Will the French revolt cripple European reform?

For free marketers, it was a breath of fresh air. Last July, French carmaker Renault, 46% government-owned and hit with massive losses, announced it would close its 3,100-worker plant in Vilvoorde, Belgium, and lay off 3,000 employees back in France. The move was hailed as a triumph of corporate common sense over labor-coddling tradition. But campaigning before France's June 1 election, candidate Lionel Jospin promised voters that if he became France's new Prime Minister, he would push Renault managers to reverse their decision and restore the French and Belgian jobs.

The magnanimous gesture sent a chill through French companies. When Jospin's Socialist Party swept to victory the next day, business leaders steeled themselves for what they fear will be a dangerous step backward for the French economy. If the Socialists carry out their agenda, they will increase government intervention in the economy, stall privatizations, bolster a costly welfare state, and tighten labor market rules that are already too rigid.

Jospin didn't seek a mandate to return France to the spendthrift socialism of the early 1980s. But that's what he got. By giving the conservatives allies of President Jacques Chirac the boot, the electorate rejected economic reform, fiscal austerity, and other realities of the global economy--just when France most needs such measures to compete in world markets.

Ironically, the French are reacting to a process that has barely begun. Because the welfare state remains largely intact, they have felt relatively little pain from globalization--unlike the U.S. and Britain or even "noncore" European nations such as Italy, Ireland, Spain, and Sweden, which have carried out reforms that are now restoring their economies to growth. "The States, Britain, Holland, and others have had their revolution....But France looks like it may be the last wagon on the train," says Jacques Buhart, a corporate lawyer with Coudert Freres in Paris.

POOR PITCH. Voters also showed that the government has done a bad job of selling them on European Monetary Union, which comes with strict requirements on inflation, debt, and deficits that the French blame for their economic woes. The election results represent "a defeat for France and for Europe," says Dominique Moisi, deputy director of the French Institute of International Relations, a Paris think tank.

The backlash could reverberate around Europe. Encouraged by their French counterparts' strong showing, Social Democrats--already in power in a majority of EU nations--could militate against further economic reform in their countries. If European governments backpedal on budget-cutting, the long-heralded goal of monetary union could be postponed or even scotched. That would throw financial markets into turmoil as investors once again move their money only into countries they perceive as stable.

If Europe still rushes into a common currency by dumping fiscal prudence, the new euro will be born weak. In the short term, that could boost Europe's economies by making its exports cheap. But it would also end its leaders' dream of creating a strong, unified trading bloc and a new global reserve currency to rival the dollar and the yen.

Because that dream is what drives German Chancellor Helmut Kohl, the French vote is likely to cause him serious political problems at home. As Jospin presses Bonn to soften the terms of monetary union, German voters may rebel against trading their rock-solid marks for a wobbly new euro. "Europe has gotten itself into a terrible situation," says Jonathan Story, professor of international political economy at the European Institute of Business Administration (INSEAD), the French business academy.

Already, the French election has fired up leftists around Europe who believe that creating jobs, not competitiveness or monetary union, should be governments' priority. Jospin's cabinet, appointed June 4, includes technocrat Dominique Strauss-Kahn, the father of the Socialists' plan to create 700,000 new jobs and now France's economic czar. French unions, feeling empowered, are demanding pay increases that could boost wage costs by 20%. In Germany, the opposition Social Democrats immediately called on Kohl to hold an early election, a suggestion Kohl will ignore. Polls show that if a vote were held today, he would lose.

Kohl is vulnerable because, like Chirac, he has so far failed to convince voters of the need to face up to the global economy. In fact, the two champions of European integration are looking more and more like the Continent's economic laggards. A Europe split into two tiers--countries that tackle their competitiveness problems and those that refuse--is another recipe for volatility. "It's clear now that the biggest threat to the whole of Europe is the lack of dynamism at its core," says economist Christopher Potts of Paris brokerage Cheuvreux de Virieu.

Indeed, France's 12.8% unemployment and flagging growth are why voters are so mad. But despite Jospin's campaign promises, his policies won't produce many new real jobs. The Socialists played to their core constituency, government workers, by saying they would hold off on privatizing state-owned companies, such as France Telecom and Air France, and banks. To create the 700,000 jobs, half of them in the public sector, the Socialists intend to cut the workweek from 39 hours to 35 while maintaining pay at existing levels.

In the long term, however, France will boost growth and job creation only by becoming more competitive. "The risk is that there will be a lag in the pace of restructuring French industry," worries Serge Tchuruk, CEO of telecommunications giant Alcatel Alsthom.

France can ill afford to wait. Airline deregulation threw Europe's protected markets open to competition on Apr. 1, allowing low-cost carriers to proliferate. Air France, which in 1996 showed its first profit in eight years, now seeks privatization as a way to keep pace with leaner rivals. But unions that fought Air France's streamlining will fight privatization even harder now that their Socialist allies are in power in Paris.

Similarly, starting on Jan. 1, dozens of lean and savvy players such as British Telecommunications PLC and COLT Communications will race into France as telecom deregulation begins on the Continent. Although France Telecom Chief Executive Michel Bon has won support over the past 20 months for price cuts and a surprising degree of internal restructuring, the $26.5 billion company will be handicapped in the fight for market share outside France. "A state-owned company won't be able to compete. It doesn't have the right incentive structure," says INSEAD's Story.

LOST CAUSE. The fate of Europe's biggest defense electronics company, $6.4 billion Thomson CSF, also hangs in the balance. Long nurtured on a steady diet of French defense contracts, state-owned Thomson no longer has the clout to compete in a rapidly changing global defense industry, where size and breadth are key. To stand up to U.S. behemoths such as Lockheed Martin, and the threat of a teamed-up Boeing-McDonnell Douglas, Thomson needs to merge with other European defense companies, such as Germany's Daimler Benz Aerospace or Britain's GEC. But the Socialists' win, says a Daimler official, will slow any efforts at consolidation.

Jospin's main antidote for unemployment, the shrunken workweek, could backfire. The 35-hour week would raise unit labor costs by around 11%, reckons Carl B. Weinberg, chief economist of High Frequency Economics in New York. If the new week is introduced without any measures to improve efficiency, it would send French unemployment soaring, as companies cut back on their headcounts. "Being a leader in not working won't create employment," says Bernard Giroud, a venture capitalist with Schroder Partners in Paris.

To be sure, top drawer private-sector French companies, like their counterparts elsewhere in Europe, are quietly working behind the scenes to boost competitiveness despite the hostile environment. After two years of restructuring, Alcatel posted a $438 million profit in 1996, up from a $4.4 billion loss in 1994. Companies such as Air Liquide, LVMH, Rhone-Poulenc, and Carrefour lead the list of France's strongest global players. But a huge swath of French industry is behind the curve, and even the best companies can't stop streamlining yet. "We are still living on past strength," warns Alcatel's Tchuruk. "Standing still now is the biggest danger."

The new respect that big French and German companies pay to profitability and shareholder value is one reason European bourses didn't blink after the French election. But bond and currency markets could be in for a rough ride as the new government's agenda unfolds. The reason is that traders have their eyes fixed on progress toward monetary union. Although the Socialists are officially behind the euro, they want to ease the pain of whipping France's budget into shape for its creation. In the days following the election, benchmark French 10-year bonds and the franc both slumped.

The German mark is already seesawing (chart). Even after the election's first round, investors deserted the mark for the dollar, expecting Jospin to press Kohl for easier terms on EMU. But if Bonn and Paris reach such loggerheads that the project is postponed, the mark could once again become a safe haven in a new round of European currency turmoil. "[It's] not at all clear that the markets have factored in the true extent of a Socialist victory," says Union Bank of Switzerland economist Richard Reid.

Indeed, the odds that Jospin and Kohl can reach agreement on how much austerity EMU requires seem to be getting lower. On June 3, Kohl's government caved in to the hard-money Bundesbank over using paper profits from revalued gold reserves to make Germany's budget deficit look lower. If Bonn won't fudge its own books, it probably won't tolerate any more doctoring from France.

The Bundesbank's power play makes it unlikely that Germany will go for Jospin's squishy interpretation of the single-currency rules. To make EMU more palatable to voters, Jospin wants to amend the Maastricht treaty with clauses that emphasize job creation and growth, soften penalties for countries that don't meet their budget targets, grant early admission to Italy and Spain, and create a euro that is "not overvalued" against the U.S. dollar. "What we now know is that monetary union must be compatible with more jobs and more growth in Europe or there won't be a monetary union," warns Paris-based economist Potts.

TIME-OUT? A body blow to EMU would reverse 10 years of hard-won convergence in Europe's bond and currency markets. The European Union has fought hard to keep its money values and bond yields in sync, to reduce the volatility that makes it tough for companies to raise capital and manage their cross-border trade. If the markets don't see a stable euro in Europe's future, the Continent will once again fall victim to investors' whims.

But in the short term, a well-managed delay of EMU could be a blessing for Europe--and not only because it would save the political skins of its beleaguered leaders. Some observers believe that giving France and Germany a few more years to restructure, boost growth, create jobs, and become more globally competitive would give the Continent a far better chance in making another stab at monetary union down the road.

French voters certainly aren't ready for it now. Indeed, perhaps Jospin's biggest challenge will be to convince his constituents--as his predecessors couldn't--that reform alone can save them from economic ruin. Chirac and former Prime Minister Alain Juppe had begun to cut spending, overhaul social security programs, and reform parts of France's overburdened pension system. However, they never really explained that changing France to meet the challenges of a global economy is in the national interest.

Whether Jospin can do better is questionable. Although his Socialist Party seems to have shed the corrupt image that drove it out of power in 1993, it is ill-prepared to govern. Jospin will have to depend on the hard-bargaining Communists in his left-wing alliance for support on key votes. Among other points of contention, the Communists vehemently oppose EMU.

The political landscape in France will remain treacherous. The conservatives' disastrous showing at the polls has left Chirac in perhaps the weakest position of any French President in decades. His party now begins the painful process of remaking itself in what Chirac ally Philippe Seguin calls a "knife fight" over policies that could derail the right's reform efforts.

Given the cynicism among French voters, Jospin remains vulnerable, too. Chirac has the option of dissolving the National Assembly in a year's time, giving the voters another chance to change French rule. If Jospin cannot deliver on his promises to create jobs, he could be rolling out the red carpet for the quasi-fascist National Front to capitalize on French malaise.

It's a problem that even the victors were unable to deny. "The country is disturbed," admits Michel Rocard, the former Socialist Prime Minister who may be named to a senior post in the Jospin government. That's bad enough at a time when France's economic health and global status are at risk. It's even worse for a country that must play a pivotal role in deciding Europe's future.

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