Second Quarter GDP Shows More Of The Same

The expenditure breakdown of second quarter GDP from France and Germany released recently emphasised the continuing disparity between rates of domestic demand growth within the Eurozone and, consequently, the policy setting problems faced by the ECB.

French GDP grew at a robust 0.8% on the quarter or 3.0% on the year, well above its trend rate of growth. German growth was lower at just 0.5% on the quarter, 1.5% on the year. As in recent quarters, this difference in overall growth rates was mainly a reflection of the underperformance of German domestic demand. German household spending increased just 0.1% in the second quarter, and with capital goods investment flat and construction investment falling 2.0% q/q this resulted in an overall contraction of domestic demand of -0.1%.

All of the overall expansion in German GDP during the second quarter was therefore accounted for by export growth (and although still strong, this component also showed signs of slowing; exports grew at 3.2% in the second quarter compared to 4.3% in the first quarter).

In contrast, French household spending grew 0.7% in the second quarter and business investment growth accelerated from an already robust 0.8% rate of growth in the first quarter to 2.2%.

Chart 1: Household spending growth and overall GDP growth

France appears to be benefiting from what might be considered a 'traditional' recovery - with export growth translating into domestic income growth, increasing domestic demand and so resulting in a self-sustaining, steeper recovery. Somewhere along the line, however, the German recovery seems to have short-circuited. Despite historically very high rates of export growth (and significantly higher than France) there remains no evidence that this is translating into domestic demand. As the second quarter numbers confirm, investment spending continues to decline and household spending is broadly flat.

Chart 2: More of the same - 3 years of German household spending underperformance

When Is A Tax Cut A Good Tax Cut?

It wasn't meant to be like this. The 'Agenda 2010' reform package introduced in Germany during late-2003 and early-2004 included a range of personal and corporate tax cuts and even brought forward to 2004 some tax cuts that had originally been planned for the following year.

France did not have a comparable tax cutting epiphany, although the overall size of a series of individually smaller-scale tax cuts introduced over the course of the last three years are comparable in size to the German measures. Income tax reductions have reduced income receipts by around 10% (or 0.3% of GDP), tax credits have been increased to low income workers (around a 0.2% of direct GDP effect), social security payments for workers earning less than two times the minimum wage have been reduced and even indirect taxation has been cut, VAT being reduced 1% to 19.6%.

French tax cuts have worked in supporting domestic demand, whereas German tax cuts appear to have had less impact. There are three main reasons as to why we think this has been the case, listed here in order of importance:

1. Keeping it simple: The German tax cut package was part of a wider agenda of reforms aimed at making the German economy, and especially the labour market, more efficient. Healthcare and pension provisions provided either by the state, or which employers were obligated to provide, have also been reduced, resulting in a larger proportion of these costs coming out of households' disposable income. Allowing for increased health and pension costs, the actual disposable income effect of the reform package is flat to mildly contractionary.
2. Timeliness: The French tax cut measures outlined above were implemented throughout 2001-03, although the greatest impact was felt in 2001-02, just at the time that export and domestic demand were simultaneously declining. The French tax cuts therefore combated the demand deficiency problem at its source, where as the German government waited for the problem to develop. In other words, both governments may have had the right diagnosis, but Berlin waited until the disease had taken hold before administering the medicine. Unsurprisingly, it is now proving less effective.
3. Progressiveness: French tax cuts and tax credits have been carefully targeted at lower income groups. The French government has explained this in terms of an ideological commitment to make the taxation system more progressive, but it also has the convenient side effect of putting money in the pockets of those households with the highest marginal propensity to spend rather than save. The German tax cutting package, however, had the ideological backdrop of increasing incentives, rather than social equality, and so has not been so explicitly progressive - both low and high tax rates were reduced. This may have longer-term supply-side benefits, but the immediate demand-side impact is certainly less potent.

The political balance in France (especially after the March 2004 regional elections, in which left wing parties made strong gains, taking control of 20 of the 22 régions, having previously held only 8) means that, no matter how much Chirac's self proclaimed "gouvernement de mission" may wish to emulate some of the German reforms, it is not politically feasible to do so. This may be storing up longer term problems for the French economy, but in the short term it has meant that, unlike in Germany, tax cuts have not coincided with an increase in the savings rate.

The Employment Virtuous Circle

Timely, well targeted tax cuts and the absence of any 'nasty' reforms has meant that since the first quarter of 2000 real household spending has expanded 8.5% in France compared to 0.7% in Germany (an almost insignificant average annualised rate of 0.16%). Of course, all this French outperformance cannot be explained with reference to the direct effect of tax cuts (only worth around 1.7% of GDP in total), but rather by the 'virtuous circle' by which consumption has supported employment growth, so increasing consumer confidence and lowering the savings rate. Real private sector wages have increased 6% in France since 2000, compared to 2% in Germany (although still lagging the 12% growth over the same period produced by the ultra-tight UK labour market) and the household net savings rate has declined steadily from 8.2% in 2000 to 4.7% in 2004 (see chart 4).

Chart 3: The French connection - more jobs, more income, less spending, more jobs, etc…

Too Good To Last?

French net household savings has now reached almost the lowest level since the data became available (1978) and in recent quarters it has shown signs of levelling off. If the savings rate stops declining, as already seems to be the case, this means that future household spending growth will be proportionately more dependent on actual income growth. This would break one of the connections in the virtuous circle of French growth, although there is no reason to suppose that it should lead to a German style stagnation.

Chart 4: French household net savings - levelling out?

Employment indicators of most French business surveys are at broadly neutral levels suggesting that, while not hiring at the pace they were during 2000-02, employers do not expect any significant pick-up in lay-offs.

Chart 5: Living in hope - EU consumer confidence survey, 12-month economic expectations component

This confidence is reflected in the component of the EU Commission's consumer confidence survey that measures households' expectations of the economic situation over the forthcoming 12-months (see chart 5). This has improved recently in France (and in the UK) and is at similar levels to the start of 2004. In contrast, the German households' expectations for the next year have recently declined, likely a reaction to the worsening employment outlook and stagnant wage growth.

Considering the recent trend toward improving household expectations, a sharp correction of the net savings rate away from its current low level seems unlikely. A levelling off of the savings rate, however, does mean that household spending growth is likely to slow a little from the above-trend rates of growth recorded in the first half of 2004.

We expect household spending growth to moderate over forthcoming quarters - although even this need not necessarily translate one-for-one into a moderation of domestic demand growth. In particular, business investment is expanding quickly in France (+2.2% q/q in the second quarter, 4.2% y/y) as producers aim to meet increased levels of both domestic and external demand.

Conclusion

France is currently in the midst of a 'traditional' economic recovery; an initial boost from export demand firmed the labour market and encouraged household spending. With both external and domestic demand growing, producers are now expanding investment in order to meet that increased demand. This virtuous circle was encouraged by a well-targeted fiscal expansion that primed domestic demand at an expedient point in the cycle.

A host of structural problems initially inhibited this virtuous circle developing in Germany and, faced with the problem of an already underperforming economy, the tax cuts implemented in January 2004 were perhaps not too little as such, but were certainly too late. Additionally, the costs imposed on households by the simultaneous healthcare and pension reform meant that the German tax cuts had very little, if any, stimulative effect when introduced anyway.

The most powerful phase of the 'traditional' French recovery, with households reducing savings and quickly increasing consumption, however, is drawing to a close. As a consequence, household spending growth is likely to moderate in the second half of the year relative to the above trend growth rate of 3.2% annualised achieved during the first half.

The pick up of investment spending, however, means that both French domestic demand and overall GDP growth should continue to significantly outperform Germany. As a result, the demand-drag effect of Germany and the policy conundrum it presents to the ECB will be a theme that continues well into 2005.