The Daunting Problem of Economic Reform

~ Frederic Sautet ~

Last week Paul Krugman told the world about a plot against France, as Standard and Poor’s downgraded the country’s bond rating to AA+. Bearing in mind that the public debt of most major Western countries will never be repaid, what agencies look at is the extent to which countries can service their debt.

But consider the following stylized facts for France in 2012:

• Public debt represents more than 90% of GDP.
• Annual interest payments alone (i.e. less than debt servicing since it does not include repayment of principal) amount to the entire receipts of the income tax (and it’s been that way for more than a decade).
• Tax revenues amount to 46% of GDP (while total revenue, which includes the receipts of government-owned corporations is higher).
• Public expenditure represents 56% of GDP.
• Public deficit reaches almost 5% of GDP (while it is supposed to be no more than 3 % under EU rules).

Most of the increase in public spending since the 1960s is due to social transfers and debt servicing. In other words, the welfare state has been financed through debenture. And the trend continues. Commentators such as Veronique de Rugy have argued that Krugman is wearing rosy glasses. Even Philippe Aghion from Harvard, who is not known for being a free marketeer, criticized Krugman in a recent column in Le Monde. The idea that Krugman is mistaken, misguided, and misled by his Keynesian deficit-spending-creating-wealth-view is hard to deny. But what strikes me here is how far he is from realizing what is currently taking place in France and in other European countries.

Just take unemployment in France (a topic he doesn’t talk about in his column), which is officially at around 11%, but is in reality (that is, once you remove all the subsidized jobs) perhaps 4 or 5 percentage points higher (and that’s without taking into account the bloated public sector). Youth unemployment is above 25%. Unemployment in Europe results mostly from labor market regulations and subsidies to idleness; and it has been structurally high since the 1980s (on average 2 to 3 points higher than in the US). The emotional and physical toll of unemployment on the population is immense. Far from being reassured that the welfare state will take care of them, French people fear the risks of being unemployed. It is always part of the conversation, even if you are highly educated — which also explains the brain drain. 

Interestingly one sees more and more public intellectuals of all parties agreeing that the country is in dire straights and that something must be done rapidly to avert disaster. The fundamental question now is not only which reforms should be pursued, but also, how can the country be reformed? And this is an issue for most Western countries that are on the same path as France, including the US. Can the system of majoritarian parliamentary democracy enable social change on a vast scale? The French president François Hollande has just reached approval ratings below 20% and seems completely paralyzed. The population doesn’t know whom to trust anymore and where to go. The conservatives failed under Sarkozy and now the socialists, who had promised a new era for France, are failing even more. The French suffer from promise fatigue and do not know where to turn. Like in Greece, Spain and Italy, the population has lost its belief in the political class and its leaders.

As I stated in a post in 2012, Hollande is an insider, which means that the likelihood that he will engage in any meaningful reform is very small. Reforms are often the result of the combination of two factors: (a) the arrival of outsiders who have no interest in maintaining the status quo and (b) an external event such as an uncontrollable crisis that gives outsiders a chance to implement reforms. France and many European countries are on the verge of social implosion. The tax revolt in Brittany over the last few weeks is an example of the tensions that exist. It’s only a matter of time before things go really bad. To engage in the type of reforms France, Spain, Greece, Italy, the US, and many other countries around the globe need would require sacrificing short-term interest for long-term gains (the opposite of the dynamic of majoritarian parliamentary democracy). But who would be willing to do that considering what it takes to succeed in politics? Who would be willing to abandon deficit spending once in power, and then put the fiscal house in order? Not Hollande. Not Obama. Meaningful economic reform seems impossible before it happens. But let’s remember what James Buchanan used to say: “I am an optimist if I look backward, and I am a pessimist if I look forward.” That’s perhaps the only hope we have now for Europe: while theory shows that reform seems impossible, history proves that great leaders often emerge in times of despair.

Comments

[Rafe Champion]

An alternative to the Krugman view.
http://us1.campaign-archive2.com/?u=bf16b152ccc444bdbbcc229e4&id=9114a1817b&e=aefe4de8f1

[Roger McKinney]

This is largely a debate between macro and micro. Krugman see micro as irrelevant and monetary policy as impotent. Of course, he has been right about monetary policy.

In a recent column he blamed Germany for the problems of all of Europe because Germany runs a current account surplus. He called on Germany to quit harming its neighbors and to ruin its economy as the others have by saving less and being less productive. He totally ignores the micro problems that the Big EZ South has created for itself.