The French Connection Is Slipping

After the Berlin Wall fell and Germany was reunified, it struggled for several years as the "weak man" in Europe, before enacting structural reforms. Italy and Spain, as well as the periphery of Europe more generally, are being forced by investors and the EU to enact structural reforms. If only France were that lucky...

France has simply not been compelled to institute structural reforms or to make such difficult choices. Perhaps without the exogenous shock, the domestic forces of change are too weak.

Ironically, President Hollande's Socialist Party has as much power as any government in the fifth republic. The Socialist Party appears to suffer the same split that the Green Party in Germany experiences--between the fundos and realos--between those who are most principled and reluctant to compromise and those who believe that half a loaf is often better than none.

So split, Hollande's Socialists have failed to offer or articulate an alternative to neo-liberalism. Instead Hollande appears to be defining Socialism as a rearguard action to slow the enactment of neo-liberal reforms.

On Monday, the neo-liberal solution was again laid out by the IMF in its annual review and separately by the report prepared by Louis Gallois, previously CEO of EADS. When Sarkozy was first elected, he asked a reknown left of center economist and former head of the European Bank for Reconstruction and Development Jacques Attali to study why France was losing its competitiveness. The recommendations were all broadly similar--labor market reform was essential.

The French government will formally respond on November 6. The pushmi-pullyu tendencies of the Socialists can only generate soft response, which suits Hollande. Instead of cutting the payroll taxes, Hollande reportedly will off 20 bln euro temporary tax cuts linked to keeping jobs in France and a new public investment bank aimed at small and medium-sized businesses. It is also thought that Hollande will support a small increase in the VAT (from 19.6% to 20%) and make some small cuts in public spending.

Although the "fundos" want to jettison the commitment to bring the budget deficit down to 3% next year from a projected 4.5% this year, Hollande recognizes the significance. It is necessary to be taken seriously by Merkel, who clearly supported Sarkozy over him. To reject the 3% target is to take a significant step down the road that leads to the periphery.

Maintaining the pretense requires the slight of hand of optimistic forecasts, which is the last refuge of the desperate. Hollande's 2013 budget, which already includes 20 bln euro in tax hikes, assumes this year's growth to be 0.3% and 0.8% next year, roughly twice what the Bloomberg consensus and the IMF expect.

Without bolder action the rot will continue. The rot is how France, with a diversified representation of global companies and brands, impressive infrastructure, access to cheap energy and high productivity continues to steadily lose competitiveness.

To be sure, the rot began before Hollande. It began before the crisis, but the crisis may accelerate that trend. Previously uncompetitive peripheral countries are becoming more competitive. Of course more work needs to be done, but unit labor costs are falling throughout most of the periphery. In France they are still rising.

France's share of euro zone exports is falling. A decade ago, France was running small trade surpluses. Last year's 70 bln euro deficit was a record. Germany recorded a 150 euro surplus. Some industry estimates suggest that Germany has more than 2.5 times as many companies that export than France.

Hollande's Socialism also means to focus on what some call "no-cost" issues, like fostering innovation and enhancing quality. These sound nice and, who cannot be sympathetic, but there is a reason why the so-called "low hanging" fruit is so elusive.

Public spending in France is about 56% of GDP, the leader among the high income economies. It needs to raise 53% of GDP in revenue. This is a heavy burden no matter how it is distributed. The current distribution of the burden prices French labor out of the market. French unemployment is over 10% and German unemployment is below 7%.

French Finance Minister Moscovici makes references to new pact. There has been no national discussion on the basket of goods that French citizen get and how they should be paid for. It is not clear what is being received in exchange for greater labor market flexibility (broadly understood). Will capital become less mobile and commit to expanding capacity in France ?

Recent data warns that risks that the economic contraction carries over into next year are growing. As the periphery adopts deflationary policies and see unit labor costs fall, France is likely to get increasingly squeezed. It can barely compete with Germany and will be losing competitiveness against the periphery going forward.

A lukewarm, largely unimaginative superficial response to the Gallois study Hollande himself commissioned will push France a little further down a slippery slope. Each step down that slope is an erosion of French power and prestige.

There is one sense in which France and German are equals: How the French question is resolved is just as important for the future of the euro as how the German question is resolved and in many ways the former can still shape the latter.