With public debt markets showing every sign of stress, from high gold prices to warnings from international institutions, two neighbouring European economies have come under particularly unwelcome scrutiny.

Comparisons are always instructive…

The UK and France have so much more in common than a thin strip of water. With very similar-sized populations and output (give or take a few purchasing power parity adjustments), public debt levels on or above 100% of national income and struggles to contain fiscal deficits, their economic problems look remarkably similar. But some points of difference help explain the challenges their respective governments are confronting.  

To start with historic basics. On France’s side, a massively larger geographical footprint (more than twice the size of the UK’s) means fewer problems associated with population density: lower land and house prices in particular. It may be this made easier a self-engineered advantage: a switch to nuclear power that has made France much less vulnerable to spikes in fossil fuel prices, coupled with less need to switch to expensive alternatives. (Another natural advantage over the UK - its climate - is however being somewhat eroded by the effects of global warming.)

On the UK side, deep capital markets, the English language and global attitudes led to the build-up of greatly superior financial and professional services, a well-remunerated way for workers in developed economies to earn their living. And historically, the UK has been the recipient of more overseas investment, not least, between 1986 and 2016, from countries attracted by the combination of lighter touch regulation with its access to the Single European Market. 

Historically, lower add-on employment costs and regulation also made for a much more flexible labour market (and hence lower unemployment) in the UK, but this relative advantage has been eroded by recent tax and legislative changes, driving up UK employment costs and pushing the minimum wage about 20 per cent higher than in France.

The two countries have one particular challenge in common: both are now struggling to find fiscal space to make the necessary increases in defence spending. (Between them, they are carrying a weight for Europe so far evaded by, for example, one of its fiscally healthiest economies - Ireland.)

Then again, health services are under pressure from ageing populations in both the UK and France. But French health outcomes are notably better. Under their system of social insurance, the French spend more on health than the British do, but few now believe that simply handing the tax-funded NHS more money would cure all its weaknesses. Other European health models are beginning to be looked at with increasing envy in the UK.

Meanwhile, both sides of the Channel are struggling to control spending on benefits, but the pattern is different in each. To start with pensions. The “triple lock” ratchet for pension increases in Britain gives rise to frequent criticism that policymakers favour the older generation over the younger: but, even so, spending in pensions is still far lower than in France. That’s not likely to change soon, after yet another retreat by one of France’s transitory governments from plans to raise pension age to 64.   In the UK the pension age is already 66 and scheduled to rise to 67 next year. 

Any cause for comparative self-congratulation north of the Channel however fades when you come to look at spending on sickness and disability benefits, special education and social care. Escalating costs in these areas have created the British Chancellor’s biggest spending headache.

Even so, overall the UK faces a fiscal struggle from a better position than France. Its deficit is still (a bit) smaller and so is its debt-to-gdp ratio. The UK also has a much more stable political position.  There is a functioning government with a large parliamentary majority (and so far at least, no former Prime Minister in jail). The current British Prime Minister’s opinion poll ratings may be poor, but perversely, for a strong-minded leader, that could be an advantage, since no sane government backbencher would want to undermine him to the point of precipitating a general election. 

But political stability is only a massive advantage if (a) government takes the right decisions, and  (b) has the courage to force them through - which is why the UK government’s backing-off from welfare reforms sent such negative signals to debt markets. For it has remained uncomfortably true that despite its relative advantages in terms of deficit, debt and government stability, the UK has been having to pay a significant premium over France for financing its debt. What could change that? Is it something in its governance, or the economic fundamentals?

Most obviously, inflation in the UK is currently significantly higher than in France. And since gilt markets are forward-looking, persistently higher yields in the UK might seem to indicate a certain market disbelief that British monetary policy will bring inflation down in line with the French.  

The Bank of England is three centuries older than the European Central Bank, but it became fully independent less than three decades ago, within months of the creation of the ECB. In those decades the ECB has acquired a hawkish reputation reflecting the historic fear of inflation in its largest member country. Its reputation was enhanced by hanging tough with Greece, admittedly not its most influential member, which has emerged from a massive financial crisis in remarkably good shape.  

So far as France is concerned, that’s inevitably a more open question.  In a crisis, Germany would clearly be readier to use its influence to temper the wind to France than to Greece. When the euro’s predecessor, the European Monetary System of semi-fixed exchange rates, came under intense pressure in 1992, Germany was content to let the UK fall out but gave backdoor help to keep the French in.  So whether help were now to come to France in the form of strong external discipline or a generous bail-out, the markets seem to be assuming the role of the ECB makes French debt less risky than British.

By contrast, the Bank of England’s reputation is still on the line. National central banks need to continually demonstrate their independence from domestic political pressures. After decades of successfully maintaining inflation in line with its target, its most recent performance has raised more questions. The Bank does not enjoy the luxury of being able to toggle between concerns over growth and inflation control as if there were no other players in the economic game: it must stick to its primary function, which is to control inflation.

To do the Bank justice, rate cuts have been counter-balanced by some continued quantitative tightening - at a slower pace from September, but involving more active sales because fewer bonds are maturing. (However QT is a decidedly mixed political blessing. If it is less publicly obvious than high interest rates, it is expensive to the Treasury.) 

As inflation shows signs that it may have peaked for now, the Bank is subject to speculation that it will want to greet the Budget with another rate cut, as confirmation that the fiscal position had been brought under control. But it would be wrong to see that decision as a test of confidence in the Chancellor’s decisions. Another cut from August’s 4% would take the Bank’s key rate perilously close to the 3.5% minimum that it maintained during its most successful period of inflation control, and the inflation battle is still not won.

The second, more intractable difference in economic fundamentals is that investment has been much weaker in the UK.  This is the main explanatory cause of the difference in productivity, which is estimated to be 10-20% higher in France.  Low investment in the UK has been a trend clearly exacerbated by Brexit, and today capital per worker is estimated to be as much as a third higher in France - much higher than can be explained by a lower employment rate.  

France has overtaken the UK to become Europe’s highest recipient of foreign direct investment.  Another small sign of Brexit damage to investment has been the UK’s exclusion from the European Investment Bank, of whose funds it received more than France and which have not been replaced by domestic investment.  The British Government is now openly proclaiming the extent of the damage, with the Bank of England, a little belatedly, raising its voice too.

The scorecard for the two economies highlights lessons to be learnt on both sides of the Channel. Most of them are glaringly obvious to their policymakers, but need to land in public consciousness before (difficult) actions are taken. The French can’t get a grip on pension spending until they have a functioning government, while radical reform of the NHS, social care and benefits is still not on the table in Britain.  And with so many pressures and demands on the British Chancellor, it will be hard to keep focus on the urgent priority to increase investment, which in an case will take decades to fix.  But comparisons should help to keep attention fixed on the scale and priority of the task.

Guest Author: Baroness Sarah Hogg, Former Frontier Economics Chairman