European reforms: A Franco-German beauty contest

Date: 18/10/03

Jacques Chirac and Gerhard Schröder still have lots of economic reforming to do

EUROSCLEROSIS. An ugly word, coined for an ugly phenomenon in the 1980s, is back. The heady days of January 1999, when Europe's new single currency, the euro, was hailed as a certain harbinger of economic revival, are a distant memory. In fact the performance of the 12-country euro area over the past five years has been a bitter disappointment. And at the heart of that poor performance lie France and Germany, which account for roughly half of euro-area GDP. Unless France and Germany recover their zip, the euro area will be condemned to remain an under-achiever.

That is why the current debate over economic reform in the two countries matters so much. On October 17th, after this newspaper went to press, the German Bundestag was expected to approve, albeit by only a tiny majority, a set of labour-market and tax changes that are central to Chancellor Gerhard Schröder's “Agenda 2010” economic-reform programme. In France, the government of President Jacques Chirac is pursuing its own reforms, which it cheekily calls “Agenda 2006”. Both countries' governments face opposition to their proposals from political rivals, public-sector workers, trade unions and others. For Europe's sake, they must defeat that opposition and continue their reforms.

Various explanations have been put forward for the sluggishness of Europe's biggest economies. Some pin the blame on the European Central Bank, for its overly tight monetary policy. Real interest rates have indeed been uncomfortably high in Germany, where inflation is dangerously low; but other economies in the euro area have done better, and average euro-area inflation remains over 2%. A stronger case can be built against Europe's “stability and growth pact”, which has kept fiscal policy in both Germany and France tighter than it should have been. But in practice both countries have readily breached the supposedly inviolate ceiling for budget deficits of 3% of GDP. In any case, experience suggests that fiscal stimulus is not the best long-term route to growth.

A third culprit is the after-effects of German unification. Partly because it happened more than a decade ago, this is now easy to forget. Yet, thanks in large measure to the mistaken decision not only to equalise the western and eastern currencies but, worse, to equalise most wages and benefits, the eastern Lander of Germany have continued to act as a huge sponge, soaking up German public subsidies, and sucking down the economy's competitiveness and growth. That in turn has dragged down the rest of the euro area.

Even unification can no longer take the main blame for Germany's (and hence France's) sclerosis, however. Over the past ten years, the British economy, once the sick man of Europe, has grown at an annual average rate of 2.9%. In Germany, once the continent's Wirtschaftswunder, the equivalent figure has been a meagre 1.3%. Macroeconomic, demand-led differences, such as monetary and fiscal policy, and even the strains of unification, can account for only a small part of this big gap. The bulk of it must have microeconomic, or supply-side, causes. Specifically, rigidities in labour and product markets in France and Germany, aggravated by high taxes and social-security contributions, have discouraged investment and the hiring of labour, keeping growth down and unemployment high.

The reforms now proposed in Germany and in France represent the first joint effort that the two countries have made to begin remedying these failings. Starting with pensions and labour markets, and moving on to health care and social security, the two governments are partly co-operating, partly competing to outdo one another. Such rivalry is welcome and could prove highly productive, as in both countries there is now a political opportunity for reform. At present, Germany seems to be in front; but there are reasons to expect that France may in the end move ahead. Even Italy, the euro area's other poor performer, has started to make reforms, though it has further to go than the big two.

There is another pressing reason for pushing forward with reform: the strength of the euro. In the currency's early days, its relative weakness helped to keep the continental economies growing by boosting exports. But that may also have allowed reluctant reformers to put off hard choices. With every likelihood that the dollar will continue to weaken, such a let-out is no longer available. A rising euro will make the case for economic reform in Europe even more urgent.

In others' footsteps

The doubt on which opponents of reform play is simple and seductive. They maintain that countries such as France and Germany should accept lower growth (and higher unemployment) as a price worth paying to sustain the perceived benefits of the “European social model”. Rather preserve the warm comfort of that model, they advise, than embrace the cold logic of the American way, even if this yields faster growth.

Yet this is a false choice. To see why, the French and Germans need only look at some of their European neighbours, such as the Netherlands, Finland, Denmark and Sweden. These countries - two in the euro, two out of it but still dependent on euro-area growth - have reformed their labour markets, increased their competitiveness and improved their social-welfare systems, all without sacrificing the essence of their protective social model. All bar Finland now have lower unemployment than America. Small countries may find reforms easier to make. But given enough political will, France and Germany should surely be able to copy their example.

Lack of it is still the biggest obstacle to economic reform in Europe. Neither Mr Schröder nor Mr Chirac has anything like the zeal for change that Margaret Thatcher demonstrated to such effect in Britain in the 1980s. Both have put off reforms for as long as they can. Both have backed down in the face of opposition to change in the past. Ominously, Mr Schröder this week conceded some last-minute watering down of his social-security reforms to buy off left-wing rebels. Yet the good news is that, in both countries, public opinion has swung in favour of economic reform. The two leaders should seize the moment to press on while that public mood lasts.

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