Krugman Warns France Faces a Potential Debt Crisis

France faces growing financial risks as rising government debt, persistent budget deficits and political divisions raise concerns about its ability to maintain investor confidence. Nobel laureate economist Paul Krugman warned this week that France could become too large for the European Central Bank (ECB) to rescue, while former ECB President Jean-Claude Trichet urged French politicians to agree on credible measures to reduce the deficit.

In a Substack post published Thursday, Krugman described France's fiscal trajectory as unsustainable. He pointed to mounting interest payments, a high debt-to-gross domestic product ratio and continued budget deficits as factors increasing the country's vulnerability to a debt crisis.

Krugman also identified France's relatively low retirement age as a concern, arguing that the country has failed to address the issue as its population ages. The government is attempting to pass a contentious 2027 budget under Prime Minister Sébastien Lecornu, while student demonstrations over learning conditions have added to the country's domestic political pressures.

Krugman warned that France's membership in the euro area could intensify the consequences of a loss of market confidence.

"France's reliance on the euro means that it's all too easy to see how this loss of confidence could turn into an ugly crisis... We saw this movie in 2009-2012, first in Greece, then in Portugal, Spain and Italy," Krugman wrote.

He referred to the sovereign debt crisis that affected several eurozone countries and prompted extensive intervention by the ECB. Investors withdrawing from government bonds can increase borrowing costs and heighten fears that a government will struggle to meet its debt obligations.

Krugman described how that process can reinforce itself as investors lose confidence.

"First, investors stop buying a euro-area nation's bonds, raising the specter that the government will be forced into default because it simply doesn't have the cash to pay interest and principal on its debt. Fear of default then leads to even more capital flight, which increases fears of default and the interest rate, and the vicious circle deepens."

He noted that the ECB's response during the earlier crisis included a 2012 commitment by then-President Mario Draghi to do "whatever it takes" to prevent national defaults. Krugman said that reassurance was accepted in large part because southern European countries implemented major spending cuts.

Krugman argued that supporting France would carry substantial financial and political costs if the country continued moving away from fiscal discipline.

"France may have crossed the line from too big to fail to too big to save. In short, it's all too easy to describe a really ugly scenario for a French crisis that would be extremely divisive within Europe," he wrote.

Trichet, who led the ECB from 2004 to 2011 and previously governed the Bank of France, told CNBC on Friday that French political leaders must reach an agreement on reducing the deficit. He said restoring credibility with financial markets would be essential if the country eventually required central bank support.

Trichet placed responsibility on elected officials to demonstrate that France could manage its public finances and maintain market confidence.

"The ball is in the camp of the French government and parliament, and they have hard work to do," Trichet said.

He said European authorities have several tools available to address financial instability, drawing on his experience during the sovereign debt crisis.

"Of course, if there is destabilization, the instruments are very numerous and proved in the past to be very effective. And I have known, of course, such a period in my own time," the former ECB president told CNBC's Squawk Box Europe.

Potential measures include the European Stability Mechanism and the ECB's Transmission Protection Instrument (TPI). Finalized in 2022, the TPI is designed to preserve the transmission of monetary policy and support market stability when financial conditions become fragmented across the euro area. The instrument had not been used at the time described in the report.

Trichet said any intervention would require the French government to request assistance from the ECB, adding that the government currently maintained that such help was unnecessary. He urged political groups to act responsibly amid a complicated political environment ahead of the presidential election.

He called on politicians across the political spectrum to demonstrate that France could act as a responsible participant in financial markets.

"My recommendation to all political sensitivities in France, and you know that the situation is complex in terms of political preparation for the presidential election, but I would ask all of them to be responsible in those circumstances."

Trichet emphasized that restoring confidence required a credible plan capable of convincing investors and savers that France was pursuing a sustainable course.

"All political sensitivities, whatever they are, they have to understand that it is about time to prove that France, the market player, that they are responsible."

He also said political negotiations would need to produce a credible outcome before the ECB could activate its protective instrument.

"I call on them, of course, to be as, I would say, effective in their discussion as possible and prove that they can deliver something which would be credible. That, of course, is one of the conditions to activate TPI," he said.

Drawing on his experience during the sovereign debt crisis, Trichet said governments must first demonstrate their own commitment to restoring confidence rather than relying on external assistance alone.

"Trichet said his own experience during the Sovereign Debt Crisis showed that "you first have to help yourself, because we cannot win if you are not yourself convincing market participants, investors, and savers that you are credible."

He added that domestic confidence in the country's economic direction was also important, noting that the position was consistent with the views of the governor of the Banque de France and the French government.

"Of course, you have to get the country convincing itself that it goes in the right direction. That goes without saying. It is the conviction, if I understand well, of the governor of Banque de France and of the French government," he added.