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.