LONDON – France played a decisive role in shaping not only the euro system but the entire European project. This history has predisposed French leaders to the goal of preserving the euro at all costs. Those costs, as we explained in Part 1 of this article, have become quite insupportable. A new strategy is needed, and France’s role in shaping it will once again be pivotal.
France sits on the fault line between the euro system’s deficit and surplus countries. It runs a large and costly welfare system with high-quality public services, often referred to as the French model, founded on a deep and dearly held national consensus.
But unlike the Scandinavian countries, which have a similar preference for expensive welfare, the French model has been financed not by high taxes on income and spending, but by punitive taxes on employment (notably through employers’ social-security contributions) and capital, and by heavy public borrowing. Public debt has surged to about 90 percent in 2012 from about 64 percent of gross domestic product in 2007.
This emphasis on taxing employment has been the path of least political resistance. It maintains the illusion of a welfare state financed by business, not citizens. The idea that taxing companies is a painless way to finance welfare and public services has reaped chronically high unemployment, eroding competitiveness, weak growth and living standards that are stagnant at best.
The Ile-de-France region has the highest average labor cost in Europe. The problem is aggravated by excessive regulation — of labor, and of markets for goods and services. Transport, professional services and retailers are more heavily controlled in France than in most other rich countries. The result is higher prices, and higher costs.
This burden stifles entrepreneurship. President Francois Hollande’s tax assault on high incomes, dividends, capital gains and wealth isn’t helping. Business sentiment is falling fast. In the past decade, France’s share of export markets has dwindled. The country is running a current-account deficit.
The French economy needs a “supply-side shock.” That’s what last year’s report by Louis Gallois — a leading, left-leaning industrialist — recommended. Instead of the deep and permanent cut in social levies on business urged by Gallois, the government announced a complicated system of temporary tax credits, conditional on the rebated cash being used to invest and recruit new workers. This approach cannot correct the tax system’s gross and long-standing distortions. In any case, the proposal’s complexity means that companies won’t get relief until 2014-15.
In January, employers and trade unions signed an accord that lightens labor regulation and gives businesses more flexibility to reduce working hours and wages in return for preserving jobs. That’s something, but most other new measures to boost competitiveness boil down to new forms of dirigisme. Instead, France needs fundamental structural reform — lower public spending and a shift in taxation from employment to consumption.
But there’s a catch — and it’s a big one. The immediate effect of such a program would be weaker domestic demand and slower economic growth. Compensating pro-demand forces also need to be set in motion. The government could do this by easing the short-term fiscal stance and tapping external demand through currency depreciation, but neither is possible in the euro system: The deficit rules constrain fiscal policy, and France no longer has a currency to devalue. Since nothing else can give way, the euro system will have to.
For France and for the euro system as a whole, the best strategy is to dismantle the monetary union from the top — via the exit of Germany and the other most competitive countries. Appreciation of the new German currency would improve the deficit countries’ trade balances.
In some cases, debt write-offs would still be necessary, but the scale of reduction and the cost to creditors would be smaller because the monetary dismantling would boost the deficit countries’ growth. The surplus countries would have to recapitalize their banks after losses due to any debt reduction, so exiting the system doesn’t mean abandoning the crisis countries. The difference is that, after the exits, their assistance would help put the deficit countries on a recovery path, whereas the current bailouts lead only to a dead end.
The European Central Bank would have to strive to maintain credibility and trust during any controlled dismantling of the euro system. The ECB could be preserved, at least for some time, as the central bank responsible for monetary policy in all 17 member countries, even after some had replaced the euro with new currencies.
This would facilitate strong policy coordination among the former members and demonstrate that the segmentation was an orderly transformation carried out under the control of the most respected and credible European institution.
Many observers concede that the euro was a mistake but think there’s no going back. They reckon that dissolving the monetary union would lead to economic chaos, first in Europe, and then around the world. European leaders are afraid that backtracking on the euro project would also be a lethal blow to the larger cause of European integration and could be the beginning of the end of the EU and the single market. These fears give rise to what we regard as the disastrous strategy of defending the euro at all costs.
Although a controlled segmentation of the euro system through the exit of the most competitive countries would actually be the most effective way to help the deficit countries, it could still be seen as a decision by the strong to abandon the weak. Europe’s history makes it difficult for Germany’s leaders to initiate such a move.
The deficit countries, struggling with recession and internal political divisions, and trying to get better terms for assistance from the rest of the EU, might be afraid of worsening their negotiating position by taking the lead. EU institutions, such as the European Commission and the ECB, couldn’t propose the solution we advocate.
French leadership in advancing this idea might work — and could be the only thing that will. France has played the leading role in EU integration for more than 50 years. The euro is very much a French product.
In 1990, President Francois Mitterrand won Chancellor Helmut Kohl’s support for the single European currency in exchange for France’s acceptance of German unification. Persuading Germany to give up the deutsche mark, whose strength had given the Bundesbank de facto control of monetary policy throughout Europe, was a remarkable French success — or so France believed.
The euro was seen as the ultimate underpinning for the edifice of European integration. The financial crisis and its aftermath have shown that the euro instead has the potential to destroy the whole project. It impedes the reforms necessary to restore France’s fading international competitiveness. Retaining the present euro system whatever the cost will cripple the French economy, undo French social cohesion, and weaken France’s position in Europe and the world.
As Europe’s founding father, only France has the standing to advocate a strategy of dismantling the euro system for the sake of the European Union. The alternative is economic failure, deeper divisions and bitter resentments among Europe’s nations, putting the most valuable achievements of European integration at risk. One way or another, Europe’s house will be divided.
The question is how much, or how little, this division will sweep away. Splitting the euro in the way we advocate is vital to the survival of the European idea.
Brigitte Granville is a professor of international economics and economic policy in the School of Business and Management at Queen Mary University of London. Hans-Olaf Henkel is a professor of international management at the University of Mannheim and a former president of the Federation of German Industries. Stefan Kawalec is chief executive officer of Capital Strategy and a former vice minister of finance in Poland. The opinions expressed are their own.