Cracks Appear in the French Economic Model

Today's PMI data point to a deepening recession in France at a time when Germany is showing tentative signs of life. Is the euro crisis exposing the weaknesses of the French economic model?

Until now, France’s economic problems have been a slow-burning issue. France did not experience the asset-price bubble faced by many peripheral countries in the run-up to the crisis in the euro area. Equally, the adjustment needed to stabilize its public finances is comparatively small.

But France does share some unwelcome characteristics with the periphery. Top of the list is the competitiveness lost since joining the euro in 1999.

This is most noticeable against Germany. According to our calculations, the gap between the actual (irrevocably fixed) exchange rate between Germany and France and the one required to offset the divergence in unit labour costs since the late 1990s now stands at 20%.

The deterioration in France's relative competitive position is confirmed by the export performance of both countries. During the 1980s and 1990s, both countries’ exports grew broadly in line with their respective export markets. Since then, though, Germany has hugely outperformed its southern neighbour.

In spite of these problems, France has grown at an average annual rate of 1.4% since joining the euro, the same as Germany and the euro area as a whole. How has this been possible?

Part of the answer is that France has run a large and persistent annual budget deficit since joining the euro, equal to 3.7% of gross domestic product (GDP) on average. This compares with 2.1% for Germany and 2.8% for the euro area as a whole.

These high deficits have been caused by government spending. According to European Commission data, government spending has been above 50% of GDP for over two decades and last year stood at 56%, the highest of any euro-area country. The gap with Germany is particularly revealing: since 1999, the difference between French and German public spending has widened from 4% of GDP to 11%.

Until recently, these excessive levels of public spending have been tolerated by bond investors. But now, under pressure from the bond markets and its euro-area partners, the French government is starting to tighten fiscal policy. It may be this which is weighing on growth at a time when signs of light are appearing in Germany.

But there is an additional problem for France. Most of the peripheral euro-area countries have already started to improve their competitiveness and embark upon long-overdue structural reforms. France cannot afford to fall too far behind.

The good news for France is that it still retains investor confidence. The bad news is that this will not last forever. If today's survey data do, indeed, point to a deepening recession, then markets will soon start to focus on fiscal slippage and structural barriers to growth. In simple terms, France cannot forever avoid the hard choices needed to make a success of its euro-area membership. The government needs to learn the lessons from the sovereign-debt crisis before it, too, becomes a target.

Darren Williams

Senior Economist—Europe
Darren Williams is responsible for economic analysis, interest-rate forecasting and bond market strategy for western Europe. He has covered the major economies of western Europe for over 25 years, and has written extensively on the European Economic and Monetary Union and the monetary policy decision-making process of Europe’s central banks. Williams joined the firm in 2003, having previously held senior positions in the economics departments of several leading investment banks, including Citigroup, UBS and Merrill Lynch. He holds a BSc in banking and finance from Loughborough University (UK). Location: London

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