The price of free money: France's debt-cancellation debate

Jean-Luc Mélenchon, France's far-left presidential candidate, has promised voters the nearest thing modern finance offers to free money: cancel the 18% of the national debt held by the Bank of France. Polls put the leader of La France Insoumise within reach of a run-off against Marine Le Pen next year, and his pitch is simple—wipe out the debts the state owes to an institution it happens to own, then spend the "savings." France's finance minister, Roland Lescure, will have none of it; cancelling part of the debt, he warns, would bring a "financial crisis" and jeopardize the country's credibility with markets. The exchange looks like a squabble over accounting. It is really a referendum on what makes a government's promises believable, and its verdict is already visible in the price of French debt.

The appeal of the proposal is easy to see, because France's numbers are grim. Its public debt is equivalent to more than 116% of GDP, its deficit runs near 5% of output against the euro area's 3% limit. Erasing the fifth of the stock owed to the central bank would, at a stroke, shrink the headline ratio and open room to spend. No wonder a candidate campaigning against austerity likes it.

The trouble is that the arithmetic does not do what its advocates claim. As Olivier Blanchard, a former IMF chief economist, points out, the French state is the sole shareholder of the Bank of France. Cancelling the bonds the state already owes itself simply voids the interest and profit that would otherwise flow back to the treasury. On the government's own books, the gesture is, over time, a wash. The relief Mélenchon advertises does not even land.

So why does Lescure cry crisis? Because sovereign debt is not repaid from a balance sheet. It is repaid because lenders expect it to be, and that expectation is fenced off by a taboo written into European law: Article 123 of the EU treaty forbids central banks from financing governments. Christine Lagarde, the ECB's president and a former French finance minister, dismissed the scheme as "financially dangerous" and legally impossible; the Bundesbank's Joachim Nagel insists that no central bank in the euro system may cancel national debt. Set aside the arithmetic and the real question remains: would a president who proposed this scare the people who lend France money?

Markets have been answering for months. The premium investors demand to hold a French 10-year bond rather than a German one sits near 85 basis points, creeping toward the 90-basis-point ceiling last seen at the height of the eurozone crisis. French 10-year yields are at their highest since 2008. Credit-rating agencies have noticed: Standard & Poor's stripped France of its double-A rating, Moody's holds a negative outlook, and the deficit keeps breaching the euro cap with little parliamentary appetite to cut it. The sharpest detail is France's financing need: the state must raise a record €310bn (about $360bn) from bond markets this year—the very year its presidential front-runner is asking creditors whether it still honours its promises.

That is what makes the debate self-referential. Every airing of the idea raises the premium France pays; every rise in the premium makes its hole deeper and its promises harder to keep. The defenders of cancellation, such as the banker Matthieu Pigasse, maintain the act would have "no economic or financial impact"; Blanchard calls the notion "idiotic" and "irresponsible." Both are right about the accounts and wrong about everything that matters: an act that changes nothing on the state's own books can change everything on its creditors'.

For an American investor, the episode is a reminder of what "safe" sovereign debt actually is: not a balance sheet but a promise held together by institutions and the expectation of repayment. European government-bond funds and the banks that hold French paper are the channels through which a wobble in that expectation travels. France has not defaulted, and nobody serious thinks it will. But the financial price of flirting with free money—a few tens of basis points on hundreds of billions of refinancing—is now a measurable line on the country's bill. The fantasy costs; that is the whole of the matter.