Seeking Alpha
Small-cap, macro, value, momentum
Profile| Send Message|
( followers)  

The French economy is in a deep funk. It is supposed to be one of the leading eurozone powerhouses, but it has been slowly drifting towards peripheral status, not unlike Italy. It's problems are numerous:

  • Historically depending on a centralized state since the days of Colbert, the state has become overburdening, soaking up more than half of the country's GDP
  • A slow, ongoing erosion in competitiveness
  • A lack of dynamism and entrepreneurship
  • A fairly sclerotic labor market
  • Public debt at 93% of GDP
  • Being caught in a low-growth equilibrium, much like Italy

Once a rather competitive, the French economy has run a similar, albeit less dramatic, trajectory as many of the eurozone peripheral countries, accumulating competitiveness losses in the first decade of the euro's existence. In the figure below you see how France gradually moved from having a current account surplus to a deficit.

(click to enlarge)

Estimates differ on how big the accumulated competitiveness deficit is, but France could need overall wage cuts of up to 14% to a whopping 40% (the latter is a Goldman Sachs estimation, who are we to differ). We suggest that these have to come from a combination of big tax cuts and labor market reforms.

Before we forget, the French economy still has some strengths:

  • World class brands in luxury goods that enjoy booming sales in emerging markets
  • Cheap energy due to nuclear power
  • A growing population

A Mitterand turn?

Reforming the French economy is notoriously difficult, reform proposals often meet fierce opposition, leading to street protest, and a soft death. But, with a mere 20% approval rating (and some personal issues), François Hollande, the French president has little to lose.

He could get inspiration from the famous policy U-turn that a previous socialist president, François Mitterand embarked upon in 1983, with Jacques Delors, the later EU President and author of the famous rapport that led to the single currency as his Finance Minister.

The Mitterand U-turn was the day that the French establishment had to accept the D-Mark dominance and abandon most of its more radical socialist policies, in order to rein in spending and stop the bleeding at the balance of payments.

The resentment at the Bundesbank supremacy that this created no doubt contributed to the urgency of adopting a European Central Bank where the French would be equal partners with equal voting rights to the Germans, instead of always having to follow their lead.

Mitterand was also politically very unpopular at that time, but the U-turn revived his presidency. Hollande was working for Mitterand at the time, finding himself baked into a similar corner, no doubt he gets inspiration from this example.

The general idea

The general idea sounds relatively solid, it is to restore competitiveness by reforms and reducing the burden of the state and taxes, and generally move France in the direction of the so called Nordic model, after Scandinavian countries. These generally have a fairly extensive welfare state and high taxes, but they combine this with active labor market policies and relatively free markets.

A note of warning should be that these active labor market policies ("flexicurity", a combination of flexibility through a flexible labor markets, combined with the security of extensive retraining and relatively generous social insurance programs) don't come cheap.

The details of the reforms were rather vague. Probably not surprising, as this was more of a statement of intent, rather than the roll-out of a detailed reform program, but still, it has a whiff of Abe's "third arrow," those mythical Japanese structural reforms that are supposed to improve long-term growth but details keep eluding us.

The world is paved with good intentions, no more so than in the field of structural economic reforms. These things are hard. But give the French some credit, they have already been working on enlisting social partners for reform (another "Nordic" element), and this even delivered some results in the field of pension reform. Here is the French Finance Minister:

for the first time, pension reform has been carried out in France in continuous consultation with employers' associations and trade unions.

However, Brussels was less impressed:

The reforms, unveiled last month, aimed at closing a €20bn deficit the pay-as-you-go pension system is set to reach in 2020, included an annual €2.2bn in new contributions by employers, as well as employees. In an interview with Le Figaro newspaper, Mr Rehn said: "We are waiting to hear how its negative impact on the cost of labour will be compensated . . . the reform of the pension system should not raise the charges on business or discourage employment." [FT]

We're also not so sure whether the new cooperation with social partners got off on the right footing:

Although the government has pledged to reduce other charges to offset the pension reform costs, it has yet to give details and has come under fierce criticism from Medef, the business federation, for increasing France's already high labour costs. [FT]

Can they do any better this time around?

Details, details..

The devil is usually in the details. Reforms are often very difficult, due to their 'political economy' aspects. That is, benefits of reforms usually take time and fall on society as a whole, while those bearing the cost of reforms are a much smaller, and therefore often a much better organized group and they often experience these costs immediately.

Added problem is that much political capital was wasted on austerity and Hollande is rather unpopular. On the other hand, many in France realize that the present route is a dead end (albeit painfully slowly), and something has to give. As the old saying goes, never waste a good crisis.

So what are, if any, the concrete proposals on the table since Tuesday? Here are a few we could assemble from the press:

  • 50 billion euro of spending cuts by 2017, about 4% of GDP in cuts [AP]
  • 30 billion euro of payroll tax cuts by 2017 [AP]
  • He called for France and Germany to harmonise corporate taxation [Reuters]
  • Create a joint venture to manage the transition to renewable energy, modeled on European plane giant Airbus [Reuters]
  • Cutting the regulatory burden on companies [Reuters]

But as you can see here, the spending cuts are not new and the 30 billion in tax cuts are merely offsetting the 30 billion in tax hikes his government has put on businesses and households since it took office in May 2012. Perhaps the most promising part is this:

Mr Hollande's plan is based on a "responsibility pact" with the employers federation Medef. The group's chief, Pierre Gattaz, said he is willing to "play ball", praising Mr Hollande for a genuine shift in strategy after 18 months of half-measures, false-starts and back-sliding. Medef has pledged 1m jobs by 2020 in exchange for a shake-up of labour laws and a €100bn cut in labour costs over five years, split between tax cuts and lower social security contributions. [The Telegraph]

If this responsibility pact flies, then we could have some real meat on reforming France. Before we get to the meat, first the risks.

The risks

France is presently stuck in a low-growth equilibrium not unlike the one we described with considerable alarm for Italy. Being forced to embark on austerity without any monetary expansion (like in the UK or the US) has proved counterproductive even in its own terms.

While the French Finance Minister Jean-Marc Ayrault could boast that:

Our efforts have been unprecedented, resulting in deficit reduction amounting to 1.5% of GDP in 2012, 1.7% in 2013, and an estimated 0.9% in 2014. By 2015, deficit reduction will rely entirely on spending cuts.

Reality is that this enormous effort has stalled growth, increased unemployment, and most of all, it has send public debt on an upwards trajectory because of the denominator effect (public debt/GDP ratio increases because of low nominal GDP growth).

(click to enlarge)

And it's getting higher still, despite all the austerity:

France's national debt has reached a danger zone at an estimated 93.4 percent economic output last year, the head of the public audit office said on Thursday. [Reuters]

As we understand it, the public sector cuts come before the tax cuts, which runs the risk of stalling French growth further, and postponing the recovery. Add to that structural reforms that could very well have some negative impact initially, and the risk is compounded.

We would start this program with a really big bold tax cut in order to reduce labor cost and give the economy a shot in the arm, creating some enthusiasm back that could help introduce more difficult reforms. It's also more easy to cut spending against the background of a growing economy.

But, alas, such policy runs afoul, like almost any sensible policy these days, of European limitations and rules, in this case the insistence on public finance norms like the 3% deficit rule.

The meat

At the first sign of implementation of the responsibility pact we urge you to buy into French shares, for instance through the iShares MSCI France Index Fund (NYSEARCA:EWQ). After the Mitterand U-turn in 1983, French shares outperformed German shares by 100% over the next four years:

A real supply side revolution could really pay off, give France some much needed dynamism and economic growth back and set their stock market alight.

Source: Buy French Equities