French ‘ticking bomb’ can be safely defused
Look elsewhere for systemic threat to euro area
France has been characterised by some as a “ticking bomb” at the heart of the euro area. This has been overdone, although there remains no doubt of the need for substantial restructuring.
Progress with adjustment has been modest to date. But the ticking bomb has failed to detonate. French growth has resumed, albeit at anaemic pace, and sovereign bond yields remain at multi-decade lows. A French sovereign crisis akin to those seen in the periphery remains remote.
In short, “France-bashers” have been disappointed.
Has the bomb been defused? Or is it simply on a slow-burning fuse?
France is benefiting from the fact that institutional investors, including Northern European insurance companies, Asian central banks, and sovereign wealth funds, have little choice but to hold longer dated, euro-denominated assets. Peripheral debt remains too risky for such conservative investors. Having sold peripheral bonds in a flight to safety at the peak of the eurozone crisis, they loaded up on holdings of German Bunds . But with France still identified as part of Europe’s core, higher yielding French sovereign debt finds ready buyers.
Market pressure on France to implement reform is therefore muted – at least when compared with the acute coercion faced by the periphery at the peak of the sovereign debt crisis.
Slow-burning fuse
On one interpretation, absence of market pressure creates complacency. Fiscal indiscipline leaves public expenditure at levels that cannot be maintained indefinitely, even if generous financing conditions sustain them at shorter horizons.
This is the slow-burning fuse: unsustainable policy choices lead inevitably to crisis, even if onset is delayed by easy financing.
Even in our more optimistic view there is no expectation that rapid economic reform will transform the French economy overnight. Domestic political sensitivities preclude this. But the breathing space offered by France’s favourable sovereign funding environment creates scope for a gradual – and potentially more efficient – adjustment process. This prospect raises the possibility that the French “time-bomb” can be defused safely.
The case for gradual adjustment is strong. The abrupt nature of Spain’s macroeconomic restructuring under market pressure has proved costly, as illustrated by the evolution of Spanish unemployment. And enacting aggressive consolidation in the eurozone’s second-largest economy threatens to exacerbate the area-wide demand shortfall, thereby intensifying deflation risks.
Yet the desirability of gradualism in theory may simply act as a smokescreen for inaction in practice. There are two reasons for greater optimism.
First, the French authorities have delivered more than they get credit for. Labour reforms agreed a year ago permit greater flexibility at the firm level.
Admittedly, such initiatives barely touch on politically more sensitive and macroeconomically more crucial issues: lowering longer term unemployment benefits; reducing public employment; promoting a reallocation of resources across sectors, not just within firms. But you have to start somewhere.
Hesitant process
Reform in France will remain a hesitant process, conducted beneath the political radar. A stealthy approach is the only politically viable option. While the macroeconomic benefits of restructuring remain distant, market participants should be alive to the microeconomic value created by reform, even when implemented without the fanfare one would expect in the Anglo-Saxon world.
Second, while the French state may be too big, it retains the institutional capacity to implement reform once the political courage to initiate it has been summoned. This cannot be said of all France’s euro area partners. This institutional capacity is what makes France still part of Europe’s core, despite its formidable economic challenges.
This is not to paint a Panglossian picture of adjustment in France. Much needs to be done. President François Hollande’s recent statements demonstrate understanding of the challenges, but action is needed, not just words.
The Franco-German axis remains the motor of European integration. Restarting that motor is crucial to making the euro area workable. German trust in France’s willingness and ability to reform – and to take the implied economic and political pain – needs to be rebuilt. That requires results, not just promises.
Yet change is in the air in France, more credibly than most perceive. If you are seeking the source of a systemic threat to the euro area in the coming years, look elsewhere.