Long Live The Welfare State!

Will the French revolt cripple reform throughout Europe?

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 to the spendthrift socialism of the early 1980s. But that's what he got. By giving President Jacques Chirac's conservative allies the boot, voters 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, whose reforms 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.

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.

NEW FIRE. 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.

Already, the French election has fired up leftists around Europe who believe 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 his campaign promises, Jospin's policies won't produce many new 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 want to cut the workweek from 39 hours to 35 while keeping pay at current 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, chief executive of telecommunications giant Alcatel Alsthom.

CLIPPED WINGS. 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 competitors. But unions that have resisted 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 Jonathan Story, professor of international political economy at INSEAD, a business school near Paris.

Jospin's main antidote for unemployment--the shrunken workweek--could also 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 head counts. "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 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 strong global players. That's partly why the French stock market rose steadily in the days after the election.

But bond and currency markets could be in for a rougher 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 hit such loggerheads that the project is postponed, the mark could once again become a safe haven in a new burst 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. Kohl's government on June 3 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, either.

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, impose softer 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 economist Potts.

THE BIG SALE. French voters certainly aren't ready for EMU 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. But they never explained that changing France to meet the challenges of a global economy is in the national interest.

Whether Jospin can do better is questionable. "The country is disturbed," admits Michel Rocard, the former Socialist Prime Minister who may be named to a senior post in the new 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.