REFORMS; INVESTMENT AND GROWTH: AN AGENDA FOR FRANCE

From a report submitted by Jean Pisani-Ferry to Emmanuel Macron, Minister for Energy, Industry and Digital Affairs

The most urgent challenge facing France remains the need to implement deep structural reforms. Only these will increase investment, create jobs and boost growth. Structural reforms are also the best way to rebuild the trust needed to provide the economy with effective credit once more. Reforms by Hollande's Socialist government since 2012 - such as modest re-workings of labor and pension arrangements go in the right direction but barely cover 10 percent of what needs to be done. Serious structural reform has yet to begin. Efforts must go beyond the deregulation of a few closed professions and easing of labor rules

Thus far reforms, however, have not broken with the piecemeal approach of the past, which results in two shortcomings: First, partial reforms often fail to provide enough clarity to economic agents – primarily employers and employees. As reforms often pave the way for further ones, it is hard to get a sense of the rules of the game, the direction for the future, and what policy initiatives imply for concrete individual decisions. This reduces the effectiveness of reforms.  Second, external perception of French priorities and directions remains blurred at best. Many outside observers simply see the country as having not reformed at all.

In many respects, France appears to stand at mid-point in its course of transformation. This is a source of both discomfort and uncertainty. In the years to come, French reform efforts should concentrate on three priorities each associated with a “cluster”. For each cluster, a critical mass of complementary actions should be taken that result in providing clarity and predictability.

Reform Cluster F1: A new growth model

 The French post-war economy relied heavily on a relatively stable industry structure and a combination of large, increasingly internationalised world-class companies and nationally oriented subcontractors. This model, which served the country well in the post-war decades, has now reached its limits:

• Larger companies, which have become global leaders in their fields, have reorganised their international value chains without necessarily giving a prominent role to their French subcontractors. This logic of global integration challenges the organisation of the economy.
• Innovation is increasingly taking place within open networks that involve established companies, start-ups and public labs. The potential for productivity gains derives less and less from within-firm improvements and increasingly more from the reallocation of resources across firms. This logic of the network economy requires a different economic, legal and institutional environment.

The new growth model should target an agile economy that rewards innovators bringing new ideas, products and techniques to the market and, at the same time, an inclusive social model that provides opportunities to workers throughout their professional career.

France has formidable assets conducive to embracing this model. As a result of efforts undertaken since the 1980s, its labour force is now much better educated and compares well to that of its neighbours, including Germany. France can also count on an innovation culture, excellent laboratories, a vibrant start-up scene and dynamic cities. But its scientific, economic, social, territorial and financial institutions have not yet adapted to the new model. These institutions are generally attuned to a more static economy and a more segmented society.

Reforms facilitative of this model cover a wide range of fields, from university policy to finance, but the most catalytic are probably those concerning the labour market and product market competition. Two tasks should be prioritised: first, build an effective flexicurity system; second, reform the framework for labour laws.

Reform Cluster F2: Lasting and broad-based competitiveness

The French tradable-goods sector as well as its manufacturing sector (which still constitutes the largest share of the sector overall) have weakened significantly over the last 15 years. Employment and value added have fallen markedly, corporate profits have dwindled and the share of French producers in global exports has declined. In comparison to Germany, both French exports and imports are low, which is indicative of the country’s limited insertion in global value chains. Even the number of exporting firms has decreased, from 130,000 in 2000 to 120,000 in 2013. In a nutshell, there are too few internationally oriented producers and their domestic production is not profitable enough. Consequently, French producers neither innovate nor export enough.

French labour costs in manufacturing are at the same level as in Germany, but French firms suffer from two handicaps. First, German producers can build on a reputation of high-quality products and sell their output at premium prices. Second, the price of other inputs (e.g., land, rents, professional services, transport, other services) is considerably higher in France. Only energy remains cheaper but the gap has narrowed as the bulk of higher German energy costs has been passed on to households.

Overall, in France, relative prices have in recent years consistently evolved to favour mostly sheltered sectors over the tradable-goods sectors; the opposite development can be observed in Germany. As a result, tradable-goods sectors in France have become less attractive for both capital and labour. This trend must be reversed.

Measures have been taken in France to strengthen competitiveness, first and foremost through the aforementioned cuts in social security contributions and other tax incentives such as the CIR, a tax credit for research. However, in the context of high taxes, high levels of public spending and a persistent deficit, there are no budget resources available for additional fiscal support to competitiveness.

More structural responses are needed in France, especially as real wage growth has remained relatively dynamic in spite of high and increasing unemployment levels. Whereas we might have expected compensation growth in France to slow down in response to worsening labour market conditions (as it has in other European countries), real wages exhibited considerable inertia. This has helped sustain demand in the short term, but in the medium term inertia contributes to prolonging competitiveness problems. There are fears that some of the benefits of the employment and competitiveness tax credit (CICE) introduced in 2013 are being passed on to employees in the form of higher wages.

Wage growth inertia results from a series of factors. These include mandatory annual wage negotiations at the company level, which derive from a context of high-inflation and create pressure for positive settlements even when there is no income growth to distribute.

Relatively tight labour market conditions for intermediate and higher skilled labour is another factor. Generous wage settlements achieved in globally active firms (for which France is no longer a major production base) also account for wage growth. An additional factor is the partial indexing of the minimum wage on average wages, which creates a feedback loop. More generally, the combination of very low inflation and downward nominal wage rigidity contributes to the inertia of real wage growth. (NB: Public-sector wages, which have not increased for more than four years, are not to blame.)

In a situation where tradable-goods firms have watched their profitability decline, a strong signal should be sent that steps are being taken to prevent real wages from growing at a faster pace than labour productivity. When fighting inflation in the 1980s, France was able to take significant and ultimately successful steps to end pervasive indexation. It should follow a similar route now.

We propose the following measures:

•  Reduce rents and promote efficiency in the non-tradable sectors. A series of actions should be taken to release land for construction in densely populated areas. Actions considered under Cluster 1 targeting improved efficiency and competition in services sectors would contribute to the same goal.
• The law currently requires annual wage negotiations at the company level (though there is no obligation to reach an agreement). However, inflation and productivity are both tepid, leaving little room (if any) for upward wage adjustment. Changing the legal requirements for the frequency of negotiations from an annual to a triennial basis (unless otherwise agreed upon by social partners) would send a strong signal that economic conditions have changed.
• Change the minimum wage indexation formula. The current formula automatically sets an annual increase in line with inflation plus half the average real wage increase. We believe that the real increase of the minimum wage should instead be made dependent on the overall increase of productivity in the economy. Indexation should be a way to ensure that the benefits of growth are shared, not a way to disseminate wage increases over and above productivity gains.  We propose French-German minimum wage convergence as a policy target over a ten-year horizon. Evolutions in both countries in the years to come should be consistent with this goal. For France, this would imply rebalancing the relative roles of the national minimum wage and the branch-level wage minima, which should be given a stronger role in wage-setting.

 In the medium term, these actions should be supplemented with more structural initiatives aimed at broadening the export base of the French economy. Tourism is a case in point, as are services such as higher education and health care, which are in high demand in emerging countries.

 Reform Cluster F3: A leaner, more effective state

 France is still subject to an excessive deficit procedure within the context of the Stability and Growth Pact. Given that discussions are currently underway between the European Commission and the Eurogroup on the measures needed to bring French public finances consistent with EU rules and on the corresponding timetable, elaborating on the French public deficit and debt within the context of this report would have little value added. We do note, however, that within the framework of the Stability and Growth Pact, France has no remaining fiscal space. Discussions on the pace and pattern of consolidation should take into account the aggregate balance between supply and demand in the euro area and actions taken by partner countries, but there is no room for additional demand support.

The size and effectiveness of government is, however, an issue we need to address. France has the second highest public spending-to-GDP ratio in the EU and one of the highest in the world. In 2014, the primary expenditures-to-GDP ratio (excluding interest payments on public debt) is set to reach 55% of GDP in France against only 42% in Germany. France’s high spending ratio in this regard can be explained in part by specific institutional features that result from social choices (such as, for example, the nearly exclusively public character of pensions). But, in part, it also results from inefficiencies.

France often relies on palliative public spending as a substitute to a more structural approach to its problems. Housing offers a case in point: corresponding public spending exceeds 2% of GDP, yet housing is certainly no more affordable in France than it is in Germany. Spending on employment offers another example: in 2012 (i.e., before the introduction of new tax credits) it exceeded German employment spending by about 0.7% of GDP. Differences in spending on unemployment support (resulting in part from higher unemployment) accounted for only half a percentage point. By the same token, public support to private-sector companies in the form of subsidies and tax credits amounts in France to another 4% of GDP.

These examples illustrate the broader point that reforms designed to improve the functioning of markets can contribute significantly to reducing public expenditure ratios.

Reforms should also address the organisation of government. As indicated by the OECD, in spite of its much higher public spending, France pays its teachers significantly less than Germany pays its teachers. Sustained wage restraint in lieu of fundamental efficiency-enhancing reforms carries the risk of eroding the quality of public administration and public services at a time when they play a major role in the overall economic and social performance of a nation. The French government suffers from costly overlaps between government levels, insufficiently targeted economic and an insufficient reliance on modern public management methods.

Public spending restructuring takes time. This raises credibility issues for the process. France in this regard suffers from a credibility handicap. As observed by its independent fiscal committee (the Haut Conseil des Finances Publiques or HCFP), over the last fifteen years medium-term targets set in the annual Stability Programmes have repeatedly been missed. As a result, policymakers run the risk of being compelled to introduce tax increases and spending cuts that deliver adjustment in the short run but do not improve structural efficiency and effectiveness.

 We suggest that France:

•  Set itself an overall goal for the primary government spending-to-GDP ratio. Reducing this from 55% in 2013 to below 50% in the years to come could be a sensible target that would provide for effectiveness and allow the government to fulfil the spectrum of responsibilities French citizens expect.
• Carry out a comprehensive medium term-oriented spending review. This should take into account short-term savings as well as the savings brought by efficiency gains, a better selection of policy priorities and the substitution of reforms to palliative public spending.
• Involve an independent fiscal body (presumably the HCFP) in evaluating the impact of expenditure-saving measures. This would help strengthen internal and external credibility.