What Have the French to Be So Happy About?

It's easy to get inured to the grotesque when tracking European leaders 'tackle' the crisis of their own making and sustaining. But not today. Because today  I  read of the trials of Bankia. This is a Spanish savings bank, which, sadly, not longer enjoys access to the money markets.  Consequently, it joins the queue at the ECB's lending window of last resort. When it gets to the head of the queue and explains its predicament, the ECB's man at the window says: 'And what collateral can you offer me?'  Bankia rootles around in its exquisite leather briefcase, produces a piece of paper and say, triumphantly, 'Well, I've got this!'  And 'this' turns out to be the £80 million loan Bankia made to Real Madrid to allow it to buy Portuguese dribble-wizard Ronaldo from Manchester United.  In truth, the Bankia is offering to the ECB is nothing more or less than Ronaldo.  

So even if the ECB can't rescue the Eurozone, it still should have a sporting chance at the World Central Bank Football Cup, to be held in Basel (or Beijing) in 2015.

But back to France. What have the French to be so happy about? (except the wine, cheese, weather, light . . . oh God, the list goes on). Earlier this week, as Europe's financial foundations crumbled, French consumer confidence was measured as its most joyeux of the year.

The Franco-German relationship is au fond the point of the European Union: back in the 1950s the European Iron and Steel Community was initiated precisely a de-fang the strategic industries of the Ruhr (principally Krupps - read William Manchester's 'The Arms of Krupp' for details), so that they could never again subvert democratic governments into making war on their neighbours. The Krupps did magnificently out of the Franco-Prussian War, and also World War One, and the Krupp family spotted Hitler's potential, and funded his rise in the early 1930s - so you can see how powerful the analysis would have been. When President Mitterand announced that 'L'Europe, c'est la paix', that's how he understood it.

Notice, however, that even at this stage, the point of the pan-European institutions was to provide a countervailing institutional force to the enduring dissimilarities between France and Germany.  So when we look at the Euro, the really crucial question is not whether Greece or Portugal or Spain (or even Italy) is a viable part of a common currency zone, but whether France and Germany can coexist in the same economic, financial and fiscal state.  The introduction of the Euro finally seemed to answer that question with a triumphant 'Oui'. Now look at this:

That's the spread between French and German 10yr government bond yields. I've averaged it over the last month to make it easier on the eye - and as a result it mildly underestimates the current spread. As of yesterday's (Friday's) close, the spread was 68bps. The Greek 'rescue' packages, whether ultimately successful or not, seem irrelevant to the development of this spread. 

I'm conflicted about how to read it. One could say that it represents the market's correct judgement that France's fiscal foundations are somewhat flimsier than Germany's, and so the market is working. Or one could say that the emergence and endurance of a noticeable spread represents the market's view that should push come to shove, German tax payers won't be in the business of paying French state pensions. In short, that Franco-German fiscal union will never happen. 

Whatever the reason, unless one really believes in the possibility of Franco-German fiscal union one should expect the spread to widen over the medium and longer term.  Because when it comes down to it, the French and German economic models - ie, the way they grow - are now radically different. And for historic and structural reasons, that difference is going to be far more pronounced in the next decade than it was in the previous decade.  

The next couple of charts explain how and why. The first shows the different trajectories of return on capital in France and Germany, based on an indicator measuring the flow of GDP as a return from a an estimated stock of capital. (Nb, this is a directional indicator only, not a direct measurement of ROC.)

As you can see, Germany's ROC was climbing sharply before the financial crisis (as it economically digested East Germany), and has rebounded to near record levels since. No guesses for which way it's likely to continue to go.  France's ROC record, on the other hand, has been one of sustained and enduring erosion. More, only now is it beginning to show some recovery from the financial crisis. Germany's historically low ROC surpassed that of France in late 2007 and has never looked back (perhaps coincidentally, just at the time that the yield gap also opened up). The gap between the two has widened, is widening, and there's no reason to think that won't continue.

France's growth strategy meant that is didn't notice much, because it compensated for a slightly lower relative ROC by building its asset base faster than Germany. So in the years immediately prior to the financial crisis, French capital stock was growing 5%-7% pa, whilst Germany's was, well, hardly growing at all.  France grew by growing its asset base whilst its ROC fell; Germany grew by sweating a relatively static pool of assets. Taken together, the two models resulted in pretty similar growth rates.

But, as the economically observant of you will already have noticed - these were two growth rates passing like ships in the night. Regardless of the crisis eroding the fringes of the Eurozone, there are very different economic futures beckoning for Germany and France. Germany's higher and rising ROCs invite and justify further expansion of its capital stock - something that will become only more attractive as German labour markets tighten. All in all, then, we should expect a fundamentally-based acceleration in German GDP growth sustainable over the medium and long term. For France, the opposite it true: stagnant ROC will likely continue to weigh on investment spending, growth of capital stock and ultimately growth in the medium and longer term.

To sum it up, Germany's medium and long term economic future looks rather different (and considerably brighter) than France's, in a way which reveals a fundamental difference in the growth models of both countries.That difference has been masked throughout the short lifetime of the Euro by the costs imposed on Germany by its absorption of Eastern Germany. No longer - the mask is off, and Germany's underlying outperformance is going to become more and more obvious.

All of which raises two questions. First, can France change its growth model? And second, what have the French to be so happy about?