Wednesday, December 23, 2009

The EU must learn from its mistakes over the past decade

by Hugo Brady

The EU needs new thinking. After eight years of stop-start negotiations, the Union finally has a new rulebook, the Lisbon treaty, which entered into force earlier this month. The member-states are waiting for a new European Commission and a new European Council president to take office early next year. But, despite Europeans’ shared anxieties about economic growth, government debt, the stability of the euro, immigration and the environment, there is not yet a clear sense of what the EU’s priorities for the next five years should or will be.

Given the global recession, many assume that the EU’s next ‘big idea’ will have an economic focus. Mario Monti, a former competition commissioner, has already proposed that EU countries should quicken their recovery from the crisis by opening up trade in services in exchange for a deal on harmonising tax bases. Others expect a new initiative on climate change – like a European carbon bank – or tighter rules on deficit spending to prevent the risk of default in the euro area.

But those thinking seriously about the EU’s future would do better to use the dying days of the decade to consider carefully the Union's mistakes and failures over the last ten years – before they chart ambitious new courses. The EU was neither sclerotic nor paralysed during the years 2000-09. It successfully rolled out a single currency, expanded to 27 members, established the world’s first functioning carbon trading scheme, deployed its first military missions and agreed a common arrest warrant to tackle cross-border crime. Nonetheless, the member-states would be wise to acknowledge several key failures from the same period:

• The EU spent most of the decade following the will o' the wisp of a grand constitution, to the detriment of its reputation both within the Union and in the outside world. That the Union repeated the exercise of treaty-writing so soon after a similarly troubling experience with the Treaty of Nice reveals a weakness for introspection which should be resisted in future. Let us hope that the innovations to EU business brought in by the Lisbon treaty will justify the time and effort spent on it.

• The premature accession of Bulgaria and Romania to the Union in 2007 damaged the credibility of EU enlargement, due to persistent problems with corruption and organised crime in these countries. Now that they are full EU members, reform of public administration and the judiciary has slowed.

• The EU made a similar error in allowing the accession of Cyprus in 2004. In doing so, the member-states removed probably the only international leverage that could have helped to push the island's territorial conflict to resolution. Since then the Cypriot government has unabashedly used its EU veto to complicate the Union’s ties with Turkey and NATO. Both of those relationships are critical for the Union's geopolitical standing.

• The EU spent most of the decade trying to convince key global players like the US or China that it is an emerging actor in a multipolar world. Yet it has been unable to overcome internal divisions over its relations with Russia, energy policy and reform of European representation in international organisations. Even the Union's jealously guarded image as a global leader on climate change is exaggerated (the final deal at the Copenhagen climate change summit was crafted in the absence of the EU). Unless the member-states find a way of summoning the political will to forge common positions on sensitive issues like, for example, how to handle meeting the Dalai Lama, the Europeans will continue to play ping pong while the rest of the world plays chess.

• The EU was wrong to lump together its external policies towards non-EU countries in the Mediterranean and Eastern Europe in the so-called European neighbourhood policy. Within a few years that policy error had to be tacitly acknowledged with the decision to create both a 'Union for the Mediterranean' and an 'Eastern Partnership'. But both these initiatives still suffer from a lack of substance.

• The EU's agreement on a lacklustre 'services directive' in 2005 was a missed opportunity to boost intra-European trade in services and thus help complete the single market. If the EU had been able to agree on something like the original ‘Bolkestein directive’ – before member-states and the European Parliament watered it down – the ability of the eurozone to withstand economic shocks like the current recession would have been greatly strengthened.

• In 2005, the member-states failed to find the political courage to reform the EU's budget and have so far reneged on a commitment to engage in a serious review of how the Union's annual expenditure of €120 billion should best be allocated. This is despite the Sapir report, commissioned by the European Commission, which described the EU's budget as “an historical relic”, in which “expenditures, revenues and procedures are all inconsistent with the present and future state of EU integration.”

• The EU's Court of Auditors declined to sign off its accounts at any point throughout the decade, mostly due to irregularities in how funds are dispersed within the member-states. This, plus a number of scandals over expenses paid to MEPs, have damaged the EU's credibility with taxpayers. Any future increase in the size of the EU's budget would be politically untenable without demonstrable reform.

The Irish historian and former diplomat, Conor Cruise O'Brien, famously said of the UN that the institution was prized by its member governments because of its “proven capacity to fail, and to be seen to fail.” To avoid a similar fate – that of a powerless body towards which its member-states push intractable problems – the EU must use the period 2010-15 to demonstrate that it can learn from the failures outlined above, correct them where possible, and avoid their repeat at all costs.

Governments and EU officials looking to the future should also reflect on the wisdom of reflections by Ralf Dahrendorf, a German-born British peer, who died earlier this year after a unique life committed to bringing Europeans closer together:

“All too often, today’s European Union forces its supporters to apologise for its strange ways: towards democrats for its bureaucratic opaqueness, towards free traders for its protectionism, towards applicants for membership for its apparent lack of a sense of urgency, and towards trading partners elsewhere, notably in the poorer parts of the world, for its crude and at times destructive pursuit of self interest. If such apologies continue to be necessary, support will wane and eventually vanish. European reform is imperative if the European Union is to survive.” *

A fine mission for the EU in the years ahead would be to ensure that these words – written in 1996 – do not ring true in 2015.

Hugo Brady is a senior research fellow at the Centre for European Reform.

* Why Europe Matters: A personal view, Ralf Dahrendorf, CER essay, 1996.

Hugo Brady is a senior research fellow at the Centre for European Reform.

Friday, December 18, 2009

Gazprom’s uncertain outlook

by Katinka Barysch

Many people in the EU tend to see Gazprom as a mighty giant that uses energy as a political tool on behalf of the Kremlin. They say that Russia has leverage because it controls 40 per cent of the EU’s gas imports. They fear that Gazprom may again cut gas flows to Ukraine this winter. They should think again. Realities on the international gas market have changed. Gazprom faces almost unprecedented uncertainty. It should therefore be keener on stable energy relations and co-operative customers. There may be an opening for a revived EU-Russia energy dialogue.

Gazprom’s energy strategy, and its political swagger, were predicated on the assumption that gas demand in the EU – by far the company’s most lucrative market – would continue growing. But in 2009, European gas demand fell for the first time ever. In the short term, this may even have suited Gazprom. Many analysts had warned that Russia may be unable to fulfil its export obligations from 2011 onwards because it does not invest enough in developing new gas fields in Yamal and Shtokman. Russia’s ability to supply is now more in line with gas demand.

In the medium term, however, the outlook for the gas market is foggy. For a company that must ponder multi-billion dollar investments to prevent an impending output decline, sits on a $40 billion debt pile and faces tougher competition, this is an uncomfortable position to be in.

The sluggish global economy will cap energy demand at a time when technology has opened up entirely new possibilities for producers. In 2009, output of so-called unconventional gas (gas coming from rock formations) in the US has risen so fast that the US has mothballed its LNG terminals. LNG tankers from Qatar started sailing to Europe instead. The additional supplies have depressed prices in the ‘spot’ market for short-term gas contracts. Spot gas became very cheap compared with piped gas from Russia or Algeria, which is tied to the oil price with a lag. European companies bought more supplies on the spot market and Gazprom lost out.

If the price gap persists, the big European companies, such as E.On, Gaz de France or ENI, will want to renegotiate their long-term ‘take or pay’ contracts with Gazprom. Russia, so far, wants none of it. If the Europeans buy less than the minimum amount fixed in these agreements, Gazprom can charge them a fine. But if spot prices are sufficiently low, that may still make business sense.

It is not only slow global growth and new technology that are causing uncertainty for Gazprom. So are the EU’s climate change targets and its emerging diversification strategy.

The gas industry argues, somewhat optimistically, that tougher CO2 targets will play in its favour as EU countries are forced to shut down polluting coal plants. Energy experts are not so sure. If the EU is to achieve both its target to increase energy efficiency (by 20 per cent by 2020) and boost the share of renewables to 20 per cent, the role of gas in the energy mix will have to shrink. At the same time, the Europeans are debating how to diversify their gas supplies away from Russia, to minimise the risk of further gas crises like the ones in 2006 and 2009. Many in Europe ridicule the EU-backed Nabucco pipeline as a pipe dream. But Gazprom has taken it sufficiently seriously to move ahead with its €20 billion South Stream pipeline that would compete with Nabucco for both Caspian gas reserves and South East Europe’s fast-growing energy markets. Austria is the latest country that appears to have switched sides from Nabucco to South Stream.

Pipeline competition, disputes over long-term contracts and uncertainty over both supply and demand make for an antagonistic energy relationship. Neither the EU nor Russia can want this.

The EU’s energy majors will want to wiggle out of their inflexible 30-year agreements but without endangering their working relationship with Gazprom. Some of them have upstream interests in the exploitation of Russian oil and gas fields. Some are involved in multi-billion euro joint pipeline projects with Russia. Long-term contracts will remain important for EU-Russia energy ties, but perhaps without the outdated practice of linking gas prices to those of oil.

Pipeline competition is souring the political climate in Europe. The EU and Russia should discuss whether Nabucco and South Stream might be merged. Russia will need western capital and know-how to develop difficult new gas fields. The EU wants Russia to sign up to joint principles on energy sector investment and transit, especially after Moscow recently withdrew its signature from the Energy Charter Treaty. Russia seeks European help to make its hugely wasteful industrial and power sectors more energy efficient. The EU wants Moscow to adopt greener policies.

These issues, and plenty more, could fill a reinvigorated EU-Russia energy dialogue with substance. Gazprom’s weakened position may bring Moscow to the negotiating table in a more compromising and constructive mood. Progress on energy co-operation could help dissolve the gridlock in EU-Russia relations.

Katinka Barysch is deputy director of the Centre for European Reform.

Monday, December 14, 2009

Rocky road back to growth

by Simon Tilford

There is no doubt that governments had to take exceptional steps in response to the financial crisis. Without such unprecedented action, many economies would have slipped into slump and probably deflation. With both public and private debt levels so high, deflation would have been crippling. But the point is approaching where stimulus and other monetary measures could become counter-productive. New asset price bubbles are inflating and there are signs of a return to excessive risk-taking in the financial markets. Fiscal positions are now terribly weak in many European countries. Deficit spending on this scale risks depressing rather than simulating economies, if investors lose faith in the sustainability of countries' fiscal positions and borrowing costs rise.

However, although there is no option but to start exiting soon, no-one should be under any illusions about the economic outlook. The short to medium-term looks bleak. Banking crises are typically followed by deep downturns and sluggish recoveries. This is no exception. Investment risks being held back by enfeebled banks. It is imperative that losses are disclosed and banks recapitalised. This is happening too slowly. Household borrowing is already high in many member-states and this will inevitably constrain private consumption. Cuts in public spending will soon be a drag on economic growth across most of Europe. Nor will external demand come to the rescue, not least because the euro looks set for a period of serious overvaluation.

Over the medium to long-term, the only way of bringing about sustainable economic expansion in Europe will be by boosting productivity growth and increasing employment rates. This demands markets that combine high skills and flexibility. Some European countries have one or the other; some neither; very few both. It demands an improved climate for innovation. A genuinely single market for high-tech products and pan-European capital markets would help high-tech firms to expand. Governments also need to increase public support of both pure and applied research as well as product development. Europe needs to learn from the US, where public procurement of one sort of another has made to the fostering of new technologies. Europe needs more, not less, competition. Without it, resources will be slow to move from underperforming or declining sectors to faster-growing, higher-tech ones. Finally, the financial system needs to allocate capital to those that can employ it most productively. The last few years suggest that financial markets are a long way from being perfect at doing this. But they are surely still better than governments.

However, governments will find it hard to implement many of these measures. One of the most striking trends of recent years has been rising inequality. Falling demand for unskilled labour is one reason for this. However, there is more to it. The rewards of economic growth have been accruing disproportionately to the rich rather than to skilled labour in general. Board-room pay is still rising rapidly across Europe, inflating wage differentials. This is not just a trend specific to the financial sector problem and it is certainly not confined to member-states that are considered to be 'economically-liberal'. Moreover, to a greater or lesser extent, governments have also had to step-in to bail-out the financial sector, and hence in the process some of the most highly rewarded people in Europe.

These developments threaten to be poisonous for the political economy of reform. Governments will have to do a number of things if they are to succeed in restoring order to public finances and in pushing through further reforms of labour and product markets. They will have to ensure that the burden of public spending cuts and tax increases is borne equitably. They must do a much better job of demonstrating how greater EU integration and reform benefits the average worker. And they will have to address the issue of excessive pay, both in public and private sectors. If they fail to address these problems, they will have a hard time cutting spending and pushing through tax increases. And they will struggle to pass anything that looks like a 'supply-side reform'.

Simon Tilford is chief economist at the Centre for European Reform.