Europe’s real problem: France can’t sell cars

July 24, 2015, 4:00 PM UTC
Renault cars are seen at a dealership of French car maker Renault in Haguenau
Renault automobiles are seen at a dealership of French car maker Renault in Haguenau, North Eastern France, January 21, 2014. Renault said its vehicle sales rose 3.1 percent in 2013 and pledged further growth this year after its no-frills cars helped the company defy a European slump and gain ground in Russia and emerging markets. REUTERS/Vincent Kessler (FRANCE - Tags: TRANSPORT BUSINESS) - RTX17O40
Photograph by Vincent Kessler—Reuters

The way Greece is hogging headlines and tormenting heads of state, you’d think a “Grexit” is the biggest threat to the eurozone’s future. It isn’t. The greatest danger—and it’s being mostly ignored—is the shocking slide in competitiveness of the single currency’s second- and third-largest economies, France and Italy. One ailment encapsulates Europe’s énorme problème: France can’t sell cars.

Put simply, the cost of making products in France is far higher than in the nations it competes with. The hourly labor expense of manufacturing a car or steel beam in France rose 17% over the past decade, more than twice the increase in Germany. And even though wages have merely tracked inflation since 2008, costs keep climbing because workers are getting less and less productive. That’s chiefly because France’s manufacturers are so starved for profits that they can’t afford to replace or refurbish antiquated plants and IT systems.

By contrast, Ireland, Spain, and Portugal have all acted while France fiddled, liberalizing their labor markets and lowering unit costs over the past six years by 7% to 12%. The results have been disastrous for France’s competitiveness. In the past 10 years its share of all EU exports dropped from 12% to 9.5%, the worst performance of any major country in Western Europe.

And it’s not just France that’s struggling. Italy’s products are now even pricier. From the late 1990s to mid-2000s, Italy’s manufacturing costs exploded. “Italy is the nation I’m watching,” says Uri Dadush, an economist at the Carnegie Endowment. “It’s lost an enormous amount of competitiveness to Germany, and things aren’t improving.” Despite the reform efforts of Prime Minister Matteo Renzi, Italy still sets wages mainly by national labor agreements that ensure pay rises faster than output.

Export growth has stagnated in France and Italy, Europe’s second- and third-largest economies.Source: Eurostat

That brings us to the economic bellwether for the two nations—cars. Both France and Italy mainly manufacture inexpensive autos. Because they’re basic transportation, the Peugeots, Renaults, and Fiats require low prices and low costs to sell well at home and in other European nations. Germany, which has lower costs and sells more luxury cars, isn’t subject to the same constraints.

In the past decade the number of cars sold in Western Europe by France’s Renault and Peugeot dropped from 3.5 million to 2.5 million. Meanwhile, the number of cars sold by Germany’s VW, Daimler, and BMW increased by 200,000 to 4.5 million, despite a decline in the European market.

That downward trend reversed in the first four months of this year, as French and Italian exports surged. But a main catalyst was the decline in the value of the euro vs. other world currencies. That will take the countries only so far. Only reductions in pay, shedding rigid labor laws, and a move to high-margin products will revive their flagging exports, and both France and Italy are regressing as their rivals march forward. The euro’s next existential crisis won’t arise from a weakling state but from these two large, pivotal economies that too few are watching.

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A version of this article appears in the August 1, 2015 issue of Fortune magazine with the headline “Europe’s Real Problem: France Can’t Sell Cars.”