Tuesday, November 12, 2013

Why France Deserved the Credit Rating Downgrade from Standard & Poor's

France took another coup as its credit rating from Standard and Poor's (S&P) was downgraded to AA status. I read S&P's report that outlined its decision to downgrade, and I found it to be good reading, although not everyone might agree with that opinion. Paul Krugman had a fit about this report yesterday because Krugman believes that the idea of France's downgrade being based on the notion of needing to cut back on taxes or deregulation is ludicrous. Krugman is just throwing a hissy fit because France is just another example of how high taxes, high levels of government spending, and onerous regulations translate into an anemic economy, but more on that in a moment.

Remember that Fitch downgraded France's credit rating this past July (see the credit rating report), and Moody's did so last November (see credit rating report here). A few days before Moody's decided on its downgrade last year, I performed my own mini-analysis on France's credit rating, focusing on levels of government spending, taxation, and labor rigidities. Additionally, reports from the European Commission, the OECD (this OECD report goes into how France can reinforce competition with labor reforms), and even the French government do not paint the rosiest picture of France's financial situation. Looking at this issue a year later, especially in light of another credit rating downgrade, is most interesting and makes me ask the question of what has triggered all these credit rating downgrades.

France's government spending is not any more inspiring than it was when I looked at it last year. Much like with the case in Britain, Krugman does not have an understanding of what austerity really is because if there were austerity, there would be some actual evidence that austerity has taken place. As Veronique de Rugy, senior research fellow at the Mercatus Center, points out, government spending as a percent of GDP has remained well into the mid-fifties (Ministère de l'Économie et des Finances, p. 111). Last year, it 55.9%, and this year, it is 56.9%. Looking at the Eurostat statistics for government expenditures are not any better because government spending has not decreased at all. Since 2006, France's debt-to-GDP ratio increased from 63.7% to its current 90.2%. Once a debt-to-GDP ratio reaches three digits, it becomes very difficult to lower that ratio, which makes sense because increased, indiscriminate government spending means that the probability that the government can lower that ratio without resorting to expropriating property, high levels of taxation, or printing more money is very low. For a country whose debt-to-GDP ratio has no promise of decreasing, I'd ask Krugman to actually take a look at France's budget to see what unnecessary expenditures exist, but I don't think the term "budget cuts" exists in Krugman's vocabulary.

To lower the debt-to-GDP ratio, the government uses taxation to accrue more revenue. Even before reaching 100%, government tends to use taxation as a method to lower that ratio. Much to Krugman's dismay, taxing citizens into oblivion does not have the desired effects. Why? When taxation becomes a large percentage of the GDP, like we see with France (Ministère de l'Économie et des Finances, p. 61) having its taxation currently be at 45.0% of its GDP, not only does the dependency on taxation signal weak economic development, but taxation also adversely affects incentives to work, save, and take risks in business. Even the IMF recommends that the French government reduces spending over increasing taxation. A look at the World Bank's Doing Business Index, which measures how business regulations make it more difficult to do business, can give us some insight to this phenomenon. According to the index, France has actually gotten worse since last year. If it is more difficult to acquire a construction permit or hire an employee, it would explain why S&P predicts France's unemployment rate will remain in the double digits until 2016, and why real GDP growth has been at zero for the past couple of years.

Fortunately for France, it is not doing as bad as Italy or Greece. As S&P states in its credit rating report, France absolute high levels of productive and wealth, high diversification, financial sector stability, a well-educated workforce, and political stability. S&P is not predicting further instability in France, but recovering its previous credit rating doesn't look all that hopeful, either. Without decreasing its levels of taxation and government spending, France can never become the economic powerhouse that it once was.

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