Europe has become the 'sick man of the world economy'
by Jean-Luc Gaffard and Francesco Saraceno
30 January 2013
Continued austerity both in peripheral troubled economies and, even less justified, in the stronger core to which France still belongs has transformed the continent into the 'sick man of the world economy'
In France, the short-term effects of the euro crisis compound a long-standing problem of competitiveness. In response to this challenge, the French government designed a two-armed strategy. First, it embraced austerity aimed at bringing the deficit to 3 per cent through a shocking €36bn budget law for 2013 - mostly based on tax increases. The second arm of the government's strategy, a 'competitiveness pact', was initially aimed at shifting an important part of the burden of social security – estimated at €20bn - from firms' contributions to general taxation. Social partners further agreed to changes in labour market regulation, introducing some flexibility and favouring both hiring and firing with the hope that this will stimulate innovation and growth.
It is good news that the problem of competitiveness has made it onto the government's list of priorities. For France, the persistent trade deficit is of greater concern than the public deficit. In a developed economy, competitiveness primarily rests on companies' ability to occupy a technological or market niche. Few would argue that Germany's success today depends on its costs rather than on its capacity to be competitive in high value-added sectors. But regaining this type of non-cost competitiveness requires investment and time. Furthermore, non-cost competitiveness is not independent of immediate cost competitiveness. Restoring acceptable profit margins is a necessary, although probably not sufficient condition, for a return to non-cost competitiveness. This requirement is all the more stringent today when obtaining captive markets through differentiation can often be very costly in terms of research and development, and capacity building. Therefore, the decision to reduce the tax wedge on firms is a welcome first step.
However, shifting the burden of social security towards taxation - mostly indirect - impacts the purchasing power of households already dented by the harshness of the crisis. The government seemed to be at least partially aware of this issue when it announced that the increase of taxation on households would be postponed to 2014. The problem remains that competitiveness gains could remain a dead letter if final demand were to stagnate. Moreover, restoring margins per se is unlikely to result in investment recovery in a contest of depressed demand, therefore putting out-of-reach the non-cost competitiveness that must remain the final objective for the French economy. And so it is a risky gamble to implement the competitiveness pact in a context of austerity. Not only are the two strategies mutually inconsistent but they risk to sum their negative impact and hence become self-defeating.
The government bet is to reconcile fiscal discipline and a return to growth. It seems to be confident in a recovery already in 2014, as if the on-going crisis was only a recession along a standard business cycle. Is this right? There are reasons for doubt. The latest International Monetary Fund economic outlook forecasts a growth rate of just 0.4 per cent in 2013. And in its fall forecasts the French Economic Observatory estimates that French growth will be curtailed of 1.7 per cent of gross domestic product if the austerity measures are implemented. This is not surprising: as the same IMF outlook acknowledges, the impact of austerity has systematically been underestimated in the past years, both in forecast exercises and in constructing budget laws across Europe. There is a case for arguing that in today's conditions, austerity is self-defeating and disrupts the environment that is needed for improving non-cost competitiveness.
The unavoidable truth is that frontloaded austerity efforts mostly affect long-term investment, in human and physical capital, with the risk of making the competitive pact vain. The path chosen is narrow and, quite frankly, dangerous. It would have made more sense to implement the productivity shock right away, compensating its recessionary effects through appropriate fiscal measures; this would have meant a more gradual return to public finances equilibrium - gradualism, incidentally, is also advocated by the IMF - but also provide a better chance to succeed in the attempt to boost competitiveness.
One may argue that the French government had no choice. Financial markets, European partners and the pressure of globalisation would prevent any policy different from austerity. It is undoubtedly true that few countries today can hope to have a significant impact on the world economy and France is no longer one of them. But the European Union is. It is too often forgotten that the EU as a whole has sustainable debt and deficit levels. The solution to the old continent's chronic growth deficit needs to be found at the European level, where a milder fiscal consolidation should go hand in hand with sizable investment efforts and reinforced industrial cooperation. The continued austerity both in peripheral troubled economies and, even less justified, in the stronger core to which France still belongs has transformed the continent into the sick man of the world economy.
Jean-Luc Gaffard and Francesco Saraceno work out of the French Economic Observatory and the Skema Business School
In France, the short-term effects of the euro crisis compound a long-standing problem of competitiveness. In response to this challenge, the French government designed a two-armed strategy. First, it embraced austerity aimed at bringing the deficit to 3 per cent through a shocking €36bn budget law for 2013 - mostly based on tax increases. The second arm of the government's strategy, a 'competitiveness pact', was initially aimed at shifting an important part of the burden of social security – estimated at €20bn - from firms' contributions to general taxation. Social partners further agreed to changes in labour market regulation, introducing some flexibility and favouring both hiring and firing with the hope that this will stimulate innovation and growth.
It is good news that the problem of competitiveness has made it onto the government's list of priorities. For France, the persistent trade deficit is of greater concern than the public deficit. In a developed economy, competitiveness primarily rests on companies' ability to occupy a technological or market niche. Few would argue that Germany's success today depends on its costs rather than on its capacity to be competitive in high value-added sectors. But regaining this type of non-cost competitiveness requires investment and time. Furthermore, non-cost competitiveness is not independent of immediate cost competitiveness. Restoring acceptable profit margins is a necessary, although probably not sufficient condition, for a return to non-cost competitiveness. This requirement is all the more stringent today when obtaining captive markets through differentiation can often be very costly in terms of research and development, and capacity building. Therefore, the decision to reduce the tax wedge on firms is a welcome first step.
However, shifting the burden of social security towards taxation - mostly indirect - impacts the purchasing power of households already dented by the harshness of the crisis. The government seemed to be at least partially aware of this issue when it announced that the increase of taxation on households would be postponed to 2014. The problem remains that competitiveness gains could remain a dead letter if final demand were to stagnate. Moreover, restoring margins per se is unlikely to result in investment recovery in a contest of depressed demand, therefore putting out-of-reach the non-cost competitiveness that must remain the final objective for the French economy. And so it is a risky gamble to implement the competitiveness pact in a context of austerity. Not only are the two strategies mutually inconsistent but they risk to sum their negative impact and hence become self-defeating.
The government bet is to reconcile fiscal discipline and a return to growth. It seems to be confident in a recovery already in 2014, as if the on-going crisis was only a recession along a standard business cycle. Is this right? There are reasons for doubt. The latest International Monetary Fund economic outlook forecasts a growth rate of just 0.4 per cent in 2013. And in its fall forecasts the French Economic Observatory estimates that French growth will be curtailed of 1.7 per cent of gross domestic product if the austerity measures are implemented. This is not surprising: as the same IMF outlook acknowledges, the impact of austerity has systematically been underestimated in the past years, both in forecast exercises and in constructing budget laws across Europe. There is a case for arguing that in today's conditions, austerity is self-defeating and disrupts the environment that is needed for improving non-cost competitiveness.
The unavoidable truth is that frontloaded austerity efforts mostly affect long-term investment, in human and physical capital, with the risk of making the competitive pact vain. The path chosen is narrow and, quite frankly, dangerous. It would have made more sense to implement the productivity shock right away, compensating its recessionary effects through appropriate fiscal measures; this would have meant a more gradual return to public finances equilibrium - gradualism, incidentally, is also advocated by the IMF - but also provide a better chance to succeed in the attempt to boost competitiveness.
One may argue that the French government had no choice. Financial markets, European partners and the pressure of globalisation would prevent any policy different from austerity. It is undoubtedly true that few countries today can hope to have a significant impact on the world economy and France is no longer one of them. But the European Union is. It is too often forgotten that the EU as a whole has sustainable debt and deficit levels. The solution to the old continent's chronic growth deficit needs to be found at the European level, where a milder fiscal consolidation should go hand in hand with sizable investment efforts and reinforced industrial cooperation. The continued austerity both in peripheral troubled economies and, even less justified, in the stronger core to which France still belongs has transformed the continent into the sick man of the world economy.
Jean-Luc Gaffard and Francesco Saraceno work out of the French Economic Observatory and the Skema Business School
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COMMENTS
And the UK spent millions and millions of pounds celebrating a birthday for a Queen that has money. And what about all the unemployed in the UK?
Last year, I stayed in Southhampton for three days and could not believe the unhappiness of the people. Low salaries and high taxes? And long live the Queen? How about Alice in Wonderland?
Ilsa - Houston, US.
