Debt sustainability looked more sensitive

>> Is the UK economy more like the US or the euro zone?

It’s certainly a live issue in the US, with many arguing that debt is not on a sustainable path. And now, in France, the shock election announcement has focused minds on the country’s poor debt position. Of the two, many would see the US’s position as the most troublesome, given the rather dysfunctional situation in Congress when it comes to deficit control. However, there are good reasons to think that it is France – and other high-debt euro zone countries – that are far more vulnerable than the US, so putting euro zone bonds and the euro at greater risk.

On the surface, at least, there does not seem to be much to choose between the debt outlooks in the US and France. The bi-partisan Congressional Budget Office (CBO) in the US sees the debt/GDP ratio rising from around 97% right now to 122.4% by 2034. That’s an increase of around 25% points of GDP. In Europe, the EU projects the French debt/GDP ratio rising by around 20% points of GDP over the same period from around 110% right now to 130% in 2034. But while the numbers might not be too dissimilar, the fiscal and market risks facing the US and France are very different.

We can see this if we look through the prism of Modern Monetary Theory (MMT). For this theory, amongst other claims, stipulates that debt is not a problem if it is issued in the local currency. That’s essentially because the monetary authority has the ability to monetize the debt. The monetization route is cut off for those that issue debt in a foreign currency and hence high debt is far more problematic. This would seem to make sense, particularly for those who have succumbed to the external currency debt curse. Of course, most of these lie in emerging market countries.

However, we can argue that even a developed country, specifically France, does not issue debt in its own currency. Yes, it clearly issues debt in euros, which is the currency of France, but the French central bank does not print euros and therefore cannot monetise in the event of a debt crisis. This, of course, is what ensnared Greece and a small number of other euro zone countries during the debt crisis of 2010-2012. If it snared Greece back then, why not France now, or other high-debt euro zone countries such as Italy?

>> Measuring currency risks

One argument to suggest that things are different now relates to the changes that were put in place during this crisis. These included government/IMF bailouts for Greece which probably sets a precedent should France get into difficulty (although size clearly matters here with France being much larger than Greece).

In addition to this, the ECB has bought French debt through its EMU-wide asset purchase programs and has the ability to zone in on any weakness in French bonds specifically via its Transmission Protection Instrument (TPI). But the question is whether these changes are sufficient to avoid another Greek-like scenario. This is hard to say but the key point that we would make in any comparison between the US and French debt profile is that this issue means that any level of French debt is potentially more dangerous than the equivalent amount of US debt. This could be of importance when it comes to elections in France and the US as a ‘negative’ outcome in France, which might be political paralysis for instance, could see a far sharper rise in yields than a similarly ‘negative’ outcome in the US (which might be a Trump win but Democrat-controlled Congress).

Does this also mean that the euro is at greater risk? While the answer is ‘yes’, we should remember that the founding decision to outlaw monetisation in EMU was done largely to ensure the stability of the euro. Outlawing the ability of national central banks to inflate their way out of a debt crisis (by printing euros) serves as a source of support for the single currency. This helped the euro hold up pretty well during the debt crisis, despite the turmoil in bonds. Nonetheless, there will still be some vulnerability in the euro; just a lot more vulnerability in bonds.