3 June 2017

The rift between the Trump administration and the other Group of 7 nations (also G20) became increasingly evident following the gathering in Taormina, Sicily. The new American president’s approach to global trade and climate change (among other key issues) represents a break from the prevailing international policy consensus.  Reflecting growing frustration, German Chancellor Angela Merkel has questioned publicly the reliability of the new US government, to which President Trump has responded angrily via his now infamous Twitter account.

Despite the questionable diplomacy from both leaders, an important geopolitical shift is emerging.  Reflecting her concern about American political leadership/partnership, Chancellor Merkel has called upon European leaders to “shape their own destiny” through a renewed commitment to regional integration (as well as deepening contacts with Asian giants China, Japan, and India).  Despite its economic prowess, however, for historical reasons Germany has never been able to provide the political guidance for the European project. As German Finance Minister Wolfgang Schauble recently suggested, especially in light of the Brexit vote, only France can play this role.  If the Franco-German alliance is to rebuild the momentum behind European integration, however, France must break out of its economic malaise.  Can the Macron government implement the reforms required to halt France’s economic underperformance?  Much is at stake during the First 100 Days of the Macron government (following the 18 June elections).

France:  Staying In the Core or Drifting to the Periphery?

To be sure, the past decade has been difficult for all, but the financial crisis exposed serious structural problems in France.  While tepid productivity gains have contributed to subpar economic performance world-wide, France has lagged other key nations.  For example, while US and German GDP has advanced an unimpressive 1.5% annually during the past 10 years, France has grown a meagre 0.9% per year (opening a 6% ppt overall gap).  Indeed, French performance mirrors more that of the crisis-ridden Euroland economy, rather than that of the core countries.  Even during the recovery since 2010, the underperformance has widened: 1.3% GDP gains in France compared to 2.1% in Germany and the USA.  Reflecting the sharp deceleration in productivity, the IMF estimates French long term growth potential at only 1-1.5%.

French fiscal performance also has diverged from Germany.  During the financial crisis the German budget deficit rose to 4% of GDP and government debt exceeded 80% of GDP in 2010. However, tough measures (including spending cuts totalling 4% of GDP) produced a surplus last year, and government debt is declining now towards 60% of GDP.  Meanwhile, the French deficit now stands at nearly 4% of GDP. And, the recent success in reducing the red ink, which exceeded 7% of GDP in 2009, occurred despite government spending rising a further 4% of GDP in the past decade. As a result, government debt is now approaching 100% of GDP, and will continue rising indefinitely under current policies.  French recent performance is more akin to Italy’s than Germany’s.  Indeed, Italy’s budget deficit is now 2% of GDP, and while public debt stands at a staggering 132% of GDP, it is set to decline (albeit modestly) in coming years. The experience of both Italy and Japan illustrates the deleterious effect of a large debt burden on a nation’s long term growth potential.

France has also lost competitiveness compared to its powerful neighbour.  Since 2001, for example, real wage growth has exceeded Germany’s by roughly 8%.  And, while this gap has narrowed more recently, German exports have outperformed, rising 25% since 2007 compared to 20% in France.   In Italy, as inflation-adjusted pay has been declining since the Euro crisis, competiveness has improved nearly 10% compared to France since 2001.

The Time Is Now:  The First 100 Days

To be sure, France is not Italy.  However, immediate economic reforms – especially fiscal and labour market — are essential to remedy this underperformance, improve competitiveness, and halt this drift towards Europe’s periphery.

Fiscal Reform: Can Macron Deliver Spending Cuts?

• France’s tax burden at over 53% of GDP is Europe’s second highest (Denmark top), and towers above the USA at 33% and Euroland 46%. Post-crisis fiscal consolidation has relied so far fully on a higher government receipts, as the tax burden has risen another 3% of GDP in the past decade. High French taxes produce many disincentives, especially in the labour market (more ahead).  Macron has pledged to reduce the 34% corporate tax to the EU average 25%.
• Curbing France’s seemingly insatiable appetite for higher government spending cuts must be at the heart of the government’s plan to reduce the deficit by at least 2% of GDP in the next five years. Public sector spending stands at 56% of GDP (Europe’s second highest after Finland), and has risen steadily since 1990. This compares unfavourably with Germany and the EU average at 44% and 47% respectively, and even Italy seems relatively modest at 51%. President Macron’s manifesto pledge is to cut spending to 52% of GDP by 2022 – ambitious, but still leaving outlays well above the EU level.
• Social spending and public sector pay account for 90% of the gap in the level of outlays compared to the EU, and reforms on both will be required to achieve deficit targets. Public sector pay represents 13% of GDP compared to 8% and 10% in Germany and Italy respectively. The government has accounted for all job gains since 2007, as private employment is only now returning to pre-crisis levels. President Macron’s manifesto promises to reduce public sector jobs by 120,000 (nearly 2% of the total) – unpopular, to be sure, but further cuts would be required eventually to cut public employment towards the EU level.
• The toughest choices will be on social spending, which represents an imposing 26% of GDP compared to 18% in the Euro area (43% higher). Both French policymakers and the public are justifiably proud of France’s “social model”, and are understandably concerned about the implications of such spending cuts. The IMF, however, indicates that the “redistributive power (RP)” of French social spending is amongst the lowest in Europe.  That is, the achievement of social objectives (poverty reduction, etc.) from social spending is inefficient.  And, if France could improve the efficiency of its social spending towards the EU average, the nation would achieve the current degree of income distribution, while saving 3.5% of GDP annually!

As an example, France enjoys a very generous public pension scheme – accounting for 13% of GDP compared to 8% in the EU.  However, as affluent pensioners receive the largest pay outs, 27% of overall social spending accrues to the population’s wealthiest quintile, compared to only 17% to the poorest.  Only 11% of French social spending is means tested (much lower than Germany and the UK).  Wider means testing would not only reduce spending, but would allow greater targeting of social spending on poverty reduction and other goals. Pension reforms, e.g. raising the retirement age from 62, and reducing the benefits from 70% of final salaries to the EU level of 65%, will need consideration.

Labour Reforms: Make France Competitive Again!

The World Economic Forum ranks countries in terms of competitiveness and attractiveness of the investment climate.  Of the 138 countries involved, France ranks 21^st (compared to Germany 5^th and Italy 58^th), not great for a G7 country. France’s high tax burden, inefficient government bureaucracy, terrorism costs, and an insufficient capacity to innovate are oft-mentioned shortcomings.  However, labour market inefficiency is by far the most frequently cited source of France’s worsened competitive position. Indeed, France ranks 110 (out of only 138) in labour-management relations!

• Unemployment stands at 10% compared to 4% in Germany and 6% in the European Union. Joblessness is especially high among the young (25% versus EU at 13% and Italy 40%) and the unskilled 18% (twice the level in Germany and UK). Long term joblessness (over 1 year) totals 2.5 million, and accounts for well over half of those out of work!
• Much of the unemployment is structural, and will require immediate, wide ranging labour market reforms by the Macron government. Not only have recent real wage hikes eroded competitiveness, high labour taxes (e.g. social security contributions shared by the employers and workers) add an additional 50% to overall wage costs – amongst the highest in Europe.  Indeed, even though French salaries are lower than in Germany, high taxes make French workers more expensive by roughly 10%.  High labour taxes not only reduce employment incentives, but also lower workers’ take home pay. French labour force participation of 65% is markedly lower than Germany and the UK (75%). In the WEF survey, France ranks 125 of 138 nations on labour taxes!
• The French minimum wage is twice the EU average – a major contributor to youth unemployment.
• Unemployment compensation is generous: France spends 2.3% of GDP on benefits, 15% higher than the EU average.
• In the WEF survey, France ranks a stunning 129 of 138 on the efficiency of rules about hiring & firing employees. Judicial uncertainties and high redundancy costs are often impediments to adding staff.  Macron passed controversial legislation which began to address these issues during his tenure as the Economic Minister. He promises further action.
• The narrow gap between public and private sector pay provides disincentives for private hiring. Indeed, public jobs account for 20% of the total, including all new jobs created since 2007, and add to government spending.
• While unionisation is low, centralised collective bargaining reduces wage flexibility (WEF rank 65). President Macron hopes to expand pay negotiations at the firm level.

What to Watch

The success of President Macron in steering the French economy in a new direction will have several important implications.  Following Macron’s election, Chancellor Merkel welcomed him warmly in Berlin, but took a tough stance suggesting that France should pursue German-style reforms.  While there is truth in this view, France and Germany do not always see eye-to-eye on specific aspects of the European policy agenda.  However, given the Chancellor’s recently expressed doubts about American leadership, Germany may adopt a more accommodating approach towards its European partners.

Even more importantly, successful reforms are imperative to reverse sustainably the appeal of nationalist movements in France and throughout Europe.  Nationalist voices may be quiet for now, but recall the FP did win 33% of the vote in the presidential election.  Unless French (and European) leaders demonstrate that the benefits of globalism/European integration are widely shared, nationalist movements again will find a wide audience in future election cycles.

As President Macron lacks political experience and a clearly defined base, he will need to successfully build a coalition of like-minded, pro-European reformists following the June parliamentary elections.  In Italy in the 1990s, the demise of the established political parties produced a fluid political environment for many years.  Despite the devastating performance of the French Socialists and republican movements, I do not expect a similar fate at this stage at least.

I advocate still an overweight stance in European equities based on economic recovery, low inflation, and easy ECB monetary policy.  Election results in France and the Netherlands – and I suspect in Germany in September – will provide policy makers breathing room to demonstrate that the gains liberalism and European integration can be widely shared.  France will play a crucial role in the outcome of that story.