Apres Madelin, Le Deluge?

Ever since France's new government took power last spring, Parisian political insiders have wondered how much common ground really existed between Prime Minister Alain Juppe, a consensus-building technocrat, and Economics & Finance Minister Alain Madelin, a free-market crusader and intellectual godchild of Margaret Thatcher.

On Aug. 25, they got their answer: None. After weeks of rebuffing his maverick minister's calls for unpopular spending cuts and civil service reform, Juppe abruptly demanded Madelin's resignation. His replacement, Jean Arthuis, is a team player who won't try to upstage Juppe.

The Prime Minister's victory may have landed him in an impossible situation. By asserting control over economic policy, he's betting that he alone can deliver on President Jacques Chirac's campaign promise to spur job creation and restore economic dynamism while cutting the budget deficit. With Madelin gone, uneasy investors will be quick to punish the franc if they see any backpedaling from Juppe's goals of cutting spending and supporting a strong currency. Ultimately at stake is France's ability to maintain the tight link between the franc and the German mark, the financial backbone of Europe's integration hopes.

Madelin's imprint on actual policy had been so faint as to be imperceptible. But he had tremendous importance as a symbol of Chirac's willingness to achieve deep change. "Chirac had an opportunity to overcome investor skepticism, but with Madelin's departure, that credibility has to a large extent been wasted," says Christopher Potts, chief economist at Paris brokerage Chevreux De Virieu.

RATE CUT. Investors wasted no time taking the news of Madelin's ouster out on the French franc and equities. On Aug. 28, the French bourse tumbled 2.5% before recovering partially the following two days. The franc, after rising some 4% against the German mark since May, also slipped and now appears unlikely to improve on recent gains. Potts says the suspicious market is likely to widen the spread between French and German 10-year bonds, to 100 basis points from their recent level of 60. That would leave the French little room for dramatically lowering interest rates to kick off domestic growth, as long as they want to keep a strong link with the mark. Thus, France may find it difficult to take full advantage of the Bundesbank's substantial cut in official German interest rates on Aug. 24.

The news could get worse for Juppe. He's betting heavily on global economic growth to increase French exports and reduce unemployment. But last year's growth spurt appears more and more an aberration. Europe's economic recovery is softening, so France's export growth is slowing, as is gross domestic product growth, which is likely to dip below a 3% annual rate this year. As a result, "we'll have to take our hats off to Juppe if he even generates half" his target of 700,000 new jobs by next year, says Markus Rusgen, European equity strategist at Morgan Stanley & Co. These problems have nagged at the French stock market, which despite low inflation and Chirac's conservative victory has barely advanced since January.

FRONTAL ATTACK. For his part, Juppe vows to stay the course, relying on gradual reforms to cut the budget deficit to 3% of gross domestic product within two years, from 5% now. "My method is to make reforms that don't brutalize the social contract, because I want the reforms to succeed," Juppe said in a televised interview on Aug. 29. This autumn he plans to stage a big policy-making colloquium, where he hopes to cajole needed concessions from the unions and interest groups that had attacked Madelin so vehemently over public-sector pension reforms.

The outcome of Juppe's plan might not satisfy investors, who were banking on Madelin to lead a frontal attack against social security excesses and inflexible labor rules. It might have been bloody, but such head-on reform may have been the only way to quickly restore economic dynamism to France. As Madelin said in a parting shot: "You can put the Finance Minister aside, but you can't put aside the problems."

The best hope for Chirac's government is that his Prime Minister proves to be as tough with opponents as he was with his Finance Minister. "Government action is not a sentimental affair," Juppe said in dispatching Madelin, who had worked closely with him as co-strategist in Chirac's election campaign. Nor will the market's reaction be, as investors skeptically test each step of Juppe's economic program.


SPECIAL INTERESTS They helped topple Finance Minister Alain Madelin, who wanted welfare and pension reform.

UNEMPLOYMENT It's declining, but still above 11%.

NUCLEAR UPROAR Planned nuclear tests have sparked huge opposition at home and abroad.

BIG DEFICIT Fears that it won't be cut are unsettling the currency and stock markets.


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