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Federal elections in Italy highlight the horrific state of the country's economy, but for global markets, the problems of southern Europe – Spain, Italy, Portugal and Greece – are already reflected in asset prices. Lurking in the background, however, is a much larger potential problem, as France, the euro zone's second largest economy, slides into the same structural morass that crushed Spain. Thankfully, a prominent economist may have a solution.
Global investors have largely ignored the terrible economic data from Europe after August, 2012, when ECB president Mario Draghi pledged to do "whatever it takes" to save the region's financial system. But the market's confidence is likely to be shaken as the strain on France's economy intensifies.
Investors generally view the northern European nations of Germany and France, which account for 34 per cent of euro zone GDP, as a bulwark against the declining fortunes of southern Europe. If France moves to the negative side of the growth ledger into a recession, this would leave Germany virtually alone as a source of growth in the region.
And unfortunately, recent economic signs from France have not been good. Fourth quarter gross domestic product was reported at minus-0.3 per cent. Industrial production and manufacturing reports confirm a contracting economy and the highly public war of words between the French government and the CEO of Titan International has underscored France's lack of competitiveness.
Faced with the same lack of policy options as Spain, the French government is reportedly looking to the work of Harvard economist Gita Gopinath. Professor Gopinath, (the first Indian woman to gain tenure at Harvard according to Bloomberg Businessweek), is advocating a novel "pseudo devaluation" strategy that offers a potential solution to Europe's economic woes.
In essence, Prof. Gopinath's idea is to slash payroll taxes and replace them with consumption taxes. This would increase take-home pay for employees – at no expense to employers – who could then spend more. The higher consumption tax would aid the relative competitiveness of domestically manufactured goods. Goods imported to France from countries where wages and payroll taxes are lower will have less of a pricing advantage after the new tax is slapped on.
The French government has already proposed $27-billion (U.S.) in corporate tax cuts and raised consumption taxes and officials have attributed the idea to Prof. Gopinath.
The pseudo devaluation strategy represents a rare source of hope for European economies at a time of sluggish U.S. growth and skepticism regarding the sustainability of the Chinese growth miracle. At the very least, Prof. Gopinath has shown that even if some of the policy solutions of the past are now unavailable, human ingenuity is capable of uncovering new strategies. For that, all global investors are in her debt.
Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here for more of his Insights, and follow Scott on Twitter at @SBarlow_ROB.