Fake five hundred Euro banknotes are placed by Pole Emploi Strikers on the gates outside the Paris Stock Exchange on November 14, 2011. France needs to reform its economy to stave off a debt crisis.
Credit: Pascal Le Segretain

PARIS, France — The euro zone’s debt crisis took an ominous turn for the worse last week, when a German bond auction failed. That raised concerns that Europe’s biggest economy — the strongest pillar of the continent’s bailout program — was beginning to crumble as well.

Ironically, the news actually caused many in Europe to breathe a sigh of relief, briefly at least. With Germany feeling the heat, leaders in France, Italy, Spain and Greece could finally hope for some compassion from Berlin. Germany, and particularly its Chancellor Angela Merkel, has staunchly claimed the high moral ground in the crisis.

Despite fears that Europe's economy could suffer a deep and painful crisis, Merkel has seemed more intent on allowing the markets to punish the profligate political sinners than in devising a solution to stave off contagion.

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But now that investors are shunning German debt as well as that of the rest of Europe's major economies, would Berlin see the logic of a more accomodating approach?

The answer came late last week, after a meeting with French President Nicolas Sarkozy and Italian Prime Minister Mario Monti. Merkel stated that her views remained unchanged. So much for compassion — at least for the moment.

Divergent views over how to contain the crisis has driven a wedge in the euro zone, and particularly between France and Germany.

French President Nicolas Sarkozy wants the European Central Bank to play the role of lender of last resort, to protect sovereigns from having to pay the high interest rates that increasingly-nervous investors are demanding. Merkel, in contrast, insists that solution to the crisis lay with government austerity, rather than  taking a more agressive monetary approach.

For France, the German resistence leaves few options, and test President Sarkozy's power less than six months before national elections.

Credit rating firms have warned that France’s prized triple AAA rating is not entirely secure. Fitch Ratings says the world fifth-largest economy has limited room to absorb any new shocks to its public finances. Investors are increasingly shunning French bonds, which means the country’s borrowing costs have started climbing.

Economists fear that, in a worst case scenario, France risks being sucked into a debt trap: rising interest rates would push up borrowing costs for the government, making it harder to pay down debt. Heftier debt payments would, in turn, would suck money from the economy, and make it more expensive for companies to finance investments. Less investment would mean slower growth, putting people out of work, reducing tax revenues and increasing the payments that the government will need to make to the unemployed.

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Greece is currently suffering from this type of debt trap.

Sylvain Broyer, chief economist at the French bank Natixis, cautions against panic. Interest rates on French bonds have peaked at nearly 3.7 percent — that’s a little over half the Italian rate of 7 percent.

Broyer suggests officials should react like the British government in 2009, when the Bank of England massively bought assets to calm markets.

The problem is, France can’t do this, because as a member of the euro zone, its central bank doesn’t control the money supply.

"Only the European Central Bank can do this. France isn’t in charge. [It] doesn’t control its own destiny," says Broyer.

On the contrary, Germany currently controls France’s destiny, given its effective veto power over using the deploying the power of the ECB in this way. The ECB’s charter specifically forbids the bank from lending directly to governments, to prevent it from bailing out spendthrift politicians within the 17 member currency union. Reversing this policy would require German acquiescence.

So far, Germany has argued that France and other troubled sovereigns need economic reforms rather than a quick fix from the ECB.

There’s some validity to this argument. Alarm bells are ringing for France, and many worry it is falling behind other AAA rated countries. In a recent report by the Lisbon Council, a leading think tank, France ranked below Spain — a country with 21.5 percent unemployment – in its overall economic health, due to bloated government spending, poor competitiveness and youth unemployment.

President Sarkozy, who suffers from a rock bottom popularity rating, is well aware of his country’s problems, but he’s too weak to do much about it.

In an attempt to appease investors, his government has pushed through two austerity plans, but they’ll save a mere $25.7 billion by the end of 2012, compared to nearly $2 trillion owed, according to OECD figures. Top measures included increased VAT for restaurant meals, new taxes on tobacco and sweet drinks. It’s the fiscal equivalent of scraping the bottom of the barrel.

The plans lack something that reassures investors: vision, strategy and scope.

"The government has failed to convince others that they have a long term strategy to protect France’s AAA rating. The measures won’t damage growth, that’s a smart move. Overall, they are trying to buy time," says Broyer.

Some see the crisis as an opportunity to address a few of the country’s real problems: sluggish growth, youth unemployment and growing social inequalities.

"I think the crisis will encourage politicians to talk about European reform and [about] adjusting spending policies. It’s a great opportunity to discuss these topics ahead of an election," says Agnès Bénassy-Quéré, director of the French research institute CEPII as France prepares for presidential elections in April and May.

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Bénassy-Quéré says the government must reduce public sector spending, which has reached 53.7 percent share of GDP over the past decade. That’s eight percent more than the euro zone average.

Bénassy-Quéré warns that structural reforms will also be needed if budget recovery measures are to be successful. "We need to introduce more competition in the sectors of transport and distribution…. Excess returns should be used to increase buying power and push up demand," says Benassy. "That’s what is missing in the French plan."

There’s a clear sentiment in France that their economic model is running out of steam. The French want change but they don’t want to write off their generous welfare state. And the suspicion is high that rating agencies — often derided by the press as "Anglo-Saxon" and somewhat imperialist — have their own free-market agenda.

However, Norbert Gaillard, consultant and author of "A Century of Sovereign Ratings," says Europeans need not sacrifice their welfare state to stay competitive. Gaillard would like to see his government increase taxes for the richest 5 to 10 percent, but reform retirement and labor legislation, two explosive topics in France.

Economists are now looking abroad, to success stories in Sweden or Germany, to draw inspiration.

Gaillard says Sweden’s credit rating was downgraded several times in the 1990s before they successfully reformed their welfare policies.

Are the French politicians seizing this opportunity for renewal? Not yet, and not fast enough.

"Political parties and presidential candidates haven’t yet fully integrated the changes that are taking place. They don’t understand how quickly investor sentiment is changing," says Gaillard. "They need time."

Leading candidates, incumbent Nicolas Sarkozy and Socialist candidate François Hollande, have yet to explain how they will tackle the debt crisis.

They have time. But if politicians do not seize this moment to make France’s system more sustainable, later down the line, it might be too late.

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