Friday, November 30, 2012

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.

Thursday, November 15, 2012

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.

Wednesday, November 07, 2012

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.

Tuesday, November 06, 2012

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 RĂ¼he, 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