Time to stop the EIB’s carbon subsidies

The European Investment Bank (EIB) is greener than it used to be – it now lends half its annual energy pot to energy efficiency and renewables. But it is still lending to coal projects. This is inconsistent with EU climate policies, and must stop now.

Some leading politicians, such as UK Chancellor of the Exchequer George Osborne, are arguing that, given the continuing economic crisis, we cannot afford to ‘go green’ at the moment. This is a serious mistake.  Climate change is not only an environmental problem; it is already causing death and want. A recent report on vulnerability to the effects of climate change (http://daraint.org/climate-vulnerability-monitor/climate-vulnerability-monitor-2012/) found that climate change is already killing nearly 400,000 people annually world-wide each year. And it is already costing the global economy €930 billion each year.

The EU’s 2011 Energy Roadmap, a document laying out the Union’s aspirations that was backed by all member-states bar Poland, proposes the need for an 80 per cent reduction in carbon emissions by 2050. New coal-fired power stations would make it impossible to meet this target, since they emit high levels of carbon dioxide, the main greenhouse gas. Taking account of the full life-cycle (including construction and decommissioning), coal plants emit around twice the amount of carbon dioxide per unit of electricity generated as gas plants do, eight times as much as nuclear plants and 32 times as much as wind farms.

Since 2007, the EIB has lent a total of €1.88 billion to three coal projects in Slovenia, three in Poland, two in Germany and one each in Romania, Italy and Greece. It is true that the EIB does take climate change into account when making investment decisions, to some extent. Its rule is that the new plant has to replace an existing coal or lignite plant and lead to a decrease of at least 20 per cent in emissions, compared to the old plant. It also has to be ‘carbon capture ready’, so that if carbon capture and storage (CCS) proves to be effective at scale and affordable, it can be retrofitted to the plant. But that remains a very big ‘if’, and the EU’s failure so far to award any money to a CCS demonstration does not bode well for rapid progress. In practice, the requirement that a plant be carbon capture ready means little more than ensuring that a patch of land suitable for a CCS plant is left free near the new power station.

Carbon emissions, like all form of pollution, have externalities. The EU has a scheme to force the producers of the pollution to pay – the Emissions Trading System. But the price under this system is languishing below €8/tonne. This is far too low to have any impact on investment decisions. To its credit, the EIB uses instead what it calls an ‘economic price of carbon’. This is a calculation of the full costs to society of dealing with each tonne of carbon emitted, and is currently set at €30/tonne. This will increase €1 every year from now on.

However, this does not prevent the EIB from lending to coal projects without CCS. So the economic price sounds a good policy instrument, but does not actually stop the EIB from lending to projects that they think will be financially profitable. This lending amounts to a massive subsidy to coal, which undermines the renewables target.

The EIB currently takes decisions on energy projects based on the guidelines in its 2006 energy policy document. But it is consulting on a new approach, which it aims to adopt next year. The science and understanding of climate change have moved on considerably since 2006, and the situation is much more urgent. A minimum of 2 degrees of warming now looks all but inevitable – driven largely by the burning of coal. The top priority for the EIB’s new policy must be to stop lending to all coal and lignite plants unless they have CCS. Without this change, the EIB will continue to undermine the EU’s climate policies.

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

Europe’s youth job crisis

Youth unemployment rates in some EU countries are scandalously high. Many EU countries are hoping to copy the success of the German apprenticeship system. Although countries should be encouraged to learn from each other, there is no one-size-fits-all solution to the job crisis. And many measures will not bite until growth returns.

Unemployment among young people has always been higher than general joblessness but the economic crisis has widened the gap further. According to Eurostat, 22 per cent of 15-24 year-olds in the EU are unemployed. In those countries hardest hit by the crisis, such as Greece and Spain, the rate is 50 per cent.

Such figures are shocking but also somewhat misleading. Just like general unemployment statistics, youth unemployment is measured as the share of job-seeking youngsters in all youngsters who are either working or looking for work. But many young people do neither. Millions are in education. Many have simply given up looking for a job. These groups are not captured in youth unemployment statistics, which pushes up the youth unemployment rate.

A more accurate indicator of the youth employment crisis is the NEET concept: the total of young people not in employment, education or training. Last year, Europe had 7.5 million NEETs aged 15 to 24. Extend the age bracket to 29 and the number swells to 14 million – the equivalent of 15 per cent of all young people in the EU.

NEET rates are highest among the South and East European EU countries and lowest in the Nordics, Germany and the Netherlands. In Greece and Bulgaria, almost a quarter of all under 30s are NEET, in Austria and the Netherlands it is only 5-8 per cent. The UK – unusually for a country with a flexible labour market and decent education – has one million NEETs, roughly the same as Italy and Spain (because of its bigger, younger population, the British NEET rate, at around 16 per cent, is still below those of Italy and Spain, at just over 20 per cent).

NEETs are a big burden for European countries. According to Eurofound (an EU research agency that looks at work and welfare), they cost the EU countries €153 billion in social benefits and lost output in 2011. That is more than the entire EU budget. More importantly, a prolonged inactive period can scar youngsters for life: many a NEET’s earnings will never catch up with their peers; many face long-term unemployment and social problems. Some economists already talk of a “lost generation”.

What should, what can, European countries do to help their young people find work?

Growth is obviously important: those countries that have suffered the sharpest downturns in the crisis  – Greece, Ireland, Portugal and Spain – have also seen the most pronounced rise in youth unemployment rates.  Germany, Austria and the Netherlands have been doing better economically and have also so far escaped the youth job crisis. Demographics also matter: because of persistently low birth rates, fewer young Germans are entering the labour market. France and the UK, with better demographics, have more young people to look after.

However, the persistence of youth unemployment in many EU countries implies that growth alone will not fix the problem. And a country such as Italy has a shrinking population and yet young people cannot find jobs. Deeper reforms are needed.

A good education is in many cases the best unemployment insurance. In France, for example, over 80 per cent of those with a university degree have a job but only 55 per cent of those with basic education do. A university degree is not a job guarantee: in Spain, the share of those getting a degree is roughly the same as in in the Netherlands. Yet Spanish students struggle much harder to find a job (and did so even before the current crisis) than Dutch ones. Governments must ensure that universities teach the kind of skills that employers are looking for.

Often employers prefer a well-trained apprentice to a graduate with an unsuitable degree. Countries with well-functioning dual education systems – that combine on-the-job training with schooling – tend to have lower NEET rates. Germany, Austria and the Netherlands are good examples.

These dual systems make it easier for youngsters to move from education into the world of work, reducing drop-out rates. They are also a good feedback mechanism to show school leavers what companies need and want.

The UK is only one of several EU countries that have been trying to emulate the benefits of the German apprenticeship system. Success has been mixed. Only about 8 per cent of British companies train apprentices, compared with over 30 per cent in Germany.

As Hilary Steedman from the London School of Economics points out, Britain tends to play politics with its apprenticeship system. Labour sought to get youngsters off the street so it focused on training that is short and easy. The average duration of a British apprenticeship is only one year (three in Germany), theoretical training can be as little as one hour a week (at least one day a week in Germany) and the proliferation of vocational qualifications leaves potential employers confused and unenthusiastic. The Conservative party is focused more on higher skill levels and so prefers training that is longer and more sophisticated. The current coalition government has promised to help pay for an extra 250,000 apprenticeships. The result is a huge increase of older apprentices as cash-strapped companies re-classify their retraining schemes as ‘apprenticeships’ in order to qualify for government support.

Although the UK and other countries are right to study the German success, there are many features that are not easily replicated and others that are not worth copying. For example, while the British labour market is rather flexible, in Germany over 300 professions are accessible only for people with formal qualifications. In other words: no apprenticeship, no job. Such entry regulations have some benefits as they push up general skill levels, which in turn makes it easier for young workers to switch jobs later. But they also make labour markets more rigid and prevent innovation. 

Improving education and building functioning dual education systems will at least take a long time. In the meantime, EU countries might use so-called active labour market policies (ALMPs) to get people working again. Currently, less than a fifth of those taking part in such retraining and make-work programmes in the euro countries are under 25. But many EU countries are now designing ALMPs specifically for young people.

Sweden, Finland and Norway pioneered the idea of ‘youth guarantees’ in the 1980s and 1990s. The employment services there work out a personalised plan for every youngster who is at a loose end and then quickly pack him or her off into either education, work experience or a job. Low NEET rates in all Nordic countries suggest that these programmes are working. However, despite low unemployment rates, the Nordics spend lots of money on such schemes (1-2 per cent of their GDP for all ALMPs). And even their efficient employment services were overwhelmed when youth unemployment rose as a result of the crisis. South European countries with millions of unemployed youngsters would struggle to replicate the Nordic youth guarantees, especially at a time when they are forced to cut budgets and sack civil servants.  The EU has made some money available to help EU countries set up ALMPs for youngsters, encourage them to start businesses and to improve apprenticeship systems. But the sums (€8.3 million for 27 countries in 2012-13) are tiny compared with the scale of the challenge.

Another – potentially cheaper – way of helping young people to find jobs is to make labour markets more flexible. Eurofound presents evidence that strict regulations, such as job protection laws, hurt young job-seekers disproportionately. A company will not hire young inexperienced workers if it cannot get rid of them in case they turn out to be useless or the business outlook deteriorates. Measures that are on the surface designed to benefit young workers – such as stronger rights for temporary and part-time workers or minimum wages – can push up NEET rates. However, although politicians regularly deplore Europe’s high youth unemployment rates, the steps to improve the situation are often timid.

Employment specialists at a recent World Economic Forum workshop in Rome agreed that successful labour market reforms are not usually imposed by governments. They are haggled out between trade unions and employers. However, Europe’s trade unions tend to represent older workers with full-time, permanent positions. They fight less fiercely for the interest of young workers, those in part-time or temp jobs or those looking for work. Only 10 per cent of young workers are members of trade unions in the UK. In the Netherlands, roughly two-thirds of trade union members are over 45. The average age of officials in Germany’s powerful engineering union is almost 50.

The result is that the needs of young people are not properly represented in debates about how to change labour markets. Hence another – perhaps somewhat surprising – solution to the youth unemployment problem is for more young men and women to join trade unions and make their voices heard.

Europe’s young people are suffering disproportionately in the current crisis. European countries, and the EU, must do more to prevent them becoming a lost generation. Although many structural reforms will only really yield results when economic growth returns, the time to put them in place is now.

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

How to confront the carbon crunch

Emissions of damaging carbon dioxide within the EU have fallen over the last two decades, but not primarily due to climate action policies. The de-industrialisation of much of the continent and increase in goods imported from countries such as China has been a much greater driver of the reduction. Worldwide, carbon emissions continue to increase.  The 1997 Kyoto Protocol has made little impact, partly because – despite being legally-binding – it is not really enforceable, and partly because it seeks to address carbon emissions arising from production. It should instead address emissions arising from consumption.

At a recent CER meeting, Dieter Helm, a professor of energy policy at Oxford University and a leading voice in European energy policy, outlined a possible new approach to EU climate action. (These were based on his new book, ‘The carbon crunch: how we’re getting climate change wrong – and how to fix it’.) Helm favours market mechanisms, such as price signals, over direct state intervention, such as governments deciding whether we should use gas or offshore wind power to heat our houses. The EU has established a market-based mechanism to reduce carbon emissions, the Emissions Trading System (ETS), but it does not work.

The ETS has not lead to a significant reduction in emissions, nor to much investment in low-carbon energy technologies. The main reason is that the EU has handed out too many permits to pollute to EU-based companies. As a result, the carbon price has been too low to encourage companies to become greener.

In 2008, the European Commission implemented a number of useful steps to fix the system: it started auctioning permits rather than handing them out for free and it set a Europe-wide cap for overall emissions, rather than leaving each EU country to set its own. But then the EU economy plunged into recession, economic output fell and the number of permits once again was much higher than needed.  The carbon price has fallen to around €8 per tonne of carbon dioxide, far below the €30 that experts say is needed to have an impact. The Commission has rightly proposed that permits now need to be withdrawn from the market. But EU member-states are reluctant to put pressure on their companies in the middle of the downturn.

Helm argues that instead of trying to fix the system, the EU should opt for a carbon tax. A carbon tax , levied on each source of carbon pollution or on retailers of, for example, transport fuel, would introduce much greater certainty and predictability than the ETS has done. The EU could introduce the tax at a low level but with a pre-announced escalation.

However, faced with a higher carbon price, many European companies would relocate yet more of their production to countries that do not impose a price on pollution. Climate experts refer to this process as carbon leakage. Europe would consume the same amount of goods. But these goods would be produced in countries that are less energy-efficient and often use more of the most polluting fuel, coal. Add the carbon emitted through transporting these goods back to Europe and it becomes clear that carbon leakage increases global emissions. For the world’s climate it does not matter where emissions occur.

Helm therefore argues that the 1997 Kyoto Protocol has a central flaw: it seeks to reduce greenhouse gas production in signatory countries. It should instead address greenhouse gas emissions resulting from consumption. If goods are manufactured in, say, China but then imported into, say, Europe, the emissions caused by the goods’ manufacture and transport should be attributed to Europe, not China.

Helm would address this problem through imposing a tariff on goods that incorporate a high carbon content, a so-called border tax adjustment. To avoid falling foul of World Trade Organisation rules, any country that imposes a carbon price would be exempt from these border taxes. Countries around the world would then have a strong incentive to establish a carbon price, to gain free access to the world’s single biggest internal market.  As Helm points out, governments will prefer to collect revenue from carbon taxes or a version of an ETS rather than seeing the EU collect the revenue through border taxes. So this approach could help to spread carbon pricing.

Helm’s solutions are well-thought out and intellectually coherent. He is right to argue that a bottom-up approach based on carbon pricing and carbon consumption would achieve more than the defunct ETS and the top-down carbon production targets of the Kyoto Protocol. But he fails to take into account sufficiently the political context in which such solutions would have to be implemented.

Helm is not alone in advocating carbon taxes. Many economists do so. Indeed, Jacques Delors, perhaps the most persuasive president the European Commission has ever had, argued strongly for a carbon and energy tax during his tenure from 1985-1994. Then, as now, the governments of the member-states insist that tax is a matter of national sovereignty and each country has a veto over EU proposals. The UK in particular is categorically opposed to the EU getting involved in tax policy, even if its purpose is to help the climate. This is why the EU then opted for the ETS – which as a trading system could be established by qualified majority voting.

A more promising route would therefore be to add a carbon floor price to the ETS to push carbon prices up and imbue them with the stability needed to trigger investment in new technology. The floor price would be a ‘safety net’ rather than a tax so it would not require unanimity.

An effective ETS would still need to address the issue of carbon leakage. The Commission explored the idea of border tax adjustments in 2008, when it last amended the ‘emissions trading directive’. Nicolas Sarkozy, then French president, was a strong supporter. But Germany and other exporting nations feared reprisals from international trading partners and a generally negative impact on global trade. The Commission shelved the idea.

The current Commissioner for Climate Action, Connie Hedegaard, says that border tax adjustments should not be ruled out, but she has little support in the rest of the Commission. There is, however, an example of EU proposed action on border taxation. The EU has recently included emissions from airplanes in the ETS. All airlines will be required to buy permits for emissions generated by flights to and from Europe. Since this increases the price of flying from say, Dallas to Paris or from London to Shanghai, it is a de facto border tax adjustment. Chinese and Indian airlines in particular have threatened reprisals. The Commission has agreed to postpone the operation of the new system until the autumn of 2013 to see if international agreement on a carbon price for aviation can be reached. But Hedegaard made clear that if no agreement is reached, the EU will proceed with the inclusion of aviation in the ETS.

What are the chances of EU governments agreeing an ETS floor price and border tax adjustments? Countries such as Poland, which burns a lot of coal, would oppose a floor price but the threat of being outvoted would make them more likely to compromise. The French government would support this approach, given France’s reliance on low-carbon nuclear energy and its predilection for industrial policy and managing trade flows. The UK government has introduced its own ETS price floor, but it is increasingly hostile to anything proposed by ‘Europe’.

Germany’s position will be key. The country’s decision to phase out nuclear power will inevitably increase its greenhouse gas emissions, at least in the short to medium term where it will rely more on coal. So it might be cautious about imposing a higher price on carbon. Berlin also remains hostile to any interference in international trade.

The Germans could, however, be brought round if the economic arguments stacked up in favour. Michael Grubb of Climate Strategies calculates that if an ETS price floor of €15 per tonne was introduced in 2015 and raised €1 each year, the cumulative revenue by 2020 would be €150-190 billion, depending on how many permits were given out for free. Around a third of this revenue would go to the German government. Germany could do with this extra money to finance its so-called Energiewende – the very costly transition from nuclear, coal and gas to renewables. Other countries, such as the UK, would also use the extra revenue to keep energy bills down despite the mounting costs of renewables.

A Berlin-Paris-London coalition in support of a stronger ETS and border tax adjustments is unlikely in the near future but not inconceivable. All those concerned about the global climate – and about European economies – should support Helm’s proposed path the tackling the carbon crunch.

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

Much ado about little: Britain and the EU budget

As almost all European governments are cutting spending, it is hardly a surprise that the EU’s budget is under fire. The European Commission has rather optimistically proposed a real terms increase of five per cent in total spending over the next budget period, which runs from 2014 to 2020. This amounts to 1.05 per cent of projected EU GDP over that period. Most of the countries that pay more into the budget than they get back reject this proposal. Germany and Ireland want the budget limited to one per cent of EU GDP (which means that as Europe’s economies grow, the budget can grow too, but at a slower rate than the Commission wants). However, British Prime Minister David Cameron wants to go further: he has promised to veto anything but a freeze in real terms. It may be difficult to back down from this position in budget negotiations: the opposition Labour party combined with backbench Conservative rebels to win a parliamentary vote last week that called for a cut to the budget, defeating the government. Cameron would be unlikely to get a larger EU budget through the UK’s parliament if he compromises at the summit, on November 22nd.

Britain is not the only budget hawk: Sweden and the Netherlands have also demanded big cuts to the Commission’s proposal. But neither has demanded a freeze. The UK is likely to be further isolated in Europe, after its veto of the fiscal compact in December last year, if Cameron refuses to compromise. Amid the politicking over the size of the total budget, Westminster has paid little attention to the potential costs to the Exchequer of the proposals on the negotiating table, and how much extra the UK could pay. This note offers some answers, and in doing so allows us to judge whether UK obduracy is likely to achieve very much.

How much does the UK currently pay, and how much does it receive?
As a comparatively rich country with a small agricultural sector, the UK has in recent years been a net contributor to the EU budget. The UK passes tax revenue to Brussels, and receives less expenditure in the form of Common Agricultural Policy (CAP) payments, regional development funds, and other transfers in return. But it has a rebate from Brussels – a reduction in its contributions negotiated by Margaret Thatcher in 1984, which many other EU countries consider to be unfair now that Britain is one of the richer members of the club.

Britain’s net contribution is how much it pays in, less how much it receives back, in EU spending and the rebate. In most budget negotiations, British governments try to reduce wasteful and iniquitous farm spending and the size of the budget, and protect the rebate. Tony Blair’s 2005 agreement to cut the rebate to help pay for the costs of EU enlargement is the exception that proves the rule: even Blair, a pro-European prime minister at the height of his power, did so reluctantly, and fought hard for CAP reform.

Given that any country can veto the EU budget, member-states must build alliances to succeed. The UK is isolated after its veto of the fiscal treaty, and so would do well to be cautious if it wants to reduce spending. Britain wants the budget frozen at its 2011 level. But if the talks collapse, which is a distinct possibility, the 2013 budget will simply be rolled over to 2014, but with inflation added. The budget would end up far larger than 2011.

If the UK really wanted to cut wasteful spending and promote growth, it could accept the German proposal for a budget capped at one per cent of EU GDP, in exchange for cuts to the CAP and a transfer of that money into infrastructure and regional development spending. France has threatened to veto any budget that does so, but they could be isolated if Britain were prepared to make concessions, which President Hollande may wish to avoid, given the difficult negotiations over the euro.

But such a deal may be difficult for Cameron, who has chosen to make budget cuts his priority. The UK’s net contribution grew by three-quarters between 2006 and 2012, from £3.9 billion to £7.4 billion (€4.8 to €9.2 billion). The UK’s transfers to Brussels were low in 2008 and 2009 because it suffered a larger recession than other member-states, and in 2010 and 2011 payments were larger because its economy made a (small) recovery. On the expenditure side of the ledger, European Social Fund and Regional Development Fund spending in the UK is falling over time. These funds provide support for struggling regions with an income less than three-quarters of the EU average. Over the course of the last budget, Brussels has phased in the poorer newer members in Central and Eastern Europe, so that a greater proportion of structural funds go to these countries. These two factors explain most of the rise in the UK’s net contribution.

As regional funding has declined, agricultural payments have become the large majority of EU spending in Britain. This change in the composition of spending explains why Cameron is in a difficult negotiating position. Switching money from the CAP to regional spending would mean that the UK’s net contribution would rise, as fewer regional funds are disbursed in Britain, thanks to enlargement. If Cameron were to try to offer up more of the rebate to convince France to reform the CAP, the UK’s net contribution would rise even further. Thus, Cameron can either try to limit the UK’s contribution to the EU or try to improve what it is spent on. The best policy would be the latter, but the best politics – at least in domestic terms – is the former.

How much could the UK contribute to the next budget?
Britain’s net contribution to the next budget will not be decided before the negotiations at the summit in late November – and quite possibly not even then. But we can make some assumptions about how much more the British taxpayer might end up paying. The UK’s fiscal watchdog, the Office of Budget Responsibility, assumes that the UK net contribution is going to stay at around the 2012 level as a percentage of the total EU budget – five per cent. This seems right, for the following reasons. The UK is unlikely to give up or reduce its rebate. British economic growth is projected to be around the EU average: if it grew faster than other countries, the budget arithmetic would mean it would become a bigger net contributor. Finally, regional development funding is not coming back to the UK: Central and Eastern Europe will remain poorer than Western Europe between now and 2020. Given that the UK contribution should stay at around the same level, as a proportion of the total budget, we can then project forward how much it is likely to contribute, given the three main proposals on the table.

* A budget freeze (UK proposal: the British Parliament’s vote for a cut is only advisory, and this remains the UK government’s position)
* A budget capped at one per cent of EU GDP (the German position)
* A five per cent increase in the budget, as a proportion of EU GDP, to 1.05 per cent (the Commission proposal)

The UK government’s position implies a continued UK net contribution of around £7.4 billion (€9.2 billion). The German government’s proposal would mean the UK paying slightly more – an average of £400 million (€499 million) a year over the budget period. The Commission’s proposal would see the UK contribution grow, in tandem with Europe’s economic growth. So, under the Commission’s proposal, the UK’s net contribution would grow from £7.4 to £8.2 billion (€9.1 to €10.2 billion), an average of £550 million per year (€690 million) higher than under the UK proposal. This would mean a total increase, above the UK’s proposal, of £3.9 billion (€4.8 billion) over the seven years. (See chart).

 

 

Source: author’s calculations, based upon the GDP and budget projections in European Commission, ‘Proposal for a Council regulation laying down the multiannual financial framework for the years 2014-2020’, (2011) p. 20.

These numbers are difficult to appraise without context. Under either Germany’s proposal, or the Commission’s, the UK could end up paying around £400 and £550 million per year more, at most. This is around 0.03 per cent of GDP. It is the same amount that England and Wales spend each year on flood and coastal defences, or the same size as Oxfordshire County Council’s budget.

Furthermore, Britain’s hand is weakened, because of the rebate. It is difficult for Cameron to build consensus for either an overall freeze to the budget, or a cut to the CAP, because of it. Britain's net contribution is smaller than other big EU countries. Germany is the largest net contributor, followed by France and then Italy. The UK is the fourth largest, despite being both richer and larger than Italy. If Cameron brought down the negotiations over such a small sum, the UK would find itself pressed further into the margins of Europe. It would do better to compromise on the overall size of the budget, and negotiate for it to be spent more wisely.

John Springford is a research fellow at the Centre for European Reform.

Russia needs a plan for modernising its economy

Russia’s economy is not performing badly. Thanks to the high oil price, economic growth is likely to stay at 4 per cent or a little less for the next few years – respectable by West European standards. The problem is that Russia’s rulers do not appear to have a plan for modernising the economy, which is alarmingly unbalanced. Oil and gas provide half the government’s revenue and almost 70 per cent of export earnings. Output of oil and gas is flat and few new fields are coming on stream. Even if the oil price stays high, Russia is heading for current account and budget deficits in the years ahead.

But Vladimir Putin, now in his third term as president, seems unconcerned. I recently attended the Valdai Club, a group of Russian and foreign think-tankers, academics and journalists that meets Putin and other Russian leaders once a year. Compared with six or seven years ago, when I first attended these meetings, Putin’s attitude has evolved. He has become increasingly relaxed, to the point of complacency. He displays little sense of urgency about tackling the challenges facing Russia.

One participant, former German defence minister Volker Rühe, asked Putin an easy question: “Historians will say that in your first two terms as president, you brought stability to Russia. What would you like them to say about your third term?” Putin answered that he did not care what historians said, and that he was a pragmatist. He was happy that personal incomes had doubled during his time in charge, that Russia had $500 billion of foreign currency reserves and that the demographic decline had been arrested. He had nothing to say about his vision for Russia’s future or his own role in shaping it.

Asked whether it was important for Russia to reform its institutions, Putin merely talked about some legal reforms that were underway, adding that the central bank was an efficient body and that the tax administration had improved. Probed on the brain drain from Russia, he was insouciant: he said it was normal for people with skills to move from one country to another, in the way that many Britons went to the US. He told us that Russia was enticing lots of foreign academics to spend periods at its universities by offering them scholarships.

Putin was particularly upbeat about economic co-operation with China. It is now Russia’s biggest trading partner, with $83.5 billion of trade a year, compared with Germany at $70 billion, according to Putin. He said that both sides wanted trade to reach $100 billion a year. “This will happen as we are happy to buy more Chinese goods and they will buy more oil – and in the future, gas.” That last point is debatable: the Chinese seem unwilling to pay the price for gas that Russia is demanding. Putin added that there would be more co-operation on nuclear power – the first plant built by Russia in China was running and there would be more to come – as well as aviation and space technology. Other Russian leaders told us that growing economic ties to China – plus co-operation over Syria at the United Nations – would not extend to security (in Beijing there are reports that Russia proposed closer military relations earlier in the year, but had been rebuffed by Chinese leaders).

“We don’t need to go east or west, we are in a good place in the centre of Eurasia,” asserted a senior parliamentarian. Russian leaders are proud of the initial success of the Customs Union with Belarus and Kazakhstan, which has boosted trade (by 40 per cent, according to the parliamentarian). Russian economists say the Customs Union has led to regulatory competition between Russia and Kazakhstan, as they seek to attract investment. This competition may have helped them move a little way up the World Bank’s ease of doing business index – Kazakhstan has climbed to 47th place, and Russia to 120th.

The Russian economy can certainly benefit from more trade within the Customs Union and with China. But neither will bring about the structural changes that it needs. Russia’s liberals are in a gloomy state. On my previous visit to Moscow, last March, some of them – both within the government and outside it – were optimistic about the prospects of change. Following the winter demonstrations, Putin seemed to have understood that Russia needed political reform. He had announced that regional governors would be elected and that it would be easier to register political parties. But now the state is clamping down on opposition leaders. While the Valdai Club met, Leonid Razvozzhayev, a leftist opposition politician, was kidnapped in Kiev, taken back to Moscow and charged with various crimes.

There are still plenty of economic liberals in positions of power, either as ministers or advisers inside the government, or think-tankers on the outside who provide reports for ministers. But they see that Putin is leaning in an authoritarian, statist direction and that improving the rule of law is not his priority. They know that so long as the judiciary remains subject to pressure from the state or special interests, foreigners will think twice before investing in sectors other than oil and gas.

One senior figure in the Russian system summed up the liberals’ despair: "Russia needs a new model of economic growth, and a new system of governance – the current one is not suited to meet new challenges. Putin has been an outstanding leader. But the destiny of Russia depends on the mind of a single person and his ability to change the paradigm of how he sees things."

The ‘tandem’ system of government – when Prime Minister Putin shared power with President Dmitri Medvedev – has been replaced by what the Russians call an extreme vertikal of power. Although the presidential elections were not conducted fairly, Putin’s victory reflected the popular will and has enhanced his legitimacy. This has facilitated the concentration of power in one person’s hands to a greater degree than ever happened in the Soviet system, post-Stalin. President Putin alone decides foreign policy. On economic policy, according to some observers, Medvedev, now prime minister, still has a little influence.

Everyone in government pays lip service to the idea that the economy should rebalance, so that manufacturing and services play a greater role. But nobody seems to have a convincing plan for achieving that objective. One minister admitted: “We don’t understand how to break the dependency on oil and gas, since different players have different interests.” In fact, the hard-liners in the security establishment and some of the clans around Putin probably do not want rebalancing: it would curb the rent they extract from the natural resource industries and would have to be accompanied by a strengthening of the rule of law, which would constrain their freedom of action.

The Valdai Club heard two views on how the economy could rebalance: top down and bottom up. Some senior figures said simply that the state needed to invest more in high-tech industries like space-science, biometrics, pharmaceuticals, nano-technology and nuclear energy. Putin said the government had found an extra $60 billion for a special fund that would invest in hi-tech industries.

The bottom-up view, which is much more plausible, was well expressed by one of Putin’s advisers: "The only way to rebalance the economy is to improve the investment climate, so that we get more foreign investment into non-oil and gas sectors. That means tackling corruption." 

One leading banker was extremely critical of the government: "Russia is a big exporter of oil and gas, entrepreneurial talent and capital." He described the customs administration as "totally corrupt". He complained bitterly about Putin’s election promises to raise the salaries of public sector workers, which had led to knock-on wage inflation throughout the economy. Several ministers expressed worries about the economy’s declining competitiveness – one of them reporting that Russian wages were now 2.5 times comparable ones in Ukraine.

Another senior banker said the government did not have a mechanism for implementing decisions except by shouting at people. Since German Gref had departed as economy minister in 2007, he said, the government had had no comprehensive vision; now each ministry did its own thing.

A year ago Alexei Kudrin, an economic liberal, resigned as finance minister, partly because he disliked plans for a massive boost in defence spending. Many Russian economists agree with Kudrin that the boost will harm the economy. In the ten years to 2020 the defence budget is due to grow by 23 trillion roubles (more than $700 billion) – at the cost of spending on infrastructure, health, education and R&D. The share of government spending taken up by the defence, interior and emergency ministries is due to stay in the range of 18-20 per cent from 2011 to 2015. But the proportion spent on education, science, healthcare, justice and culture is due to fall from 8.3 per cent to 5.8 per cent. 

Putin, predictably, defended the military build-up. “We see the growing application of force in the international arena, and this is revitalising international relations, so we are strengthening our defence and military capabilities.” Also, he pointed out, a lot of Russia’s defence systems were old and needed replacing.
 
Amidst all the gloom over the Russian economy, some of the more liberal ministers took a brighter view. They talked of the seven-year plan for selling off stakes in state companies that would run to 2019. Its purpose, they said, was not only to make companies more competitive but also to raise money for the budget.

These liberals also pointed to the benefits of membership of the World Trade Organisation (WTO), which would subject Russian industries to increased competition – though more from China than from the West. The WTO will force Russia to lower its average tariffs from 9.5 per cent to 6 per cent by 2015. WTO membership will also make the government curb subsidies to some industries and to farming. “We will have to learn how to apply government support in ways that don’t break the rules,” said one senior minister, who predicted disputes over cars and agriculture.

But the liberal ministers know that Russia cannot properly modernise its economy without progress on the rule of law and democratisation. "We have a working judicial system and democratic rules, though they’re not ideal," said one. “Many people are unhappy about that, but the majority don’t care – they are focused on their wages, children and housing, rather than the political system. That is an argument for more democracy.” He is almost certainly right that less than half the population cares about political freedom. This is the root of Putin’s power and bodes ill for the economy.

Charles Grant is director of the Centre for European Reform

Will the euro crisis lead to the break-up of EU member-states?

Last month over a million Catalonians marched for independence in Barcelona. Opinion polls say that support in the province for separation from Spain has doubled since the economic crisis started – and some polls put it at over 50 per cent. The Economist sees a clear link with the economic crisis, noting recently: "Whereas one-third of Catalans are convinced separatists, many others are simply enraged by their tax money propping up poorer regions." Meanwhile in Belgium, Bart de Wever's nationalist New Flemish Alliance did well in Flanders' local elections, and de Wever has become mayor of Antwerp. Like Catalan separatists, the Flemish dislike subsidising their poorer neighbours in Wallonia.  The two events seem to suggest a trend. But while bailouts and the austerity that stems from the euro crisis are making central governments unpopular throughout Europe, Spain's and Belgium's woes may be a poor predictor of developments elsewhere.

The growing support for independence in Catalonia is only partly driven by the crisis. Jordi Vaquer of the Barcelona Centre for International Affairs notes that the Partido Popular's (PP) return to power in Madrid in 2012 bears some responsibility for the surge of pro-independence sentiment in Catalonia. The conservative PP blames Spain's budgetary woes on the provinces' profligacy (they represent 40 per cent of total public spending in Spain). The Madrid government has set out to tighten control over the regions' finances. Many in Catalonia think the PP is using the crisis as an excuse to pursue their longstanding agenda of curbing regional autonomy. They note that Spain's economic woes are mainly the result of excessive private sector borrowing, over which the provinces have had no control.

Pro-independence sentiment in Spain and other parts of Europe has also grown stronger because some separatist parties have grown more adept at selling their message. The New Flemish Alliance (NVA) is a much smoother party than the hard-right Flemish Interest, who NVA replaced as the standard-bearer for independence. In Edinburgh, Alex Salmond of the Scottish National Party (SNP) has proven to be a capable leader, who has governed competently during his five-and-a-half years in power (Scotland has enjoyed considerable autonomy since the 1998 devolution of some powers from London to Edinburgh). In an effort to showcase his party's new moderation, he recently persuaded it to ditch its longstanding policy of withdrawal from NATO. Both de Wever and Salmond say they would keep a common army with their southern neighbours. The success of these moderate, articulate nationalists in some parts of Europe has boosted the appeal of pro-independence movements elsewhere. "Previously, voters in Catalonia saw separatism as something that dictators in the former Soviet Union and Yugoslavia did. Now it has become difficult to brush aside nationalists as crazies," Vaquer observes. 

But while the Flemish and Scottish pro-independence parties have learned not to scare voters, the appeal of nationalism in other parts of the EU has waned. The Slovaks elected a parliament in 2012 that for the first time in the country's 20-year history does not include the Hungary-bashing Slovak National Party (voters have grown wary of infighting in its top ranks, and of its leader's penchant for yachts and jets). A mildly-separatist party of ethnic Hungarians in Slovakia has also lost its place in the parliament in the same election; another mostly Hungarian party that openly favours good relations with the central government in Bratislava has taken its place. Politics in Europe remains deeply local – and while nationalist leaders in Spain or Flanders have being doing well, others have fallen victim to their own hubris or incompetence.

In 2014 the Scots may dampen separatist spirits in Europe. Earlier this month, the SNP agreed with the London government to hold a referendum on Scottish independence in the autumn of that year. However, a recent Ipsos MORI poll shows that only 35 per cent of those who plan to vote will opt for separation from Britain. If the Scottish referendum on independence fails, nationalist movements like those in Catalonia or the Basque country may find their case weakened (though the Scottish nationalists may make progress with their demands for greater autonomy from the central government).

In Scotland, ironically, the euro crisis has proved very damaging to the cause of independence. In the past the SNP said that an independent Scotland would join the euro. In current circumstances that policy would not be a vote winner. So the SNP’s new line is to favour independence but keep the pound. But if there is one thing that the euro crisis has taught people, it is that currency unions do not work without some sort of fiscal union. A separate Scotland that used the pound would have to accept the constraints of a 'fiscal compact' with the remainder of the United Kingdom. So it would not be as free from London’s dictat as many Scots would wish.

There is little doubt that austerity measures have generated anger against political classes everywhere in Europe. In Spain, this protest takes the form of demonstrations against the 'Madrid elites', from which pro-independence movements benefit. In the future, similar conditions may exist in other parts of Europe, such as Italy or France, so events in Catalonia or Flanders bear watching. But it would be too simple to extrapolate from them that other countries will go the way of Spain or Belgium. The grievances that drive pro-independence movements differ from country to country. And so does the quality of local political elites, both on the pro-independence side and among the central governments, which have the job of addressing the grievances that fuel separatism.

Tomas Valasek is former director of foreign policy and defence at the CER.

Alice in euroland: What political union for the single currency?

"When I use a word," Humpty Dumpty said, "it means just what I choose it to mean – neither more nor less." 
"The question is," said Alice, "whether you can make words mean so many different things." 
"The question is," said Humpty Dumpty, "which is to be master – that’s all." 
(Lewis Carroll, Through the Looking Glass, Chapter 6)

The underlying purpose of the ‘European project’ has always been clearer than its ultimate destination. Its purpose – to escape a traumatic past disfigured by dictatorship and war – has never been particularly contentious (what sane European would want a return to that?). But the same cannot be said of the EU’s final destination. For much of its history, the EU has hidden behind the foggy ambiguity of its aspiration to build an “ever closer union among the peoples of Europe”. The trouble is that this worthy aspiration has always meant very different things to different people. Those of a minimalist disposition, often to be found among the British, have usually understood it to mean little more than the removal of cross-border barriers to the free movement of goods, services, capital and people. Those of a more ambitious bent, more often to be found in continental Europe, have seen the ultimate goal of the project to be some sort of ‘political union’ (however understood).

The eurozone crisis has once again exposed the gulf between British and continental visions of the EU. But it has done a lot more. It has also forced European leaders to speak a little less airily about ‘political union’ than they have become accustomed to in the past. All agree that the single currency must be embedded in a real ‘political union’ if it is to survive. But they are being forced to define their terms. Roughly speaking, two schools of thought have emerged. One (mostly northern European) school thinks that the crisis resulted from errant behaviour. For it, political union means tighter rules, more strictly enforced. The second school believes that the architecture of the eurozone is flawed. For it, political union means transferring a number of critical responsibilities from national to European level. If the first school frets about moral hazard, the second worries about a dearth of solidarity. The first school emphasises collective discipline, the second mutual burden-sharing.

Which of the two schools has the better story to tell? Although Greece is a convincing poster child for the first school, the balance of evidence weighs heavily in favour of the second. To start with, compliance with rules before 2008 turned out to be a poor predictor of countries’ subsequent plight. Like Mark Twain’s stories, the eurozone had its good little boys to whom bad things happened and its naughty boys who prospered. (Ireland never broke the fiscal rules before 2008 but is now in a slump, while Germany did and is not.) Second, despite having lower levels of debt in aggregate, it is the eurozone, not the US, which has been in the eye of the storm – strong evidence that it is the eurozone’s architecture, rather than the behaviour of its constituents, which is to blame. Third, the more the principle of collective responsibility has been asserted, the worse the eurozone’s plight has become: efforts to instill discipline have signally failed to restore confidence in the eurozone.

The symptoms of this failure are numerous. Financial markets within the union have fragmented as private-sector capital has drained out of countries in the ‘periphery’. Long-term borrowing costs inside the union have become unsustainably polarised, pushing systemically important countries such as Spain and Italy perilously close to insolvency. Target 2 balances within the European System of Central Banks have ballooned as public-sector capital flows have replaced private ones. Countries experiencing private-sector capital flight have been forced to pursue self-defeating policies of fiscal austerity. Sound banks domiciled in countries with stressed sovereigns have become vulnerable to depositor flight. And so on. The countries under strain partly have themselves to blame. But they are also victims of the eurozone’s structure: Spain’s borrowing costs are vastly higher than those of euro ‘outs’ such as the UK, even though Spain’s public finances are in no worse shape.

European policy-makers have been slow to accept that the eurozone’s institutional configuration makes it structurally unstable. But in June 2012, the so-called ‘Gang of Four’ – a group consisting of the presidents of the European Council (Herman Van Rompuy), the European Commission (Jose-Manuel Barroso), the European Central Bank (Mario Draghi) and the Eurogroup (Jean-Claude Juncker) – submitted an important plan to set the eurozone on a more stable long-term footing. It marked an important departure, because its focus shifted to correcting the eurozone’s architectural flaws rather than the behaviour of its members. The policy areas covered – banking supervision, resolution regimes, deposit protection – may have been dry and technical. But the plan was deeply political. It proposed that the stabilisation of the eurozone required key functions to be moved from national level to European level. It was, in other words, a plan to federalise the eurozone.

Why is the federalisation of certain functions necessary to restore confidence in the eurozone? The answer is not that the tasks concerned will necessarily be carried out more competently at European level (the reverse may even be the case). It is that the existence of federal powers and instruments is both a symbol and a guarantee of member-states’ commitment to the union. The reason the eurozone faces an existential crisis while the US does not is not the result of a financial market conspiracy orchestrated by Anglo-Saxons (as some Europeans darkly claim). It is that the eurozone’s decentralised configuration raises doubts about individual states’ commitment to the union. Unlike in the eurozone, bank failures in the US did not push any of the constituent states (such as Delaware) into insolvency, because the associated costs were mutualised. No one thinks that the parlous state of California’s public finances will result in its exit from the US (unlike, say, Greece from the eurozone).
  
A currency union embedded in a fiscally decentralised confederation, it turns out, has been a highly unstable arrangement (particularly in the aftermath of a financial crisis). The adoption of new rules that constrain national sovereignty have not really helped to restore confidence or stability. Indeed, as new rules have proliferated, the eurozone has come to look less like a single currency and more like a rigid fixed exchange rate system on life support. For much of the past two years, redenomination risk has stalked the eurozone. So the Gang of Four is right. The eurozone needs a degree of federalisation to persuade investors and depositors that its members are committed to the currency union’s integrity and survival. Far from being some obscure technocratic fix, a banking union is better understood as an essential pillar of the sort of political union that the eurozone needs if it is to endure and prosper. The question, then, is whether the member-states now accept this.

The answer is that they are still split. The recent report by EU foreign ministers on the future of Europe (the ‘Westerwelle report’) hinted at a number of unresolved arguments between confederal and federal visions of Europe. A striking feature of the report was the number of reservations placed by certain member-states on the proposals of the Gang of Four. On the subject of a banking union, for example, the report said that “some members of the group underlined the importance of a common deposit protection scheme and of a restructuring and resolution scheme”. By implication, other member-states still think that such steps are unnecessary. Indeed, the impression created by the Westerwelle report is that there is more agreement among member-states about the need to develop the foreign policy than the economic dimension of political union. If this is what EU leaders end up doing, they risk creating a Potemkin village rather than a political union that stabilises the eurozone.

Alice’s question to Humpty Dumpty was spot on. Words can be made to mean very different things. Since the onset of the eurozone crisis, two meanings of political union have done battle. The first has emphasised collective discipline, or the need for rules that bind member-states. This is the language of confederalism. The other has emphasised mutualisation, or the need for solidarity and common institutions. This is the language of federalism. For much of the past two years, the language of confederalism has dominated: reforms have focused on improving behaviour rather than on fixing the eurozone’s flawed structure. But a more federal language is starting to emerge. There is more acceptance now than there was two years ago that rules may be necessary to curb moral hazard, but that they are insufficient to eliminate redenomination risk (and so restore confidence in the eurozone’s stability). This view, however, is still far from being universally shared by the member-states

Philip Whyte is a senior research fellow at the Centre for European Reform

Hollande, the Germans and political union

Before becoming French president, Franҫois Hollande did not appear to take much interest in the EU. However, in his youth he was a protégé of Jacques Delors, the French left’s great European, and his instincts seem to be broadly pro-EU. Hollande’s arrival in the Elysée has not led to dramatic changes in France’s EU policy, but a new approach is emerging. Compared with Nicolas Sarkozy, Hollande is less hostile to EU institutions, more willing to work closely with the southern European member-states and, most crucial of all, keener to demonstrate that France does not slavishly follow German wishes.

Hollande knows very well that a strong Franco-German relationship is indispensable to sorting out the problems of the eurozone in particular and the EU in general. But, as officials in the Elysée, the finance ministry and the foreign ministry made clear during recent conversations, Hollande wants a more balanced Franco-German relationship.

These officials emphasise that the ‘Deauville’ model of Paris-Berlin relations has been scrapped. At the Franco-German summit in Deauville in October 2010, Chancellor Angela Merkel made Nicolas Sarkozy, the then French president, accept the principle that private-sector holders of sovereign bonds of countries needing a bail-out should suffer losses. At an EU summit a few days later, the ‘Merkozy’ duo imposed that principle on their fellow leaders, who feared that its adoption would destabilise sovereign bond markets (which is exactly what happened).  At many other summits, too, Merkel and Sarkozy set the agenda or delayed decisions while they consulted each other. This upset other member-states and the EU institutions.

Hollande understands what drove Sarkozy towards followership vis-à-vis Merkel: for several years the German economy had out-performed France’s – notably on unit labour costs, employment, export performance and growth – so that the relationship had become unbalanced.

Hollande has therefore sought to strengthen France’s position relative to Germany in a number of ways. One is to consult other countries – especially Italy and Spain – and the European Commission on key issues. Sarkozy avoided getting too close to ‘problem’ member-states, lest the financial markets associate France with southern Europe. But Hollande does not have that hang-up. At his first summit, when he lined up with Italy’s Mario Monti and Spain’s Mariano Rajoy, the Germans were not amused, but they have now – according to the French – seen that a more inclusive system of leadership is in their interests. Hollande’s officials claim that he has not been and will not be so crude as to try and put together a bloc to counter Germany.

Hollande’s second way of strengthening French influence is to retain the austere fiscal targets that he inherited, notably by limiting the budget deficit to 3 per cent of GDP in 2013. Some government officials believe that this and the budgetary targets adopted by other EU governments – partly because of German pressure – are excessive and counter-productive. They nevertheless say that France needs to stick to 3 per cent in order to win credibility in Berlin. They think that as long as economic growth this year holds up to the predicted 0.8 per cent, the target is feasible. Although the current emphasis is on shrinking the budget deficit through tax rises, in future years spending cuts will predominate, officials say.

The third way of raising France’s standing is to improve the country’s competitiveness. Outside France, the president and his ministers are not perceived as being particularly committed to structural economic reform. During the presidential election campaign, Hollande avoided the subject. But some of the key officials in Paris say that the government is determined to reduce unit labour costs and to reform labour markets. If the current negotiations between the social partners on labour market reform break down, they say, the government will legislate. Many previous French governments have declared their commitment to such reforms, only to back down in the face of street protests. But Hollande’s people are adamant that he will stand firm – and it is arguable that over the past 30 years, Socialist governments have reformed more boldly than Gaullist governments.

Having got off to a rocky start with Merkel – who refused to meet him before the French presidential election – Hollande now has a good working relationship with her, his advisers say. Although personalities matter much less than interests in Franco-German relations, this pair may end up with a more affable relationship than Merkel and Sarkozy had. The dour Merkel, who likes to move slowly and cautiously, and the mercurial Sarkozy, who is impatient and partial to bold initiatives, were not natural soul-mates. Hollande, however, tends to be soft-spoken and a consensus builder – as is Merkel.

French officials claim that Hollande helped to persuade Germany’s leaders to shift their thinking on the euro crisis. For example, Merkel and Wolfgang Schäuble, her finance minister, have rallied behind Mario Draghi, the president of the European Central Bank (ECB), and his scheme to intervene in bond markets to lower the borrowing costs of peripheral countries (but the French worry that Jens Weidmann, the Bundesbank president who opposes the scheme, is winning the public relations battle inside Germany). The German government has also made clear that – like France – it wants Greece to stay in the euro, for fear of the consequences of its departure.

But many tensions remain between Paris and Berlin. The French support the Commission’s proposals for an EU-wide system of bank supervision that would cover all Europe’s banks; the Germans want only the largest, cross-border banks to be covered – apparently oblivious to the fact that many of the problems in European banking emerged in small or medium-sized banks. Germany seems to want to slow down an agreement on EU banking supervision, although the European Stability Mechanism (the permanent bail-out fund that will soon be operational) cannot help banks in difficulty until the new supervisory regime is in place. Furthermore, the German government is counselling Spain not to activate the Draghi mechanism to intervene in bond markets, perhaps because it fears a vote in the Bundestag; the French believe that the mechanism must be used soon, lest the financial markets cease to believe in its potency.

On longer-term issues of eurozone governance, too, there is a huge distance between Paris and Berlin. The French worry about the incoherence of the way the eurozone is managed – nobody is in charge, and governments do not know what different leaders have said to each other. They want the Eurogroup (the regular meetings of eurozone finance ministers) to provide some of the missing leadership by appointing a full-time president and by introducing majority voting. But some Germans worry that a stronger Eurogroup could erode the independence of the ECB.

The French think that, because they have swallowed the painful medicine of the fiscal compact – that they will soon ratify – and thus given away some of their cherished budgetary sovereignty, Germany should be keener to discuss ‘eurobonds’ (the mutualisation of European debt), pan-European bank deposit insurance and a bank resolution regime. But Germany still says no to those ideas, since they would cost it money.

Another broad disagreement is over the woolly concept of ‘political union’, which is moving up the EU’s agenda. On September 12th, José Manuel Barroso, the Commission president, called for a “federation of nation-states” when he spoke to the European Parliament. He promised proposals for a new EU treaty before the 2014 European elections.

In Berlin, there is much talk of ‘more Europe’, treaty change and political union. Indeed, a reflection group led by Guido Westerwelle, the German foreign minister – with the participation of eight other foreign ministries – published a report on September 17th on Europe’s future. This proposed classic federalist solutions to the EU’s problems: majority voting on foreign policy, a stronger role for the High Representative for foreign policy, a European army, an elected Commission president, a stronger European Parliament and a new system for ratifying treaties (to prevent small countries holding back everybody else). Many of the report’s proposals would require treaty change. However, several ministers taking part in the Westerwelle group have dissociated themselves from certain proposals, and some of the governments not involved have reacted coolly.

In Paris there is no enthusiasm for the concept of political union. Although France was involved in the Westerwelle group – sending a junior minister, rather than the foreign minister – some French officials talk disdainfully of it. “When the EU is in crisis, the Germans have a Pavlovian reaction and call for political union, without really meaning it,” said one. Another opined that Merkel did not support many of the ideas in the Westerwelle report and that the Germans did not know what they wanted from treaty change (in many other capitals, too, there is scepticism about Merkel’s commitment to the report).

The negotiation of a major new EU treaty would have to be preceded by a convention on the future of Europe (“a nightmare”, in the words of one French official) and followed by ratification in every member-state, with some holding referendums. The French are in no hurry to re-open institutional questions. In the words of one key official: “The EU spent the last decade dealing with treaty changes and institutions, when it should have been worrying about the ‘Lisbon agenda’ [on competitiveness] and the flaws in eurozone governance”. The EU’s priority, the French believe, should be fixing the euro: the 17 that use it should agree on whatever arrangements are necessary, and then allow others that wish to join the euro to participate later.

Some French officials think they can postpone a major new EU treaty for two or three years. But others, notably in the finance ministry, are less hostile to treaty change; they know that neither a stronger Eurogroup nor EU-wide deposit insurance can be established under the current treaties.

Despite their wariness of political union, French officials are thinking about the future of EU institutions. They recognise that the increasing centralisation of decision-making on eurozone issues creates a greater need for democracy and accountability at eurozone level. Some officials talk of a new body of national parliamentarians and MEPs that could approve key appointments and hold to account eurozone decision-makers such as the Eurogroup president, or the ECB body that will be responsible for bank supervision. That idea is similar to a recommendation in the Westerwelle report, as is the view of many French officials that MEPs from countries outside the euro should not be allowed to vote on euro issues.

In general, the people around Hollande and finance minister Pierre Moscovici are less inter-governmentalist than were Sarkozy’s advisers. Some of them view the European Parliament quite sympathetically, though they do not think that in its current form it can play much of a role in eurozone governance. They are less keen than Sarkozy was to give national parliamentarians a role in EU decision-making. They criticise the Commission less viciously than Sarkozy’s people, though they complain about the quality of its leadership and its tendency to interfere on little things that should be left to member-states. They accept, albeit reluctantly, that the Commission must play a role in supervising the economic and budgetary policies of eurozone member-states. Hollande’s relatively communautaire approach puts him closer to traditional German thinking than to Gaullist thinking.

So far, Hollande’s new approach to Germany – working closely with it, but not following slavishly – seems to have been moderately successful. But in the long run, if he wants French influence in the EU to approach that of Germany, he will have to deliver on his promise to boost the competitiveness of the French economy.

Charles Grant is director of the Centre for European Reform

Time for a European Civil Liberties Union?

Today's EU faces retreat on several fronts. One is a possible break-up of the euro with unknowable consequences for the single market and the Union itself. Another is the apparent decay of the rule of law, democracy or media freedoms in certain member-states. Bulgaria, the Czech Republic, Hungary, Lithuania, Romania and Slovakia all show some symptoms of the latter, according to Freedom House, an NGO watchdog for democracy and civil liberties worldwide.

The EU's institutions have tried to react to such developments. The European Commission is taking Hungary to court over the plan by the prime minister, Viktor Orbán, to weaken the independence of the judiciary there. During the summer, José Manuel Barroso, president of the Commission, intervened to stop an arbitrary attempt by Romania's prime minster to remove his president, Traian Basescu, from power. And neither Romania nor neighbouring Bulgaria are likely to join the Schengen passport-free travel zone until their political and judicial cultures approach something resembling the EU norm.

The EU can shepherd its wayward democracies only so long as their governments risk losing power and status by being labelled second class members. In the past, this desire to stay at, or travel towards, 'the heart of Europe' gave EU membership a transformative power, especially over those countries which joined from 2004 onwards. Most have better records at implementing EU legislation than some long-standing members.

Now the eurozone crisis threatens to chip away at this benign influence. The Union may segregate into a top tier of tightly-integrated euro area countries and an outer rim of ten or so non-members. (Only five of those countries which joined after 2004 currently use the euro.) Despite a treaty obligation on new members to join, eurozone creditor countries are not keen to admit countries with poor governance records for fear of having another Greece in the club. Governments which feel condemned to be permanent outsiders, or which do not wish to adopt the euro while the crisis endures, are likely to feel less bound by the constraints of EU membership.

Hence other influences must be brought to bear to help copper-fasten the peaceful transition of central and eastern Europe to capitalist democracy and the rule of law. The region lacks the self-sustaining popular narratives that characterise the confident democratic traditions of Western Europe. Britain has its 'history of British liberty'; France, its self-image as 'the mother of human rights'; and Germany is rightly proud of the 'never again' protections enshrined in its Basic Law. By contrast, the countries of central and eastern Europe spent most of modern history under various forms of totalitarianism. (An honourable exception is democratic Czechoslovakia between 1918-1938.) This makes them vulnerable to a return of the political strongmen.

NGOs and other observers hope that Europe's courts can help prevent any such scenario. For example, the European Court of Justice (ECJ) in Luxembourg is gradually transforming itself from a tribunal that deals mainly with regulatory and EU staffing matters to more fundamental issues of rights and civil liberties. Its judges are getting to grips with the Charter of Fundamental Rights – made legally binding with the passage of the Lisbon treaty – and deliberating more on civil liberties as their writ expands to migration and security questions.

There are hazards in relying too much on judicial solutions, however. First, legal deliberations take time, and delays due to huge backlogs of cases can put effective justice out of reach for those seeking protection from corrupt or malicious regimes. In 2011, over 150,000 cases awaited a decision from the European Court of Human Rights in Strasbourg, a non-EU institution connected to the Council of Europe. The ECJ fears that its own caseload is also set to become unwieldy due to its expanded jurisdiction under Lisbon. Its president has called for an increase in the number of its serving judges.

Second, ordinary people struggle to access European courts. The European Court of Human Rights is only supposed to be a 'last resort': plaintiffs must have already tried and failed to get justice in national courts. (This rule is likely to be applied more strictly following reforms announced earlier this year.) And - except in very rare cases - citizens or civil society organisations cannot directly petition the ECJ at all. Access to the Luxembourg court is normally restricted to EU governments, institutions, or businesses impacted by the Union's regulatory decisions. Even if the ECJ investigates a breach of the Charter by a particular member-state, it cannot make the government in question desist from such behaviour while the facts of the case are established. This contrasts with the powers of the Strasbourg Court. (See this interesting paper from the Centre for European Policy Studies.)

More broadly, 'government by judges' is a precarious way to protect democracy or resolve political crises such as the recent shenanigans in Romania. No judiciary can protect and uphold rights indefinitely in the absence of a healthy political culture where civil liberties and independent checks on executive power are uncontested. One idea to aid the development of such a culture throughout the EU would be the establishment by liberal activists of a European Civil Liberties Union (ECLU). This could be modelled to some extent on the American Civil Liberties Union (ACLU), founded in the 1920s primarily to protect the right to free speech in the US. One of main goals of an ECLU should be to capture the spirit of the region's glorious emergence from communism after 1989 through a mix of grassroots activism, litigation, educational initiatives and public awareness-raising.

A central ECLU office might receive EU funding but its national chapters would mostly depend on volunteer efforts, philanthropy and membership drives organised by university associations and others. (The ACLU has some 500,000 members and a budget of over $100 million.) In some cases, there will be no need to establish new national organisations from scratch: existing bodies performing democratic watchdog functions could receive the organisation's support if they feel the need.

ECLU chapters could co-ordinate their activities across the region and share resources such as legal and campaigning expertise. They should act as a counterweight to a 'domino effect' in the region where political strongmen in one country are encouraged by the success of fellow travellers elsewhere. An annual plenary meeting of all European chapters could be held each October 2nd, the anniversary of the drafting of the Charter.

In time, an ECLU could expand anywhere there was a need to open a local chapter or support a pre-existing organisation. Western Europe has plenty of foibles of its own: the treatment of migrants in Italy, the rise of hate crime in Greece and the weakened state of civil liberties in some countries due to disproportionate counter-terrorism measures. But its first priority should be central and eastern Europe – a region where the rule of law cannot yet be taken for granted – as the EU itself goes through fundamental change.

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

How seriously can investors take Draghi’s assurances?

ECB president, Mario Draghi, has repeatedly claimed that the central bank will do everything necessary to save the euro. Nothing has been formally agreed yet, but the ECB is expected to announce a new government bond-buying programme following next week’s meeting of its Governing Council. To have a significant impact on Italian and Spanish borrowing costs, the latest effort must be big enough to dispel the convertibility risk that lies behind the extreme polarisation of government bond yields across the eurozone: investors are loath to hold Spanish and Italian debt because they fear that the two countries’ membership of the currency union might be unsustainable. Unfortunately, the ECB is highly unlikely to do enough to convince investors that membership is unequivocally forever, not least because the Bundesbank opposes any open-ended commitment to cap borrowing costs.

Spain, Italy and the periphery of the eurozone face unprecedentedly high real borrowing costs, which are preventing a recovery in investment and hence economic growth. Without a return to growth, they will fail to dispel investor fears over the sustainability of their public finances and the solvency of their banking sectors. The Italian and Spanish governments argue that their high borrowing costs largely reflect convertibility risks and that the ECB should do as much as necessary to address these fears. The eurozone’s members that currently benefit from exceptionally low borrowing costs – Germany, Austria, Finland, the Netherlands and to a lesser extent France – maintain that very high Italian and Spanish borrowing costs largely reflect these countries’ failure to reform their economies and strengthen their public finances. There is merit in both these positions, but much more to the Spanish and Italian argument than the opposing one.

Opponents of open-ended ECB action argue that Italian and Spanish borrowing costs are not actually that high. Interest rates have just returned to levels seen in the run-up to the introduction of the euro, when investors distinguished properly between the countries that now share the euro. High borrowing costs are needed to focus minds and instil discipline. Were the ECB to take aggressive action to bring down borrowing costs, it would create so-called moral hazard; countries would be free to delay reforms in the knowledge that they will not be punished for it by having to pay high borrowing costs. According to this argument, it is a positive development that investors are now differentiating so strongly between the risks of lending to various governments. After all, the failure to do so in the run-up to the crisis contributed to the under-pricing of risk across the eurozone and reduced pressure on governments to reform their economies.

In nominal terms Italian and Spanish borrowing are indeed comparable to the levels of the late 1990s. But it is real cost of capital (that is, adjusted for inflation), that is crucial, and not the nominal cost. Both countries face much higher real borrowing costs than they did in the run-up to their adoption of the euro. Moreover, it is erroneous to compare the present with the late 1990s. Italy and Spain are at very different points of the economic cycle now than they were then. In the late 1990s both economies were growing, in the Spanish case rapidly, whereas now they face slump and mounting risk of deflation. Countries facing depressions and rapidly weakening inflation typically face very low borrowing costs: investors invest in government bonds for a want of profitable alternatives. This is what we see in the UK and US; borrowing costs remain at all-times low despite the extreme weakness of both countries’ public finances and poor growth prospects. Investors certainly need to differentiate between eurozone governments, in order to ensure that risk is correctly priced. The Italian and Spanish authorities acknowledge this. But the current spread between the yield on German government debt and that of the Italian and Spanish governments wildly exceeds what is required to make sure investors differentiate appropriately.

The polarisation of borrowing costs has politically explosive distributional effects: Germany is borrowing and refinancing its existing debt at artificially low interest rates. According to the German Institute for the World Economy, investor flight from the government debt markets of the eurozone’s struggling members to Germany has already saved the German government almost €70bn. Other countries face ruinously high borrowing costs, which are simultaneously increasing the scale of their reform challenges and narrowing their political scope to make the necessary reforms. The longer Italian and Spanish borrowing costs remain at such elevated levels, the greater the economic damage to those economies will be and the harder it will become for the two countries’ governments to shore up the necessary political support for further reforms.

Why have government borrowing costs across the eurozone diverged so much? The principal reason for the size of the spread between the periphery and Germany is convertibility risk. Investors believe that there is a chance that Italy and Spain will ultimately be forced out of the currency union and are thus demanding a hefty premium to insure against this eventuality. This feeds the convertibility risk by weakening countries’ fiscal positions and raising private sector borrowing costs (government bond yields set the cost of capital for the private sector). With private and public consumption in both Italy and Spain set to remain depressed for years to come, economic recovery requires stronger investment and exports. But borrowing costs are crippling and credit scarce. In a vicious cycle, the steep fall in the value of Italian and Spanish banks’ holding of government debt, combined with mounting bad debts as a result of recessions made worse by punitive borrowing costs, are forcing the banks to further rein in business lending. 

The ECB’s latest programme of bond purchases will be big enough to ensure that Mario Draghi does not lose face. But it will not be big enough to dispel convertibility risk and hence demonstrate its credibility as a lender of last resort. And it is this credibility problem, rather than the relative ‘credibility’ or otherwise of member-states policies, that is the principal reason for the unsustainably high borrowing costs faced by Italy and Spain.

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

Will a new German constitution save the euro?

If the Social Democrats win next year’s general election in Germany, they will ask voters to adopt a new constitution in a referendum. The new document, so they plan, would remove the legal fetters that currently prevent Chancellor Angela Merkel agreeing to eurobonds or joint deposit guarantees. Not only the Social Democratic Party (SPD), also politicians from Merkel’s ruling coalition are now speaking out in favour of a referendum. Some analysts are rejoicing that Berlin is finally preparing the ground for the fiscal union that will save the euro. But this is Germany, where policymaking is complex and slow. The debate about a new constitution might sap political energies without contributing much to the stability of the single currency.

German politicians mean different things when they talk about a euro-related referendum. Sigmar Gabriel and his fellow leaders of the SPD say they want voters’ consent to a eurozone fiscal union that involves not only debt mutualisation but also joint budget-planning, harmonised tax rates and tough financial regulation. Some pro-European MPs in Merkel’s own Christian Democratic Union (CDU) agree on the need for a new constitution. But many others insist that the current document leaves enough leeway for euro rescue measures. Some CDU politicians use talk about a referendum mainly as a warning shot to the constitutional court: if you judges continue constraining Merkel’s euro policies, a new constitution will restore power to elected politicians. Finance Minister Wolfgang Schäuble predicts that a constitutional referendum will happen “quicker than I would have expected a couple of months ago”. But he does not say what it would entail.

Horst Seehofer, leader of the traditionally euro-wary Christian Social Union (CSU), the CDU’s smaller Bavarian sister party, wants a referendum each time the EU assumes new powers, bails out a struggling member or admits new countries. And he probably hopes voters will say no to these. Foreign Minister Guido Westerwelle from the Free Democratic Party (FDP, another coalition member), contemplates not a German but a Europe-wide referendum on euro rescue measures. All parties are spooked by the recent successes of the Pirate party which campaigns for more country-wide referendums.

Even if Germany’s politicians could agree on a referendum strategy, this would not be a quick fix to save the euro.

Germans are having this debate right now because the constitutional court has indicated that EU integration could not go much further on the basis of the current constitution. Stricter budgetary oversight from Brussels, as envisaged by the fiscal compact, could be problematic. Eurobonds or any other kind of unlimited liability involved in a fiscal or banking union would be incompatible with the constitution. These would undermine Germany’s statehood and democracy by constraining parliament. If politicians cannot promise different fiscal policies, voters are deprived of a real choice and democracy suffers.

These constraints cannot be removed easily because the German constitution contains an ‘eternity clause’ (Article 79) that sets in stone certain principles, notably democracy, federalism and the market economy. No parliamentary majority and no referendum can alter these principles. Hence, the only way for Germany to accede to a fiscal union is to convene a constitutional assembly, work out a new constitution and put it to a referendum.

Some lawyers say this could be done quickly: only the eternity clause and the one detailing how Germany transfers powers to international organisations (Article 23) need to be tweaked. But more likely the constitutional assembly would be inundated with calls for more extensive social rights, a reform of federalism and a new voting system, to name but a few. “This would be an extremely long process”, predicts a constitutional expert.

Nor is it assured that Germans would vote yes in the ensuing referendum. Eurosceptics will argue that the new constitution will lead Germany into the dreaded transfer union, characterised by permanent money flows from Germany to the eurozone’s South. And even if a new constitution was adopted, who says there would be a political majority for eurobonds? Most Germans are against debt mutualisation even if it comes with tough budgetary oversight, according to a recent Emnid poll. Even among SPD voters, less than 40 per cent are in favour. “It’s not that if we had a new constitutional clause we would just wave through debt mutualisation”, says one CDU advisor.

And there is a last hurdle: Germany might adopt a plan for fiscal union only to be blocked by Austria, Finland or the Netherlands. After all, this is not really a debate about the German constitution but the future shape of Europe.

Nevertheless, the constitutional debate will continue because it suits both the opposition and the government. The SPD seeks to sharpen its political profile ahead of the 2013 election. It has so far loyally supported Merkel’s euro policies in parliament. Now many voters complain that they no longer know what the SDP stands for. The SDP is trying to change that, not by blocking Merkel’s policies but by going beyond them.

The CDU also gains from the constitutional debate. The opposition accuses Merkel of lacking a blueprint for the euro, of reacting to market panics, and of recklessly putting taxpayers’ money at risk without delivering more European integration. By talking about a new pro-European constitution, the government looks like it has a plan while it can put off hard decisions until after the 2013 election.

Now all eyes are on the constitutional court again. On September 12th the judges will issue a preliminary verdict on the European Stability Mechanism and the fiscal compact. They are unlikely to strike them down. But they will define conditions for making the ESM and the compact compatible with the constitution.

Some constitutional experts expect that the court will use the occasion to pronounce on what a process of constitutional renewal might look like. Others think that the court will shy away from encouraging such a process and instead widen the government’s room for manoeuvre within the current basic law.

Whatever the court does, the debate about a new, pro-European constitution will hot up this autumn. But do not be fooled: Germany is still a very long way from agreeing to eurobonds.

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