Ukraine after Yanukovych: Dropping the pirate?

President Viktor Yanukovych of Ukraine clearly had no sense of irony when he placed a mock pirate ship in the lake at the mansion he built on (stolen) state land outside Kyiv. With all his vices, however, as long as he remained in power Russia, the West and Ukrainian politicians had no reason to reconsider their own inadequate policies on Ukraine. Now he has gone, all three must raise their game. This insight looks at each in turn, but focuses on what the EU can do for Ukraine, and what Ukraine needs to do for itself.

For Russia, Yanukovych was an acceptable leader of Ukraine, despite his faults. With his power base near the Russian border and his ties to oligarchs dependent on Russian markets, he was not the man to stand up to Moscow’s pressure to walk away from an association agreement with the EU in autumn 2013. His reward for doing Moscow’s bidding was a one-third cut in the price of Russian gas (to be reviewed quarterly, in case he thought of changing his mind) and a $15 billion loan (about €10 billion), of which $3 billion (€2 billion) was disbursed before his fall.

The Russians clearly did not expect that Yanukovych’s failure to sign a one-thousand page document that few if any of his opponents had read would lead to a revolution. Yet three months after Yanukovych cast his lot in with Russia, he is out of office and – as Russian Prime Minister Dmitri Medvedev said on February 24th – “We do not understand what is going on there”.

The smart thing for the Russians to do would be to join Yanukovych’s Ukrainian ex-supporters in denouncing his crimes, and then to rebuild their influence. Russia will continue to supply much of Ukraine’s gas. It already has a free-trade agreement with Kyiv, and mutually profitable trade should continue, particularly in areas like defence equipment where Soviet-era supply chains still exist. Many Ukrainians have family ties in Russia or work there. These people have no reason to feel enmity towards Moscow. A prosperous, EU-aligned neighbour should pose no threat to Russia’s interests. It could even be a better customer for Russia; it might pay its bills, for one thing.

So far the signs are that Russia is not doing the smart thing. Russian foreign minister Sergei Lavrov has claimed that the political opposition are following the lead of “pogromists”; Medvedev has claimed that what has happened threatens the lives of Russian citizens. In Crimea, the only region of Ukraine where there is an ethnic Russian majority, visiting members of the Russian Duma announced an initiative to make it easier for Crimean residents to get Russian passports. These are provocative moves. The presence of large numbers of similar ‘Russian citizens’ in Georgia’s separatist enclaves of Abkhazia and South Ossetia provided a pretext for Russia to step in to ‘protect’ them in 2008. The occupation of the Crimean parliament and major airports by armed men, and large-scale Russian military exercises near the Ukrainian border, all add to the tension.

For the West also, the fall of Yanukovych demands fresh thinking. The UK and the US were co-signatories with Russia of the ‘Budapest Memorandum’ of 1994, in which (in return for Ukraine sending Soviet nuclear weapons back to Russia) the other three countries undertook to respect Ukraine’s independence, sovereignty and borders; not to use or threaten force; and not to use economic coercion. The memorandum said that the three would consult “in the event a situation arises which raises a question concerning these commitments”. It is time the UK and US used this agreement to deliver firm messages to Moscow about the impact of its actions on future relations.

The thuggish and corrupt Yanukovych had few friends in Europe. Now the EU will have to deal with a government in whose creation it has had a hand, and an interim president who has already said that a return to the path of European integration is his priority. Brussels and the member-states should not wait passively to see what happens, as they did after the 2004 Orange Revolution. They should drive change with a judicious mixture of generosity and tough love.

Ukraine will need assistance to avoid default almost immediately. It needs to pay its various creditors over €10 billion by the end of this year; it has gas debts to Russia of over €1 billion. The IMF suspended lending to Ukraine in 2011 because of its failure to carry out agreed reforms. IMF managing director Christine Lagarde made clear after the G20 finance ministers meeting on February 23rd that Ukraine would have to start reforms before international lenders would return. If Kyiv takes her advice, Western countries should be ready to step up technical assistance and political engagement to ensure that key reforms in areas such as energy pricing are implemented quickly and effectively. They could help with funds and advice to reduce the impact of cuts in fuel subsidies on poor customers. A sharp reduction in energy subsidies in Bulgaria in early 2013 led to protests and the fall of the government.

A lot of the short-term pain of reform will fall on un-modernised heavy industries in the east and south of the country, which have relied on unsustainably low gas prices to remain viable. The deep and comprehensive free trade agreement (DCFTA) offered by the EU should offer a significant long-term boost in growth (estimated at about 0.5 per cent per annum), but the gains will be diffused widely, while the losses will be concentrated. Russia has put a considerable propaganda effort into heightening the fears of the likely losers. Moscow will probably now put up the price of gas and perhaps restrict the flow in order to punish the new Ukrainian government, further hitting Ukrainian competitiveness. The EU is close to offering Ukraine financial assistance (likely to be more than the $1 billion (about €700 million) announced by the US). Regions of western and central Europe which have successfully undergone economic restructuring should share their expertise with Ukraine. The EU should also press forward with plans to enable Ukraine to get gas from Slovakia, assistance with energy efficiency and other steps to mitigate Ukraine’s dependence on Russian gas.

The EU has concluded that although the interim government might like to sign the association agreement as soon as possible, it would be better not to do so before presidential elections in Ukraine on May 25th. One reason for this is to avoid questions about the legitimacy of the transitional authorities; another is to allow more time for an increased public information campaign to explain what the association agreement means for Ukraine. The British government commissioned research in Ukraine in early 2013 which showed low levels of knowledge about the EU and high levels of suspicion, particularly in the east. The British Embassy in Kyiv has done much since then to ensure that information about the agreement is available, including translating a summary into Russian as well as Ukrainian. Meanwhile the EU delegation’s staff have taken the lead in ensuring that the Ukrainian authorities are technically prepared for the time when the agreement is in force. But it is time that the information effort was stepped up and properly resourced, ideally with the EU delegation and as many member-states as possible spreading the word. Central European countries have a particularly important contribution to make because of their own experiences of transition, association agreements and ultimately EU membership; senior visitors from these countries could help to reassure eastern Ukraine of the benefits of association with the EU.

As a result of events in Kyiv, member-state resistance to offering Ukraine an EU membership perspective seems to be fading, gradually. The last statement by EU foreign ministers ended enigmatically: “the Council expresses its conviction that [the association] agreement does not constitute the final goal in EU-Ukraine co-operation”. Several senior European officials have gone further, including President of the European Council Herman Van Rompuy, who said that the future of Ukraine belonged with the EU. Successive Ukrainian governments have defined their country as ‘European’; it is time that the EU started to set out the conditions Ukraine would have to meet in order to become a member of the Union.

There is a Russian saying that it is better to see once than hear a hundred times. The EU should press forward as quickly as possible with visa liberalisation for Ukrainians, to make it easier for people to see what two decades of transition have achieved in countries like Poland and the Baltic states. The Union should also increase funding for student exchange programmes and study visits to EU countries by officials, particularly from eastern Ukraine.

One reason Ukraine’s economy is in such a mess is the immense scale of corruption. The Swedish economist Anders Aslund estimates the Yanukovych family fortune at $12 billion (almost €9 billion), but the president and his relatives were not the only ones profiting at the expense of the Ukrainian state. A number of EU member-states, including Austria and the UK, have been happy to put out the welcome mat for members of Yanukovych’s circle. Former prime minister Mykola Azarov and his wife have property in Austria; companies which are alleged to be fronts for Yanukovych and his family are based in London.

These and other European countries should now help the Ukrainians to recover some of the loot. They should also look closely at their own implementation of anti-money laundering legislation. In 2011 the UK’s Financial Services Authority found that three quarters of the banks it investigated had not done enough to establish that customers who were senior politicians or their families had acquired their wealth legitimately. Putting this right would help Ukraine (and other countries) recover funds from corrupt politicians, and also set the tone for the future. Western countries should not preach good governance and the rule of law in Kyiv while allowing Ukrainian leaders to launder their money in European capitals.

Ukraine’s economic future will not be secured, however, by asset recovery (however politically valuable it would be). It needs trade and investment to drive growth. Even before the DCFTA comes into force, the EU should be generous with market access. The Union set an important precedent by increasing Moldova’s wine export quota in January 2014 to compensate for Russia restricting its imports of Moldovan wine; if Russia takes similar steps against Ukrainian agricultural and industrial products (as seems likely), the EU should respond by opening its markets again.

Finally, the Ukrainians themselves need fresh thinking. It has been easy to blame Yanukovych for all that ails their country. But his departure does not mean the end of their problems; and he was not responsible for all of the mess. From independence onwards, Ukrainian presidents and governments have ducked hard choices and allowed corruption to flourish.

In 2004 the protesters in the Orange Revolution were (to some extent at least) led by the politicians. In 2014, the protesters on the Maidan were consistently ahead of the politicians and wary of the opposition as well as the government. When Vitali Klitschko, leader of one of the main opposition parties, announced to the crowd the terms of the (still-born) deal brokered between Yanukovych and the opposition by the French, German and Polish foreign ministers, he was booed off the stage. The engagement of civil society in political life is in some ways encouraging: much better than apathy. But it also contains threats: the risk of vigilante justice, and the temptation for politicians to resort to populist measures, rather than attempting hard but necessary reforms.

The new authorities need to prioritise. Whether Ukraine defaults or not, its economy is a mess. The interim government needs to be frank with the population about how tough it will be to turn Ukraine round after two decades of decline, and it needs to start the process quickly, without waiting for the presidential elections in May. That way, all parties in the unity government will share responsibility for the reforms required to put Ukraine on track for sustainable economic growth. The interim prime minister, Arseniy Yatsenyuk, a highly intelligent technocrat, has started to explain how bad things are; he needs support from other politicians. Leaders should not be distracted by peripheral issues: reducing the status of the Russian language will no doubt please some western Ukrainians, but it should not have been one of the first pieces of legislation passed by parliament after the fall of Yanukovych. It will do nothing for the economy, and will exacerbate worries in the south and east on which separatists can then play.

Ukraine needs a constitution that works. The 2004 constitution left too many uncertainties about the division of powers between the president, the prime minister and parliament; the 2010 constitution put too much power in the hands of the president. With the help of the Council of Europe’s Venice Commission on democracy through law, the new authorities should start work on a new constitution, to be put to a referendum as soon as possible. The president to be elected in May 2014 should serve a shortened term pending adoption of the new constitution.

Ukraine also needs honest politicians. The Office for Democratic Institutions and Human Rights (ODIHR), part of the Organisation for Security and Cooperation in Europe (OSCE), judged the 2012 parliamentary elections to have been a step backwards for Ukraine, characterised by abuse of administrative resources, murky campaign finances and biased media coverage. The resulting parliament is now in charge of the country. Various oligarchs ‘own’ blocks of seats in the Rada; it was their decision to drop Yanukovych which led to the vote to replace him. The interim government should ask ODIHR to help draw up new electoral legislation, including on campaign finance, establish a new electoral commission and hold parliamentary elections as soon as a new constitution is in place. It should also work with international anti-corruption bodies to draft and implement far-reaching legislation to force politicians and officials to declare their assets and any possible conflicts of interest.

Ukraine itself does not have the resources to pay for a major economic change programme itself; it will need foreign investments, as the countries of Central Europe did. To attract foreign investment it will need to change the ingrained culture of corruption. By leaving behind a treasure trove of documents showing the extent of graft, Yanukovych has strengthened the hands of transparency campaigners (some of whom are now poring over the evidence). Ukraine should work with organisations like the Open Government Partnership and Transparency International to build openness into government contracting processes and the tax system. It should also ask for help from the OSCE and the Council of Europe to rebuild the judiciary and law-enforcement bodies so that they serve the people and the state, not the elites who corruptly buy their services.

Ukraine has rich agricultural land, an industrial heritage and an educated population. It should be doing much better than it is. After two false starts, perhaps it will be third time lucky. The pirate king has gone; now Ukraine should be helped to chart a new course.

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

Sherlock and the European catastrophe

Benedict Cumberbatch sat across from the prime minister in best thin white duke mode, a look of disbelief frozen on his face. “David, you do realise that I’m an actor? 'Sherlock' was just a TV detective show adapted for today's Britain. We've made too many seasons of it already. I’ve moved on.”

David Cameron fixed him with his fleshy, good-natured gaze. “Oh, I'm well aware. But you in particular seemed, well…just so natural as Sherlock. My predecessor-but-one was a thespian too, Benedict. And there's literally no-one else I can turn to: I’m in serious trouble on my Europe file.”

It was 2017 and a sunny May morning in Downing Street. PJ Harvey's anguished tones drifted down a corridor from a radio in one of No 10's over-stuffed offices. “Goddamn’ Europeans! Take me back to beautiful England...” The TV detective’s mouth turned up a corner. “What appears to be the problem, prime minister?”
 
“Well, as I say, it's my European policy.” He glumly nodded towards the desk. “Anyone who sits in that chair has Europe waiting for them like a great ugly toad from the first day they get in the door. I don’t see why I should be the one the whole thing finally caves in on...This EU referendum we promised: the vote is on Saturday.”

...
Fog rolling down behind the mountains,
On the graveyards, and dead sea-captains
…

Cumberbatch’s fingertips pyramided to his lips. “Yes, it’s all over the news, special debates on Newsnight for a month and all that. The newspapers are full of it. Everyone says it’ll probably be a narrow Yes to stay in.”

Cameron looked pained. “No. The Yes side is going to lose, Benedict.”

The actor stared. “But the polls look 50-50. Whatever about all the bluster, people hardly expect us to leave Europe, do they?”

Cameron went on, unhearing. “I suppose that I sort of, hoped – you know – that something would just turn up, as Mr Micawber says. I did everything I could to keep the Conservative party happy. I pulled my MEPs out of their cozy, chummy group in the European Parliament and made them hang around with a bunch of political wild-men instead, even before we got into office at all. Not that anyone here ever gave me credit for it. They noticed on the continent though. But the really serious trouble started when the eurozone crisis broke out and I vetoed their fiscal compact. That sent my thrill-seeking backbenchers into ecstatics. My God, it got the other leaders’ backs up something terrible. Before then, our usual policy was to be in the room for those kinds of discussions. I took a big risk walking away from that.”

“But how did that help the UK?” asks Cumberbatch, crossing his legs pensively.

“Well, it looked like the lights were going out all over Europe...my economic advisers told me the eurozone was doomed. I mean I'm no expert but anyone can see the thing is hardly an economic miracle. We thought they'd be re-making the entire EU by now, that we’d have the chance to extract some concessions before having to hold the blessed referendum. You know, on social policy and so forth. So I wanted to show them I was prepared to block things early on. Can someone please turn that radio off – we’re trying to have a meeting in here!”

…
And the grey damp filthiness of ages,
And battered books
…

“And…what happened then?”

“Nothing”, lamented Cameron. “The whole euro crisis just went into a sort of political deep freeze after they cooked up some legal mumbo jumbo. I got a few helpful noises on immigration from the other governments after the European elections alright. Then I floated this ‘Regulation Treaty’ idea the year we got re-elected, but I just couldn’t sell it. The only thing I could point to in the end was pulling out of European policing. Gordon Brown already got that during the Lisbon talks though, before I got in.”

“David, you’re a PR man. Surely, you know not to take political risks on crime. Look how successful Sherlock and the other crime dramas are for goodness sakes.”

“Yes, but no-one ever asks the French police for help in them, do they Benedict? And we were getting ready for the 800th Magna Carta celebrations in 2015. I was hardly going to adopt the Code Napoleon the same year, was I? Even the main villains in Sherlock were only Swedish and Irish.”

Cumberbatch snorted. “Ha; well, our producers thought that was as foreign as the British viewer likes to go on a Tuesday night. Hang on, that's interesting. How have Sweden and Ireland done in Europe over the last few years?”

“Well, Ireland got bailed out by the other Europeans and us. After that, they got bossed around by the ECB for a bit. But then they started raising money on the markets at a better rate than the Treasury. The continentals even made Kenny, the Irish prime minister – or whatever it is they call it – European Council president. They called it: “a gesture to the Anglo-Saxons”. The Irish just loved that. We only got the pesky development commissioner.”

“Ok. Well, how did Sweden do then? We agree with them on most things too, don't we?”

“Fredrik? Obviously, he thinks the whole euro thing is bonkers as well. He told me Halley’s Comet will be here again before the Swedes sign up. But he just sort of sat on the fence at the Council meetings, pledged a few kronor to the bail-outs, even signed up to the fiscal compact. Says if the Danes can wear it, so can he.”

...
The sky move, the ocean shimmer,
The hedge shake,
And the last living rose quiver
...

“Let me put it another way, David. If Sweden or Ireland needed a leg up from Brussels or the other Europeans for some reason, would they be more or less likely to get it than us?” 

“Theoretically: more likely. But you don’t understand: the whole treaty change thing is a damned dangerous business. No-one wants it because it means referendums everywhere. Can you imagine that around Europe with the economy the way it is now? Angela made sure I got my ‘Declaration That Britain Has A Point, Whatever It Is’, at the December summit even though everyone’s already mad at her for taking the French to court over their national debt. But that won’t be near enough to get us out of trouble here. Can you believe the way this campaign has become such a godsend for Boris? He has all the fun running the No side while I just get abuse up and down the country. His tweets are sickening.”

Cumberbatch looked at the prime minister, wondering. “But David, it’s a bit premature to rehearse your resignation speech, no? Everyone says that the debate has turned out to be surprisingly cathartic; that the No side is split and on the defensive; that the country has quietly Europeanised since the last poll forty years ago. You know: we’re drinking drinkable wine, calling our kids Radek, letting Deutsche Bahn run the railways – all that. If anything, people seem bored with the whole EU thing at the moment.”

Cameron winced: “Exactly, Benedict: Turnout, turnout! I couldn’t get the idea of a minimum quorum into the referendum bill. The pity is we didn’t go back into government with the Lib Dems; they would have insisted on it, even after their demolition in the elections. I know the debate is lively: what with the fabrications from the No side and the counter-fabrications from the Yes side. The young people tell pollsters that they'd prefer to be in, so long as we don’t join the euro. But who’s going to get up out of bed on a Saturday morning to vote for Brussels?

...
Past the Thames River, glistening like gold
Hastily sold
For nothing

...

 “…only the hardcore anti-EU people, that’s who. We’ll end up leaving the Union in a fit of absence of mind. And Boris and his wild-eyed friends have fooled enough people into believing that only a No vote can get us “the real deal” from the bureaucrats. Well, if he wants my job so much, let him stay up all night arguing in that abattoir in Brussels. Nothing makes the continentals gang up together more than a good Brit-bash. They don’t have a bloody thing in common otherwise. But can’t all that be avoided somehow, even now?”

Cumberbatch’s grey blue eyes widened. He stood up and flicked on his high-collared Milford coat. “Prime Minister, this really isn’t my area, you know. But Sherlock would deduce that you’d missed something obvious and hidden in plain sight somewhere along the way. Anyway, my flight to Los Angeles leaves in a few hours.”

“Don’t remind me about the Americans; I’ve had HRC on the phone every week for the past two months asking me what my ‘strategic vision’ is for after the referendum. Look, couldn't you ask your brother in MI6, Mycroft Holmes? He was a great help to us during the Olympics.”

“You're scaring me now David...”

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

NB: Lyrics reproduced from PJ Harvey’s ‘The Last Living Rose’.

What explains Europe’s rejection of macroeconomic orthodoxy?

The 1930s depression led to the birth of Keynesian economics, because the prevailing economics orthodoxy had no answers to the crisis. Keynes demonstrated that the government could, and should, intervene to correct a shortfall of demand in the economy. The rise of monetarism in the 1970s saw the challenging of the Keynesian reading of the 1930s. Monetarists argued that the 1930s depression was caused by governments failing to prevent the collapse of the money supply (the amount of money in circulation), which led to a collapse of demand rather than a collapse of demand leading to a collapse of money, as per the Keynesian analysis. Despite their differences, both camps agree that there is an indispensable role for macroeconomic policy in combating a slump.

By contrast, the depression that started in 2008, and which Europe is still struggling to emerge from, has led to the explicit rejection of Keynesian economics across Europe, and the implicit rejection of monetarism. How has a crisis borne largely of poorly run and regulated financial institutions, combined with the creation of a currency union modelled on the gold standard been used to turn the clock back on both economic theory and history? And what does it mean for Europe?

Keynesian critics of the direction of macroeconomic policy-making in Europe have long become accustomed to having their views caricatured. Their criticism of the pace of austerity is presented as a call to ‘artificially pump up demand’. This assertion rests on two assumptions: Keynesians ignore the supply side of the economy, and that Europe’s crisis is a result of government failure to push through supply-side reforms. This chorus of criticism has picked up further with signs of economic improvement in the eurozone and UK, despite fiscal austerity for the last three years.

What have Keynesians actually said, as opposed to what has been attributed to them? They argue that fiscal policy is an indispensable tool to stabilise economies suffering from a drop in domestic demand. This is especially so when interest rates had fallen to close to zero (neutering the effectiveness of monetary policy). When businesses and consumers do not want to borrow and invest even when nominal interest rates are close to zero, monetary policy is unable to stimulate demand. Keynesians also argue that fiscal policy is especially important in a currency union (where interest rates are set for the currency union as a whole rather than for the needs of individual economies). Few Keynesians dismiss the importance of supply-side policies; rather they argued that supply-side reforms will not help address a crisis of demand (and that the wrong macroeconomic policies can outweigh the potentially positive impact of supply-side policies). Finally, mainstream Keynesian economists have not said that austerity would prevent economic recovery at some point. Instead, they have said that recovery would take place at a lower level of activity, with an unnecessary accumulation of debt and the risk of deflation.

Keynesian advice was followed (up to a point) in the early stages of the crisis, and by late 2009, the European economy was recovering (see chart). However a dramatic tightening of fiscal policy in 2010 helped push the eurozone and UK economies back into a recession, which in the case of the eurozone only came to an end with an easing of fiscal austerity over the second half of 2013. Since then, European governments and the European Commission have argued that any attempt to boost demand would be at best useless and at worst damaging.

The rejection of monetarism has been less strident, but no less striking. Monetarists are sceptical that governments can affect the amount of demand in the economy through fiscal policy, but are unequivocal that central banks should prevent a collapse in the money supply. Following the launch of the euro, the ECB initially focused on two pillars when setting interest rates – an inflation target of 2 per cent and a ‘reference value’ of 4.5 per cent annual growth in money supply (M3) – but has quietly dropped the second pillar. Annual growth in M3 slid to just 1 per cent in December 2013.

The ECB is not entirely to blame for this, of course – fiscal austerity at a time of weak domestic demand was always going to hit demand hard (and so reduce inflation). But the ECB (though not the Bank of England) was slow to cut interest rates and reluctant to embrace unorthodox policies such as quantitative easing. This is all the more puzzling as the ECB is modelled to a large extent on the German Bundesbank, which was instrumental in making sure that the ECB targeted the money supply as well as inflation.

Where has this rejection of orthodox thinking led Europe? The chart below shows the relative performance of the US, eurozone and UK economies since the beginning of 2008. The US authorities have followed a pretty much standard textbook approach to the crisis, providing some fiscal stimulus to offset the weakness of demand and injecting as much monetary stimulus as possible. The US recovery has been disappointing (by US standards) but still compares highly favourably with what has happened in Europe.

What about growth prospects? Advocates of Europe’s current approach argue that the reforms being pushed have improved Europe’s growth potential. However, even the European Commission and the IMF – the architects of the European approach – expect a very modest recovery, averaging 1.3 per cent a year for the next three years (compared with over 3 per cent in the US). Many other forecasters are even more pessimistic about Europe’s prospects.

The reason for this pessimism is obvious – the damage done to the supply-side of European economies by low rates of investment (both public and private) and high unemployment (the longer someone is out of work, the less likely that person is to find a job). Far from boosting the supply side of the European economy, austerity has made structural changes less, not more likely: fiscal stimulus in the US allowed the private sector to reduce debt levels, hastening the point at which investment recovered. By contrast, the process of reducing private sector debt levels has much further to go in Europe.

Real GDP (Q1 2008 = 100)

Source: European Central Bank

What has happened to public debt? The argument for fiscal austerity was that it was necessary in order to arrest the rise in debt ratios, even if the result was a hit to economic growth. The eurozone’s ratio of debt to GDP has risen by a bit less than the US’s since the beginning of 2008 (see chart), but the US ratio is now falling quite quickly as economic recovery boosts tax revenues. The eurozone’s debt ratio did drop slightly in the third quarter of 2013, but this reflected an exceptional fall in Germany rather than the start of a trend. Moreover, in a fiscally decentralised monetary union, the aggregate debt figure is pretty meaningless. What matters in the eurozone are the debt ratios of countries such as Italy and Spain. The UK has experienced a huge rise in debt partly because it suffered a very deep recession and slow recovery and partly because of the costs of clearing up its banking sector (around 10 percentage points of GDP).

Public debt (per cent, GDP)

Source: European Central Bank

The reason why the ratio of eurozone debt to GDP is likely to keep rising is a combination of weak growth prospects and weak inflation across much of the eurozone. The ECB would never wait until inflation hit 4 per cent before it raised interest rates, yet it has allowed inflation to fall below 1 per cent, arguing that it needs time to gauge the scale of deflationary pressure. This is a risky strategy. Inflation does not need to turn negative to do a lot of damage. The lower the inflation rate, the bigger the primary budget surplus a government needs to run in order to prevent the stock of public debt to GDP rising , hastening the point at which debt becomes unsustainable. Low inflation also pushes up real interest rates, further depressing demand.

How low is inflation across the eurozone going to go? Much will depend on the international environment. A prolonged emerging market crisis would push up the value of the euro, compounding deflationary pressures in the eurozone.  The other crucial variable is Germany. If German domestic demand were to pick up strongly (lifting the country’s inflation rate), this could help offset deflationary pressure elsewhere in the currency union. Higher German inflation would help struggling members of the eurozone to regain export competitiveness relative to Germany, as well as reduce the value of the euro, boosting their exports to countries outside the currency union.

 ‘Core’ consumer price inflation (annual, per cent)


Source: European Central Bank

Greece aside, the European crisis was not a product of fiscal largesse. Mismanagement of public finances in the run-up to the crisis meant that some countries had less scope to impart fiscal stimulus than they should have done (the UK and Italy, for example). But the crisis was caused by the private sector (the failure of the financial system to allocate resources efficiently and to price risk appropriately) and policy-makers’ failure to acknowledge the implications of launching a single currency. So what explains Europe’s rejection of economic orthodoxy, be it Keynesian or monetarist?

Ideological leanings have played a part in some countries – they explain the restrictiveness of fiscal policy in the UK and Germany, for example. The British government has used the fiscal crisis to push through radical reforms of social welfare in an effort to shrink the size of the state. For its part, the German government has dismissed as ‘Keynesian folly’ calls for it to impart a fiscal stimulus to boost Germany’s lacklustre domestic demand, despite running a budget surplus in 2013.  

However, the lack of integration within the eurozone is easily the most important reason for the dramatic decline in the quality of macroeconomic policy in Europe. Eurozone governments’ inability to agree a form of fiscal burden-sharing led to highly pro-cyclical fiscal policy in some countries and has prevented rapid action to address the region’s banking sector problems. The banking systems of some economies are both fragile and too large for their governments to comfortably backstop. This pushes up the cost of capital for banks in these countries, leading to big differences in borrowing costs across the currency union and cementing differences in economic performance. Finally, the ECB has been reluctant to ease monetary policy further for fear of the political reaction in Germany (where officials and policy-makers are worried about the economy overheating and low interest rates are angering savers). Savers cannot reasonably expect a return on their savings when there is a glut of capital across the eurozone as a whole, and businesses are loath to invest, but they are an important electoral constituency, especially in fast-ageing Germany.

In conclusion, it is hard to be optimistic about Europe’s economy while conventional economic thinking and history are being ignored. ECB representatives from the countries facing the most acute deflation threat are becoming more assertive, but the central bank will remain politically constrained. Moreover, the fiscal stance across the eurozone will remain restrictive, not least because of the impact of weak inflation on deficits and debt levels and hence on the scope for governments to ease up on the pace of austerity. Modest steps by the ECB, a gradual clean-up of the banks and a very modest cyclical economic recovery are unlikely to be enough to head off the threat of deflation.  

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