What Germany's new coalition government means for the EU

Almost three months after the general election in September, Germany finally has a new government. In a grassroots referendum, members of Germany’s Social Democrats (SPD) voted to accept a coalition agreement that party leaders had drawn up with Angela Merkel’s Christian Democrats (CDU) and its smaller, more conservative sister party, the Christian Social Union (CSU). The new government is unlikely to change EU policy a great deal.

In German, the coalition agreement is called Koalitionsvertrag, or coalition treaty. Germans like treaties and other rules that bind. But Germans also know that coalition agreements do not necessarily bind the politicians that sign them. Few of the big decisions that have shaped German politics in recent years were included in coalition agreements; for example the decisions to send troops into foreign wars, abolish conscription or shut down all nuclear power stations were not. The last coalition agreement of 2009 said nothing about the euro crisis.

Therefore, the new coalition treaty should be taken for what it is: a declaration of intent and a snapshot of what the three parties involved are thinking at the moment. Even bearing this in mind, the European policy chapter of the new agreement will inspire few people. The three parties make a strong commitment to the EU (“European integration remains our most important task”) and to the euro (“Germany stands by the single currency”). But like the rest of the text, the Europe chapter often papers over conflicts by simply adding up positions: we want fiscal consolidation; and growth. We want a stronger Europe; and subsidiarity. We want more solidarity; as long as countries take responsibility for their own problems. And so on.

There are few concrete proposals for reforming the EU. Beyond a vague promise to “adjust the treaty provisions on economic and monetary union” (perhaps to allow for banking union, stronger fiscal oversight or reform contracts), there is no mention of a major treaty change, nor of a move towards fiscal or political union.

The agreement reconfirms the ‘community method’ as being central to EU decision-making (the community method involves the European Commission, Parliament and Council of Ministers in EU law-making) – despite the fact that Merkel has on several occasions expressed a preference for inter-governmental decision-making. Unless the euro crisis flares up again, European governance is likely to revert from crisis mode (late-night phone calls between big country leaders and dramatic Eurogroup summits) to the established interaction between Commission, Parliament and Council. However, other than stronger fiscal oversight, the Commission is unlikely to gain much additional authority as long as Merkel stays in power.

Guido Westerwelle, the FDP foreign minister, has been replaced by Frank-Walter Steinmeier, who held that job during the last grand coalition. Steinmeier is less of a true believer in European integration than Westerwelle. Nevertheless he will be one of the strong figures in the government and the weight of the foreign ministry – traditionally, sympathetic to the EU – in decision-making may grow.

The agreement advises Brussels to “focus on the big issues of the future” instead of meddling in policy areas that are better left to the member-states or their regions. It also calls for a measurable reduction of EU regulation in selected areas, specifically those that affect small and medium-sized businesses. The new German government also wants to see a “more streamlined and efficient college of commissioners, with clearer responsibilities for individual commissioners”. This implies that the German government is open to the idea of dividing the college into junior and senior Commissioners (as proposed in a recent CER report).

The coalition agreement seems to confirm a gradual disillusionment of the German political class with the European Parliament. Traditionally, Germany has been one of the strongest backers of the EU’s legislature. However, the coalition deal states that for the democratic legitimacy of the EU, the involvement of national parliaments in EU business is “equally important as” a strong European Parliament. This will please people in Britain, the Netherlands, Denmark and other countries that want to see a stronger role for national legislatures in the EU. But it will surprise and infuriate many MEPs.

Relations between Berlin and the Parliament may be rocky in the coming years, partly because Merkel does not like its idea that the party with the most seats after the European elections should see its designated candidate automatically become Commission president (see the recent CER essay by Heather Grabbe and Stefan Lehne). The coalition agreement does not deal with this topic, but instead calls for an EU-wide electoral system with a minimum threshold to keep fringe parties out of the European Parliament.

When it comes to handling the euro crisis, the coalition treaty reconfirms the traditional German line that the main responsibility for dealing with it lies with the euro countries that got into trouble. “The public debt ratios in the euro countries need to be reduced further”, states the agreement. And it calls for the EU to strengthen its oversight and control over national budgets.

But the coalition parties also acknowledge that fiscal overspending was not the only reason for the crisis. The debate in Germany has in any case moved on from stereotyping work-shy Southern Europeans. But it is noteworthy that the coalition text explicitly lists fundamental flaws in the construction of the euro, mentioning financial market distortions and macro-economic imbalances among the causes of the crisis. It is equally noteworthy that the agreement does not offer new solutions to these problems.

The agreement states that economic imbalances in the eurozone need to be addressed through the efforts of “all euro member-states”. But those who had hoped that the inclusion of the Social Democrats in the government would result in Germany spending much more, and thus helping to rebalance the eurozone economy, are likely to be disappointed. Sebastian Dullien from ECFR has calculated that the extra spending promised for infrastructure, education, municipalities and pensions amounts to 0.1 per cent of German GDP for each year that the new government can expect to be in power. Most of the additional spending will go on consumption. A new national minimum wage and the first strengthening of trade union rights in decades could push wages up, which might lower Germany’s large current-account surplus. What Germany particularly needs for sustained growth, however, is more investment. On growth-boosting structural reforms in Germany, the coalition agreement says little.

The agreement demands that the EU must finally break the “interdependence between private bank debt and public debt”. It does not promise faster or more wide-ranging steps towards a banking union than had hitherto been proposed by Angela Merkel and Wolfgang Schäuble, her finance minister (who will stay in post). The new government insists that shareholders and creditors must be first in line when a bank gets into trouble, and that a new eurozone resolution fund should be paid for by the banks themselves, not taxpayers. Until the new fund has collected enough money, the European Stability Mechanism, the eurozone’s bail-out fund, may be used for bank recapitalisations, but only as a last resort (if bail-ins and national bail-outs are exhausted) and only up to a limit of €60 billion. As expected, Germany does not want its local savings banks included in the banking union, and it still rejects joint European deposit insurance.

Looking beyond the crisis, the coalition agreement puts a lot of emphasis on the need for structural reforms in the eurozone, to increase economic growth rates in a sustainable way. The idea of “reform contracts” between individual euro countries and the “European level” is taken up again. However, there is no explicit commitment to a new eurozone budget to motivate countries that struggle with tough reforms. Instead, the coalition agreement calls for a better use of EU Structural Funds and the European Investment Bank to underpin structural change and modernisation.

The SPD’s influence is visible in a lengthy section about the need to strengthen the “social dimension” of the EU. However, the only tangible measures in this respect are German help for neighbouring countries that want to improve their apprenticeship systems (this started under the last Merkel government) and the drawing-up of an EU social “scoreboard”. This scoreboard (a Commission idea) would be an attempt to feed warning signs of high employment and social pain into the EU’s strengthened fiscal and economic surveillance.

It should not come as a surprise that the coalition agreement largely perpetuates Germany’s euro policies of the last four years. First, when it comes to euro crisis management, Germany has effectively had a grand coalition since 2010. In her last government (a coalition with the liberal FDP), Angela Merkel was faced with a small but persistent anti-bailout rebellion within her own ranks. Therefore, she had to rely on the SPD to pass almost all big euro-related measures in parliament. Therefore, Germany’s euro crisis management was already to some extent a compromise between the CDU/CSU and the SPD.

Second, existing and pending rulings by the powerful constitutional court put clear limits on what any German government can do. The court has ruled that no German government is allowed to create unlimited liabilities for the German taxpayer. The coalition agreement’s reiteration that the new government will not support eurozone debt mutualisation is therefore not surprising.

Third, German voters overwhelmingly support the cautious course that Merkel has charted in the crisis so far. For the SPD to demand a radical departure would have been politically risky – and hard to sell now that most Germans think the worst of the crisis is behind them.

Finally, the past four years have taught German politicians that it would be foolish to lay down either ambitious goals or rigid red lines at a time of crisis. As long as the eurozone looks shaky, German politicians will want to have a large degree of flexibility to react to developments. For some, the fact that the coalition programme is rather vague on EU policy will be disappointing. But this vagueness will allow the new German government to react flexibly if there is renewed instability in the eurozone.

Katinka Barysch is director of political relations at Allianz SE. The views expressed here are her own.

Not flashy but effective: Closer EU co-operation in defence investments

This month, European leaders will discuss how to strengthen EU military co-operation. It is the first time that defence has been on the European Council’s agenda since 2008 and EU officials had hoped the member-states would unveil bold initiatives to stem the deterioration of their armed forces. But governments remain wary of ambitious joint efforts in defence. So the best that can be hoped for is that the Council will endorse EU military reforms which are relatively modest, but easier for member-states to support. One of these should be closer co-operation in regulating private investments in European defence companies – somewhat technical and unspectacular but nonetheless useful.

European governments acknowledge that the case for EU defence collaboration is even stronger today than it was when France and the UK launched the Common Security and Defence Policy (CSDP) fifteen years ago: the US will not always be able or willing to help Europeans stem violence in their neighbourhood, so European states must be capable of upholding regional security alone. And EU countries could save money through closer co-operation amongst their armed forces, and by more integration between their fragmented defence markets.

Over the last decade and a half, however, EU states have often disagreed about which parts of their neighbourhood threatened their security and how to respond. Many governments have been averse to putting their troops in danger. They have also been wary of pooling military capabilities without knowing where or how the equipment would be used. And since the outbreak of the economic crisis, governments have also worried that voters would be angry if they funded large joint equipment programmes when ministries of defence are cutting civilian and military personnel.

As a result, EU defence co-operation has struggled. Member-states have deployed under the EU flag 29 times. But many of the missions have been civilian operations. At times, the security restrictions EU states have imposed on their personnel have hampered operations’ effectiveness. Recently, for example, some of the staff from an EU mission designed to help the Libyan authorities improve border security were evacuated to Malta because of concerns about their safety. 

The EU published a security strategy in 2003 (and updated it in 2008) in which governments committed to tackle global threats together. But member-states have not paid the strategy enough attention or based national defence planning on it. The European Defence Agency (EDA) has helped member-states improve some of their capabilities, by providing helicopter pilot training for example. But EU countries continue to do much of their maintenance and logistics alone. The EU has introduced rules to make it easier for governments to use competition to drive down prices when buying defence equipment, and to reduce the bureaucracy needed to send military equipment to the armed forces of another member-state. But many equipment programmes are still inefficiently duplicated across the EU. For example, according to the European Commission, there are 11 suppliers of frigates in the EU. Even Europe’s largest defence companies remain relatively small, limiting their ability to reduce costs through economies of scale and to be more innovative. The average American aerospace firm is over 20 times bigger than top EU companies. The challenge for the EU is to find the sweet spot between an oligopoly of suppliers who can raise prices at will, and a proliferation of niche manufacturers serving national markets, whose high unit prices reflect short production runs.

If EU governments want to boost their contribution to international security without increasing their defence spending, they will have no choice but to overcome their various aversions to closer European co-operation. As the CER’s Ian Bond argues, member-states ought to base their co-operation on a common security strategy. Otherwise they will continue to disagree on where to deploy, and refuse to own military equipment in common. But as the last 15 years attest, it will take time for EU states to forge a common military culture. So in the meantime, EU governments should exploit those collaborative measures which are relatively easy to introduce.

One example would be harmonising the system for regulating domestic and foreign investments in their defence companies. Large shareholders can influence a firm’s decisions and access sensitive information, so government checks on investors are essential to national security. But rigid and excessive state controls can unnecessarily restrict the ability of European defence firms to access capital. In France, an EU country with particularly cumbersome controls, the government can investigate attempts by foreign investors to acquire more than a 33 per cent stake in any French defence firm. The state also controls its defence industry through golden shares – enabling it to bloc acquisitions of more than 10 per cent of shares in Thales. And the government itself is a large, and sometimes exclusive, shareholder in several defence firms. In contrast in Sweden, where investment safeguards are lighter, the state has no equity or golden shares in Swedish defence companies. According to former US official Jeffrey Bialos, foreign investors need merely to receive the government’s approval in order to buy a Swedish defence firm (and the CEO must remain Swedish).

As the CER has argued in the past, EU states could streamline their controls on investments in defence companies by relying primarily on ministerial committees instead of inflexible rules and government ownership. As these committees draw on advice from officials and independent experts to examine investment requests on a case by case basis, they reduce the risk of blocking investors unnecessarily.

As a safeguard for the interests of other member-states, EU governments could also make it a legal requirement to consult each other before accepting a sizeable domestic or foreign investment in one of their defence firms. An investment in one EU state could adversely affect another country’s security of supply. For example, the German army might rely on radios produced by a company in Sweden. Deployed German troops could be put at risk if new owners of a Swedish firm decided to stop producing such equipment. The six European countries with the largest defence budgets are already committed to consult each other on such matters. And the EDA has been encouraging all EU member-states to do so. But according to EU officials, governments still rarely check with their neighbours. Legally-binding commitments would change that.

In preparation for the European Council, the European Commission has proposed that it should identify shortfalls in national controls on defence industries and explore options for an EU-wide monitoring system for investments. EU heads of state and government should encourage the Commission to pursue its proposal in close co-operation with the EDA, in order to avoid any duplication of efforts.

Not all European governments yet feel ready to jointly own fleets of drones, or rely on other countries to provide minesweepers for the entire EU. But it would be a missed opportunity if leaders did not use the December European Council to improve the workings of the European defence market in ways that do not require large sums of money or even shared security priorities.

Clara Marina O’Donnell is a senior fellow at the Centre for European Reform and a non-resident fellow at the Brookings Institution 

The Eastern Partnership: The road from Vilnius leads to …?

The EU’s Eastern Partnership has run out of steam. It was launched in 2009 with the stated goal of creating "the necessary conditions to accelerate political association and further economic integration” between the EU and its partners. But of the six partners, one (Belarus) was already under EU sanctions in 2009; and one (Azerbaijan) has shown little interest in the partnership – particularly those aspects which would require it to improve its governance and human rights record.

Approaching the Vilnius Eastern Partnership Summit on November 28th-29th, Armenia, which was on the point of initialling an Association Agreement with the EU, succumbed to Russian pressure, put the relationship with the EU on hold and agreed to join the Russian-led Customs Union; and Ukraine announced that it would not sign the Association Agreement which it had initialled in March 2012. Thus only Georgia and Moldova continue to subscribe wholeheartedly to the Eastern Partnership.

Rather than trying to keep all six partner countries in a single framework as they increasingly choose divergent paths, the EU should accept reality and not pretend (as it did in the Vilnius summit declaration) that there has been “considerable progress made in … bringing Eastern European partners closer to the EU”.

Azerbaijan and Belarus show no sign of changing course, so Europe should continue to support hard-pressed civil society organisations there, and regional or cross-border projects which benefit their more democratic neighbours, but nothing else. Armenia, dependent on Russia for gas, support for its ageing nuclear power plant and security against Azerbaijan, has for the moment no alternative to doing Moscow’s bidding, though the EU should do what it can to keep Armenia’s long-term options open.

Ukraine, larger in population than the other five partners combined, has a poor record of reform, but is too important for the EU to turn its back on. The country in its current state may not be much of a geopolitical prize for the EU, but a permanently impoverished and unstable Ukraine on Europe’s borders would be worse.

At the time of writing, large pro-EU demonstrations are continuing in Kyiv, while the authorities are still trying to see whether they can squeeze more attractive terms out of Moscow or Brussels. The ball is now in Yanukovych’s court, but the EU can influence where he hits it. Rightly, the EU has made clear that it is still ready to sign the Association Agreement once Ukraine meets the necessary conditions, including an end to politically motivated prosecutions of opposition leaders. But the EU has done a poor job of explaining the impact and implications of the Association Agreement to Ukrainians, particularly in the Russian-speaking east and south of the country. Commission President Barroso told the media after the Vilnius Summit that the agreement would save Ukrainian exporters 500 million euros per year through cuts in EU import duties and add 6 per cent to its GDP in the longer term, but the EU has done little to publicise this, particularly in Russian-speaking eastern Ukraine. An easy win for the EU delegation in Kyiv would be providing more information in Russian: a handy brochure explaining the main points of the Association Agreement is currently available on the delegation’s website, but only in Ukrainian.

Without such information, many Ukrainians will be left to rely on misleading scare stories from the Russian media about the terrible impact the agreement will have. The EU should at least ensure that Ukrainians know the facts, so that they can make up their own minds about whether their leadership is taking the right decisions for the country.

Tempting though it is for EU leaders to write off the current Ukrainian government and its oligarchic backers, they should step up their political engagement, rather than giving the Russians free rein to threaten, flatter and bribe the Ukrainian elite. Former Polish President Kwasniewski and former European Parliament President Cox visited Kyiv 27 times before the Vilnius Summit with a mandate to secure the release of former Prime Minister and Yanukovych’s rival Yulia Tymoshenko. Though they were ultimately unsuccessful, they should be given an enlarged mandate to use their relationships with government and opposition to move Ukraine towards signature of the Association Agreement. 

Cox and Kwasniewski should not be alone in this effort. Those EU Foreign Ministers who went to Kyiv for the OSCE Ministerial Council meeting on December 5th-6th were right to do so; those who made time to see the opposition as well as the government deserve even more praise. Senior Western visits to Kyiv should continue; the fact that Yanukovych agreed with Barroso to host EU High Representative Catherine Ashton in the week of December 9th is a positive step.

Now that Georgia and Moldova have become the EU’s closest partners in the region, they are likely to face the wrath of Russia, particularly once the Sochi Winter Olympics are out of the way and the Russian authorities no longer have to worry about international protests or boycotts. Tbilisi and Chisinau will need European support. The EU should move as quickly as possible from initialling to signature of the Association Agreements with the two countries (neither is likely to be subject to the kind of political delays which affected Ukraine, whose agreement was initialled in March 2012). Thereafter, it should be generous in provisionally applying the agreements before EU member-states have ratified them, to ensure that Georgia and Moldova can feel the earliest possible benefit from their association.

That may not be enough, however. Moldova in particular looks vulnerable to Russian pressure. It relies on Russian gas and has an unresolved conflict with the separatist Transnistrian region (where Russian troops are stationed). Remittances from Moldovans working in Russia make up almost 10 per cent of GDP. Russian Deputy Prime Minister Dmitry Rogozin has already warned Moldova that it might freeze this winter, and compared the country to a locomotive on a twisty track, which might “lose some of its carriages” (ie Transnistria) on the way to Brussels. In October the Russian Federal Migration Service threatened to expel 190,000 Moldovans working illegally in Russia. In September, Russia banned imports of Moldovan wine on “health grounds” – a serious blow, given that annual wine sales to Russia amount to about 2 per cent of Moldova’s GDP. The fragile coalition government of pro-EU parties faces an election next year; an economic crisis which could be blamed on the current government turning its back on Moscow might help the pro-Russian Communist Party back into power.

The European Commission has already proposed increasing export quotas for Moldovan wine to compensate for the loss of the Russian market. A gas pipeline is being built from Romania to Moldova (but will not be ready this winter). The Commission is proposing to give visa-free access to the Schengen area to Moldovan citizens with biometric passports. But Moldova, already the poorest country in Europe, will need financial and political support for the foreseeable future to buttress its European choice. US Secretary of State John Kerry sent a positive signal by visiting Chisinau on December 4th; EU leaders should follow his example.

Georgia is a little less vulnerable, in part because it re-oriented its economic relations away from Russia after their 2008 war. Even so, remittances from Georgian workers in Russia made up 4 per cent of GDP in 2012. Georgia needs three things from the EU: continued technical and financial assistance; diplomatic support in its unresolved conflict with Russia over the separatist regions of Abkhazia and South Ossetia; and, above all, consistent political engagement.

After ten years of the mercurial pro-Western Mikheil Saakashvili, Georgia now has the politically inexperienced Giorgi Margvelashvili as President. Prime Minister Bidzina Ivanishvili has resigned in favour of his loyal lieutenant, 31 year-old Irakli Garibashvili (who as Interior Minister was responsible for arresting former senior figures in the administration of then-President Saakashvili). Though the new government has restated its commitment to European integration, there have also been hints that it might continue settling scores with its political opponents. Western visitors need to encourage continued political and economic reform, while reminding the new leadership of the effect political prosecutions have had on Ukraine’s European integration prospects and its internal stability.

Not only does the EU need to take a fresh look at its eastern partners; it also needs a comprehensive and clear-sighted review of its approach to Russia. There should be no more illusions that the EU needs only to explain the Eastern Partnership better for Russia to see it as beneficial. It should be clear by now that President Putin and his government have decided that their interests are better served by having weak and dependent autocracies as neighbours than prosperous and independent democracies.

The EU should defend its own interests in stability and prosperity on its borders, not least by action to uphold international trading rules. Georgia, Moldova and Ukraine are all WTO members (as is Russia). Russian actions to block the export of Ukrainian and Moldovan goods to Russia are almost certainly contrary to WTO rules, so either country could invoke the WTO dispute settlement system. The EU would have the right to declare itself a third party to such a dispute, and make submissions to WTO dispute settlement panels in support of its neighbours. If the Eastern Partnership can no longer be “win-win-win” for the EU, its partners and Russia, then at least it should be “win-win” for the EU, Georgia, Moldova and (hopefully) Ukraine.

In the long run, the best way to anchor in Europe those countries that are serious about reform is to look again at offering them an explicit membership perspective, however distant. In present circumstances, there would be no sense in making this offer to all six members of the Eastern Partnership. But Article 49 of the Treaty on European Union states that any European state which respects the principles of liberty, democracy, human rights and the rule of law may apply to become a member of the Union. The Vilnius Summit Declaration avoided referring to this article or describing the eastern partners as European states, merely acknowledging “the European aspirations and the European choice of some partners”. If the EU treats even its most reform-minded and pro-EU neighbours as less than fully European, then it is little surprise if Russia does the same.

Ian Bond is director of foreign policy at the Centre for European Reform.

David Cameron and EU migration: Nasty, visionary – or just necessary?

David Cameron said last week that Britain will try to limit EU migrants’ access to the UK’s welfare system, within the current rules. His statement comes one month before Bulgarian and Romanian immigrants gain the right to work in Britain and other member-states, and six months before the UK Independence Party may top the poll in the European elections.

Cameron has proposed that no EU migrant living in Britain will be entitled to receive benefits until they are a resident for at least three months. Nationals of other member-states will also start to lose any entitlements they get after being out of work for six months, if they have no genuine chance of finding a job. If they are homeless or begging, they could be expelled. But the UK already qualifies EU migrants' access to benefits with a 'right to reside' and 'habitual residency' test. (The criteria for these tests vary depending on the circumstances of each individual migrant. But, broadly, both are intended to deter welfare tourism by non-workers, especially the newly-arrived.) Healthcare costs incurred by EU migrants for the first three months of residency are supposed to be reclaimed from their home governments. And the long-term unemployed and those who pose a danger to society can already be expelled by the British authorities.

Therefore Cameron must only mean that the UK will interpret the existing rules more strictly and enforce them more rigorously. However, the prime minister also wants to discuss with other EU leaders ways of qualifying the right to free movement in future. When Margaret Thatcher signed up to the 1986 Single European Act, most member-states assumed the free movement of people meant the 'free movement of workers', or migrants with existing job offers, moving between their countries. But the European Court of Justice (ECJ) ruled in the 1991 Antonissen case that the term 'worker' also meant unemployed job-seekers. The judges were perfectly right: no serious labour market can function unless people are free to move around to seek work rather than waiting to be recruited.

The Antonissen decision took on greater significance as the Union enlarged to much poorer regions in 2004 and 2007. This is especially true for Britain which has a universal welfare system where the level of entitlements is not specifically linked to personal contributions, unlike most other European countries. The ruling and the 2004 enlargement prompted the UK to introduce, respectively, its 'right to reside' and 'habitual residency' tests. And there is an extra twist in the shape of the eurozone crisis. Britain – which stood aloof from the single currency and is not responsible for its fate – still functions as a safety valve for the eurozone because large numbers of unemployed workers from its austerity-stricken periphery move there. (It does share this exposure to the crisis with other non-euro members, however, and also benefits greatly from a ‘brain-drain’ of skilled workers from Italy and other euro countries.)

The ECJ has gone on to join free movement rights to the concept of EU citizenship, introduced by the Maastricht treaty in 1992. That has resulted in such rights – including access to healthcare – being extended to the partners and families of EU nationals and, to the great relief of the British in Spain, pensioners. Again, there are good reasons for this. Workers are more likely to move around the EU if they can bring their loved ones with them. And older people who have worked up a pension in one country should be entitled to spend it wherever they like. So Spain’s young unemployed take temporary refuge in Britain, helping to man its economy, and elderly Britons get to retire on Spain’s beaches. This is free movement working well.

But ECJ rulings have also had some unintended effects on national immigration policy. For example, its 2008 Metock decision has led to an increase in fake marriages across Europe whereby foreigners marry EU citizens for money, in order to use their free movement rights in other countries, including work permits, benefits and visa-free travel to the US. (Malta even plans to sell citizenship, and therefore EU migration rights, for €650,000 per head.) The Luxembourg-based Court has staunchly upheld free movement rights in a series of cases, sometimes on what seem like weak premises to non-lawyers. One example is allowing foreigners free movement and residency rights even after their relationship with an EU citizen ends. Rulings like these mean that UK immigration tribunals will rarely expel EU nationals, or those who are or have been dependent on them, if they have already been resident in Britain for two years.

The ECJ is now qualifying its support for free movement in a number of rulings such as the Alopka case last October in which a Togolese national failed to annul a deportation order from Luxembourg despite relying on free movement rights acquired from her children. But the European Commission displayed a political tin-ear during the summer when it chose to take Britain to court over its ‘right to reside’ test. Furthermore, British civil servants worry about open legal questions concerning EU migrants' access to benefits. For example, EU workers living in Britain can receive child benefit for children not resident there. To many, that seems unfair. The British state might even have further legal responsibilities to these children as they grow up, such as offering them loans to attend university.

Such issues could be clarified by updating the EU laws that govern free movement: a 2004 directive on the rights of EU citizens and a 2009 regulation on how member-states co-ordinate their social security arrangements. Some ideas include having a single set of EU benefits available to anyone who uses their right to move around the Union; or finding a way to 'individualise' free movement rights so that only actual residents can benefit from them.

Cameron’s statement on free movement may be intended to manage a ‘nasty’ British tendency to see EU migrants as scroungers or welfare fraudsters. (Most evidence indicates they are overwhelmingly the opposite. See John Springford's CER policy brief here.) But the prime minister has also pointed to a more fundamental problem. EU countries need to create a better legal and administrative infrastructure for free movement that allows them to anticipate and manage certain issues before they become political problems. The alternative is to let the public debate rage on and leave the key questions to the courts.

Hugo Brady is the CER’s Brussels representative and a senior research fellow.

The EU's 'yellow card' comes of age: Subsidiarity unbound?

EU law-making is undergoing a profound change in an oddly-shaped annex to the European Parliament building in Brussels. Here, officials working on behalf of 28 national parliaments are helping their members flag up draft EU laws that may fail to respect ‘subsidiarity’. That is the idea that the Union should act only when strictly necessary, and that the national governments should act where possible. The 2009 Lisbon treaty gave national parliaments the right to police subsidiarity through the creation of a so-called 'yellow card' system. This allows a third or more of them, acting together, to vet and temporarily block draft laws proposed by the European Commission. (For legislation in the sensitive area of justice and home affairs, the threshold is only a quarter.)

Each parliament has two votes, or one per chamber for the 13 member-states that have bicameral systems. Each chamber that votes for a yellow card provides a 'reasoned opinion' why the EU law in question is an unwarranted trespass on their sovereignty. A yellow card requires 19 reasoned opinions (14 for a piece of justice legislation). The Commission can get around a yellow card by giving clearer justifications for its actions and proposing the law again, perhaps with some changes or caveats added. But if it does, half the national parliaments can still block the second attempt, rather than just a third the first time around. This is the unwieldy 'orange card' (29 reasoned opinions). At this point, if either a majority of governments or MEPs agrees that the orange card is justified, then the legislation is defeated outright.

National parliaments have yellow-carded new legislation only twice. The first occasion was last year when they rejected the adoption of common EU rules on the right to strike (known as 'Monti II'). But last month, parliaments in Britain, Cyprus, Hungary, Ireland, Malta, the Netherlands, Slovenia, Sweden, Romania, as well as the French and Czech senates, rejected a proposal by the European Commission to create an EU prosecution office. (See here for a fuller analysis of the stakes in the European public prosecutor debate.) National parliamentarians' deliberate blocking of a project that has a distinctly federalist flavour marks their arrival as serious players in how the Union is governed. Why?

First, because the Commission has so far treated a yellow card as a virtual veto. In 2012, EU officials withdrew Monti II, albeit while insisting that the legislation did not fall foul of the subsidiarity principle. European Commissioners have even amended draft legislation pre-emptively, such as the 2012 directive on public procurement and another (the IORP directive) on pensions, just to ward off a likely yellow card from national parliaments.

Second, most national parliaments have long had their own offices in Brussels. But the existence of the yellow card regime since 2009 has made this network of offices – cooped up in their shared corridor – more coherent by giving it a common purpose. These officials are getting better at using the brief two-month period allowed for assessing draft legislation to connect the debates in their home parliaments to each other, and to the EU's legislative process. So it is likely that yellow cards will become more frequent in future.

Third, the yellow card scheme is making national parliamentarians more assertive on EU issues. Apparent attempts by Commission officials to pressure wavering parliaments over their EU prosecutor proposal only served to turn more chambers against the idea. And now, one national parliament, or even a single chamber, has a powerful means to signal that they do not fully agree with their own government's European policy. For example, France's government, and its National Assembly, supports the creation of the proposed EU prosecutor. The French Senate clearly has a different take. (The powers of such chambers over EU business could become pivotal if a member-state has a minority government.)

Hence the yellow card innovation is encouraging governments to be more careful about consulting national parliamentarians first – including the frequently ignored upper chambers – before striking deals in Brussels. It may even make the lines of democratic accountability within individual member-states stronger than they were before the Lisbon treaty. And the scheme should demonstrate to eurosceptics in Britain and elsewhere that the checks on EU executive power provided for under the Lisbon treaty are far better than they would perhaps like to believe.

The spectacle of national parliaments acting in concert to limit EU action is aptly symbolic at a time when euroscepticism is rising to unprecedented levels across the Union. But it is more likely that the yellow card system will act as a safety valve for such pressures, rather than a US-style filibuster for those who would like to stymie the EU altogether. Governments could also make a minor, surgical change to the treaties to expand the procedure so that it can be more constructive. For example, new rules could allow a third of national parliaments to request the Commission to bring forward new laws and a half of them could ask for useless or out-of-date legislation to be repealed. Furthermore, eight weeks is only a heartbeat in European politics. The amount of time available for parliaments to consider the Commission's draft proposals should be extended to twelve weeks. (These ideas were recently proposed in a major CER report.)

Twenty years ago, Jacques Delors, then president of the European Commission, jokingly offered a €200,000 prize for a clear definition of what 'subsidiarity', a concept drawn from Catholic theology, actually meant. Lord Mackenzie-Stuart, a former British president of the European Court of Justice, later termed it mere “gobbledygook”. But the actual answer is neither theological nor legalistic. It is being eked out politically, on a case-by-case basis, as some 40 parliamentary chambers across Europe slowly learn how to form alliances, determine what their shared interests are, and – when warranted – take action vis-à-vis Brussels.

Hugo Brady is a senior research fellow & Brussels representative of the Centre for European Reform.

Britain is held back by its business culture, not the EU

British ministers like to talk of the British economy being in a ‘global race’, and of the need for their countrymen to shape up and raise their game if they are to compete in the global economy. In practice, they mean less red tape, tax cuts for business, and reforms aimed at making it easier to hire and fire employees. Many Conservatives blame the regulatory burden on the EU, and want to either renegotiate the terms of Britain’s membership or withdraw altogether. With the notable exception of Liberal Democrat Business Secretary, Vince Cable, these ministers never mention business short-termism, and the British system of corporate governance that encourages it. Yet this is undoubtedly the most important reason for the UK now having the second lowest investment rate in the OECD (after Ireland, where investment is very volatile). The government wants to rebalance the UK economy towards investment and exports. This will require a reform of corporate governance, especially the incentives faced by executives.

Chart 1: Gross fixed investment (per cent, GDP)

Source: OECD

British ‘short-termism’ has long been blamed for the country’s low levels of investment, especially in manufacturing where success requires long-term commitment to product development and distribution as well as to training. The issue received less attention during the boom years when debt-fuelled private consumption and (towards the end) deficit spending by government drove growth, but it hardly went away. There is no perfect correlation between the level of investment and the rate of economic growth – too much investment can be wasteful and unproductive, as was the case in Ireland and Spain in the run-up to the crisis. But Britain’s investment rate is clearly damagingly low. The country’s corporate sector became a net saver in 2002, and hence long before the onset of economic crisis. Profits have risen and investment has fallen, as the corporate sector – in a reversal of the normal order of things – has become a large creditor to the rest of the economy.

Why is this such a problem? If firms invest too little, a country’s capital stock suffers and with it productivity growth, trade competitiveness and overall economic performance. Moreover, if the corporate sector is a net saver (that is, it spends less than it earns), other parts of the economy – households and the government – must spend more than they earn, or the economy will slump. The only way the economy can grow if households, firms and the government are all saving simultaneously is if net exports are consistently positive (exports grow more rapidly than imports). The British economy is now growing relatively strongly, propelled largely by declining household savings and a resurgent housing market (which could presage another boom and bust). There is no sign, however, of a rebound in investment.

Despite having one of the lowest investment rates in the OECD prior to the crisis, the UK experienced one of biggest declines in 2008-09 and one of the weakest recoveries since. While public investment only fell slightly, business investment collapsed and is still more than 30 per cent below pre-crisis levels. Cuts in corporate taxation and regulation are unlikely to spur a recovery in investment, as the government hopes. The tax treatment of capital spending is less generous in the UK than in some EU countries, but business taxes are lower than the average. There is little doubt that certain types of regulation are a deterrent to investment, but it is hard to argue that regulation explains lower levels of investment in the UK than in other EU countries. After all, Britain is already lightly regulated, according to the OECD and the World Bank. Patchy infrastructure and skills shortages may be deterring some firms from investing, but these problems are hardly unique to the UK, and they are certainly not preventing companies from delivering healthy profits; profit margins remain well above their long-term average.

The British government is ignoring a pair of elephants in the room. The first is the fall in the proportion of national income accounted for by wages and salaries (labour share). The fall in labour share is the flipside of the rising proportion of national income accounted for by profits. Labour share has fallen in the UK, as it has done elsewhere, and is undoubtedly one reason for the weakness of consumption and investment in the UK. The British government (like its counterparts across Europe) believes that demand is profit-led as opposed to wage-led; that is, they believe that the higher corporate profits are, the more likely corporates are to invest. The fact that a rising profit share over the last thirty years has gone hand on hand with a steady decline in investment strongly suggests otherwise. (See http://www.cer.org.uk/publications/archive/policy-brief/2012/economic-recovery-requires-better-deal-labour).

Reversing the decline in labour share will be difficult, even if governments acknowledge that it is a problem. It partly reflects technological change, for example, which governments should not try to resist. But governments do not have to compound the problem. For example, the UK government continues to shift the burden of taxation from firms to households, and favours labour market reforms which further erode the bargaining power of employees. However, labour share is even lower in many eurozone countries where investment rates are higher, so there must be another reason for the particular weakness of British investment.

This leads to the second elephant in the room: a system of corporate governance (in particular, executive remuneration) that gives managers little incentive to sign off on long-term investment. A major reason for this is the mantra of ‘shareholder value’ which has gone further in the UK than anywhere else in Europe. Executive remuneration (in particular, bonuses) is tied more closely to short-term profits than elsewhere. The result is a strong incentive to prioritise short-term profits or returns on equity over long-term investment and organic growth. Non-financial UK corporates are now sitting on unprecedented cash holdings, currently around £700 billion (up from £240 billion in 2002), equivalent to almost 50 per cent of GDP. No other major European economy has seen so much money essentially being sucked out of the economy. If the UK is to flourish, companies must start investing this money. However, executives have a personal interest in boosting short-term share prices by using the cash to buy back shares and boost dividends, rather than stepping up investment in the businesses they run.

Advocates of untrammelled shareholder value base their support on two key arguments. First, it benefits everyone because it forces managers to run firms efficiently rather than for themselves. Second, it makes it easier to reallocate capital from declining to fast growing industries; the owners of capital do not have to engage in time-consuming and expensive negotiations with workers or other stakeholders before withdrawing their capital and putting it to more productive use.

Neither of these arguments is convincing, at least from a UK perspective. First, the prioritisation of short-term returns and the drive to give money back to shareholders wherever possible may well be in the interests of managers and fund managers (because of the way their remuneration is structured). But it is far from clear that it is in the interests of the workers, suppliers and the broader economy, or of the ultimate owners of company shares (ordinary employees through their pension funds). Their interests are in long-term profits and long-term share values.

Second, if capital was moving more quickly from declining to dynamic sectors in the UK than elsewhere in Europe, the UK’s mediocre productivity performance would be much better than it is, and GDP per head higher (see chart 2). The innovative capacity of the British economy would also be stronger. R&D spending is an imperfect measure of innovation – it fails to capture innovation in the services sector, for example. But even allowing for this, the UK’s R&D performance is poor: at just 1.8 per cent of GDP it is lower than the already poor EU average of 2 per cent. As befits a country with the strongest scientific research base in Europe, there are plenty of high-tech start-ups in the UK. But few have grown into large firms (most suffocate in the so-called ‘valley of death’), suggesting that Britain’s financial system is pretty poor at allocating capital.

Chart 2: Real GDP per capita (EU28 = 100)

Source: Eurostat

Their focus on rebalancing the economy means that British ministers are now more aware of the importance of long-term investment by firms. They no longer try to convince the rest of the EU of the merits of unfettered shareholder value. But this has not been translated into institutional changes in the UK. Executive pay and bonuses (and those of fund managers) need to be more closely linked to long-term performance, and not just to the share price; a range of metrics is needed. Executives’ duty should be to the long-term performance of the company and those that work for it. At the same time, the government needs to make it financially attractive for investors to hold company shares for longer periods (that is, encourage investing over trading) and to take bigger stakes in companies. Together this would give investors an interest in making sure companies invest enough to maximise their competitive advantages and sufficient leverage to intervene if they fail to so; at present, ownership of listed British firms is highly dispersed, and shares are being held for shorter and shorter periods.

Britain’s biggest competitiveness problem is entirely home grown. Corporate governance is an unsexy and complex subject, and plenty of powerful interests have an incentive in prolonging the status quo. But if the government is serious about lifting investment rates, it cannot simply ignore the issue. If it does, its pleas for more long-term thinking and investment will start to ring hollow.

Simon Tilford is deputy director of the Centre for European Reform.

Ukraine: Edging towards the EU?

Ukraine, to its sorrow, has always been on the frontier between Russia and the rest of Europe. Its name even means “Borderlands”. For centuries it was partitioned between its neighbours. When it gained its independence from the collapsing Soviet Union it was politically and linguistically divided between the Ukrainian-speaking West and the Russian-speaking East. Many observers in the early 1990s expected it to fall apart sooner or later. The first line of its national anthem seemed grimly appropriate: "Ukraine has not yet died".

Twenty years on, its independence and national identity seem more solid, even if many Russian politicians, from President Vladimir Putin to his arch-opponent Aleksey Navalniy, still talk of Russians and Ukrainians as “one people”. But Ukraine, and the European Union, now face a moment of decision: will Ukraine be the Russosphere's border with the EU, or the Eurosphere's border with Russia?

Ukraine seemed for a long time to be dodging this choice: President Viktor Yanukovych tacked between Brussels and Moscow after his inauguration in 2010. Now, however, with the Vilnius Eastern Partnership Summit a month away, Ukraine seems to be turning decisively towards the EU – ironically, partly because of Moscow’s pressure on it (described in Charles Grant’s recent CER Insight 'Is Putin going soft?') to join the Russian-led Customs Union instead of signing an Association Agreement with the EU. Both government and opposition in Ukraine support closer integration with the EU, and opinion polls show that even in Russian-speaking eastern Ukraine there is a majority in favour of EU membership (though this is not on offer at this stage).

The deal is not yet done: the EU set a series of conditions for Ukraine to meet before the agreement could be signed. It has made some progress, for example on electoral reform, following EU criticism of the conduct of parliamentary elections in October 2012. The biggest obstacle remains, however: ending ‘selective justice’, and in particular pardoning former Prime Minister Yulia Tymoshenko, currently serving a seven-year sentence for abuse of office. Former Polish President Aleksander Kwasniewski and former European Parliament President Pat Cox have been working persistently on behalf of the European Parliament (where Tymoshenko has many supporters) to achieve this.

Up to now, this has remained too much for President Yanukovych to swallow. The Ukrainian government has a draft law prepared which would release her on humanitarian grounds and allow her to travel abroad for medical treatment; but it would not void her conviction. Yanukovych evidently still considers her a political threat, and hopes that his compromise offer will be enough for the EU. 

So far the EU has not blinked: Enlargement Commissioner Stefan Füle, Swedish Foreign Minister Carl Bildt and EP Foreign Affairs Committee Chair Elmar Brok all delivered the EU message to Yanukovych at the Yalta European Strategy meeting in September. The EP has extended the mandate of Kwasniewski and Cox for a few more weeks in the hope that they can still clear the way for Ukraine to sign the Association Agreement, which includes a Deep and Comprehensive Free Trade Agreement (DCFTA), in Vilnius. As an incentive, both the Parliament and the Council have supported provisional application of the trade aspects of the agreement as soon as possible after signature, prior to ratification.

Assuming that a solution is found, both Ukraine and the EU will face challenges in implementing the agreement and benefitting from it. For Ukraine, the immediate threat is that Russia will punish it for rejecting the Customs Union. Russia has repeatedly used gas deliveries to Ukraine and other neighbours as instruments of political pressure. When Deputy Prime Minister Dmitriy Rogozin recently warned the Moldovans against initialing their own Association Agreement with the EU, telling them that he hoped they would not freeze, Ukraine will have got the message.

Overall, Ukraine's trade is quite well balanced between Russia and the EU: in 2011, the last year for which WTO figures are available, 29 per cent of its exports went to Russia and 26 per cent to the EU; 35 per cent of its imports came from Russia and 31 per cent from the EU. But Ukraine is vulnerable to a Russian squeeze on its energy imports. Despite some domestic production, Ukraine relies on Russia for about 60 per cent of its gas; imports from other sources have historically been negligible. This year it has cut imports from Russia by about 30 per cent, and increased imports from Western and Central Europe (saving money in the process). Ukraine hopes to exploit its shale gas reserves (though international oil and gas majors have been slow to invest, deterred by the poor business climate). But in the short term, Russia can make life uncomfortable economically. It can also step up political pressure: Putin’s adviser Sergei Glazyev warned in September that Russia could no longer guarantee “Ukraine’s status as a state” if it signed the Association Agreement.

Russia's claim that it would need to take "defensive measures" against Ukrainian imports if Ukraine signed the Association Agreement is questionable. Suggestions either that EU goods will replace domestic production on the Ukrainian market, forcing Ukrainian goods onto Russia, or that EU agricultural products of dubious quality will reach Russia via Ukraine, seem fanciful. There is no reason why Russia could not continue to trade normally with neighbours who sign EU Association Agreements, rather than trying to force them inside the high and economically distorting tariff wall of the Customs Union. But Russia has so far paid more attention to geopolitics than economics in building its Customs Union. Ukrainian heavy industry might struggle to replace its markets in the former Soviet Union if Russia closed the door, but Russian customers would also suffer from the loss of familiar suppliers.

Whatever Russia does, Ukraine will have to accelerate its own reforms in order to benefit from the DCFTA. Research by the European Bank for Reconstruction and Development (EBRD) shows that among Eastern European states, Ukraine has made the least progress since 1989 in converging with the EU-15 in terms of GDP per capita. In the 33 countries in which the EBRD operates, real GDP has grown since 1989 by about 40 per cent; in Ukraine it is still almost 40 per cent below its 1989 level. The main reasons for this are weak institutions and rule of law; poor governance and high levels of corruption (in Transparency International's 2012 Corruption Perceptions Index, Ukraine was 144th - worse than Russia, Azerbaijan or Kazakhstan, among others); and a lack of modernisation in key sectors (for example steel and agricultural production). With or without an Association Agreement, Ukraine will have to tackle these problems if it wants to close the prosperity gap with the rest of Europe.

In addition, the Association Agreement will require Ukraine to incorporate several hundred EU directives into its domestic legislation, in areas from agriculture to transport. There are transitional periods of up to eight years for Kyiv to come fully into line with EU standards and regulations, but even so the capacity of Ukraine's public administration is likely to be stretched to its limit.

In the long run, meeting European standards will enable Ukraine to compete more effectively not only in EU markets but (perhaps even more importantly) in third countries. With some of the most fertile soil in Europe, for example, it should be well-placed to increase agricultural exports.

In the short term, however, there may be more pain than gain, even if the Russians refrain from imposing trade sanctions on Ukraine. Other countries in central Europe and the western Balkans going through a similar process of adjustment have had the incentive of eventual EU membership. This has spurred them to accept increased competition from the EU, and to invest political and economic resources in coming up to EU standards. But against a background of general enlargement fatigue and specific concern about Ukraine's size, poverty and institutional backwardness, and about the likely Russian response, support for offering Ukraine a membership perspective has been limited to a few central European countries. It may be objectively true, as the EU has often argued, that all the reforms sought by the EU are also in Ukraine's own long-term interest. But the political reality is that the downsides will be apparent sooner than the advantages. 

How much does it matter to the EU whether Ukraine leans west or east, or stays uncomfortably balanced between the two? It is the largest country with its territory wholly in Europe. But it lacks the hydrocarbons that have lured foreign investors to Azerbaijan, and the leaders of the Orange Revolution squandered the chance to join Georgia as darlings of the West with their dysfunctional, bickering rule. If Russia cares enough to want Ukraine in its camp, why not let it have it?

The EU could look at Ukraine in grand, geopolitical terms. The American statesman Zbigniew Brzezinski wrote in the early 1990s that "Russia can be either an empire or a democracy, but it cannot be both. ...Without Ukraine, Russia ceases to be an empire". But it would be a mistake for the EU to see Ukraine only through the prism of Russia.

Looked at in its own right, a prosperous Ukraine with functioning institutions and a modern economy would be a more attractive neighbour and partner than anything likely to emerge if it is left to its own devices, either joining the Customs Union or remaining in a no-man's land. 

Europe should therefore increase both its pressure on the Ukrainian government to reform and its practical support for the changes it seeks. Whatever their reservations about Yanukovych as an individual, European leaders should step up their engagement with him and his government. They should encourage Ukraine to make even more use of twinning arrangements and other forms of technical assistance offered by the European Commission to enable Ukraine to implement the necessary EU directives. They should maintain the Kwasniewski/Cox mission, which has proved its value over the last year as a means of strengthening the rule of law in Ukraine. Above all, they should offer Ukraine a membership perspective – certainly not in the short term, and with a list of reforms attached, but reflecting the fact that, for all its shortcomings in media freedom and rule of law, Ukraine has managed to remain a more or less democratic state for two decades. 

As they head for Vilnius, European leaders should remember that Tymoshenko and Yanukovych are not the only people in Ukraine who matter. And as he ponders how to respond to Kwasniewski and Cox, Yanukovych should remember it too. Forty-five million Ukrainians also have a stake in getting closer to the EU.

 Ian Bond is director of foreign policy at the Centre for European Reform.

Is Putin going soft?

'The Valdai Club' is an annual public relations exercise for the Russian leadership. A group of international think-tankers, academics and journalists gathers in a Russian region and then meets President Vladimir Putin and his senior ministers. This forum has not been particularly successful PR: in recent years much of the world’s press has written critically about the Kremlin. Last month, however, when the club gathered for the tenth time, by the shores of Lake Valdai in Northern Russia, some of the discussions were positive for Russia’s image.

Putin had a clear message for the outside world: Russia’s political system is starting to open up, at least at the local level. He also spoke gently about the US. Only on the fraught question of Russia’s relations with neighbouring Ukraine and Moldova did Putin appear – to a western audience – somewhat harsh.

What accounts for Putin’s softer approach to domestic politics and to Washington? Russia’s mounting economic problems, the opposition’s surprisingly strong showing in September’s local elections and the emerging US-Russian consensus over Syria’s chemical weapons are probably relevant.

In the final session of the Valdai Club, broadcast live on Russian TV, a relaxed and confident Putin sat on a panel with three European grandees: François Fillon (former French prime minister), Romano Prodi (former Italian prime minister) and Volker Rühe (former German defence minister). They urged him to listen to young Russian protestors and to take seriously ‘the responsibility to protect’ Syrians. In the audience were opposition leaders who questioned Putin on electoral fraud and the imprisonment of activists. He answered calmly that Russia was “on the way to democracy” and reminded everyone that the recent elections in Moscow, where Alexei Navalny scored 27 per cent, and in Yekaterinburg, where Yevgeny Roizman (another opposition politician) became mayor, had been free and fair.

Given Putin’s track record, one should treat his words with scepticism. But an earlier session with one of his chief advisers had surprised participants. “The trend for fair elections will be more pronounced; there will be more political competition in future”, said the adviser. “Yekaterinburg and Moscow were successes that should be repeated elsewhere.” The adviser urged opposition parties to focus on municipalities, hinting that it was too soon for them to win regional governorships or national elections. I asked opposition politicians what they made of all this. Vladimir Ryzhkov (a liberal) and Ilya Ponamarev (a leftist) told me that the Kremlin really had taken a new approach – though it could still use the courts to clobber anyone considered a threat.

One reason for this modest political opening may be the economic slowdown, which is likely to fuel unrest. Perhaps Putin and his advisers want to create channels for peaceful protest that they can control. Having grown at about 4 per cent a year in the previous three years, the Russian economy may not achieve 2 per cent growth in 2013, despite a favourable oil price. Foreigners and Russians are investing less. The brain drain and capital flight continue. The technocrats running the economy know that politics is holding it back. One former minister told the Valdai Club that “the keys to improving the economy are independent courts and the protection of property.” Investment would suffer so long as the courts remained subject to the whim of the executive, he said.

Putin and his ministers were uncharacteristically polite about Obama, welcoming co-operation with him over Syria’s chemical weapons. Yet very recently their relations with Washington had been toxic, with rows over the Syrian civil war, Russia’s granting of asylum to Edward Snowden and US plans for missile defence. Obama cancelled a summit that had been due in September.

The reasons for the Kremlin’s shift of tone towards the US are unclear. The Russians worry a lot about their citizens fighting in Syria and Afghanistan, and then returning to infect Russia’s Muslim regions with Islamic extremism. They want the Americans to help to manage the situation in both war-zones. Perhaps the Russians think they can be magnanimous to those who misread the Middle East: they always said that the Western response to the Arab spring was naïve, that Arab countries were incapable of democracy and that it would all end in tears. They feel vindicated by events in Egypt, Libya and Syria.

Notwithstanding the politeness, Putin’s entourage can still be hostile, if not paranoid towards the US. I asked one minister if NATO remained a threat to Russia’s security. “Of course, why else does it try to creep as close as possible to our borders?” he answered. “It has punished regimes it dislikes – Yugoslavia, Iraq and Libya – without any regard to the UN Security Council.” He accused NATO of deceiving Russia by enlarging after promising it would not (which is partly true) and said that Russia could not be a friend of NATO unless it renounced further enlargement.

Most Russians share this suspicion of NATO. And they believe that NATO wants to absorb Ukraine – though in fact that idea that has virtually no support in Kiev or the major western capitals. It is true that the EU hopes Ukraine will sign both a ‘deep and comprehensive free trade agreement’ and an ‘association agreement’ in Vilnius in November, as part of its ‘Eastern Partnership’. The EU also hopes that Moldova, Georgia and Armenia will sign similar deals. Putin wants to stop these countries signing as they could then not join the Customs Union established by Russia, Belarus and Kazakhstan. Putin is keen for the Customs Union to expand into much of the former Soviet Union and to evolve into a more powerful ‘Eurasian Union’.

Russia is using bully-boy tactics to prise countries away from the Eastern Partnership. In August it blocked imports from Ukraine for several days, saying this was a ‘dress rehearsal’ for the measures it would have to take if Kiev went with the EU. And it told the Moldovans that they would have their gas cut off, their exports blocked and their migrant workers expelled from Russia (Moldovan exports of wine to Russia were stopped in September, but the EU, to its credit, said that it would import an equivalent number of bottles). What the Russians told Armenia is unclear, but in September it decided to join the Customs Union rather than the Eastern Partnership. Countries in the EU have also been targeted by Russia: earlier this month, Lithuania – presumably because it is hosting the Vilnius summit – found its dairy products excluded from the Russian market for a week.

The Russians have genuine concerns about the Eastern Partnership, since it will affect their trade with their neighbours. Putin told the Valdai Club that EU goods would flood into the countries of the Eastern Partnership; Ukraine and Moldova would therefore have to dump the goods that they produced on the Russian market; and then Moscow would be forced to take protective action. The Russians may have a point that the EU should have made more effort to talk to them about the impact of the Eastern Partnership. Nevertheless Ukrainian and Moldovan participants in the Valdai Club reported that Russian bullying is damaging the appeal of the Customs Union in their countries. Armenia is a special case: it dare not cross Moscow, since only Russian troops prevent Azerbaijan from invading the territory of Nagorno-Karabakh, currently occupied by Armenian forces.

Besides Armenia, Russia cannot count any neighbour as a true friend. It has been slow to understand that ‘soft power’ – the appeal of a country’s social, economic and political system, and of its behaviour – may achieve as much as machismo. Russia’s leaders appear to see the value of treating the opposition, and possibly the Americans, with a little more courtesy. They should try the same with their neighbours.

Charles Grant is director of the CER. A different and shorter version of this article appeared in the print edition of the New Statesman of October 11th to 17th.

Eurozone recovery: The world is not enough

The end of the eurozone’s long recession has been met with relief by its policy-makers, with some jumping on the news to justify their management of the eurozone crisis. They argue that the eurozone economy is on the mend, and the recovery will gain momentum over the coming quarter. If they are right, then the outlook for the euro has indeed improved: faster growth will make it easier for countries to service their debt, bring down unemployment and help contain political populism. Unfortunately, their optimism is almost certainly misplaced. The basic problem is that the world cannot accommodate a Europe refashioned in Germany’s image.

Economists should always be wary of extrapolating from a period of exceptionally bad economic performance. Economies do recover, as the sudden jump in the UK’s growth rate over the course of 2013 shows. But there are reasons to doubt that the eurozone’s return to growth in the second quarter of 2013 (ending six consecutive quarters of contraction) is the start of an economic rebound strong enough to get on top of debt ratios and bring down unemployment.

First, so far the recovery is not worthy of the name. The eurozone expanded by just 0.3 per cent, and will have grown at best by a similar amount in the third quarter. At that pace it will take two and a half years for the eurozone to regain its pre-crisis size.

Second, the return to growth hardly vindicates the eurozone’s austerity strategy; growth in the second quarter was boosted by an easing of fiscal austerity. Investment did pick up marginally, bringing to a close eight consecutive quarterly declines. However, investment was still down almost 4 per cent compared with the previous year. Private consumption, meanwhile, was lower in the second quarter of 2013 than the first. The biggest contribution to growth came from net exports (growth of exports outpaced that of imports).

This is not the basis of a sustainable recovery. It is highly unlikely that fiscal policy will continue to make a positive contribution to growth beyond the third quarter of 2013. Many eurozone economies are falling behind on their deficit reduction targets, and will therefore come under pressure to tighten policy. Germany has indicated that it has no intention of imparting any fiscal stimulus, despite running a budget surplus and the German economy barely expanding (the Deutsches Institute für Wirtschaftsforschung, for example, expects growth of just 0.2 per cent in the third quarter). Fiscal policy may not act as a major drag on economic activity across the eurozone over the next few years but neither will it be a source of economic growth.

Net exports have kept the eurozone economy afloat. Between the trough of the crisis in the second quarter of 2009 and the second quarter of 2013, the eurozone economy expanded by 3 per cent. Over this period domestic demand fell by 0.7 per cent. Put another way, all the growth the eurozone enjoyed was dependent on demand generated outside of the currency union; without it the eurozone would have continued to shrink.

The result has been a big swing in the eurozone’s current account position. In 2008 the eurozone had a deficit of around €85 billion (less than 1 per cent of GDP); it is on course to have a surplus of close to 2.5 per cent of GDP in 2013. Eurozone policy-makers cite this shift as evidence of improved competitiveness. The truth is simpler: falling eurozone domestic demand hit demand for imports, whereas rising demand around the world boosted demand for eurozone exports.

It is a moot point whether the external surplus can continue rising. Leaving aside the fact that the eurozone is flouting its G20 commitments to prevent the growth of large trade imbalances, it is probably already hitting the limits of the possible. The eurozone is simply too big an economy for the rest the world to keep it afloat. A surplus of 2.5 per cent of eurozone GDP already comprises a big drag on the global economy, which the eurozone in turn is increasingly dependent upon.

Much of the growth in eurozone exports over the last ten years has come from emerging markets. For example, between 2002 and 2012 eurozone exports to China rose fourfold. But that growth has now slowed rapidly – over the first six months of 2013 exports to China were less than 1 per cent higher than a year earlier. It is a similar story with exports to Latin America and Central and Eastern Europe. The share of the eurozone’s total exports accounted for by the US and UK has fallen to less than a quarter, so modest economic recoveries in those two countries will not boost eurozone exports that much.

Nor will it be easy for eurozone economies to boost net exports by increasing their shares of global markets (or even maintain their shares of growing global trade volumes). Germany managed this from 2002 onwards, building up a huge external surplus in the process. But Germany had an undervalued real exchange rate – both relative to other members of the eurozone and relative to the rest of the world (because of the weakness of the euro). The euro remained weak because Germany’s surplus was offset by the deficits of the other member-states. That is now changing as all eurozone economies have current account surpluses or are close to having them. An economy with a big trade surplus tends to experience currency appreciation, because demand for its currency outstrips the supply of it. Eurozone policy-makers bemoan the strength of the euro, but it is a product of their strategy. A strong euro will hit demand for eurozone exports, especially the more price sensitive ones of the southern European member-states.

Rising exports are not going to trigger a substantial recovery in investment demand and hence employment and consumption. True, some rebound in investment is inevitable. Economic recoveries tend to be driven by investment because it falls by more than any other component of GDP in a recession. The eurozone is no exception: investment is down around 20 per cent relative to the pre-crisis period. Machinery and equipment will wear out and need to be replaced. Some firms will get round to making the investment which they had put on ice. But there is little chance of spending returning to pre-crisis levels in the foreseeable future for a number of reasons.

First, a big recovery in investment across the eurozone requires debt relief for the struggling member-states. Relief will happen but it will inevitably be drawn out. The strategy towards Greece gives a good indication of how the issue is likely to be managed. Policy-makers will eschew the big write-offs that could kick-start a recovery in confidence, preferring instead to lengthen pay-back periods. One reason for this is that much of the debt is now held by public institutions; it is much harder to write-off debt when it is tax-payers rather than private investors who face losses.

Second, the weakness of bank balance sheets means that credit is expensive and scarce; eurozone bank loans were down almost 4 per cent in August compared to a year earlier, and by much more in the hardest-hit economies. Banks will remain undercapitalised and confidence in them weak due to the likely failure to put in place a sufficient pan-eurozone fiscal backstop.

Moreover, even if the eurozone were to move aggressively to reduce the debts of the struggling member-states and to recapitalise their banks, investment is unlikely to rebound to pre-crisis levels, because some of the investment in the south and elsewhere was unsustainable. For investment to return to pre-crisis levels over the eurozone as a whole, it must rise in Germany. But there is no indication of this happening. In the second quarter of 2013, German investment was still 5 per cent lower than five years ago, and lower as a proportion of GDP than 10 years ago.

A rebound in private consumption requires a mixture of lower unemployment, rising real wages and a fall in the proportion of household income saved. In light of the weakness of investment, it is hardly surprising that unemployment remains high across the eurozone as a whole. Against a backdrop of exceptionally weak domestic demand, the bargaining power of labour is feeble and real incomes are under pressure; small gains in Germany are being more than offset by falls elsewhere in the currency union. Wage restraint could price people back into work, as it did in Germany. But if Germany is anything to go by, that will have little impact on consumption or investment. Private consumption fell from 59 per cent of German GDP in 2002 to 56 per cent in 2012. It is now growing but not by enough to raise its proportion of GDP. With the language of austerity still dominating politics, and public services being cut in most eurozone economies, it is hardly surprising that households are reluctant to spend money.

Implicitly or explicitly, Germany is the benchmark for the eurozone. Its experience should worry advocates of the current strategy. German policy-makers like to argue that domestic demand is now contributing as much to economic growth as net exports. But net exports are still positive, which means the country is becoming more, not less, dependent on foreign demand. And although domestic demand is expanding, it is doing so at an anaemic pace. Unlike Germany, the eurozone will not be able to rely on an undervalued currency and net exports to boost economic growth.

The eurozone needs policies suited to a large continental economy which cannot rely on exports for economic growth. First, countries with large trade surpluses should not be allowed to tighten fiscal policy; instead they should be trying to boost demand and rebalance their economies. The European Commission should be as concerned about excessively low wage growth and large structural trade surpluses as it is about excessive rapid wage growth and trade deficits. Second, the institutional fault lines cannot be fudged indefinitely. The eurozone does not need to become the United States of Europe, with a large federal budget and fiscal transfers of the kind present within existing member-states of the EU. This would be politically impossible and of uncertain economic merit. But it does need a functioning banking system. And member-states’ debt burdens have to be reduced to a level which are consistent with a return to sustained economic growth. The end of the eurozone’s recession may do more harm than good if it emboldens policy-makers to persevere with the current strategy.

Simon Tilford is deputy director of the Centre for European Reform.

What would a Brexit mean for EU competition policy?

The debate over Britain’s future in the EU has to date failed to highlight the threat posed to EU competition policy and enforcement, which both play a critical role in underpinning the single market. Yet a British exit from the EU could have important repercussions for competition policy.

Several dangers present themselves. The first is the risk that the ground-rules for EU competition policy could be weakened in any future treaty renegotiation without the British at the table. Secondly, even absent such an explicit renegotiation, removing Britain’s input into policy and enforcement might encourage some drift in the way existing rules are applied. Thirdly, and regardless of the possibility of renegotiation or drift, there would be heavy additional costs for both government and for business. Lastly, a British exit could harm the global dialogue between competition authorities.

The threat of a tectonic shift in competition policy if the UK left the EU cannot be ruled out. It was, after all, the UK that led the counter-attack against President Sarkozy’s attempts to demote the principle of “undistorted competition” during the 2007 negotiations that led to the Lisbon treaty. Some crafty drafting in a new protocol, added to the Treaty at Britain’s behest, somehow did enough to allow the European Commission to maintain that nothing had changed. But the Sarkozy tendency, present even before today’s economic crisis, is far from a spent force: the forces of protectionism are alive and well, in France and elsewhere. A future treaty renegotiation could witness renewed calls to promote European champions, protect strategic national industries and slacken state aid disciplines.

Even without a change in the ground rules, a British exit from the EU might still weaken EU competition policy. National competition authorities together form the European Competition Network (ECN). The ECN co-ordinates policy with the European Commission, and national authorities are consulted on individual decisions via an advisory committee. The UK is an active voice in all these fora. Over time, Britain’s absence from them would probably lead to policy drift, as other voices became more prominent in the debate. British companies active across Europe would remain subject to EU competition rules, regardless of Brexit. But the UK would have voted itself off the committee that sets and applies the rules.

A British exit from the EU would also impose instant additional costs. Since Britain would no longer be part of the one-stop shop for reviewing mergers, these would need to be separately reviewed by the UK’s future Competition and Markets Authority (CMA). This would place extra costs on businesses, as well as an increased burden on the CMA, which would need more staff (and a budget to match). The same would apply to action against cartels and cases involving abuses of dominant market positions: complainants and defendants would have to meet in an additional and unnecessary forum. Of course, the UK could, like Norway, allow the Commission in Brussels to adjudicate on its cases. But with no British officials left in the Commission, and with policy possibly veering away from the UK’s attachment to free competition, this seems unlikely.

Finally, a British exit from the EU could harm the dialogue between competition authorities. Competition laws have proliferated around the globe. When the UK joined the EEC in 1973, there were only a handful of active jurisdictions, with the US far out in the lead, both in policy thinking and in enforcement. Today’s club of anti-trust authorities, the International Competition Network (ICN), counts members from 111 countries. Chinese policy is now a major pre-occupation, with India’s new law also starting to be felt. The spreading burden of compliance should bring its own reward, with markets becoming more open and competitive around the globe. But aligning these systems is also becoming a real challenge. The EU has been a key mover in the ICN, and has long since been recognised as a twin motor of global anti-trust action and advocacy alongside the US. Indeed, in recent years the EU has been much the more vigorous enforcer of the two. But a British exit from the EU would weaken the EU’s standing in the international anti-trust dialogue, and exclude the UK from the collective clout that goes with being part of the EU. It would also deprive the US of an interlocutor within the EU camp that shares its common law heritage. Worse, if the EU falls prey to protectionism, there could be more fundamental damage to the dynamic of anti-trust enforcement around the globe.

Competition policy in Europe has always been about more than just free competition: it also serves the goal of breaking down barriers between countries. Single market legislation removes legislative barriers, and competition policy ensures that firms do not erect private barriers in their place. Believers in the single market should pause to reflect whether the UK is better on the inside of EU competition policy, or on the outside looking in.

Alec Burnside is Managing Partner in the Brussels office of Cadwalader, Wickersham & Taft LLP.

Division and indecision over Syria

The deal on chemical weapons reached by Russia and the United States marks the latest chapter in the West’s effort to stay out of Syria’s civil war. After Russia’s diplomatic initiative, a military strike has been avoided. The White House says that diplomacy backed by a credible military threat has succeeded, and European leaders claim that their appeal for a UN process was heard. Obama’s wish to avoid military solutions may have created new momentum for negotiations with Iran. But this moment of jubilation could be short-lived: a daunting task at the UN awaits; military action may still be needed; and transatlantic cohesion has been damaged.

For more than two years, US and European governments have successfully navigated developments that could otherwise have formed a casus belli and led to Western entanglement in Syria. In the summer of 2012, the Syrian military shot down a Turkish air force jet, and was accused by Ankara of lobbing mortars over the Turkish-Syrian border and staging car bombings in southern Turkish towns. The attack on a NATO member-state could have triggered military action against Syria, but instead the alliance showed restraint and sent German, Dutch and US air defence batteries to southern Turkey.

In November 2012, France and the UK – followed a month later by the US  –  stated that President Assad no longer represented the Syrian people, but no action was taken to force a change of regime. The US and Europe have also long resisted arming the rebel groups. When it became clear in early 2013 that Assad was winning, the European Union – under French and British leadership – and the United States lifted the arms embargo. But the subsequent flow of arms to rebels has been limited, reflecting concerns that the weapons might end up with Al Qaeda affiliates. The US, UK and France have been providing jeeps and communications technology, and possibly small arms, but most heavier material, mortars and anti-tank weapons, are sent by Qatar and Saudi Arabia.

The aftermath of the chemical weapons attack on August 21st is the closest the US and its allies have come to military intervention in Syria. If it were not for the use of poison gas, the US and others would have remained on the side-lines, but moral imperatives and presidential credibility required action, however reluctant. European division and US foot-dragging followed.

What makes the current crisis so uncomfortable and damaging for the West is that it is largely self-inflicted; Obama’s red lines on the use of chemical weapons, when crossed, forced his hand. European divisions have made matters worse, particularly when Britain’s prime minister David Cameron – initially in favour of a strike – deferred to the House of Commons and lost, while the French president remained committed to military action. Without a united Franco-British front, Germany, the Netherlands and others continued to prevaricate and say they had not been asked to support a military strike, or – like Poland – did not have relevant military capabilities. Other European states, including Italy, Spain and Belgium, believed the UN should act. Only Denmark backed the French.

Meanwhile, more than two weeks of intense diplomacy passed before the EU’s High Representative Catherine Ashton was able to forge a common European position. A carefully-worded statement agreed on September 7th said that “a clear and strong response is crucial” to the poison gas attack, but it fell short of calling for military action. Instead it urged the Security Council to push for a political solution.

A divided West was inching towards a military intervention for which there was little political appetite and even less public support. President Putin’s initiative to get rid of Syria’s chemical weapons could be the ‘deus ex machina’ to avoid an unwanted military campaign.

While it is impossible to know for sure, Putin’s diplomacy may be informed by the fear that any US military involvement could decisively turn the tables on Assad. A shift in the military balance would cause Moscow to lose an ally in the region and perhaps its Mediterranean naval base, but Putin’s support for Assad is fuelled by the concern that Al Qaeda-linked groups might take over in Syria and could eventually spread to Russia.

In spite of comments by President Obama that a strike would be limited – or in Secretary Kerry’s words “unbelievably small” – any military action has unpredictable consequences. A strike was meant to ‘deter and degrade’ Assad’s capability to use chemical weapons. The US was aiming for a ‘Goldilocks’ intervention; too soft, and it would only be a symbolic punishment; too hard, and it might topple Assad, strengthening jihadist rebel groups. But reality is never so straightforward, and the adversary always has a vote in a conflict. Assad could make life difficult for any US-led coalition, for instance by using chemical weapons again; placing human shields around potential targets; or using Syrian-sponsored Hezbollah to strike Western assets or Israel. US credibility would then demand further escalation. By regaining diplomatic momentum, Putin was able to protect his interests, and his client in Damascus. Whatever the outcome, Moscow will have bought time for Assad, and Russia will step up its arms shipments to Syria, hoping to tilt the military balance in favour of Assad. The US, UK and France should consider balancing this by increasing their efforts to arm moderate rebels.

The agreement between Russia and the US will have to be enshrined in a UN Security Council resolution. France, the US and UK prefer a resolution under chapter 7 of the UN charter, which could allow the use of force in the event of non-compliance. But Russia has said an explicit reference to military action is unacceptable.

If the Russians stand firm, Obama will face a choice between a resolution without ‘teeth’, or circumventing the gridlocked Security Council. In the first case, the Russians and the Syrian regime will claim that UN-backed military enforcement is off the table; and Obama will be criticised by US hawks in Congress for weakness. But the outcome could be more ambiguous. During the Iraq crisis ten years ago, the UN Security Council adopted resolution 1441, pushing Iraq to fulfil its disarmament obligations. It was adopted under chapter 7, but did not explicitly mention the use of force. The Security Council could pass a similar resolution now.

Washington and Moscow have an interest in agreeing a resolution because the alternatives are less palatable. But given the distance between the Russian and US positions, a face-saving compromise would leave the enforcement mechanism deliberately vague. In 2003, as Saddam Hussein continued to defy the UN weapons inspectors, this clause – and its lack of specificity – became the focus of a dispute in the Security Council. Unfortunately, a similar resolution on Syria will sow the seeds for future US-Russian disagreement. The technical obstacles associated with a verification mechanism in a war zone are plentiful, and if Syria breached the resolution, a fractured West could still end up being drawn into the conflict.

Nevertheless, if a resolution is adopted and the Syrians carry out their side of the bargain, this may do more than just prevent Syria’s future use of chemical weapons. Iran’s new moderate president, Hassan Rouhani – strengthened by a policy of US restraint in Syria – has signalled a willingness to talk to Obama. This positive momentum offers the best hope for some time to move diplomacy on Iran’s nuclear programme forward, and should be embraced by the US and Europe.

Progress on chemical weapons could also create some momentum for a general ceasefire and the start of a peace process. The EU ought to be able to unite around this goal, at least. It should now start working with Russia, the US, Iran as well as the groups in Syria to get the Geneva 2 negotiations underway in the hope of moving towards a political solution.

A stalemate at the UN would be damaging; Putin could say he produced an olive branch that the US was unwilling to accept, and paint Obama as a warmonger; while members of Obama’s own party and isolationist Republicans will accuse him of risking US entanglement in another war. The EU would find itself in an uncomfortable position. Fundamental to the EU’s foreign policy is support for international norms, of which the prohibition on chemical weapons is one (the 2003 EU security strategy describes the proliferation of weapons of mass destruction as “potentially the greatest threat to our security”) and support for the United Nations is another. These conflicting norms would ensure that Europe remained divided.

The worst option for US credibility is if a resolution is not agreed and the United States shies away from military action. Credibility is an important currency in international relations. It would be seen as a victory in Damascus, Tehran and Moscow, it would sap the morale of Syria’s rebels and it would send a message that the use of chemical weapons may go unpunished. It would make Israel and Saudi Arabia uncertain about US assistance on Iran’s nuclear programme. Pyongyang’s hand would be strengthened, and among allies in the Asia-Pacific – where US security guarantees are considered crucial to check the rise of China – signs of US weakness would make leaders nervous. Western impotence in Syria will reduce America’s – and by extension the West’s – international standing, strengthening those that believe Western decline creates opportunities to expand their influence.

Deal or no deal, the crisis has negatively affected transatlantic relations. In 2011, then-Secretary of Defense Robert Gates complained publicly that Europe was not equitably sharing the burden of military risks and expenses. Not much has improved since then. In Libya, eight out of twenty-eight NATO allies participated in the bombing phase of the air campaign. Now an even smaller number of Europeans would stand by the US. Washington has not drawn upon NATO’s command headquarters or common surveillance assets (as happened in Libya) or even mentioned NATO. The US probably wanted to avoid bringing Europe’s division into the North Atlantic Council, where unanimous support would be needed. While much has been made of the US rebalance towards Asia and the consequent need for Europe to bear a greater burden for security in its neighbourhood, most of Europe is still passing the buck to Washington. Once again, the US and Russia get to sort out a security issue in Europe’s neighbourhood without Europe being at the table.

Rem Korteweg is a senior research fellow at the Centre for European Reform.