German and French economic reforms: A long, hard climb

Date: 18/10/03

The German and French governments are, belatedly, reforming their economies. But will they overcome inevitable opposition to change?

OPEN a newspaper, pick up a bestseller or listen to a debate: the mood in France and Germany these days is irredeemably glum. Europe's two biggest economies are bumping on the edge of yet another recession. Already-high jobless rates are rising again. The brief flicker of growth in 1999-2000 was snuffed out by a gloomy world economy, exacerbated by tight monetary and fiscal policies in the euro area, and shows little sign of reacting to the general global revival now under way. Above all, both countries suffer from longstanding structural rigidities in labour and product markets, and from an overly generous welfare system.

France has “plunged into decline”, says Nicolas Baverez in a new book, “La France Qui Tombe” (France is falling over). Germany “is in crisis, because there is no political model and no vision for the future”, argues Wolfgang Schauble, a conservative politician, in another book, “Scheitert der Westen?” (Is the West failing?).

Yet, for all this morosity, something is stirring on both sides of the Rhine. Chancellor Gerhard Schröder of Germany and President Jacques Chirac of France have both been sounding like reformers. Mr Schröder this week put his job on the line, threatening to resign if left-wing Social Democratic rebels refused to back new social-security rules that are a key part of Agenda 2010, his reform programme. The vote in the Bundestag, which Mr Schröder was expected to win narrowly, was due on October 17th. In France, Jean-Pierre Raffarin, Mr Chirac's prime minister, has a far bigger parliamentary majority. But he too will have to face down protests to push through his own measures, which the French have christened Agenda 2006.

It would be easy to dismiss the Franco-German reforms as thin gruel, likely to be watered down further in the face of hostility. But public opinion has changed. In France, a new realism is taking hold: the word “privatisation” has passed from unmentionable to commonplace. The government won praise for sticking to its pension reforms after this summer's protests. Officials say France has no choice but to change. “We have lived for too long with the idea that the state was always right,” declared Mr Chirac on July 14th. “We must move out of this impasse...the state cannot decide everything.”

The change is even more evident in Germany. The word “reform” now crops up with monotonous regularity in the press. After long declaring Germany the “sick man of Europe”, economists at investment banks are now putting out bullish reports with such titles as “Germany Gets Going”. Have Europe's two giants at last accepted the case for change?

The similarities between Agenda 2010 and Agenda 2006 are certainly striking. Both focus on three big issues: pensions, health care and labour markets. In neither is the need for generous social protection challenged. But each makes a serious effort to reduce the burden. The two countries are keenly comparing notes, to the extent of having joint working groups to examine policy options. As a symbol of their close relationship, Mr Schröder even asked Mr Chirac to represent him at part of this week's European summit, so that he could return to Berlin for the Bundestag vote.

Both governments are trimming pensions by making people work longer. A commission has proposed cutting German pensions to 40% of average gross earnings, from today's 48%, and raising the retirement age from 65 to 67. Mr Raffarin's pension reform has already passed into law - despite protests. It raises from 37.5 to 40, and later to 42, the number of years that public-sector employees must work to gain a full pension. Both countries' reforms have shortcomings: neither abandons the pay-as-you-go system, and France has left untouched special regimes for railway and utility employees. Yet in both, some responsibility for security in old age is shifting towards individuals.

On health care, the two countries share the same problem: a first-class health system bedevilled by ever-rising costs. Germany's reform is the more advanced. Last month, Mr Schröder pushed through a measure making people pay for more of their dental and optical care. Mr Raffarin began a discussion of health care only this week; proposals are due in mid-2004, after next spring's regional elections.

As for labour markets, both countries are introducing more flexibility. Germany plans to make it easier to fire workers, at least in small firms, to curb unemployment benefits and to make jobseekers take unattractive jobs. The French are working on similar lines, though hampered by the 35-hour-week introduced by the former Socialist government. With an annual cost put at €8 billion-15 billion ($9 billion-17 billion), this policy has frozen pay of many workers who would work longer if they could earn more. Even a majority (61%) of French people now think the 35-hour week has penalised France. Mr Raffarin has ordered a study of its economic effect.

The two governments are also tackling other difficult reforms, such as education and decentralisation in France, or bureaucracy and a loosening of the laws regulating craftsmen in Germany. And both governments are trying to kick-start their economies with tax cuts, even though these are pushing their budget deficits above the ceiling of 3% of GDP set by the euro area's “stability and growth pact”.

The burden of history

Europe's cherished social model has a long history in both countries. It was Bismarck who pioneered the welfare state; France started to build a comprehensive social-security system in the 1930s. The two countries now offer comparably high levels of protection, financed by payroll taxes rather than income taxes, for health care, state pensions and unemployment insurance. Until the 1980s, this worked well enough, with no discernible cost to growth. But in recent years, the European social model has proved a strong disincentive to growth and to job creation (unemployment is 9.4% in both countries); it has deterred foreign investors; and it has kept labour costs uncompetitively high.

The economies of both countries are burdened by too many bureaucrats, too many rules and too many taxes. There are some 3m civil servants in Germany, and over 2m in France, though the numbers are slowly coming down. Despite recent cuts, corporate and income taxes still make both countries expensive places to live in or to do business. Average growth rates in France and Germany have been declining every decade since the 1970s.

Given all this, why did it take so long for the two countries to deal with their structural problems? The response may also answer a second question: what grounds are there for believing that, this time, the two genuinely want to push through reforms?

One answer to the first question is that things were never bad enough to persuade people that change was necessary. In the late 1990s, the French economy grew faster than the European average, allowing the Socialist government to indulge in such goodies as the 35-hour week. Germany, for its part, was distracted by unification, and took some years to grasp the cost this was imposing on the economy. Neither Mr Chirac nor Mr Schröder is a naturally enthusiastic reformer; both prefer the quiet life and the calming hand.

The institutional setting in both countries has also led to political gridlock. In France, there have been several periods of “cohabitation”, when the president and prime minister are of different political stripes. Union opposition has been especially effective during such periods. Now cohabitation is over, at least for the time being. And Mr Raffarin has started to decentralise the country's public administration, breaking up another French institutional obstruction to reform.

As in France, the Germans have been frightened by the trade unions. But the collapse in June of the IG Metall strike in support of shorter working hours in the east has weakened the unions in general. Germany still suffers its equivalent to France's cohabitation in the form of its federalist system. In particular, most federal legislation must be approved by the Bundesrat, Germany's upper chamber, which consists of representatives from the German Lander, many of them under opposition control. Unsurprisingly, important laws are often blocked by the Bundesrat.

If Germany's chief barrier to implementing reform remains institutional, in France the problem is more a lack of political will. French politicians are haunted by the street, a fiercer source of opposition than any deputies in parliament. The right was bruised by the experience of Alain Juppé, prime minister in the mid-1990s, who abandoned ambitious reforms after paralysing strikes and protests. French politicians have singularly failed to make the case for reform to the electorate. It is nonsense, argues Mr Baverez in his book, to say that France is unreformable: “It is the government which is incapable of conceiving and implementing reform.”

Will it be different this time? Perhaps. For a start, a long economic slump, more competition and a weaker dollar have blown away all conceivable covers for structural weakness. Both countries are heading for budget deficits of nearly 4% of GDP. Social-security deficits are out of control. The shortfall in the French public health-insurance fund, for instance, will reach €10.6 billion in 2003 and €14.1 billion in 2004. Unless changes are made, social-security contributions might have to rise to prohibitive levels. In Germany, social-security payments (by employers and employees) could rise from over 45% of pay to 54% in 2030, by some estimates.

Such numbers are finally driving home the message that reforms, even painful ones, are inevitable. Today, only 35% of Germans believe that comprehensive social protection is possible without high contributions, down from 53% a decade ago; and as many as 70% agree that reforms are necessary. In France, a recent poll suggested that 51% of French people are in favour of the government continuing with reform. That Mr Raffarin got his pension changes through was due to the fact that people believed there was no alternative. Mr Raffarin has learnt from Mr Juppé's failure in 1995-96: where the former centre-right prime minister was imperious and heavy-handed, Mr Raffarin is a painstaking seeker of consensus and compromise. Some observers note that the parlous state of French public finances could also help to persuade the voters of the need for more reform, especially spending cuts.

Moreover, in both countries there is now an unusual opportunity to force through reforms. In France, the president and prime minister are of the same political party, the government has a crushing majority in parliament, and national elections are not due until 2007. Mr Raffarin, with a firm eye on the rise of the National Front, has cultivated an image as a blokeish man of the people, ready to take on the establishment. If Mr Schröder wants to have a chance of winning the next general election in 2006, he too must bet everything on reform. The opposition is unlikely to block him completely in the Bundesrat, because many of its key supporters in business urgently want change.

Cautionary words

All this said, however, some caution is in order. Nobody expects either France or Germany to subject their social models to genuine shock therapy. In France, the heavy weight of the public sector continues to hold up reform, however well-intended. The government has already deferred some changes, officially in the name of public consultation, but plainly with an eye on next March's regional elections. Although there is a reforming instinct in some parts of the French government, notably in the finance ministry and the prime minister's office, well-placed observers say that anything too likely to provoke public anger may still be blocked by Mr Chirac, whose instincts for survival are greater than those for reform.

In Germany too, there remain big barriers to change. Unsurprisingly, people's eagerness for reform drops when they are told they must share the pain. And the idea of social equality is still as central for Germans as, say, personal liberty is for Americans. Mr Schröder's commitment to reform may be stronger than Mr Chirac's, but past experience suggests that it cannot be relied on.

Despite this, the two countries may go further than they would have on their own, as peer pressure comes to bear. So which will go furthest and fastest? At present, Germany is in the lead, concede the French. Yet this could change, even if Mr Schröder wins his Bundestag vote, as Agenda 2010 gets stuck in other bits of what Germans call the Politikverflechtungsfalle, or joint decision-making trap. It could turn out that the French, whose programme looks on paper to be the less ambitious of the two, manage to manoeuvre more of it through in the end.

Conversely, a failure of the French and German reforms would be a watershed, perhaps as significant as the emergence of the welfare state in both countries. In a way, this is the last chance to modernise the social-market economy without abandoning it.

If the reforms succeed, and their economies pick up, France and Germany may yet surprise with a strong performance after years of relative weakness. If both countries would fully embrace labour- and product-market reforms, the International Monetary Fund has calculated that their GDP could be 10% higher than otherwise. There is, in other words, a high upside risk very much worth taking.

The German and French governments are, belatedly, reforming their economies. But will they overcome inevitable opposition to change.

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