What Europe needs from France and Germany

France and Germany, which together account for half of euro-area GDP, are rightly considered the key to the euro area’s exit from the current impasse of low growth, falling inflation and increasingly dangerous debt trajectories. But more importantly, the German-French couple is a clear example of the need for a coordinated strategy. Their unit labour costs have diverged by some 20% since the introduction of the single currency. This would not necessarily be worrying, but the world market share of French exports has fallen by more than twice that of Germany, and the current account gap has increased by more than 8% of GDP. France has not compensated for its rising costs by higher non-price competitiveness, while the German low-cost strategy has made the country more and more dependent on foreign markets.

The steady decline in inflation and the increase in the euro area’s current-account surplus are an indication that aggregate demand is too low in the euro area and in France and Germany. The stagnation of total factor productivity since the mid-2000s in several euro-area countries (including France) is an indication that deep reforms are needed for long-term growth to restart, and therefore for the sustainability of social systems.

To break out of the current economic impasse, a bold, coordinated Franco-German strategy is needed. It requires simultaneous implementation of measures in both countries.

Currently, there is no political consensus in France for far-reaching reforms that would encompass structural spending cuts and changes to some services market regulations, and would also improving the functioning of the labour market. This could be done, for example, by reconsidering the labour contract in order to incentivise long-term hiring, or averaging working time across the year, rather than week by week, which would be a smooth way of reducing unit labour costs. There is also, so far, no consensus in France on the need for education system reform. Such reforms would boost French productivity growth, stimulate innovation and also help to narrow the unit labour cost gap with Germany.

Before the full gain from productivity can be reaped, wages and other costs such as housing will need to grow more slowly in France than in Germany, so that the former can regain competitiveness and the latter can alleviate its excess dependence on external demand.

Germany should gear its efforts to boosting its own economic activity. Boosting domestic demand is part of the answer and could be quickly achieved through lower taxes on low-income households and a credible strategy for public investment. For this, accepting that the “black-zero” balanced budget must be given up is essential. But structural reform to develop the non-traded goods sectors, for example IT services, is also essential. The introduction of a minimum wage next year increases the need to focus on such high value-added sectors. The education system should support a shift to the new growth sectors of the 21st century, where Germany is lagging behind. This renewed economic dynamism needs eventually to lead to an inflation rate of above 2 percent, which is required to support the rebalancing.

With the prospect of an increase in demand and inflation in Germany, the French government would have more leeway to cut social contributions and social spending, and to implement far-reaching structural reforms. The French government’s recent announcements of reforms to protected sectors, although going in the right direction, will not be sufficient. Aggregate demand is not only a question of fiscal stance. France needs to reduce the uncertainty surrounding future policies, which is currently a powerful drag on private investment. Clarifying the future path of tax rates and energy and carbon prices is one issue. Agreeing on a number of medium-term fundamental objectives covering issues such as vocational training, tertiary education, lifetime working hours, the health system and housing subsidies, are needed to anchor expectations. Credibility, through political agreement on medium-term objectives is needed to trigger private investments

The success of such a joint strategy will of course depend on what happens at euro-area level: on the ability to finance European Commission president Jean-Claude Juncker’s €300 billion investment project with fresh money, on the willingness of the European Central Bank to do what it considers necessary to meet its target of an inflation rate “below but close to 2 percent”, and on the ability of the European Commission and the European Council to enforce the fiscal rules without suffocating the economy. France and Germany have a major responsibility as shareholders in the European Investment Bank and as direct participants in the European Council. But, equally importantly, they have a responsibility to reduce the structural divergence between them by introducing coordinated deep economic reforms at national level.

Published in collaboration with Bruegel

Author: Agnès Bénassy-Quéré is the Director of the CEPII. Guntram Wolff is the Director of Bruegel.

Image: The Euro currency sign is seen next to the European Central Bank (ECB) headquarters. REUTERS/Lisi Niesner