Another domino falls as Hollande pushes France into depression

If French President François Hollande thinks he can assuage the bond markets by dishing out tax-heavy austerity instead of genuine reform, he has been given very bad advice.

By Ambrose Evans-Pritchard

7:24PM BST 30 Sep 2012

'Francois Hollande proposes nothing credible to restore France’s viability within EMU, or to stop public debt spiralling beyond 90pc of GDP.' Photo: Reuters

He does not tell us how he will stem the slide in France’s share of eurozone exports over the last decade, down from 17pc to 13pc, or what he will do about the disastrous swing in France’s trade balance from a surplus of 2.5pc of GDP to a deficit of 2.4pc since 1999.

He proposes nothing credible to restore France’s viability within EMU, or to stop public debt spiralling beyond 90pc of GDP. Instead he has served up the most drastic retrenchment in forty years, at the worst possible time, and in the worst possible way. And markets are supposed to applaud?

The budget will tighten discretionary fiscal policy by 2pc of GDP next year into the teeth of deepening depression, without offsetting monetary stimulus or exchange rate relief.

Mr Hollande likes to quote Leon Blum, the Popular Front leader of the interwar years. The reality could hardly be more cruel. He is replicating the disastrous deflation policies of Labour Chancellor Philip Snowden in 1931, before the Labour Party woke up to the delicious possibility that you could lift two fingers to the forces of reaction and leave the Gold Standard.
Worse yet, he is perilously close to re-enacting the desperate deflation decrees of Pierre Laval -- an ex-Socialist dreamer, pacifist, and utopian who lost his way, and ultimately cleaved too closely to foreign ideologies -- and like Laval he is doing so to uphold a fixed exchange system that is slowly asphyxiating his country and no longer makes any sense.

His budget is pro-cylical error of the first order, carried out to meet an EU deficit target of 3pc of GDP that has no economic logic and is plucked out of thin air to meet bureaucratic tidiness and enshrined like so much other idiocy into EU treaty law. The certain result will be hundreds of thousands of lost jobs.

"To save the dogma of single currency, they are imposing absurd hyper-austerity on France," said Marine Le Pen from the National Front, France’s unlikely apostle of Keynesian doctrine.

France now joins Italy, Spain, Portugal, Greece, Ireland, and parts of Eastern Europe in synchronized tightening, with the Netherlands and Belgium cutting too, all dragging each other down in a 1930s slide into the political swamp.

Mr Hollande has not been entirely passive. He threw his weight behind the Latin revolt earlier this summer, forcing German Chancellor Angela Merkel to sanction mass bond purchases by the European Central Bank. This would not have been possible in the Merkozy era, when Nicholas Sarkozy sacrificed all else on the altar of the Franco-German unity.

But he has not followed through and there were in any case two quid pro quos to this deal with Germany. One was that Spain and Italy must submit to Troika Hell before the ECB buys a single bond. The second was that France must submit to fiscal Hell.

Mr Hollande has his own motives for bowing to austerity demands. He learned the lesson as an aide to François Mitterrand that you cannot deviate too far from Germany if you share a currency peg. There will be no repetition of 1983, the epic U-turn or `tournant de la rigueur.

He may judge it tactically clever to get his recession out of the way early in the electoral cycle. If so, it is a very risky strategy.

Professor Jacques Sapir, director of the École des hautes études en sciences sociales in Paris, says the more likely outcome is a downward economic spiral, pushing the declared numbers of jobless from 3m towards 4m -- and the real number to 6m -- by the end of next year. The economy will not spring back of its own accord this time because the contractionary structure of EMU has jammed the mechanism.

Prof Sapir fears global markets will turn on France with "full fury" before long, at which point events will slip entirely beyond political control. "François Hollande is making a dangerous bet that he can only lose," he said.

The French economy has already been in quasi-slump for five quarters. Dominique Barbet from BNP Paribas says the latest crash in the manufacturing PMI index to 42.6 -- the lowest since April 2009, and lower that at any time in the dotcom bust -- is "potentially alarming".

Indeed it is. Data collected by Simon Ward at Henderson Global Investors shows that a key leading indicator of the money supply --`six-month real M1 money -- is now contracting even faster in France than in Spain. The shock will hit over the winter. "The budget looks increasingly misguided and self-defeating," he said.

Mr Hollande thinks his budget will safeguard jobs. The fiscal burden will fall on the rich with a top tax rate of 75pc, and on industry.

Barclays Capital says three quarters of the total will come by raising revenue, with the taxes "front-loaded" while spending cuts are "back-loaded". The ratio of taxes to gross wages will rise to an all-time high of 46.3pc. (Finance ministry estimates).

Harvard Professor Alberto Alesina says this flies in the face of all we have learned about austerity. "The accumulated evidence from over 40 years across the OECD speaks loud and clear: spending cuts are less recessionary than tax increases," he said.

France above all screams out for a blast of tax-cutting Thatcherism and pension reform. The International Monetary Fund says the country’s "tax wedge" - or tax as a share of labour costs - is one of highest in the world at almost 50pc.

Just 39.7pc of those aged 55 to 64 are in work, compared with 56.7pc in the UK and 57.7pc in Germany. Early retirement incentives are to blame. "French workers spend the longest time in retirement among advanced countries," says the Fund.

France coasted through the last decade, losing 20pc unit labour cost competitiveness against Germany as it screwed down wages and pushed through the Hartz IV reforms. French industry has been losing 60,000 jobs a year for a decade. Manufacturing has shrunk to 12pc of GDP, as bad as Britain.

Renault chief Carlos Ghosn warned last week that France’s biggest car company would "cease to exist" in its curent form unless there was a radical change in the country’s work climate. "Not over three or six months perhaps, but over three years, or five years, yes, the danger is real," he said.

The whole economic structure of France is an anachronism in a Chinese world and a German currency union. "We are consuming the leftovers of a past prosperity," says Jean Peyrelevade, ex-head of Credit Lyonnais.

Sovereign debt strategist Nicholas Spiro says growing doubts about the "credibility of French fiscal and economic policy" may soon bring Mr Hollande’s strange honeymoon to a close. It is a widely-shared view. Danske Bank’s bond team sees a "significant risk that the market will turn on France in 2013".

Huw Pill from Goldman Sachs said the detonator may be activation of the European Stability Mechanism to bail out Spain and then Italy.

The potential ESM demands are too large for the "vulnerable core" of France, Belgium, and Austria. Their own fiscal health would come under the microscope. The shock would push them "from one equilibrium to another."

Mr Hollande has swallowed the argument that drastic cuts are the only way to cap debt at 90pc of GDP and keep the debt trajectory under control.

Yet we already know from Greece, Ireland, Portugal, and Spain that fiscal shock therapy makes little dent on the deficit without monetary shock absorber. It causes nominal GDP and the tax base to shrink, making debt ratios even worse.

France does not have to put with destructive 1930s policies imposed by Germany. It is not a vassal state. It remains a great nation, the beating heart of Europe and the EU’s balancing force.

It can break out of this awful trap by leading a yet more determined Latin revolt, this time marshalling its voting majority in the Council to force an end to contractionary policies.

A French-led growth bloc can strike back by inflicting an intolerable level of inflation on Germany. It can if necessary cause the North Europeans to walk out of EMU altogether -- the optimal solution for the North and South respectively.

For that, Mr Hollande must be willing to abandon the Franco-German condominium, the central tenet of French foreign policy for almost sixty years. The cautious, plodding Enarque from the Limousin is not the type for fireworks, but give him time.

10/02/2012 12:38 PM

'Dangerous Territory'

Concerns Mount that ECB Bond-Buying Program Is Illegal

By Christian Reiermann

The markets have celebrated Mario Draghi's announcement that the European Central Bank will embark on unlimited purchases of sovereign bonds from crisis stricken countries. But are such purchases really legal? Draghi's own justification for the program leaves plenty of room for doubt.

European Central Bank President Mario Draghi is spending a lot of time on the road these days, not unlike a traveling salesman. The product he has on offer is credibility, but in Germany at least, it is proving difficult to find eager takers.

Last week, for example, Draghi gave a speech to several hundred business leaders at the Berlin Congress Center -- and the mood was reserved. German business owners still have fond memories of the old deutsche mark, and Germany's central bank, the Bundesbank, still has a good reputation.

Draghi's recently announced plans to launch unlimited purchases of sovereign bonds from crisis-stricken euro-zone member states, on the other hand, are being met with disconcertment and concern.

"These new steps are not a departure from our mandate," Draghi told German industrial leaders. The ECB, in other words, isn't just focused on price stability, but is also engaged in "ensuring the proper transmission of monetary policy." Beyond that, though, concerns are unfounded. The moves made by the ECB, Draghi insisted, "do not aim to finance governments, and nor would they if they were activated."

Draghi, of course, was not as concerned about those gathered in the room before him as he was about a man sitting 425 kilometers (266 miles) away in Frankfurt: Bundesbank President Jens Weidmann. Weidmann believes that, with its bond purchases, the ECB will help euro-zone governments gain access to funds at attractive rates by pushing down interest rates on those bonds. But that, in Weidmann's view, is fiscal policy rather than monetary policy and is thus outside the ECB mandate.

A Difficult Question to Answer

The duel between Draghi and Weidmann is not new, but it has become more pointed of late. And its importance would be difficult to overstate: It has to do with the future course of the ECB and, with it, one of the world's most important currencies. Does the ECB's bond-buying program fall into the category of monetary policy consistent with the bank's mandate of maintaining price stability? Or does it step over the line into fiscal policy by intervening in countries' efforts to obtain capital, which it is expressly forbidden from doing?

It's a difficult question to answer. There is, after all, no clearly defined boundary where monetary policy ends and fiscal policy begins.

The ECB is prohibited from directly purchasing bonds from governments, and yet purchases on the bond markets are among the instruments at its disposal. It is permitted to make such purchases, but only for reasons of monetary policy, such preventing deflation, for example.

Bond purchases are a treatment with side effects. Falling interest rates on sovereign bonds reduce the cost of government borrowing. The question is whether these side effects are the real motivation behind the ECB decisions, while the arguments surrounding monetary policy are merely a pretext. In that case, the purchases would be little more than government financing in disguise.

Germany's Federal Constitutional Court could very well be of the same opinion. In its recent ruling on the European Stability Mechanism (ESM), the court did not fail to express its skepticism of the bond purchases. The court will address the legality of the bond purchases in upcoming proceedings.

Even then, however, the German court will likely refer the case onwards to the European Court of Justice, which will then be forced to decide whether the central bank is still acting within the bounds of its mandate. Both the ECB and the Bundesbank are already preparing for the legal battle and are reviewing the legal underpinnings of their respective positions.

The Weakness of His Argument

Draghi and the majority of the ECB Governing Council argue that high interest rates on government bonds also make borrowing more costly for businesses, consumers and homebuyers, despite the central bank's current low interest-rate policy. By buying government bonds on secondary markets, the ECB hopes to push down rates on the credit markets.

During his speech in Berlin, Draghi insisted that the ECB must ensure that interest rates do not continue to drift apart within the euro zone. He noted that it is unacceptable for businesses and consumers to have to pay varying levels of interest on their loans within the same monetary zone, depending on the country. A company in Germany, he said, pays 3 percent for a five-year loan, while its Italian competitor pays 5.5 percent. A German home builder can borrow money at 3 percent interest, while a Spaniard pays 7.5 percent.

"In these circumstances, monetary policy cannot work properly," Draghi told his audience. "The ECB's Governing Council therefore faced a choice: to accept this situation and allow the singleness of its monetary policy to be undermined; or to take actions within its mandate to restore the normal transmission of monetary policy across all parts of the euro area. We decided in favor of the latter."

But it is precisely such examples that reveal the weaknesses of his argument. Draghi claims that the monetary cycle is disrupted and the credit supply to the economy is jeopardized if there is a 4.5 percent difference between interest rates for comparable real estate loans in different countries. Yet if that were the true cause of his concern, he would have had sufficient reason to intervene in January of this year.

At that time, there was a 6 percent spread between interest rates for German and Spanish housing loans. But that was precisely when the ECB, under the leadership of its new president, Draghi, allowed the first bond-purchasing program to expire. In the ensuing months, the ECB also saw no reason to step in, even though the spread between German and Spanish housing loans was higher than in July, when Draghi perceived the difference as alarming.

Compelled to Intervene?

Draghi also deftly chose his example for business loans. It applies to loans with terms of five or more years. The situation is more favorable for other commercial loans.

This becomes apparent when additional business loans are taken into account. The comparison shows that there have frequently been substantial spreads in interest rates in the history of the euro. This occurred most frequently at the beginning of the monetary union. But it has been a repeating phenomenon even in more recent years.

The average deviation from the mean interest rate serves as a benchmark for comparisons. Statisticians refer to this value as the standard deviation. This value is currently at about one for all commercial loans within the euro zone. It was higher at the beginning of 2005, that is, the deviation was larger. In September 2009, there was a 2.6 percent spread between Finnish and Portuguese interest rates for commercial loans, similar to the difference between German and Italian rates today, and yet the ECB did not feel compelled to intervene in the market.

Similar comparisons can be made for other types of loans. Mortgage rates in relatively healthy countries like Germany, France and the Netherlands, on the one hand, and crisis-ridden countries like Greece, Spain and Italy, on the other, are currently closer together than they were in 2004.

The standard deviation for these loans is currently about 0.9, as compared with 1.1 in February 2005. A similar development can be seen in consumer loans.

Draghi and his experts at ECB headquarters in Frankfurt are aware that history would seem to make their current alarmism appear questionable. Yet their only admission of that fact can be found in a brief aside buried within an expert opinion in the ECB's August monthly report. The 22-page opinion explains the alleged imbalance in the interest rate mechanism. The spread in interest rates has grown since 2010, they note, however "it is still significantly lower than the level observed before the crisis, especially in the period 2004-06." The ECB does not explain why it did not intervene then.

'Into Dangerous Territory'

This suggests that Draghi's objective is in fact not to achieve low interest rates for businesses, consumers and home builders, but that he has a different clientele in mind: the governments in Madrid and Rome.

It is also difficult to use concern over interest rates for businesses and homebuyers as justification that the ECB only buys government bonds when the country in question submits to an ESM restructuring program. Do political decisions suddenly make the need for monetary policy intervention more acute? Hardly.

"The ECB's argument that the bond purchases have to do with monetary policy is a pretext," says Jürgen Stark, the central bank's chief economist until the end of last year. "If the transmission mechanism of monetary policy is indeed disturbed, the ECB must intervene, irrespective of whether or not a country has subjected itself to a bailout program."

For Stark, who resigned in protest over the ECB's first bond-purchasing program, a red line has been crossed once again. "We are talking about the financing of governments here," he says. That, he points out, is in violation of European Union treaties. "The ECB is operating outside its mandate," he concludes.

Academics share his assessment. "Common sense tells us that the ECB, with its purchasing program, is doing something completely different from expressing its concern over price stability," says Clemens Fuest, a professor of economics at the University of Oxford. According to Fuest, the ECB, following the example of the International Monetary Fund, is upgrading itself to a European bailout institution, which provides assistance based on certain conditions. It loses its independence as a result, says Fuest, because it can hardly refuse to provide assistance if its conditions are met. "The ECB has overstretched its mandate," Fuest believes.

Even supporters of the bond-purchasing program are critical of Draghi's approach. "The ECB should have continued to cite market failure as justification for its purchases," says Peter Bofinger, a monetary expert at the University of Würzburg in southern Germany and a member of the German Council of Economic Experts which advises the government on economic issues. "Then it could have intervened whenever it felt it was appropriate."

Instead, says Bofinger, the central bank is making itself dependent on the decisions of politicians and on the bailout fund. "In doing so," Bofinger explains, "the ECB is increasingly getting into dangerous territory."

Translated from the German by Christopher Sultan