France: We Have a Problem, Mr(s) President

Eric Chaney | Paris

2007 is an important year for France. First, the macro environment will be less friendly for growth and profits than it was in 2006, since France’s two main trading partners, Germany and Italy, are undertaking major fiscal consolidations that should slow their imports. Second, the presidential election, immediately followed by parliamentary elections, will give the country a new leadership for the next five years. In a context of still low interest rates, domestic demand should be robust enough to allow the economy to grow by around 1.9%, i.e., only a couple of tenths below potential. However, tougher competition from German producers – the VAT rate hike is partially financed by exporters to Germany but not by German exporters — combined with a stronger euro and slower global demand will squeeze profit margins and make companies more reluctant to hire.

The risk of populism in the electoral debate

Against this tepid macro backdrop, I see a significant risk that the political debate might drift toward populism, as it has already started to do. Candidates from either side of the political spectrum may find it rewarding to overbid on themes such as the mandate of the European Central Bank, household purchasing power, or globalisation. Changing the ECB’s mandate in order to include growth and employment in the bank’s targets is totally unrealistic: It would require a unanimous view from all EMU countries, which has a zero probability. All candidates know that fact; they are also aware that the financial markets do not really care about these statements, because traders cannot short the French franc as they would certainly have done eight years ago.

However, this behaviour may weaken the credibility of the next government regarding EMU governance issues and, in any case, reinforces the impression that French politicians are more interventionist than ever, which cannot be good for investment. Increasing purchasing power by either raising the minimum wage or distributing more taxpayers’ money to low income families is a more serious threat in my view, against a backdrop of eroded competitiveness and record high government spending (53.8% of GDP in 2005). Also, letting French voters think that policy makers have the power to insulate the economy from globalisation is a dangerous illusion: Even though promises on that front are cheap, they have dangerous side effects such as increasing capital outflows and reinforcing domestic rigidities. This brings me to the broader picture and to the challenges the French economy is facing.

We have a problem, Mr(s) President

Three indicators show how serious are these challenges. First, French exports outside of the euro area are 16% lower than at the outset of the monetary union, relative to EMU exports. Comparable numbers for Germany, Italy and Spain are respectively +11%, -1% and +2%. In this zero sum game, France is the loser, Germany is the winner, while Italy and Spain have broadly maintained their relative positions. Although the time frame is somewhat arbitrary – at the outset of EMU, Germany’s competitive position was still deeply damaged by the consequences of the unification — this rough competitiveness indicator is consistent with more elaborate studies (see for instance Pr. Lionel Fontagné and Patrick Artus’ report to the Council of Economic Analysis, ‘Recent trends in French foreign trade’, 2006). Second, French unemployment, at 8.8% (October 2006, Eurostat definition) is now the second highest in the euro area, just behind Greece, and more than a full point above the euro area average (7.7%). Third, the share of wage earners at the minimum wage level has risen to 16.5%, while it was less than 10% in 1996. Not only does this imply that rigidities have increased since 1997, but also that unemployment could rise disproportionately during the next downturn. If his or her economic advisor dares tell the truth, the first words the next President of the French Republic hears from him should be: “We have a problem, Mr(s ) President”.

Three priorities for the next President

I believe that three reforms should be undertaken in the very first period of the President’s mandate: 1/ labour markets, 2/ public finances and 3/ deregulation of services. Without entering into the details, the labour market reform should tackle the minimum wage abscess, by freezing its real value until the share of minimum wage earners is back below 10%. Also, the government should introduce a new generic labour contract which would allow employers to fire employees without obstacles, in exchange for a progressive severance compensation (an idea promoted by Pr. Olivier Blanchard of the MIT, among others). Progressively, this would cure what I have called the ‘insider disease’ that characterizes the labour market rigidities and generates dangerous frustrations in French society.

As for public finances, the main target of the reform in a first stage should be to reduce welfare spending (social transfers), in particular medical spending. The spirit of the healthcare system, i.e., guaranteeing free access to medicine with very few restrictions, is naturally generating inefficiencies and waste. At stake is nothing less than unemployment: since the healthcare system is mostly financed by payroll taxes, every euro saved would reduce the cost of labour and thus help create jobs. Last, deregulating services, from the retail sector to hotels, cafes and restaurants, is the surest way to create jobs in France, given that, in manufacturing, globalisation will continue to reduce headcounts, especially at the low end of the qualification ladder. In this regard, freezing the minimum wage would help considerably in low-skilled labour-intensive services, as well as cutting payroll taxes. This last remark shows how entangled are the three fields I have selected and answers the priority question. All three reforms should be undertaken simultaneously in order to create a virtuous circle of job creation and support from the population.

There is nevertheless a priority: Tell the truth to the French. If, as in 1981, 1988, 1995, and 2002, candidates tell fairy tales to voters, history might repeat itself: Reforms would progress at a snail’s pace while the world accelerates, a trap I once called the “White Queen Syndrome”.