ECB President Christine Lagarde currently sees no reason to help her home country France

France is the new Italy: heavily indebted and ungovernable . This is why the financial markets are once again discussing the danger of a new debt crisis in the euro zone.

French national debt is expected to rise to 116 percent of gross domestic product this year, with no reversal in sight. In the eurozone, only Italy, at 135 percent, and Greece, at 154 percent, have higher levels of debt. However, these countries have maintained or even significantly reduced their debt levels in recent years. Furthermore, they have stable governments.

On Monday, the second French government in just a few months failed in its attempt to get the debt under control. Prime Minister François Bayrou failed to survive the vote of confidence in parliament. Left and right parties refused to support his course of reducing national debt.

As a result of the government crisis, yields on French government bonds rose significantly in the financial markets. Events in France also overshadowed the European Central Bank's (ECB) interest rate meeting on Thursday.

As expected, the central bank left its three key interest rates unchanged. The current benchmark deposit rate thus remains at 2 percent. The ECB initiated the interest rate turnaround for the euro area in June 2024, lowering key interest rates by a total of 2 percentage points in eight steps, as inflation in the euro area also moved steadily toward the desired medium-term level of 2 percent.

The ECB has various instruments in its toolbox to shield eurozone member states from the financial markets if necessary. This would be necessary if the interest on the debt burden became so high that a country ran into financing difficulties. The newest and not yet deployed instrument is the so-called TPI, the Transmission Protection Instrument.

The ECB reiterated on Thursday that the TPI is available "to counteract unjustified, disorderly market dynamics that pose a serious threat to the transmission of monetary policy in the euro area." The central bank thus argues that the TPI is about ensuring the transmission of monetary policy for the entire euro area – and not about protecting member states from unpleasant pressure from financial markets.

President Christine Lagarde declined to comment on the events in her home country, France, at the press conference. Members of the central bank traditionally do not officially comment on developments in individual countries. However, Lagarde said that European government bond markets are currently "functioning properly and smoothly." Therefore, central bankers currently see no reason to activate the TPI.

Last week, yields on 30-year French government bonds, in particular, reached their highest level since 2011, triggered by the government crisis in Paris. The same was true for bonds issued by Germany, a key stability anchor, where the new government significantly relaxed the debt brake. However, German yields are still 0.8 percentage points lower than French ones. In the equally heavily indebted United Kingdom, yields on 30-year government bonds even rose to their highest level since 1998. This further fueled the debate about a new debt crisis.

Immediately following the collapse of the Bayrou government, French President Emmanuel Macron appointed a new prime minister, former Defense Minister Sébastien Lecornu . He is now expected to reach an agreement with the opposition on austerity measures and form a new government. This has brought some calm to the financial markets for the time being.

At 3.45 percent, however, yields on ten-year French government bonds are still at the same level as Italy and even higher than those of Greece, Spain, Portugal, and Ireland. These countries were at the center of the 2011 sovereign debt crisis.

Inflation, which reached a record high of 10.6 percent in October 2022, appears to be somewhat under control. According to an initial estimate by the statistics office Eurostat, inflation rose again this August from 2.0 to 2.1 percent. However, economists expect the inflation rate to fall below 2 percent again in the coming months.

The main reason for this is the continued decline in energy prices, which fell by almost 2 percent year-on-year in August. Food, alcohol and tobacco (3.2 percent) and services (3.1 percent) continue to be the drivers of inflation. However, ECB economists expect prices in these two segments to normalize in the coming months.

According to the ECB's forecasts updated on Thursday, headline inflation is expected to average 2.1 percent in 2025, 1.7 percent in 2026, and 1.9 percent in 2027. These figures are roughly in line with previous expectations. However, the ECB revised its growth forecast for 2025 upwards, from 0.9 percent to 1.2 percent. However, the growth projections for 2026 are now slightly lower at 1.0 percent, and for 2027 they remain unchanged at 1.3 percent.

President Lagarde had already emphasized in July that the central bank was well positioned to monitor further developments. Furthermore, the ECB believes it has now reached the neutral interest rate level, at which key interest rates neither slow down nor stimulate the economy. The ECB announced on Thursday that the determination of the monetary policy stance will continue to depend on the data and will be made from meeting to meeting. The central bank will not commit to a specific interest rate path in advance.

At the same time, geopolitical uncertainty has decreased significantly since the summer break, as the trade and tariff dispute between the US and the EU has not escalated but has been settled for the time being. While geopolitical uncertainties regarding the transatlantic relationship have calmed, they have increased within the euro zone.

Whether a new debt crisis originating in France depends primarily on whether a majority of parliamentarians in Paris can agree on a significant debt reduction. Bayrou wanted to reduce the budget deficit from 5.4 percent this year to 4.6 percent in 2026. That would have corresponded to a cut of €44 billion. But even then, the budget deficit would still be far too high. The new Prime Minister Lecornu faces a difficult task.

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