Germany’s plans for treaty change – and what they mean for Britain

Last year, German leaders talked of the need to strengthen the eurozone through changing the EU’s treaties. One person who listened carefully was David Cameron. The British prime minister may have assumed that what Germany wants in the EU these days, it gets. When he made a big speech on Europe in January, Cameron predicted that the EU would need a new treaty in the next few years. He implied that Britain would be able to extract concessions from its partners, in return for signing the treaty – all in time for the referendum on UK membership that he promised in 2017.

But Cameron’s strategy is based on a false premise. The mood has changed in Berlin. Recent meetings there with government officials and politicians have convinced me that Germany will not push for the kind of treaty that Cameron wants, at least not in time for his 2017 deadline.

The Germans, it is true, are keener on treaty change than most of their European partners. When they encounter a problem, they look to contracts, laws and treaties, rather than to political fixes. And they may have a preference for treaty change rather than mere legislation, since politicians can easily change the latter. German officials also worry about the constitutional court in Karlsruhe, which has expressed concern about some steps taken by the EU to manage the eurozone crisis. The court could block further moves unless they are backed by new treaty articles.

In Berlin people talk about two sorts of treaty change – big and little. Proponents of a big new treaty want it to establish a ‘political union’. The first step would be a ‘convention on the future of Europe’, including MEPs and national parliamentarians, of the sort that met in 2001-03, before the drafting of the constitutional treaty. The second step would be an inter-governmental conference to draw up a treaty introducing changes like more power for the European Parliament, direct elections for the Commission president and tighter co-ordination of economic policy. Guido Westerwelle, the foreign minister, and Wolfgang Schäuble, the finance minister, have at various times supported big treaty change. Some Bundestag members and Foreign Ministry officials share their federalist sentiments.

But Chancellor Angela Merkel is in overall charge of EU policy. And she told a conference of the Trilateral Commission in Berlin on March 15th that Europe does not need a major new treaty in order to become competitive. She and much of her government have cooled on the idea of big treaty change for four reasons.

First, the government thinks – notwithstanding the imbroglio in Cyprus – that the eurozone crisis is more or less under control. The risk of the currency union breaking up has receded, and with it the need for dramatic moves towards greater integration. Second, the Germans understand Cameron’s tactic of using treaty change as a tool for extracting concessions from Britain’s partners, and they have no desire to give him that leverage.

Third, France and most other member-states do not want a big new treaty. They worry about the difficulties of ratification: some, such as Ireland and perhaps France, would have to hold referendums. The Germans have listened. As one German official commented: “If we embark on another major EU treaty, it could take us about ten years to get the whole thing negotiated and ratified, just like it did with the Lisbon treaty.”

Fourth, the more that some Germans have thought about political union, the more wary they have become. French officials often make the point that the Germans can easily enthuse about political union because they have never had to define precisely what it means. But if EU leaders sat down to draft a text for political union, the Germans would have to acknowledge that greater economic and political integration would cost them money, whether through a eurozone budget, eurobonds or some other mechanism for helping poorer countries.

Even if Germany’s general election in September produces a new coalition, there is little chance that any German government will pursue big treaty change in the foreseeable future. However, many German officials want minor amendments.

In the Chancellery they are keen on changing one or two articles that would allow stronger co-ordination of economic policies. They want to give the old ‘Lisbon agenda’ of economic reform – which ran from 2000 to 2010, with only limited success – some teeth. Their proposed mechanism is a system of economic contracts between particular member-states and the EU. After a dialogue between the government and parliament of the country concerned, and the Commission, the member-state would commit to certain reforms – for example of labour markets or pension systems – in a contract. Discipline would come through penalties for non-compliance, or rewards for good performance, perhaps via a eurozone budget. German officials acknowledge that such economic contracts could be drawn up under the existing treaties, but reckon that either penalties or a eurozone budget would require them to be amended.

In the German Finance Ministry, officials are unenthusiastic about the contracts, but supportive of a different treaty change. They worry that the board of the European Central Bank will be responsible for both monetary policy and banking supervision, and could therefore face a conflict of interest. So they want a new article to entrench the independence of the supervisory system (most other member-states think that legislation can ensure the necessary independence).

Until recently, German officials wanted a minor treaty change to strengthen fiscal discipline. They liked the Dutch idea for a ‘super-commissioner’ with the power to tell national governments to amend budgets. But German officials now realise that tighter budgetary rules than those already set out in the fiscal compact treaty and in recent EU legislation would be unacceptable to many member-states. Furthermore, German attitudes are shifting slightly: though most officials still support strict budgetary targets, they now place a greater emphasis on structural reform as the best way to put the eurozone on a sustainable footing. So they have dropped the idea of a treaty change to enforce greater fiscal discipline.

Some Berlin officials think that a small treaty change to cover economic contracts could be pushed through quickly, without a cumbersome convention, but others disagree. The current treaties allow amendments to be made without a convention in two ways. First, through the ‘simplified procedure’, which cannot be used for changes that increase the EU’s competences. A new article on economic contracts might increase those competences. Second, through the ‘ordinary procedure’. This normally involves calling a convention, but need not if the European Parliament deems it unnecessary. Two recent changes to the EU treaties – to enable the creation of the European Stability Mechanism (the bail-out fund), and to alter the number of MEPs – used the ordinary procedure without a convention. However, the Parliament would probably be unwilling to waive through economic contracts without a convention, given its current support for big treaty change.

Some German officials are quite relaxed about the prospect of a convention. They believe that the European Council would give the convention a specific and limited mandate, to discourage it from attempting to rewrite all the existing treaties. And even if the convention exceeded its mandate, they say, the governments could ignore any unpalatable proposals when, after the convention, they meet in an inter-governmental conference.

Though some German officials are eager for the EU to amend the treaties to underpin economic contracts, they are pessimistic about their ability to persuade the French to agree. The French say that they would not accept the contracts – which they consider unnecessary – without other amendments, for example to allow the mutualisation of sovereign debt, which Germany would balk at. The context for this bargaining is that, as one German official put it, “in more than 20 years of working on Franco-German relations, I have never seen them in such a bad state”. Other countries, too, could seek to balance German demands by asking for new articles that could trouble Germany. So German officials are resigned to the eurozone muddling along without treaty changes for the next few years.

It is possible that at some point France and the other member-states will give the German government the small treaty change it desires. But that would still not solve Cameron’s problem. If the British government wished to, it could probably block a major revision of the EU treaties; the others would find it very hard to bypass a British veto. But if Britain’s partners wanted to change just one or two articles affecting eurozone governance, they could probably get round a British veto as they did in December 2011, when 25 member-states committed to the fiscal compact that was technically not an EU treaty.

If a future Conservative government wanted to renegotiate the treaties, and the other member-states did not, it could not force them to open an inter-governmental conference. The calling of such a conference requires a simple majority – and any ensuing treaty changes would have to be ratified by every member-state. In practice the only option available to Britain would be to activate the Lisbon treaty article that allows a country to quit the EU. That would lead to a negotiation that could, conceivably, conclude with the UK and its partners agreeing on changes that would leave the British inside the EU.

Evidently, moods can change quickly in the EU. A profound crisis in the eurozone could revive talk of a quantum leap towards political union. A new German government could push more forcefully for treaty change than the current one. If France fell into severe difficulties it could become less resistant to German pressure for treaty amendments. And the European Parliament to be elected in May 2014 will certainly – alongside the Commission – press for a federal future. But on current trends, David Cameron will be denied the major treaty change that he seems to be counting on.

Charles Grant is director of the Centre for European Reform

Could Cyprus reignite the eurozone crisis?

Each of the crisis-hit eurozone countries shares some responsibility for its predicament. Italy used membership of the single currency as an excuse to go slow on pushing through much-needed structural reforms of its economy. The Irish and Spanish were excessively relaxed about their booming housing markets. Greece and Portugal were simply not sufficiently converged with the rest of the eurozone to be able to flourish within it; they should not have applied to join or been allowed in. At the same time, all were to a greater or lesser extent victims of the structure of the currency union and the tardy response of its member-states.

But Cyprus is different. The country really is the architect of its own misfortune. This makes finding a workable solution to the crisis even more difficult, and explains why a country with a population of around 1 million could pose a systemic threat to a currency union of 400 million.

How did Cyprus get into this mess in the first place? The answer is that it managed to combine all the excesses of every other European country. Cyprus was Spain, Ireland, Iceland, and Greece rolled into one – but with a Russian twist. Like Spain, it ran large current-account deficits. Like Spain and Ireland, it experienced a real estate bubble. Like Ireland and Iceland, it developed a runaway banking system (with assets reaching 800 per cent of GDP). As in Greece, the public finances were mismanaged. And as in Iceland, the sovereign could not afford to rescue insolvent banks. The twist is that Cyprus achieved all of this while offering high interest bank accounts to non-resident ‘residents’ – mostly wealthy Russians. So Cypriot bank liabilities consisted primarily of deposits, rather than bonded debt.

Ever since the eurozone crisis flared up in late 2009, the politics of crisis management have been marked by the conflicting perspectives of creditor and debtor countries. The same has been true of the Cyprus crisis. Given the sheer accumulation of Cypriot sins, the desire of creditor countries to draw a line in the sand over moral hazard is understandable, not least because of domestic political constraints: it would be impossible for political leaders in other eurozone countries to explain to taxpayers at home why they should have to honour commitments made by Cypriot banks to wealthy Russians. Even so, the terms of the proposed bail out of Cyprus were badly designed. In effect, policy-makers brandished threats that undermined much of what they have spent the past year trying to achieve.

Broadly-speaking, the deal agreed on March 15th looked like this. The Cypriot sovereign would be bailed out by the eurozone, provided it agreed to ‘bail in’ the creditors of its banks. Since Cypriot banks mostly funded themselves from deposits rather than by issuing debt, this meant that depositors in Cypriot banks would have to take a haircut. The precise form of that haircut would be for the Cypriots to decide. But if they refused to play ball, no bail out would be forthcoming – and Cypriot banks would not qualify for ECB funding under its Emergency Liquidity Assistance (ELA) programme. The result: Cyprus would default and its banking system would collapse. Faced with this choice, Cyprus agreed to ‘bail in’ bank depositors. It announced a 9.9 per cent tax on deposits over €100,000 and a 6.75 per cent tax on deposits under €100,000.

By March 18th, however, the deal was already beginning to unravel under the weight of its contradictions. Several problems had become apparent. First, the Cypriot tax cast doubt over commitments under EU law to guarantee deposits up to €100,000. Second, the Cypriot tax seemed to subordinate the interests of ordinary depositors to those of bondholders. Third, the deal seemed to be at odds with broader attempts to build a banking system in which investors, rather than taxpayers, pay for banks’ mistakes. Fourth, the deal did not ‘bail in’ creditors of the banks in the framework of an orderly bank resolution procedure. Fifth, the ECB’s threats to cut off emergency funding to Cypriot banks cast doubt upon its willingness to do “all that it takes” to save the euro (or to keep a country in it). Finally, the bail-out highlighted some of the design flaws of the currency union that have still not been resolved.

Where does this leave Cyprus? The Cypriot authorities appear to believe that it is still possible for Cyprus to remain in the eurozone while retaining the country’s offshore banking model. It is not. The only hope the Cypriots have of staying in the currency union is to impose much larger losses on their foreign depositors. These creditors knew what they were doing when they deposited money with Cypriot banks, and the investment has proven highly profitable for them. Only by forcing much larger losses onto foreign creditors can the Cypriots have any hope of raising their share of the costs of the bail-out, and of defusing the understandable anger felt elsewhere in the eurozone at the prospect of tax-payers’ money being used to bail-out Russian oligarchs.

In exchange for forcing the Russians and other foreign creditors to finance more of the cost of the clean-up, it is possible (though far from a foregone conclusion) that the rest of the eurozone could increase the amount of money it is prepared to contribute to the bail-out. Any attempt by Cyprus to raise the necessary funds by imposing haircuts on domestic bank deposits or attempting to borrow the needed funds against future revenue streams from offshore gas or privatisations will end in failure. First, the needed sums of money are simply too big in the context of an economy as small as the Cypriot one. Second, the Russians need to be seen to be taking a big hit if other eurozone countries are to be able to persuade their reluctant electorates to come up with more money for Cyprus.

Where does this leave the rest of the eurozone? If the Cypriots fail to impose the lion’s share of the costs onto foreign creditors, some eurozone governments (not least the German one) could face insurmountable political obstacles to a bail-out of the country.  However, if Cyprus imposes a big haircut on large (mostly foreign) creditors, the rest of the eurozone would have more political wiggle room, possibly opening the way for a workable deal. If not, the outcome will be an uncontrolled default. Cyprus would not necessarily have to leave the currency union, but in reality would probably have little choice because the Cypriot central bank would need to print money in order to keep the country’s banking sector afloat.

So far, financial markets have taken the latest crisis in their stride, suggesting that they do indeed see Cyprus as a special case. But the ramifications of an uncontrolled default and/or exit from the currency union could still be far-reaching. In such an event, investors could conclude that the membership of other indebted member-states cannot be taken for granted, igniting a fresh wave of capital flight from the periphery which may be difficult to control.


Simon Tilford is chief economist and Philip Whyte is senior research fellow at the Centre for European Reform

Two cheers for Beppe Grillo

The Achilles heel of the euro has always been democracy. Although the euro is unlikely to break up, that risk cannot be entirely excluded: one day, voters may choose a government committed to policies that are incompatible with the conditions set by Europe’s leaders for membership of the single currency.

Democracy in the eurozone suffers from a structural problem and a policy problem. The structural problem is that the new rules agreed since the euro crisis began – including the ‘six pack’, the ‘two pack’ and the fiscal compact – have deprived national parliaments of the freedom to set the budgets which they believe are best for their country. The European Commission and other eurozone governments can now order a national government to revise its budget.

The policy problem is that the particular prescriptions pushed by eurozone governments, the Commission and the European Central Bank (ECB) – all dominated by German thinking – have exacerbated the debt problems of southern Europe, including in Italy. So long as the southern European economies shrink or fail to grow, subjecting many people to considerable pain, the EU and its leaders are going to be unpopular in those countries.

There is no silver bullet that can instantly revive growth in the eurozone’s periphery, but the EU’s current emphasis on austerity is condemning these countries to further stagnation. And so long as that endures, the risk of populist revolts against EU-driven policies will be permanent.

The strong showing for Beppe Grillo’s Five Star Movement in the Italian election shows that voters wanted to kick Italy’s corrupt and incompetent political class. But the fact that Grillo and Silvio Berlusconi between them won 56 per cent of the votes also signals a rejection of the austerity policies that Prime Minister Mario Monti and eurozone leaders prescribed for Italy. Both Grillo and Berlusconi made a point of criticising excessive austerity during the campaign.

Monti, who restored some sobriety to the governance of Italy and pushed through long-needed reforms, such as those to labour markets, is an admirable figure. Neither the ethically-challenged Berlusconi nor the flippant Grillo are inspiring leaders. Peer Steinbrück, the German Social Democrats’ chancellor candidate, may have been offensive when he said that the Italians had voted for two clowns, but he was not inaccurate. Nevertheless, Grillo, Berlusconi and those who voted for them had a point.

Italian borrowing costs came down following Monti’s election, as investors hoped that this would open the way for concessions from the German government. However, once it became clear that it would not, and that austerity was pushing the Italian economy deeper into slump, borrowing costs rose back to record (or very close to) record levels.

Of course, Italy’s problem of low growth preceded the formation of the Monti government: it has grown more slowly than all the other members of the euro since 1999. But fiscal austerity, which increased when Monti came into office, proved self-defeating. The economy shrunk by 0.8 per cent in the final three months of 2012, the sixth consecutive quarterly decline. It slumped by 2.2 per cent in 2012 as a whole and is now around 8 per cent smaller than it was prior to the onset of the financial crisis.  Despite running only modest deficits, Italy’s debt burden has been rising: the ratio of public debt to GDP moved from 103 per cent in 2007 to an estimated 128 per cent at the end of 2012.

Sadly, voters now associate structural reforms with slump, rising unemployment and social stress. The Berlin-Brussels-Frankfurt consensus on austerity implemented by the Monti government – and to some degree, the preceding Berlusconi government –  has discredited the very reforms that are needed to boost the performance of the Italian economy.

Of course, austerity alone is not responsible for the weakness of Italy’s economy; the lack of structural reform since the start of the euro in 1999 has contributed to a very weak record on productivity and thus growth. But as the IMF observed last November, the tightening of fiscal policy by eurozone governments (including Italy’s) has been excessive given the weakness of private sector demand. The tightening depressed an already fragile Italian economy and made it harder to consolidate the public finances. This is what Keynes meant by the paradox of thrift: if everyone spends less and saves more, everyone will become poorer (across much of Europe, citizens and especially companies are taking demand out of the economy by sitting on cash rather than spending it).

The implications of Italy’s elections for the eurozone will depend to a large extent on how the Commission, the ECB and the German government respond. They could react by acknowledging that their strategy for combating the eurozone crisis needs recalibrating. They could agree that the pace of fiscal consolidation in the eurozone periphery and France should be slowed, that Germany should embark on a fiscal stimulus and that the way should be opened for the ECB to cut interest rates and launch quantitative easing. Such shifts could help to prevent the further radicalisation of Italian politics and enable an Italian government – perhaps following another election – to sell structural reforms to the Italian electorate. 

However, if the Commission, the ECB and the German government respond to the election by saying, to quote Margaret Thatcher, “there is no alternative”, they will be laying the foundations for future and increasingly serious crises. Such an inflexible response would almost certainly undermine Italy’s already weakened mainstream and pro-EU political forces. And that, in turn, would almost certainly preclude the construction of an Italian government that was willing and able to push through structural reforms and fiscal consolidation. Politicians and voters in other southern European countries would take note.

Eurozone policy-makers had become strikingly complacent about the eurozone in recent months, with some going so far as to claim that the crisis was over. Although the spread between southern European government bonds and German bunds had fallen, helping to create an atmosphere of confidence, that did not reflect a revival of the problematic countries’ economies or the readiness of governments to address the eurozone’s weaknesses. Indeed, the economic situation in the peripheral economies has worsened rapidly since last summer, as have their debt burdens. Eurozone governments have agreed to place responsibility for supervising the region’s biggest banks in the hands of the ECB, but they are no closer to agreeing to mutualise risk by establishing a joint eurozone back-stop for their banks or by launching eurobonds.  

Borrowing costs fell steeply in the autumn of 2012 after the ECB announced it was ready to buy potentially unlimited amounts of peripheral country government debt (through ‘Outright Monetary Transactions’, or OMTs). This went a long way to dispelling the break-up risk that had caused borrowing costs across the periphery to balloon. But the OMTs always involved an element of bluff: for the ECB to commence bond-buying, the country in question would have to request a rescue from the European Stability Mechanism (ESM), the eurozone’s bail-out fund. That would involve the supplicant signing up to a programme of fiscal austerity and structural reform, which would have to be approved by all 17 eurozone governments, and in Germany’s case, its Parliament.

So the OMTs cannot work for a country whose government rejects austerity and supply-side reform. Grillo would probably oppose ESM conditionality, but is unlikely to form a government. Whatever Italian government does emerge, it is likely to be moderate, weak and incapable of delivering much in the way of spending cuts or reforms that tackle vested interests. Investors could start to doubt the credibility of the pledge by ECB president Mario Draghi to “do whatever it takes to save the euro”. Italy’s borrowing costs would soar as investors started to factor in the risk of the country leaving the euro.

The politics of the eurozone crisis are now formidably difficult, not least because the stand-off between Italy and the eurozone will be played out against the backdrop of Germany’s general election campaign. This will make it very hard for the Germans to alter their stance. Merkel has a huge interest in maintaining the pretence that the current strategy is working. And in Germany, the Italian result is seen more as evidence that Italians are unwilling to face up to their problems than as an understandable reaction to an intellectually bankrupt strategy.  The fact that the beneficiaries of the anti-austerity vote in Italy are unappealing populists such as Berlusconi and Grillo has reinforced the Germans’ view.

If Italy can find a serious government to negotiate with its eurozone partners, it does have cards to play. It is in a stronger position than the other peripheral eurozone economies. First, the Italian government runs a primary budget surplus (that is, a surplus before the payment of interest on outstanding debt). This makes it much less dependent than the others on support from the rest of the eurozone: if Italy were to default, the Italian government could still pay its bills. Second, Italy’s banking sector is essentially sound; the country does not face the need to raise large sums of money to recapitalise its banks. Third, despite having such a high level of public sector debt, Italy’s overall debt burden (that is, its stock of both public and private debt) is not only lower than the other peripheral economies, but also below that of France and the Netherlands. Fourth, Italy’s external asset position (Italians’ foreign assets minus foreigners’ investments in Italy) is broadly balanced; by contrast, Spain, Portugal and Greece owe large amounts of money to the rest of the world.

In summary, Italy is not quite the basket-case it is often portrayed as abroad. It cannot be so easily bullied as the other peripheral countries. Leaving the eurozone would pose fewer risks to Italy than to the others. This puts the Italian government in a stronger position to play hard-ball in negotiating its fiscal policy. 

In the short term, Italy’s voters have made it harder for Europe’s leaders to manage the euro crisis. But the Italians may have done Europe a service by shaking those leaders out of their complacency. Since François Hollande became France’s president, he has sought to soften the eurozone’s emphasis on austerity. His officials hope that, after the German elections in September, a coalition government including Social Democrats may be more willing to shift Germany’s stance. It is true that the Social Democrats are a little less austerity-focused than Merkel. French officials believe that countries with big current account surpluses such as Germany can and should do more to stimulate demand in the eurozone. But France needs to improve its own economic performance before it can gain much leverage over German policy. And if Italy, too, can somehow conjure up a stable and respected government – one that is serious about reform, but softer on austerity – it might help persuade Germany to rethink its policies.

Charles Grant is director and Simon Tilford is chief economist of the Centre for European Reform.