France's long fight for monetary credibility

Viewed through Anglo-Saxon eyes (and I am a Celt), the current stance of macro-economic policy in France appears extremely difficult to comprehend. The economy is suffering from a recession that has been prolonged and deep, the inflation rate is among the lowest in the developed world, and the balance of payments is comfortably in surplus. If ever there were a justifiable case for very low interest rates, this would appear to be it. Yet real short-term interest rates remain well over 4 per cent.

There have been several occasions this year - the election of the Balladur government in the spring, the widening of the exchange rate mechanism bands in the summer, and the appointment of Jean-Claude Trichet to the governorship of the almost-independent Bank of France in the autumn - when a change of stance could have been introduced without much political loss of face. But no change was made.

It is too easy for thoughtless Anglo- Saxons to dismiss French policy makers as 'crazy' - a description often heard in the financial markets. But the French establishment is in fact among the best- trained and most intelligent in Europe; in many respects, the crack troops of Europe's administrative army. So what are they up to?

On a recent trip to Paris, I found two themes constantly cropping up as the policy was explained. The first, predictably enough, was that France remains absolutely committed to monetary union with Germany, and as soon as possible. The partial break-up of the ERM in the past 12 months is of course recognised as a big setback to these hopes, but it is certainly not viewed as fatal.

The French believe that the small decline in the franc against the German mark since the old ERM bands were breached on 2 August (only about 2 per cent so far) has been insufficient to constitute a collapse of their strategy of maintaining a semi-fixed exchange rate with Germany. They accept that there will not be a return to narrow bands in the ERM in the near future, but they believe that the next best thing is simply to keep the exchange rate trading as near as possible to its old bands, and preferably inside them.

In fact, with French industry clearly extremely competitive relative to Germany's at existing exchange rates, the Paris authorities are quietly confident that the franc/mark rate will be back inside its old bands within a year or two.

In the meantime, they see no point in allowing a temporary devaluation to take place, not least because every pfennig of weakness in the franc now will, they believe, make it harder for them to persuade the Germans to accept a monetary union later.

In other words, the French are playing a long game to convince the markets that they were wrong to force the franc out of the ERM grid in the first place (and if they can impose some belated losses on the 'speculators', so much the better). Simultaneously, they are determined to convince the Germans that they really are serious about maintaining monetary credibility.

Clearly, there is an unspoken assumption that the Kohl government, after its painful experience with German monetary union, will not countenance another such enterprise with weaker economic brethren. The only option for the French, therefore, is to convince the Germans that Franco-German union would be a coming together of monetary equals.

These strategic objectives are quite definitely seen by the French as sufficiently compelling to justify the acceptance of short-term losses to jobs and output if this is necessary to achieve them. But the second theme heard in Paris is that these sacrifices are in fact small, if they exist at all. This is because the French are far from convinced that they could declare monetary independence from the Germans, even if they wanted to.

The first graph shows the current rates of interest on bonds of different maturities in five important economies. Rates in France and Germany are now virtually identical throughout the yield spectrum, and UK rates are not dissimilar.

The French believe that this is caused partly by the very close integration that now exists between the capital markets of the large European economies. This, they think, automatically causes interest rates to be very similar across economies with similar inflation performance.

They see Italian rates as higher because of the much greater inflation risk in that country, and American rates as lower because of the much smaller degree of economic integration between the US and Europe.

To the extent that the French believe they have the freedom to reduce short- term interest rates below those in Germany, they strongly believe that the inevitable result of this would be to reduce the credibility of their counter-inflation policy, and to push long- term bond yields in France upwards.

They note, with a certain satisfaction, that UK bond yields remain markedly higher than those in France and Germany, and they point out that most mortgages in France, unlike those in Britain, are on long-term fixed interest rates.

Therefore, reducing short rates at the expense of increasing long rates would actually damage economic activity. And the decline in French long bond yields to under 6 per cent, which has now occurred, should, they believe, be sufficient to rekindle economic activity in 1994.

Gross domestic product stabilised in the second quarter of 1993, and early indications suggest that output will resume an upward path in the third quarter of the year.

With the worst now over for activity, the authorities see it as madness to contemplate throwing in the monetary towel when 'victory' is so close.

These arguments obviously have force, but if in the end they fail - implying that French interest rates will eventually be forced below those in Germany, with some temporary weakness for the currency - it will be because of the strong fundamental undercurrents depicted in the second graph. This shows the level of GDP on both sides of the Rhine, relative to a common GDP trend which can validly be drawn for the two economies up to 1989. (This is extrapolated thereafter at the trend growth rate of 2.3 per cent per annum, which seems common to both countries.)

French GDP is now about 5 per cent below this trend, implying that there should still be intense downward pressure on inflation, interest rates and (for a while) the franc.

Meanwhile, German GDP is less than 1 per cent below the 'trend', reflecting that the recent 'recession' has merely seen the unwinding of the remarkable 1989-91 unification boom.

These huge differences between the 'output gaps' of the two countries - which will persist for some years, even if activity now recovers more rapidly in France than in Germany, as seems likely - would normally be expected to lead to large differences in interest rates, with obvious consequences for the currency. These are the fundamental forces that the French authorities must continue to combat.

The Bank of France has clearly won its battle for 'monetary credibility', in the sense that the bond markets now view French and German instruments as interchangeable at the same interest rates. But the French will not be satisfied until they have also won the battle for full monetary union with Germany - and, given the fundamental differences that continue to separate the two economies, that remains an uphill struggle.

(Graphs omitted)