Will Europe Be Willing but Disabled?

Mohamed A. El-Erian

02 July 2012


NEWPORT BEACHWhen it comes to describing Europe’s ever-worsening crisis, metaphors abound. For some, it is five minutes to midnight; for others, Europe is a car accelerating towards the edge of a cliff. For all, a perilous existential moment is increasingly close at hand.

Optimistsfortunately, there remain a few, especially in Europe itselfbelieve that when the situation becomes really critical, political leaders will turn things around and put Europe back on the path of economic growth, job creation, and financial stability. But pessimists have been growing in number and influence. They see political dysfunction adding to financial turmoil, thereby amplifying the eurozone’s initial design flaws.

Of course, who is ultimately proven correct is a function of eurozone governments’ willingness to make the difficult decisions that are required, and in a coordinated and timely fashion. But that is not the only determinant: governments must also be able to turn things around once the willingness to do so materializes. And here, the endless delays are making the challenges more daunting and the outcome more uncertain.

Experienced observers remind us that crises, rather than vision, have tended to drive progress at critical stages of Europe’s historic integration – a multi-decade journey driven by the desire to ensure long-term peace and prosperity in what previously had been one of the world’s most violent regions and the site of appalling human suffering. After all, the European Union (including the eurozone’s 17 members) remains a collective of nation-states with notable divergences in economic, financial, and social conditions.

Cultural differences persist. Political cycles are far from synchronized. And too many regional governance mechanisms, with the important exception of the European Central Bank, lack sufficient influence, credibility, and, therefore, effectiveness.

Left to its own devices, such a grouping is vulnerable to recurrent bickering, disruptive posturing, and disagreement over visions of the future. As a result, progress towards meaningful economic and political integration can be painfully slow during the good times. But all of this can change rapidly when a crisis looms, especially if it threatens the integrity of the European project.

That is where the eurozone is today. A debt crisis that erupted in Greece, the eurozone’s outer periphery, has migrated with a vengeance towards the core, so much so that the survival of the eurozone itself is at stake.

The more the policy response has lagged, the broader the set of questions about Europe’s future has become. Maintaining a 17-member monetary union is no longer a given. Talk of countries exiting, starting with Greece (the “Grexit”), is now rampant. And only hard-core idealists dismiss altogether the mounting risk of the eurozone’s total disintegration.

Nonetheless, many veterans of the European integration project see a silver lining in the dark clouds massing over their creation. For them, only a crisis can stop politicians from just kicking various cans farther down the road and, instead, catalyze the policy initiativesgreater fiscal, banking, and political union – that, together with monetary union, would ensure that the eurozone rests on a stable and sustainable four-legged platform.

But this view is not without its own risks. It assumes that, when push comes to shove, political leaders will indeed do what is necessary – the willingness question. It also presumes that they will have the capacity to do so – the ability question. And, over time, uncertainty concerning the latter question has risen to an uncomfortable level.

Today’s eurozone is beset by an unprecedented degree of rejection – on economic, financial, political, and social grounds – by citizens in a growing number of countries. The longer this persists, the harder it will be for politicians to maintain control of their countries’ destinies and that of Europe’s collective enterprise.

Private-sector activity is slowing, and it is nearing a standstill in the eurozone’s most vulnerable economy (Greece), where a bank run is in full swing.

Elsewhere, too, depositors are beginning to transfer their savings to the strongest economy (Germany) and to safe havens beyond (Switzerland and the United States). Weaker companies are shedding labor, while stronger firms are delaying investments in plant and equipment. And global investors continue to exit the eurozone in droves, shifting countries’ liabilities to taxpayers and the ECB’s balance sheet.

No wonder that social unrest is evident in a growing number of countries. No wonder that fringe political movements are gaining traction throughout the eurozone. And no wonder that voters in almost two-thirds of eurozone countries have turned out the incumbents in their most recent elections.

All of this serves to undermine the effectiveness of government policies – by reducing their credibility, clogging their channels of transmission to the economy, and making it difficult to offset the withdrawal of private-sector capital and spending. As a result, the market-based economic and financial systems that prevail in Europe, and that, not so long ago, were a source of significant strength, are losing their vibrancy.

I, too, am fond of metaphors. During a trip to the continent last week, I heard one that captures very well the key dynamic in Europe today.

The eurozone’s leaders are on a raft heading towards a life-threatening waterfall. The longer they wait, the more the raft gains speed. So the outcome no longer depends only on their willingness to cooperate in order to navigate the raft to safety. It also hinges on their ability to do so in the midst of natural forces that are increasingly difficult to control and overcome.

The message is clear. The current crisis might indeed eventually break eurozone leaders’ inherent resistance to compromise, collaboration, and common action. But the longer they bicker and dither, the greater the risk that what they gain in willingness will be lost to incapacity.

Mohamed A. El-Erian is CEO and co-Chief Investment Officer of the global investment compamy PIMCO, with approximately $1.4 trillion in assets under management. He previously worked at the International Monetary Fund and the Harvard Management Company, the entity that manages Harvard University's endowment. He was named one of Foreign Policy's Top 100 Global Thinkers in 2009, 2010, and 2011. His book When Markets Collide was the Financial Times/Goldman Sachs Book of the Year and was named a best book of 2008 by the Economist.

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Last updated:July 5, 2012 9:59 am

France: Ready to jump ship

Growing anxiety at moves to raise taxes on the rich reflects divisions over the Socialists’ response to the crisis
france, saint tropez.©Photoshot

Roger, a senior expatriate executive working for an international company in Paris, is thinking seriously of taking a walk down David Cameron’sred carpet”.

The UK prime minister last month riled France’s new Socialist government when he declared he would lay on a five-star welcome for anyone moving to London to avoid the tax re­gime promised by President François Hollande – including his election pledge of a 75 per cent marginal rate on incomes above €1m a year.

“I’m very happy in Paris. My wife and I love Paris. We came here by choice. But I’m reconsidering our situation given the changes in the pipeline,” says Roger, who declined to be identified by his real name.

More than the 75 per cent rate, it is a move to higher wealth and inheritance taxes that worries him – and what he perceives as a cultural hostility to the rich. “The anti-wealth rhetoric is just not encouraging. I’d rather be in a country where I don’t have to deal with that,” he says.

It is not just expatriates who are concerned. Henri de Castries, head of Axa, the insurer, is one of France’s most respected business leaders. “I’ve listened to Mr Hollande. He wants to see more growth and lower unemployment. He wants to see business prospering. We want to see that, too,” he says.

“The question is how to achieve these goals? There is no example, in modern economic history, of a country that has succeeded in reducing its deficits by bringing taxes to a confiscatory level. On the contrary, it leads to a decline in activity, and an increase in the deficits.”

The anxieties of business reflect a broader question about the bold policy stance Mr Hollande has taken since ousting Nicolas Sarkozy in May. The leader of Europe’s second-biggest economy – the only leading EU state headed by a socialist – has made waves across the continent with his determination to shift the focus of the battle against the eurozone’s crippling sovereign debt crisis from German-led austerity to promoting growth.

At home, he has struck a new tone with his insistence on making the wealthy and big companies bear much of the brunt of fiscal adjustment.

The issue is whether his approach risks alienating the business community just at the moment when the country is in desperate need of investment and growth to rally a seriously weakened economy.

France is not isolated from the rest of the world and Paris needs to be competitive,” says Guillaume Poitrinal, chief executive of Unibail-Rodamco, the European shopping mall group based in Paris.

“[Our] large companies provide business to small and medium-sized enterprises and are France’s best asset – they provide a large part of what’s left of economic growth today.

“I am sure that the government realises that if they are weakened vis a vis their competitors abroad, this would be a negative for employment, tax resources and economic growth.”

It was the banks that first felt the lash of Mr Hollande’s tongue when he declared that his “true adversary” was not Mr Sarkozy but “the world of finance”. The president, who has spent almost his entire career in the public sector or working for his party, once said: “I don’t like the rich.”

A few weeks after his attack on the bankers, he added the 75 per cent tax rate pledge, set to be introduced next year. On Wednesday, his government announced an increase in wealth and inheritance taxes, an extra tax on company dividends, a big rise in taxes on stock options, and surcharges on banks and petroleum stocksworth a total of €7.2bn. Further measures, notably to align taxes on capital with income tax levels, are promised for next year.

Beyond taxes, a decree will limit the salaries of the chiefs of state-controlled companies such as SNCF railways, and nuclear energy groups EDF and Areva, to €450,000. For Henri Proglio of EDF, this will amount to a cut of nearly 85 per cent. Ministers are talking of restrictions on plant closures and tighter employment protection.

Strong appeals from Medef, the employers’ confederation, for relief from high social charges on employment have met the response that labour costs are not the primary cause of declining competitiveness. Alarmed by the trend at a time when the eurozone economy is in crisis and growth has stalled, Laurence Parisot, Medef boss, said last month: “We fear a systematic strangling.”

The chief finance officer of a big industrial company says the first question asked by investorsFrench and foreign – is now about the government’s policies and whether the tax rises will affect senior management. But he says the main effect will be to drive away owners of smaller businesses who fear not being able to cash in their wealth when they want to sell their companies. “It will be like the UK in the 1970s,” he says. “We will lose a generation and they won’t come back.”

Philippe Kenel, partner at Swiss-based tax lawyers Python & Peter, says that he relocated 12 people from France to Switzerland up to the end of Apriljust before Mr Hollande was elected. “I did in four months what I usually do in a year.”

Roger says another danger is that foreign managers will no longer be drawn to the country. “In the past five to 10 years, French companies have been attracting more international talent. But who would want to come to Paris to run a company in the current environment?”

So far, the government has shown little sympathy for these concerns. “The liberal and financial model has ravaged our industry. It also pushed the world into the worst crisis since 1929. All this must change,” said Arnaud Montebourg, the minister in charge of industry, in an interview in Le Parisien newspaper this week.

The tax hikes are a central part of the government’s political and fiscal strategy. Mr Hollande insists it is only fair that the wealthy and big companies shoulder a large part of the fiscal burden. It is an important argument if he is to retain support, particularly within strongly anti-austerity Socialist ranks, for the public spending cuts and broader tax increases needed to haul down France’s debt, which is set to exceed 90 per cent of gross domestic product this year.

The president has always been clear that the 75 per cent tax rate, which he says will affect only 3,000 households, is much more important as a symbol to deter excessive executive pay than as a revenue-raising measure. But James Johnston, private client lawyer and head of the French group at London-based Bircham Dyson Bell, expects the increase to lead to the departure of wealthy French citizens to the UK, Switzerland and Belgium.

France already has one of the highest tax rates for high-net-worth individuals. A 75 per cent top rate of income tax would bring the total theoretical marginal rate of tax, with everything added in, up to 90 per cent. This is a rate that the rest of the world is not resorting to.”

François Pérol, chairman and chief of BPCE, one of France’s largest banks, and a former senior financial adviser to Mr Sarkozy, says: “We need to see what the details are before concluding it’s a catastrophe. If it’s a temporary measure, it will aim to create a consensus around other, more difficult reforms. If it’s structural, then I think there will be an impact on competitiveness because it will discourage people, such as young entrepreneurs, from setting up their own businesses.”

Government insiders insist Mr Hollande’s administration is far from the hotbed of radicals sometimes portrayed. They point out that plans to separate retail from speculative investment banking are no more than the Conservative-led UK government intends to introduce. A much-anticipated rise in the minimum wage was limited to just 0.6 percentage points above inflation, to the consternation of trade unions, taking it to €9.40.

Though Mr Hollande has avoided being seen in public with business leaders, senior figures known to be sympathetic to the government include Gérard Mestrallet, chief executive of GDF Suez, the big energy utility; Matthieu Pigasse, head of the French operations of Lazard bank; and Pierre Bergé, co-founder of fashion label Yves St Laurent. One of the president’s closest aides in the Elysée palace is Emmanuel Macron, a former Rothschild banker, who before the election was an enthusiastic adviser, particularly on financial issues.

Setting out his government’s programme to parliament on Tuesday, prime minister Jean-Marc Ayrault, said he recognised the importance of “creators, innovators and entrepreneurs”. He said: “I value business leaders and I know them. I salute their contribution to our economy. I do not confuse them with those who get golden parachutes or unscrupulous speculators.”

The administration’s industrial policy is focused on fostering small and medium-sized businesses, innovation, research and skills. It is introducing lower corporate tax rates for smaller companies and setting up savings vehicles to funnel private savings into industrial investment. Next year it launches a public investment bank with a brief to fund new and small businesses.

Despite the fears of Medef and others, Alexia de Monterno of the Montaigne institute, a Paris-based think-tank, says there are signs the government is prepared to address industry’s big concern about labour costs. As for its stress on “non-costcauses of flagging competitiveness, she acknowledges: “There has been a lack of investment and innovation, which has been a particular issue in the car industry, and there is a problem of vocational training, with a big gap between skills available and those needed by industry.”

With a solid majority in parliament to underpin his five-year term, Mr Hollande is not about to make a lurch to appease rumblings of discontent from the business world. Tensions between the two sides are likely to continue. Disagreement looms over a spate of industrial closures and redundancies some large companies have begun to unveil. They are under government pressure to limit the damage.

But, while some executives may head for Zurich or Mr Cameron’s red carpet, the biggest groups seem likely to hunker down, albeit warily. “We want this business to re­main competitive, and therefore we will watch very carefully all the steps that are going to be taken and we will behave accordingly,” says Mr De Castries.

Mr Poitrinal of Unibail-Rodamco commented: “At this stage, we have no plan to move our headquarters outside of France. And we hope that France will remain an attractive place in which to invest and to recruit and remunerate top people.”

The argument between French business and the new Socialist government about taxes and regulation reflects a shared concern over the serious erosion of France’s competitive edge during the past decade, which is compounding the effects of the current economic slowdown.

The signs are evident in a series of industrial redundancy programmes now emerging.

The government is braced for what trade unions predict will be the loss of some 45,000 jobs during the next few months, which comes on top of the disappearance of 350,000 manufacturing jobs over the past five years.

PSA Peugeot Citroën, which has struggled to match competition especially from German rivals, is one of the highest profile companies in trouble, with its unions predicting up to 10,000 job cuts. Last month Air France announced a restructuring plan to shed 5,000 jobs as it battles to overcome non-fuel running costs that are on average 30 per cent higher than those of its competitors.

The starkest illustration of France’s competitive problem lies in its trade deficit, which hit a record €70bn last year, while Germany ran a surplus of some €150bn.

The International Monetary Fund says France lost about 2.5 percentage points of world export market share in the past decademore severe than its peers. In the euro area it lost about 1.5 percentage points in the latter half of the decade, compared with a 0.25 percentage point loss for Germany. Industry’s share of gross domestic product shrank in the decade to 2010 to 16 per cent from 22 per cent.

The government stresses the lack of investment, innovation and skills as core issues, but French business blames high labour costs for much of the problem.

A big chunk of the country’s large social welfare programmes are financed by charges on employers and employees. A recent European Commission report said the implicit tax rate on French labour was 41 per cent, one of the highest in the EU.

Philippe Varin, Peugeot’s chief executive, has estimated that in 10 years the hourly cost of a worker has risen 31 per cent in France, compared with just 19 per cent in Germany.

Fitch, the rating agency, commented in May: “The room for manoeuvre for further increasing the tax burden is limited by the need to strengthen France’s international competitiveness.”

One effect has been a sharp decline in profitability, by 50 per cent since 2000 for industrial companies, according to the GFI, an industrial sector association. French companies tend to absorb slowdowns by cutting profit margins because restrictions on shedding labour and high charges on employment limit their ability to adjust costs.

Copyright The Financial Times Limited 2012.