France And Reforms: A Comparison With The U.S.

Includes: EWQ, SPY
by: Evariste Lefeuvre

It might seem a strange to compare the French and US economy given the huge differences in terms of size, institutional setting, and regulation, to name a few. Yet, both economies provide good examples on how market forces and fiscal policy succeed (or did not succeed) in correcting imbalances.

1. Similarities: In the years leading to the crisis (and the post-crisis years in France), domestic demand has persistently grown at a pace above that of GDP in both economies. If the outcome was the same - a widening of the current account deficit - the cause were clearly different:

i. Never-ending growth in indebtedness for US households resulting from the housing bubble but also from the lack of sufficient growth in real wages to maintain a high level of consumption.

ii. A disconnect between wage growth and the state of the labor market in France, due to the administrative growth in the minimum wage (SMIC, to which many medium range wages are implicitly indexed) and the existence of an "insiders job market" (wage, not jobs, will grow during a recovery, meaning a price vs. quantity adjustment).

2. Differences: for the reasons stated above, the outcome has differed strongly in both countries with completely opposite consequences in terms of aggregate distribution of income.

i. A high profit share and historically low compensation share in the US. Not only did business profitability recover sharply after 2008, it also reached a historically high level in 2011. This excess saving (cash, notably) could be explained by a wait-and-see attitude before demand picks up and investment recovers. Another explanation is that corporations have shunned bank/loan financing in favor of bond issuance - a pattern that would require a higher cash (insurance) buffer. Yet, the combination of wider wage inequalities, household deleveraging, ongoing downward pressure on compensation and excessive saving by corporations explains why the recovery has been so slow in the US.

ii. The situation is completely different in France. Profits make up 28% of gross value-added against an average level of 30.5% in the late 2000's. The self-financing ratio (operating profits as a share of total investment) has collapsed to a historical low of 60%, below that of Italy (80%) and far behind Germany (105%) and the US (107%, after a peak at 135% in late 2009). This huge dependence on bank lending coupled with poor domestic (and European) growth prospects and a gripped credit channel (in spite of the ECB's efforts) has led to a collapse in productive investment (13% below its 2008 level): productive capacity in the manufacturing sector stand at the same level as in 1998 (while they rose by 30% in Germany).

3. Correcting the imbalances: there are several ways to adjust. Here I focus on two: market forces and fiscal policy.

a. US: Even though the gap between profits and compensation has been partly breached by an increase in public transfers (unemployment benefits, food stamps…), the rebalancing between profits and wage is mostly dependent on market forces.

ii. Fiscal incentives for businesses to invest their excessive cash have been limited: Business Energy Investment Tax Credit (ITC), small business tax incentives with the Taxpayer Relief Act (2012).

iii. As the Small Business survey (NFIB) shows, the cost of labor is not an issue for US businesses (much less that credit access or "red tape"). Wages should rise once the job market has tightened. This is another reason for the wait-and-see attitude. Of course, pockets of the job market are under pressure for lack of skilled workers. But the overall picture is a depressed job market with a low level of participation and no signs of public efforts to increase the qualification of the labor force.

b. France: Market forces are much less significant in France even though, for the first time in more than two decades, real wages are decelerating as a response to a rise in the unemployment rate.

i. This pattern should continue, as France has tentatively reformed its labor market with the ANI (National Inter-professional Agreement) whose purpose is to revamp dismissal procedures, provide working-time flexibility (retention scheme) and encourage labor mobility. The lingering question is whether the nature of the industrial relations, which has historically been highly conflicted, can become more consensual? In addition, for the real wage to be more flexible and be more cycle-sensitive, the nature of working (fixed) contracts would also have to be changed.

ii. Yet, most of the rebalancing between wages and profits goes through taxation/fiscal transfers. An easy way to do it would be through a lower corporate tax, which is close to the highest level in Europe. For understandable political reasons, this option in not in the cards. Among many other proposals, the National Pact for Growth, Competitiveness and Employment, lowers corporate taxation (tax credit), while the budget proposal for 2014 increases the VAT. This is the way France's administrative rebalancing between profits and wages has to be understood: market forces might play a role in the medium run if more reforms are carried out, but in the short run most of the improvement in corporations' relative GDP share should come through taxation and public transfers.

Bottom Line: as the US is (still) facing a demand problem (excess saving by corporations, household deleveraging (nearing its' end), and lower public spending through the sequestration), France has to deal with its supply side (low profitability of businesses, dwindling productive capacities, and insufficient innovation and price dependency). One way to correct those imbalances is to resort to market forces, but as the US case shows, the process can be significantly low with the absence of tax incentives. On the contrary, French authorities have decided to tackle the problem without resorting to any shock therapy on the labor side (flexibility and nature of job contracts) but rather through an administrative rebalancing that might also show some positive outcomes in the medium term. Don't lose your faith in France.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.