Short-term pain before long-term gain? A look at French labor reform and economic growth

Our latest November Consensus Forecast for France, obtained by polling 36 leading macroeconomic analysts, sees French GDP growing a mere 1.3% in 2016 and 1.2% in 2017—forecasts which have been gradually downgraded throughout this year from 1.5% and 1.6% respectively back in January. French GDP unexpectedly contracted for the first time in over three years in the second quarter this year on the back of a sharp deterioration in domestic demand, particularly the components of private consumption and fixed investment. Much of the poor performance was due to one-off factors—including strikes over the labor reform proposals at the time—and so GDP unsurprisingly picked up again in the third quarter. However, an initial estimate released in late October puts Q3 growth at a meagre 0.2% in quarter-on-quarter terms, which is still an undeniably disappointing result. Year-on-year, GDP grew at the slowest rate in a year.

Given that France’s current account deficit is one of the largest in the Eurozone and the external sector detracts from growth, the country is reliant on domestic demand, especially private consumption and to a lesser extent fixed investment, to fuel its weak expansion. But the signs of robustness that private consumption showed early in the year have not lasted. Private consumption failed to grow from the second to the third quarter, which contributed to the failure of domestic demand to improve on its weak Q2 performance. Overall, our panel of analysts foresees private consumption increasing by 1.6% in 2016 before decelerating to a 1.3% increase in 2017, but uncertainty over changes in the labor market is one among several risks that might cause private consumption to decelerate even further. Private consumption is the growth component most likely to suffer in the short-term when structural reforms that are ultimately intended to be growth-enhancing are introduced in a tough economic climate.

The experiences of southern Eurozone countries in recent years have sparked attempts to better understand the impact of structural reforms on demand—and thereby economic growth—when they are introduced in a context where internal and external demand are already weak and there is limited scope for demand-management policies. In fact, an OECD study published this year found that the risks of failing to lift activity in the short-term or even further depressing demand were particularly high in the case of reforms easing employment protection on regular contracts or reforms of collective bargaining arrangements—two key features of the recent French labor reform. Why? Because during an economic downturn, the outflow from unemployment following such a structural reform may take more time to exceed the rise in the inflow rate than in normal times. And the uncertainty regarding the impact of such reforms on citizens’ personal economic situations also tends to pose a downside risk to consumer confidence and therefore spending. This situation is particularly likely in environments where there is little scope to accompany such structural reforms with macroeconomic policies to support demand, as is currently the case in the Eurozone, where accommodative fiscal policies are discouraged. While the ECB has attempted to spur economic activity through record low interest rates and also through unorthodox measures such as quantitative easing, the effects on growth have been limited.

There is a chance that domestic demand could receive a bit of a boost in 2017 if, as analysts fear, the beleaguered French government ups its spending to attract votes from an austerity-weary electorate ahead of the 2017 general elections. At its 2017 budget presentation in September, the government announced plans to lower taxes and increase spending. Any potential upside effects on demand in this case would however be limited at best and would not outweigh the sizeable risks of further weakening France’s public finances, putting its required fiscal consolidation in jeopardy.

The labor reform in more detail

The French government finally forced its controversial labor reform through parliament in July, which dares to allow companies to negotiate working hours beyond the sacred 35-hour week and made it more feasible for them to cite economic reasons as a justification for layoffs. Moreover, companies large enough to have union representation should now be able to bypass sector- or industry-wide collective agreements to negotiate company-specific arrangements on overtime and wages with staff.

Nevertheless, the reform in its final format was watered down in significant respects compared to the initial proposals, following intense opposition. For example, some of the crucial provisions about limiting severance payments were dropped. And the ability to prioritize company-level arrangements applies only to companies large enough to have union representation, meaning that most SMEs—which are the most likely to need flexibility to enable them to create jobs—are still tied to collective bargaining arrangements at sector level. In reality, very few see the reform as satisfactory: while employees and trade unions claim it goes too far, employers’ associations widely see it as failing to go far enough.

Structurally, the French economy has long suffered from a lack of competitiveness and persistently high unemployment. Although unemployment did not increase as rapidly during the financial crisis as in some other Eurozone countries, it had already been stuck at around 8% since the early 1980s—now it is around 10%—with youth and the long-term unemployed the worst affected. While criticism of France’s inflexible and overly protectionist labor market has existed for decades, pressure from EU authorities in recent years finally spurred efforts to do something about it.

Is France mirroring Spain?

The French labor reform bears several similarities to its equally controversial Spanish 2012 equivalent, particularly in terms of giving priority to firm-level over sector-level agreements and making it cheaper for companies in financial trouble to lay people off. And yet four years after the Spanish labor reform, debate continues to rage about whether it has done more good or harm in that time. Proponents of the legislation attribute improvements in job creation seen since then to a reform which they laud for taking significant steps towards making the labor market more flexible. Its detractors, however, argue that the still meagre job creation has been thanks to the strength of Spain’s GDP growth rather than the reform, which they suggest has only served to increase short-term precarious contracts while failing to significantly reduce Spain’s stubbornly high unemployment rate.

Unlike Spain, France does not currently benefit from a robust growth rate. And of course, unemployment in France is not simply caused by the nature of French labor legislation, but also—as detractors of the reform have repeatedly pointed out—by feeble economic growth, which could be dragged further down in the short-term by structural reforms that may not start to produce economic benefits until later on. Potential transitional losses also risk eroding the already minimal public support for additional reforms going forward. And so the vicious circle continues, which risks postponing the upside effects of structural reforms which France desperately needs further into the future.

Author: Caroline Gray, PhD, Senior Economics Editor

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