NATO ponders austerity and US 'pivot'

When NATO heads of state meet in Chicago this Sunday and Monday, two key worries will be on their minds. In a departure from the past six decades, the US has come to style itself as a Pacific, rather than Atlantic, power. And the Europeans are busy plundering their defence budgets in order to cope with the economic crisis. Any one of those two events alone would have a dramatic effect on how the alliance works. Taken together, they risk pushing NATO into irrelevance.

The CER recently explored NATO's future in a new report, 'All alone? What US retrenchment means for Europe and NATO'. It concluded that the US 'pivot' away from Europe towards Asia will remain in place irrespective of who wins the presidency in November. Because the US is cutting defence budgets too, the Pentagon will conserve resources. And the United States sees few threats emanating from Europe; it also regards the remaining ones, such as the frozen conflicts in the former Soviet republics, as matters for diplomacy, not arms. NATO has also lost some of its military utility to the US. The Americans have invested far more than the Europeans in their armed forces, and have greatly improved their ability to strike quickly and across long distances. The US military has less need for help from European allies, and finds it increasingly difficult to assign them meaningful roles in joint operations.

In principle, the Europeans ought to be buying new weapons to fill the gap created by the reduced US role in European security.  But the US demand for Europe to do more for its defence has come at the worst possible time: Europe is in the midst of an economic crisis, and the allies, instead of buying more weapons, are busy cutting defence budgets to stave off defaults. The UK will be without aircraft carriers for a decade, Spain seems ready to mothball its only remaining one, while Denmark has abandoned submarines and the Netherlands has ditched its tank forces.

This will have a three-fold impact on NATO. Firstly, the Pentagon is cutting two of its four brigades in Europe. While the US is not reconsidering its obligation to come to its allies' defence, the reduction will extend the timelines on which military enforcements can be rushed there. This will delay the actual moment at which the US comes to the continent's defence, and shifts more of the burden for common defence onto the Europeans.

Secondly, in operations fought not in self-defence but on behalf of causes such as human rights, the US will not necessarily lead. The Libya war established a new operating principle: there, the US handed the command to France and the UK after destroying Gaddafi's air defences. From now on, America will sometimes behave like any other ally, sitting out some of NATO’s wars, and doing just enough to help other operations to succeed.

Thirdly, NATO may well fight fewer wars in the future. The Europeans lack some of the hardware such as spying and targeting 'drones' and precision bombs, which are crucial to making wars swift and relatively safe for allies and civilians. If NATO is to fight wars without American help, conflicts will take longer, cause more unintended civilian casualties, and more lives on the NATO side. The European allies, with exceptions such as the UK and France, are already reluctant to fight today's wars. They will grow even more skittish if human and political costs of future conflicts increase. In practice, this means that some future crises similar to those in Kosovo or Bosnia in the 1990s may go unanswered.

Given the confluence of budget cuts and US rebalancing, NATO ought to give serious consideration to reducing its ambitions. Its militaries aspire to be able to fight two major wars and six minor ones simultaneously, which does not seem very credible. To stem further loss of military power, the European allies also need to try much harder to squeeze efficiencies out of collaboration. As a forthcoming CER policy brief notes, governments can buy more power for less money by getting rid of unneeded equipment, merging their defence colleges, sharing training grounds, or buying and maintaining future generations of weapons together ('Smart but too cautious: How NATO can improve its fight against defence austerity', out in May 2012). At Chicago, the alliance will take the first steps by announcing that NATO countries are to jointly finance a new fleet of spying drones. More such projects are needed: the US pivot and European budget cuts have left the alliance undermanned and underpowered, and collaboration is one of the few good solutions the allies have at their disposal.

Tomas Valasek is director of foreign policy and defence at the Centre for European Reform.

How Hollande should handle Merkel

The election of François Hollande as French president has excited some of those who blame Germany’s emphasis on fiscal austerity for many of the eurozone’s ills. Hollande has promised to refocus EU policies on growth and employment. Countries such as Greece, Portugal, Spain and Italy – their recessions aggravated by the EU’s insistence that they shrink their budget deficits – would welcome a new approach. Even Marios Draghi and Monti, respectively president of the European Central Bank and prime minister of Italy, and both economically conservative, have called for growth initiatives. But can Hollande – as he prepares for his first ever meeting with Chancellor Angela Merkel – really make a difference? He might, but only if he handles Merkel with great diplomatic dexterity.

Many commentators have interpreted Hollande’s victory on May 6^th, alongside the defeat of the established parties in Greece on the same day, as part of a Europe-wide revolt against austerity. However, France has not yet experienced painful austerity. And Hollande has promised to match President Nicolas Sarkozy’s target of bringing the budget deficit down to 3 per cent of GDP next year, and also to balance the budget by 2017, a year later than Sarkozy had promised.

Opinion polls showed that more voters trusted Sarkozy than Hollande on economic policy, but the election was about much more than economics. Many French people felt strong antipathy towards Sarkozy’s character and what they considered to be his un-presidential and undignified style. He also lost because the right is badly divided. There is a natural right-wing majority in France – which is why in the first round of voting the right won more than half the votes. The centre-right Gaullists always find it difficult to deal with the far-right National Front, but this year that difficulty was compounded by Marine Le Pen’s success in rebranding her party as more moderate than it was in her father’s day. This enabled her to win 18 per cent in the first round of voting. Le Pen’s refusal to endorse Sarkozy for the second round meant that only half of her voters switched to him.

However, Hollande did campaign on a policy of ‘renegotiating’ the EU’s recently-agreed and German-driven fiscal compact – which seeks to impose budgetary discipline – to take account of the need for jobs and growth. In most EU capitals, including Berlin, politicians are now calling for an EU ‘growth strategy’. German officials met Hollande’s advisers before the presidential election and told them that Merkel would not reopen the fiscal compact. But they said that Germany could support some of Hollande’s ideas – including enlarging the European Investment Bank’s capital base by €10 billion, targeting unspent EU structural funds on infrastructure and introducing a financial transaction tax (FTT). The Germans are divided on whether to back Hollande’s idea for EU ‘project bonds’ (the European Commission is already working on a scheme to boost infrastructure investment with such bonds). But none of these initiatives would increase economic growth significantly – and not even its advocates claim that an FTT would create jobs.

Hollande’s prescriptions for the European Central Bank – that its mandate should not focus only on inflation, and that it should lend directly to governments – are unacceptable to Berlin. Another difficulty for Hollande is that the Germans – and many others, including the two Marios – think a growth strategy must include structural reforms that would boost productivity and thus competitiveness, even though such reforms seldom deliver growth immediately. Hollande appears to be as allergic to structural reform as most of his compatriots. His election speeches called for growth to be boosted through public spending on infrastructure and through investment in new technologies – and explicitly ruled out deregulation and liberalisation. He seems oblivious to the fact that France’s very high non-wage costs of employment are one cause of relatively high unemployment (10 per cent, against 6.8 per cent in Germany).

Some of Hollande’s election rhetoric implied that he wants a complete reversal of the EU’s austerity-based strategy for dealing with the eurozone crisis. Many of his supporters on the French left expect him to join the Greek leftists who denounce Greece’s bail-out package, and other so-called Keynesian forces across the EU, to dethrone Angela Merkel from her dominance of EU policy-making.

But if Hollande tried to gang up with, say, Italy and Spain, to force Germany into a complete U-turn, he would fail. A crude Keynesian approach would achieve very little: some EU governments have borrowed excessively, need to curb their deficits and cannot spend their way out of recession. Furthermore, France has much less clout in the EU than Germany. The financial crisis and the euro crisis have highlighted the vulnerabilities of the French economy: its waning competitiveness means that its share of world export markets has fallen – by 20 per cent from 2005 to 2010 – while its public debt and borrowing costs have been rising.

This weakness meant that when the euro crisis began, Sarkozy decided to follow the Germans on the broad lines of their eurozone strategy, but to haggle over the details. He probably should have fought the Germans harder over some of their proposals for the eurozone crisis. But because Germany is the biggest contributor to the EU budget and to the bail-out funds, and the strongest EU economy, its views cannot be ignored (as President François Mitterrand discovered when he went for reflation in one country in 1981 – at a time when the economic imbalance between France and Germany was less pronounced than today). In any case, Germany has eurozone allies in its emphasis on austerity, such as Austria, Estonia, Finland, Slovakia and Slovenia, and to some degree the Netherlands.

Nevertheless, Hollande has every right to tell Merkel that the strategy into which Germany has pushed the EU needs amending: by imposing too-rapid reductions of budget deficits on problem countries, it is decreasing their ability to repay their debts. According to the IMF, the ratio of gross public debt to GDP in Spain, Italy, Ireland and Portugal will rise every year between 2008 and 2013. The EU’s strategy is also stimulating waves of political populism, extremism and anti-EU sentiment in many parts of the Union.

The French and German bureaucratic machines put enormous pressure on their respective governments to forge compromises on difficult issues. Hollande probably has enough sense to try to work with the Germans rather than against them. That will mean accepting and ratifying the fiscal compact that the Germans care so much about. He may also have to accept at least modest doses of structural reform. He would then be in a strong position to ask the Germans to be flexible in other areas.

Hollande should prioritise two initiatives. One would be to give the problem countries a greater number of years in which to cut deficits and reach fiscal targets. In Greece, the steepness of the spending cuts has made output fall so fast – GDP is almost 20 per cent below where it was five years ago – that the debt burden has become unsustainable. The deficit reduction targets that Spain has had to adopt – more than 5 per cent of GDP from 2011 to 2013 – may have a similarly harmful effect. There is a fine line to be drawn between two lax an approach, which allows governments to postpone painful choices on spending, and may lead the markets to lose confidence in their ability to repay debts; and excessive austerity, which may smother so much economic activity that markets lose confidence in governments’ ability to repay debts. But Hollande should give a clear message to Merkel that spending cuts are being imposed too quickly in some countries.

Might the Germans be flexible on this point? Two days before the second round of the French presidential election, I was in Berlin talking to government officials. They were obdurate in saying that deficit reduction targets should not be and would not be relaxed. However, most EU governments, the Commission and the IMF believe that the problem countries need to be given longer periods to reduce deficits. Merkel will find it hard to resist them all.

A second priority for Hollande should be to encourage Germany’s leaders to facilitate a rebalancing of their economy. If Germany invested more, consumed more and imported more, it would help to reduce the imbalance between its massive current account surplus and the current account deficits in Southern Europe. For an economy of its great size, Germany has unusually low levels of consumption. If one tells Germans that the structure of their economy is contributing to the eurozone’s ills, they generally don’t like it. They also tend to say that a government cannot have much influence on whether citizens choose to spend or save.

But the good news is that the German economy seems to be doing a bit of rebalancing of its own accord. Investment is increasing. Consumption has risen over recent years (though, until recently, less than overall growth). A report from the IMF this month foresaw the possibility of domestic demand leading a German recovery. Imports from the eurozone are rising – for example there has been surge of wine imports from Spain. According to the Federal Statistical Office, Germany’s trade surplus with the rest of the eurozone in the 12 months to the end of March 2012, of €62 billion, was 29 per cent down from the previous 12 months (though some economists believe these figures are unreliable).

Even better, Germany’s leaders seem to have – finally – woken up to the need for rebalancing. Jens Weidmann, the Bundesbank president, has said that Germany might have to tolerate inflation that was a little higher than the eurozone average. Wolfgang Schaüble, the finance minister, has said that higher wages for German workers could help to combat eurozone imbalances. It had hitherto been a taboo for government ministers to comment on wage settlements.

If Germany experienced higher domestic demand and wage inflation, South European countries could more easily export their way out of recession. Hollande should urge the German government to encourage these trends, for example by cutting VAT and telling employers that it is relatively relaxed about wage inflation.

The political crisis in Greece makes it urgent for Merkel and Hollande to find a modus vivendi. They should tell the Greeks that if they wish to stay in the euro they cannot avoid austerity and structural reform. But to raise the Greeks’ morale the EU will have to relax Greece’s deficit reduction targets, write off much more Greek debt and think more imaginatively about how to encourage external investment in Greece. Merkel will find such policies harder to embrace than Hollande. If Greece moves towards exiting the euro, the EU will have to focus on ensuring that contagion does not affect other member-states. The EU would then need to enlarge its bail-out funds and prepare other emergency measures. Once again, Hollande’s role will be to work with other EU leaders in nudging the Germans to be flexible.

 

If the Germans spurn such efforts they will risk sacrificing not only their special relationship with France but also many of the achievements of 60 years of European integration. Until recently, many German leaders seemed disconcertingly certain that their policies for dealing with the eurozone crisis were absolutely right. Now some of them understand that at least some of their policies are not working. Hollande and other EU leaders need to explain to them that an inflexible Germany risks becoming isolated.

Charles Grant is director of the Centre for European Reform.

Germany’s choice: Higher inflation or sovereign defaults

The battle lines are hardening. More and more eurozone governments are calling for the ECB to loosen monetary policy, for example by directly purchasing government debt in an attempt to bring down borrowing costs and arrest their slide into slump. For its part, the German government and the Bundesbank are calling for the ECB to exit the currently loose strategy, fearing a surge of inflation in Germany. But higher German inflation is the inevitable flipside of a strategy that places the full cost of adjustment on the struggling economies. It is also indispensable if the crisis-hit economies are to rebalance and avoid insolvency. Higher inflation presents formidable political challenges for Germany, but the alternative is a wave of national defaults, culminating in either a fully-fledged transfer union or a collapse of the currency union.

Germany’s strategy for dealing with the eurozone – fiscal austerity and internal devaluations across the south of the currency union – can only work if economic activity strengthens (and prices rise) elsewhere in the currency union. The struggling members of the eurozone (a group that is steadily increasing in size) are trying to regain price competitiveness by reducing their costs relative to the rest of the eurozone, and attempting to reduce public indebtedness by pursuing aggressively pro-cyclical fiscal policies. The result has been a collapse of inflation in Greece, Ireland and Portugal and rapidly weakening inflation pressures in Spain and Italy, as they slide into depression.

The ECB targets inflation of ‘close to but under 2 per cent’ for the eurozone as a whole. Assuming inflation falls to zero in Spain, Italy and the peripheral trio, and averages around 2 per cent in France and the Benelux trio (it is unlikely to be any stronger given the headwinds facing these economies), it follows that inflation in Germany (plus Austria and Finland) will need to rise to around 4 per cent. The German economy’s growth prospects are not as strong as many believe, with the OECD, the European Commission and the IMF forecasting only modest growth over the next few years. However, the IMF estimates that the German economy is running at close to (or even above) capacity. The country’s so-called output gap (the difference between the actual output of an economy and the output it could achieve at full capacity) is zero and its trend rate of growth (the rate of expansion consistent with stable inflation) is low.

The current monetary stance is certainly too lose for Germany given these capacity constraints. Assuming that the German economy is not derailed by the slump across much of Europe (an admittedly large assumption), German inflation will start to rise relative to the rest of the eurozone. If the ECB treats Germany like any other eurozone economy, it will hold eurozone interest rates at their current levels (or even cut them) irrespective of the level of German inflation, as long as eurozone inflation as a whole remains on target. After all, the ECB was sanguine about above average Irish or Spanish inflation in the run up to the crisis.

In reality, it is a moot point whether the ECB would allow German inflation to run to 4 per cent. Germany is considered the anchor of the monetary union. Many at the ECB (and not just those from Germany and core countries closely aligned with it) believe that higher inflation in Germany would constitute a loss of price stability, threatening the credibility of the euro. ECB members will also be aware of the threat that higher German inflation could pose to the legitimacy of the euro in Germany. The German government won over sceptical Germans to the euro by promising that the ECB would deliver the same degree of ‘price stability’ as the Bundesbank. The Bundesbank and the German government would resent much higher German inflation. A sharp rise in German prices would almost certainly harden German opposition to other reforms of eurozone governance, not least any form of debt mutualisation.

But assuming the ECB does treat Germany like any other eurozone economy, what would happen? Germany could try to tighten fiscal policy further in an attempt to offset the very weak monetary stance. But it is unlikely to be any more successful than the Spanish or the Irish were in nullifying the impact of inappropriately loose monetary policy. Negative real interest rates in Germany would stimulate economic activity in Germany, increase the demand for labour and push-up wages. Higher German prices and wages would help facilitate the necessary adjustments in price competitiveness between the eurozone economies: the peripheral countries would be able to reduce their wage costs relative to German ones without having to cut nominal wages. German costs would rise relative to the rest of the currency union, removing one of the obstacles to a return to economic growth (and debt sustainability) across the south of the eurozone. This is how adjustment takes place within a currency union, and was how Germany managed to engineer such a large real depreciation (or ‘internal’ devaluation) in the first place – against a backdrop of robust inflation elsewhere in the currency union. Any attempt to permanently lock-in the competitiveness gains will simply perpetuate the crisis.

In a welcome intervention, the German finance minister, Wolfgang Schaüble, recently argued that German wages should rise more quickly than in the other eurozone economies as this would help the needed rebalancing within the eurozone. But such a recognition has yet to permeate official thinking as a whole, and has not really reached the Bundesbank. There are signs that the Bundesbank accepts that German inflation will need to exceed the eurozone average, but certainly no acknowlegement that the differential needs to be very substantial. The Germans are proud of the ‘competitiveness’ eked out within the eurozone. Indeed, they continue to argue that every other member-state can pursue the same strategy as them.

Germany faces a difficult choice: either it accepts higher inflation and risks the German electorate’s confidence in the euro, or it paves the way for a wave of defaults culminating in either a fully-fledged transfer union or the collapse of the euro.

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