Home > Fiscal Policy, Growth, Structural Reforms > Austerity is Bad for Competitiveness

Austerity is Bad for Competitiveness

December 20, 2012 Leave a comment Go to comments

I wrote this piece with my friend Jean-Luc Gaffard. It is part of our ongoing thinking on the early steps of the new French administration. But I think it applies beyond France.


The French government faces a double challenge. The short run effects of the euro crisis compound a long-standing problem of competitiveness: from 1997 to 2012, the French market share fell from 5.3% to 3.3% of world exports. France is therefore suffering more than its neighbors, notably Germany, for the current slowdown.

In response to these challenges, François Hollande designed a two-arms strategy. First, he embraced austerity. To reduce public deficit to 3% next year, the French government presented a shocking 36 billion euros budget law for 2013. That will be mostly composed of tax increases. The second arm of the government strategy, a “competitiveness pact”, was, initially, aimed at shifting an important part of the burden of social security (20 billions euros) from firm contributions to the general taxation.

It is good news that the problem of competitiveness has made it into the government’s priorities.  Trade imbalances, at the world level, contributed to the weakening of the world economy prior to the crisis. And for France the persistent trade deficit is of greater concern than public deficit. In a developed economy competitiveness primarily rests on companies’ ability to occupy a technological or market niche. Few would argue that Germany’s success today depends on its costs rather than on its capacity to be competitive in high value added sectors. But regaining this type of non-cost competitiveness requires investment and time. Furthermore, non-cost competitiveness is not independent of immediate cost competitiveness. Restoring acceptable profit margins is a necessary, although probably not sufficient condition for a return to non-cost competitiveness. This requirement is all the more stringent today that obtaining captive markets through differentiation can often be very costly in terms of R&D and capacity building. Thus, the decision to reduce the tax wedge on firms is a welcome first step.

Problems emerge, nevertheless, when we look at the strategy as a whole. Shifting the burden of social security towards taxation, mostly indirect, impacts the purchasing power of households, already dented by the harshness of the crisis. The government seemed to be at least partially aware of this issue, when it announced that the competitiveness shock would be postponed to 2014 to avoid an excessive burden of taxation on households. The problem remains that competitiveness gains could remain a dead letter if final demand were to stagnate. Moreover, restoring margins per se is unlikely to result in a pick-up of investment in a contest of depressed demand, thus putting out-of-reach the non-cost competitiveness that must remain the final objective for the French economy. It is therefore a very risky gamble to implement the competitiveness pact in a context of austerity. Not only the two strategies are mutually inconsistent, but they risk to sum their negative impact and hence be self defeating.

François Hollande’s bet is to reconcile fiscal discipline and a return to growth. He seems to be confident in a recovery already in 2014, as if the on-going crisis was only a recession along a standard business cycle. Is he right? There are reasons to doubt. The latest IMF Economic Outlook forecasts a growth rate of just 0.4% in 2013. And in its fall forecasts, OFCE estimates that French growth will be curtailed of 1.7% of GDP if the austerity measures are implemented. This is not surprising: as the same IMF outlook acknowledges, the impact of austerity has systematically been underestimated in the past years, both in forecast exercises and in constructing budget laws across Europe. There is a case for arguing that, in today’s conditions, austerity is self-defeating, and disrupts the environment that is needed for improving non-cost competitiveness.

The unavoidable truth is that the frontloaded austerity effort mostly affects long-term investment, in human and physical capital, with the risk of making the competitive pact vain. The path chosen is narrow and, quite frankly, dangerous. It would have made more sense to implement the productivity shock right away, compensating its recessionary effects through appropriate fiscal measures; this would have meant a more gradual return to public finances equilibrium (which, incidentally, is also wished for by the IMF), but also better chance to succeed in the attempt to boost competitiveness.

One may argue that the French government had no choice. “External constraints” (financial markets, European partners, the pressure of globalization) would prevent any policy different from austerity. It is undoubtedly true that few countries today can hope to have a significant impact on the world economy, and France is no longer one of them; but the European Union is. It is too often forgotten that the EU as a whole has sustainable debt and deficit levels; the solution to the old continent chronic growth deficit needs to be found at the European level, where a milder fiscal consolidation should go hand in hand with sizable investment efforts and reinforced industrial cooperation. For a large economy like the EU it would be an obligation, more than a possibility, to support its domestic demand and contribute to world growth. The continued austerity both in peripheral and troubled economies and in the stronger core to which France still belongs, have transformed the continent in the sick man of the world economy. We had a solution, the Lisbon Strategy, that was derailed by lack of resources. Contrary to the common wisdom, it is precisely at this time of crisis that we need to revive its objectives through substantial investment in the restructuring of our economies.

The recent controversial episode involving the Arcelor-Mittal plants at Florange is instructive. The French government considered temporary nationalization of the blast furnaces that Arcelor-Mittal is closing, in order to resell them to a company supposedly more apt to maintain the production of steel. Even abstracting from the competition issues that such a public intervention would have raised, it remains that as of today the lack of demand makes steel production not profitable. The misplaced focus on microeconomic issues when the problem is essentially macroeconomic is an illustration of the inconsistency between the long-term objective of growth and a short-term macroeconomic policy that could aggravate the crisis. Industrial policy, whatever its coherence, cannot counterbalance global forces leading to a depression.

François Hollande had raised the expectations of a number of other European countries, too small, and/or too indebted, to oppose the policies imposed by Berlin and by EU institutions.  The hope was that France could act as a catalyst and form a coalition of countries large enough to reverse the self destructive EU austerity.

The embrace of austerity disappointed these expectations both domestically and in Europe, and is a missed opportunity. Furthermore, we argued, it makes a solution to the competitiveness problems of France harder to find. We already saw this happen in Europe. France wants to head towards Berlin, but risks steering towards Athens.

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