Keywords

French balancing act; French public debt; creative destruction; limit to socialist policies; French dilemma; cutting entitlements; debt is a timebomb; French banks; the banks’ exposure

9.1 The French Balancing Act

Like other Western European countries, after the end of World War II, France experienced nearly 30 years of growth and low unemployment. These so-called trente glorieuse approached an end with the oil shocks of the 1970s and the reversal started with the election of François Mitterrand in 1980.¹ Since then, France has spent 33 years moving backward or sideways.

During the first half-dozen years of the 1980s, the French economic model has been characterized by a rather high inflation and of currency devaluation,² while growth stalled and unemployment increased. This came as a result of Mitterrand’s effort to reignite the economy through an expansive (and expensive) fiscal and monetary policy. With the socialist experiment’s failure:

Another false step was that of renationalizations³ at the cost of a lot of public money. Then the Mitterrand government made a U-turn. It adopted the German model of a strong currency. France emulated its eastern neighbor trying to keep steady the exchange rate of the franc to the German mark, thereby laying a foundation of the euro a decade and a half down the line.

The economic disasters which accompanied the first years of his presidency taught Mitterrand that a debt-ridden France is in no position to dictate to Germany. At best it can influence, but only if his government gains credibility by pushing ahead with badly needed reforms. Reforms however were not forthcoming. Mitterrand and his socialists remained deliberately vague over how they will prune the country’s public accounts while at the same time increasing the entitlements to keep alive the French model of an ever-expanding nanny state.

The current account balance also suffered as imports continued being in excess of exports. The 12 years of the Jacques Chirac presidency, which followed Mitterrand’s 14, were just as dull; a do-nothing epoch. The next 5 years of Nicolas Sarkozy presidency were better, albeit not too different, while the public debt reached for the stars.

With the socialists back to power in 2012, François Hollande, the new president, confronted the accumulation of more than three decades of mistakes—reflected in a mountain of public debt and fiscal imbalance—while trying to defer his own reforms. He also attempted to kill two birds with one stone. On the one side, his first words on taking office were that “public debt is an enemy of the country,” and on the other he assured his electorate that there would be no cuts to family allowances, health care, pensions, and social services.

These have been political promises, and promises oblige only those listening to them, according to Charles Pasqua, another French politician. The budgetary deficits remained, and La Cour des Comptes (the French government’s state auditor) said that the Hollande administration needed to find an extra euro 20 billion ($26 billion) in savings each year just to stick to deficit targets. That was before adding on the spending pledges Hollande made on the campaign trail which were not negligible.

Centuries ago France had ministers of finance renown for budgetary discipline and measures taken to promote the country’s economy. Under the reign of Louis XIII, Colbert has left a long record of successful economic and budgetary policies, followed up by Cardinal Mazarin, his successor. These prudent fiscal policies changed, and the debt culture took over as a result of financing the never ending wars of Louis XIV. By the time his long reign ended, the French government was on the brink of its third bankruptcy in less than a century.

History provides valuable insight. Louis XIV, the sun king of France whose famous dictum was “L’Etat c’est moi” (I am the state), died in 1715. Hardly was he in his grave that it was revealed the finances of the country were in a state of utmost disorder. He was criticized as a profuse and corrupt monarch who brought the country to the verge of ruin, his profusion and corruption imitated by almost every functionary. The national debt amounted to 3 billion livres, a high multiple of the kingdom’s GDP.

The state revenues, at that time, amounted to 145 million livres and the government expenses to 142 million, leaving nearly nothing to pay the interest upon the 3 billion livres public debt. Asked by the Duke d’Orlean, the Regent, for his advice the Duke de St. Simon was of the opinion to declare national bankruptcy,⁴ but other notables opposed this solution. In the middle of the chaos stepped John Law, later on of Mississippi Bubble fame, who offered two memorials to the regent setting forth the evils that had befallen France, owing to an insufficient currency at different time depreciated.

May be, but only may be, we are witnessing a repetition of that epoch. Balancing the books is becoming harder as growth disappoints and another of Hollande’s campaign pledges, to twist Angela Merkel’s hands and revise the fiscal compact to his favors, fell in a vacuum. Merkel, who had backed Sarkozy’s campaign, said she will welcome Hollande “with open arms” but also pointed out to this French president and everyone else that a renegotiation of the European Unions’ fiscal compact “is not up for discussion.”

Together with Mario Monti of Italy and Mariano Rajoy of Spain, Hollande attempted the trick of the June 28/29, 2012 Brussels “Summit”,⁵ but the trick of overwhelming Merkel failed. Supporting Italy and Spain in their call for more taxpayers money coupled with rather lousy fiscal consolidation targets was a long shot, and it proved to be a nonstarter. Hollande was left with the classical approach of putting the government’s hand in the French retirees’ pockets and cutting their pensions by 10 percent—as a start.

In fact, there is no reason to believe that even if France, Italy, and Spain were ever getting all the money they wanted from Germany and the rest of Euroland, this would have provided anything more than temporary relief. A weak credit and export environment coupled with inordinate public spending, an imports over exports policy and subdued public confidence, are keeping economic growth at low level and negatively affects employment.

A lesser known irony of Euroland’s debt crisis is that even if their fiscal deficits have a ball and growth is sluggish, the Lisbon Treaty obliges France, Italy, and Spain to keep on financing Euroland. This is also true of any other of its member states including Ireland, Portugal, and Greece which are on bailouts. Taking as an example the initial guarantors of EFSF, the top member countries’ shares of guarantees are:

But if Spain and Italy request financial support, then the share of EFSF guarantees for each one of the other members significantly increases with the lion’s share of contributions falling on Germany and France:

Correspondingly, the share of Hollande goes to 9.0 percent from an initial guarantee of 5.7 percent; of Belgium to 5.5 percent from 3.5 percent; of Austria to 4.4 percent from 2.8 percent; and of Finland to 2.8 percent from 1.8 percent. No wonder that countries such as the Netherlands and Finland are so careful about both their commitments and the use being done of their money. Now think what would be happening in contributions if France was asking Euroland for financial support.

If one studies the statistics, one might come to the conclusion that this may not be so unthinkable. From 2000 to 2012, unit labor costs in France increased nearly 30 percent.⁶ The unemployment rate fluctuated, and in 2012, it crossed the 10 percent level from slightly over 8 percent in 2000. Government spending as percent of GDP is over 56 percent. The budget deficit has been nearly 5 percent in 2012 (it was over 7 percent in 2009). The current account balance steadily moved south, from +2.5 percent of GDP in 2000 to −2.5 percent in 2012. And GDP growth while somewhat positive in 2012 is projected at −0.5 percent in 2013.

Worse yet, France has been among the more reluctant and slower Euroland countries to reform its labor market, pension, social security, and welfare. It largely failed to undertake the radical shake-ups that happened in Holland, Scandinavia, and Britain during the 1980s and 1990s and in Germany in the 2000s. In addition, as the IMF pointed out, it is still being left behind even by the mild reformers in Italy and Spain.

An evident consequence is a pronounced erosion of competitiveness particularly compared to Germany. The French economy has been deteriorating for many years, and this became fully obvious with the euro which precludes the usual policy of devaluation. Ever since the beginning of the Mitterrand presidency, France came to rely heavily on public spending for growth.

Critics say that French citizens reap too many benefits from the nanny state which are unaffordable and unsustainable. Furthermore, France has 90 civil servants for every 1000 inhabitants, compared with just 50 in Germany,⁷ a number which adds up to a large and growing 22 percent of the workforce. France also showers its immigrant population from its former colonies with way too many free services and goodies negatively affecting its budget.

9.2 Creative Destruction and the Limits of Socialist Policies

Like Britain, France is still dominated by the mindset of a world power with neither the reach nor the means of being one. But unlike the British, the French political system tends to produce politicians who are all of a type. The fable of the difference between “home de gauche” and “homme de droite” is just that a fable, while few French political leaders have business or international experience, or speak foreign languages.

Many French political leaders have been graduates of one of the grandes ecoles,⁸ though Nicolas Sarkozy was an exception. Others, like Hollande, are énarques which simply means that they attended ENA (Ecole National d’Administration⁹), which is widely regarded as the high temple of bureaucracy.

A basic characteristic shared by all bureaucrats is that they take no initiative for fear of making mistakes. This is hardly what France needs at this moment. Maurice Levy, the CEO of Publicis, a large public relations firm, argues that a leader who wants to reform France needs two things, a real sense of crisis and balls, and implies that Hollande lacks both.¹⁰

“Man’s character is his daemon, his destiny,” wrote Heraclite, the ancient Greek philosopher, who searched for knowledge and believed in a world of “becoming,” or eternal change.¹¹ Change through creative destruction has been the real power of the West, and of capitalism. But after WWII, the process of creative destruction in the West has ebbed, because political leaders supposed to promote it have not been up to the standard it requires.

Economists say that France’s fragility directly affects the euro crisis. Moreover, France is no more in position to provide a counterweight to other big nations in the EU. Not only it has one of the largest debt and deficit ratios among Europe’s higher credit rated countries, but also its banks are dangerously exposed to Club Med countries. Mid-October 2011 in a summit in Berlin, a journalist from Le Monde, the Paris newspaper, asked Angela Merkel whether she was in a partnership of equals with Nicolas Sarkozy, “given that France and its banks have been attacked by the markets.” There was no reply.¹²

The name of the French president has changed, but the problems are roughly the same. If anything they have grown worse, as documented by the pitiful request to be excused for the colonization of Algeria by the French. Hollande made this plea to be excused on December 19, 2012 in his address to the Algerian parliament. Colonization, the French president said, was unjust and led to plenty of suffering for Algerians.

If this mea culpa was so important for good behavior in politics, I would like to see Recep Tayyib Erdogan present his excuses to the Greeks for nearly 400 years of colonization; David Cameron to the Indians; Mariano Rajoy to the Mexicans, Columbians, Peruvians, and so on—a list without end. By all likelihood, none of them will admit that his country has been the author of a mischief.

Hollande’s unfortunate (and bad taste) expression of sorrow and his asking the Algerians for redemption of French “sins” was just an admission of weakness. Let’s face it; unless France restores its economic strength and its self-esteem (the former is prerequisite to the latter), it will be an enfeebled partner for Germany at a time when the two countries should urgently seek to work through their (many) disagreements. If France and Germany cannot settle on a well-rounded deal for the euro, it will be useless to talk about:

The rebirth of economic strength, like that of self-esteem, has prerequisites. Neither will come out of apologies and of the status quo, even if politicians feel more comfortable by keeping things as usual and hiding the facts under the carpet. Living with crumbling structures is, however, dangerous. Once authority falls in ruins, raising it again is a Herculean task.

One of the most daunting decisions confronting Hollande and his socialists is to decide whether France will continue being the waste basket for illegals. On May 2, 2012, just prior to the presidential elections, during the televised Sarkozy–Hollande debate it was revealed that 180,000 legal immigrants come to France every year, the lion’s share from North Africa and Sub-Saharan Africa. Anecdotal evidence suggests that the illegals are probably double that number. By contrast, what France needs to promote its economy is well-educated immigrants, and of them only 5000 came to live in the country during the last decade.

Another daunting question for Hollande and his team is how to bend the curve of ever-growing entitlements (Section 9.4); still another is the two-edged sword of employment and the financial support the French government (like all sovereigns) gives to selected industries. The latter two issues correlate among themselves and with the popularity of the country’s chief executive in the polls.

With growth stalled and unemployment rising to nearly 11 percent of the workforce, by January 2013 Hollande’s approval ratings languish at about 35 percent versus the 55 percent he had in May 2012 when elected president. Critics say that this was unavoidable because he lacks credibility and is leading France toward a dead end in economic and industrial development.

Hollande answers his critics by saying that thanks to him Euroland had been “safeguarded” by action taken since he came to power, and now he is set at a single goal: inverting the unemployment curve within a year. That is unlikely even if he abandons his pledge for a balanced budget and starts hiring hundreds of thousands of bureaucrats.

Apart from radically reforming the French labor market, cutting social net costs and introducing flexibility in business, the French socialist president needs to decide behind which industries will thrust the power of the state in economic and financial terms. France is not Spain, where in January 2013 general unemployment hit 26.5 percent and youth unemployment a dramatic 56.6 percent. Still some of the decisions to be made resemble those of Spain and Italy. Should the government give preference to:

Neither France nor any other western nation has the money to do everything at the same time. Choices are necessary, and they are both hard and urgent. No excuses should be found for delaying decisions and actions. Hollande’s socialists hold power at all levels, from the Senate and National Assembly down to the Regions and other local government. As of January 2013 he has little to lose, as he is already unpopular. But as he is at the start of a 5-year term, there is enough lead time to earn him an electoral payback.

In terms of choices regarding which French industries to nurture, if Hollande does not do the right thing now, he probably never will. Anecdotal evidence suggests that between the quiet salvaging of self-wounded banks and pulling up from under Peugeot, the weaker of the two French automobile makers, the government has spent an estimated euro 60 billion ($78 billion).

The Peugeot case dramatizes the choice between old and new industries. In July 2012, a couple of months after Hollande took office, Peugeot came at the center of a political storm, at home, after it announced a restructuring plan leading to a net reduction of 6100 French jobs and the closure of its plant in Aulnay, near Paris. To verse gear, at the end of October 2012, Peugeot got from the French Treasury euro 7 billion ($9.1 billion) in exchange for more government clout and preservation of jobs.

In a first time, not knowing exactly how to react, the French government unveiled a recovery plan for the car industry including incentives to buy hybrid and electric cars, but its magnitude and scope was restricted by the country’s need to cut debt. Both the market and the automakers were unimpressed. Three months later came the euro 7 billion subsidy.¹³

Then in September 2012 Sanofi-Aventis, France’s leading pharmaceutical group, downsized its redundancy program after being paid a visit by Arnaud Montebourg, the socialist minister for “industrial resurgence” considered by many to be the bruiser en chef. This was no courtesy call. In the minister’s words: “I explained that the lay-off plan was abusive and needed to be reduced.”¹⁴

Forgotten in his exercise of “save the jobs at any price” has been the fact that in France research and development has become a chronic weakness. To “save jobs” at all cost not enough money is spent on R&D, with the result that no truly outstanding new products are coming out of labs. The job cuts at which Montebourg aimed his fire were part of Sanofi’s effort to reposition its resources and address the new products issue.

Worse has been the November/December 2012 case of a real smokestack industry: the ArcelorMittal steel plant at Florange. The president of the Republic, the prime minister and minister for “industrial resurgence” aired three different opinions on how to handle the rights of the steel plant’s owner and the fact that labor unions were in revolt.

The socialist minister for “industrial resurgence” wanted to throw ArcelorMittal out of France. His first problem was that in France, Mittal employs some 20,000 people and these are jobs which would be gone if the company “was thrown out of France”—while in Florange are employed 1800 and of these only some 800 jobs were in peril.

Montebourg’s second problem was that the nationalization of the Florange steel plan, contemplated after no credible party had shown up to purchase it, would have costed euro 1 billion according to some sources, and the French Treasury was short of money. To this was added the fact that ArcelorMittal itself is not in the best of health.

Lakshmi Mittal, chairman, chief executive, and main owner of the world’s biggest steel company, said the international economy remained fragile, with evident aftermath on selling conditions for steel. Mittal added that his firm was particularly affected by Euroland’s crisis, with the severity of the resulting economic weakness triggering an operating loss for ArcelorMittal’s main European plants.¹⁵ That was not the best time to push the steel maker toward the cliff, and the affair ended in a stalemate.

9.3 When the Government Tries to Be Everything to Everybody, Public Debt Is King

There is an interesting parallel between the deep economic crisis in France of Louis XV, in 1720, and the present-day situation in America, Britain, France, and Euroland’s Club Med, nearly three centuries later. The seeds for the crisis in early eighteenth century were planted in 1716 when John Law created his bank in Paris. Within a year he set up another bubbly institution, the Compagnie d’Occident to exploit Senegal, the Antilles, Canada, and Louisiana.

With the Regent’s patronage, money was created out of thin air. In January 1718 Law won a fight with French politicians scared of leveraged finance. His bank prospered through the introduction of paper money, and by end of that year it was rechristened the Royal Bank. In 1719, a royal decree made him the Kingdom’s tax collector. In January 1720, after being named controller general, he took charge of all public financial matters of the French kingdom and put the printing presses of the Royal Bank to work full speed at the request of the royal authorities.

Sounds familiar? Then as now speculation carried the day, then as now the practical day-to-day problems were brushed away, and the spirit of society is identified by the slogan “Let it Be Money.” All attention concentrated on creating money for money’s sake, and for the benefit of insiders, as enormous amount of liquidity could not be absorbed by commerce.

The mass of money served to feed the fires of an ever higher degree of speculation, while the real assets’ counterpart to the increase in money supply, was little or nothing. Then as now there has been no comparable growth in real goods such as merchandize, factories, or gold and silver to back up the newly minted paper “wealth.” All there was (and is today) has been more paper money to balance the books and confront the public debt by rolling it over.

Little attention was paid to the fact that imaginary assets, the wealth made of paper money, don’t last forever. The bubble grows and grows and eventually it bursts. In Law’s time that was the Mississippi Bubble which as long as it grew it made fortunes and by bursting it ruined them. In our time, the new name for “Mississippi” is public debt for the social net.

After the end of WWII, from 1945 till 2007, France accumulated a public deficit of euro 1250 billion. First, the deficits were relatively small but with time they grew up, with the interest due contributing to their increase. Then, public debt started to grow exponentially. Between 2007 and 2012 more than euro 500 billion were added to the public deficit, at an average rate of euro 100 billion per year.

True enough, France did not have a balanced budget since 1974, but the rapid rise in public and private deficits started in the early 1980s with the Mitterrand governments, the rapid rise in entitlements, an all out effort to spend money on new immigrants (legal and illegal), and the government’s desire to avoid another student revolution like the one of May 1968. The French say that, as far as the young are concerned, this has been a lost generation. Both the state and their parents gave them everything to shut up their mouth. It has not been too different in other western countries.

French teenagers of the generations which followed the 1980s have been called enfants minute (minute kids). The “minute” is the time it takes to satisfy their desires. When they want something they don’t even ask for it. They buy it with a credit card on the internet, simply adding to household debt which is in competition to the public debt on who will do the most damage to the economy.

While the western central banks’ zero interest rates, and resulting very low longer term cost of money, reduced the French government’s near-term sensitivity to pressures from bond markets, persistent structural deficits and low growth led to an unsustainable increase in public debt. In France, this is now in excess of 90 percent of GDP, and after having lost its AAA rating, the country is likely to face further credit rating cuts.

Interest rates are important as big time borrowing has become a way of life. On November 25, 2010, for example, the finance commission of the French senate approved an urgent credit of euro 930 million to assure that employees of eight ministries, including Defense, Education, Interior, and Budget will be paid at end of December 2010. This euro 930 million was part of a bigger account of 1.39 billion with the difference going to other public expense chapters which had overrun their budget.

Non-statisticians sometimes say that statistics¹⁶ are nothing more than dry numbers. But when on November 20, 2012 it was officially stated that French public debt stands at euro 1832 billion ($2380 billion), which represents 21 percent of total public debt in Euroland, this was by no means something to be brushed away as “dry number.” Interest paid on such a mountain of public debt is a weight around the neck of the real economy, and this is not only true of France but as well as of all other sovereigns: Britain and America included.

This euro 1832 billion in debt also means that sea of red ink approaches 100 percent of GDP; it does not stand at the more modest level of 93 percent of GDP as it is generally believed.¹⁷ The interest paid for this euro 1832 billion is estimated at euro 65 billion, which means that it represents 144 percent the taxes paid by households.¹⁸

As the public debt is king, expenses continue rising including those unnecessary or fancy. The cost to the French Treasury of the intervention in Libya, in 2011 (along with the British and American forces), has been euro 300 million—evidently paid by increasing the public deficit. Other expenses have been structural. The cost of social security (including health care) is well in excess of contributions to it. Year in and year out health care and pensions provided by the State Supermarket are in the red.

Many economists are worried about the French state’s finances. Critics say that when one is deeply in debt, he does not try to play good Samaritan to everybody. France forgave the debt to Ivory Coast, to the tune of euro 2 billion; Republic of Congo, euro 700 million; Morocco, euro 625 million; Madagascar, euro 375 million; Mexico, euro 300 million; and a number of other countries, each for a sum of 125 million or less—but altogether adding up to euro 5 billion.

Another unwarranted expense has been Hollande’s pension-age rollback from an inadequate 62 years to an even more profligate 60 years.¹⁹ This was not made to inspire confidence that France faces its economic problems head-on. His 75 percent tax rate for people earning over euro 1 million per year applied only to a tiny minority yet, according to critics, this 75 percent policy indicated hostility to entrepreneurship and wealth creation. (The 75 percent taxation has been struck down by the Constitutional Court’s decision, but most likely it will be reborn under different form, as a nineteenth century socialist relic.)

As 2012 came to a close, the forecast has been that by 2016 the French public pensions system will have a deficit of euro 20 billion. The public pensions’ black hole is not included in the euro 1832 billion of current public debt—and the same is true of the public health care’s deficit where the torrent of red ink is much stronger than in pensions, estimate at another euro 140 billion.

Day-to-day expenses are also running out of control. On January 2, 2013 came the news that the French budget deficit projected for 2013 is euro 61.2 billion²⁰ (over $80 billion). Just 3 months earlier, the talk was of a euro 30 billion 2013 deficit. The role played in this increase by the (probably temporary) cancellation of the 75 percent tax is minor, as the receipts were estimated to be at the euro 400 million level.

Since public debt is rapidly rising, the fundamentals are grim. Public spending, at 56 percent of GDP, eats up a bigger chunk of output than in any other EU country. Exports are stagnating. The banks are undercapitalized. French banks are geographically diversified across Europe, but this also means sizable operations in peripheral countries: Italy, Greece, Spain—and therefore current and potential losses.

French banks have to increase their capitalization, continue to deleverage their balance sheets, and become fully Basel III compliant. By being itself highly indebted, the government is not in a position to come to their help, though it will undoubtedly do so by further increasing its own debt if one of the bigger banks risks bankruptcy.²¹

One of the more accurate problems confronted by French banks is that they have been losing lots of money because of their sovereign loans: the cost of the Greek crisis to the big French credit institutions has been euro 3 billion, and this is a trifle compared to their exposure to Spain and Italy which is estimated to stand at euro 105 billion.

Statistics on the French current account talk of another gapping hole. From January 1 to July 31, 2012 the deficit reached euro 33 billion versus euro 29 billion a year earlier. While this primarily reflects the lack of competitiveness of the French industry, it also has a direct economic impact. Budget deficit and current account deficit are a double whammy. As the Court des Comptes, the French government’s auditor, has pointed out, in 2013 it would not be possible to make ends meet.

9.4 The French Dilemma: Cutting Entitlements or Going Bust

Both geographically and economically, France sits between the profligate Club Med countries of southern Euroland and the northern hard-working ones. Since the end of World War II, the French economy has never been truly strong. Persistent budget deficits have left their footprint, but everything counted, it is the runaway entitlements which offered to speculators their next victim.

Health care for all, nearly free medicaments and other goodies provided by the State Supermarket, became a second income for practically everyone—and this created the so-called French way which nowadays is an untouchable. To preserve it, every consecutive French president tended to be an even bigger money spender than his predecessor, leaving up to the electorate to answer the question “What’s next?”

Even conservative members of society say “Don’t touch my entitlements;” the more radical cry is: “We want more;” the greens and so-called extreme-left like to see the entitlements extended to all illegal immigrants making “the rich” pay for them. Nine points will help the reader appreciate how far this chorus goes:

Scared of noisy street demonstrations and the aftereffect of trimmed entitlements in the polls, the majority of politicians (both in France and abroad) look at the nanny state as taboo. Yet, it would have been wise to phrase the question on entitlements in a way opposite to the one in which it is typically asked. Not “do you want more of them,” but:

What the electorate perceives as austerity measures becomes more palatable when everyone appreciates that those who benefit from wide-spreading “social services” are those who at the end of the day pay for them through new taxes and wider unemployment induced and sustained by the mountains of debt. The public does not know this, because the large majority of politicians would not dare even to tell the truth. But there are exceptions.

In early November 2012 when the French public debt stood at euro 1835 billion, this represented euro 63,000 ($84,000) for every French family, René Doscière, a socialist member of parliament, said clear and loud that it was necessary to reduce this unsustainable figure by retiring some debt or, alternatively, to suspend lots of public services.²⁴ The point of no return Doscière suggested is not far away. It is typically reached when:

According to the same parliamentarian, the trend is toward this inflection point because every hour France increases its debt by euro 22 million ($29 million), and also every hour the nation pays euro 6 million (nearly $8 million) of interest on the public debt. (Over and above that comes the social security’s outstanding deficit of euro 140 billion ($182 billion), including health care and pensions.)

Economists say that no matter how you look at this issue of ever-growing entitlements and public debt, France is showing itself to be a country in denial about its economic challenges. The same can however be stated of the United States, Britain, and many other most countries in Europe—surely of the Club Med.

Just prior to the early 2012 presidential elections, Nicolas Sarkozy had said that the current situation in Spain and Greece reminds of the prevailing economic realities. He also went on to imply that left-wing politics is to blame for the Spain’s economic faltering. At the same time, however, his remarks embodied the typical French belief that the government is responsible for everything that happens to a country, no matter what.

By taking Spain and Greece as examples of socialist mismanagement, and there was plenty of it in both cases, Sarkozy avoided to mention the fact that between 1999 and 2007 France failed to meet the Maastricht public deficit criteria 4 years in a row, from 2002 to 2005; and it did not maintain its public debt-to-GDP ratio at 50 percent level. Instead, successive governments tried to reduce the ranks of unemployment by adding workers and employees to the public payroll.²⁵

It is not surprising, therefore, that the country’s public finances have been permanently in deficit for decades, as fiscal discipline is a rare quality while oversized “social benefits” continue to grow. Since August 2011 (still the Sarkozy years), the government introduced two emergency savings programs but it found it difficult to stay on fiscal track. A steady threat to the deficit and debt targets has been posed by flagging growth, even if higher borrowing costs did not follow the February 2012 downgrade of the country’s creditworthiness from AAA to AA+ by Standard and Poor’s.²⁶

The job of an independent credit rating agency is to estimate, to the best of its knowledge, the creditworthiness of sovereigns, companies, and debt instruments. For highly indebted western governments, however, AAA and AA+ credit rating is a bit like those outposts of empires that still dot the globe, but are nothing more than an accident of history. Let’s face it. For the majority of western governments:

Prestige aside, one of the advantages of high credit rating is that it helps keep borrowing costs down. Other things equal, downgrades bring the cost of debt up and may well turn away investors trying to find a home for their money. There is a global shortage of assets regarded as “safe.” This however does not mean that there are no dangers associated to dollar, yen, pound, and euro investments.

9.5 The French State Spends Too Much. Its Debt Is a Timebomb

The title of the feature article in The Economist of November 17, 2012 has been “The timebomb at the heart of Europe,” and the subtitle “Why France could become the biggest danger to Europe’s single currency.” In mid-November 2012, anecdotal evidence suggested that Merkel had asked a committee of six wise men to tell her what Germany could do to pull France out of the abyss, in case it fell in. (Later on, it was stated that this was not an ad hoc committee, but the German chancellor’s team of economic advisors.)

At the core of the Economist’s article was the statement that while France still has many strengths, its weaknesses have come to the fore with the euro crisis. France spends too much and without the option of currency devaluation, public expenditures add to an already top-heavy public debt. One cannot defy economic fundamentals for long, this article suggested, and if sentiment in the markets shifts quickly to the negative side, the crisis could hit as early as 2013.

At face value, these arguments are right. As the Economist article stated, the business climate in France has worsened—but so did all over Europe. The European governments, like Britain, that have undertaken big reforms have done so because they felt a deep sense of crisis, but they are the exception.

Indeed, the bad news for Europe is not that France is not alone in its travails with public debt. Instead, it is the model. Nineteenth century socialist thinking is widespread (thought it retreated in Sweden). And it has been good to see that the still new in office socialist government of France has been forced into retreat by an online revolt by entrepreneurs and investors, against its plans to raise capital gains taxes.

The strength of the protest by the so-called pigeons, French slang for suckers, caught Hollande and his boys and girls off-guard. The finance minister met leaders of the online protest and said changes would be made in favor of entrepreneurs who started their own business. Still the French president knows that scaling back public spending will be painful for a country accustomed to an omnipresent and generous State Supermarket.

Many observers nowadays question how serious Hollande is in meeting his target for a balanced budget by 2017—which is anyway 4 years away and a nebulous statement: a similar question is raised on his determination to go ahead with not-so-popular and difficult reforms giving them a chance of success.²⁷ On new year’s eve 2013, his statement to increase employment opportunities was widely interpreted as a decision to hire even more public workers.

Other issues, too, seem to be already decided on the negative side. An example is the French reaction to political union in Euroland, which ranges between mute and outright hostile. Le Monde, the Paris newspaper, called it a strategy of silence designed not to stir up divisions. But other sources say that the French government’s aim is the so-called integration solidaire (integration with solidarity) whose philosophy rests on two pillars:

If a referendum was done today, 64 percent of French voters will reject Maastricht²⁸ said a pollster in a meeting. The common currency is not the only subject Hollande’s voters don’t like. They also object to his government’s not-so-left economic policies. In the left of the French president, Jean-Luc Mélenchon and his Left Front excite the citizens with promises of social insurrection sweeping away the country’s recent pledges of austerity and providing:

While it is far from clear how the Left Front would handle the costs (the health bill alone is estimated at an extra euro 76 billion yearly), Mélenchon has given a hint: confiscation of annual individual income above euro 360,000. Little or no thought has been given to the fact that this would lead to massive exit of capital from France as well as a drain of the brains creating wealth.

The Left Front seems to have discovered the wheel for perpetual motion, as its program for debt bubbles and mere cheats includes a monthly minimum handout of euro 800 to everybody “to do away with insecurity;” a SMIG²⁹ of euro 1700 monthly (at the cost of euro 30 billion); general retirement at 60 (which adds euro 35 billion per year to the budget deficit); vast expansion of research and teaching; the nationalization of EDF, GDF/Suez, Areva, Total, and others (estimated at over euro 150 billion); and so on and so forth.

Mélenchon’s world view matches his economic policies. He describes the United States as “the world’s primary problem” and wants the US Sixth Fleet out of the Mediterranean. While this is simply big-headed thinking, the big question remains whether he and the other fire eaters of the extreme left appreciate that all the sclerosis of the French economy, labor inflexibility, and spend-and-spend policies make the economic situation so much worse than it is.

Mélenchon’s Left Front is not part of the government (at least not yet), and the budgetary fraud implied by its political program is not the order of the day. But when it comes to wild spending of not-yet-earned money, neither the left nor the right are opposed, even if they know that it would prove fatal in its consequences—ruining the French economy. The timebomb, however, is not hidden only in the European shore of North Atlantic (see Chapters 10 and 11).

The feature article in the January 5, 2013 issue of The Economist put it in this way: “For the past three years America’s leaders have looked on Europe’s management of the euro crisis with disguised contempt … Those criticisms were all valid, but now those who made them should take the planks from their own eyes … the temporary fix³⁰ ignored America’s underlying fiscal problems. It did nothing to control the unsustainable path of “entitlement” spending … and virtually nothing to close America’s big structural budget deficit.”

The core message of the Economist’s feature article is that while François Hollande and Angela Merkel avoided coming forward to explain to the French and Germans what it will take to fix the euro. Barack Obama, too, does not come clear. He did not tell the American people what is really needed to fix the fiscal mess. High public debt timebombs have been planted at both shores of the North Atlantic, and they might (just might) blow up almost simultaneously.

Prospects of imaginary wealth created by the printing presses of the Federal Reserve and the ECB are an evil of first-rate magnitude. The political leaders as well as the central bankers know it but they play the “I hear nothing, see nothing” game. Both the European and American political top brass is desperately looking for other issues which could divert the public’s attention from the economic timebomb ticking away in their country.

In other times, the threat of a war, supposedly to protect vital national interests, would have been the smoke screen to help the politicians in saving face in a retreat. Soon after he took office Hollande tried to start and lead a cold war in Euroland, against Germany, by way to extravagant demands and a personal attack against Angela Merkel. But it did not work. Instead it is he who adopted Merkel’s fiscal compact as a bible.

Therefore, in a second effort to show strength while continuing his determination to preserve the French nanny state model at all costs, and his resistance to change, focused his wrath on Britain. He said that euro transactions should not be done in London, since Britain is not a member of Euroland, but in reality attacking London as global financial center. The same day Boris Johnson, London’s mayor, answered: “The euro is a calamitous project.”

London is the global financial center, and it is not Hollande’s wrath which will change that (apart from the fact that because of socialist high taxation many of the better French forex traders have relocated to the British capital). Of all forex transactions done in the world, the greatest concentration is indeed in London. Statistics are an eye opener:

Not only financial transactions but also financial direct investments and capital management activities have deserted the French capital since the socialists took over. Of the 2012 euro 158 billion invested in Europe, more than euro 90 billion have gone to Luxembourg-based wealth management companies and another euro 50 billion to Dublin. For Paris, the catchment is nearly zero.³¹

The value of some continental stock exchanges, too, has fallen like a stone. The week prior to Christmas 2012, Intercontinental Exchange (ICE)—an electronic exchange based in Atlanta, GA—announced that it was near the end of negotiations to buy NYSE Euronext (the company resulting from the merger of New York Stock Exchange and of the holding of four European stock exchanges: Paris, Brussels, Amsterdam, and London). The agreed upon price is $8.2 billion³² and ICE let it be known, however, that when the deal is confirmed it will sell Euronext.

The indicative price put on the holding of four continental stock exchanges was a mere euro 1.5 billion, while Frankfurt-based Deutsche Börse masters by itself euro 9 billion.³³ The stock exchanges of Paris, Brussels, Amsterdam, and Lisbon seem to be priced at a mere 16.7 percent of the Deutsche Börse’s worth. This is a measure of how low the Paris exchange has gone. On an average, the number of daily transactions in the Paris stock exchange is equal to those for only Apple and Google at NYSE.³⁴

* * *

In a report that underscored the fiscal task facing François Hollande’s socialist administration La Cour des Comptes, the French government’s auditor, said: “France is hardly halfway towards budgetary consolidation which begun in 2011 and the easing of the timetable, justified by economic slowdown, does not allow for any relaxation.” The EU’s executive demand for keeping the agreed upon reform timetable angered Paris, with socialist ministers attacking Manuel Barroso, the commission president.

Barroso hit back in Les Echos of June 27, 2013 defending the reforms and saying it was a “complete error” to blame the commission for the rise of populism. “We are worried about France’s loss of competitiveness over several decades. If France has too big a gap with Germany we all have a problem in Europe.”³⁵

9.6 The French Banks’ Fragility as Lenders

Both in the United States and in Europe, the majority of banks have been using above-average levels of leverage to run their operations. After the 2007 subprimes crisis hit, this became counterproductive, and in response to equity market pressure, the banks’ management announced large-scale deleveraging. Balance sheet restructuring programs have been undertaken and plans were made to reduce their combined risk-weighted assets by billions.

What the French as well as the other European and American banks have found the hard way is that deleveraging after a credit bubble is a painful exercise, as well as a long process. But it is also necessary. Many economists now agree that the deleveraging process gripping the western world will likely continue for several years and remain a drag on growth. But there is no alternative because high leveraging in an economy which is in crisis can be the kiss of death to a financial institution.

In many cases, retrenchment amounts to a scale-down of roughly 12 percent to 15 percent, with banks attempting to downsize assets with the highest regulatory risk weights. Loans to sovereigns have been a case in point. By the end of 2011, the biggest French banks had already reduced considerable amounts of Euroland’s peripheral sovereign debt, and wrote down Greek government bonds to 40 percent of par value in preparation for the PSI³⁶ action.

In early 2012 with the so-called voluntary private sector loans writedowns, this 40 percent proved to be inadequate. At the same time, while a 60-percent haircut of other loans in distress strengthened their balance sheets, it simultaneously reduced their profitability. French credit institutions were penalized by the fact that they built up strong franchises in several countries over the preceding decades, and they lent heavily to foreign sovereigns.

Some of the banks sought to deflect ongoing concerns of lending too much to governments. Since late 2011, BNP Paribas reportedly cut in half the amount of Italian government bonds it owned, saying it would be able to maintain an adequate capital cushion by selling assets and reducing the amounts of loans it makes.

Several French bankers, however, blamed the US Federal reserve for their predicament as, worried about the escalating sovereign debt crisis, in the summer of 2011 the Fed asked US money managers to reduce their dollar funding to European banks. (This was allegedly stated by a senior French banker who spoke on condition of anonymity, citing the sensitivity of the situation.) True or false, that caused French financial institutions to pull back on the big business of lending to aircraft companies and other companies to whom they regularly made loans in dollars.

Given the fact that roughly half of global banking assets are European, other markets including the United States and emerging markets faced some funding pressures in the interbank market. According to estimates by their peers, French banks have combined capital needs of euro 30 to euro 36 billion, and at the same time they are holding large positions in Italian and Belgian bonds.

As 2011 came to a close, BNP Paribas reportedly had loans to debtors in peripheral Euroland countries of about euro 135 billion; and Crédit Agricole had euro 101 billion. In late 2011, French banks were downgraded by Moody’s due to the pressure they faced on liquidity and in funding markets. Among their challenges in 2011 were the Greek PSI, political upheaval in Egypt, and the downgrade of French government bonds. Available statistics indicate that the French banks exposure to sovereigns divided between:

The policies followed by Euroland’s sovereigns and banks landed them in a deadly embrace, particularly in the peripheral countries. As their heavy public debt led southern European governments into the danger zone, their lenders have suffered and investors are loath to risk more money on banking stocks.

There is an undeniable toxic relationship between banks and overly indebted governments, which economists call “death spiral” and French banks are part of it. “The French banking system is extremely fragile,” said an analyst. “Whether it will result in spectacular events is difficult to say.” French credit institutions have as well expanded into business sectors such as:

where they held market shares of up to 30 percent. But as the majority of these businesses are dollar-based and French banks had (and are having) difficulty funding themselves in money markets, they have been obliged to reduce their exposure to these operations which were otherwise lucrative.

Retrenchment is a defensive policy appropriate in an economic environment which is teetering. This principle of survival is just as valid of sovereigns as it is of financial institutions. Back in August 2011, Nicolas Sarkozy, the then French president, summoned his key ministers back from holiday for an emergency meeting as concern mounted over prospects for growth and the country’s ability to meet its debt targets. In an effort to reassure nervous markets, Sarkozy said his “pledges will be kept whatever the evolution of the economic situation.”

In fact, that meeting came as rumors circulated about French credit rating downgrade, with Société Générale plunging by as much as 23 percent on August 10, 2011. It closed down 15 percent, after it denied rumors over its financial stability, while Crédit Agricole was off 12 percent and BNP Paribas down 9 percent. Other European banks slumped too.

Given their sizeable assets in peripheral countries French banks have become nervous as concerns about Euroland’s breakup mounted. They could see that recovery of Club Med countries is not for tomorrow, and elevated credit spreads reflected a fading trust. Financial analysts recommended to their clients to avoid new positions in senior and subordinated bonds of BNP Paribas, Crédit Agricole, and Société Générale.

One of the financial analysts said in the course of our meeting that a euro breakup would be particularly disastrous to French banks; over and above the likelihood, it will lead to financial tsunami in Europe, a double-dip in the US economy and severe repercussions in Asian economies. Already Euroland’s crisis took a toll on Asian export activity as China became more dependent on demand from Europe than from the United States.

To restore faith in their financial health and regain access to money markets, European financial institutions, not only the French banks, must increase the cash they hold in reserve against losses. But bank executives complain that under present conditions the only way for them to raise more capital is to sell assets and curtail lending. The problem is that:

This leads to tough choices. Further weakening of the economy is evidently unwanted, but if the capitalization level of large banks is too low, then banks have to be recapitalized to restore market confidence. This in turn means that governments will have to step in if institutions cannot get money in capital markets, but the sovereigns themselves are short of capital. Cash from the ECB does not count as capital for regulatory purposes, though it addresses the problem that credit institutions face in raising money to lend to customers. Commercial banks typically:

In conclusion, the troubles Euroland’s economy has been going through are evidently reflected in the financial health of credit institutions. Big European banks have seen the average 5-year CDS spreads rise from just north of zero in 2007 to 450 basis points in 2012. (Though the average has fallen to 230 basis points later on, but rose again to 350 basis points.)

It is not without reason that near the end of June 2012 Moody’s Investors Service downgraded the credit ratings of 15 big banks. Economists said that the financial crisis exposed three decades of hubris. Banks that were powered by leverage expanded heavily onto trading, capital markets became very difficult to manage, and the big banks lost a lot of their freedom of action and credibility.

9.7 Efforts to Stabilize the French Banking Industry

In an interview he gave to CNN on June 6, 2012 Jeffrey Sachs, of Columbia University, said that the European debt crisis can be solved only after the banks have been stabilized. Sachs, and all other economists supporting a similar opinion, are only half right because they don’t account for the policies and effects of the big unholy connection between banks and governments which we discussed in Section 9.6. As ECB’s LTRO experience documents:

The irony with the ECB’s LTRO which loaned the banks more than euro 1 trillion ($1.3 trillion) is that they pay ECB a trivial 1 percent per year for 3 years, while the Spanish and Italian government bonds gave them 4 percent to 5 percent. In part, this wrong way risk was assumed because of greed. Another part, however, was plain pressure by sovereigns on banks domiciled in their real estate.

Speculation and stabilization are most evidently opposing concepts. Euroland’s banks with the biggest capital shortfalls are those from Spain, Italy, and Greece; but both Crédit Agricole and Société Générale faced serious problems. Some bailouts are a tragedy. On December 27 was announced that Bankia, Spain’s fourth largest bank, had benefited from a tandem of multibillion euro rescues—again had a negative equity of euro 4.1 billion.

Among French banks, Dexia is the competitor to Bankia in terms of bad loans and poor management. It has been the subject of three highly costly salvage operations by the French and Belgian governments within a few years. The euro 2.5 billion in public money dates December 31, 2012.

Four months earlier, on September 1, 2012, the French government rescued a distressed domestic mortgage lender. It had to seek approval from the European Commission for its bailout of Crédit Immobilier de France (CIF). Just to explain what can be a zombie bank, CIF had liabilities of about euro 40 billion and equity of euro 2.4 billion. In October 2012, it also faced the repayment of euro 1.75 billion in covered bonds. Moodys’ had:

Crédit Agricole, the third biggest bank in France by market value, is one of the French institutions which took a hit with the troubles in Greece, as well as with the derivatives gambles of its subsidiary Crédit Lynonnais (LCL). The cost of its withdrawal from Emporiki (Commercial) Bank, its Greek subsidiary, is estimated to exceed euro 6 billion.

Analysts said that back in 2006 the initial Crédit Agricole venture of euro 2.6 billion in Emporiki, and what followed it, would make an excellent case study on what “not to do” in banking. The formerly French farmers’ bank thought that it could make a fortune of Emporiki’s units in Romania, Bulgaria, and Albania. Altogether Crédit Agricole lost billions and suffered goodwill impairment. The story ended by selling Emporiki to Greek investors for 1 symbolic euro.

Italy, where its main arm is retail lender Cariparma, is Crédit Agricole’s largest market after France. The formerly agricultural bank also has stakes in banks in Spain and Portugal though it said it had reduced its stake in Spanish Bankinter to less than 20 percent and was open for its remaining holdings to all potential outcomes.³⁷

Critics say that Crédit Agricole’s foreign forays look set to haunt it long after it has retreated from foreign ventures. Apart the Emporiki debacle, it has suffered a euro 430 million impairment on its stake in Italian bank Intesa, and profit at its own subscale corporate and investment bank fell almost 60 percent.

Like its French peers, BNP Paribas and Société Générale, Crédit Agricole is retrenching to reduce risk and boost its capital, and it is also downsizing its corporate and investment banking operations. Part of the reason for the French banks’ retrenchment is fear of increased supervisory intervention, with legislators given power to limit what the banks can earn from the market as opposed to their clients. This is likely to eat into margins while, at the same time, French banks fear being put to a competitive disadvantage to peers in the United States, where the implementation of Basel III capital rules is likely to be delayed.

On the other hand, American banks have to work within the framework of the Dodd–Frank Act,³⁸ whose rules are much more severe than any regulation so far existing in Europe. They must also comply with the Volcker rule which bars banks from trading securities on their own account (Although the Volcker rule has yet to be formally implemented in law, American banks have already closed down their proprietary trading desks.).

British banking policy in the coming years has been outlined by the Vickers Commission report of 2011, which is currently on its way through the legislative process. Its basic concept centers on ringfencing to isolate the retail side of the bank, safeguarding its activities.

In Euroland, and the EU at large (probably with the exception of Britain), the basic concept on which will be based bank supervision and the stability of financial institutions is the report by the Likanen Commission, of September 2012. Its implementation will force groups with a universal banking model (comprising investment and retail banking) to ringfence almost all of their trading operations within separately capitalized and funded subsidiaries.³⁹ French banks have vigorously lobbied in Brussels to stop this plan from being implemented. But the EU Commission is pressing ahead, having concluded that nothing will be gained from reforms which are modest.

Two important themes have not been addressed by the Dodd–Frank Act, Vickers Commission, and Liikanen Commission. The one is how to break the vicious cycle created by the bank–sovereign deadly embrace, which is largely a political subject. The second is more technical than political, and it concerns first of all the wisdom of the policy and then, if this is proven, the criteria for salvaging badly damaged and self-wounded big banks.

Economists say that this too is a largely political issue and its impact is largely cross-border. Euroland’s ministers of finance who approved up to euro 100 billion ($130 billion) for recapitalizing (read: salvaging Spanish banks falling off the cliff) were not rushing to do so for philanthropic reasons. They have fallen to the same political fallacy which prevailed in the first months of 2010 when they rushed to “save Greece.”

Among them, the French and German big banks have an exposure of nearly $200 billion to Spain, while taken together the exposure of British and American banks exceeds $100 billion. But “saving Spain and the Spanish banks” in no way guarantees that the creditors will get back their money. If the Greek experience is any reference, the German, French, British, and American banks may well be in for losing 75 percent of their wrongly loaned capital.

Christine Lagarde, boss of the International Monetary Fund, was right when, on June 8, 2012 in a CNN interview, she made the point that serious deals don’t work that way. Asked if she would consider an IMF contribution in salvaging the Spanish banks, she answered that there are three prerequisites which, among themselves, constitute the golden rule of stabilizing the banking industry.

This, of course, presupposes first class management at European Union, the governments’ and the banks’ level. Unfortunately for everybody, first class management is in short supply and the same is true of strong leadership. Successful stabilization requires the breaking of the unholy banks–government alliance which has been a policy for decades. Short of that no solution is going to worth the money which will be thrown at it.

The slogan of May 1968 student revolution in Paris was “imagination in power.” In the four and a half decades which elapsed since then, two generations have come to power at both sides of the North Atlantic, but imagination did not accompany them. Life is organized around the old oak, and after the oak is cut down, the hard realities are emerging.

De Gaulle had seen coming the time of mediocrity. “The French,” he said to André Malraux (his minister of culture), “I have amused them with flags… (but) the country chose the cancer.”⁴⁰ This is true all over the West.

End Notes