As expected Francois Hollande has triumphed over Nicolas Sarkozy in the French presidential elections and his Socialist Party is favourite to emerge as the leading party in next month’s parliamentary elections. This will provide a strong domestic mandate to dilute the fiscal austerity provisions of the European Fiscal Pact, however, the French economy is not strong enough to fulfil this new mandate. France is not a triple AAA economy but it considers itself to be core. This dichotomy leaves France at the mercy of Anglo-Saxon markets and politically subordinate to Germany. Two famous exponents of Anglo-Saxon markets, Margaret Thatcher and George W Bush, have sound pieces of advice for the new President. “The French are always there when they need you” has been attributed to George W Bush, while Margaret Thatcher famous maxim has been paraphrased to “the trouble with socialism is that eventually you run out of other peoples’ money to spend”.
Together, these phrases highlight Monsieur Hollande’s dilemma. The unwelcome news for the new President is that German help will not to extend beyond meaningless political gestures and France’s Socialists have already run out of fiscal leeway. The government has run a budget deficit continuously since 1974 and debt to GDP is expected to reach 90% of GDP by 2013. This level has been identified by Kenneth Rogoff and Carmen Rienhart as statistically significant, beyond which there is a material slowdown in productive potential. It is certainly incompatible with triple AAA status and we expect both Moody’s and Fitch to follow S&P’s example of removing this accolade from France. The trigger for these downgrades will be evidence that the French economy is likely to contract this year. We expect real GDP to fall by 0.7%. This is likely to boost the unemployment rate into double figures from its current rate of 9.8% and raise youth unemployment from the current level of 23.2%.
The contraction in activity reflects the sharp loss of competitiveness since the introduction of the single currency. French exports have performed even worse than Italy and the trade deficit reached 2.7% of GDP in 2011. The banks are now being forced to deleverage and the simultaneous deleveraging of the public sector will deepen the recession. Francois Hollande’s campaign promises include the creation of an extra 20,000 teaching posts, included in the total of an extra 150,000 civil servants; the reversal of the increase in the retirement age from 60 to 62years for those workers who have worked more than 42yrs; an increase in the minimum wage; and an emphasis on technology and infrastructure investment as well as support for small businesses. More important than the specific promises that returned the first Socialist President since Francois Mitterrand was the recognition of an electorate unwilling to contemplate serious fiscal retrenchment or accept necessary structural reform to improve long-term competitiveness.
Hollande has made it clear that this program will be funded by higher taxes on high incomes and banks, which in turn will accelerate the contraction of domestic demand and credit. He also wants to extend the timetable for fiscal retrenchment. An extended timetable for fiscal retrenchment would not restore potential growth or reduce unemployment. Instead the outlook would be very similar to the UK with positive, but weak, growth.
We have some sympathy with this extended timetable. After all, the 2013 target date was dreamt up by Brussels bureaucrats in summer 2009 when they believed that the massive fiscal and economic stimulus had returned these economies to long-term growth rather than providing a short-lived inventory-led boost amid a prolonged period of deleveraging. As Winston Churchill once noted, “trying to tax your way to prosperity is like standing in a bucket and trying to pull yourself up by the handle”.
The simultaneous contraction of consumer, government, corporate and financial sector balance sheets evokes the classic paradox of thrift. France needs Germany to agree to an increase in balance sheets. Germany is unlikely to materially increase its Federal balance sheet having enacted its own debt brake, but Francois Hollande would like Germany to agree to the issuance of Eurobonds. This would enable governments to slow fiscal consolidation without being punished by the financial markets and/or allow the ECB to buy primary and secondary government debt to prevent counter-productive increases in interest rates. In the absence of this countervailing balance sheet expansion, the ECB will be condemned to providing regular but temporary relief through more long-term repurchase operations, much to the vocal disdain of the Bundesbank.
We do not expect Germany to agree to either of these two provisions since they contravene the German and ECB Constitutions, but Germany is willing to expand the European Investment Bank’s balance sheet to promote infrastructure investment. However, the proposed capital increase of €8-12bn would increase lending capacity by up to €200bn. But spread over 27 countries, the economic impact of this political symbolism would be negligible. The growth pact currency envisaged by Germany and other Northern European economies will not ease the austerity fatigue or defuse the European Sovereign Debt crisis.
This reflects the dysfunctional nature of the single currency. History shows that currency unions that lack fiscal and political union are unsustainable. The expansion of a currency across a large area creates winners and losers and in any political system cohesion is maintained by winners compensating losers. Germany is not willing to compensate weaker economies through fiscal transfers and it is not prepared to lose international competitiveness by deliberately provoking domestic inflation.
The consequences of this will be an unstable and unsustainable equilibrium of disinflationary, sub-trend growth in the eurozone. Germany will be forced to choose between destroying the single currency and funding it. However, based on the current 17 members this would imply an annual transfer of funds equivalent to between 5-8% of German GDP. We believe that Germany is willing to save the single currency, but not with all of the current membership, Nor is it willing to accept contingent liability of all of the peripheral government debt. This means exit for some members and debt restructuring for others.
The most likely members to exit are Greece and Portugal, while Ireland, Spain, Italy and Belgium are likely to suffer public debt restructuring. The election of Francois Hollande will simultaneously help accelerate this crisis and also delay the final dénouement. We believe that a compliant and europhile M Hollande will help deliver further EU bailouts for Greece and Portugal delaying the inevitable exits, but the lack of alternatives to austerity and structural reform will ultimately force debt restructurings and exits. The implications for French government bonds are that conditions will remain volatile, with spreads to Germany going up in the escalator and down in the elevator, but the overall trend will be further widening over three, six, twelve and twenty four months.
Chief Economist, Co-Fund Manager
May 10, 2012 at 3:29pm