by Tomas Valasek
Libya has been a difficult war for NATO. It has shown the alliance divided: only eight out of 28 allies sent combat forces. Some of them ran out of ammunition and Italy withdrew its aircraft carrier in the midst of the conflict because the government needed to cut expenses. The Americans’ frustration with European performance boiled over in June, when the then-secretary of defence Robert Gates warned that NATO faced a ‘dim and dismal’ future.
Yet critics of NATO’s performance are missing a bigger story: in Libya, the Europeans have for the first time responded to Washington’s calls to assume more responsibility for their neighbourhood. In complete contrast to the Balkans in the 1990s, they have taken decisive military action. As a result, the United States could take a back seat while the Europeans have absorbed most of the risks and costs of the ultimately successful war. This should be cause for cautious optimism about NATO.
Libya is an unheralded triumph for US diplomacy. One of Washington’s consistent aims has been to convince its allies to relieve the US military burden. In Libya, the US at last did what it had long threatened to do: the Obama administration, never too keen on the intervention in the first place, turned over most operations to allies shortly after the war’s initial stage, which had been led by US forces.
The US’s policy has had the desired effect on Europe: it has energised the key allies. French and British air forces, along with other European, Canadian and Middle Eastern colleagues, have performed the majority of the bombing raids since early weeks of the six-month war. In a sense, Libya is the antithesis to Europe’s failure to act in Bosnia. When bloodshed in the Balkans broke out in the 1990s, senior politicians on the continent hailed the ‘hour of Europe’, when an economic power would become a security player. But key European capitals could not summon the political will to use force, and, embarrassingly, it fell mostly to the US to end the civil war in Bosnia. In Libya, European governments acted swiftly, and helped the rebels win the war. In the process, the allies established a new division of labour for NATO operations on Europe’s borders, which should be encouraged and developed further.
This is not to say that all is well in NATO. Germany’s refusal to support the mission is worrying; Europe’s diplomacy and military operations in Libya lacked the punch they would have had with the continent’s largest country on board. Money is also a concern. The new division of labour inside NATO can only work if European governments continue to invest in their militaries. They are failing to do this: over the past few years, European countries have cut defence budgets dramatically. The Libyan conflict has done little to change the trend: the fiscal crisis is ensnaring more governments each month, prompting deeper and deeper cuts in government expenses including defence. On present trends, the Europeans may well lose the ability to mount another Libya-style operation in the future.
However, as a recent CER essay points out, there are things that the governments in Europe can do to avoid such outcome: from getting rid of legacy Cold War equipment to buying new weapons jointly and integrating their exercise ranges, maintenance facilities and military academies. There is evidence that the Europeans are moving in the right direction – the French and the British recently agreed to share the costs of building and maintaining nuclear weapons; they also plan to buy missiles and drones together in the future. More governments are exploring other ideas for collaboration, and the Dutch and the Belgians as well as the Nordic countries have been doing so for several years. These measures will not completely offset the impact of budget cuts but they may soften the blow until the fiscal situation in Europe improves.
For their part, the American military leaders need to challenge overly negative assumptions about the alliance in the United States. The success of US efforts to delegate responsibility to Europe has gone almost completely unappreciated in Washington’s political discourse, whose focus has been on European military failings. This damages the image of NATO in the US, with potentially serious consequences. The US-European defence relationship can only work if the Americans continue to see the alliance as useful for their own security. And this should not be taken for granted: as time passes, politicians and the military in the US tend to be less and less informed by the experience of the Cold War, and less inclined to view Europe as their default partner. Undue criticism of allies’ military shortcomings only accelerates the de-Europeanisation of US foreign policy.
Encouragingly, the message from Washington has changed in recent days, with the new secretary of defence, Leon Panetta, praising NATO’s operation as an example of international cooperation. The success in Tripoli, along with the new-found will in London, Paris and other European capitals to assume greater responsibility for the security in its own neighbourhood, ought to give the Americans more reasons for optimism.
Tomas Valasek is director of foreign policy and defence at the CER.
Friday, August 26, 2011
Thursday, August 25, 2011
The US and the EU should support the Palestinian bid for UN membership
by Clara Marina O'Donnell
For months, the US and the EU have tried to discourage the Palestinians from asking the UN to recognise the state of Palestine. On both sides of the Atlantic, governments are concerned that the UN bid will exacerbate the conflict with Israel. But so far, American and European efforts have failed. Instead Washington and its EU counterparts should exploit the Palestinian initiative. If framed constructively, UN recognition could actually strengthen the prospects for peace.
Since spring, Palestinian President Mahmoud Abbas has been planning to ask the UN to recognise a state of Palestine based on the 1967 borders, and grant it UN membership in September. Abbas is portraying the initiative as part of a campaign of non-violent protests against Israel, designed to make headway towards a two-state solution at a time when peace talks have stalled.
The UN bid is very popular amongst the Palestinian population and it has gained support from numerous countries, including those in the Arab League. But the US and several EU governments worry that UN recognition would only make peace harder to achieve. Israel is already threatening to sever all assistance and contact with the Palestinian authorities out of concern that they will use recognition to pursue claims against Israel at the International Court of Justice. Furthermore, emboldened Palestinian grass roots movements and Israeli settlers might try to reclaim land from each other in the West Bank, triggering unrest and potentially violence.
The Obama administration has already publicly declared that it will oppose any UN resolution recognising a Palestinian state. This would prevent the Palestinians from obtaining the UN Security Council’s endorsement – required for UN membership. But they could still ask the General Assembly to recognise them and give Palestine the status of a UN observer state.
As a result Washington and the Europeans have been trying to re-launch peace talks in an attempt to entice the Palestinians to drop their bid for recognition. But this approach is not working. A special meeting of the Quartet (a group set up to support the peace process, made up of the US, the EU, Russia and the UN) in July failed to reach any conclusions, never mind convince Palestinians and Israelis to restart negotiations. In early August, according to some press reports, Israeli Prime Minister Benjamin Netanyahu agreed to negotiate with the Palestinians on the basis of the 1967 ceasefire lines. In light of Netanyahu’s long standing opposition to the idea, this would be a significant breakthrough. But the Palestinians have so far rejected the offer because Netanyahu – whom Palestinians suspect is still not truly committed to negotiations – would only hold such talks if they recognised Israel as a Jewish state.
Instead of opposing the UN bid, Washington and its European partners should use the Palestinian initiative to strengthen their efforts to re-launch peace talks. The US and the EU should inform the Palestinians that they will support a request for UN membership so long as the Palestinians ask the UN to recognise a state of Palestine whose borders broadly resemble those of 1967; they commit themselves to resolving outstanding disputes with Israel through negotiations (including the exact demarcation of borders); and they extend their executive control over the territory only through agreement with Israel.
Such a resolution would curtail the risks envisaged by Israel and others about UN recognition. It would reaffirm the primacy of negotiations as the way to solve the conflict. And by eliminating legal ambiguities about who controls Palestinian territory, it would reduce the scope for Palestinian and Israeli popular protests. In addition, when presented under such terms, UN recognition could help address some of the obstacles which have stalled the peace process in recent years. It would ensure that the Arab world, while undergoing a major upheaval, endorsed the concept of a two-state solution. And it would force the militant group Hamas, which is still in control of Gaza and has so far been disdainful of the UN effort, to either endorse it or lose support amongst the Palestinian people.
It is unusual for the UN to grant membership to a state with such extensive caveats. And many of the challenges which have blighted peace talks in the past are set to remain. Nevertheless Abbas’ initiative could offer the best platform to re-launch negotiations between Israelis and Palestinians. And at a time when violence is flaring up around Gaza and the Israeli-Egyptian border, the US and the EU must do their utmost to ensure that the Palestinian UN bid does not trigger further instability.
Clara Marina O'Donnell is a research fellow at the Centre for European Reform.
For months, the US and the EU have tried to discourage the Palestinians from asking the UN to recognise the state of Palestine. On both sides of the Atlantic, governments are concerned that the UN bid will exacerbate the conflict with Israel. But so far, American and European efforts have failed. Instead Washington and its EU counterparts should exploit the Palestinian initiative. If framed constructively, UN recognition could actually strengthen the prospects for peace.
Since spring, Palestinian President Mahmoud Abbas has been planning to ask the UN to recognise a state of Palestine based on the 1967 borders, and grant it UN membership in September. Abbas is portraying the initiative as part of a campaign of non-violent protests against Israel, designed to make headway towards a two-state solution at a time when peace talks have stalled.
The UN bid is very popular amongst the Palestinian population and it has gained support from numerous countries, including those in the Arab League. But the US and several EU governments worry that UN recognition would only make peace harder to achieve. Israel is already threatening to sever all assistance and contact with the Palestinian authorities out of concern that they will use recognition to pursue claims against Israel at the International Court of Justice. Furthermore, emboldened Palestinian grass roots movements and Israeli settlers might try to reclaim land from each other in the West Bank, triggering unrest and potentially violence.
The Obama administration has already publicly declared that it will oppose any UN resolution recognising a Palestinian state. This would prevent the Palestinians from obtaining the UN Security Council’s endorsement – required for UN membership. But they could still ask the General Assembly to recognise them and give Palestine the status of a UN observer state.
As a result Washington and the Europeans have been trying to re-launch peace talks in an attempt to entice the Palestinians to drop their bid for recognition. But this approach is not working. A special meeting of the Quartet (a group set up to support the peace process, made up of the US, the EU, Russia and the UN) in July failed to reach any conclusions, never mind convince Palestinians and Israelis to restart negotiations. In early August, according to some press reports, Israeli Prime Minister Benjamin Netanyahu agreed to negotiate with the Palestinians on the basis of the 1967 ceasefire lines. In light of Netanyahu’s long standing opposition to the idea, this would be a significant breakthrough. But the Palestinians have so far rejected the offer because Netanyahu – whom Palestinians suspect is still not truly committed to negotiations – would only hold such talks if they recognised Israel as a Jewish state.
Instead of opposing the UN bid, Washington and its European partners should use the Palestinian initiative to strengthen their efforts to re-launch peace talks. The US and the EU should inform the Palestinians that they will support a request for UN membership so long as the Palestinians ask the UN to recognise a state of Palestine whose borders broadly resemble those of 1967; they commit themselves to resolving outstanding disputes with Israel through negotiations (including the exact demarcation of borders); and they extend their executive control over the territory only through agreement with Israel.
Such a resolution would curtail the risks envisaged by Israel and others about UN recognition. It would reaffirm the primacy of negotiations as the way to solve the conflict. And by eliminating legal ambiguities about who controls Palestinian territory, it would reduce the scope for Palestinian and Israeli popular protests. In addition, when presented under such terms, UN recognition could help address some of the obstacles which have stalled the peace process in recent years. It would ensure that the Arab world, while undergoing a major upheaval, endorsed the concept of a two-state solution. And it would force the militant group Hamas, which is still in control of Gaza and has so far been disdainful of the UN effort, to either endorse it or lose support amongst the Palestinian people.
It is unusual for the UN to grant membership to a state with such extensive caveats. And many of the challenges which have blighted peace talks in the past are set to remain. Nevertheless Abbas’ initiative could offer the best platform to re-launch negotiations between Israelis and Palestinians. And at a time when violence is flaring up around Gaza and the Israeli-Egyptian border, the US and the EU must do their utmost to ensure that the Palestinian UN bid does not trigger further instability.
Clara Marina O'Donnell is a research fellow at the Centre for European Reform.
Wednesday, August 24, 2011
Race to the bottom
by Tomas Valasek
For decades, European countries cut defence budgets with little worry. The United States kept enough troops on the continent to deter all potential enemies, almost irrespective of how small European militaries became. But the US contingent has been steadily shrinking, and the pace of this downsizing now seems certain to accelerate because of the economic crisis. The Europeans should be worried – yet they will probably respond by hastening their own defence cuts.
The July 31st agreement under which US Congress increased the ceiling for national debt cuts defence spending by $350 billion over the next ten years, White House calculations say. However, the deal also calls for a joint committee of six Democrats and six Republicans to find ways to decrease the deficit by another $1.5 trillion. The lion’s share of those reductions is certain to come in the form of expenditure cuts (as opposed to tax increases). And these further cuts – even if spread across government departments – will include significant reductions in the Pentagon budget, beyond the $350 billion that it is already scheduled to lose. Military spending now consumes more than 20 per cent of the total federal budget (for comparison, in the UK the figure is 6 per cent). Assuming that the joint committee makes roughly proportional cuts among government departments, the Pentagon will lose another $250 billion; this would put total reductions in military spending at $600 billion over ten years.
There is also the possibility that members of the committee will fail to agree, which would be even worse for the US military. Under the borrowing agreement, such a failure would lead to an automatic imposition of a $1.2 trillion cut in government spending, half of which would come straight from the Pentagon’s budget (for accounting reasons, the final amount would be slightly less than half: $534 billion). Including the $350 billion in cuts agreed last week, total loss to US defence spending over the next ten years could thus reach nearly $900 billion. The Republicans have been traditionally supportive of defence spending so in theory they have strong reasons to work with the Democrats on averting such draconian cuts to the military. But Democrats want further deficit reduction to include tax increases, which the Republicans oppose. And the ‘new’ Republican party is considerably less pro-defence than it used to be in the days of John McCain and Bob Dole; its top priority now is deficit reduction. If Democrats insist on tax raises, there is a chance that Republican members of the joint committee would rather choose an impasse, even if this led to deep defence cuts.
Whether the final amount is $600 billion or close to $900 billion, reductions of such magnitudewill have considerable impact on contractors and allies around the globe. One mitigating factor is that the cuts will be calculated on the basis of future projected spending (which was scheduled to rise) rather than current spending. Also, after 13 straight years of increases, the defence budget has reached a monumental $530 billion in fiscal year 2011 (not including another $160 billion allocated specifically for the wars in Iraq and Afghanistan). However, much of this amount is committed to manpower and benefits. Military healthcare alone consumes around $50 billion a year, and Congress is unlikely to agree to reduce it before the 2012 elections. The brunt of the newly ordered cuts will therefore fall on relatively few budget categories. Research is likely to suffer (because it can be cut with little immediately visible impact) and so is procurement (because some new weapons have incurred controversial cost overruns).
Importantly for America’s allies, many of the cuts will lead to closure of overseas bases. These have no political constituency in the United States, and thus no defenders in Congress, which will have to approve cuts. Europe is certain to suffer disproportionately in any future base closures. The continent is not high on the Defense Department’s list of priorities and it is seen as relatively free from danger. The allies have capable militaries, which, the Pentagon believes, should be able to assure security of Europe’s periphery (in places such as Libya) with little US help.
Even before the latest cuts, in April 2011, the Obama administration ordered the withdrawal of one of the four remaining US brigade combat teams (BCTs) from Europe. This was a less dramatic reduction than the one that George Bush’s government initially ordered in 2004 – then, the Pentagon decided to cut half the BCTs but subsequently put the decision on hold because they were needed in Afghanistan. In reducing the cut to just on BCT in 2011, the Pentagon cited the need to assure allies (mainly in Central Europe) that Washington remains committed to their defence. But it now seems very probable that the Defense Department, under pressure to save money, will withdraw the second BCT after all.
Many US military facilities in Western Europe are in danger. Their number has gradually dwindled as the US reduced forces from the Cold War average of 311,000 to fewer than 80,000 today. Many more will now be closed. The US military sees the smaller bases in particular as a source of relatively easy savings. While installations such as the large US military hospital in Landshut, Germany are likely to fare well, the 700-strong US Air Force base in Lajes, Portugal, will probably go. Non-essential facilities such as the George C Marshall Center in Germany (a school for military officers, mainly from Eastern Europe and Asia) are also vulnerable.
These departures are certain to be unpopular with local governments around Europe, some of which will suffer a double or triple setback. In addition to expected US base closures, NATO and national governments have also been cutting budgets and forces. Portugal, which will probably lose Lajes, had recently seen NATO decide to close its ‘Joint Force Command’ near Lisbon. Germany plans to close many of its own bases to save money; it now stands to lose some of the US ones as well. The closures will cause tensions among local and national governments but the impact on transatlantic relations will be limited – because virtually all allied capitals are reducing forces, none will be in a position to complain. But the US and European militaries will lose some of the existing opportunities to train together. And the loss of schools such as the George C Marshall Center would deprive the allies of the ability to win the hearts and minds of young officers in dangerous parts of the world such as South Caucasus and Central Asia.
With cuts to US defence budget looming, the US will also forgo its ability to pressurise the Europeans against reductions in their own spending. Apparently at the first meeting between Leon Panetta, the new Pentagon chief, and Liam Fox, the UK defence secretary, the two swapped lessons on how to cut budgets with least political pain. A year ago the US defence secretary would have sought to restrain the UK from cutting in the first place.
There is a real danger that cuts on one end of the Atlantic will encourage more cuts on the other end, thus degrading NATO’s credibility. While some of the bases that the United States is thinking of closing may well be redundant, NATO defence guarantees will lose their meaning unless the allies maintain a certain minimum number of forces and military installations. In theory, the Europeans should be responding to US force cuts by studying whether NATO is close to reaching this threshold, and whether they need to augment their forces to replace the departing US ones. But the opposite is likely to happen: without US pressure, many European governments will feel freer than ever to reduce military spending and forces. This may yet turn out to be the most significant and corrosive legacy of current US budgets cuts for allied security.
Tomas Valasek is director of foreign policy and defence at the Centre for European Reform.
For decades, European countries cut defence budgets with little worry. The United States kept enough troops on the continent to deter all potential enemies, almost irrespective of how small European militaries became. But the US contingent has been steadily shrinking, and the pace of this downsizing now seems certain to accelerate because of the economic crisis. The Europeans should be worried – yet they will probably respond by hastening their own defence cuts.
The July 31st agreement under which US Congress increased the ceiling for national debt cuts defence spending by $350 billion over the next ten years, White House calculations say. However, the deal also calls for a joint committee of six Democrats and six Republicans to find ways to decrease the deficit by another $1.5 trillion. The lion’s share of those reductions is certain to come in the form of expenditure cuts (as opposed to tax increases). And these further cuts – even if spread across government departments – will include significant reductions in the Pentagon budget, beyond the $350 billion that it is already scheduled to lose. Military spending now consumes more than 20 per cent of the total federal budget (for comparison, in the UK the figure is 6 per cent). Assuming that the joint committee makes roughly proportional cuts among government departments, the Pentagon will lose another $250 billion; this would put total reductions in military spending at $600 billion over ten years.
There is also the possibility that members of the committee will fail to agree, which would be even worse for the US military. Under the borrowing agreement, such a failure would lead to an automatic imposition of a $1.2 trillion cut in government spending, half of which would come straight from the Pentagon’s budget (for accounting reasons, the final amount would be slightly less than half: $534 billion). Including the $350 billion in cuts agreed last week, total loss to US defence spending over the next ten years could thus reach nearly $900 billion. The Republicans have been traditionally supportive of defence spending so in theory they have strong reasons to work with the Democrats on averting such draconian cuts to the military. But Democrats want further deficit reduction to include tax increases, which the Republicans oppose. And the ‘new’ Republican party is considerably less pro-defence than it used to be in the days of John McCain and Bob Dole; its top priority now is deficit reduction. If Democrats insist on tax raises, there is a chance that Republican members of the joint committee would rather choose an impasse, even if this led to deep defence cuts.
Whether the final amount is $600 billion or close to $900 billion, reductions of such magnitudewill have considerable impact on contractors and allies around the globe. One mitigating factor is that the cuts will be calculated on the basis of future projected spending (which was scheduled to rise) rather than current spending. Also, after 13 straight years of increases, the defence budget has reached a monumental $530 billion in fiscal year 2011 (not including another $160 billion allocated specifically for the wars in Iraq and Afghanistan). However, much of this amount is committed to manpower and benefits. Military healthcare alone consumes around $50 billion a year, and Congress is unlikely to agree to reduce it before the 2012 elections. The brunt of the newly ordered cuts will therefore fall on relatively few budget categories. Research is likely to suffer (because it can be cut with little immediately visible impact) and so is procurement (because some new weapons have incurred controversial cost overruns).
Importantly for America’s allies, many of the cuts will lead to closure of overseas bases. These have no political constituency in the United States, and thus no defenders in Congress, which will have to approve cuts. Europe is certain to suffer disproportionately in any future base closures. The continent is not high on the Defense Department’s list of priorities and it is seen as relatively free from danger. The allies have capable militaries, which, the Pentagon believes, should be able to assure security of Europe’s periphery (in places such as Libya) with little US help.
Even before the latest cuts, in April 2011, the Obama administration ordered the withdrawal of one of the four remaining US brigade combat teams (BCTs) from Europe. This was a less dramatic reduction than the one that George Bush’s government initially ordered in 2004 – then, the Pentagon decided to cut half the BCTs but subsequently put the decision on hold because they were needed in Afghanistan. In reducing the cut to just on BCT in 2011, the Pentagon cited the need to assure allies (mainly in Central Europe) that Washington remains committed to their defence. But it now seems very probable that the Defense Department, under pressure to save money, will withdraw the second BCT after all.
Many US military facilities in Western Europe are in danger. Their number has gradually dwindled as the US reduced forces from the Cold War average of 311,000 to fewer than 80,000 today. Many more will now be closed. The US military sees the smaller bases in particular as a source of relatively easy savings. While installations such as the large US military hospital in Landshut, Germany are likely to fare well, the 700-strong US Air Force base in Lajes, Portugal, will probably go. Non-essential facilities such as the George C Marshall Center in Germany (a school for military officers, mainly from Eastern Europe and Asia) are also vulnerable.
These departures are certain to be unpopular with local governments around Europe, some of which will suffer a double or triple setback. In addition to expected US base closures, NATO and national governments have also been cutting budgets and forces. Portugal, which will probably lose Lajes, had recently seen NATO decide to close its ‘Joint Force Command’ near Lisbon. Germany plans to close many of its own bases to save money; it now stands to lose some of the US ones as well. The closures will cause tensions among local and national governments but the impact on transatlantic relations will be limited – because virtually all allied capitals are reducing forces, none will be in a position to complain. But the US and European militaries will lose some of the existing opportunities to train together. And the loss of schools such as the George C Marshall Center would deprive the allies of the ability to win the hearts and minds of young officers in dangerous parts of the world such as South Caucasus and Central Asia.
With cuts to US defence budget looming, the US will also forgo its ability to pressurise the Europeans against reductions in their own spending. Apparently at the first meeting between Leon Panetta, the new Pentagon chief, and Liam Fox, the UK defence secretary, the two swapped lessons on how to cut budgets with least political pain. A year ago the US defence secretary would have sought to restrain the UK from cutting in the first place.
There is a real danger that cuts on one end of the Atlantic will encourage more cuts on the other end, thus degrading NATO’s credibility. While some of the bases that the United States is thinking of closing may well be redundant, NATO defence guarantees will lose their meaning unless the allies maintain a certain minimum number of forces and military installations. In theory, the Europeans should be responding to US force cuts by studying whether NATO is close to reaching this threshold, and whether they need to augment their forces to replace the departing US ones. But the opposite is likely to happen: without US pressure, many European governments will feel freer than ever to reduce military spending and forces. This may yet turn out to be the most significant and corrosive legacy of current US budgets cuts for allied security.
Tomas Valasek is director of foreign policy and defence at the Centre for European Reform.
Friday, August 05, 2011
Eurozone crisis: Can contagion to Italy be arrested?
by Philip Whyte
Ever since the EU and the IMF ‘bailed out’ Greece in May last year, the eurozone has fought a desperate rear-guard battle to stem contagion to other countries – with little success. Ireland and Portugal have since been bailed out, and Cyprus could be next. The most disquieting development, however, has been incipient contagion to larger economies like Spain and Italy. Unless this contagion is arrested, the eurozone could face a potentially terminal crisis. For the past year, the Spanish government has been battling valiantly to persuade financial markets that it will not be the next domino in the chain. But the change in sentiment towards Italy has been more recent – and is perhaps more alarming. What explains it?
Until early July, Italy had just about convinced the financial markets that it was not the ‘next Greece’. A cynic might justifiably wonder why. The country’s structural problems, after all, are as profound as they are well-known. It has a rapidly ageing population. Its ratio of public debt to GDP is the second highest in the eurozone (after Greece). Productivity has barely risen over the past decade. Rising wages have consequently pushed up unit labour costs, eroding the country’s trade competitiveness. Governance, moreover, is notoriously weak: because of the dysfunctional nature of the political system, few eurozone countries have done less in recent years to improve the supply-side performance of their economy.
Given these longstanding weaknesses, why did sentiment towards Italy not sour earlier? Until recently, Italy was thought to have several advantages over other countries in the eurozone’s troubled geographical periphery. Unlike Ireland and Spain, it did not experience a domestic credit boom in the run-up to the global financial crisis. Private sector balance sheets are therefore stronger: households are not over-indebted, and Italian banks fared well in recent stress tests. Italy, moreover, has been running smaller budget deficits than Greece or Portugal; in 2011, it is expected to run a primary budget surplus. Unlike in Greece and Portugal, budget deficits did not seem to pose a threat to Italy’s public debt sustainability.
Since July, however, market sentiment has changed alarmingly. At the time of writing, the yield on 10-year Italian government bonds stands at 6.12% – up from 4.73% at the end of June (and from 3.73% in October 2010). The spread over German bunds, which had fallen to almost zero in 2008, has now widened to 370 basis points. As in Greece, heightened perceptions of sovereign risk are hitting sentiment towards Italian banks (which have large exposures to their home country’s sovereign debt). Even banks that fared well in the EU’s recent stress tests have not been spared: the share prices of all Italian banks have taken a pummelling. Why has sentiment towards Italy soured so dramatically over the past month?
It is tempting to pin all the blame on political infighting and paralysis. It certainly does not help that the government is hamstrung by a small majority in parliament, or that relations between the prime minister and the finance minister are poor. Nor does it help that Silvio Berlusconi seems more inclined to use the office of prime minister to advance his private interests than the public one. But it is not as if these factors became apparent only in early July. Besides, Spain, whose government has shown greater focus and determination than Italy’s over the past year, has also experienced rising borrowing costs. So a strong political commitment to reform is necessary to restore confidence in Italy. But it may not be sufficient.
To see why, consider Japan – a country that displays many of the same ills as Italy. Like Italy, Japan has a rapidly ageing population. It also suffers from political paralysis and low economic growth. Japan’s public finances, moreover, are in much worse shape than Italy’s: its ratio of public debt to GDP is almost twice as large as Italy’s, and it is set to run a bigger budget deficit in 2011. If the recent spike in Italian government bond yields was solely driven by market fears about political stasis, low growth, weak public finances and a dearth of economic reforms, one might have expected Japanese bond yields to have risen in tandem with Italy’s. Yet they have fallen: 10-year Japanese bonds now yield just 1.2%.
Why have two countries with similar problems experienced such contrasting fortunes? Beleaguered European politicians may be tempted to blame market irrationality. A more plausible explanation is that less creditworthy sovereign issuers are more fragile inside a monetary union than outside, as they issue debt in a currency over which they have little control. The emerging framework for dealing with stressed sovereigns in the eurozone has heightened perceptions of fragility. A sovereign can only remain solvent if markets are confident that a ‘credit event’ is not in prospect. That confidence has weakened in the eurozone because ‘bail outs’ are increasingly seen as a prelude to, rather than a means of avoiding, a default.
The result is that bond yields inside the eurozone have become increasingly polarised between the weak and the strong. Italy could certainly do much to restore market confidence in the long-term sustainability of its public debt by enacting reforms that raise the economy’s long-term rate of growth. But it is illusory to believe that the country’s borrowing costs can be restored to more sustainable levels by action in Italy alone. The fate of Italy – and, by extension, the eurozone – is likely to be determined as much as by decisions in Berlin and Brussels as by those in Rome. It is becoming harder to see how the polarisation of yields within the eurozone can be reversed unless European leaders adopt a common Eurobond.
Philip Whyte is a senior research fellow at the Centre for European Reform.
Ever since the EU and the IMF ‘bailed out’ Greece in May last year, the eurozone has fought a desperate rear-guard battle to stem contagion to other countries – with little success. Ireland and Portugal have since been bailed out, and Cyprus could be next. The most disquieting development, however, has been incipient contagion to larger economies like Spain and Italy. Unless this contagion is arrested, the eurozone could face a potentially terminal crisis. For the past year, the Spanish government has been battling valiantly to persuade financial markets that it will not be the next domino in the chain. But the change in sentiment towards Italy has been more recent – and is perhaps more alarming. What explains it?
Until early July, Italy had just about convinced the financial markets that it was not the ‘next Greece’. A cynic might justifiably wonder why. The country’s structural problems, after all, are as profound as they are well-known. It has a rapidly ageing population. Its ratio of public debt to GDP is the second highest in the eurozone (after Greece). Productivity has barely risen over the past decade. Rising wages have consequently pushed up unit labour costs, eroding the country’s trade competitiveness. Governance, moreover, is notoriously weak: because of the dysfunctional nature of the political system, few eurozone countries have done less in recent years to improve the supply-side performance of their economy.
Given these longstanding weaknesses, why did sentiment towards Italy not sour earlier? Until recently, Italy was thought to have several advantages over other countries in the eurozone’s troubled geographical periphery. Unlike Ireland and Spain, it did not experience a domestic credit boom in the run-up to the global financial crisis. Private sector balance sheets are therefore stronger: households are not over-indebted, and Italian banks fared well in recent stress tests. Italy, moreover, has been running smaller budget deficits than Greece or Portugal; in 2011, it is expected to run a primary budget surplus. Unlike in Greece and Portugal, budget deficits did not seem to pose a threat to Italy’s public debt sustainability.
Since July, however, market sentiment has changed alarmingly. At the time of writing, the yield on 10-year Italian government bonds stands at 6.12% – up from 4.73% at the end of June (and from 3.73% in October 2010). The spread over German bunds, which had fallen to almost zero in 2008, has now widened to 370 basis points. As in Greece, heightened perceptions of sovereign risk are hitting sentiment towards Italian banks (which have large exposures to their home country’s sovereign debt). Even banks that fared well in the EU’s recent stress tests have not been spared: the share prices of all Italian banks have taken a pummelling. Why has sentiment towards Italy soured so dramatically over the past month?
It is tempting to pin all the blame on political infighting and paralysis. It certainly does not help that the government is hamstrung by a small majority in parliament, or that relations between the prime minister and the finance minister are poor. Nor does it help that Silvio Berlusconi seems more inclined to use the office of prime minister to advance his private interests than the public one. But it is not as if these factors became apparent only in early July. Besides, Spain, whose government has shown greater focus and determination than Italy’s over the past year, has also experienced rising borrowing costs. So a strong political commitment to reform is necessary to restore confidence in Italy. But it may not be sufficient.
To see why, consider Japan – a country that displays many of the same ills as Italy. Like Italy, Japan has a rapidly ageing population. It also suffers from political paralysis and low economic growth. Japan’s public finances, moreover, are in much worse shape than Italy’s: its ratio of public debt to GDP is almost twice as large as Italy’s, and it is set to run a bigger budget deficit in 2011. If the recent spike in Italian government bond yields was solely driven by market fears about political stasis, low growth, weak public finances and a dearth of economic reforms, one might have expected Japanese bond yields to have risen in tandem with Italy’s. Yet they have fallen: 10-year Japanese bonds now yield just 1.2%.
Why have two countries with similar problems experienced such contrasting fortunes? Beleaguered European politicians may be tempted to blame market irrationality. A more plausible explanation is that less creditworthy sovereign issuers are more fragile inside a monetary union than outside, as they issue debt in a currency over which they have little control. The emerging framework for dealing with stressed sovereigns in the eurozone has heightened perceptions of fragility. A sovereign can only remain solvent if markets are confident that a ‘credit event’ is not in prospect. That confidence has weakened in the eurozone because ‘bail outs’ are increasingly seen as a prelude to, rather than a means of avoiding, a default.
The result is that bond yields inside the eurozone have become increasingly polarised between the weak and the strong. Italy could certainly do much to restore market confidence in the long-term sustainability of its public debt by enacting reforms that raise the economy’s long-term rate of growth. But it is illusory to believe that the country’s borrowing costs can be restored to more sustainable levels by action in Italy alone. The fate of Italy – and, by extension, the eurozone – is likely to be determined as much as by decisions in Berlin and Brussels as by those in Rome. It is becoming harder to see how the polarisation of yields within the eurozone can be reversed unless European leaders adopt a common Eurobond.
Philip Whyte is a senior research fellow at the Centre for European Reform.
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