Thursday, October 28, 2010

Britain's defence review: Good news for European defence?

by Clara Marina O'Donnell

On October 19th, the UK's coalition government published its 'strategic defence and security review' (SDSR), laying out the future shape of Britain's armed forces. As was to be expected at a time of budget austerity, the SDSR foresees significant cuts in military capabilities. But the review also has some good news. The need to save money has made the UK government more willing to move towards long-overdue European co-operation. In addition, the coalition is keen to see the EU play a role in defence, a pragmatism which stands in stark contrast to the eurosceptic views held by the Conservative party before the general election last May.

As part of its plan to reduce the UK's budget deficit, the government has been forced to cut an already overstretched defence budget by 8 per cent in real terms over the next four years. Prime Minister David Cameron has claimed that Britain will continue "punching above its weight" in the decades to come. But, inevitably, the UK's level of ambition has been scaled back.

Britain will no longer be able to maintain a long-term operation of the size that is currently deployed in Afghanistan: while there are nearly 10,000 British troops in Afghanistan today, the maximum size of such operations in future will be around 6,500. The size of large-scale fighting operations will also be cut back – to around two-thirds of the forces that went into Iraq in 2003. The government has also been forced to give up big items of military equipment. Britain will mothball or sell one of the two new aircraft carriers it has committed to build; the UK is also retiring its Harrier fleet of military jets early, leaving the other carrier without any British aircraft for several years.

Extensive cuts in UK defence capabilities risk further weakening the ability of Europeans to contribute to global crises, already poor as a result of years of insufficient and inefficient defence spending across the continent. But at least the British government is showing an unprecedented interest in closer defence co-operation – not only with the US, but also with its European allies. Acknowledging that it can no longer afford to maintain capabilities alone, the government has committed to exploring the possibilities of joint formations for future operations, joint training and maintenance, and even sharing assets or relying on others to provide some military equipment.

Frustrated by the inefficiencies and cost overruns of large multinational programmes, the coalition wants to focus on bilateral co-operation. In particular, the government wants to work more closely with France, which has a similar defence budget and shared military ambitions. Prime Minister Cameron and President Nicolas Sarkozy are expected to announce a series of common defence projects at a bilateral summit in Paris in early November. Now that both France and the UK will rely on only one aircraft carrier each, this should also lead to new avenues for co-operation. Britain has already decided to redesign its remaining carrier so it can be used by French (and US) aircraft.

The coalition government's plan to work more closely with its allies is both positive and long overdue. For decades, Britain and other European countries have wasted a lot of money by duplicating the development of military equipment. Depending on the outcome of the Franco-British summit, the new UK government might go further in promoting the cause of European defence co-operation than any of its predecessors.

But London must invest the same political energy it has devoted to France towards exploring additional savings with other European countries. In the SDSR, the government opens the possibility of closer defence co-operation with Germany, Italy, the Netherlands and Spain. But other countries could also offer niche savings, including Poland and Sweden which have shown a keen interest in improving their military capabilities in recent years. The UK should also actively encourage its European allies to strengthen co-operation amongst themselves. As Britain's own military preparedness diminishes, it has a greater interest in other European countries taking up the slack.

The second piece of good news in the SDSR is the rather constructive attitude of the UK towards EU defence co-operation. Before the general election last spring, key members of the Conservative party – in particular William Hague, now the Foreign Secretary, and Liam Fox, now in charge of defence – voiced serious reservations about EU efforts in defence. Liam Fox worried that federalists within the EU were trying to develop a European army. He openly opposed some of the steps towards a stronger EU foreign policy foreseen in the Lisbon treaty. And he was keen to withdraw the UK from the European Defence Agency, a body which encourages common efforts amongst EU countries in developing defence capabilities.

But since their arrival in government with the Liberal Democrats, the Conservatives have agreed to support the new institutions created by the Lisbon treaty. The coalition has chosen to remain in the European Defence Agency for a trial period of two years. And the SDSR has recognised that while NATO remains the "bedrock of Britain’s defence", an "outward-facing" EU also has a role to play in “promoting security and prosperity”. In the defence review, the government even stresses its support for EU military and civilian missions – as long as they offer good value for money and NATO does not want to intervene.

The new government's stronger focus on value for money in EU missions has already ruffled feathers in Brussels, as the UK has become more critical of EU deployments that it considers are failing to deliver – such as the EU mission in support of security sector reform in Guinea-Bissau (which was ended in September 2010) or the military training mission for Somali security forces. But the coalition's desire to see EU missions deliver a real impact on the ground should be seen as a good thing. Too often EU deployments have been too small to make a lasting contribution to stability, like the police training mission in Afghanistan, or their effectiveness has been damaged by an ambiguous mandate, as was the case at the beginning of the police mission in Bosnia-Herzegovina.

If the UK government is going to oppose missions which it considers are not adding value, it must also be willing to strengthen those missions which are effective. Britain is actually one of the EU countries keen to maintain the EU's military deployment in Bosnia-Herzegovina (which some other member-states want to dismantle). But the UK should go further and, when appropriate, increase the budget of effective EU operations and send more British personnel – notwithstanding the UK's budgetary troubles.

If the coalition strengthens EU missions, it would help reassure EU partners that the UK is not opposed to EU operations out of principle. More importantly, effective EU military and civilian deployments would contribute to one of Britain's key objectives within its SDSR – to strengthen stabilisation and conflict prevention efforts around the world.

At a time when additional defence cuts cannot be precluded down the road, the UK must work closely with its European partners over the next few years – in developing military capabilities and deploying stabilisation and crisis management missions, including through the EU. Only through co-operation now will Britain feel more comfortable to explore even deeper common efforts when the next SDSR takes place in 2015.

Clara Marina O'Donnell is a research fellow at the Centre for European Reform.

Friday, October 15, 2010

What currency wars mean for the eurozone

By Simon Tilford

The dollar has now fallen to $1.40 against the euro. This is still below the low of almost $1.60 that it reached in the middle in July 2008, but it represents a steep decline from under $1.20 in early June. Moreover, the US currency is likely to weaken further. The euro has also risen sharply against the British pound in recent weeks. Why is this happening? And what are the implications for the eurozone economy and, in particular, the member-states currently experiencing difficulties funding their government deficits?

The renewed strength of the euro is not down to optimism about the eurozone’s economic prospects. Most forecasters foresee only modest growth in the eurozone economy next year and in 2012. Nor does the appreciation in the value of the single currency reflect receding investor concerns over the solvency of various eurozone economies. The spreads between the German government’s borrowing costs and those of the struggling member-states of currency union remain very high. The reason for the strength of the euro reflects the differing policies of the US Federal Reserve (and the Bank of England) on the one side and the European Central Bank on the other.

The Federal Reserve will almost certainly embark on a further round of so-called quantitative easing before the end of 2010. The Bank of England may follow suit. Quantitative easing involves pumping money into the economy through the purchase of assets (usually government bonds), ostensibly with the aim of boosting credit growth and hence consumption and investment. Both central banks are considering such action because of the failure of their respective economic recoveries to gain traction and their consequent fears that inflation will fall too low. Weak economic growth and low inflation (or worse, deflation) is very dangerous for highly indebted economies, because it makes it much harder to reduce the real value of their debt.

The ECB has taken a different line. Some of its board members believe that they need to tighten monetary policy. The bank has already reined in its policy of providing unlimited liquidity to eurozone banks, with the result that market interest rates have risen sharply. Axel Weber, head of the influential German Bundesbank, has called for an increase in official interest rates and spoken out strongly against any quantitative easing comparable to that under consideration by the Federal Reserve or the Bank of England. The institutions’ contrasting approaches partly reflect philosophical differences – the ECB believes the potential inflationary risks of quantitative easing outweigh the threat of deflation. But the differing economic outlooks of the various eurozone economies are also a factor. For example, the German economy is expanding rapidly, explaining Weber’s call for tighter policy.

The problem for the eurozone is that unorthodox monetary policy such as quantitative easing tends to depress the currencies of the countries whose central banks are engaged in it. The reason is that some of the money issued flows abroad. The weakness of the dollar (and the pound) has led many to question whether the US and UK are engaging in competitive currency devaluations. In short, they stand accused of attempting to bolster their trade competitiveness at others’ expense. Because the ECB has elected to pursue a different monetary policy course and because – unlike East Asians countries such as China, South Korea and even Japan – the ECB does not intervene in the foreign currency markets to hold down the value of the euro, it is the single currency which is bearing the brunt of a weaker dollar.

There is no doubt that the Federal Reserve and the Bank of England are keen to keep their respective currencies weak. It is not hard to see why. For the best part of three decades, both economies have more or less continuously run current account deficits as their domestic savings have fallen short of their investment levels. They now need to close these external imbalances, which are a drag on their economies, and are one reason why both are running such large fiscal deficits. Savings rates in both countries have certainly picked up and investment remains weak, but a rebalancing of their economies remains elusive. Indeed, after narrowing in the immediate aftermath of the financial crisis, the US trade deficit is widening. A major reason for this is that many countries remain wedded to export-led growth and are unwilling or unable to rebalance their economies in favour of domestic demand.

Global imbalances were one of the key drivers of the financial crisis. They led to excessive capital flows into the US and other fast-growing developed economies. These pushed down the cost of capital and encouraged – together with poor management – excess leverage and risk-taking. US attempts to cajole the Chinese and others to pursue more balanced economic growth have largely fallen on deaf ears. By pumping out lots of dollars, the US central bank hopes to make it more costly for countries to hold down their currencies. China will have to buy more dollars if it is to maintain the renminbi’s peg to the US currency. This will be costly because the dollar will ultimately have to fall in value, reducing the value of China’s dollar holdings. Moreover, the inflows of dollars into China will prove destabilising, exacerbating bubbles and pushing up inflation. This, in turn, should make Chinese goods less competitive on the US market. However, it is impossible to say how long it will take before the Chinese and other East Asian governments blink.

In the meantime, the euro is set to remain very strong. This is bad news for the stability of the eurozone. If it persists, the adjustment facing struggling members of the currency union, such as Spain, will be even harder to bring off. Spain requires strong growth in exports to offset the weakness of its domestic economy, and a strong euro will make its goods and services less competitive in export markets outside the currency bloc. But is the eurozone an innocent bystander in all this? The eurozone’s trade with the rest of the world is broadly in balance, and no-one could accuse of the ECB of adopting policies aimed at weakening the euro. However, to an extent, the eurozone economies are reaping what they have sown.

First, Spain is so dependent on exports to the rest of the world to dig itself out if its current hole because the eurozone has failed to take action to address the trade imbalances between member-states of the currency union itself. Spain must close its external deficit without any corresponding obligation on countries such as Germany and the Netherlands to narrow their surpluses. In short, the eurozone is relying on demand generated elsewhere in the world to bail it out. In essence, its strategy to overcome the crisis involves running a trade surplus with the rest of the world. US action to weaken the dollar combined with the mercantilism of East Asian governments makes this all but impossible. Second, the Chinese were not the only ones who were deaf to US calls for action to rebalance the global economy. The German government was instrumental in preventing any discussion of imbalances within the G20, joining the Chinese in arguing that it is for the deficit countries alone to put their houses in order.

The G20’s failure to agree a global strategy to address imbalances leaves the eurozone in a tricky position. At the very least, the ECB should hold off tightening monetary policy, as this would further increase the attractiveness of the euro relative to the dollar. Secondly, it must get serious about removing barriers to stronger domestic demand across the eurozone. There will be no export-led exit from the eurozone crisis. Signs of a pick-up in German domestic demand are positive in this regard, but it remains to be seen how vulnerable this is to a weakening of external demand for German goods.

Simon Tilford is chief economist at the Centre for European Reform

Tuesday, October 12, 2010

The EU should be much bolder on energy efficiency

by Stephen Tindale

The most pain-free way for European governments to fight climate change is to use energy more efficiently. At a recent energy conference hosted by the European Commission, it struck me that the EU still has a poverty of ambition when it comes to energy efficiency. This is hard to fathom at a time when it could alleviate several of the ills currently troubling European governments: unemployment, energy security and climate change.

EU policy and performance in this area has been disappointing to date. In a speech to a conference on EU energy policy on September 30th 2010, energy commissioner Gṻnther Oettinger identified energy efficiency as his “first priority”. However, he then talked mainly about how energy is used by consumers and the importance of improving the insulation of buildings. This is a significant part of the energy equation, but not the only important part of it. The EU must also focus on how energy is produced.

Too much of the debate on climates focuses on targets. The EU has legally binding targets to reduce greenhouse gas emissions by at least 20 per cent (from 1990 levels) by 2020, and to get 20 per cent of energy from renewables by the same date. A third target, energy savings of 20 per cent by 2020, is so far only for for guidance. Oettinger has said that he will decide whether to make this target binding after evaluating progress made towards the voluntary target in 2012. Targets have some value; they lead to greater political and business attention and help secure agreement on specific policies. However, it would be a waste of political and negotiating capital to spend too much time or effort making the target binding. It would be more sensible for governments, businesses and non-governmental organisations to focus instead on specific regulations and on funding.

The Commission is due to publish a new Energy Efficiency Action Plan before the end of 2010. This should identify regulations and funds to deliver improved efficiency, both in energy use and in energy production. The Energy Performance of Buildings Directive, Energy Services Directive and Cogeneration Directive should be strengthened. The Energy Performance of Buildings Directive mandates that all buildings undergoing major renovation will have to meet minimum energy performance requirements, but these are to be set by member-states. Germany already requires that any building undergoing substantial renovation should meet high energy efficiency standards. Sweden has gone further: every time a building is sold or rented out it must meet high efficiency standards. All member-states should follow the Swedish example, and the new Action Plan should require that strong building regulations be met whenever a building is renovated, sold or rented.

The Energy Services Directive is an attempt to get energy companies to act as energy services companies, delivering not just power and heat but also advice to help their consumers use energy more efficiently and so reduce costs. The directive requires energy suppliers to promote energy efficiency to their customers and to expand energy metering. But it is vaguely worded and has no significant regulatory teeth. It should in future require energy companies to give money to organisations which carry out energy efficiency work at no up-front cost to customers.

The third directive to strengthen is the Congeneration Directive. When a fuel is burnt to generate electricity, heat is also produced. Most of the heat from most power stations is simply wasted up chimneys. Additional fuel is then burnt to provide heat for homes and industry. It is quite possible to use the heat from electricity generation for industrial or domestic heating. Cogeneration is a well-established technology which makes obvious economic, energy security and climate sense. Yet in 2007 only 11 per cent of EU electricity and 13 per cent of heat used came from cogeneration plants.

The Cogeneration Directive requires member-states to remove barriers to cogeneration. It allows, but does not require, them to support cogeneration. Some governments have done so, but the leading countries were doing this well before the directive was adopted in 2004, and the directive has not delivered a significant increase in cogeneration Europe-wide. Cogeneration should therefore be made mandatory. Whenever anything is burnt to generate electricity, the heat must be captured and used.
As well as regulation, the EU must focus on funding. Grants will be necessary to expand cogeneration and district heating networks. In 2008 the Commission allocated €4.8 billion of cohesion policy funds to renewables, decentralised energy production (which makes cogeneration much easier) and district heating. It has recently proposed that €115 million of unspent money from the European Economic Recovery Fund to be allocated to energy efficiency. The Commission should go much further. It should propose a substantial increase in energy efficiency funding, using some of the estimated €112 billion that will be raised by auctioning Emissions Trading Scheme permits.

Whatever the Commission does, most of the finance will have to be mobilised nationally. Much of the funding should come via low-interest loans, as has been done successfully in Germany through the publicly-owned KfW bank, resulting in the improvement of more than 1.5 million homes. The Energy Services Directive allows member-states to establish energy efficiency funds, but does not require them to do so, while the Energy Performance of Buildings Directive merely requires them to list existing and proposed financing schemes. These provisions are too weak. Member-states must be required to set up energy efficiency financing schemes.

The EU likes to claim to be a world leader on tackling climate change. It cannot claim any sort of leadership in energy efficiency, but there are some reasons for optimism that 2011 will at last see significant progress. President Herman Van Rompuy has called a summit on energy in February 2011. This will be a good opportunity to make progress on implementing the Energy Efficiency Action Plan. Hungary, which holds the EU presidency for the first half of 2011, has particularly strong reasons to focus on improving existing buildings. Doing so could reduce its annual gas imports by 40 per cent, and prevent up to 2,500 people dying from hypothermia every winter. Poland, which has the presidency in the second half of 2011, has improved residential energy consumption by almost 20 per cent over the last five years by retro-fitting existing buildings.

Progress is no guaranteed, of course. Raising the price of energy through taxation is one way to encourage less consumption, and would also help reduce fiscal deficits, but energy taxation proposals provoke extensive and often effective lobbying by industry and consumer organisations. Public grants don't face opposition, but will be limited by the economic situation. Nevertheless, the Commission does now appear to be serious about energy efficiency. It has estimated that reducing EU energy consumption by 20 per cent by 2020 would reduce the cost of energy imports by €100-150 billion annually, and could create a million new jobs. The means to achieve this 20 per cent reduction are already known, and the technologies are available. Yet under current policies the EU will only reduce consumption by 10 per cent, so the EU will miss out on at least €50 billion a year in cost savings and half a million new jobs. Stronger policies to save more energy must be the top priority for Oettinger and Jose Manuel Barroso for the rest of 2010 and the whole of 2011.

Stephen Tindale is an associate fellow at the Centre for European Reform.

The arguments outlined above will be expanded in a CER policy brief, 'Delivering EU Energy Efficiency', in November 2010.

Friday, October 08, 2010

Divisions remain over euro reform

by Katinka Barysch

Europeans agree that the management of the euro must be improved to prevent future crises, or deal with them better if and when they happen. The European Commission is hopeful that it can get all 27 EU countries to agree on a package of reforms it published at the end of September. However, recent conversations in various EU capitals left me with the impression that divisions still run deep on crucial aspects of eurozone reform. Not everyone shares the Germans’ sense of urgency, and there is a risk that complacency sets in before a sustainable new framework has been created.

On September 29th, the European Commission published six draft laws designed to improve the management of the euro. The package foresees earlier and tougher sanctions on countries that break agreed limits on budget deficits and debt levels, new procedures for macro-economic co-ordination to avoid harmful imbalances among EU countries, and a harmonisation of the way EU countries draw up their budgets. The conclusions of Herman Van Rompuy’s taskforce on eurozone governance are expected to go broadly in the same direction. The Commission hopes that the proposed reforms can become law by the summer of 2011 – an ambitious timetable even by the Commission’s own admission.

So far, discussions have mainly taken place among finance ministers, either among 16 of them in the Euro Group or all 27 in Van Rompuy’s taskforce (a slightly enlarged version of Ecofin). Finance ministries tend to welcome strict EU rules, which help them to fend off spending pleas from cabinet colleagues. But the same unity of purpose does not exist among the EU’s heads of state.

In rough terms, the EU countries fall into two camps: a German-led one which puts the emphasis on strict rules and automatic sanctions to enforce discipline; and a French-led group of mainly South European countries that – although aware of the need for fiscal discipline – want more political wiggle-room for economic policy co-ordination that could require an effort also from surplus countries, for example by trying to boost demand.

France’s club Med is weaker than the German stability camp: members such as Greece, Portugal and Spain are in the dock and their voices count for less in the current debate. Italy traditionally punches below its weight in European policy debates; and Rome’s opposition to attaching sanctions not only to excessive deficits but also stubbornly high debt levels is a little too predictable (its own debt being the second highest in the EU).

The German camp looks firmer and stronger. Austria and the Netherlands agree on the need for tough spending limits and sanctions. So do the Nordics, including non-euro countries such as Denmark and Sweden. Most of the Central and East European member-states, having imposed fierce austerity programmes at home, are not afraid of strict rules. “We are Germany’s natural allies in this”, insists one Polish official. “That’s why the Germans are stupid to try and keep the East Europeans out of the euro.”

However, the German-led group is not as cohesive as it appears at first sight. The non-euro countries do not only want stronger rules for the eurozone. They also want to forestall the emergence of a two-tier EU where euro countries closely co-ordinate their economic policies while non-euro ones wait outside the door. The price most non-euro countries are willing to pay for this is to be bound by the tough new rules and even accept financial penalties. However, the EU treaties allow eurozone countries to agree on new measures and sanctions among themselves but not to extend them to non-euro countries. Some in Central Europe now silently hope that the euro reform debate will drag on for so long that they can slip into the euro in the meantime. Poland has added a long-standing demand to the eurozone debate, namely that the costs of pension reform be excluded from budget deficit numbers. Other EU countries could complicate the reform effort with their own idiosyncratic issues. The UK is in the special position that it wants stronger rules for the euro – knowing that another eurozone crisis would harm its exports and finance industry – but under no circumstances does it want to be bound by them.

Although Germany has so far dominated the eurozone reform debate, it still faces an uphill struggle to get all 27 governments to back new rules and penalties. A restive European Parliament will also have a say on some of the proposed changes. The most important condition for creating a consensus on swift eurozone reform is still for France and Germany to reach an agreement. Christine Lagarde, France’s finance minister, and her German counterpart, Wolfgang Schäuble, have put on an admirable show of unity in the euro debates. But it is not always clear in how far they speak on behalf of their bosses at home. Divisions between Germany and France still run deep.

French policy-makers and economists think that the single currency suffers from a design flaw: a lack of economic governance. Closer economic policy co-ordination, including on such things as tax levels and industrial policy, is therefore what the French government is aiming for. Most Germans think that the reason for the current mess is that existing fiscal limits were not applied properly [for the reasons why they should re-think see How to save the euro, by Simon Tilford]. Germans demand stricter rules not only at the EU level but also at the national level. They want other EU countries to emulate Germany’s new constitutional clause, which mandates all future German governments to run balanced budgets from 2016 onwards. Germans do not mind that this clause will give the country’s already mighty constitutional court a direct say in economic management.

Policy-making by judicial decree would be anathema to most French. For them, discretion is the essence of politics, at home and in the eurozone. “Leaders need to be able to lead, especially in a crisis. They should not tie their own hands”, says one of Sarkozy’s economic advisors. The Commission proposals already embody a compromise between Germany and France: the fines proposed by the Commission will bite unless a qualified majority of EU countries votes against them. For many Germans, that still leaves too much room for political cop-outs. For most French, the thought of the Commission deciding something so eminently political as fines is still hard to accept.

Another profound disagreement concerns the idea of bolstering the euro through a permanent crisis resolution mechanism. The Commission omitted this from its September reform package, which is looking only at steps that can be implemented without changing the Lisbon treaty. The Commission, alongside the French, also argues that the EU should first see how its €440 billion safety net (the European Financial Stability Facility) works before it talks about new institutions.

But Berlin is in a hurry. It refuses to contemplate extending the EFSF beyond 2013. And it will accept a permanent rescue fund only if it comes with a bankruptcy procedure for countries that can no longer service their debt. “Without a resolution mechanism, we will have endless bail-outs and no incentives for countries to run a responsible fiscal policy”, warns one German finance ministry official. He speculates whether the EU could use the treaty adjustment that will be necessary for Croatia to join the EU over the next couple of years to set up this new mechanism.

French officials argue that talking about a bankruptcy procedure for countries now would only spook the markets. Generally, the French do not appear to feel the same sense of panic about the fate of the euro that has gripped many Germans. “The euro?” asks one Paris intellectual somewhat tongue in cheek. “France suffers from an identity crisis! It fears about its role in the world, its traditional dominance of Europe, its social model, even its way of life.” While France is concerned about losing its AAA credit rating and being ‘decoupled’ from the German economy, it has been less pro-active in the euro reform debate. Without a sense of urgency, France and Germany are unlikely to make the concerted effort that is still needed to get all EU countries to support a comprehensive reform package. The spectre of an EU lurching from crisis to crisis has not been banished.

Katinka Barysch is deputy director at the Centre for European Reform