Hamish McRae: Vive l'eurozone – as long as France accepts more austerity

It is countdown to a new regime in France, with the latest negative data on the economy tipping the balance of probability against the incumbent – however unfair that might be. It may well be that the outcome will be determined by the campaign itself, but what can be said ahead of the two rounds of voting is that whoever wins, there will be a change of direction in French economic policy. The French will not be voting for more austerity, indeed they may vote against it, but that is what they will get.

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What happens in France matters enormously to the future of the eurozone, and not just because of its size as second only to Germany within it. It matters because it is the hinge of the zone. In some ways it resembles the southern fringe, having lost competitiveness since the euro was founded and having relatively high national debts. But in other ways it resembles the northern bloc, with competitive companies and a government that has been committed to correcting its budget deficit. It has not made as solid a recovery out of recession as Germany, but its performance is vastly better than that of Italy or Spain. So far France has avoided dipping back into recession, but the economy is currently flat, and if you look at the implications from surveys of company opinion, at least one quarter of negative growth looks on the cards, as the top graph shows.

You can catch a feeling for this "in between" status by looking at bond yields. German 10-year bonds trade at around 1.7 per cent; Italian ones are 5.5 per cent; and French are currently 3 per cent. (UK 10-year gilts are just under 2.1 per cent; US bonds just over 2 per cent.)

Of course that is just a snapshot, and before Christmas, when fears about the eurozone were at their height, French yields reached 3.5 per cent. But you can see the way the country's creditworthiness is regarded: not as good as Germany (or the UK and US), but not bad by eurozone standards.

The issue is whether that might change – in one direction or the other – after the election.

There are two broad ways in which you can analyse the election. One is to look at the two candidates' stated plans; the other is to make an intuitive judgement, not just about what they might do in practice but how the country might respond.

On the plans, there have been the high-profile comments of François Hollande on tax and the labour markets: a millionaires' tax rate of 75 per cent, some cuts in VAT, and job creation in the public sector. At a macro-economic level, Mr Hollande promises a slower correction of the budget deficit than President Sarkozy. You can see some projections in the next graph: the government's present plans, the somewhat slower correction planned by Mr Hollande, and what might happen were economic growth to be slower than official forecasts. The present government forecast is for growth of 0.7 per cent this year; Nomura, which did those projections, thinks the economy will shrink by 0.2 per cent.

As you can see, on present plans the deficit would be eliminated by 2016, or under Mr Hollande, 2017; but if growth is slower, then the deficit would fail to close under either candidate.

Well, those are the stated plans. You could say that under a Sarkozy presidency the markets would have more confidence that the deficit was being brought under control, whereas under a Hollande presidency there would be a danger that there would have to be some sort of emergency change of direction a few months in. But if growth disappoints this year, actually both candidates would have to change course. Nomura notes that both are committed to correcting the deficit, and that under both some further fiscal consolidation seems likely to be necessary.

The problem for France, however, is not just that it needs to keep marching towards a budget balance. That is a task facing just about every government in the developed world, including our own. It is that France has progressively lost competitiveness vis-à-vis Germany since the eurozone was founded, and even before. You can see how French labour costs have moved out of line since the middle 1990s in the final graph. In the absence of a devaluation, impossible under the euro, the answer to that can only be structural reforms that have the effect of depressing French pay rates. Faster growth would help correct the fiscal imbalance, but it would not of itself correct the labour cost imbalance.

It is hard to see quite how this will play out. On the face of it, the proposals of Mr Hollande – such as boosting public sector employment – would move the country in the wrong direction, encouraging a less flexible labour market rather than a more flexible one. But in practice I'm not sure. The question really is whether a change of president would encourage the country to look back to its dirigiste past or whether a change of leadership would itself have a positive impact. It might be easier for someone coming from the left to sell structural change to the French than it would be for an incumbent from the right to continue doing so.

There is a further practical issue. France is the second largest guarantor, after Germany, of the eurozone rescue funds, so it is important for Europe that it retains is own fiscal credibility. You cannot have Germany effectively as the sole guarantor of the euro support mechanism, though in practice that is the way things have been heading. So there will be tremendous European political pressure on the next president to scrunch down on France's fiscal deficit. If Europe is to move towards greater fiscal convergence, with ever-tighter central controls on what a government can and cannot do, then France has to fall into line. If it were to fail to do so, then the idea of a European fiscal compact would fail with it.