Europe's Governments Face Higher Borrowing Costs as Cheap Money Era Ends

Europe's governments have been living in a world of cheap money for over a decade, but that era is coming to an end. The recent energy shock from the Iran war has pushed inflation back up, and central banks are responding by raising interest rates. The European Central Bank raised its deposit rate to 2.5% in early September, while the Federal Reserve followed with its first rate rise in over three years, taking its benchmark rate to 3.75%-4%. Long-term borrowing costs, which reflect what investors demand to lend to governments for a decade or more, are also on the rise.

The key driver of this change is 'competition for capital', according to Fed Chair Kevin Warsh. Governments are no longer the only big borrowers in town; they're competing with the AI boom, rearmament, and the energy transition, all of which need enormous sums at the same time. When everyone wants to borrow, lenders can name their price.

The impact is already being felt in France, where debt interest payments are projected to rise by €9.4 billion next year. The country's finance ministry has also announced a significant increase in defence spending, which will further strain the budget. French 10-year borrowing costs have reached levels not seen since November 2008, and the market is expecting a deficit of 5.4% of GDP in 2026.

The danger of higher rates is that the damage arrives slowly and then all at once. Governments do not refinance all their debt at once, so every year a slice of old, cheap debt is replaced with new, expensive debt. The European Commission expects French interest payments to rise from 2.6% of GDP in 2026 to 2.8% in 2027.

This is not just a problem for governments; it's also a concern for businesses and households that rely on government bonds to set borrowing costs. When the state pays more, companies and households pay more too, on mortgages, corporate loans, and every refinancing that comes due.