12 November 2018

Last weekend’s gathering of world leaders to commemorate the centenary of the World War I armistice was also an occasion to celebrate 70 years of European peace and stability.  It was also appropriate to recognise the European Union’s contribution to this extended period of prosperity. However, there existed also a sense of foreboding, as this institution and the stability to which it greatly contributed are under threat like never before.

The Global Financial (GFC) and Euro Crises exposed many of the weakness of the European project. The region must now find solutions to sluggish economic and productivity growth, flagging competitiveness, high unemployment, bloated public sector debt, an aging population, and a lack of consensus on immigration policy. The recent crises also highlighted that the financial underpinnings of the Single Currency remain inadequate. To be sure, many of the answers must be found at the national level, but the future relevance of the European Union itself depends on its ability to contribute to enhancing living standards and full employment in the region.

French President Macron’s electoral victory raised hopes that EU reform would gain traction. Indeed, the surge in European GDP growth in 2017 provided ideal conditions to tackle this challenging agenda. Unfortunately, the impetus for European reform has yet to gather momentum. Moreover, recently GDP growth has decelerated again into the 1-1.5% range — what appears to be the region’s tepid growth potential. Even more worrisome, public discontent continues to grow. Populist, nationalist governments exist in Poland and Hungary. Similar parties are involved in ruling coalitions in Austria and Italy. And, historic party structures have been decimated in Germany, France, Italy, Sweden, the Netherlands, and elsewhere.  Not to forget, there’s Brexit.

Put simply, EU reform can only succeed with the combination of French political leadership and German financial muscle — the cornerstone of the European project from the beginning. Despite its enviable economic performance, even Germany has succumbed to similar political outcomes, as support for the historic CDU/CSU and SPD parties has collapsed at the expense of the left-wing Greens and nationalist AfD. In addition to the impact on local politics, Chancellor Merkel’s decision to resign as CDU leader casts doubt on Germany’s role in advancing EU reforms.

Bluntly, Europe can not afford an inward-looking Germany. As a start, Germany’s bloated current account surplus (a staggering 8% of GDP) threatens both a transatlantic trade war and the future of the Single Currency. Fortunately, precisely the same policies required to boost Germany’s own future prosperity will help reduce the unsustainable external imbalance. But, Germany must act boldly once again!

Meanwhile, for France to play its leadership role in Europe, President Macron must first demonstrate that the French economy can reverse its relative decline of the past decade. The new government has launched an energetic reform agenda. Let’s assess its progress.

President Macron: Europe Needs You to Succeed!

President Macron’s reform agenda encompasses four, inter-connected themes: competitiveness, labour markets, public finances, and deregulation. To be sure, the benefits of many of the necessary measures will take place over the medium-term. However,  we can evaluate the early results, and gauge whether the reforms are sufficient to produce the desired outcomes.

Chart 1 illustrates that as a result of out-sized increases in labour costs in recent decades, French competitiveness has eroded, and exports have lost world-wide market share.

The Chart above shows prior to the GFC and Euro Crisis, French labour costs outpaced Germany’s by a considerable margin.  Beginning in 2012, fortunately, France has made considerable progress narrowing the gap. However, there remains a  long way to go.

The  Chart above illustrates that much of France’s competitiveness problem emanates from poor productivity growth, which decelerated sharply in recent decades (as has occurred world-wide). However, unlike in Germany, where efficiency appears to have picked up recently, the pace of French productivity improvements continues to slow. Overall, French competitiveness may be improving, but largely resulting from better control of compensation, not efficiency gains. In addition, current trends suggest another 5-10 years will be needed to eliminate the competitiveness gap relative to Germany.

Fiscal Policy: The central objectives of Macron’s five-year budgetary program are to reduce the structural deficit by 1.5% of GDP by 2023; to lower public spending by 3% of GDP;  and to stabilise and eventually reduce the debt/GDP ratio.

On the bright side, France’s budget deficit should decline to 2.5% of GDP in 2018 compared to 3.6% in 2016 — meeting the Euro Stability 3% target for the second straight year — although the shortfall is projected to rise to 2.8% of GDP next year. Nevertheless, not enough progress has been made to stabilise France’s elevated debt ratio, which both continues to rise and diverge from Germany’s. The underlying deficit, therefore, must decline another 1% of GDP simply to cap the liability ratio — which is the plan, but will leave the debt burden well above 90% of GDP.

Likewise, the objective to lower government spending by 3% of GDP is a step in the right direction (about one-third of that amount has already been achieved). However, the following Chart highlights that outlays, which have risen 5% of GDP since 2007, will remain the highest in Europe. This unambitious spending goal limits the extent the tax burden, second highest in Europe (after Norway), can be reduced (at 54% of GDP compared to the OECD at 38%).

President Macron’s room for maneuver is limited , as even the proposed cuts are unpopular. For instance, the government aims to eliminate 120,000 government jobs, as public sector pay accounts for nearly 25% of budgetary spending. Under this modest proposal, government employment will still account for 20% of all jobs. Public sector job cuts totalling 250,000 would be needed just to come into line with the European average.

Pensions are another big-ticket item, representing 25% of government spending. A simplification of the system will begin next year. However, progress towards fundamental changes, e.g. raising the retirement age, reducing payouts, or means testing the benefits, has been minimal. In addition, French social spending, e.g. unemployment protection, health care, etc., is also the highest in Europe. And, while changes in monitoring  the benefits system have occurred, the program’s generosity remains well above the EU average.

Labour Markets: Numerous labour market reforms have been enacted, and more are planned for 2019. They aim to improve the flexibility of wage-setting, to reduce non-wage costs (e.g. social security, etc), to improve the legislative process regarding hiring/firing workers, to enhance the educational and apprentice system, and much more.

While the benefits of these critical policy changes will take time, what impact can be observed so far? During the past two years, French employment has risen 0.8% per year. This represents an improvement compared to the long-term trend of 0.6%, but the performance lags the EU average of 1.5%. Similarly, while French unemployment has declined, joblessness has fallen by less than in Europe overall, and the rate remains above the region’s average (Chart below). Likewise, youth unemployment has also fallen sharply, but again the decline has been less than in Europe, and remains above the region’s average. Thus, most of the recent labour market improvements appear cyclical in nature, and we await the structural declines anticipated from recent reforms.

Overall, therefore, President Macron’s reforms are improving competitiveness, but there’s a long way to go. Fiscal policy is delivering on its modest ambitions, and additional, unpopular spending cuts will eventually be required.  Labour market reforms should improve job prospects, but the program will need to become more ambitious. For example, despite recent social security tax cuts, non-wage costs remain among Europe’s highest. Likewise, progress on controlling the minimum wage could help job creation.

Germany: It’s Time to Act Boldly Again

There is much to admire in Germany’s performance. The economy, however, confronts two crucial challenges.  First of all, in the aftermath of the GFC, Germany’s long-term growth potential has declined sharply. Meanwhile, its bloated current account surplus is unsustainable, threatens the Euro’s future, and risks a transatlantic trade war. Fortunately, the measures needed to solve the domestic problem — stronger productivity, investment, and labour supply — will help shrink the external imbalance as well. Time to act.

The reason for Germany’s foreign surplus is simple — the nation saves too much, invests and spends too little. The Chart above illustrates that all three major sectors — households, government, and corporations — play a role.

Excessive corporate savings usually is associated with a lack of business investment. Indeed, the next Chart illustrates German capital spending lags the rest of Europe, and has declined by 3% of GDP since 1990. Stronger corporate investment would both help boost productivity and reduce the external surplus through more imports.

Households have been similarly cautious. The following Chart shows consumer spending (as a share of GDP) has declined dramatically since the GFC. There are many ways government policy can support household spending.  For instance, if precautionary savings are rising as the population ages, boosting the pension system would help.

Or, simply cut taxes! For example, German social security taxes are amongst Europe’s highest (exceeding even France). A reduction would provide immediate relief to consumers.

And, of course, Germany’s enviable budget position provides considerable scope to increase spending, especially in productivity-enhancing activities.  For example, public sector investment — particularly infrastructure — has been declining for decades, and now lags well behind the rest of Europe (Chart). The IMF identifies other potential spending priorities, e.g. expanding educational outlays (both primary and for adult learning to keep seniors in the labour force), improving the digital infrastructure, etc.

In addition to under-investment and weak productivity trends (see chart in France section), Germany’s aging population will remain a drag on the nation’s growth potential. Indeed, the IMF estimates the working age population will decline by 15 million people in coming decades. To be sure, Chancellor Merkel’s unpopularity stems largely from the handling of the 2015/16 refugee crisis. Inevitably, however, she will be vindicated, as immigration will be needed to boost Germany’s labour supply. Indeed, the following Chart illustrates that without immigration, Germany’s population would already be shrinking sharply. In addition, high-spending immigrants will help curb the current account surplus.

Meanwhile, with the USMCA finalised, President Trump may look to address the American trade deficit with the European Union. Fortunately, the following chart shows that Europe’s export/import ratio is similar to other US trading partners, suggesting the bilateral imbalance largely stems from US budget deficits. Germany, however, is an exception, as weak spending limits imports from the USA.

German efforts to boost spending, therefore, would help avert a trade war, as well as correct trade imbalances with its European partners; thereby, helping to ensure the Euro’s future.  Liberalisation of its heavily regulated service sectors would help create jobs in this key area,  potentially boost service imports (especially from the USA), and produce lower prices for key services (boosting household incomes and spending).

Strategic Implications

• In part, the case of European equity outperformance requires a reinvigorated program of EU reform. Brexit will continue to dominate the agenda through the end of the year, at least. Thereafter, unless EU reform gains momentum, markets’ patience will wear thin.
• Likewise, insufficient reform efforts coupled with lacklustre European economic growth could keep the US dollar stronger for longer.
• Far more importantly, unless European reform prospects accelerate, the public discontent is likely to be reasserted in the European elections next May.
• Chancellor Merkel is a consensus builder, not a radical. Consequently, I believe she will use the remainder of her time to pave the way for her successor, rather than driving EU reforms. A poor CDU result in the European elections could lead to her removal. I expect a new German Chancellor within 12 months.
• A transatlantic trade war should be averted, largely as American attention will focus on China.
• Risks within the Eurozone will heighten as global growth cools and ECB begins normalising interest rates next year.
• I repeat, Europe can not afford an inward-looking Germany. However, without German leadership and financial muscle, meaningful reform of the Euro’s architecture (regional fiscal budget, risk sharing, banking union, etc) is unlikely in the coming year.
• President Macron will continue to find life difficult, especially as deeper reforms are likely to be necessary to achieve the desired transformation of the French economy.