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Tuesday, May 8, 2007

France - Europe's New Sick Man?

As France recovers from the election of Sarkozy as new president this Sunday one of the topics which quite naturally has been high on the agenda throughout the campaign is the French economy and how to move things forward in what, after all, constitutes the Eurozone's second biggest economy. I am of course not the only one who has made the assessment that the French economy may now be on the brink of something of a new era after so many years with Chirac at the helm and scoping around through the economic commentaries the French economy is apparently not in a particularly good shape. Over at Morgan Stanley's GEF, for example, Eric Chaney recently nominated France as the new sick man of Europe invoking four macroeconomic indicators (GDP growth, exports, unemployment and public finances) as being worrying beacons of Europe's new economic laggard. However, as Emmanuel from AFOE has recently tried to argue by taking the BBC fact sheet on the French economy to task, the real position is much less clear than many pretend, and France's long-term growth potential may be being systematically underestimated in the same way that Germany's is being systematically overestimated. Indeed just as one swallow definitely does not make a summer, one year's performance definitely does not constitute a trend.

So, is the French economy really in such bad shape? In this note, which accompanies Manuel's excellent posts on the French Presidential elections, I will try to answer just that question. In fact I will argue that France indeed faces important and non-negligible challenges in the immediate future, among them most notably how to better manager the y-o-y and long term evolution of public finances, as well as the need to reform a rather rigid labour market. However, I will also argue that the invocation of France as the new sick man of Europe represents a fallacy and that such analysis does not adequately take into account the (potential) long term fundamentals of the French economy which look healthier than those in many of France's European peers.

France and the Eurozone – A Laggard?

Much of what recently has been written and said about the relatively poor state of the French economy compared to the other large Eurozone countries comes on the back of 2006 which saw a record year of economic growth in GDP in the Eurozone and indeed the whole of Europe. And clearly looked at in this context France would seem to have fallen somewhat behind Germany, for example, which as well all by now know only too well posted an impressive growth rate of 2.6% compared with France’s rather more modest 2%. Yet, if we take a look at real GDP growth in France over the past 12 years there is nothing to suggest that France is not, in fact, by and large monsieur average in terms of economic growth in the Eurozone.

This overview puts in some kind of perspective the rather hasty conclusions being drawn on the basis of what is, after all, only is one year's relative performace, and, as Emmanuel from AFOE points out, this clearly is far from constituting a trend, at least not the way I have been taught in economics it doesn't. Now none of this means that France does not face important economic challenges, and it certainly does not mean that France could not do with some badly needed reforms. Most notably, France needs to reform its rigid labour market. I will not dwell on the very complicated structure of France’s labour market here but there is no doubt that France needs to fundamentally rethink and re-invent the notion, width and depth of job contracts and on that same note re-invent its social security scheme (la protection sociale) whose two tier employee/employer financing is at the heart of a troubled French labour market.

And the problem is of a somewhat pressing nature. In particular, and despite the fact that I shall talk rather favorably of French demographics below, France, along with other developed economies, is set to age rapidly over the next 20 years as a result of the ongoing demographic transition. This means that the labour market needs to be a well-functioning one so that the supply side of the economy is not constrained as workers become an ever scarcer resource compared to elderly dependents. Especially noteworthy in this context is youth unemployment in France, which is running at rather alarming levels, as is demonstrated by the figure below.

Another aspect where France needs to improve its performance is in terms of the management of public finances. Since 1995 France has been running a structural budget deficit and although many will take comfort in the fact that it is now below the dreaded threshold of 3% set by the growth and stability pact under the EU framework there are still fundamental economic issues to be resolved related to getting France’s books in good financial order.

The first issue to be addressed is, I think, of an institutional nature, since the lingering budget deficit first and foremost tells a tale of a state apparatus where expenses are quite simply badly managed compared to receipts. But in terms of the broader and longer term picture we need to talk about the structural drivers of public debt, and here it is clear France also needs to improve.

More worryingly, as also aptly noted by Eric Chaney (linked above), the window of opportunity for France - as with most other major European countries - is closing fast due to the pace of the evolving demographic transition. Chaney presents estimates which show that liabilities will rise to 120% of French GDP as a result of the ageing process alone. This will of course only be exacerbated if France continues on its current course so there is good reason to think in terms of implementing reforms and changes today rather than tomorrow.

Now taking up the baton on the demographic situation in France, as I noted above I am going to speak rather favorably about this. In this context I am, I am afraid, only going to offer a relative exercise as it were, and simply compare with France its European neighbours Italy and Germany. Now if we look at fertility in France we in fact get a rather different picture to that which is to be found in Italy and Germany.

In France fertility rates have rebounded since the middle of the 1990s and are now close to replacement (a situation which has only really be attained by the US among the developed nations), and if we are all busy criticizing French public policy in many areas we might perhaps do well to recognise that pro-natalist policies in France do seem to have had some effect, and this is one thing which certainly seems to have been done well.

This relatively favourable fertility situation by no means saves France from a structural shock to its population pyramid as the effects of the demographic transition ripples across the age cohorts, but it does mean that compared to Italy and Germany where fertility levels stubbornly continue to lingers close to the 1.3/1.4 range the future does look just a little bit brighter for France, with of course the proviso that future trends in net migration represent an unknown in all cases. The key point on fertility however is that although the picture points to an apparent return to 1980 standards so to speak the figure hides the cumulative effect on the size of future generations. As such the size of the various cohorts currently passing through their reproductive ages is smaller than that of the preceding ones, so the absolute numbers of children being born will be commensurately lower (with pension sustainability implications), and again all of this means that the crude figures need to be treated with some caution.

Lastly before I conclude this note I want to dwell a bit on another aspect highlighted by Chaney as part of France’s misery, namely her exports. In many ways, Chaney’s analysis on France’s exports is airtight and he even includes the following point which I fully endorse although growth rate of populations perhaps should be changed to something like ‘changing structure’ …

By itself, a trade deficit is not a symptom of macro illness (nor is a government budget deficit). Diverging domestic demand growth between countries having similar productivity and cost trends generates temporary surpluses and deficits, with temporary maybe meaning several years. That Germany and Japan have large trade surpluses is largely explained by the slow growth rate of their populations and of their domestic demand. That is why it is more revealing to look at export performances.

Essentially, I think Chaney is spot on in terms of his focus on the structural nature of French export business and most notably the relative lack of innovation when compared with other European countries. Yet there is another subtle point here I think which is ever so important both in a European and global context.

In a world where populations are ageing, and where trade surpluses are ballooning and becoming structurally inbuilt in some of the oldest societies, we logically also need importers to make the global books balance. In fact, as was demonstrated by the figure in my recent piece on global decoupling France constitutes Germany biggest export market in terms of total volume on a country basis. Given that background it is clear that the growth of Germany and France is of somewhat a symbiotic nature (like growth in China and the US?) which is also why this idea of France as the sick man of Europe seems to be rather inappropriate I think or at least why we need to think about eurozone and cross-country dynamics too.


Looking into future of France with a new president at the rudder it is my hope and optimistic belief that Sarkozy will now command the legitimacy to carry out what is sure to be big changes in French society. Hopefully theses changes will be for the better both for the French and for the European economy.

To finish where I started with Eric Chaney's notes over at Morgan Stanley’s GEF (see links above) I do not agree with the overall label of France as the new sick man of Europe. Essentially, Chaney makes a whole lot of sense in his analysis and as I have also noted above France indeed needs reforms in order to combat high unemployment as well as shaky public finances. The only qualifier that I would attach Chaney analysis is on France’s trade deficit which actually is much needed to sustain growth in the Eurozone as a whole and once again I feel as if the account of how demographics affect capital and trade flows is somewhat missing in the general analysis. In terms of Europe I still believe that the scarlet letter of sick man rests firmly on Italy mainly due to its government debt at about 100% of GDP, a problem which poses a fundamental risk to the future of the Italian economy, as well as to its future membership of the Euro and public pay-go benefits system; all this of course especially given the demographic realities. Put another way, I don’t think Chaney’s analysis on France is flawed as such, but his headline is.