French Finance Minister François Baron confirmed to France 2 television today that Standard & Poors will strip the country of its AAA rating soon.
It's difficult to know what drives S&P to make these calls—last year they downgraded the United States of America even though it's completely impossible for the U.S. government to ever run out of dollars and default. But in this case, the move makes sense. Twelve months ago, I would have said that European countries are fundamentally in the same position as America or Japan or the UK. Eurozone members borrow euros, and euros are a creation of Eurozone governments. But the European Central Bank's handling of the Italian situation last summer and fall called that all into doubt. Unlike Greece, Italy hadn't engaged in any budget shenanigans and was running a primary budget surplus. Had the central bank firmly committed to rolling Italy's debt over at an affordable rate, the crisis would have been nipped in the bud. Instead, the ECB chose to use its moment of leverage to unseat the country's prime minister and push for a series of structural reforms. Silvio Berlusconi was not a good prime minister and many of the reforms the ECB favors were good ideas, but this fundamentally altered the world's perception of European budget situations. One can now really imagine a situation in which a European sovereign is hit by a panic or a run, the ECB tries to sweep in with a bunch of smart ideas, and the elected governments tells them to bug off and risk default.
In practical terms, the downgrade of France will further exacerbate the global shortage of liquid AAA-rated assets that can be used as the medium of exchange in repo transactions. $20 trillion of such assets existed in 2007, and after a French downgrade will be down to something like $5 trillion. The France aspect of this isn't huge, but the fact that this global crunch is getting worse rather than better is a dark cloud for the world economy.