Can France Escape The European Austerity Trap?

Written by Hilary Barnes

As France’s economic problems mount up for President Francois Hollande, elected last May, one begins to understand why his predecessor, Nicolas Sarkozy, lets it be known how happy he is to be free of the responsibilities of government.

Last year saw industrial output decline by 2 %, housing starts crash by 18 %, new car registrations fall by 8 % (16% in December and 15% in January this year), and unemployment rise by 10 % to 3.1m or 10.5 % of the labor force, and slated to increase. Over 60,000 corporate failures, involving 200,000 lost jobs cost, creditors about €4bn, according to credit assurance company Coface in Paris.

To cap a bad year, gross domestic product in the final quarter fell by 0.3 % compared with the previous quarter, leaving GDP for the year unchanged after an increase in 2011 of 1.7 %. It appears to heading for zero growth and perhaps worse in 2013.

France’s international competitiveness was undermined from 2000 onwards by a three hour cut in the working week to 35 hours, with no reduction in the weekly wage. Unfortunately for France, the Germans implemented a virtual wage freeze at the same time. Today wage rates in manufacturing are slightly higher than in Germany whereas in 2000 they were about 20 % lower.

Table from Natixis.

Goldman Sachs’ chief European economist was quoted as saying in January that France needed a 30 % wage cut. That may have been on the high side, but there are French economists who would not quarrel with a figure of around 20 %.

Before the euro was invented, France regularly restored its competitive position by devaluation. That is no longer possible. For a country with a debt to GDP ratio that has now passed 90 % and a substantial deficit on its current balance of payments account, fiscal expansion, Keynesian style, is no longer an option either.

Quite the contrary. The real lock on France’s economic policy is its treaty commitments to the European Monetary Union, which binds member states to reduce general government budget deficits to zero by 2016 (2017, Hollande has stated, in France’s case), starting with a reduction in France’s 2012 deficit of 4.5 % of GDP to 3.0 % in 2013.

With no growth in sight, this target will be missed. The IMF among others estimates the 2013 deficit at around 3.5 %.

The government can now be expected to tell the European Commission – already exasperated by the French government’s tardiness in bringing forward structural reforms that could make the economy more efficient and competitive – what it plans to do to put its budget deficit reduction program back on track.

The government will no doubt point out that it is committed to cutting public expenditure by €60bn (about 3 % of 2012 GDP) over the five years to 2017. So far it has not said how, but a road made is due in March.

Implementation is not expected before 2014.

Its pay-as-you-go pension system (those at work now pay the pensions of retirees) is rapidly going bankrupt as the ratio of retirees to the employed labor force increases. Action is urgently needed. A substantial increase in the standard age of retirement from 62 has to come, although this alone will not solve the problem : the concept on which the pension system is based is fundamentally flawed, a fact that has been well known for more 20 years.

All the while, however, the government knows that more austerity at a time of zero growth and continued deleveraging in the private sector will land it in the same trap as its Club Med neighbours, Italy, Spain, Greece and Portugal.

Austerity in these countries has reduced output and sent unemployment rocketing (to over 25 % in Greece and Spain). This reduces government revenue at the same time as demands on social welfare spending increase. But even though budget deficits have come down, the ratios of government debt to a stagnating level of output have increased. The cure is killing the patients.

The president and his government also know, and frequently point out, that if the budget deficit is not seen to be under control, there is the risk of a negative reaction in the market for France’s sovereign bonds.

So far however these have remained extremely low at about 2.25%, and the market has not punished the present government.

Chart from Bloomberg.

There may be a technical factor at work in France’s favour. The other Club Med countries were, or were believed to be, in need of a bail out from European funds that are available for this purpose.

Short sellers therefore contributed to pushing down bond prices and pushing up interest rates to unsustainable levels before reaping huge profits from the subsequent rise in bond prices when the assurance of bail out (whether actually paid out or not) were forthcoming.

France is too big to save : the available funds will not run to a bail out for France. The short sellers may therefore have been sold short.

More importantly, France can now bring into play the fact that the IMF has admitted that it got its austerity economics in a twist by under estimating the impact of the multiplier effect of fiscal retrenchment.

The European Commission’s budget commissioner, Olli Rehn, hitherto a staunch advocate of the orthodox austerity doctrine, has been heard to admit that its results have not been quite what was expected.

It would not be surprising (this is pure speculation) if the French government brought into play a modified version of austerity policy concocted by the Paris elite university SciencePo’s French Economic Observatory (known as OFCE) together with Danish and German researchers.*

They proposes a gradualist approach to Euro zone deficit reduction at a rate of 0.5 % of GDP per year over the 16 years from 2016 to 2032.

This would allow the economy to grow, instead of suffocating growth as present policy does, and would be equally efficient in reducing budget deficits and debt ratios, they claim.

They point out that history shows that reducing budget deficits for countries with large debt-to-GDP ratios is just about impossible unless the economy is growing at the same time.

The OFCE economists also say that France should argue that it is its structural deficit (deficit adjusted for cycle factors) that should be reduced, not the crude deficit, and that the Euro zone’s Growth and Stability Pact of March last year, which lays down the rules for austerity policy, has ample loopholes to allow for a less drastic application of fiscal retrenchment than the European Commission, with the strong backing of Germany, has so far insisted on.

It would remain, of course, to convince the rest of Europe of the wisdom of such a course.

*See the report, ‘FAILED AUSTERITY IN EUROPE THE WAY OUT‘, November, 2012, available (free) at iAGS.