Letter from France - Reflections on stability and growth

In his annual letter, Alan Kirman, Université d’Aix Marseille III, looks at France’s recent difficulties with the EU’s growth and stability pact and at the government’s incoherent policy towards public spending.

Well, it would be difficult to say that things have not changed since I last wrote this letter and it would be even harder to say that France has not been involved. Jacques Chirac took a strong stand on Iraq, neither one suspects for moral nor for religious reasons, unlike others involved, and most of the French and vast numbers of Europeans were with him. Nevertheless the war was rapidly fought and ‘won’ and George Bush and Tony Blair assure us from behind serried ranks of police and bodyguards that the world is now a safer place. Curiously enough this Gulf War unlike the last seems not to have dented the confidence of French consumers perhaps because it is already at a rather low level, and no appreciable drop in consumption has been observed by the INSEE. What the French found puzzling in all this was the motivation of the US. They are unconvinced by the moral argument and found it hard to understand how the moment was chosen. The most cynical view that one finds here is that the U.N. inspectors were left there just long enough to be absolutely sure that Saddam had no weapons of mass destruction and that nothing nasty could happen to the invading troops before the final decision was reached.

France’s problèmes domestiques
All of this was a distraction from the major domestic problems facing France. On the one hand the budget deficit is set to stay well above the 3 per cent level for the third year running and on the other hand there is the problem of pension reform. The two are far from unrelated since the increase in the debt diminishes France’s capacity to meet the pension obligations that are looming in the near future.

On the first point there is a debate with France and Germany on one side, and most of the other members of the eurozone and the non-euro members of the EU on the other side. The French and the Germans, it is said, are undermining any credibility that the Maastricht Treaty and subsequent agreements, might have had. If, as seems likely after the November meeting of the finance ministers, they are let off the hook again many people forecast future economic instability. In particular Jean Claude Trichet the new, (French) governor of the European Central Bank suggested that interest rates might have to rise. This is a far cry from the days when it was the Bundesbank that used to condemn French indiscipline.

Just before his death I had lunch with Emile Noel, the former secretary general of the EEC. We discussed the Maastricht Treaty and when I suggested that putting hard numbers into a treaty did not make a lot of sense, since they were, after all, only statistics, and what is more, at some point, some country would feel the need to break the barriers imposed and would probably do so. He answered that without numbers the pact was not credible, but he was convinced that the numbers would be interpreted in a flexible way! So for him the numbers were purely symbolic. Furthermore, he added that I could be sure of one thing, it would not be Germany that broke the rules!

Although the debate is heating up, and the Franco-German alliance is strengthening by the minute, with the two countries being accused of sapping the economic strength of the Union it might be worth looking at the Maastricht Treaty again. Indeed many lawyers in France and in Germany argue that these countries are not in breach of that Treaty and that the criticism of their policies is based on a false reading .

The article in question is 104c and I reproduce the essential parts on the next page.You will see straight away what Emile Noel had in mind. The procedure for countries who violate the Treaty was rather progressive and the criteria quite vague. Under a liberal interpretation you might argue that France and Germany’s agreement to be back in line with the reference levels by 2006 was enough to keep them within the Treaty’s stipulations, particularly if you believe that 3.6 is ‘close’ to 3.

However after the Maastricht Treaty, when the eurozone was being set up, this entailed the control of interest rates passing from national governments to the European Central Bank (ECB), whose mandate was to keep inflation under control. Something had to be done to assuage the fears of the architects of European Monetary Union — especially, ironically, Germany that the introduction of the euro would lead to runaway inflation.This, because they feared that some countries would get round the tough monetary policy of the ECB by increasing government spending and running large budget deficits. So they introduced the stability and growth pact (SGP) which was voted in Amsterdam in 1997 and led to the much more draconian rules that hold today. It is the SGP that has led to trouble now, in the face of French and German pressure for what amounts to abandoning these rules.

Has France undermined the euro?
Why is all this of interest? The current situation has been widely interpreted as some sort of constitutional crisis for the new money. Yet, in fact, the SGP was voted by the European Council in 1997 and can be modified by a simple decision of the Council and, unlike any modification of the Maastricht Treaty, does not need to be ratified by the parliaments of the countries of the eurozone.

Where is the problem then, and why is there such an outcry in Europe? The first answer is that any economic policies based on a single figure are always likely to cause problems since the figures involved—the inflation rate, the deficit, government debt—are only statistics and what is more, reflect complicated realities. Where did the numbers come from? According to Noel the 60 per cent figure for debt was simply the average debt of the EU countries at the time of Maastricht. The 3 per cent figure is even worse, since, for clarity, it had apparently to be an integer and that meant that had 3.473 been the appropriate figure it could not have been put into the pact and we were already in trouble.

However, one might ask a naïve question. Why choose deficit and debt as criteria and why both together when one might reasonably suggest that a country with very low debt might more easily run a high deficit temporarily than its counterpart with high debt?

The standard argument is that excessive deficits lead to problems in any case, and particularly to inflation. Yet, examination of the performance of the euroland countries since the introduction of the euro shows that there is no significant relation between deficit level and inflation. This is not good news since this relation is the premise on which the SGP was based. The other argument used in the SGP was that low deficits would promote growth and there is, indeed, a clear positive relation between growth and government fiscal balance. There is, of course, a question of causality here. There are those who would say that government laxity revealed by a large deficit slows growth but since Germany whose government spends no more than the average eurozone country has also the lowest growth rate the truth must be a little more subtle.

France is a nice illustration of what is going wrong. Low inflation compared with the other euro countries and the fact that interest rates are set by the ECB mean that real interest rates are relatively high and this slows growth. This, in turn, aggravates the deficit. So countries like France do not seem to be suitable candidates for fiscal restrictions. The SGP condemns them to a vicious circle whereas they would be better off in such a system with a higher inflation rate. However, since the relation between fiscal deficit and inflation is not clearly established, loosening the fiscal restrictions may not produce higher inflation. Yet, this seems to be fine, since if higher inflation does not result, those who feared its onset will be relieved and if it does go up, France might get back onto a better growth path.

In any event, since the November finance ministers’ decision many claim that the pact is almost a dead letter. The French newspapers were full of the ‘victory’ that was won by the Germans and the French in persuading the other countries not to fine them. However, this is far from what has really happened. France is committed, for the moment at least, to be back under the 3 per cent bar by 2005 and one does not have to look far to see what the consequences of this have to be for public spending. Here the question is, has France simply bought some time, in order to negotiate changes to the SGP which will allow it to avoid paying the price that it has promised in return for not being fined, or does it really intend to reduce the deficit? If the latter is the case then there will be a substantial reaction from those who will have to bear the burden of the reductions in government expenditure. But before coming to France’s efforts to start on the road to deficit reduction it is worth reflecting on what sort of changes in the SGP might be possible.

Changing the SGP
Many modifications have been suggested There has been the argument advanced by Barry Eichengreen that somehow institutional arrangements should be taken into account. He argues that countries that collect taxes centrally and disburse them regionally are more susceptible to overspending. How one bers. Another suggestion is that an independent committee should make fiscal spending conditional on inflation forecasts thereby restraining those moving into an inflationary phase. To say the least, such a proposal seems to involve a moral hazard problem.

Another, perhaps tongue in cheek, suggestion is that one should subtract the net contribution to the EU budget from a country’s debt. This would have radical consequences, since Germany contributes 5.1 billion euros, France 2.2 and Spain, for example receives net 8.9. If this were done France would fall below the 3 per cent level.

But back to the start. Why are we here? The SGP, which France and Germany are openly flouting, was supposed to ensure price stability, strong growth and a strong euro. Yet, on the last point, Germany and France together ran current account surpluses last year which were of the order of 80 billion euros as opposed to the total eurozone surplus of 73 billion euros. They have thus contributed to the strength of the euro, which at the time of writing is at a record high of over $1.20, at a time when many would prefer to see it weaken.

Having seemingly defended, to my discomfort, the current government’s position on the SGP, let me now ask a basic question. What about France’s own policies?

Current French ‘policies’
To keep Chirac’s election promises France, despite weak protests from the finance minister, has been systematically reducing income taxes and thus aggravating the deficit problem. This seems both inequitable and irrelevant. Irrelevant because income taxes generate only 20 per cent of government revenue and what is more French tax rates are very low. A very small number of individuals pay the maximum marginal rate of 50 per cent since, unless you have a very high income indeed, you have an automatic deduction of 20 per cent if you are salaried and of 10 per cent additionally if you do not itemise expenses. Add to this the system of ‘parts’ which means that you divide your income by the number of members of the family, (first two children count as a half each and subsequent ones as a full part) and income tax bills are relatively low.

Cutting taxes is unlikely to have any serious stimulating effect, particularly since at the same time the government is trying to increase revenue by increasing the tax on cigarettes, a rise of 20 per cent and a second to be made within four months. This is, of course, they tell us, for health reasons but has had some interesting effects. Apparently a number of hard drug dealers have shifted into cigarette dealing, the penalties are lower and the profits are now very satisfactory since the price differential with surrounding countries is now significant. The black market is flourishing, since tobacco is not a free market and there is still strong state control of sales and manufacture in France.

Another characteristic of the current government is a capacity to yield to pressure and as soon as a banner is unfurled the retreat is sounded. On the cigarette tax a promise has been made to freeze the tax for four years after the next rise. This is because tobacconists have been up in arms. It is also rumoured that the next rise may not actually happen. Another example: the tax on diesel fuel has been raised just as technology has advanced enough to make diesel engines for cars less polluting than their petrol equivalents, especially given their lower consumption but, as you can imagine, the rise did not affect the lorry drivers, the latter being renowned for their ability to bring the country to a standstill.

A particularly bizarre measure has been to abolish Whit Monday as a public holiday. In addition to the revenue raised from the government’s share of the extra 0.38 per cent of GDP generated by this decision there is to be an extra solidarity tax of 0.3 per cent on the extra income generated and this is supposed to go to a programme to care for elderly people. This has, as its pretext, the extra 15,000 deaths, mainly of old people, that occurred in the heat wave this summer. This figure, confirmed by the health ministry is somewhat of a mystery to me. What does it mean that a death is premature? There was clearly an excess of deaths in comparison to a normal summer, there was a substantial waiting list for funerals and bodies were stocked in the meat storage halls at Rungis outside Paris. Yet how many of these poor people were on the point of dying and how many lost a significant part of their expected life? It seems to me that we can only know the answer when we have the statistics for deaths over the next couple of years. Nevertheless the government’s reaction does not seem to have been the subject of much reflection. It does, however, show a certain political awareness since there is no obvious pro-Whit Monday lobby and the cause for which the revenue is to be used has popular appeal.

The pension problem
A serious problem which has loomed large has been the pension system and its reform. The French, like most other European countries are growing older and the discussion on pension reform has occupied centre stage. This is not unrelated to the discussion on the deficit since there will be a growing demand on resources to meet the contractual obligations inherent in the system. The idea of capitalised pensions has been ruled out and the current system will remain in force. The solution to the growing demands has been to increase the number of years to qualify for a full pension to 42 years. This will happen over the next few years. The retirement age of at most 65 has not been touched, though a number of early retirement schemes have been set on one side. This is evidence of the French desire for uniform rules. Any increase in the retirement age would be interpreted as preventing people with disagreeable jobs from taking their well-earned rest. The notion that some people might choose to continue working while their colleagues, in similar jobs, might not, smacks of anarchy. Yet such a scheme could make some contribution to the problem.

Once again it is worth asking what the basic problem is. There is no doubt that, even at current growth rates, pensions could be financed at current rates by suitable transfers. The issue is a political one. The transfers involved would deprive the next young generations of almost all the gains from growth and, what is worse, taxing the wealthy would not really make a dent in the problem. Thomas Piketty has shown that increasing the effective maximum marginal tax rate to 100 per cent on those in the top 10th percentile would not finance even 10 per cent of the pension bill.

So with a government intent on cutting taxes on income there does not seem to be an obvious solution. One obvious answer would be the reduction of unemployment, but there are those of us who do not believe that making labour markets more flexible would be a panacea, and no answer to the European problem is on the horizon. Another is to increase immigration but this would not go down too well in Marseille!

So there we are, resisting the pressure to slow things down with fiscal restrictions at a time when growth is poor and at the same time conducting a rather haphazard and almost frivolous economic policy. There is however one indication that the crunch will have to come and that the government may have to be prepared to face up to it. It has just been announced that public employees will have no wage increase for 2003 and 0.5 per cent for 2004. Since the public wage bill makes up 45 per cent of government expenditure it is clear that not even paying the rate of inflation as an increase will save a substantial amount. A 1 per cent increase in the salaries of the 5.3 million public employees costs about 1.5 billion euros per annum. To hold expenses down there are likely to be increases for the next few years considerably below the inflation rate. Yet, unless there has been a complete shift in attitude, a sure way to have large numbers of protestors in the street is to cut the real wages of public employees. How will the government face up to this when it had such difficulty dealing with protesting tobacconists?

One other item is going to cause a lot of problems. The heath bill has been growing at over 6 per cent p.a. recently and no remedy has been offered. The tax to help care for the elderly is one way of reducing the burden but is far from bringing the rate of increase of expenditure down to any feasible growth level for GDP.

If we couple this with the recruitment of more police and an increase in the military budget, the government must be counting on a very optimistic growth rate for GDP to save their bacon or maybe, as some suggest, not counting at all.

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