There’s something missing from the eurozone crisis.
By now, we’re all getting very used to hearing about Greece, Italy and Spain’s problems. We also hear plenty about how irritated the German establishment is with its feckless neighbours.
But France – the second-biggest power in the eurozone – has been keeping a surprisingly low profile. Since the presidential election in the late spring it has fallen from the headlines.
Those who expected new President Hollande to pick a fight over austerity measures have been disappointed. Indeed, some have described his budget – which was announced on Friday – as the ‘toughest in decades’.
Trouble is, it’s tough in all the wrong places – it will squeeze growth without fixing France’s debt problem. That could leave an already heavily indebted France looking more and more like one of the dodgy ‘peripheral’ countries that everyone is so worried about.
The French market could be in for a hard time when the next panic rolls around…
The French Budget: Lots More Tax, and a Little Less Spending
Hollande has come up with plans to cut France’s deficit – the amount the government spends over and above what it gets in taxes each year – to below 3% of GDP by the end of next year.
It’s currently around 4.5% of GDP.
In all, it means finding €37bn in savings. That might sound like a recipe for pretty severe austerity measures. However, the trouble with his budget is that he plans to do most of the heavy lifting by raising taxes, rather than cutting spending.
The budget raises the top rate of income tax from 45% to 75%. It also increases the number of people who have to pay a wealth tax. These measures are supposed to raise around two-thirds of the €37bn. The other third comes from public spending cuts. It also increases the number of people who have to pay a wealth tax and raises business taxes.
Why is this a bad idea? Because these tax increases may not bring in any extra money. The economist Arthur Laffer came up with theory of the ‘Laffer curve’. He argued that, as income tax rates begin to rise, people adjust their behaviour by working less – they don’t see the point, basically. Eventually the lost labour outweighs the impact of the higher rate.
Wealth taxes are also a bad idea because they encourage people to move their assets outside the reach of the taxman. As my colleague Merryn Somerset Webb points out, most attempts to tax wealth other than through inheritance and property have either failed or have had to be scaled back.
The lack of borders in the European Union makes this problem even worse. Already several wealthy citizens have threatened to leave France.
The chairman and chief executive of LVMH Moet Hennessy, Bernard Amault, caused uproar when he took out joint Belgian citizenship.
Meanwhile, many French citizens in the banking industry and business are thinking of moving to London. Earlier in year [UK Prime Minister] David Cameron said that those fleeing the new top tax rate would be welcome in the UK.
French Bond Markets Could be Next to See Turmoil
Even as taxes are raised, Hollande has few plans to cut state spending. Indeed, the latest proposals assume French spending remaining at 56% of GDP – in other words, the state doesn’t shrink at all.
As Ambrose Evans-Pritchard puts it in The Telegraph, France has a Nordic-sized state, but ‘without Nordic labour flexibility or Nordic free markets.’
This means that France’s national debt is likely to continue to climb. Indeed, it is hovering around the critical level of 90% of GDP.
While this doesn’t necessarily spell doom, it is seen as the point beyond which it becomes significantly harder for a country to deal with its debt problems, as the weight of the debt starts to inhibit growth.
The weak short-term growth prospects for the French economy are likely to make this even worse. Even the government now thinks that overall growth will be just 0.3% this year and less than 0.8% in 2013.
However, even those predictions are seen as too rosy. Other economists see GDP rising by 0.1% this year, and a similarly weak figure next year.
Aggressively raising taxes will only make growth even harder to come by. In short, says Pritchard, Hollande ‘has served up the most drastic retrenchment in forty years, at the worst possible time, and in the worst possible way.’
So, overall, the French economy is a lot more vulnerable to disappointment than most. Investors still price it as a ‘core’ eurozone economy, but in many ways it’s more like one of the troubled southern countries.
We may not see a bond market panic over France in the near future – too many other nations are in a worse state – but there’s more scope there for disappointment than in most markets.
Matthew Partridge
Contributing Writer, Money Morning
Publisher’s Note: This is an edited version of an article that originally appeared in MoneyWeek
From the Archives…
Why This Crisis Still Has a Long Way to Run
28-09-2012 – Kris Sayce
We Said This Four Years Ago, But Nobody Would Listen
27-09-2012 – Kris Sayce
The Grave Mistake of Telling the Truth
26-09-2012 – Murray Dawes
The Mission Creep Destroying Wealth Around the World
25-09-2012 – Tim Price
He Wobbles, He Flails, He Prints
24-09-2012 – Nick Hubble
