The Last Model Standing Is France

The rules-based approach embodied in Europe's Stability and Growth Pact (which was adopted at Germany's behest) has not fared much better. Germany's reluctance to acknowledge the depth of the economic crisis in late 2008, and to design a policy response, allowed France and others to effectively abolish the fiscal rules. Almost all major European economies are likely to breach the pact's 3 percent deficit ceiling in 2009 and 2010.

The "go it alone" approach has failed, too. The credit crunch has brutally reminded many smaller European nations why it makes sense to adopt the euro. Even Denmark, which runs a better economic policy than almost any other European country, had to seek help from the ECB and raise interest rates to prevent a run on its currency in October 2008. The safe-haven appeal of the euro is even more glaringly obvious for fragile economies such as Hungary and Poland.

While all these models have lost credibility, French-style pragmatism is spreading across Europe. When financial markets were working well, the Parisian penchant for supporting state-favored industries and national policy objectives was met with deep skepticism abroad. But with the unfolding crisis, the French habit to readily intervene in market processes has become a more widely accepted norm.

At its core, the French approach to economic management reflects a deep-rooted suspicion that the free movement of capital may not always yield politically desired outcomes. Unfortunately, the global credit crunch has strengthened this French argument, although closer inspection suggests that much of the financial excesses that turned to waste can be traced back to misguided signals sent by governments and central banks, rather than to alleged private-sector malfunctions. We expect France to continue its calls for tighter regulation of global capital markets.

Fortunately, France's forceful president, Nicolas Sarkozy, is not only an interventionist. He also champions a common-sense approach to labor markets, with a strong emphasis on old-fashioned work ethics and a contempt for socialist lunacies such as the compulsory 35-hour workweek. So far, the European Union has been characterized by a very liberal regime for capital markets, and often grossly inefficient labor markets. If the French model continues to gain steam, this may be flipped—labor markets may be allowed to work better, while financial systems may be more regulated than before. Global investors can only hope that Europe gets the balance right. If ad-hoc interventionism spreads too far, the continent may eventually have to pay a hefty price in terms of constrained opportunities for innovation and growth. Europe would then be outclassed once again by the eventual resurgence of the more flexible United States.

Schmieding is chief European economist at Bank of America.

© 2009