Hamish McRae: A French vote against the constitution could revitalise the European economy

Where in the world should investors place their savings? The trouble at the moment is that you can make very good reasons for not investing anywhere or in anything.

Where in the world should investors place their savings? The trouble at the moment is that you can make very good reasons for not investing anywhere or in anything.

Look around the world. The case against the US is that the huge imbalances - both external and internal - will have to be corrected at some stage and that correction may come in a sudden way. So there are big risks both to the dollar and to asset prices. The case against the UK is a milder version of the US: that demand has been sustained artificially by an enormous swing of public finances from surplus to deficit and by an unsustainable level of consumer borrowing.

But at least there has in the US and UK been sustained growth. It looks as though growth has stalled in Japan and it has slowed right down in core Europe. However, despite flat domestic demand at home and despite the strong euro, many German companies are doing very well out of their exports. Germany last year passed the US as the world's largest exporter.

This leads to an intriguing thought: could it be that the risks in Continental Europe are indeed lower than elsewhere in the developed world? This would be despite the effective collapse of the Stability and Growth Pact, despite double-digit unemployment in several countries, despite the damage the strong euro is doing to exports, despite weak domestic demand and despite the slow progress of structural reform?

That is the background to a new issue that is starting to concern the markets: the possible rejection by French voters of the new European constitution at the end of May. What France does on this issue is much more important that what Britain or indeed any other EU member decides to do. That is not just because it was one of the founder members of the enterprise; it is also because French voters are fundamentally better disposed towards the EU venture than, for example, British ones (top chart).

The French referendum is a way off yet (and we will have had a general election by then) but at the moment a majority of French voters are opposed to the deal (middle chart). If there indeed were to be a "non", it would have a profound political and financial impact. The constitution would be dead.

So what? Well, there are two profoundly different views. The conventional one runs like this. The rejection of the constitution, coming on top of the weakening of the Stability and Growth Pact, suggests that European integration will come to a halt. President Jacques Chirac's own position would be weakened, making it harder for him to push through structural reforms, and inevitably there would be a prolonged period of investor uncertainty.

The markets are just starting to focus on the financial consequences. In the judgement of Capital Economics, the direct impact will be quite limited for most countries, though the uncertainty could damage confidence on the bond markets (something that the watering down of the Stability and Growth Pact did not do). But the impact on the "new" EU countries could be greater, as it would be assumed that their entry into EMU and the euro would be delayed. And the effect would be greatest on the next wave of entrants, as it might be assumed that their membership might be delayed.

Further, Capital Economics argues, if financial markets were to start factoring even a small risk of a country leaving the eurozone, then financial markets could face huge swings - though the company reckons that the likelihood of a country actually leaving is small, given the costs involved.

The fundamental point here is that uncertainty has always been bad for financial markets. So a French no vote, by increasing uncertainty, would inevitably be bad for them.

This line of argument is sensible, rational and probably right. It is interesting that several financial market commentators are starting to pose the possibility of a country leaving the eurozone but the conclusion that this is unlikely, at least in the medium term, is probably right too.

There is, however, a rather different, maverick interpretation of the consequences of a French rejection. It would run like this.

The EU would have to come to terms with the fact that the project of having an ever-closer union would be dead. The future would be a multi-speed Europe, with piecemeal co-operation on political issues and greater internal competition on economic ones. The fringe - in particular the UK, Sweden, Denmark and the new member states of central and eastern Europe - would continue not only to grow more swiftly than the core, but as a result of their better economic performance would exert a greater influence on core policies. The possibility of British membership of the eurozone would of course vanish for the foreseeable future. Because of greater internal competition within Europe the pace of reform would quicken and the EU's economic performance would improve. For example, ideas such as the flat tax system pioneered by the Baltic states would spread to core Europe.

This would be a radical interpretation of the consequences of the defeat of the European elite: not the end of the EU at all but rather its rebirth as a more vigorous institution that focused on economic success rather than political integration. Were this to happen, the EU would of course become a much more attractive entity in which to invest. It would incorporate something of the dynamism of the US without the fiscal (and to some extent monetary) irresponsibility. It is a seductive notion.

Seductive but this is all maybe too early. On balance the mainstream view is more likely: that the disruption and uncertainty that would follow rejection of the constitution would damage the markets, not inspire them. Big business would be alarmed - confidence has recently turned down again, though this may have more to do with economic rather than political uncertainty (bottom graph).

There may, however, be a timescale matter here. In the short term rejection of the constitution might well be bad for investors and companies alike. But in the medium term it might be better. The rewards would go to investors that could look through the period of uncertainty and spot the prizes at the end of it. In other words, both interpretations would be right, the former in the short term, the latter in the long.

That is quite a common conundrum in economics: two outcomes, utterly opposed to each other, can both be right but on different timescales. The task of financial markets, as always, is to spot the turning points early, so gauge when a negative influence flips and becomes a positive one.

The other point to make is that financial assets are inevitably in competition with each other. They do not have to be marvellous to be more attractive than the alternative. You do not have to buy the widespread concerns about a dollar crash to be worried that the US economy will be running into a strong headwind in the next couple of years. That would be just about the time when the longer-term case for European investment would start to become more evident - if indeed the more competitive Europe is the outcome.

But first, of course, French voters have to exercise their democratic rights and throw the constitution out.