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Monday, January 14, 2008

The French Economy Is Back At Number 5 Globally

Well, following the good results for French GDP produced in Q3 2007 (as detailed in this post here) - and the weakening performance of the UK economy as the credit crunch starts to really bite, we have a surprising result:

"The size of the British economy has slipped below that of France for the first time since 1999 thanks to the slide in the value of the pound. Sterling’s rapid fall to 11-year lows against European currencies has also pushed Britain into sixth place in the world. The US, Japan, Germany, China and France all had larger economies than the UK in the third quarter of 2007."

Basically the facts behind the story are that in 2006 French GDP was worth €1,792bn compared with £1,304bn for the UK. With sterling worth €1.47 on average in 2006, this put the UK economy comfortably 6.7 per cent ahead of the French one. But with sterling on the slide - it has fallen by more than 10 per cent against the euro in the past six months (to the current €1.32 to the pound), the UK economy entering 2008 is now 4 per cent smaller than France's.

Now this sea change is very likely to produce all kinds of politically motivated commentary, but in economic terms most of that is beside the point. What we have here are two, distantly connected, phenomena. In the first place there is a major currency realignment taking place as I write, and in the second we have very different changes in population growth rates and relative age structures from one developed economy to another at this point (more on this below). If we examine the currency allignment problem first, then we should note that initially this re-alignment produced a steady decline in the value of the dollar and the yen, and a consequent upward movement in the pound sterling and the euro (amongst other developed economy currencies like the Canadian and Australian dollars). But with the new credit conditions some of these previous valuations are no longer really justified, and sterling has been the first to feel the pressure. Those who are in countries which form part of the eurozone should try to avoid any feeling of glee or excess of mirth at this point though, since in all probability the euro will be the next to head south, as housing related crdit crunch issues take their toll in construction driven economies like Ireland and Spain, while the low trend growth ageing societies (Germany and Italy essentially) begin to feel the pressure on exports which comes from the rise in the euro and the slowdown in the global economy (not to mention difficulties which may arise in the context of any large East European correction).

In all probability will all come to a head as and when the ECB have to change course and start to reduce interest rates (as Claus indicates in this post), and at that stage we should expect round two of the currency adjustment (or transition from Brettton Woods II to Bretton Woods III) to lock-in, as the whole batch of developed economy currencies are realigned with the big new players in the emerging economy scene (the yuan, the rupee, the real, the Turkish Lira etc, as explained in this post here). So, with relative currency values set to change and change again (this is what they call volatility), it is hard to draw any meaningful conclusions from this new comparative readout between France and the UK. Other, of course, than to stress that it is always foolish to make too much out of short term transitional currency dynamics.

Institutional Reforms and Demographics

But there is a bigger picture story here, and that is to do with the fact (as Claus tried to sketch out here) that France is far from being the "sick man of Europe" in economic terms, and this is the result of some very important underlying macroeconomic structural features.

This view must surprise some people, since it is obviously a long way away from a lot of conventional wisdom which is being written on the matter. Basically, if you follow the institutional reforms discourse, then the UK should be streaking ahead of France following the latters failure to grasp the nettle and "reform" itself (something, please note, that the present author considers highly desireable in and of itself). But such reforms only focus on micro level phenomena, and do not take into account certain key macro economic trends, and in particular they seem almost never to take into account important macro level phenomena like comparative demographic shifts. What this means quite simply is that something here isn't being measured as it should be, and the outcome is bad results and bad forecasts.

This use of bad arguments (or at best partial ones) also makes it very difficult to persuade some people - in this case French voters - to do something that they are evidently very reluctant to do, and that is support the reform process. When your key argument is flawed, and you can't point to the benefits you would like to point to. This has also recently been made very clear by those eternal "bette noires" of the international financial institutions - Argentina and Thailand - who only last year complained to the world bank that since the normal "competitiveness" indexes were giving them very bad ratings, while at the same time their economies were putting in strong performances, then there must be something wrong with the indexes. I imagine they are still waiting for a coherent reply.

Basically the whole "institutional reforms" story is wrong, not because such micro level competitiveness-oriented reforms are unnecessary (they normally are), but because they are only part of the picture, and thus offer a very misleading perspective. I couldn't help noticing this whole issue in another context this morning, in the Financial Times's recommendations as to how to solve the economic mess which the Spanish economy is now headed towards.

Spain has been content to enjoy the benefits of cheap credit and strong European demand for its goods and services. Unlike France, it has not embarked on the structural reforms needed for longer lasting prosperity.

Mr Zapatero pretends these are not needed. But, if re-elected, he should rethink. Generous tax cuts should be avoided in order to maintain a mildly restrictive fiscal stance. Measures to foster competitiveness are essential. These should include dismantling barriers to competition in retailing, transport and energy. He should ditch a preference for national champions.

Persistent weakness in productivity growth must be addressed too. Recent steps to expand Spain’s small technology base, promote entrepreneurship and bolster its ossified education system are positive. But universities need more independence. Allowing companies to opt out of collective wage deals would make the labour market more flexible. This is far from a comprehensive manifesto. But it is the least Spain must do if it is to remain one of Europe’s pacesetters

Now I think we could pass quietly over the little detail that France is now being cited as a country which is benefiting from structural reform. What is notable about the kind of "rescue package" being proposed for Spain is that it is almost a political manifesto for the coming elections, and it largely ignores the substantial underlying macro economic questions which are in play - like the health of the banking system, some evaluation of the impact of "financial efficiencies", interest rate policy at the ECB, the value of the euro, the presence of five million immigrants (who have largely arrived over the last 6 or 7 years at just the same time as the current account deficit - which the FT does mention -has balooned), the role of the eurosystem and covered bonds in making cheap interest loans available at what were effectively negative real interest rates, etc, etc, etc.

Evidentaly non of this is directly Mr Zapatero's fault, any more than it was Mr Aznar's fault. This is not the moment to attempt a fuller analysis of Spain's current problems - you can find a first attempt at getting to grips with these here. Rather my objective is to point out that basing yourself on micro economic analysis alone you will never get to the heart of major economic issues which face us. And this is what the current mainstream economic discourse seems to do, spilling in the process and excessive amount of ink about shop opening hours, flexible labour contracts, and privatisation of "national champions" (all of which, please note, may well be a good idea, but I can tell you now, none of these are going to get Spain out of the problem which is about to arrive, nor, for that matter, will they prevent the inflation bonfire from roaring away in Eastern Europe).

The theoretical issues which are involved in trying to understand why France is so apparently robust, while Germany, for example, is so fragile are hard to get to grips with. I have had a first stab at offering and explanation in this post here. Doubtless there is still a lot more to do and a lot more to adequately understand, but for now I would simply to present a couple of "exhibit A" type charts, and cite a piece of standard neo-classical growth theory. The piece in question is not any old piece, it is infact the cornerstone on which most of the present economic micro analyses are based. The problem is it may actually turn out to be wrong.

First the charts. These are based on data prepared by Eurostat, and show the volume index of GDP per capita as expressed in Purchasing Power Standards (PPS) (with the European Union - EU-27 - average set at 100). If the index of a country is higher than 100, then this country's level of GDP per head is higher than the EU average and vice versa. Basic data is expressed in PPS which then effectively becomes a common currency eliminating differences in price levels between countries and thus making possible meaningful volume comparisons of GDP between countries. Please note that the index, since it is calculated from PPS figures and expressed with respect to EU27 = 100, is valid for cross-country comparison purposes rather than for individual country inter-temporal comparisons. Nonetheless these charts are extraordinarily revealing.

I have presented these charts in two separate groups. The first is a high-population-growth (near replacement fertility) group, and the second is a low-to-declining-population growth (lowest-low fertility) group. As we can see, in PER CAPITA income growth terms all three of the former hold their comparative position much better than all (or any) of the latter three. The reason why this is the case is not hard to get at since the first three are all ageing much less rapidly than the latter three. So population median age does seem to matter. Worse, for conventional theory, rising population is not necessarily a negative factor for economic growth. Now this finding is important, since Mankiw, Romer and Weil begin what has become a highly influential paper - A Contribution To the Empirics of Economic Growth (see bibliography below) - in the following way:

This paper takes Robert Solow seriously. In his classic 1956 article Solow proposed that we begin the study of economic growth by assuming a standard neoclassical production function with decreasing returns to capital. Taking the rates of saving and population growth as exogenous, he showed that these two variables determine the steady-state level of income per capita. Because saving and population growth rates vary across countries, different countries reach different steady states. Solow's model gives simple testable predictions about how these variables influence the steady-state level of income. The higher the rate of saving, the richer the country. The higher the rate of population growth, the poorer the country.

That is, Solow offers us two testable predictions, and one of them - in the case of higher median age societies at any rate - seem to turn out to be false. So this isn't simply an issue of longer shop opening hours, or some such. There are bigger fish on the plate to be eaten for dinner here.

As I say, all of this still needs a lot of work, and really the argument is only in its initial stages. But what I would argue is that - and again looking at what is currently happening with inflation in Eastern Europe only gives me more power to my elbow I think - the whole idea that fertility wasn't important in the longer run needs to be reexamined, and quickly.

Lastly, oh what the hell, some more charts, this time showing the comparative rates of population growth between the above mentioned countries.

Of course, the observant eye, and the thoughtful reader (who can still remember the starting point of this post) will note that in actual fact the UK and France are moving up in population terms more or less in tandem (so we should expect their relative GDP values to fluctuat more or less as their currency value does). More to the point both of them are catching up on Germany fast. If present trends continue (and possibly even accelerate) the point is not that far off when France may not only overtake the UK in GDP terms, she may even overtake Germany too!


Mankiw, N. Gregory, David Romer, and David N. Weil, “A Contribution to the Empirics of Economic
Growth”, Quarterly Journal of Economics, 107, May 1992, 407-37.


CV said...

Excellent write up Edward ...

Especially, the GDP per capita graphs are marvelous. Definitely, something which needs to be emphasised as we move forward.


Anonymous said...

How does Ireland compare to these countries? It is not a large economy but if I remember right, it has a rapidly increasing population.

My feeling is that France missed the upside and is now not affected by the downside. It has always been a solid stable economy notwithstanding the sometimes unexplainable Anglo-Saxon disdain towards it. To me France's stability comes as no surprise.

Edward Hugh said...

Hi Anonymous,

I take your point about the fact that France avoided a lot of the upside construction boom excesses. I have been scratching my head about why, but part of the reason must be somehwere in the banking system, and the fact that they were not as agressive as say Spain or Ireland in selling the covered bonds story. In that sense prudence is a virtue I feel.

On Ireland, clearly since the 1990s (and Spain) strong population growth correlates with rapid rises in per capita income, but I think we should wait to see the downside here (which is why I deliberately did not refer to Spain or Ireland) as the property boom unwinds. When things settle down again we will be able to get a better longer term reading, and whatever it is it will be interesting.

"It has always been a solid stable economy notwithstanding the sometimes unexplainable Anglo-Saxon disdain towards it."

Absolutely. I agree. Claus and I call France - in eurozone terms - Monsieur Average. Which means, quite coincidentally, that since it had more or less average inflation rates during the key 2000- 2007 period, it had the nearest thing in eurozone terms to an appropraite monetary policy, which is one of the explanations for its more stable economic showing, since, although again many seem to want to deny this, monetary policy does matter.

Anonymous said...

The German population is declining because of low birth rate, I wonder whether they will want to encourage more immigration to fill the holes. It is pretty much what the UK is doing. Not popular political but it does help to delay the impending demographic crisis and pension shortages. - I believe France has a real problem with all their social security commitments.


Anonymous said...

One of your best articles!
I specifically liked the comment on what is really important. We need to see the skeletal framework and not get lost in details on a micro-economic level.

The ECB will need to lower rates too and this could solve Bernanke's problem. If he lowers US rates the dollar will tank and if he doesn't the real economy will go in a severe recession (if we haven't one already).

Population seems to have opposing problems too. The absolute size could exceed/exceeds earth's carrrying capacity and projections present us with already slowing fertility and a diminishing population from 2050 on (UN projections). On the other hand the changing demographic structure poses economic challenges of all kind.

France has always been an exception and still is quite conservative and has an urge for independence.
No wonder De Gaulle (and today Sarkozy) didn't trust the dollar or that it gets 80 % of its electricity from nuclear sites. It looks like they always go their own way.


Edward Hugh said...

Hi Geert and Tejvan,

Thanks for the compliment Geert, and Tejvan, on this:

"I believe France has a real problem with all their social security commitments."

I certainly agree. They obviously (like the United States, I think it was Moody's last week who threatened the US with a ratings downgrade if they didn't start to do something) need to make substantial reforms which bring entitlement much nearer to longer term underlying realities. But the big point is that both these countries have a little more time. But this doesn't mean that they don't need to use it wisely.

"The ECB will need to lower rates too and this could solve Bernanke's problem."

Well yes, we agree, the ECB will need to lower rates, the eurozone economy is slowing much more quickly than many seem to appreciate. Whether this solves Bernanke's "problem" or not remains to be seen. My guess is that the US is going into recession, that the recession will not be as deep as some seem to imagine, but that it will turn out to be more protracted. ie there may be no automatic rebound this time (the stagflation argument). And remember, both the Fed and the ECB with low interest rates may - in the short term - simply send the problem over to China, which is having to raise rates to try to restrain inflation. Low interest rates elsewhere (and Japan) can simply make the China carry trade even more appetising, and hence produce even more overheating in China, till it can't.....

"Population seems to have opposing problems too."

Again I agree. Shooting global population up through the roof is no realistic solution, because of the resource problem you point to. Stabilising global population is therefore an important objective. The tricky part are the transitional dynamics. We need to distinguish between the excessively high population growth rates in the very high fertility societies, and the excessively low (and even negative rates) in the lowest low fertility societies. BOTH situations are undesireable. There ought to be a level which is "just right", and we ought to be trying to target that. This means applying some of the things we have learnt in the already developed societies to the now developing ones, and in particular getting across to them the importance of not letting fertility drop as low as it has done in some parts of Europe and Asia. At present this is simply not being done.

Also, it isn't clear how much of real economic worth can be achieved by increasing participation rates among older workers. Basically people who were quite well educated 30 to 40 years ago may not have the appropriate skill-knowledge set to have a lot of economic value in today's knowledge economy, as I try to point out in this very long piece on the German labour market. (Of course, this doesn't mean that it isn't socially desireable to increase participation in the older age groups, especially if your enemy is things like Alzheimer, there are clear benefits in keeping people more active. The point I am making is simply that doing this won't "save your bacon" economically speaking).

The evidence seems to suggest that countries like Japan, Germany and Italy are currently having some success in boosing employment participation rates among older workers, but that the economic value of this is very low indeed. I wouldn't say exactly comparable to the use of child labour in India or Brazil, but if you let yourself think about the possible symmetries in this situation, then you wouldn't be too far from the right ballpark.

The comparison here comes from having in both cases very large cohorts in precisely the wrong age groups.

Basically this post is one very limited attempt to suggest that the whole neo-classical tradition of growth theory (going back to Solow, who I admire enormously as an economist incidentally) needs a close re-examination.

Possibly what I am saying could be read as being rather pessimistic on long term growth (since if we get most of our growth today out of extra population, and having a disproportionate share of young workers, then as population peaks and the share of young workers declines, then growth would seem to become accordingly slower). This pessimism is not really out of harmony with the neo-classical approach, since they always took the view that economic growth in the very long run would be hard to come by. This is essentially because technology is not seen as a source of growth in the long run (ie it is exogenous to the models, but I think you need to understand quite a lot of economic theory to see why this is, as it involves applying general equilibrium theory. On this level all that stuff in the popular press about long run growth - as opposed to short run advantage - coming from TFP is the next best thing to claptrap).

The neo-classicist felt growth would taper off due to the phenomenon of diminishing returns, that is, as you applied more and more capital to the same quantity of human labour the rate of return on capital would decline accordingly, even as the rate of return on labour increases (without any efficiency improvement to justify, think what is happening to oil now).

Maybe this is all a bit simplistic, but it is more or less in the right ballpark. So neo-classical theory seems to have assumed that we would have a static population at some point, even though the theory never considered the relevant age structure components - as Myrdal, who got very close to all this some 70 years ago before it was all quietly forgotten, pointed out.

But this population stagnation was - like technology - considered to be exogenous, and is an assumption which seems to be more or less implicit, rather than being argued for and justified explicitly. I think what Claus and I feel is that this population process needs to be endogenised in the model (despite all the well known modelling challenges that doing this presents) and in this sense the Romer "new growth" and human capital literature was scratching around in the right area.

Anonymous said...

Concerning the ECB interest rate I'll quote Niall Ferguson from his book "The Cash Nexus: Money and Power in the Modern World" (written in 2001):
“Time and again in history…a leap in inflation has been the line of least resistance for governments in fiscal difficulties: the defeated powers after the First World War, for example, or Russia and the Ukraine since the collapse of the Soviet economy. This, of course, would be the moment of truth for the single currency. One possibility---which cannot be ruled out—is that the ECB will cave in, allowing the euro to depreciate and inflation in the Eurozone to rise. It seems unlikely, however, since the Bank is explicitly prohibited from acceding to a request for monetary financing under the institutional framework established by the Maastricht Treaty. To be precise, there is a strict „no bail-out rule‟ enshrined in Article 104 of the Maastricht Treaty and in Article 21 of the Statute of the European System of Central Banks. This is the crux of what has been called the „unprecedented divorce between the main monetary and fiscal authorities‟ brought about by EMU. “It is therefore not difficult to foresee a series of collisions between national governments, struggling to bring their finances under control, and the European Central Bank, which is bound to maintain price stability as its primary objective (under Article 2 of the Statute of the European System of Central Banks). The ECB is likely to ignore the „unpleasant monetary arithmetic‟ implied by the budgetary imbalances of the member states, and to retort with some „unpleasant fiscal arithmetic‟ of its own by raising interest rates. “If all countries were in approximately the same predicament, a political resolution of this conflict might be conceivable. But because there is such variation in the scale of the generational imbalances within the Eurozone, and indeed in their rates of growth and inflation, some countries will get into difficulties sooner than others. It is not hard to foresee the kind of inter-country conflicts this could lead to. Most attempts to assess the likely durability of EMU have sought to estimate effects of an „asymmetric‟ shock to the system. Generational accounting suggests that the system already has asymmetry and many not need a very large shock.” “…Still, the fact remains that history offers few examples of democratically agreed budgetary adjustments on the scale necessary in certain European countries today. What it does offer are several examples of monetary unions between sovereign states disintegrating when the exigencies of national fiscal policy became incompatible with the constraint imposed by a single international currency.”

PS I've just received this comment by e-mail

Anonymous said...


I cannot really agree that increasing the participation rate amongst the older workers will contribute little.
I've been in business for 30 years and although the productivity of the older workers declines, the quality of their work and their experience is of great value.
I readily need to admit that quality is in general much less appreciated than in the past.

Belgium has one of the lowest participation rates which is a consequence of our employment policy in the past. Even the participation rate amongst the 55 old is very low and those I don't consider older workers.
I cannot really see much disadvantages in an increased participation rate.

I do vaguely remember something about that static theory on growth and Mondiglinani's Life Cycle Theory, but I'll have to dig deep to remember that ;)


Edward Hugh said...

Hi again Geerd,

"I cannot really agree that increasing the participation rate amongst the older workers will contribute little."

OK, I will try and present some evidence to back up what I am arguing. I have just done a long study of wages and employment in Germany, and I am half way through Italy and Japan. Just bear with me a couple of days and I will try and put something coherent up as a post over the weekend.

Anonymous said...

Hi again,

I am the first anonymous poster in this thread.

I wish economic indicators would take into account long term stability in the economies of different countries relative to what happens around them. Is there such an indicator available?

I disagree with your point about France having to give up its social benefits system. Even in case of the US, Moody's has made a political statement rather than an economic one. Their threat is that they might change the rating withing 10 years but they suddenly made this call at a crucial time in the election cycle. They talk about cutting benefits to the poor but do not talk one bit about cutting military expenditure etc. They simply repeated the Republican mantra.

As for French social benefits, they are already a little too rich perhaps too luxurious. So a devaluation in quality may not affect the services provided. Also, the French economy or its benefits system is not in any form of crisis. The Anglo-Saxon world has predicted its demise many times before and it has yet to happen. The main point of French-bashing is to ensure that other developing countries do not emulate its model.

Looking forward to your study on wages and employment (and perhaps its link to ages of the employees?

Keep blogging!