Markets are skittish. The chairman of the US Federal Reserve, Ben Bernanke, spooked investors saying that the Fed "does not have the tools to ease the fiscal cliff.” In a similarly uncomfortable reality, the sovereign credit rating of France has been downgraded by Moody’s, a move that should bring into focus the budget deficit and government debt problems in the US.
While there are massive differences between the US and French economies, the things that matter to rating agencies, debt and deficits, are in fact wider in the US than France. While Standard & Poor’s has already downgraded the US rating, Moody’s has yet to take such action although it has warned the rating is on constant review and the policy reaction to the fiscal cliff will be critical to its assessment.
In France the unemployment rate is above 10 per cent, GDP growth is bouncing around zero and there are a raft of structural problems that are suppressing productivity. In this light, it was not all that surprising to see Moody’s downgrade France’s sovereign debt credit rating.
That downgrade reopened some sore points that went to the heart of the structural problems of the French economy. According to Moody’s, the reasons behind the downgrade (code for a greater risk attached to the ability of the French government to raise and repay its debt), should be ringing alarm bells for eurozone watchers and those hoping that there would be a restoration of economic prosperity in the next few years.
Moody’s move had at its core a macroeconomic view that centred on high labour costs and poor productivity. Moody’s said that these factors were undermining competitiveness, which "is the risk to economic growth, and therefore to the government's finances, posed by the country's persistent structural economic challenges."
It was not the levels of debt and deficit per se that led to the downgrade, rather it was the structural rigidities that were undermining economic growth and indirectly limiting government revenue and the deficit reduction plans. Moody’s was damning when it noted, "these include the rigidities in labour and services markets, and low levels of innovation, which continue to drive France's gradual but sustained loss of competitiveness and the gradual erosion of its export-oriented industrial base."
Moody’s concern with France is likely to extend to the US, for reasons linked to the fact that US net government debt as a share of GDP is higher and the US also has a larger budget deficit. France’s medium terms fiscal outlook is, interestingly, also superior to the US, with government debt projected to fall versus a forecast rise in the US. This in itself leaves open a huge risk of a US credit rating downgrade, a point already flagged by the major rating agencies. A downgrade will only be avoided if policy makers successfully addresses the fiscal cliff and other budgetary matters.
To be fair to France, its credit downgrade by Moody's glossed over a series of productivity enhancing reforms introduced by President Francois Hollande. In particular Hollande delivered a company tax cut of €20 billion a year, which is equivalent to a 6 per cent cut in labour costs. In addition to that productivity enhancing, pro-growth dynamic, Hollande has also announced €30 billion of budget cuts as it works to reduce the budget deficit. But these welcome policies are not enough when labour market inefficiencies are still seen to be depressing productivity growth.
The US, it must be said, has a number of macroeconomic policy advantages over France. In the US, the Fed has set interest rates at zero for four years and, some time ago, embarked on a program of quantitative easing. In France, the European Central Bank has been slow to cut interest rates and the quantitative easing is piecemeal. The US also has its own currency, unlike France which is locked into the euro, a point that has to some degree helped US exporters as the US dollar has tended to be weak in recent years.
Despite his warning about the fiscal cliff, Bernanke expressed a note of optimism. He said, "a plan for resolving the nation’s longer-term budgetary issues without harming the recovery – could help make the new year a very good one for the American economy.”
In those words, there is a clear incentive for the fiscal cliff to be addressed. A sensible mix of tax rises and spending cuts will moderate the impact of the fiscal tightening but will keep the trajectory towards lower budget deficits and a topping out of debt levels in place. If it can be achieved, perhaps the US will avoid a further credit rating downgrade and of course, a double dip recession. Unfortunately, France has missed that boat.