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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.