium for holding long-term debt that only offers a fixed return.  As such, even though inflation has edged down and the Federal Reserve has cut interest rates, the key 10-year bond yield has continued to move higher. Blackrock chief executive Larry Fink and his counterpart at JPMorgan Jamie Dimon have both warned recently that the situation is close to getting out of control.

The market for U.S. government bonds, or Treasuries, is the largest and most liquid in the world. They are a global benchmark for sovereign debt more generally — and when yields in the U.S. go up, they tend to push borrowing costs across the whole world up with them.

“Certainly when Treasuries sneeze, Europe still reaches for the tissues,” KBRA’s Egan said.

The question is — is it just another cold, or something much more serious this time?