Europe Follows the French Model

The global recession takes its toll not only on those who lose their jobs, their houses or a chunk of their retirement savings. The crunch of the century is also sweeping aside many established ideas of how societies should run their economies. This impact will still be felt when the recession has long given way to a new upswing.

Of course, it is too early to assess how the global economy will look when the dust has settled. But in Europe, some trends are emerging. For better or worse, French-style pragmatic interventionism is gaining the upper hand as other economic models have lost credibility.

First and foremost, the British model of turbocharging the business cycle with excessive private or public borrowing has failed the test of time. It will be a long time before households in Britain, and in the United States and Ireland for that matter, will again be willing and able to treat their houses as piggy banks, taking out ever bigger mortgages on seemingly unstoppable increases in house prices.

Ten years ago, Britain's Gordon Brown had promised to put an end to "boom and bust." He delivered an artificial surge in economic growth driven by runaway public spending, followed by a big bust. As the economy now contracts sharply, Britain's budget deficit looks set to reach almost 10 percent of GDP in 2009. Previous British claims that it is managing its economy better than other European countries now ring rather hollow.

However, German ideas of strict monetary and fiscal rectitude have also been undercut by the crisis. The European Central Bank, designed as a clone of Germany's stability-minded Bundesbank, initially got its policies right. While the U.S. Fed cut interest rates all the way down to 1 percent in 2003, the ECB stopped at 2 percent, helping Europe avoid the worst of the U.S.-style credit and housing market boom-bust cycle.

But when the spike in oil prices pushed up inflation in mid-2008, the bank overreacted. By raising interest rates in a cyclical downturn, the ECB weakened the economy and the financial system at the worst possible time. This damaged the appeal of its single-minded pursuit of price stability. Economic historians may well call mid-2008 the end of the Bundesbank model.

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.