Britain’s EU referendum: Cameron cannot please two audiences any longer

David Cameron kicked off the renegotiation of Britain’s EU membership at the European Council in Brussels. The modesty of his demands for reform will inevitably lead him into a breach with Conservative eurosceptics.

For some time, David Cameron has been trying to satisfy two very different audiences on Britain’s renegotiation with the EU. One is the Conservative eurosceptics. Many of them argue that he cannot achieve radical reform without making ambitious demands and threatening to recommend a ‘No’ vote unless he is satisfied. The other audience, the EU’s leaders, say they will give Cameron more help if he speaks softly and keeps his demands within the realm of the possible.

When Cameron kicked off the renegotiation at the European Council in Brussels, over dinner on Thursday night, it became clear that he will work broadly within parameters that are acceptable to his fellow leaders. British officials briefed that the government understood the EU treaties cannot be changed before a referendum. That has been pretty obvious for a long time to anyone who understands the EU’s rules on treaty change, or who talks to other EU governments, but not to all Conservative eurosceptics. As more of them come to realise that Cameron’s ambitions on EU reform are in fact quite modest, they will prepare to attack him. He is reaching the stage where he can no longer appeal to both audiences.

At the European Council, there was not a lot of time to talk about the British question. The EU’s leaders were busy with Mediterranean boat-people and the increasing danger that Greece may leave the euro. But Cameron managed to outline the broad headings of his demands for reform, repeating much of what he had already said on a recent tour of European capitals. The others listened politely and there was no substantive discussion. EU leaders asked the secretariat of the Council of Ministers to work with UK officials on the details of their proposals. Cameron hopes to clinch a final deal in December – allowing a referendum on membership to be held in 2016, probably in the autumn.

Some governments grumble that Cameron has not yet been specific on his ideas for reform. The Germans, however, think this is tactically wise. As soon as his list of demands is known, eurosceptics will attack him for a lack of ambition, while integrationists in other capitals will cry “impossible”, and he will lay himself open to the prospect of failure. Cameron may say very little on specifics until shortly before the December summit.

In recent weeks I have spoken to some of those who met Cameron on his European tour. They told me they were concerned about Cameron’s ability to navigate the many obstacles that he will face between now and the referendum. In particular, they wondered whether he regards Conservative party unity as more important than winning the referendum. They noted his recent about-turns under pressure from anti-EU Tories – on whether ministers would have to support his line in the campaign, and whether the civil service could take sides. But Cameron has a justification for these shifts: if he can retain the support of moderate eurosceptics – so that no more than, say, 50 Tory MPs back ‘Brexit’ – he is more likely to win the referendum.

Other EU governments want to see Cameron make the case for membership, which to them means taking on the eurosceptics and making enemies in his party. Some of them told me that only when he does that will they believe he is determined to prevent Brexit, and therefore worth negotiating with on a serious basis. But Cameron will not want to make the case in Britain until he has struck a deal in Europe. In the meantime, if he can convince other leaders that he will – as he said in his 2013 Bloomberg speech – fight to keep Britain in the EU “with all my heart and soul”, they will probably do business with him.

EU leaders worry that domestic politics may blow Cameron off course. Will Conservative backbenchers push him to demand reforms that are unattainable, thereby making it hard for him to claim a successful outcome? So far he has not asked for much that his partners regard as ridiculous, except for the idea that EU migrants should be denied benefits until they have lived in the UK for four years. Will he carry the cut-and-thrust of Westminster politics – focused on victory and defeat – into EU councils, which usually work towards careful compromises that offer something for everybody? Other leaders claim that if Cameron threatens them they are less likely to help. But some of them are already resigned to the December summit being the scene of a ferocious battle from which Cameron plans to emerge blood-stained but victorious.

If Cameron wants to win the referendum, he will have to upset some Tories & admit that the EU is good for Britain

Cameron’s task is that much harder because he has few friends in other EU capitals. His peers view him as a ‘transactional’ politician who is a skilled negotiator on particular issues but fails to invest in long-term relationships. For example, some Italians thought it odd that when he met Prime Minister Matteo Renzi in Milan earlier this month, asking for help on EU reform, he would not offer to take a single Mediterranean refugee. But Cameron’s recent European tour suggests, at least, that he sees the need to deploy some gentlemanly charm on his peers.

Chancellor Angela Merkel of Germany, the most influential EU leader, likes Cameron, but they have several times misunderstood each other (as in December 2011, when he refused to sign a treaty on fiscal discipline because she rejected a Treasury protocol that would have given the City of London some extra protection). Her officials have warned the British not to assume that she can fix the rest of the EU; 26 other governments, plus the European Commission and Parliament, also matter. One senior German told me that, though he thought Brexit would be damaging, allowing the UK to undermine the EU’s core principles – for example by disregarding rules on freedom of movement or non-discrimination – would be even worse for Europe.

Though the Germans share Cameron’s desire for a more competitive EU economy, they disagree with many other UK priorities. They oppose turning the ‘yellow card’ procedure – through which national parliaments can club together to ask the Commission to withdraw a draft law – into a ‘red card’, because they do not want to make it harder for the EU to legislate. They are hostile to Cameron’s desire for mechanisms to protect the single market against the risk of the eurozone imposing decisions on it, pointing out that the eurozone has never caucused; they suggest that what the British are really after is a veto for the City of London over financial rules. As for Cameron’s priority of preventing EU migrants from claiming in-work benefits such as tax credits, the Germans cite treaty articles banning discrimination on grounds of nationality. They point out that not only Poland and the other Central European states, but also countries like Spain would never agree to amend these articles.

Merkel’s advisers predict that she will ‘lead from behind’ during the British renegotiation, allowing Donald Tusk, the president of the European Council, to broker agreements among governments, while Jean-Claude Juncker, the Commission president, prepares relevant legislation. In dealing with the crises in Ukraine and Greece, Merkel has kept France’s President François Hollande at her side – to minimise the impression of German dominance and ensure that he is supportive. She will similarly enlist Hollande on the British question.

The final deal that Cameron obtains will mix EU-wide reform with UK-specific provisions. The mechanisms for delivering change will be varied: declarations and decisions of the European Council, as well as legislation and promises to amend the EU treaties at some unspecified point in the future. Those amendments will not happen any time soon. Most leaders view re-opening the treaties as a mad idea – nobody knows where the process would end, and several countries would have to hold their own referendums.

As for substance, Cameron will probably win an accord on ‘competitiveness’ that covers extending the single market, negotiating more trade agreements with other parts of the world and curbing unnecessary EU red tape (in fact the Commission is already doing these). He may get something on restricting immigrants’ rights to unemployment benefits, but nothing on tax credits unless the UK changes its own rules (for example, by introducing a residency qualification that applies to everyone, Britons included). He might win a treaty article promising to protect the single market, and an ‘emergency brake’ enabling any government to delay – but not stop – a decision that it thought damaged the market. On the treaties’ commitment to ‘ever closer union’, the British are unlikely to gain a full opt out, but words will be found to reassure them. The yellow card procedure could be beefed up so that national parliaments can more easily object to draft EU laws.

None of this will change the fundamentals of how the EU works. If Cameron tries to claim the contrary he will sound unconvincing. Besides, the essence of the campaign will be about whether Britain is better off in or out. Cameron likes the mantra that Britain should stay “in a reformed EU”, as it helps him to keep much of his party together. But if he wants to win the referendum, he will have to upset some Tories and admit that the EU per se is good for Britain. If he tries to keep both audiences happy, he will fail.

Charles Grant is director of the Centre for European Reform. An earlier and shorter version of this article appeared in the Observer on June 21st.

The four horsemen circling the European Council summit

Simultaneous crises are the new normal. Europe’s leaders must confront a quartet of challenges if they want to prevent the European Union falling apart.

Four horsemen will be circling around this week’s European Council. They represent four crises that threaten the EU: ‘Grexit’; the Mediterranean migration crisis; Russian aggression; and Britain’s threat to leave if the club is not reformed. Any of these issues could dominate the European Council’s agenda: each could alter the fundamental character of the Union. While none of them is particularly new – Greece's economic and financial woes have troubled the EU for six years – they are circling together and affecting each other.

‘Grexit’ looms first. The risk of a Greek default and possible exit from the eurozone is the most acute of the four crises.  Over the past several months, Greece’s creditors and the government of Alexis Tsipras have played a dangerous game of chicken. As a deadline approaches for Greece to repay the IMF €1.6 billion, it seems Greece may give in. An emergency summit on Monday brought renewed hope for a deal, as Greece offered more cuts to pensions and higher taxes. Tsipras now faces an uphill battle in the European Council to convince sceptical creditors like Germany and Finland, or fellow debtors like Spain and Portugal. For a deal to stick, the Greek leader must persuade sceptical members of his own party that he is not caving in to demands from Brussels. But even if a deal is clinched, as CER’s Christian Odendahl recently pointed out, a lasting solution to Greece’s economic problems will remain elusive. And so, despite the brinkmanship of the past weeks, even if Europe’s leaders hammer out an accord with Greece they may simply buy more time rather than remove the risk of Grexit.

Russia hovers over the ‘Grexit’ talks too. Should Greece leave the eurozone, it will need to attract credit, loans and investment from elsewhere, and Russia has shown an interest. This has strengthened Tsipras’ hand in the negotiations with Brussels. On Friday June 19th, the day after the Eurogroup failed to reach a Greek bailout agreement, Tsipras flew to Saint Petersburg for a meeting with Russia’s president Vladimir Putin and Alexei Miller, the head of Gazprom. The Greek leader signed a preliminary agreement to build a $2 billion pipeline across Greece, as part of Gazprom’s ‘Turkish stream’ project. The agreement is non-binding, but pokes a finger at the Commission’s plans to reduce the EU’s dependence on Russian gas imports. Tsipras’ flirtation with Moscow, at a time of high stakes negotiations with Brussels, has raised eyebrows. An increasingly Russia-friendly Greece would make it more difficult for the EU to maintain a unified position against Russian assertive behaviour in Ukraine and Eastern Europe.

Meanwhile, people continue to die on a daily basis in Ukraine’s ongoing conflict, though at less alarming rates than before. The ‘Minsk-II’ ceasefire is flawed, but most European governments are unwilling to give up on it. They think Russian help is needed elsewhere, such as the Iran nuclear talks and the Syrian civil war. As long as the fighting does not escalate dramatically, European leaders will not step up pressure on Russia to change its behaviour. Some leaders worry about the impact of sanctions on business (though statistics show the effect is limited), and argue that the current lull warrants a thaw in relations with Moscow. While France has cancelled the controversial sale of the Mistral amphibious ships, three European oil and gas companies have recently struck new commercial deals in Russia.

For now, however, the EU remains politically unified: most of the sanctions have been extended until January 2016, while those specific sanctions linked to the annexation of Crimea have been rolled over for a year. That unity may not endure, however. Regardless of what happens in the Donbass, by the end of the year, investigators will have published their official findings into the shooting down of flight MH17, which killed 298 people. One potential finding of the report could point to Russian complicity, either in delivering the missile system, or in the chain of command that led to the missile’s firing. European leaders will then need to decide whether to punish this crime or do nothing. A push for new sanctions could strain today’s delicate unity on Russia, while inaction would be a sign of weakness and an insult to the victims. The creation of an international tribunal to persecute the culprits may offer a sensible, but unsatisfying, middle road.

The desire to avoid ruffling Russian feathers means that Ukraine will not figure prominently at the European Council meeting either. But that is a mistake. Ukraine needs money: earlier this year Kyiv said that it required some $40 billion over the next five years, to avoid economic collapse, but with the economy continuing to deteriorate that sum now looks inadequate. As Charles Grant and Ian Bond have highlighted, some of that money is coming from the IMF, and some may eventually come via debt restructuring, but most of the money will need to come from the EU and the US. If Ukraine’s economy collapses, the ensuing political chaos would threaten the pro-Western leadership in Kyiv, handing Vladimir Putin the victory he has not been able to achieve through military force.

4 horsemen will be circling this week’s EU summit: Grexit, migration, Russia and Brexit

The third horseman circling is the migration crisis in the Mediterranean. In the first six months of 2015, 1,868 migrants have died trying to cross from North Africa. According to the International Organisation for Migration (IOM), some 114,000 migrants have reached Europe, mostly landing in Greece and Italy. In summer the weather is calmest and crossings increase, so both numbers are likely to rise. In response, the EU is trying to look tough. On June 22nd, it launched an Italian-led mission to monitor the maritime movements of smugglers. A subsequent stage of the operation would see European navies board and seize migrant ships, including in Libyan waters. Diplomats in New York are currently drafting the necessary United Nations mandate. The EU also wants the permission to destroy ships used by traffickers, although this is not likely to get international or Libyan support.

None of these measures will solve the migration crisis. The EU should take a broad approach, in terms of geography and reach. It will not be enough to track smugglers’ movements at sea, although it is a start. Gathering accurate intelligence on smuggling networks requires a presence on land or a credible Libyan counterpart with which to co-operate. And a focus on Libya makes sense at first, but smugglers could soon exploit the route of least resistance by shifting their activities to other parts of the North African coast. Many migrants are Syrian refugees, but a solution to Syria’s civil war remains out of reach. The EU must also review its development and humanitarian policies in transit countries like Libya, and in source countries across the African continent. A humanitarian tragedy cannot be reduced to a mere security challenge.

The tough debate in the European Council will, however, be less about the military mission or the EU’s foreign policy response, and more about migration’s ramifications within the EU. In May, the European Commission proposed a quota system, which would alleviate the burden on countries such as Italy and Greece, and redistribute 40,000 asylum seekers across the EU. Many, including the Central and Eastern European countries, object to this mandatory system. Under quotas, they would receive many more migrants than would otherwise be expected to make their way to them. Northern member-states also object because they ultimately feel these asylum seekers should be processed in southern Europe. Italy feels abandoned by the rest of the EU and has threatened to give migrants temporary visas so they can travel to other member-states. France has retorted that this might trigger the re-imposition of French border controls. The Schengen border code allows temporary border controls in exceptional circumstances, such as in the event of a serious threat to the internal security of a member-state. But in this case its invocation would not be the result of an acute threat to internal security, but of the breakdown of European solidarity. All this could cause a serious Schengen crisis, and draw into question one of the foundations of the EU – the free movement of people.

That leads to the fourth issue, which although not a crisis (yet) will preoccupy European leaders for the coming year. Britain’s prime minister, David Cameron, will outline his EU reform agenda at the summit meeting. He hopes to get results before an in-out referendum on EU membership, which may well take place in autumn 2016.

Among other things, Cameron wants to cut EU migrants’ access to benefits (particularly those going to people in work), in the hope that this would deter people from coming to the UK. This puts him on a collision course with several member-states, including Germany and Poland, which point out that this would violate EU treaty articles banning discrimination on grounds of nationality. The other member-states are very reluctant to open up the treaties to accommodate British reforms. They fear that one or other member-state would grab the opportunity to make special demands themselves. In some countries, like France, Ireland and the Netherlands, treaty change would trigger risky referendums. Cameron’s dilemma, however, is that a lot of Conservative backbenchers will not support his effort to keep Britain in the EU unless he achieves radical change.

Other British ideas may go down better in Europe, such as strengthening the EU’s ‘competitiveness’ by trimming cumbersome regulation, negotiating free-trade agreements and deepening the single market. The forthcoming European Council gives Cameron a platform to launch his renegotiation campaign, though for now he will avoid going into the details of what he wants. The secretariat of the Council of Ministers will be tasked with taking forward the detailed work, together with British officials. Cameron will find it hard to convince his European colleagues that they need to change EU policies and institutions in order to help him. As Charles Grant wrote recently, member-states fear that Eurosceptic backbenchers will push Cameron into demanding reforms that are unobtainable. The fewer allies Cameron has in the Europe, the tougher the negotiations will be, and the more the ‘British question’ will become an irritant in European politics.

The EU’s leaders will find it hard to tame these four horsemen. No country can afford to pick and choose which of these issues to take seriously and which not. All four are dangerous, and they all require a coherent European response. The four horsemen threaten the EU precisely because they raise issues that can only be solved if governments prioritise a European solution over narrow national agendas. If a European answer cannot be found, the horsemen will continue to promote chaos, instability and mutual recrimination within the EU.

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

The eurozone’s ‘five presidents’ report’: An assessment

The long-awaited report rightly aims to complete a financial union in the eurozone, but over-emphasises structural reforms and underplays the need for stronger counter-cyclical policies.

The eurozone in its current institutional setup may not survive the next severe political or economic crisis, and needs reform. The presidents of the European Commission, the European Central Bank (ECB), the European Council, the European Parliament and the Eurogroup have now presented their widely anticipated report – the ‘five presidents’ report’ – on how to complete the monetary union. It contains some important proposals, such as a strong emphasis on completing the banking and capital markets unions. But two key aspects are missing: a more activist ECB in order to prevent future shortfalls in demand, and strongly counter-cyclical fiscal policies at the national level. What is more, the case for a convergence of structural policies in the eurozone is less strong than the report assumes.

The report contains four sections, devoted to the economic, financial, fiscal, and political union respectively. Each of these unions is divided into two stages, the first to be completed by June 2017 and the second by 2025. The economic union concerns the co-ordination and implementation of economic policies such as labour market reforms, and aims to foster structural convergence among eurozone countries towards common standards (formalised as a ‘Maastricht’ for structural policies in stage two, similar to the original convergence criteria before the introduction of the euro). It also seeks to strengthen the implementation of the macroeconomic imbalance procedure (MIP, the eurozone’s monitoring system to prevent crises), and to introduce national ‘competitiveness authorities’ to monitor wage developments.

The financial union aims to complete the banking union, including common deposit insurance and a full and common backstop for the banking union’s resolution capacity. It also seeks to speed up the creation of the capital markets union, and the report suggests a proper European securities market regulator in the future. The fiscal union focuses on strengthening and streamlining the current rule-based setup, as well as the creation of a ‘fiscal stabilisation function’ at the eurozone level in stage two which tries to tie European investments to the business cycle. The political union seeks to better integrate the European semester (the coordination of economic policies) into national and European democratic processes.

What the eurozone needs

Four main shortcomings of the eurozone architecture contributed to the current crisis. First, the ECB allowed demand in the eurozone to fall below trend by conducting less aggressive monetary policies than was needed. Second, national fiscal policies were not counter-cyclical enough, both before and during the crisis. That means, policy did not lean against the wind when too much or too little demand forced wages and prices to veer off course before the crisis; and spending and tax policies were pro-cyclical during the downturn, aggravating the recession. Third, sovereign debt in some countries was allowed to reach critical levels; and because no lender-of-last-resort to governments existed, liquidity problems became insolvency crises. Finally, the banking sectors of many member-states grew too large and took on too much risk. While this also happened outside the eurozone, the lack of a common backstop meant that eurozone governments were tasked with supporting their national banking system, which destabilised government finances, too. It also meant that banks in some regions were unable to provide financing for the economy, and capital markets were to underdeveloped to pick up the slack. If the eurozone had been a true monetary union, like the US, banks and capital markets would instead have helped to spread economic shocks across the whole monetary union.

The five presidents’ report does not address the first issue at all – despite the severe fall in inflation and inflation expectations in the last two years, and the ECB’s hesitation to implement more aggressive steps such as ‘quantitative easing’ to pre-empt such a fall. There are political reasons for not touching the ECB and its mandate: the ECB is the most reliable and unconstrained institution in the eurozone. Opening a Pandora’s box of changes to its mandate or its institutional role could unsettle a delicate political balance. But at least an acknowledgement that the ECB needs to do its utmost to keep demand in the eurozone stable – something it has persistently failed to do during the current crisis – should have been included.

“It is a mistake to leave out the ECB’s monetary policy from the report.”

The second issue, counter-cyclical fiscal policy, is addressed half-heartedly. The report emphasises that fiscal policy needs to be set counter-cyclically, at both national and eurozone levels. But the five presidents aim to strengthen the existing fiscal rules that emphasise debt reduction and for which counter-cyclical policy is an afterthought. The IMF has recently shown how strongly counter-cyclical policy contributes to stronger and more robust economic growth. This applies with added urgency to members of a monetary union that by definition lack independent monetary policies and currencies to cushion economic swings. The urgency is increased still further if the monetary union concerned has trouble exiting a long economic slump, as the eurozone does.

The report should have put counter-cyclical national fiscal policy at the centre of its recommendations on fiscal matters, and urged policy-makers to review the eurozone’s fiscal rulebook in that light. Of course, the five presidents do want to strengthen the MIP. However, correcting imbalances once they appear is not the same as preventing them. Moreover, the MIP in its current form is of little use during the downturn. The report does call for the aggregate fiscal stance of the eurozone (the combined fiscal policies of eurozone countries) to be appropriate for the eurozone business cycle. This is a welcome contribution to the eurozone governance, if it can be agreed – not least because it would force a country like Germany to invest more for its own sake. But the emphasis on a eurozone fiscal stance also makes the omission of monetary policy (which serves essentially the same purpose as the aggregate fiscal stance: to stabilise the eurozone business cycle) all the more striking.

The ECB’s lender-of-last-resort function to governments is rightfully excluded entirely from the report. While such a function is of fundamental importance for the stability of a monetary union, the ECB’s OMT programme has so far been remarkably successful in arresting panic in bonds markets. Given how controversial this programme is in countries like Germany, policy-makers should not waste precious political capital on trying to formalise the ECB’s role as the eurozone’s lender-of-last-resort.

The report urges the eurozone to complete the banking union, and make significant progress on the capital markets union, by 2017. This is a laudable and ambitious agenda. In a more complete monetary union like the United States, private financial connections across state borders help to cushion regional economic developments. For example, if a business in Florida is owned by investors in Boston, both a boom and a recession in Florida will be felt in Boston, too, thereby spreading both gain and pain. Such a ‘private risk-sharing’ across states has been shown to be just as important as fiscal risk sharing in smoothing the business cycle. In the eurozone, such private cross-border risk sharing is underdeveloped, both because cross-border ownership and capital flows are underdeveloped. Banks, in addition, are so closely tied to their sovereign and to their regional economy that in a crisis, they destabilise rather than stabilise the government and the economy. De-coupling banks as much as possible from their sovereign, and making sure that capital markets and banks are diversified across the monetary union, is a crucial step toward making the monetary union more resilient, and the report is rightly setting ambitious goals both in scope and in timeline.

“Completing the financial union is a laudable and ambitious agenda.”

Why the focus on structural reform and ‘competitiveness’?

The report puts a strong emphasis on ‘competitiveness’ and structural convergence between countries, under the headline ‘economic union’ – which not coincidentally is the first chapter. And yet, the four issues outlined above were much bigger reasons for the crisis in the eurozone than the lack of structural reforms. Divergence in wages and prices, for example, was mostly a symptom of the weakness of counter-cyclical policy. Of course, the right mix of structural policies may well help countries to grow faster. But the problem is that economists do not understand very well which combination of structural policies in what sequence is most conducive to economic growth. The best hope for finding the right mix of structural policies is not an outside actor that moves a country closer to some defined benchmark; rather, it is the constant bargaining and local problem-solving that democracy is still best-placed to deliver.

Can the emphasis on economic union be explained politically? There is a political case for structural convergence. If there is ever going to be a true fiscal union, including risk sharing and temporary fiscal transfers, it needs political legitimacy, especially in the currently stronger countries. Such legitimacy is easier to establish if the public of a stronger country does not have the impression that it subsidies a more generous welfare state or laxer labour markets policies elsewhere. This is implicitly the argument that the report makes. But there is also the opposite political case. Since a true fiscal union is not on the cards, the outside meddling in domestic policy issues (and that is how the aim for structural convergence will be perceived in most countries) will delegitimise the eurozone, especially if the focus on structural policies does not improve the citizens’ economic well-being. The proposed measures to create a political union – for example to strengthen parliaments’ involvement in the European semester – are well-intentioned but unlikely to create the European polity that could overcome such national categories of thought and allegiance.

The five presidents’ report is a welcome attempt to focus the discussion on the institutional setup needed to make the euro a success. However, given the limited political appetite for further integration, it is important to focus reform efforts on where they are needed the most: to complete the banking and capital markets unions, as the report rightly recommends; to make the ECB a more activist central bank; and to make national fiscal policy strongly counter-cyclical. Such a policy mix would also be the best hope for escaping the eurozone’s current economic slump. The main obstacle to the implementation of the report will be Germany: neither common deposit insurance nor a common backstop for the banking resolution fund, nor an aggregate eurozone fiscal function and a strengthened MIP (which would target Germany’s current account surplus) will be to the Germans’ liking. If forced to make a choice, Jean-Claude Juncker should focus his political capital on completing the financial union first.

Christian Odendahl is chief economist at the Centre for European Reform.

Greece: After a deal, work on a solution

A deal between Greece and its creditors is still likely. But what the country really needs is a Greece-led, cross-party plan to transform its institutions – and less restrictive fiscal policies. 

The current negotiations between Greece and its creditors are entering the final stages – cue the involvement of Angela Merkel and François Hollande. The positions are still far apart – mostly on labour market and pension reforms that not only Syriza but also the previous Greek government refused to implement. The crucial deadline is now June 30th, when Greece promises to pay €1.6 billion to the IMF, after bundling repayments at the end of the month, followed by a €3.4 billion repayment to the ECB in July.

A deal on these reforms and fiscal targets will probably be reached in the end: neither Alexis Tsipras and Syriza, nor Merkel and the eurozone have an interest in Grexit. However, a deal will be a short-term fix rather than a long-term solution. Instead, Greece must formulate a long-term, cross-party package that addresses its institutional problems and is supported across Greek civil society. The creditors, on the other hand, need to back such a long-term plan, and put more sensible fiscal targets and debt relief on the table. If both come together, we may move toward a solution, not just a deal.

The politics of a deal

The key political question is: can Tsipras, Merkel and the leaders of other wary eurozone governments sell a deal to their own parliaments and electorates?

If Syriza were to reject a deal along the lines currently discussed, the party would probably split, opening the way for new elections, and excluding the more radical part of Syriza from power. While the polls currently suggest that Syriza has a comfortable lead, the consequences of rejecting a deal – which could result in bank closures and capital controls – might convince voters to give more moderate voices another chance. After all, polls still suggest that a majority of Greeks want to keep the euro, and want a deal in the end. Syriza is therefore likely to back Tsipras when he decides to put a deal to a vote.

Merkel frets about the wider risks of Grexit – the stability of the euro, the EU’s standing, but also the geopolitical implications of weakening a state at Europe’s crucial south-eastern border. She will not let it happen unless something forces her hand. Could that something be her finance minister, Wolfgang Schäuble, alongside CDU rebels? The answer has to be no: reports of a Schäuble-Merkel split are overblown. Schäuble can play the hawkish finance minister, which boosts his domestic popularity, because he knows that Merkel will step in to broker the compromise needed to prevent Grexit. The CDU is with reason dubbed the Kanzlerwahlverein – the “Chancellor’s supporters’ club” – by the German press. In the end, they will back Merkel, minus a few rebels.

Other eurozone countries will probably agree if Germany agrees, as they either tend to align with Germany, such as Finland, or have a less hawkish stance than Germany, such as France and Italy. For Portugal and Spain, it is important that the deal is not seen as an easy way out for Greece, as the governments in Lisbon and Madrid, which both have pushed through harsh adjustments and reform packages, are up for re-elections later this year.

The economics of a deal

The most controversial issues in the negotiations are labour market and pension reforms, and the pace of fiscal consolidation. Greece has liberalised its labour market considerably since 2011, and it is now more flexible than Germany’s, according to the OECD. Partly as a result, Greek labour costs and prices have fallen considerably (see Chart 1). And yet, exports other than tourism have largely failed to grow – contrary to those of other countries in southern Europe. Labour market inflexibility is thus unlikely to be holding back the Greek economy.

Greece’s labour market is already more flexible than Germany’s

Chart 1: Unit labour costs and GDP deflator in Greece and the eurozone

Source: Eurostat, Haver

Notes: Q1 2000 = 100. Unit labour costs measure labour costs per unit of output; the GDP deflator is a price index for the whole economy, not just consumption, as measured by the consumer price index.

The formerly very generous Greek pension system has already been substantially reformed. Further adjustments are necessary, but mainly because pension funds lost assets in the 2012 restructuring of Greek public debt, and the economy has collapsed, depriving the system of revenues. To make the system sustainable in the long term, further adjustments will have to be made, even more so with the recent court ruling against part of the cuts. However, the key to making the pension system sustainable is economic growth, not more cuts in entitlements. The political capital that could be wasted on another pension reform – with 45 per cent of pensioners already below the poverty line – would be better spent on measures to promote growth and employment.

The fiscal adjustment of Greece has been massive. The IMF calculates that spending cutbacks and tax increases amounted to 16.5 per cent of GDP between 2008 and 2013, roughly twice as much as Portugal or Ireland. The impact on the Greek economy has been devastating, increasing rather than decreasing the ratio of public debt to GDP. That the creditors still argue, despite overwhelming evidence to the contrary, that fiscal consolidation in an economic crisis reduces debt levels can only be explained by their huge investment in this false narrative. Even Sweden failed to consolidate its public finances in the early 1990s before economic growth resumed. The focus on fiscal consolidation in Greece is economically misguided.

Even Sweden failed to consolidate its public finances in the early 1990s before economic growth resumed.

What Greece really needs

What stands between Greece and prosperity is not another labour reform or wage cuts to make the economy more ‘competitive’, nor further fiscal consolidation or a pension reform to instil confidence in investors. The real issues are deeper than that. In order to unlock the potential of Greece, its entrepreneurial skills and underused natural resources, Greece needs to improve the institutions that govern its economy. 

First, Greece needs to reform its public bureaucracy, which has been opaque, inefficient, and clientelistic for decades. Successive reform attempts have largely failed, and the Greek public bureaucracy remains subject to heavy political influence. Since the crisis, Greece has made some progress, for example in tackling corruption, but the momentum for change was fading even before Syriza came to power. The problem is that institutional reform cannot happen without broad support from Greek society, politicians and bureaucrats themselves – and even then it will not happen easily, and take time.

Second, Greece needs decisive reform to its judicial system. A functioning legal system is at the heart of a market economy; it benefits entrepreneurs, investors, exporters, and lowers inequality. It currently takes 1,580 days to enforce a contract in Greece, according to the World Bank’s ’ease of doing business’ survey (the OECD average is 540 days). This places Greece 155th of 189 countries in the world, right alongside Chad, Pakistan and Italy. The broader rule of law index of the World Justice Project puts Greece at the bottom of high income countries, just above Russia. Justice reform usually takes a long time, and hence needs broad political and public support to be sustainable.

Third, Greece needs to cut unnecessary regulation and state involvement in product markets. Regulation serves the purpose of making product markets work better and minimising legal costs, but can also enable incumbents to stifle competition. The regulated therefore have an incentive to influence policy-makers to tweak regulation in their favour. State control of the economy, while useful in some areas, needs to be limited for the same reason: price controls and state companies are potential breeding grounds for clientelism. Greece uses more product market restrictions and state control of the economy than other eurozone countries, according to the OECD, although it should be noted that it has made progress in recent years and is now where Germany was in the not-so-distant past (see Chart 2). The OECD has compiled a list of 329 recommendations to improve competition in various Greek sectors, and those recommendations are part of the current negotiations. However, such liberalisation could prove short-lived if not complemented by judicial and bureaucracy reform.

Chart 2: Regulation and state control of product markets

Source: OECD

Notes: A high number indicates more regulation and higher state control.

Tackling these problems will take Greek ideas, Greek resolve, Greek perseverance – and not outside pressure. Support for reform will always be grudging if it is done at the barrel of a gun. Greek civil society and a broad coalition of political parties need to join forces and agree on a package to change these institutions sustainably, such that it is implemented regardless of the outcomes of future elections. The progress of the reform process should not be monitored by an outside actor, micromanaging Greek policies, but by a council consisting of Greek experts, Greek civil society and media, and the major political parties in parliament. Only with full ownership of the reform process can the institutions of the country be reformed.

If Greece puts together such a cross-party council and programme, the creditors should embrace it enthusiastically – and offer support in the form of less restrictive fiscal targets and the explicit and binding promise of debt relief upon the successful implementation of such a genuinely Greek package. At the very least, Greece needs fiscal policy to be neutral: that is, neither expansionary nor contractionary. Ideally, fiscal policy would be expansionary until the economy has recovered its lost output and unemployment has come down sharply. Fiscal policy is also the reason why debt relief matters: not only would a lower debt level reduce the need for further consolidation under the eurozone’s fiscal rules; lower debt levels would also increase the shock absorption capacity of the Greek economy in a future downturn by enabling the Greek government to avoid the pro-cyclical fiscal policies that it was forced to implement over the last five years.

Of course, Greece would need time to put such a package together, which is why a short-term deal at the current juncture seems necessary. After the deal, however, Greece and its creditors should start working on a solution, not just a deal.

Christian Odendahl is chief economist at the Centre for European Reform.

Know your enemy: How to break the EU’s gridlock on security measures

Terrorism and organised crime are serious threats to Europe. The EU is better placed than the member-states to deal with the transnational aspects of these threats. But disagreements between the Council and the Parliament result in gridlock over security measures. One reason is that sensitive information cannot be shared with MEPs, leaving them in the dark about both the threats and the means to deal with them. If the EU wants to tackle the threat of terrorism effectively, MEPs should be given adequate access to confidential information.

In February 2010, three months after the Lisbon treaty entered into force, the European Parliament rejected, for the first time, an international agreement concluded by the EU. The Lisbon treaty gave the European Parliament powers in the field of Justice and Home Affairs, including the power to ratify international agreements on security and counter-terrorism. The Parliament refused to ratify an agreement with the US on a Terrorist Finance Tracking Program (TFTP). The Council of Ministers and the US had spent the previous three years negotiating this agreement to trace the financial data of potential terrorists. TFTP used data provided by SWIFT, a Belgium-based company that processes international bank transfers. After the Council and the administration of George W Bush managed to reach an understanding, the European Parliament posed an unexpected obstacle. Amongst other things, the Parliament claimed that the Council had not provided MEPs with the necessary security information to show why the TFTP system was needed. The Council, however, was reluctant to disclose too much sensitive information on threats and foiled plots. And so the EU’s struggles in the area of privacy and security started.

Five years later, these struggles are far from over: institutional rows between the European Parliament and the Council have stopped the passage of several pieces of legislation (such as the EU Passenger Name Records directive (EU PNR), Europe’s system for exchanging information about airline passengers departing for or arriving from third countries). Revelations by former US National Security Administration contractor Edward Snowden on the breadth of US spying programme have eroded support for transatlantic data-sharing and other forms of co-operation (like the Transatlantic Trade and Investment Partnership, TTIP). For the first time ever, the European Court of Justice has annulled a directive (the data retention directive, which required telecoms companies to retain certain data for a period of up to two years and was championed by the UK). And international partners have definitely not figured out who to call in Europe to discuss security issues. The EU is suffering from a worrying paralysis on security measures.

This gridlock is risky: as exemplified by the recent attacks in Brussels, Paris and Copenhagen, terrorism and organised crime are, more than ever, international phenomena that require supranational responses; if the institutions do not manage to sort out the problems derived from the post-Lisbon arrangements, the EU’s security could be endangered.

When facing cross-border criminal activities, such as terrorism, having 28 different systems and legal frameworks in place is inefficient and expensive. Different standards in data sharing systems, for example, can lead to situations where information is not transmitted quickly enough between member-states. This can result in suspects being able to cross borders without being detected and make it harder to foil transnational plots. It also means more costs for the companies that need to implement the various standards (such as banks or aviation companies). Despite recent events, however, the current tendency seems to be towards less, rather than more Europe. Member-states retain many competences in the field of internal security. Unlike in other areas, such as Schengen, EU action is not compulsory. The blocking of the EU PNR directive, which has been under discussion since 2011, has prompted the adoption of national PNR systems, funded by the European Commission. While however, some member-states (like Germany) are very sensitive to data protection issues, others (like the UK) are not. Having several PNR systems in place, with different sets of safeguards and protections, will make the system less efficient and more expensive. An EU PNR system would ensure, in absolute terms, a more effective system with a higher level of data protection that would apply uniformly across the EU.

The gridlock over security measures in the EU is also detrimental to Europe’s transatlantic relations. The EU is currently negotiating a ‘Data Protection Umbrella’ agreement with the US. This deal will establish a general data protection framework applicable to all transatlantic data transfers for law enforcement purposes. With this agreement, the EU and the US hope to avoid having to negotiate data protection clauses every time a deal on information sharing is on the table.

The EU and the US are considering including transatlantic ‘data flows’ as part of the negotiations for a Transatlantic Trade and Investment Partnership (TTIP). In the wake of the Snowden revelations, there has been a public backlash against this move, due to concerns about the US framework for protecting private data. Dialogue between the EU and the US has become more constructive, but America is still unsure of who would be at the end of the line when it calls Europe to discuss security matters. And the US is getting frustrated by the institutional rows that break out every time security is at stake. The US may eventually bypass the EU as an institution and negotiate bilateral agreements directly with the member-states. This would be detrimental to the EU’s role in promoting global security, and to the efficiency of the fight against security threats in Europe.

There is a way to overcome this stand-off in the field of security. At present, the European Parliament is left in the dark about both the nature of the threats Europe faces and the kinds of tools law enforcement agencies and intelligence services need to combat them. The result is suspicion and misunderstanding. The Parliament should receive enough information to assess the real utility of security measures. This would help it to take informed decisions in the security field and contribute to a more productive dialogue between the Parliament, the Council and third parties, such as the US.

Under the current framework, the Council can only give access to confidential information to MEPs if they already have the necessary security clearances. Because security clearances are a matter of national competence, the process for obtaining them differs greatly from country to country. Some MEPs may find it easier to obtain their clearance than others. Some national administrations may not even want to issue clearances to their MEPs at all: in Ireland, for example, national MPs are not given access to any sort of confidential information. It would be difficult for the Irish administration to justify why its own national MPs do not get to access such documents while their European peers do. Moreover, many MEPs regard national vetting processes (which may include interviewing and researching friends and relatives) as highly intrusive. For these or other reasons, few MEPs are currently security vetted.

An EU security clearance system would help solve some of these issues. But such a system is currently out of the question: the EU does not have either the competence or a security agency of its own to conduct the investigations. One way to solve the problem of access to confidential information would be to set up a small group of MEPs with the necessary security clearances from their own states. The security-cleared body would have to have long-term, fixed membership. This group of MEPs would be responsible for evaluating the usefulness of tools such as PNR or TFTP on the basis of the confidential information it received. Such a group would facilitate communication between the Parliament and the Council, and would help to break the institutional gridlock, both within Europe and in the EU’s international agreements with partners such as the US.

For this system to work, both the Parliament and the Council would need to make concessions. The Council should step up its efforts to explain sensitive internal security matters to parliamentarians. It should also encourage national administrations, which may be reluctant to issue clearances for their MEPs, to do so. MEPs (and, specifically, members of the proposed security-cleared group) should accept that they will have to undergo the same security clearance procedure as any EU or national official who has access to confidential information.

The European Parliament is no angel, nor is the Council the devil. They represent different interests but they are both equally necessary for ensuring the EU’s security. They should put aside their differences over the Lisbon treaty division of labour and start working together. Europe’s security and transatlantic relations depend on this.

Camino Mortera-Martinez is a research fellow at the Centre for European Reform.