By Nicolas Delalande (Centre d’histoire at Sciences Po)

While the question of taxation was one of the major economic issues of the presidential election, it must not be forgotten that there often exists a gap between the political and media attention received by a set of campaign promises (what political scientists would call the “politics”) and their practical implications in terms of public policy (the “policies”). It is also worth asking whether any such tax reform will actually take place.

For over a year, commentators and politicians have repeatedly argued that taxation would be a key question in the presidential election. Many saw it as one of the only real issues distinguishing the outgoing majority, which with the TEPA law of August 2007 had bet on a strategy of “fiscal shock” to unleash growth (50% cap on taxes, reduction of inheritance taxes, exemption of overtime, etc.), from the Left opposition, which has been quick to denounce the injustice and inefficacy of measures that undermine progressive taxation without obtaining the expected economic benefits, while deepening the deficit. The promise of reform, or even a tax “revolution”, was high on the political agenda, particularly for the Left. However, intense conflicts and debates over taxes do not guarantee that the election of Francois Hollande will be followed by a genuine transformation of the French tax system. There may very well be a gap between the political and media attention received by campaign promises (the “politics”) and their practical implications for public policy (the “policies”). However much tax reform may be touted during the campaign, it may well be distinctly less popular when it comes time for implementation, when political will runs up against varied forms of sometimes unanticipated resistance.

There has, nevertheless, been a felt need almost everywhere in Europe to increase the taxation of the wealthy, not so much to solve the problem of government deficits as to restore a semblance of fairness and shared effort in a time of economic crisis. A number of countries have embarked on this path (the top marginal rate of income tax is 57% in Sweden, 50% in Britain, and 45% in Germany), even though some have already sounded the retreat (David Cameron’s Conservative government has proposed cutting the top marginal rate back to 45% in 2013). Even billionaires like Warren Buffett in the United States have called for raising taxes on better-off strata to put an end to the most blatant inequalities. This kind of reform actually consists of backing off the policies of the last fifteen to twenty years by reversing the trend to erode the progressivity of the tax system: strictly speaking, this is less a matter of reform than of cancelling previous reforms. Increasing tax revenue no longer results as before from creating new tax measures but from removing the tax reductions and exemptions enacted in recent years. Hence the debate, both in the US and Europe, over the real nature of the “tax increases”: the Republicans accuse the Democrats of increasing the tax burden, while the latter claim to be merely reversing exemptions that they consider unwarranted and inefficient. Reform thus amounts to nothing more than the restoration of the situation ex ante. In France, for example, the Socialists have pledged to cancel what remains of the tax package of 2007 (after having removed the tax cap in 2011), to significantly reduce tax loopholes and to establish a new income tax bracket: the reference point for these proposals is in fact the actual system as it existed only five to ten years ago, with the exception of the promise added during the campaign to create an exceptional 75% bracket on incomes of over 1 million euros.

A more ambitious structural reform, for example along the lines proposed in the recent book by Camille Landais, Thomas Piketty and Emmanuel Saez, would involve an entirely different scale. Opening the “black box” of the redistribution machine actually implies a much wider debate on the missions of the tax system, its administrative organization and its relationship to social and family policy. This is where the “costs” of policy reform, such as the eventual cancellation – or modulation – of France’s “family quotient” tax-splitting system, may be felt most directly. In any case, the erosion of the belief that the only reforms that could possibly be any good involve reducing the tax burden means that the current environment has never been more favourable for initiating this debate. The political, social and financial implications of this new configuration will certainly be complex and demanding in terms of democracy, but, in light of the numerous critics of the failings of the existing system, there is little doubt that 2012 offers a unique opportunity for undertaking ambitious reform. Tax reform implies the need for an effective political coalition to overcome the various social, institutional and technical obstacles that are likely to arise and to be able to take advantage of the favourable circumstances in which ideologies and beliefs that were thought to be firmly established are now on shaky ground. From a historical standpoint, it should not seem absurd that the current economic crisis, which is often compared to the 1930s, calls for and indeed even requires a renegotiation of the fiscal pact on a scale as significant as that experienced by Europe and America in the first third of the 20^th century. The process of reform will, however, inevitably be more complex than before: the systems for collection and redistribution, now more sophisticated than ever, are based on an array of measures that have arisen in different periods and in unique political, economic and social contexts.

* This text is taken from the article “The political economy of tax reform: a historical analysis”, which was published in a special Tax Reform issue of the OFCE Revue and is available on the OFCE web site.

By Céline Antonin

From his arrival in power on 12 November 2011, Mario Monti has explicitly set out his aims, which are structured around three points: fiscal discipline, growth and equity. Will he meet the challenge?

Mario Monti succeeded Silvio Berlusconi at a time when investors’ lack of confidence in Italy was growing continuously, as was seen in the widening gap with German bond rates and the sharp increase in CDS prices.

Ici graph

To meet his first objective of fiscal discipline, in December 2011 one of the government’s first measures was to adopt an austerity plan, which came to 63 billion euros over three years. This plan, the third in a single year, has the evocative name of Salva Italia (Save Italy) and aims to achieve a near balance of the public books by 2013 (see Italy: Mario Monti’s wager in French).

The second objective, to restore growth and enhance the country’s competitiveness, is addressed in the Cresci Italia plan (“Grow Italy”) adopted in stormy conditions by the Council of Ministers on 20 January 2012. This plan calls for further reforms, including to simplify administrative procedures (tendering procedures, business creation, digital switchover, etc.) and to liberalize the regulated professions, energy, transportation, and insurance, and in particular to enhance labor market flexibility. The ease with which the austerity measures contained in this second plan were adopted was matched by their poor reception, in particular with regard to discussion of the amendments to Article 18 of the Labour Code, which provides protection against dismissal for employees and workers in firms with more than fifteen employees.

Finally, with respect to equity, progress is still slow, especially in the fight against tax evasion and against the underground economy.

Italians knows that these measures will be painful: the financial daily Il Sole 24 Ore announced that the annual increase in taxes for an average family living in Lombardy will come to 1,500 euros per year, and almost 2,000 euros for a family from Lazio. Yet up to now the people of Italy have displayed great awareness of the national interest, accepting the cure of fiscal consolidation in a spirit of resignation. As for the financial markets, they initially relaxed the pressure on the country, with the gap in long-term government rates with Germany falling from 530 to 280 basis points from early January to mid-March 2012. Mario Monti’s actions are not the only explanation: the ECB’s purchase of bonds in late 2011 and its two 3-year refinancing operations (LTRO) of the banking system for a total of 1,000 billion euros, which greatly benefited Italy’s banks, definitely helped to ease the pressure on rates. Moreover, the success of the plan for the exchange of Greek debt with private creditors also contributed to easing rates.

The situation is still fragile and volatile: the weakness Spain showed regarding fiscal discipline was enough to trigger a renewed loss of confidence in Italy, as the interest rate differential with Germany on long-term bonds began to rise again, reaching 400 basis points in early May 2012, as did CDS premiums (graph).

So what are the prospects for the next two years? After a recession that began in 2011, with two quarters of negative growth, Italy is expected to experience a difficult year in 2012, with GDP falling sharply by 1.7% as a result of the three austerity plans approved in 2011. Their impact will continue to be felt in 2013, with a further contraction in GDP of -0.9% [1]. In the absence of additional austerity measures, this will reduce the country’s deficit, but less than expected, due to the multiplier effect: the deficit will fall to 2.8% of GDP in 2012, and to 1.7% in 2013, i.e. a pace of deficit reduction that falls short of its commitment to balance the public finances by 2013.

[1] The IMF forecast is more pessimistic for 2012, with growth of -1.9%, and more optimistic for 2013, at -0.3 %.

Jean-Luc Gaffard

The obsession with competitiveness has returned to centre stage with the election campaign. This reflects the reality that French companies are indeed suffering a loss of competitiveness, which is behind the deterioration in foreign trade for almost a decade. This loss is clear vis-à-vis the emerging markets and explains the trend towards relocating abroad. It is also clear vis-à-vis firms from other developed countries, mainly in the euro zone and in particular German companies. This latter situation is especially serious, as it challenges the coherence of European construction (cf. OFCE, note 19: Competitiveness and industrial development: a European challenge in French).
The gap in competitiveness that has emerged with Germany is clearly based on non-price competition. One of the reasons for this is Germany’s superior business model, which is characterized by the maintenance of a network of local businesses of all sizes that focus on their core business and on the international fragmentation of production. This model is especially suitable for business development that is targeted at global markets, and it largely protects the countries hosting these companies from the risk of deindustrialization.

It would, nevertheless, be a mistake to ignore that this development is also the product of an adverse change in price competitiveness. This reflects labour market reforms in Germany, which lowered the relative cost of labour, as well as strategies that are based on the segmentation of production and the outsourcing of intermediate segments, which have also contributed to lowering production costs.
Germany has thus managed to virtually stabilize its market share of global exports by increasing their level in the European Union (+1.7% in the 2000s) and even more so in the euro zone (+2.3%), while France has lost market share in these same areas (3.1% and 3.4%, respectively).

Two developments have particularly hurt France’s industry. Its network of industrial SMEs has fallen apart. They were hit less by barriers to entry than by barriers to growth. All too often SME managers have been inclined or encouraged to sell the enterprises to large corporations rather than to ensure their growth. This is due both to the lack of genuine partnerships with these corporations and to the difficulties experienced in obtaining permanent financing from the banks and markets. For their part, the large industrial firms, both those operating on a multitude of local markets and those in the international markets, have chosen to focus on acquisitions and on the geographical decentralization of both their operations and their equipment and services suppliers. This strategy has been designed to meet geographical shifts in demand and to deal with the demand for immediate profitability set by volatile shareholders, but this has come in part at the expense of the development of local production networks. This process involved a vast movement of mergers and acquisitions that primarily drew on financial skills. The financial institutions were, in turn, converted to the universal banking model, abandoning some of their traditional role of being lending banks and investment banks. These concomitant developments have proved disastrous for overall competitiveness, particularly as hourly labour costs in industry were rising simultaneously.

There are two requirements for restoring the competitiveness of French companies and thereby encouraging the country’s re-industrialization. The first is to allow immediate control of labour costs and the restoration of profit margins; this could be helped in particular by tax measures that would adjust the financing of a portion of social protection. The second requirement is to promote the reorganization of industry through the creation of a network of stable relationships between all those involved in the industrial process, especially by the use of aid that is conditioned on cooperation between large and small firms in “competitiveness clusters”.

This medium-term effort will nevertheless largely remain ineffective if cooperative policies are not implemented across Europe. These policies need both to stimulate supply through the implementation of technology development programmes and to boost internal demand wherever it is clearly insufficient to satisfy production capacity.

By Jean-Luc Gaffard and Francesco Saraceno

The emphasis on the need to complement fiscal restraint by measures to boost growth, which is rising in part due to the electoral debate in France, is good news, not least because it represents a belated recognition that austerity is imposing an excessively high price on the countries of southern Europe.

Nevertheless, there is nothing new about invoking growth, and this may remain without consequence. In 1997, as a result of a French government intervention, the Stability Pact became the Stability and Growth Pact, but this had no significant impact on the nature of strategy, which remained fully oriented towards the implementation of strict monetary and fiscal rules and a constant search for more flexible markets.

Last week, Mario Draghi, along with Manuel Barroso and Mario Monti, were worried not only about the recession taking place in Spain, Portugal, the Netherlands and Great Britain but also about the need to respond formally to a request that may come from a new French government. They too are arguing for a negotiated Growth Pact, while taking care to note that it must consist of a common commitment to carry out structural reforms wherever they have not yet been made. This position echoes the February letter of the eleven Prime Ministers to the European authorities. In other words, nothing is to change in the doctrine that determines the choice of Europe’s economic policy: growth can be achieved only through structural reform, in particular of the labour markets.

There are two grounds for criticizing this position. It is far from sure that structural reform is effective, unless, that is, it is wielded in a non-cooperative spirit to improve the competitiveness of the country that undertakes the reform at the expense of its trading partners, as Germany was able to do with the Hartz reforms. Secondly, widespread reform, including where this is justified in terms of long-term growth, would initially have a recessionary impact on demand [1], and hence on activity. Reform cannot therefore deal with what is actually the immediate top-priority requirement, namely stemming the spreading recession.

The real challenge facing Europeans is to reconcile the short term and the long term. The solution proposed so far, general fiscal austerity aimed at restoring the confidence of private actors, which would be complemented by structural reforms intended to increase the potential growth rate, just doesn’t work. This can be seen by developments in Greece, as well as in Portugal and Ireland, which are model students of Europe’s bailout plans, and also in Britain, Italy and Spain. The fiscal multipliers remain firmly Keynesian (see Christina Romer, and Creel, Heyer and Plane), and any “non-Keynesian” effects on expectations are limited or nonexistent.

Growth can neither be decreed nor established instantly, unlike the deflationary austerity spiral in which more and more European countries are currently trapped.

Growth is likely to materialize only if fiscal consolidation is neither immediate nor drastic – in fact, only if the consolidation required of countries in difficulty is spread over time (beyond the year 2013, which in any case will be impossible to achieve) and if the countries that are able to carry out a more expansionary fiscal policy actually do this in such a way that at the European level the overall impact is neutral or, even better, expansionary. This strategy would not necessarily be punished by the markets, which have shown recently that they are sensitive to the requirement for growth. Otherwise, steps should be taken by the ECB to deal with the constraints imposed by the markets. This short-term support must be accompanied by substantial medium-term investment made through European industrial programs financed by the issuance of Eurobonds – which would mean, finally, a European budget on a scale large enough to handle the tasks facing the Union. This method of coordinating short- and medium-term choices would be an important step towards the establishment of the kind of federal structure that alone will allow the resolution of the “European question”.

[1] R.M. Solow, Introduction to Solow, R.M. Ed. (2004), Structural Reforms and Macroeconomic Policy, London: Macmillan).

By Louis Chauvel

The term “middle class” is one of those social science concepts that provoke controversy due to its complex definition and dynamics and the political debate it generates. The fact that it is surrounded by sharp controversy should not therefore come as a big surprise. In a note by the OFCE – where a multifaceted definition of the middle class is proposed [1] – we review several dimensions of the social malaise afflicting this social group, which is often considered to be relatively privileged, in an effort to understand the actual situation.

Two theses are considered here:
– on the one hand, the thesis of the middle class maintaining its former status, the strengthening of the protection its members enjoy and confirmation of their economic ascent [2] – a thesis that makes the “fear of decline” that haunts them a paradox;

– on the other hand, the thesis of an objective increase in social problems that were previously limited to people in lower strata (employees and workers, two social groups whose hourly wages are similar), with the upwards diffusion of the problems through capillary action now less blocked [3].

Proponents of the optimistic thesis, that of maintenance, argue that “contrary to popular belief”, the fall in status of the middle class is a “fiction”, as this social group “simultaneously embodies a ‘France holding its own’ and a ‘France that’s rising’” (Goux and Maurin). In this view, fear of decline is a psychological reaction of the middle class with no real cause.

In the Note, which upholds a different view, we review several aspects of this analysis to understand the objective basis for the malaise of the middle class. We show that the increasing difficulties faced by lower strata – for example, the risk of unemployment – are seeping into the intermediate middle classes, who can no longer be said to be protected. This is an element of the “theory of the lump of sugar at the bottom of the cup of coffee”: while the upper and middle parts of society still seem intact, erosion is continuing through the capillary-like action of the immersed part and, if nothing is done, it threatens inevitable deterioration.

The relative standard of living of the intermediate middle class peaked in what the French call the “Trente glorieuses”, the three decades of post-war prosperity: since the end of this golden age, stagnant wages and incomes, the reduction of wage differentials with the lower classes holding jobs (see chart), the unprecedented risk of unemployment, the numerical expansion of diplomas to numbers that go well beyond the space available in the intermediary professions, and the consequent devaluation of education, etc., were a number of the problematic issues analyzed in this paper that highlight the existence of a very real malaise. It is thus possible to show that, in terms of diplomas, the intermediate middle class population increasingly consists of a share of potential managers (based on their level of education) who have not actually managed to enter the upper middle class, due to a lack of sufficient places, and on the other hand survivors of the intensified competition, a reflection of the growing number of people with the same level of education who have fallen into the lower classes.

In this note, we therefore consider the cause of the destabilization of the project of “middle class civilization” (Alexandre Koyré) that had emerged in the context of the growth and modernity that marked the 1960s to 1980. The corresponding social dynamics were not based simply on the numerical expansion of the intermediate middle class, but also on a coherent social and political project that has now become unstable. What are the ways to reconnect with this dynamic? How would it be possible to escape the vicious circle whereby the middle classes disintegrate and we develop policies targeted at those most in need without seeing that they feed the fall of groups that were previously better situated but that haven’t been supported? The answer lies in productive investment in sectors with long-term promise. Without coming to terms with the real causes of the malaise of the intermediate middle class and dealing with the root problems, we may be preparing ourselves for a difficult decade.
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[1] The middle class is defined in their plurality as falling into the upper middle classes, comparable to the “executives and intellectual professions” who make up about 10% of households, and the intermediate middle classes, which corresponds to the 20% located immediately below, and thus close to the intermediary professions as defined by the INSEE.

[2] D. Goux and E. Maurin, 2012, Les nouvelles classes moyennes, Seuil, Paris. Most of these ideas were already presented in S. Bosc, 2008, Sociologie des classes moyennes, La Découverte.
[3] L. Chauvel, 2006, Les classes moyennes à la dérive, Seuil, Paris.

By Céline Antonin

Although some of the candidates may deny it, the financial risk linked to the fiscal crisis in the euro zone is the guest of honour at the presidential campaign. As proof that this is a sensitive issue, the launch in mid-April of a new financial product on French debt crystallized concerns. It must be said that this took place in a very particular context: the Greek default showed that the bankruptcy of a euro zone country had become possible. Despite the budgetary firewalls in place since May 2010 (including the European Financial Stability Fund), some of France’s neighbours are facing a lack of confidence from the financial markets, which is undermining their ability to meet their commitments and ensure the fiscal sustainability of their government debt, the most worrying example to date being Spain. What tools are available to speculators to attack a country like France, and what should be feared in the aftermath of the presidential election?

The tool used most frequently for speculation on a country’s public debt is the Credit Default Swap, or CDS. This contract provides insurance against a credit event, and in particular against a State’s default (see the “Technical functioning of CDS” annex for more detail). Only institutional investors, mainly banks, insurance companies and hedge funds, have direct access to the CDS market on sovereign States [1].

Credit default swaps are used not only for coverage, but also as an excellent means of speculation. One criticism made of the CDS is that the buyer of the protection has no obligation to hold any credit exposure to the reference entity, i.e. one can buy CDS without holding the underlying asset (“naked” purchase/sale). In June 2011, the CDS market represented an outstanding notional amount of 32,400 billion dollars. Given the magnitude of this figure, the European Union finally adopted a Regulation establishing a framework for short-selling: it prohibits in particular the naked CDS on the sovereign debt of European States, but this will take effect only on 1 November 2012.

The FOAT: new instrument for speculation on French debt?

This new financial instrument, introduced by Eurex on April 16 [2], is a futures contract, that is to say an agreement between two parties to buy or sell a specific asset at a future date at a price fixed in advance. The specific asset in this case is the French Treasury OAT bond, with a long residual maturity (between 8.5 and 10.5 years) and a coupon of 6%, ​​and it has a face value of 100,000 euros. Should we worry about the launch of this new contract on the eve of the presidential election? Not when you consider that the launch of the FOAT addresses the gap in yields between German and French bonds that has arisen since the recent deterioration of France’s sovereign rating: previously, as German and French bond yields were closely correlated, the FOAT on German bonds allowed coverage of both German and French bond risks. After the gap in yields between the two countries widened, Eurex decided to create a specific futures contract for French bonds. Italy witnessed this same phenomenon: in September 2009, Eurex also launched three futures contracts on Italian government bonds [3]. In addition, Eurex is a private market under German law, and is much more transparent than the OTC market on which CDS are traded. Note that the FOAT launch was not very successful: on the day it was launched, only 2,581 futures contracts were traded on French bonds, against 1,242,000 on German bonds and 13,671 on Italian bonds [4].

Even if, as with the CDS, the primary function of the FOAT is to hedge against risk, it can also become an instrument for speculation, including via short selling. While speculation on French debt was previously limited to large investors, with an average notional amount of 15 billion euros per CDS [5], the notional amount of the new FOAT contract is 100,000 euros, which will attract more investors into the market for French debt. If speculators bet on a decline in the sustainability of France’s public finances, then the price of futures contracts on the OAT bonds will fall, which will amplify market movements and result in higher interest rates on OAT contracts.

The not so rosy future?

It is difficult to predict how the financial markets will behave in the wake of the French presidential election. Studying what has happened in other euro zone countries is not very informative, due to each one’s specific situation. The country most “comparable” to France would undoubtedly be Italy. However, the appointment of Mario Monti in November 2011 took place in an unusual context, where the formation of a technocratic government was specifically intended to restore market confidence through a strenuous effort to reduce the deficit, with Italy also benefitting from the ECB’s accommodative policy.

The French budgetary configuration is different, as the financial imperative appears only in the background. The candidates of the two major parties both advocate the need to restore a balanced budget. Their timetables are different (2016 for Nicolas Sarkozy’s UMP, 2017 for François Hollande’s PS), as are the means for achieving this: for Sarkozy, the focus will be more on restraint in public spending (0.4% growth per year between 2013 and 2016, against 1.1% for the PS), while Hollande emphasizes growth in revenue, with an increase in the tax burden of 1.8% between 2012 and 2017 (against 1% for the UMP).

But this is not the heart of the matter. What is striking, beyond the need to reduce public deficits in the euro zone countries, is the fact that our destinies are inextricably linked. As is shown by the graph on changes in bond yields in the euro zone (Figure 2), when the euro zone is weakened, all the countries suffer an impact on their risk premium relative to the United States and the United Kingdom, although to varying degrees. It is therefore unrealistic to think about France’s budget strategy and growth strategy outside of a European framework. What will prevent the financial markets from speculating on a country’s debt is building a Europe that is fiscally strong, has strict rules, and is supported by active monetary policy. This construction is taking place, but it is far from complete: the EFSF does not have sufficient firepower to help countries in difficulty; the growth strategy at the European level agreed at the summit of 2 March 2012 needs to be more comprehensive; and the ECB needs to pursue an active policy, like the Fed, which specifically requires a revision of its statutes. As was pointed out by Standard and Poor’s when it announced the downgrade of the French sovereign rating last December, what will be watched closely by the financial markets is the fiscal consistency of the euro zone. On 6 May 2012, what attitude will the next President then take vis-à-vis the construction of the budget and how able will he be to assert his position in the euro zone – this will determine the future attitude of the financial markets, not only vis-à-vis France, but also vis-à-vis every euro zone country.

Annex: Technical functioning of Credit Default Swaps

The contract buyer acquires the right to sell a benchmark bond at its face value (called the “principal”) in case of a credit event. The buyer of the CDS pays the seller the agreed amounts at regular intervals, until maturity of the CDS or the occurrence of the credit event. The swap is then unwound, either by delivery of the underlying instrument, or in cash. If the contract terms provide for physical settlement, the buyer of the CDS delivers the bonds to the seller in exchange for their nominal value. If the CDS is settled in cash, the CDS seller pays the buyer the difference between the nominal amount of the buyer’s bonds and the listed value of the bonds after the credit event (recovery value), in the knowledge that in this case the buyer of the CDS retains its defaulted bonds. In most cases, the recovery value is determined by a formal auction process organized by the ISDA (International Swaps and Derivatives Association). The annual premium that the bank will pay to the insurance company for the right to coverage is called the CDS spread and constitutes the value listed on the market: the higher the risk of default, the more the CDS spread increases (Figure 1). In reality, as the banks are both the buyers and sellers of protection, the spread is usually presented as a range: a bank can offer a range from 90 to 100 basis points on the risk of a French default. It is thus ready to buy protection against the risk of default by paying 90 basis points on the principal but it demands 100 to provide that protection.

To illustrate this, consider the following example. On 7 May 2012, a bank (buyer) signs a CDS on a principal of 10 million euros for five years with an insurance company (seller). The bank agrees to pay 90 basis points (spread) to protect against a default by the French State. If France does not default, the bank will receive nothing at maturity, but will pay 90,000 euros annually every 7 May for the years 2012-2017. Suppose that the credit event occurs on 1 October 2015. If the contract specifies delivery of the underlying asset, the buyer has the right to deliver its French bonds with a par value of 10 million euros and in exchange will receive 10 million euros in cash. If a cash settlement is expected, and if the French bonds are now listed only at 40 euros, then the insurance company will pay the bank 10 million minus 4 million = 6 million euros.

[1] Individuals can play on the markets for corporate CDS via trackers (collective investment in transferable securities that replicates the performance of a market index).

[2] The Eurex was created in 1997 by the merger of the German futures market, Deutsche Termin-Borse (DTB), and the futures market in Zurich, the Swiss Options and Financial Futures Exchange (SOFFEX), to compete with the LIFFE. It belongs to Deutsche Börse and dominates the market for long-term financial futures.

[3] In September 2009 for bonds with long residual maturities (8.5 to 11 years), October 2010 for bonds with short residual maturities (2 to 3.25 years) and July 2011 for bonds with average residual maturities (4.5 to 6 years).

[4] Note that this comparison is biased due to the fact that there are 4 types of futures contracts on German debt, 3 on Italian debt and only 1 on French debt.

[5] Weekly data provided by the DTCC for the week of 9 to 13 April 2012 on CDS on French sovereign debt: the outstanding notional amount came to 1,435 billion dollars, with 6822 contracts traded.

By Christophe Blot

* This text summarizes the outlook produced by the Department of Analysis and Forecasting for the euro zone economy in 2012-2013, which is available in French on the OFCE web site

The euro zone is still in crisis: an economic crisis, a social crisis and a fiscal crisis. The 0.3% decline in GDP in the fourth quarter of 2011 is a reminder that the recovery that began after the great drop of 2008-2009 is fragile and that the euro zone has taken the first step into recession, which will be confirmed in early 2012.

The fall in the average long-term government interest rate in the euro zone seen since the beginning of the year has come to a halt. After reaching 3.25% on 9 March, it rose again due to new pressures that emerged on Italian and Spanish rates. Indeed, despite the agreement to avoid a default by Greece, Spain was the source of new worries after the announcement that its budget deficit had reached 8.5% in 2011 – 2.5 points above the original target – and the declaration that it would not meet its commitments for 2012, which has reinforced doubts about the sustainability of its debt. The Spanish situation illustrates the close link between the macroeconomic crisis and the sovereign debt crisis that has hit the entire euro zone. The implementation of fiscal adjustment plans in Europe, whose impact is being amplified by strong economic interdependence, is causing a slowdown or even a recession in various euro zone countries. The impact of synchronized restrictions is still being underestimated, to such an extent that governments are often being assigned targets that are difficult to achieve, except by accepting an even sharper recession. So long as the euro zone continues to be locked in a strategy of synchronized austerity that condemns in advance any resumption of activity or reduction in unemployment, the pressure will not fail to mount once again in 2012. Long-term public interest rates in the euro zone will remain above those of the United States and the United Kingdom (see the figure), even though the average budget deficit was considerably lower in 2011 in the euro zone than in these two countries: 3.6% against 9.7% in the US and 8.3% in the UK.

To pull out of this recessionary spiral, the euro zone countries need to recognize that austerity is not the only way to reduce budget deficits. Growth and the level of interest rates are two other factors that are equally important for ensuring the sustainability of the public debt. It is therefore urgent to set out a different strategy, one that is less costly in terms of growth and employment, which is the only way to guarantee against the risk that the euro zone could fall apart. First, generalized austerity should be abandoned. The main problem with the euro zone is not debt but growth and unemployment. Solidarity must be strengthened to curb speculation on the debt of the weaker countries. The fiscal policies of the Member states also need to be better coordinated in order to mitigate the indirect effects of cutbacks by some on the growth of others [1]. It is necessary to stagger fiscal consolidation over time whenever the latter is needed to ensure debt sustainability. At the same time, countries with room for fiscal manoeuvre should develop more expansionary fiscal policies. Finally, the activities of the European Central Bank should be strengthened and coordinated with those of the euro zone governments. The ECB alone has the means to anchor short-term and long-term interest rates at a sufficiently low level to make it possible both to support growth and to facilitate the refinancing of budget deficits. In two exceptional refinancing operations, the ECB has provided more than 1,000 billion euros for refinancing the euro zone banks. This infusion of liquidity was essential to meet the banks’ difficulties in finding financing on the market. It also demonstrates the capacity for action by the monetary authorities. The portfolio of government debt securities held by the ECB at end March 2012 came to 214 billion euros, or 2.3% of euro zone GDP. In comparison, in the United States and the United Kingdom, the portfolio of government securities held by the central banks represents more than 10% of their GDP. The ECB therefore has significant room for manoeuvre to reduce the risk premium on euro zone interest rates by buying government securities in the secondary markets. Such measures would make it possible to lower the cost of ensuring the sustainability of the long-term debt.

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[1] See “He who sows austerity reaps recession”, OFCE note no. 16, March 2012.

By Vincent Touzé

The 2008 crisis almost endangered the entire global financial system. Thanks to support from governments and central banks, the banking sector has recovered and once again appears to be solid financially. In the aftermath of the crisis, the public finances of the Southern euro zone countries – Portugal, Italy, Spain and Greece – and Ireland (the “PIIGS”) have, in turn, been severely weakened. Greece was forced to suspend payments, and the risk of default is still hanging over the others. Since early 2011, bank liabilities in these economies have become a significant concern of the financial markets. Despite good stress tests, this fear intensified in August 2011. European banks then entered a new period of turmoil, and the European Central Bank was forced to lend them more than 1,000 billion euros for 3 years at a rate of 1% in order to avoid a major credit crunch.

As part of their investments abroad and through their foreign branches, Europe’s banks hold liabilities from the PIIGS countries through lending to the banking sector, to the public sector (sovereign debts and credits) and to households and private non-bank enterprises. France is one of the countries that is most heavily exposed to the PIIGS (public and private sectors combined), with a total commitment by the banking system in the third quarter of 2011 of about 437 billion euros (see table), or 21.9% of GDP. Germany’s exposure, at about 322 billion euros (12.5% of GDP), is smaller. The exposure of the UK banking system is comparable and is valued at 230 billion euros, or 13.3% of GDP. In comparison, the Japanese and US banks hold little debt: 59 billion euros (1.4% of GDP) for Japan and 96 billion (0.9% of GDP) for the United States. In the course of the financial crisis, Europe’s banks have pulled back from these countries (1). According to the statistics of the Bank for International Settlements (Figure 1), the reduction in exposure was most pronounced in Greece (-55% since Q1 2007) and lowest in Portugal (-15%). Divestments of the debt of Spain (-29%), Italy (-33%) and Ireland (39%) have been comparable and are at an intermediate level compared to the previous two.

Guarantee funds can be drawn on if a bank goes bankrupt, but generally their provisions are insufficient to support a “big” bank in difficulty. According to the principle of “too big to fail”, the state must intervene to avoid bankruptcy. Possible avenues of action include acquiring some of the bank’s capital, nationalizing it by refloating it, or facilitating its long-term refinancing through the purchase of bonds. A bank failure has to be avoided at all costs, because it is frequently accompanied by panic, with collateral damage that is difficult to predict or contain. The mere fact that a State announces credible support for a bank or a banking system is often sufficient to avert a panic. If the States were to come to the rescue of the banks in the case of the Greek default, the macroeconomic implications of a 50% default on all private and public debts seem relatively minor, since it would require, for example in the case of France, a cost of around 17 billion euros, an amount that is much less than 1% of GDP (see table). By contrast, a 50% default of all the PIIGS would require 220 billion euros in support from France (11% of French GDP). The macroeconomic cost beforehand might seem high, but it is not insurmountable. Unfortunately, the spontaneous failure of one or more PIIGS would lead to an uncontrollable chain reaction whose overall macroeconomic costs could be considerable.

This financial crisis is also hitting the life insurance companies, right in the midst of a period of reform in prudential regulations. The banking sector has just managed to come up to Basel II standards and will steadily have (until 2019) to adopt Basel III (2), while the insurance industry is changing rapidly towards Solvency II (3). These two regulatory reforms are leading to an increasing need for capital just as the financial crisis is undermining balance sheets and putting greater pressure on capital ratios. While equity capital can be used to withstand a financial crisis, at the same time regulations can compel recapitalizations in very difficult refinancing conditions. This is an undesirable pro-cyclical result of the prudential regulations.

The risk of a default on payments by some PIIGS has made ​​financial analysts pay particularly close attention to the solvency and profitability of European banks. However, the results of the stress tests (4) on the European banks published in mid-July 2011 were considered good. The hypotheses used are far from being optimistic. In the euro zone (and respectively in the other countries), they point to a fall in the growth rate of 2 points (2.4 points respectively) in 2011 and 2 points (1.9 points respectively) in 2012 compared to a reference scenario. In the euro zone, this entry into recession (-0.5% in 2011 and -0.2% in 2012) would be accompanied by higher unemployment (0.3 point in 2011 and 1.2 points in 2012), a lower inflation rate (-0.5 point in 2011 and -1.1 points in 2012), a sharp drop in property prices, a rise in long-term rates as well as discounts on sovereign debt (5) of up to 30%. The objective of this “stressed” scenario is to test the capacity of the banks to be able to maintain a “core Tier 1” ratio greater than 5% (6). Under these extreme assumptions, only 8.9% of the 90 banks tested achieved a ratio that was below the 5% ceiling that would trigger a de facto recapitalization to meet the target (7). The four French banks succeeded on the stress tests without difficulty, as they maintain high ratios: 6.6% for Societe Generale, 6.8% for the Banque populaire-Caisse d’épargne, 7.9% for BNP Paribas and 8.5% for Crédit Agricole. The countries where failures were observed include Austria (1 bank), Spain (5 failures) and Greece (2 failures). In view of the stress tests, the European banking system could therefore be considered as capable of withstanding a major economic crisis.

After the second aid package to Greece on 21 July 2011, and with ongoing pressure on the other sovereign debts, worry seized the stock markets, and European bank stocks fell sharply from August to December 2011 (Figure 2). These stock market changes were in complete contradiction with the positive results of the stress tests. There are three possible ways to interpret the reaction of the financial markets:
–    An actual crisis would be much sharper than the hypotheses of the stress tests;
–    The stress test methods are not adequate for estimating the consequences of a crisis;
–    The markets get swept up in the slightest rumors and are disconnected from basics.
For now, with respect to the most pessimistic forecasts, it does not seem that the stress test hypotheses are particularly favorable. However, they have weaknesses for assessing systemic financial crisis, in that each bank does not include in its assessment the damage brought about by the application of the scenario to other banks or the consequences for the credit market. There is no feedback from the financial interconnections. Moreover, the economic crisis can greatly increase the default rates of private companies. This point may have been underestimated by the stress tests. Note also that the tests are performed at an internal level, which can also lead to different assessments of the consequences of certain scenarios. In addition, the stress tests evaluate the financial soundness of the banks, but de facto, a bank, although solvent, can see its stock price fall in times of crisis for the simple reason that its expected profitability decreases. Most importantly, the runaway financial markets are due to the lack of a consensus on the decisions taken within the European Union on finding a definitive solution to the debt crisis but also to the fact that the statutes of the European Central Bank prohibit it from participating in public debt issues. These uncertainties reinforce the volatility of the stock price of banks that are particularly exposed to PIIGS, as evidenced by the strong correlation between CDS on private banks and on sovereign debt in the euro zone (8).

With the beginning of a solution on Greek debt, the stock market listings of European banks have been rising since January 2012. Hopefully the agreement of 21 February 2012 on Greek sovereign debt will calm the storm that hit the bond markets. The operation provides that private investors agree to give up 107 billion euros of the 206 billion of debt they hold and that the euro zone States agree a new loan of 130 billion. The agreement is a swap of debt. The old bonds are exchanged against new ones at a discount of 53.5% of the face value (9) and at a new contractual interest rate. The write-down was not a surprise for the banks, which have already set aside provisions for the losses. The operation was a clear success (10), as 83% of the holdings were voluntarily offered for exchange on 9 March (11). The level of participation was increased to more than 95% by carrying through a compulsory exchange with creditors who had not responded positively to the operation (collective action clauses for debt held under Greek law). After this exchange, the European states, the IMF, and the ECB will hold “more than three-quarters of Greek debt” (12), which means that any new crisis of Greek sovereign debt would have little impact on private investors. A new source of uncertainty comes from the CDS that were taken out for the purpose of hedging or speculation (“naked CDS”). Initially, the International Swaps and Derivatives Association (ISDA) (13) announced on 1 March that this exchange was not a “credit event”. On 9 March, it revised its judgment (14). The ISDA now believes that the collective action clauses are forcing owners to accept the exchange, which constitutes a credit event. The Greek default on payments is a legally recognized event, and the CDS are thus activated. According to the ISDA, the net exposure of CDS to Greece would amount to only 3.2 billion dollars. To estimate the overall cost of the CDS for the financial sector, the residual value of the bonds would have to be subtracted from that amount. Given the inability of Greece to resume growth, the sustainability of its remaining debt is not guaranteed, and the risk of contagion persists. In any event, the public debt of the Southern euro zone countries and Ireland are now considered risky assets, which is a factor that is weakening the European banking sector. In this respect, since late March the recent rise in interest rates on Italian and Spanish public debt has provoked a decline in the stock prices of European banks (Figure 2).

The ongoing financial crisis is weakening the banking sector in the euro zone, which could lead it to reduce its exposure to risk: a major credit crunch is thus to be feared. The latest ECB survey covering 9 December 2011 to 9 January 2012 (15) with regard to the lending conditions set by banks is not very reassuring. Tighter conditions are expected by 35% (against 16% last quarter) of banks on business loans and by 29% (against 18% last quarter) of banks on consumer loans. In light of this prospect, on 21 December 2011 the ECB conducted a long-term refinancing operation. This was a huge success, with 489 billion euros in credits granted to the banking sector. The funds were loaned at 1% for a period of 3 years. Although it is still difficult to assess the impact of this measure, ECB president Mario Draghi said in February that this injection of liquidity had clearly avoided a major credit crunch. On 29 February 2012, the ECB launched a second long-term refinancing plan (16). The subscription was very substantial, with 530 billion euros disbursed. It is therefore reasonable to think that a credit crunch will be avoided.

In conclusion, the banking sector’s escape from the zone of turbulence depends on four key factors:
1) Only a long-term return to growth across the euro zone as a whole will make it possible to consolidate the public purse and reduce the number of business failures (17), thereby de facto reducing banks’ exposure to the risk of default, with responsibility incumbent on the European governments and the ECB to identify and implement the “right” policy mix and the appropriate structural measures.
2) The Greek State is insolvent; this failure in public finances must not be allowed to spread to other economies, since the banking crisis is also a test of the strength of financial solidarity in the euro zone, and it remains to be seen whether the Germans are more inclined to support Spain or Italy in case of a risk of default than they were with Greece.
3) The banking crisis has brought to the fore the procyclical effects of the prudential regulations, which need to be corrected.
4) The maneuvering room of governments as first responders in a crisis has become very limited due to their massive debt. If there is a new major shock, the ECB could have no other choice but to be the lender of last resort.

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[1] Note that a financial depreciation (capital loss) on the balance sheet value of assets in the PIIGS implies an automatic reduction in the exposure to these economies.

[2] http://www.bis.org/speeches/sp100921_fr.pdf

[3] http://ec.europa.eu/internal_market/insurance/solvency/background_fr.htm.

[4] European Banking Authority, 2011, http://stress-test.eba.europa.eu/pdf/EBA_ST_2011_Summary_Report_v6.pdf.

[5] European Banking Authority (2011), Methodogical Note – Additional guidance, June 2011.

[6] The minimum level required by Basel II for the Core Tier 1 ratio is only 2%, which rises to 4.5% under Basel III (in force in 2013). This ratio measures the proportion of risk-weighted assets covered by equity capital.

[7] For a bank whose ratio falls to x%, the recapitalization requirement corresponds to (5%-x)/x % of post-shock equity capital. Hence if x=4%, the recapitalization requirement would correspond to 25% of the equity capital.

[8] “The correlation between interest rates on public debt and on private debt will make it difficult to resolve the sovereign debt crisis in the euro zone”, Flash marchés, Natixis, 14 March 2011 – N° 195, http://cib.natixis.com/flushdoc.aspx?id=57160.

[9] For example, each old bond with a face value of 100 euros is exchanged for a new one worth 46.5 euros. The EFSF guarantees 15 euros and the Greek state 31.5 euros.

[10] http://www.minfin.gr/portal/en/resource/contentObject/id/baba4f3e-da88-491c-9c61-ce1fd030edf6.

[11] In light of the holders of public debt who are not subject to Greek law and who are refusing to take part in the operation, the deadline of 9 March (see http://fr.reuters.com/article/frEuroRpt/idFRL6E8F54OO20120405) was put off to 4 April and then to 20 April. The Greek state considers that this refusal to exchange will not be sufficient to block the operation, as, given the collective action clauses, voluntary or required participation amounts to at least 95.7%. With regard to the recalcitrant investors, the Greek state has the choice of waiting a little longer, meeting its contractual commitments (continued reimbursement of the face value and interest as initially scheduled), make a new exchange offer (but this must be equitable with respect to those who accepted the previous offer) or default, with the risk of pursuit in the international courts.

[12] Olivier Garnier, “Comprendre l’échange de dette publique grecque”, Le Webzine de l’actionnaire – Analyses, Société Générale, 13 March 2012, http://www.societegenerale.com/actiorama/comprendre-l%E2%80%99echange-de-dette-publique-grecque.

[13] http://www.isda.org/dc/docs/EMEA_Determinations_Committee_Decision_01032012Q2.pdf.

[14] http://www2.isda.org/greek-sovereign-cds/

[15] The Euro Area Bank Lending Survey, 1February 2012, http://www.ecb.int/stats/pdf/blssurvey_201201.pdf.

[16] http://www.ecb.int/press/pr/date/2011/html/pr111208_1.en.html.

[17] “Les entreprises après la crise”, Colloquium Banque de France, 28 June 2011, http://www.banque-france.fr/fileadmin/user_upload/banque_de_france/publications/Bulletin-de%20la-Banque-de-France/Bulletin-de-la-Banque-de-France-etude-185-2.pdf

By Guillaume Allègre and Mathieu Plane (eds.)

Taxation is more at the heart of the current election campaign and public debate than ever before. The economic and financial crisis, coupled with the goal of rapidly reducing the deficit, is inevitably shaking up the electoral discourse and forcing us to confront the complexity of our tax system. How do taxes interact with each other? What are the effects? How are they measured? What kind of consensual basis and constraints does taxation require? How should the tax burden be distributed among the economic actors? How should social welfare be financed? Should we advocate a “tax revolution” or incremental reform? The contributions to a special “Tax Reform” issue of the Revue de l’OFCE – Débats et Politiques aim to clarify and enrich this discussion.

The first section of the special issue deals with the requirements and principles of a tax system. In an introductory article, Jacques Le Cacheux considers the main principles that should underpin any necessary tax reform from the viewpoint of economic theory. In a historical analysis, Nicolas Delalande emphasizes the role of political resources, institutional constraints and social compromises in drawing up tax policy. Mathieu Plane considers past trends in taxation from a budgetary framework and analyzes the constraints on public finances today. In response to the problem of imported carbon emissions, Eloi Laurent and Jacques Le Cacheux propose the implementation of a carbon-added tax.

The second section deals with the issue of how the tax burden is distributed among households. Camille Landais, Thomas Piketty and Emmanuel Saez respond to the important article by Henri Sterdyniak in which he recommends a “tax revolution”. Clément Schaff and Mahdi Ben Jelloul propose a complete overhaul of family policy. Guillaume Allègre attempts to shed light on the debate over France’s “family quotient” policy. Finally, Guillaume Allègre, Mathieu Plane and Xavier Timbeau propose a reform of taxation on wealth.

The third section concerns the financing of social protection. In a sweeping review of the literature, Mireille Elbaum examines changes in the financing of social protection since the early 1980s, and considers the alternatives that have been proposed and their limits. Eric Heyer, Mathieu Plane and Xavier Timbeau analyze the impact of the implementation of the “quasi-social VAT” approved by the French Parliament. Frédéric Gannon and Vincent Touzé present an estimate of the marginal tax rate implicit in the country’s pension system.

By Henri Sterdyniak

The financial crisis of 2007-2012 caused a sharp rise in public deficits and debt as States had to intervene to save the financial system and support economic activity, and especially as they experienced a steep drop in tax revenues due to falling GDP. In early 2012, at a time when they are far from having recovered from the effects of the crisis (which cost them an average of 8 GDP points compared to the pre-crisis trend), they face a difficult choice: should they continue to support activity, or do whatever it takes to reduce public deficits and debt?

An in-depth note expands on nine analytical points:

– The growth of debt and deficits is not peculiar to France; it occurred in all the developed countries.

– France’s public bodies are certainly indebted, but they also have physical assets. Overall the net wealth of government represented 26.7% of GDP in late 2010, or 8000 euros per capita. Moreover, when all the national wealth is taken into account (physical assets less foreign debt), then every French newborn has an average worth at birth of 202 000 euros (national wealth divided by the number of inhabitants).

– In 2010, the net debt burden came to 2.3% of GDP, reflecting an average interest rate on the debt of 3.0%, which is well below the nominal potential growth rate. At this level, the real cost of the debt, that is, the primary surplus needed to stabilize the debt, is zero or even slightly negative.

– The true “golden rule” of public finances stipulates that it is legitimate to finance public investment by public borrowing. The structural deficit must thus be equal to the net public investment. For France, this rule permits a deficit of around 2.4% of GDP. There is no reason to set a standard for balancing the public finances. The State is not a household. It is immortal, and can thus run a permanent debt: the State does not have to repay its debt, but only to guarantee that it will always service it.

– The public deficit is detrimental to future generations whenever it becomes destabilizing due to an excessive increase in public spending or an excessive decrease in taxation, at which point it causes a rise in inflation and interest rates and undermines investment and growth. This is not the situation of the current deficit, which is aimed at making adjustments to provide the necessary support for economic activity in a situation of low interest rates, due to the high level of household savings and the refusal of business to invest more.

– For some, the 8 GDP points lost during the crisis have been lost forever; we must resign ourselves to persistently high unemployment, as it is structural in nature. Since the goal must be to balance the structural public balance, France needs to make an additional major effort of around 4 percentage points of GDP of its deficit. For us, a sustainable deficit is about 2.4 GDP points. The structural deficit in 2011 is already below that figure. It is growth that should make it possible to reduce the current deficit. No additional fiscal effort is needed.

– On 9 December 2011, the euro zone countries agreed on a new fiscal pact: the Treaty on Stability, Coordination and Governance of the European Monetary Union. This Pact will place strong constraints on future fiscal policy. The structural deficit of each member country must be less than 0.5% of GDP. An automatic correction mechanism is to be triggered if this threshold is exceeded. This constraint and the overall mechanism must be integrated in a binding and permanent manner into the fiscal procedures of each country. Countries whose debt exceeds 60% of GDP will have to reduce their debt ratio by at least one-twentieth of the excess every year.

This project is economically dangerous. It imposes medium-term objectives (a balanced budget, a debt rolled back to below 60% of GDP) that are arbitrary and are not a priori compatible with the necessities of an economic equilibrium. Likewise, it imposes a fiscal policy that is incompatible with the necessities of short-term economic management. It prohibits any discretionary fiscal policy. It deprives governments of any fiscal policy instrument.

– As the rise in public debts and deficits in the developed countries came in response to mounting global imbalances, we cannot reduce the debts and deficits without addressing the causes of these imbalances. Otherwise, the simultaneous implementation of restrictive fiscal policies in the OECD countries as a whole will lead to stagnating production, falling tax revenues and deteriorating debt ratios, without managing to reassure the financial markets.

– A more balanced global economy would require that the countries in surplus base their growth on domestic demand and that their capital assumes the risks associated with direct investment. In the Anglo-American world, higher growth in wage and social income and a reduction in income inequalities would undercut the need for swelling financial bubbles, household debt and public debt. The euro zone needs to find the 8 GDP points lost to the crisis. Instead of focussing on government balances, the European authorities should come up with a strategy to end the crisis, based on a recovery in demand, and in particular on investment to prepare for the ecological transition. This strategy must include keeping interest rates low and public deficits at the levels needed to support activity.