In the last 30 years, there have been two more or less hardline socialist governments within the eurozone. Both the Mitterrand and Papandreu (father of the unfortunate Greek PM that had to preside over Greece's euro disaster) came to power in 1981 in France and Greece, respectively. Each of them created a bit of a mess. An economic mess.
We'll leave Greece for what it is, but the Mitterrand experiment is worth recalling, as it now seems that the present French president is embarking on something similar. For those of you with rusty memories or being too young, we recall Mitterrand's election to the French presidency in 1981 (after numerous failed attempts).
Difficult to imagine now, but his socialist party formed a coalition with the communist party to form a government, something which hadn't happened in France since the Leon Blum government of 1936. And it showed. In the first two years, the government embarked on a spending spree, increasing the minimum wage, boosting social programs, and nationalizing banks and companies left, right, and center.
The result was rather predictable, although it's worth to remember that the circumstances were particularly unfortunate. Just as France embarked on an epic reflation program, much of the rest of Europe (bar Papandreu's Greece) embarked on the exact opposite, austerity. Also worthwhile to remember that the early 1980s was a time of recession after the Fed hiked interest rates to unprecedented levels to sniff out inflation.
Europe had the European Monetary System (EMS), a system with fixed but adjustable exchange rates. With France embarking on reflation and the rest of the member countries embarking on deflationary policies, France suffered from a capital outflow that morphed into a currency crisis. This led to an unavoidable devaluation of the Franc, and Mitterrand had to make a rather embarrassing U-turn in 1983.
The latter was implemented by new PM Jacques Delors, yes, the author of the Delors report that led to Europe adopting a single currency. One can have some sympathy for the French predicament. Within the EMS, the Bundesbank ruled and it was near impossible for other countries to swim against the tide.
This whole experience turned out to be an important element that led up to the creation of the euro. The thinking in France (and Italy) was that it would be better to have one central bank for Europe, where France and Italy would at least have a vote, rather than having monetary policy be dictated by the Bundesbank with the option to follow, or face the consequences and devalue.
Well, now we have a new socialist government in France, albeit not quite as radical as the one three decades ago. Two things have happened as a consequence:
- The change in government in France has been crucial in wrestling control in the eurozone away from the Bundesbank, starting with the 'Growth Pact' and culminating in ECB president Mario Draghi's plan for unlimited bond buying (under conditions) which left the Bundesbank utterly isolated.
- France is again embarking on socialist policies of redistribution, albeit this time around not accompanied by anywhere near the same reflationary policies or nationalizations as under Mitterrand.
Both of these developments can have profound consequences for the eurozone as a whole, so it's worthwhile discussing them.
The 'hard money' view from the likes of the Bundesbank has been subtly undermined by events and politics alike. The arrival on the scene of the two Marios (the Italian PM Mario Monti and the ECB president Mario Draghi), together with the departure of staunch German alley Sarkozy, has made a crucial difference in wrestling control away from the Bundesbank.
Mario Monti has made a crucial difference. He's both embarking on significant reforms and austerity measures in Italy, which gained him the trust of the Germans and the markets alike. He is also tirelessly intervening on the international scene to put the pressure on Germany to do more. And, as a former academic economist, he has some strong arguments. For instance, he subtly pointed out that the large spread in bond yields between Germany and Italy is bad for both countries:
This results in a potential inflation risk in Germany, which I don't thing corresponds to the desires of the European Central bank nor to the desires of Germany. [Guardian]
And indeed, he does have a point. After all, something quite similar happened in the eurozone periphery in the last decade. The creation of the euro eliminated the devaluation risk. The resulting capital inflows producing bond yields that were too low, which resulted in the periphery accumulating inflation differentials with Germany and gradually losing competitiveness.
But the crucial shift in the balance of power within the eurozone came with the departure of Nicolas Sarkozy, the former French president. His replacement by François Hollande has shifted power away from the hard money surplus countries in the core (Germany, Finland, The Netherlands, Austria) and formed a Club Med coalition of France, Italy, Spain and Portugal. Here is Evans-Pritchard from The Telegraph:
Italy's premier Mario Monti - a fellow `Jesuit' - more or less confessed that this minor revolution could not have happened without the defeat of French leader Nicolas Sarkozy in May. The election upset broke the Franco-German axis and reordered the strategic landscape of Europe.
The 'minor revolution' is the ECB plan for unlimited bond buying (under conditions). This would have been unthinkable only a few months ago. We have to add though that another element has produced this outcome. The Bundesbank strategy, pushing the whole burden of adjustment on the deficit countries in the eurozone periphery, by means of savage austerity hasn't been successful and it's running against the limits of internal politics in many of these countries.
The 'time was ripe' so to say, to try something else. However, France might become more like a peripheral eurozone country through more than just political realignment. The danger is that France will experience the same kind of economic problems as well. What are these problems?
The eurozone periphery is liable to the following rather unfortunate economic dynamics and self-reinforcing feedback loops:
- An initial capital flow dynamic. After the euro eliminated the devaluation risk, capital flows moved to the eurozone periphery (countries that had been liable to devalue rather often), creating a boom but also a loss of competitiveness. This is how the problem originated.
- A subsequent capital flow dynamic. After the financial crisis the capital inflows stopped, and then reversed, leading to high bond yields and deposit flight from banks, undermining confidence leading to more capital flight.
- A vicious public finance-growth cycle. Bad public finances and high bond yields trigger austerity which worsens growth and the tax base, worsening confidence and triggering further bond yield increases, which undermine the sustainability of public finances further.
- A banking-public sector finance vicious cycle where banks, already plagued by deposit flight, are the main buyers of the nation's sovereign debt. Losses on this debt worsen their balance sheet, necessitating bail-outs, which worsen public finances, raising bond yields further, leading to more bank losses on their bond portfolios, etc.
- An asset price-bank balance vicious cycle, where falling house prices cause bank balance sheets to worsen, leading to forced asset (house) sales and more asset price falls.
- A Catch-22 dynamic where policy makers have to chose between two equally unpalatable options. Either they reflate in order to boost growth, but that worsens the competitiveness problem, or they deflate to deal with that but this worsens the real debt burden (a classical Fisherian debt-deflationary spiral).
- The eurozone periphery 'super' vicious cycle, where the deterioration in most (or all) of the above lead markets to question a country's continued membership of the euro, which accelerates capital and deposit flight, asset sales, worsening bank balance sheets and economic growth further, etc.
- Eurozone rescue dynamic. The more countries sign up for official bailouts, the less creditworthy remain to fund the bailout funds. Having Spain or Italy (let alone both) sign up for bailouts would not only require the kind of funds that are not there, it would remove guarantees from the funds as these clearly can't count on the Spanish and/or Italian contributions.
Austerity the French way
France is expected to have a budget deficit of 5.2% of GDP this year. Not quite peripheral heights (apart from Italy), but well above the 3% limit of the Stability Pact.
As a percentage of GDP, public dent was 89.3 percent in the first quarter, up from 86 percent in the previous three months. In the first quarter of 2011, it was 84.5 percent. One of the reasons behind the increase in debt was the EUR 9.1 billion that France contributed to the euro area rescue fund EFSF, INSEE noted. [rttnews]
And there are further uncomfortable truths. Public spending, at 55% of GDP is the second highest in Europe after Denmark (at 56%). But instead of cutting expenditures, the new budget puts most emphasis on new taxes. Expenditure cuts are supposed to reduce the deficit by 10 billion euros while tax hikes (mostly on the rich and big companies) will take in another 20 billion euros.
One of the new taxes is a 75% temporary tax on income above 1 million euros. This tax has France's richest person, Bernard Arnault, head of the luxury goods conglomerate Louis Vuitton, Moët and Hennessy (LVMH) applying for Belgian citizenship, although he denies that was the reason. Episodes like this surely bring back memories of the first two years of Mitterrand in the early 1980s described above.
It remains to be seen whether this approach is able to stabilize French public finances. Tax hikes in the context of very slow economic growth could very well tip the economy into recession, but then again, the same holds for spending cuts. Even if a recession is avoided, this hardly is the growth platform on which Hollande was elected.
Not every French boss reacted this way. Stephane Richard, CEO of France Telecom argued that the 75% tax is acceptable as long as the Government makes the French economy more competitive. Which brings us to economic reforms and the need to restore competitiveness.
The French trade balance has been steadily sliding, as a sign of worsening French competitiveness.
Well, not quite in Greek territory, but hardly comfortable. One has to take into consideration that the near zero growth artificially lowers imports (as the French spend little), deflating the trade deficit. The fact that there is a substantial trade deficit even during these economically depressed times show the seriousness of the French competitiveness problem.
Structural reform should be embarked upon as soon as possible to alleviate these problems. Even some French unions (!) actually seem to plea for this:
France's French Democratic Labour Confederation (CFDT) is pressing the Socialist Party (PS) government of President François Hollande to accelerate its social cuts. It is demanding that Hollande rapidly carry out labour market reforms-easing restriction on hiring and firing and cutting labour costs-to restore the competitiveness of French companies and formally adopt the European Union (EU) fiscal pact to impose sweeping austerity measures. [wsws]
Before you fall of your chair, this is only one union. Not nearly all unions think like this:
CGT's Thibault said France should not follow Spain and Italy in undertaking painful reforms because worsening joblessness had proved them to be failures... Viewing labour relations as a zero-sum game, hardline French unions including SUD, CGT and FO have a long history of confronting reform-minded governments and winning. [Reuters]
The debate on labor market reforms will be accelerated, but the outcome is by no means guaranteed. France has a history of reforms being overturned by "the street."
So, we have France having serious growth problems, but not quite those of much of the periphery (where growth is negative). France has a serious public finance sustainability problem, but not yet of the magnitude of much of the periphery. The competitiveness problem isn't quite of Greek or Portuguese proportions, but it has been steadily worsening and with most other countries addressing their competitiveness problems, France's could deteriorate considerably if it keeps on doing nothing.
And then there is this:
French house prices have now risen more than both American and Spanish house prices, the latter two have been big bubbles that popped.
Predictions range for a slide in prices from 12% to 15% by the end of next year, to 40% over five to 10 years. If the French housing index matched U.S. growth since 2001, it would have to fall by more than 70%. Demographics won't save France either -- as reported by The Telegraph, the consultancy PrimeView states: "Those younger than 58 are net buyers of property, those older are net sellers. The buyers stay constant at 33m, while the sellers rise by 1.2m every five years for a quarter century." Just in case the bubble wouldn't pop itself, politicians also put a new 15% tax on foreign owners of second homes, which will also help cool demand... And unlike Americans, who hold 27% of household wealth in real estate, the French have a whopping 57% tied up in housing. [Motley Fool]
These are uncomfortable figures, to say the least. There are some saving graces, one of which is that the mortgage market in France is much better regulated. Little in the way of sub-prime nonsense here:
French regulators recommend that banks shouldn't issue mortgages if payments will be greater than 33% of a borrower's income, and as The Economist reports, "banks are under a legal obligation not to push borrowers into more debt than they can manage, and cases are regularly brought to court." [Motley Fool]
Still, that graph above doesn't instill a whole lot of confidence. Should house prices start to fall, this will have serious ramifications for the whole of the French economy and will tip it deep into 'peripheral' status. There can be little doubt that should France develop into another Spain, the whole euro experiment will become untenable. Swift action in France is of the utmost importance.
For investors, those French bond yields..
All considered, we think it is likely that with France slowly starting to resemble a peripheral eurozone economy, its bond yields will slowly start to reflect that reality as well. That is, we expect French bond yields, and the spread over German bond yields, to creep upwards. At present, French yields are that of a core eurozone country, even the downgrade of its debt didn't alter that.
In the figure below, you see that French 10-year bond yields behaved more like German yields, getting progressively lower as capital flows moved from the periphery to the center. But for how long? We think that a short position in French bonds offer profit opportunities for some turbulence which will undoubtedly come.
(click to enlarge)
Unfortunately, there is only one French bond ETF, the iShares Barclays France Treasury Bond (IFRB:LN), and this is listed in London, not in the US. If you have trading access to London, this is worth a try. French 10-year yields are near a record low and we can't imagine they will stay there forever.
The implications of France slowly taking on more 'peripheral' characteristics are far more important for French bonds. Yields are almost as low as German yields while France simply isn't Germany. More importantly, it isn't going to turn into a 'Germany' any time soon.
You might wonder how French stocks will fare. There is an ETF, the iShares MSCI France Index (EWQ). Unfortunately, the case is far less clear cut for French shares than it is for French bonds.
Why? Well, the index is dominated by big corporations with a global presence, and these will move more or less in line with world 'sentiment.' That 'sentiment' is pretty good right now. Of course it can (and will) turn, but there are many more issues at play here than domestic French economic conditions.
The latter will only have an impact if there is some sort of acute crisis. Since we set out above that the French slide is gradual, and without any rapid increase in reform effort, we expect that to remain. So we can't really see much impact on French stocks at the moment, especially compared with French bonds, which are the more obvious short play.
So we think the case for shorting French stocks at this juncture, even after the strong run-up on the ECB bond buying and the 'euro positive' decision from the German Constitutional Court on the viability of the ESM isn't clear cut.
We expect bond yields to drift higher, but stocks will keep performing in line with world stock markets, until there is some kind of acute crisis in France (or elsewhere).
There has been a rally in the euro on the back of the ECB conditional bond buying plan, and continued Fed monetary easing. We don't think the euro rally will last. The slow slide of France itself will undermine the euro longer term. In fact, if the euro rally would continue, they would eat into export earnings of big French companies, which would obviously be a negative for stocks.
There are quite a few euro ETFs trading in the US:
- CurrencyShares Euro Trust ETF (FXE)
- EUR/USD Exchange Rate ETN (ERO)
- Market Vectors Double Long Euro ETN (URR)
- Market Vectors Double Short Euro ETN (DRR)
- ProShares Ultra Euro ETF (ULE)
- ProShares UltraShort Euro ETF (EUO)
- WisdomTree Dreyfus Euro Fund
Our advice here would be to let the rally run its course. We think it almost has and the euro will soon run into trouble. Greece might very well need a third bailout, France itself is not doing anywhere near enough to reform its economy, Spain has to be arm-twisted to ask for assistance, etc.. There are just too many banana peels left for this euro optimism to last much longer.