Let’s be franc: France and the euro

April 9, 2017

As the French Presidential election approaches, the contenders’ policy proposals are coming under close scrutiny. The latest opinion polls suggest that Marine Le Pen of the Front National will face a run-off in the second round against Emmanuel Macron — which she will lose by a comfortable margin. But opinion polls are often wrong, and the prospect of a Le Pen presidency is being taken increasingly seriously. Her group of advisers — the so-called ‘Les Horaces’ — are busily planning her first 100 days in office.

One of Le Pen’s key policies is that France should leave the euro and re-introduce the franc, redenominating its debt in the new currency. No details are given of how such a complex process would be carried out, but dumping the euro has also been suggested by fellow contender Jean-Luc Mélenchon, the former socialist minister and senator running on a hard-left programme, who went up in the polls this week following a vivid performance in the latest television debate.

Aside from issues of implementation, the question also arises, however, as to whether the euro itself could survive the departure of its second largest member. But for now, we will focus on the issue of whether it would be sensible for France to leave the euro, assuming that this could be done quickly and with minimum economic dislocation.

France has done OK in the eurozone… 

On the face of it, France has not done too badly out of its euro membership. France’s GDP growth since the launch of the euro in 1999 has been faster than the average for the euro area as a whole. An important element of this was the French economy’s relative resilience during the financial crisis of 2008-09. France suffered only one year of modest GDP decline, and performed much better than virtually all other EU countries, especially Germany and the UK, which both suffered severe recessions.

In addition, French inflation has tracked the eurozone average fairly closely, implying not only that France has enjoyed price stability but also that on average it has not suffered a loss of competitiveness within the eurozone. This is reflected in its current account balance, which in recent years has averaged a deficit of around 2 per cent of GDP. This compares with a surplus of over 6 per cent in Germany, and very large deficits in the periphery countries, such as Greece and Portugal, where deficits often reached double digits as a per cent of GDP. In this respect the French economy is relatively well balanced within the euro.

…but has lost ground to Germany

There are two important caveats to this generally benign picture. First, while France has performed reasonably well relative to the eurozone average, that, in itself, is a fairly low hurdle given modest eurozone growth. Over the first 15 years of the euro, French GDP growth averaged 1.9% a year compared with 1.5% in the euro area as a whole — this is hardly spectacular and it is easy for politicians to claim that growth could be faster outside the euro. (US growth over the same period averaged 2.3%, for example.)

Second, despite its relatively good inflation performance, France has nevertheless lost significant competitiveness against its biggest trading partner, Germany. This is because inflation has been lower in Germany than in France, and because non-wage labour costs have risen much faster in France (see below). France’s trade deficit with Germany has doubled since the launch of the euro, and exports have stagnated in recent years. Leaving the euro and re-introducing a new devalued French franc could immediately correct this. However, weak total demand in Germany — another main source of stagnating French exports — would in all probability persist.

Structural reform is key — inside or outside the euro    

Leaving the euro might give the economy a temporary boost through devaluation, but it would not solve the underlying structural weaknesses. France’s recent economic performance demonstrates the maxim that stable prices and financial stability are a necessary but not sufficient condition for economic prosperity. Warwick Lightfoot’s blog on 19 February, France’s Presidential Election, highlights the structural factors that limit French competitiveness. A heavily regulated labour market is the most pernicious factor hobbling the economy — and has contributed to the growth in labour costs referred to above.

In addition, by making the cost of reducing employment in a downturn onerously expensive, the demand for labour is limited in the first place, creating an insider-outsider labour market. Those inside enjoy strong protection and rights, while those on the outside face huge difficulties in finding work. This is why the French unemployment rate persistently runs well ahead of the rate in the UK, for example, with its more flexible labour market.

High levels of public spending and taxation also crowd out private-sector activity and blunt incentives. French public spending accounts for 56 per cent of GDP, which is much higher than the Eurozone average of 48 per cent. These are long-standing features of the French economy, which pre-date the euro, and could be addressed whether or not France remained in the single currency.

Le Pen’s economic policy proposals are a worry

A glance at the manifesto of the Front National offers no hope that these structural problems would be tackled under a Le Pen presidency — in fact it suggests the opposite. Proposals include a renewed commitment to the 35-hour working week, a reduction in the retirement age from 62 to 60, and an increase in welfare payments to the elderly and families with children. There is also a proposal to impose a tax on employers who take on foreign workers. These measures would do long-term damage to the economy far in excess of any temporary boost caused by devaluation on euro exit.

France desperately needs reduced public spending, major labour-market deregulation, and broader structural reform. Pursuing these policies within the euro would help France regain competitiveness relative to Germany — as they would outside the euro. But the risk here would be that the temptation to undertake monetary expansion to mask structural weakness could be too great. Whether or not it remains in the euro, France needs to maintain the realistic monetary policy it adopted with the franc-fort policy in 1983 — a policy that does not accommodate inflation, and maintains an approximation of price stability. To sum up, France needs to concentrate on structural reform — in or out of the single currency.

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