Europe's Bipolar Disorder

Milton Ezrati, senior economist and market strategist for Lord, Abbett & Co. and an affiliate of the Center for the Study of Human Capital at the State of University of New York at Buffalo

Europe clearly has bipolar disorder. Its summits demand a single-minded focus on austerity, to correct past budget excesses. Then many of its politicians, most especially France’s Francois Hollande, reject such notions out of hand and seem determined to return to the fiscal profligacy that created today’s financial crisis. Neither course is very helpful.

The latter spendthrift route has already proved unsustainable, a verdict recently reached by the credit rating agencies in response to President Hollande’s seeming embrace of the old ways. The former austerity risks a vicious cycle in which fiscal restraint creates economic decline, which enlarges deficits and evokes still more restraint. Greece’s latest agony, as well as recession elsewhere on the continent, speak loudly to this dysfunction. Europe and France in particular need a different mix.

Recent news certainly makes clear the fruitlessness of austerity alone. The Eurozone broadly has sunk deeper into recession. According to Eurostat, the European Union’s (EU) statistical agency, industrial production in the region fell 2.5 percent in September alone, the most recent period for which data is available. The weakness was widespread, too, in every major industrial category and every region, from Germany, considered the zone’s strongest economy, to Greece and Portugal, where the measure fell respectively 4.4 percent and 12 percent. Measured over a 12-month horizon, industrial output has been in decline since late last year. Unemployment rates, though uneven across the continent, are everywhere well into double-digit percentages of the workforce and in September averaged 11.6 percent for the region as a whole. Business and consumer confidence fell in October to their lowest levels in three years, and other measures of business activity continue to signal decline.

Greece, of course, is the sad poster child for the damage inflicted by a single-minded focus on austerity. For all the tax hikes and spending cuts over the years since Athens began to beg for aid, the economy and its public finances have deteriorated. Each austerity measure seems to have driven the economy deeper into recession, raising unemployment, reducing incomes and cutting tax revenues, even as the growing poverty places greater demands on the government’s social safety net.

Most recently, with unemployment rates already close to 25 percent of the workforce, Athens has had to engage in another round of austerity to secure aid from the rest of the Eurozone. The finance ministry now plans spending cuts of €9.4 billion for 2013, 20 percent deeper than the €7.8 billion originally proposed.

The additional fiscal restraint has forced Athens to adjust down its 2013 economic forecast as well. Instead of a drop 3.8 percent drop in the country’s real gross domestic product (GDP), it now projects a 4.5 percent decline. For all the budget restraint, the economic shortfall is expected to widen the 2013 budget deficit from the 4.2 percent of GDP originally expected to 5.2 and raise the expected total debt outstanding from just under 180 percent of GDP to closer to 190 percent.

Cosmetic Gestures

France stands as the model for the other pole of European silliness. President Francois Hollande, who ran for office on an anti-austerity platform, talks about growth as a means to meet budget-deficit targets of 4.5 percent of GDP this year and 3.0 percent next, but so far his program deviates little from French business as usual.

Hollande’s recently announced plan to improve the competitiveness of French industry is certainly more apparent than real, consisting of little more than a convoluted shifting of tax burdens. Recently unveiled by Prime Minister Jean-Marc Ayrault, the program would stem the recent flood of job losses by giving French industry payroll tax breaks over the next three years. These, Paris claims, would reduce labor costs some 6 percent. To make up the revenue gap, the government would turn largely to an increase in the value-added tax (VAT). While this fundamentally temporary measure might stem a portion of the recent torrent of layoffs, it offers little that would rejuvenate the French economy. Not only does it merely shift tax burdens from one group to another, but the government has retained the payroll tax itself, offering relief only through rebates.

If this is France’s answer, it is little wonder that the credit-rating agencies have lost confidence. Both Moody’s Investor Service and Standard and Poor’s have stripped France of their highest triple-A rating, accompanying the action with a sharp critique of President Hollande’s stewardship to date. “Those measures alone,” wrote Moody’s, referring to the latest steps taken by the government, “are unlikely to be sufficiently far reaching to restore competitiveness.” Not only has the rating service downgraded France, but it has put investors on watch for future downgrades, as has Standard and Poor’s.

Given the fundamentally shallow nature of France’s effort, it is also little wonder that the president’s popularity has plummeted. After winning the recent election with a 52 percent majority, recent polls show him popular with only 41 percent of the public and deeply unpopular with 40 percent. He can’t keep his campaign pledge of sustaining the old ways, but nor has he offered anything promising in its place.

Real Reform

France might do better in the circumstance to follow the lead set by Italy and other members of Europe’s beleaguered periphery. These governments, now convinced that the old ways cannot work but also fretful about the effects of austerity alone, have begun to take more fundamental, concrete steps to induce growth even as they have reined in their budgets. Following the pattern of German reforms, set some years ago under then Chancellor Gerhard Schröder, these nations have begun the difficult task of reversing those past policies that hindered growth by rendering their labor markets inflexible.

The reforms relax rules on hiring and firing, pensions, hours, terms of contracts, and collective bargaining, all of which in the past have reduced efficiency and productivity by interfering with companies’ abilities to secure the best employees and cope with the vicissitudes of the economic cycle. The progress they have made, given the vested political interests in those old labor rules, is remarkable. Clearly the crisis has acted as a powerful lever. The last two times Italy tried to relax its restrictive labor laws, in 1999 and again in 2002, the Red Brigade murdered the leading lights of reform. This time not even all the unions opposed the reform. Spain, too, seemingly against the odds, has moved similar legislation, as have Portugal and even Greece.

Labor law is not the only area inviting such structural reform. Relying on International Monetary Fund (IMF) research, these countries are also considering relief for what the IMF calls “excess product market regulation.” Calling attention to the less-than-well-thought-out rules across the entire European Union (EU), this research shows how restrictions on product design, overzealous licensing and limits on the location, size and nature of facilities have made for inefficient uses of both physical and financial capital as well as labor. The IMF’s conclusion, that those nations with the fewest such strictures have income levels 5 percent above others, has impressed, and these nations are now considering reforms in these areas.

France has not even begun to talk about such fundamental reform, in labor markets or elsewhere. In this latest effort, the government refused even to consider a relaxation in the country’s strict 35-hour work week. If it had proposed something substantive and concrete, as Italy, Spain, and others have, Hollande’s popularity might not have improved, but doubtless the rating agencies would have taken note. They might still have downgraded France, but they might have kept the country off watch for another downgrade. More fundamentally still, such measures would have offered France, as they have Italy, Spain, and these other economies, a way to pursue growth even as the authorities also implement needed budget discipline.

France, instead of its cosmetic gestures, needs an alternative to both the fiscal profligacy of the past and the vicious cycle that emerges from austerity alone.

Post-Crisis World Institute