Centre for European Reform

Greece's real challenge

2012-02-03T08:54:00.000Z

by Katinka Barysch

The German idea of sending Athens a ‘budget commissioner’ was daft. Berlin itself could not tolerate such interference in its fiscal sovereignty (the constitutional court would never allow it). But to restrict such budgetary oversight to Greece alone would be disdainful and a political non-starter. The idea predictably caused outrage in Greece. Chancellor Angela Merkel has quietly dropped the proposal but the underlying problem persists: Greece’s donors – not only Germany but also other EU governments and the IMF, no longer trust Greek politicians to turn their country around.

Greece desperately needs a deal on a new bail-out package before March 20th when €14.4 billion in debt repayments are due. The IMF and eurozone governments insist that new money will only be forthcoming if there is a realistic prospect of Greek debt becoming sustainable in the foreseeable future. The IMF says that ‘sustainable’ would mean a debt level of 120 per cent of GDP by 2020 – although most economists think that 60-80 per cent is the most that a weak economy like Greece could cope with.

Even to reduce the debt level to 120 per cent from the current 160 would require a deep cut in existing debt, more fiscal austerity, lots of further outside help and a return to economic growth. Media attention has focused on the debt restructuring talks between Athens and it private creditors. But for Greece’s future prospects, the question of whether bond holders get 3.8 per cent or 4 per cent interest on their restructured portfolios is insignificant compared with the much bigger question of whether and when Greece emerges from its devastating recession.

There is now broad agreement among eurozone donors and the IMF that Greece will not be able to squeeze more revenue out of an economy that is in its fourth year of recession. The IMF forecasts GDP to fall by a further 3 per cent this year but private sector forecasters, such as the Economist Intelligence Unit, think that the economy may contract at twice this rate. In 2010, Greece went through the most savage austerity programme ever implemented by an OECD country. Yet the budget deficit at the end of 2011 stood at around 10 per cent of GDP, so adding to the already unsustainable level of debt.

The emphasis of Greece’s negotiations with the troika (IMF, ECB and European Commission) has shifted to structural reforms designed to boost growth. The good news is that there is lots of room for improvement: by many measures, Greece is the EU’s least efficient economy. The National Bank of Greece has calculated that a comprehensive reform package could boost the annual growth rate by 1.5 per cent over the medium term, although the OCED thinks an additional 0.5 per cent is more realistic.

The previous government of George Papandreou started making headway in various areas, for example by removing some of the protection enjoyed by truckers, lawyers, pharmacists and 140 other ‘closed shop professions’, by simplifying licensing procedures, making life easier for small businesses or giving workers and their bosses more wiggle room to set pay and conditions in Greece’s over-regulated and union-dominated labour market. Papandreou’s technocrat successor, Lukas Papademos, has continued along those lines.

The bad news is that most of these reforms so far only exist on paper – and even here they are often timid and riddled with loopholes. In many cases, the biggest obstacle to real progress is Greece’s bloated and inefficient state administration. According to an OECD analysis published in December, the central government is simply not capable of designing and implementing the growth-boosting reforms that Greece so desperately needs.

The ILO counts 390,000 civil servants in Greece. But add the 660,000 working for public corporations and other semi-state entities and the number swells to over 1 million – more than one-fifth of the workforce. Even that number may be too low since there are all manner of quasi-civil servants on outsourced or temporary contracts who enjoy similar pay levels and perks as full civil servants.

For many years, public sector salaries had outstripped those in the private sector; before the crisis they were on average 60-70 per cent higher. Public sector workers also enjoyed plenty of extra benefits, in addition to job security. Since the onset of the crisis, labour costs in the public administration, defence and social security have fallen by about 6 per cent, according to Greece's National Institute of Labour. In some parts of the private economy, such as hotels and restaurants, labour costs have fallen by 30 per cent. And unemployment has predominantly hit the private sector, too. “The real conflict is not between Greece and its donors. It is between the public sector and the rest of the population”, says one Athens think-tanker.

The troika demanded early on that Greece shrink the public sector by only replacing one of five of those retiring. But between early 2010 and mid-2011, the government added 20,000 people to the public sector payroll (which still amounts to 13 per cent of GDP). Now the troika insists that the government get serious about cutting the headcount by up to 150,000 over the next three years.

The December OECD report found that the main problem with Greece's state administration was not its size but the fact that it adds too little value. There is little sensible policy-making because ministerial bureaucracies do not collect or use data on which to base their policy designs. Moreover, ministries communicate badly with each other, if at all. And even within ministries most departments work in “silos” – they produce rules and regulations without much of an idea how they fit into any broader policy plans. The average Greek ministry has 440 different departments or administrative units. One in five of these do not have any staff other than the head of department and only one in ten have 20 staff or more. The central government alone is spread over 1,500 different buildings.

The OECD also found that civil servants care little if new rules and policies are implemented, monitored and enforced. The result is a state administration that is top-heavy, inflexible, obsessed with process and is basically busy having “a conversation with itself”, as the OECD puts it. Having watched the government’s laboured efforts to improve matters, the OECD now thinks that only a “big bang” reform could give Greece a public administration capable of planning and implementing meaningful change.

Similarly, a white paper that came out of a brainstorming at London Business School last year suggests that in some government areas a completely new start is needed. The most urgent is probably the tax administration. The authors of the white paper (Michael Jacobides , Richard Portes and Dimitri Vayanos) are sceptical whether the cronyism and corruption that pervades local tax offices can ever be tackled. Although the government has told its tax collectors to get tough on evaders (some €60 billion in taxes are outstanding), many have simply failed to heed orders to, for example, conduct audits on big tax debtors. Even former finance ministry officials admit that Greece would probably be better off to abolish the 300 local tax offices because they cost more than they collect. Instead, Greece should set up an independent central tax and social security collection agency.

The white paper suggests similar independent bodies in other areas: buying medicines and equipment for the healthcare sector (here, Greece’s spending per head has been the highest in Europe for many years); public procurement more generally (public contracts amount to 11 per cent of GDP but it takes on average 230 days to award such a contract); a corruption watchdog (although graft appears to be declining, according to Transparency International, one in ten Greeks said they paid a bribe in 2010, with public hospitals and tax inspectors being the most greedy); and a central steering group to supervise structural reform – a proposal also dear to the OECD’s experts.

Such independent bodies could potentially be established quickly and make a noticeable difference. However, the few new bodies that the government has so far set up, such as the privatisation agency and the parliamentary budget office, have been woefully understaffed. And they have encountered much political resistance when trying to carry out their assigned tasks.

Greece’s donors know that there are no quick fixes for the country’s deep-seated malaise. But they no longer trust the political class to carry out a sustained reform programme. Both big parties, Papandreou’s social-democrats (Pasok) and the conservative New Democracy, draw much of their support from public sector workers and other molly-coddled groups that resist change.

The new ‘technocrat’ government will hardly make a difference: Papademos has been given only five months before the next election is due. And unlike Mario Monti in Italy, who was free to fill ministerial posts with experts and other non-political types, Papademos is lumbered with 45 cabinet ministers, most of whom are career politicians from Pasok and New Democracy.

EU politicians now insist that all party leaders must commit to the new troika reform programme beyond the April election. But both Pasok leader Papandreou and New Democracy’s Antonis Samaras are opposing chunks of the troika programme while suggesting that there is an easier way out of the crisis than radical reform.

The negotiations for the new support programme are a good opportunity for a new deal: the troika eases demands for rapid fiscal consolidation and finds additional money for growth-boosting investments, for example from Greece’s €15 billion unspent EU funds or the EIB; Greek political leaders, in turn, get serious about public sector reform and opening up the economy. Ultimately, only the Greek people – not any kind of outside watchdog – can hold the country’s often self-serving politicians to account. To help the Greek people, Greece’s donors must make a bigger effort to improve their image in Greece and explain to the Greeks what needs to be done to put the country on a sustainable growth path.

Katinka Barysch is deputy director of the Centre for European Reform.

Why France is leaving Afghanistan

2012-02-02T15:39:00.001Z

By Edward Burke

The decision by President Nicolas Sarkozy to speed up the withdrawal of French troops from Afghanistan has re-awakened suspicions that Paris is not to be trusted as an ally. Sarkozy responded to the deaths on January 20th of four French soldiers by ordering the return of all France’s combat troops in 2013, a year before NATO plans to end major operations in Afghanistan. Defence officials in London and Washington have privately condemned the decision as poorly-timed or, worse, a cynical political ploy ahead of France’s presidential elections in April and May 2012. This belittles genuine concerns in France about the conduct of the war. A closer analysis shows that the French government is ahead of other allies in recognising that NATO's strategy has not worked.

French officials believe that the alliance is rewarding a profoundly corrupt government in Kabul that has shirked its commitment to reform. French thinking on Afghanistan is in line with that of David Galula, a French military strategist, who wrote what the US military itself regards as the definitive treatise on counterinsurgency. The lesson of the French war in Algeria in the 1950s and 60s, Galula wrote, is that military accomplishments are meaningless unless accompanied by a process to establish legitimate and broadly accepted political order. In Algeria, the French won the tactical battle against the insurgency but failed to offer a credible government to run the country – and in the end, the French public turned against what it saw as a hopeless problem requiring an expensive military commitment. In Afghanistan, the Americans are repeating France’s mistake from Algeria: they have put too much faith in a government that is so self-serving and corrupt that it stands no chance of increasing its credibility with the Afghan people. A recently leaked NATO report buttresses French views: it suggests that many Afghan officials have been actively working with the insurgency in order to distance themselves from the Karzai government.

The French have bitter first-hand experience with corruption and double-dealing on the part of Afghan officials. When Barack Obama launched an Afghan ‘surge’ in 2009, Sarkozy raised France’s contingent to just short of 4,000, and the French assumed a lead military role in Kabul and the neighbouring Kapisa province. Despite minimal consultations from Washington, Sarkozy decided to give Obama’s strategy the benefit of the doubt and refused to rule out additional troop increases in the future. But France quickly found that one of its most dangerous enemies in Kapisa was the provincial governor himself, who extorted the local populace and tipped off insurgents about the whereabouts and plans of French troops. Eventually, following considerable French and coalition pressure, President Hamid Karzai removed the governor in 2010. But French diplomats were appalled when the deputy attorney general, Fazel Ahmed Faqiryar, who was responsible for prosecuting the former governor, was in turn removed by Karzai. The president also vetoed a number of investigations of his senior government officials. Today Faqiryar, one of Afghanistan's chief fighters against corruption, lives under virtual house arrest in Kabul and is forbidden to receive visitors.

The Afghan security forces should be the French troops' closest ally. But in 2011 the International Crisis Group cited Kapisa as “one of the best examples of the nexus between the insurgency and corrupt Afghan security forces”, a statement privately endorsed rather than refuted by French military officers. France lays the blame on the Kabul government, which, Paris says, needs to reform and reconcile with its enemies if NATO intervention is to make any difference. And unlike Washington, Paris sees no point in sending a short-term ‘surge’ of troops to provinces where the Afghan government refused to curb the activities of predatory and corrupt officials.

Paris is having little success in getting Washington to listen; the US frequently ignores French concerns about corruption and incompetence in the Afghan government. Throughout 2010 and 2011, French diplomats in Afghanistan warned that the sharp increase in US aid under the Obama administration fuels corruption and indirectly funds insurgency (because many subcontractors pay 'protection' money to the Taliban). US officials recognised that their contracting and oversight procedures were flawed, but they chose to keep faith with Karzai’s vague promises to curb corruption, even though the Afghan government had deliberately obstructed several prior anti-corruption initiatives. Successive commitments to reform made at high-level conferences were ignored. Despite mounting evidence of misuse, US aid to Afghanistan almost trebled between 2008 and 2011.

Another clash between Paris and Washington occurred in 2010, when the International Monetary Fund (IMF) suspended the negotiation of financial aid to Afghanistan upon the refusal of the Karzai government to stop and investigate the theft of millions of dollars of aid money through Kabul Bank. France was particularly adamant that the international community should stand united in supporting the IMF and not allocate further large-scale funding to the Afghan government until it reformed the Kabul Bank and prosecuted those responsible for the scandal. But US military leaders complained that the Europeans were interfering with their timetable to build up the Afghan security forces and committed to fund the Afghan Ministries of Defence and Interior regardless of the IMF’s position.

Rather than addressing the shortcomings of NATO strategy, coalition headquarters in Kabul have a dangerous tendency to publicly present an exaggerated picture of success. For example, NATO officials cite polls claiming that the Afghan National Police (ANP), which assumed control of the Surobi district of Kabul from France in 2011, enjoyed 70 to 80 per cent approval ratings among the local populace. But French officers, who have seen first-hand the predatory behaviour of the ANP in Surobi, dismiss the figure as absurd, and point out that respondents are often afraid to voice their true opinions: many Afghan agencies that conduct such polls are not trusted and often travel with loathed private security companies. NATO needs the figures to look good because it has based its departure upon the capability of the Afghan government to deliver improved security and governance. France initially went along with this approach because it promised a quick exit but it has long doubted its credibility. The reality is that many provinces have become less stable since the US-led surge of 2009, yet NATO stubbornly claims that its strategy remains on course.

This is the context in which Paris made the decision to withdraw in 2013. France has had enough: its government has concluded that another year or so of a large-scale NATO military presence will not make a difference in the long-term as long as the Afghan government is obstructing rather than helping NATO to improve the governance of Afghanistan.

On balance, Sarkozy’s announcement is to be welcomed. After years of hand-wringing, misspent lives and money, a major member of NATO has finally sent a clear political signal to Kabul. In future France may become the first country to completely link its aid in Afghanistan to real progress in governance, as opposed to questionable opinion polls or recruitment numbers of new police officers. (There is no point in continuing to train security forces if their commanders are not interested in observing the law and intimidate anti-corruption agencies.) France should try to convince other countries and the EU to limit aid until the Kabul government seriously tackles corruption. The evidence is on the side of Paris: despite billions of dollars of aid and thousands of NATO casualties, Afghans trust the international community and their own government less and less.

US leaders such as former Defence Secretary Robert Gates failed the key rule of coalition fighting: the need to listen to, and act on, the views of other allies. They dismissed dissenting European voices on Afghanistan as a sign of weakness rather than foresight. Instead of giving allies more influence over the strategy, Washington repeatedly demanded more ‘boots on the ground’ and money. David Galula could have told them that this is never enough.

The Baltic states and Ireland are not a model for Italy and Spain

2012-01-27T09:52:00.002Z

by Simon Tilford

Eurozone policy-makers – from President Sarkozy and Wolfgang Schäuble to the former President of the ECB, Jean-Claude Trichet – advocate that Italy and Spain should emulate the Baltic states and Ireland. These four countries, they argue, demonstrate that fiscal austerity, structural reforms and wage cuts can restore economies to growth and debt sustainability. Latvia, Estonia, Lithuania and Ireland prove that so-called “expansionary fiscal consolidation” works and that economies can regain external trade competitiveness (and close their trade deficits) without the help of currency devaluation. Such claims are highly misleading. Were Italy and Spain to take their advice, the implications for the European economy and the future of the euro would be devastating.

What have the three Baltic economies and Ireland done to draw such acclaim? All four have experienced economic depressions. From peak to trough, the loss of output ranged from 13 per cent in Ireland to 20 per cent in Estonia, 24 per cent in Latvia and 17 per cent in Lithuania. Since the trough of the recession, the Estonian and Latvian economies have recovered about half of the lost output and the Lithuanian about one third. For its part, the Irish economy has barely recovered at all and now faces the prospect of renewed recession.

Domestic demand in each of these four economies has fallen even further than GDP. In 2011 domestic demand in Lithuania was 20 per cent lower than in 2007. In Estonia the shortfall was 23 per cent, and in Latvia a scarcely believable 28 per cent. Over the same period, Irish domestic demand slumped by a quarter (and is still falling). In each case, the decline in GDP has been much shallower than the fall in domestic demand because of large shift in the balance of trade. The improvement in external balances does not reflect export miracles, but a steep fall in imports in the face of the collapse in domestic demand.

Estonia had a current account deficit equivalent to 17 per cent of GDP in 2007, but by 2011 this has become an estimated surplus of 1 per cent of GDP. Latvia and Lithuania experienced shifts in their external balances of a similar magnitude. Ireland went from a deficit of 5.6 per cent of GDP in 2008 to a small surplus in 2011. There is little argument that all four countries needed to narrow their trade deficits. But countries that have experienced such enormous declines in domestic demand, and whose economic growth figures have been flattered by a collapse of imports (and hence improvement in trade balances) hardly provide a blueprint for others, let alone big countries.

Spain and Italy could bring about huge swings in their external balances by engineering economic slumps of the order experienced by the Baltic countries and Ireland. But a collapse in demand in the EU’s two big Southern European economies comparable to that experienced in the Baltic countries and Ireland would impose a huge demand shock on the European economy. Taken together, Italy and Spain account for around 30 per cent of the eurozone economy, so a 25 per cent fall in domestic demand in these two economies would translate into an 8 per cent fall in demand across the eurozone. The resulting slump across Europe would have a far-reaching impact on public finances, the region’s banking sector and hence on investor confidence in both government finances and the banks. The impact on sovereign solvency in Spain and Italy and on the two countries’ banking sectors would be devastating.

There are other factors that undermine the relevance of the Baltic and Irish experiences. In the face of mass unemployment, emigration, especially from Ireland and Lithuania, has ballooned. In the year to April 2011 alone, Irish emigration topped 76,000. The figures are similar for Lithuania, with 83,000 leaving in 2010. Comparable totals for Italy and Spain would be 1 million and 750,000 respectively. Moreover, the Irish have overwhelmingly moved to countries outside the eurozone (Australia, Canada, the UK and US). By contrast, a significant proportion of the very much larger number of Spanish and Italians would presumably be seeking work elsewhere in the currency union. The robust German labour market could absorb some migrants, but nothing like the numbers involved.

Despite massive movements in external balances that could not be repeated elsewhere and emigration that could not easily be emulated by others, Ireland, Latvia and Lithuania have experienced dramatic deteriorations in their public finances. Including the cost of bailing out Ireland’s banks, public debt has risen from just 25 per cent of GDP in 2007 to over 100 per cent in 2011. In Latvia the debt to GDP ratio increased from 9 per cent to 45 per cent over this period and in Lithuania from 16 per cent to 38 per cent. The exception is Estonia, which has managed to run largely balanced budgets over the last four years.

Italy and Spain have few lessons to learn from the experience of the Baltic countries or Ireland. Those advocating that Italians and Spanish emulate these economies should admit that they are arguing in favour of an unprecedented slump in domestic demand. They should then demonstrate how this would be consistent with the solvency of both governments and banks in Italy and Spain. Finally, they should explain how the European economy as a whole could cope with an economic shock of this order.

Simon Tilford is chief economist at the Centre for European Reform.

Is Austria the new Finland?

2012-01-13T11:39:00.003Z

by Katinka Barysch

In August 2010, a newly elected Slovak government refused to contribute to the first Greek bail-out. A year later, the rising popularity of the anti-euro True Finns pushed the Finnish government to demand that Greece should put up collateral in return for new loans. Which eurozone country will be next in line to hold up a bail-out package or veto new rules? Austria could be a good candidate.

Each time a smallish EU country balks at euro rescue efforts, analysts and policy-makers scramble to figure out its political dynamics and wonder why they had missed the brewing storm. With populism on the rise in much of Europe, and big countries dominating eurozone decision-making, it is only a matter of time before the next member-state throws a spanner in the works.

The EU’s traditional mode of decision-making is too cumbersome to fight the euro crisis. Instead, Chancellor Angela Merkel and President Nicolas Sarkozy have regularly pre-cooked plans before euro summits. Small and discreet bodies such as the Frankfurt Group (Germany, France, the European Central Bank, two other EU representatives and the IMF) have taken centre stage. The EU’s Brussels-based institutions have often been sidelined. So have smaller EU countries. Resentment about not having a voice has helped to lift nationalist and anti-euro forces in such countries. Their interventions are making EU policy-making a lot less predictable.

Austria could be the next place where the rise of anti-euro populists turns into a problem for the EU as a whole. The anti-immigrant and anti-euro Freedom Party (FPÖ) is polling neck and neck with the established parties, the conservative People’s Party (ÖVP) and the Social Democrats (SPÖ), which currently govern the country in a grand coalition.

A national election is not due until 2013. But in Austria’s scandal-ridden politics, an early election cannot be ruled out altogether. Some say that the current impasse over a planned national debt brake and austerity measures could spell the end of the ÖVP-SPÖ coalition.

During the days of the late party leader Jörg Haider, the FPÖ joined a coalition government with the ÖVP, prompting the other EU countries to boycott the Austrian government. Wolfgang Schüssel, Austria’s wily chancellor (prime minister) at the time, managed to neutralise the FPÖ in government. The party duly split in 2005 and for a while fell back to single digit support levels. Now it could be heading back towards 30 per cent. It is too early to predict the next election outcome. But tired of their deadlocked, squabbling grand coalition, Austrians seem to dread the spectre of an even bigger coalition of ÖVP, SPÖ and Greens (to keep the FPÖ out of power) just as much as a renewed ÖVP-FPÖ tie-up.

Few Austrians think that the current ÖVP leader (and foreign minister), Michael Spindelegger, could control the FPÖ’s firebrand leader, Heinz-Christian Strache. Strache already boasts that he will be the next chancellor. Strache’s personal approval ratings are awful, he lacks a comprehensive programme, and his party is as prone to scandals as its peers. But Strache’s promises to stop sending Austrian money to Brussels, hold referendums on existing euro rescue packages and start a debate about Austria leaving the euro resonates with the many EU-sceptic Austrians.

The Austrians’ ambivalence towards the EU has long been a puzzle. As a small, open and centrally located country that lives on exports and tourism, Austria has benefited a lot from the EU single market and the euro. Yet Austria has punched below its weight in Europe, its EU policies have been rather parochial (with few initiatives beyond the Balkans) and it has not produced as many great European figures as, for example, Sweden or Finland.

In surveys the Austrians have consistently been among the most sceptical about the EU. In the latest Eurobarometer poll, published in December 2011, 42 per cent of Austrians said they had a bad image of the EU. In neighbouring Germany, France and Italy, those shares are much lower, at 20-25 per cent.

However, Austria’s euroscepticism looks shallow. When asked more specifically whether they trust EU institutions, and want the EU to get more involved in, say, protecting the environment or fighting terrorism, the Austrians show themselves as solid (though not enthusiastic) pro-Europeans. While the Austrians are much less keen on more EU co-operation to save the euro than the Dutch or Finns, over half of Austrians say they would welcome eurobonds.

If the public mood on Europe appears confused, the government’s EU policies are even more so. In a baffling U-turn on the big parties' traditional pro-EU stance, Faymann in 2008 promised to hold referendums on future EU treaty changes. But after agreeing to the new eurozone-plus treaty (‘fiscal pact’) in December, Faymann wiggled out of his referendum promise, causing glee in an FPÖ that has long demanded more direct democracy.

Having been as implacably opposed to eurobonds as Germany, the government changed its mind once Austria's own bond spreads started rising last autumn. Shortly afterwards, Faymann departed from Austria’s monetary orthodoxy when he suddenly called for the ECB to play the “leading role” in saving the euro by financing the EFSF and the ESM. Meanwhile, Spindelegger came out in support of a smaller European Commission – although Austria has always been a staunch defender of the principle that each country must have its ‘own’ commissioner in Brussels.

Asked to evaluate Austria’s EU policies in a recent interview, the Czech foreign minister, Karel Schwarzenberg, quipped that “I cannot comment on something that does not exist”. That verdict may be unkind. But the impression persists that the current muddle results from the coalition’s desperate attempt to catch the eurosceptic mood and thus stop the FPÖ’s rise.

In her euro policies, Merkel is trying to keep the ‘smalls’ on board. She makes a point of phoning leaders from smaller eurozone countries to discuss (some say inform them about) plans for the next summit. She met Faymann ahead of the December euro summit. She, and Sarkozy, need to do more to quell the impression that today’s EU is run by a directorate of big countries, or worse, by a Berlin dictate. But the smaller countries also need to take advantage of such opportunities by presenting constructive proposals. For some, it appears easier to moan about being steamrolled by the Franco-German juggernaut than to stand up for their own ideas and interests.

Austria – with its enviable growth and unemployment rates (roughly 3 per cent and 4 per cent, respectively, in 2011, on EU data) – would be well suited to act as a spokesman for eurozone’s smaller creditor countries. It could be pro-active in safeguarding the authority of the EU Commission, without which the EU cannot function well. It could use its close ties to neighbouring Germany to remind Berlin that growth-promoting strategies are needed to deal with the debt crisis.

Instead, the coalition government’s lack of an EU strategy is playing into the hands of the Freedom Party: at least Strache’s anti-euro message is loud and clear. Unless the two main parties come up with an attractive alternative, Austria could become the next euro country that feels compelled to veto a euro rescue plan to placate domestic voters.

Katinka Barysch is deputy director of the Centre for European Reform.

What Europe's new diplomatic service can do for Britain

2012-01-10T17:24:00.004Z

By Edward Burke

As the influence of individual European countries vis-à-vis rising giants such as China declines, many look to the EU’s new diplomatic corps – the European External Action Service (EEAS) –– to augment their strength. But in 2011 Britain blocked the EEAS from articulating common EU positions at the UN, the Organisation for Security and Co-operation in Europe (OSCE), and in some foreign capitals, angering other member-states. However, a recent agreement among EU countries over representation at international organisations should allow Britain to adopt a constructive approach towards the EEAS. It may also help to add European weight to British foreign policy objectives.

Even prior to the 2009 adoption of the Lisbon Treaty, which created the EEAS, the EU had routinely spoken with one voice in multilateral forums. Therefore it came as a surprise to other EU member-states when Britain decided to renege upon established procedures. In May of last year, Foreign Secretary William Hague sent an urgent diplomatic cable to all British overseas missions, warning diplomats to look out for EEAS ‘competence creep’. Hague believed that the EEAS – without the consent of the member-states – was increasingly speaking for Europe on foreign policy issues, even where competence rested with national governments rather than the EU institutions. Shortly afterwards, British diplomats began to block EEAS officials from speaking at international organisations, saying that new arrangements were needed to clarify when the EEAS was speaking for the EU institutions, the member-states or both.

Germany, the Netherlands and other countries took a dim view of Britain’s concerns, seeing a eurosceptic, ‘spoiling’ agenda behind Britain’s actions. In particular, they resented William Hague’s opposition to a more forceful EU representation at the UN. Meanwhile, the European Commission threatened to take Britain to the European Court of Justice if the UK persisted in blocking the EU from speaking at multilateral organisations where it had at least partial competence.

On October 22nd 2011 EU foreign ministers agreed to new rules on diplomatic representation. In future, the EEAS and other EU representatives will have to identify when they are speaking on ‘behalf of the EU’ (implying that common institutions enjoy full competence over the matter), ‘on behalf of the EU and its member-states’ (in cases when common institutions share competence with national governments) or ‘on behalf of the member-states of the EU’ (when EU institutions have no competence and only act upon request of the member-states). Britain believes that these arrangements will prevent EEAS officials from making commitments without first consulting the member-states.

While the UK government feels vindicated by the October 22nd agreement, other capitals are grumbling about it. They argue that precedents have long existed for the EU to represent the member-states on issues of shared competence (as they have done for the past 20 years at the UN Food and Agriculture Organisation, for example). They are concerned that the UK will use the new rules to block a more proactive role for the EEAS in international organisations. Some also worry that the squabble over representation signals a deeper UK dislike for a collective EU foreign policy, and fear that the EU’s ability to reach out to the emerging powers, in particular, will suffer.

The UK government agrees that the EEAS should co-ordinate member-states’ policies towards countries such as Brazil, China or India, and try to bring European views closer together. But London opposes any suggestion that EEAS officials should craft foreign policy. As part of its wider vision of a more inter-governmental EU – as opposed to one with strong, centralised institutions – the UK wishes the EEAS to play a limited and strictly subservient role to its own diplomacy. In a speech at the Foreign Office in September 2010, Hague rejected any reduction in Britain’s own diplomatic outreach in favour of a new, European form of diplomacy: “We cannot outsource parts of our foreign policy to the European External Action Service as some have suggested. There is not and will never be any substitute for a strong British diplomatic service that advances the interests of the United Kingdom. We can never rely on anyone else to do that for us.” This view runs directly contrary to a desire of smaller member-states for the EEAS to speak on their behalf to the rising powers of Asia, Africa and Latin America.

Britain is not alone in refusing to substitute its bilateral relations with other countries for an approach led by the EEAS. Although the UK government is influenced by a long-standing ‘euro-scepticism’ within its ranks, the concerns of Germany, France and Italy derive from a more practical standpoint. These larger member-states are simply not yet convinced that the EEAS, despite the influx of seconded diplomats from EU countries, can match their own standards for political reporting and negotiation. They think that a collective European approach in foreign capitals is desirable but impractical under the current circumstances. So the EEAS is caught between misgivings over its right to speak on behalf of member-states and a lack of faith in its ability to do so. Consequently, the hopes of smaller member-states for an integrated European diplomacy in Beijing, Brasilia or New Delhi are likely to be disappointed.

It will take time to build a capable diplomatic service. The smaller member-states should therefore scale back their ambitions for the EEAS, and the EU as a whole needs to give its diplomatic service a more focused mission. The EU’s nascent diplomacy should mirror that of an emerging power, initially focusing on trade and consolidating its influence in the European neighbourhood. The EEAS should play a complementary role to the Commission’s trade duties by providing the political information that can make or break negotiations. While the Commission’s officials are good at technical dossiers they often lack an understanding of the internal political situation in the countries with which they are negotiating. For example, at a Doha round of WTO talks in 2008, EU officials underestimated the resistance of Brazil, India and others to a deal on reducing agricultural subsidies, leaving commissioners to appear surprised and defensive.

Similarly, in September 2010, the EU delegation failed to foresee that the European Union’s bid to gain speaking rights at the UN General Assembly would run into opposition from even traditional allies such as Australia, Canada and New Zealand. Neither was the EU aware until the last moment that the Caribbean Community, an important EU development and trade partner, would lead opposition to its proposals. This defeat exposed the lack of diplomatic capability within the EU, where an overwhelming focus on internal dialogue and co-ordination prevailed over outreach to external partners and political analysis. EEAS diplomats are well positioned to address this deficit, and the UK should push the EEAS and the Commission to work jointly to help the EU craft a better diplomatic strategy for future negotiations relating to trade and other areas.

Britain also has a strong motive to encourage the EEAS to become more active in the European neighbourhood, in particular in the Middle East and North Africa. Here, Britain lacks a comparative advantage over other member-states: Paris, Madrid and Rome have more influence in parts of the Arab world than London, and they have also taken the lead in shaping the EU’s policies towards the southern neighbourhood. The UK has previously opted for a secondary role, missing a valuable opportunity for added influence in a strategically important part of the world.

Britain has a security and trade interest in fostering stability in countries such as Egypt and Libya. And while it lacks the political and economic tools to do so alone, the EU is North Africa’s biggest market and investor. The European Commission now plans to spend €18 billion in development assistance from 2014 to 2020 in the neighbourhood countries, an increase of seven billion euros from the previous funding period. The EU has adopted a ‘more for more’ principle in the wake of the ‘Arab spring’, offering to negotiate enhanced access to EU markets in return for a strengthening of democratic institutions in neighbourhood countries. The UK should now press the EEAS to come up with clear criteria to measure progress towards political reform to ensure that ‘more for more’ becomes a consistent reality rather than mere rhetoric.

The UK relationship with the EEAS has got off to a difficult start. David Cameron’s decision in December 2011 to opt out of an agreement to create a fiscal union between most EU member-states further complicated Britain's relations with the rest of the EU. But foreign policy remains a prerogative of the full EU of 27 members, and Britain will have a strong say in it, even if it is not in the fiscal union. It is in the UK’s interest to work with other member-states to set coherent and achievable objectives for the EEAS. The agreement of October 22nd provides an opportunity for Britain to turn from defensive laggard on the EEAS to constructive pragmatist. The alternative is a constant, mutually destructive clash between competing bureaucracies. Britain is entitled to resist ‘competence creep’. The best remedy is for the UK to tell the EEAS what to do and where.

The Commission’s energy roadmap is a missed opportunity

2011-12-22T10:38:00.001Z

by Stephen Tindale

The European Commission recently published its 'Energy Roadmap 2050'. The paper begins by repeating the EU's commitment to reduce greenhouse gas emissions by 80-95 per cent (against 1990 levels) by 2050, and highlights the 2020 greenhouse gas, renewable and energy efficiency targets. It then acknowledges that "there is inadequate direction as to what should follow the 2020 agenda. This creates uncertainty among investors, governments and citizens".

The Commission is right to accept the need to set policies beyond 2020, since energy investments are inherently expensive and long term. But the rest of the paper does not propose a clear direction. It simply outlines seven possible scenarios: a reference scenario; current policy initiatives; and five different scenarios involving decarbonisation. The roadmap ends by acknowledging that "the next step is to define the 2030 policy framework" and promising proposals next year on the internal market, renewable energy and nuclear safety.

This is a missed opportunity. The Commission's role is to make policy proposals and it should have spent 2011 preparing these. It should also have published a list of measures which it considers to be the key priorities for 2012.

The Commission's energy roadmap follows the low-carbon roadmap and a transport roadmap that it published last March. All these roadmaps are descriptions of various possible scenarios. Scenario planning and modeling are important, but it is not clear why the Commission thinks it should do these exercises itself; when it does so, it inevitably has to manage the different views of its own directorates-general, and the member-states, in drafting the text. The International Energy Agency publishes valuable and well-respected roadmaps. The European Climate Foundation has also published an excellent 2050 energy roadmap and 2030 electricity roadmap.

To be fair to the Commission, it did publish one significant energy policy proposal in June, the draft 'energy efficiency directive'. Adopting this should be the top EU energy priority for 2012. If Europe produced and used energy more efficiently, its economic recovery and the climate would benefit. But there is substantial member-state opposition to this Commission proposal – some on grounds of subsidiarity, and some on grounds of cost (though investment in energy efficiency will almost always be cheaper than investment in new energy supply). For example, many energy companies do not support the Commission plan to make combined heat and power mandatory on most new power stations – and energy companies have substantial influence over their host governments.

The second EU energy and climate policy priority for 2012 should be to rescue the Emissions Trading System (ETS). In 2007, so before the recession, allowances were trading at €25/tonne. They are now trading at less than €7, making the ETS irrelevant to investment decisions. All the roadmap's decarbonisation scenarios assume major increases in carbon prices. Many energy companies want the Commission to take steps to push up carbon prices. For example, the EU Corporate Leaders Group on Climate Change, whose members include Shell, Alstom, Philips and Dong Energy, has written to the Commission calling for "decisive action now".

The best way to ensure long-term ETS price stability would be to set a Europe-wide reserve auction price: governments could announce that no allowances would be sold for less than, say, €15/tonne. This could be achieved formally through an EU-wide agreement, or informally by member-states with sufficient numbers of allowances creating a 'coalition of the willing'. Such a coalition would need to include all the big economies which use large quantities of fossil fuels for electricity generation – which means all the large European economies except France.

There would be substantial opposition from Poland and Spain, because of the amount of coal these countries use for power generation, and support from the UK, where the government is already introducing a de facto carbon floor price. The view of the German government is harder to predict. Chancellor Merkel's retreat from nuclear power means that Germany will burn more fossil fuel. But Merkel's CDU is less close to the coal industry than the opposition SPD, and Merkel will be actively seeking green votes in the run up to Germany's 2013 elections.

The EU has already agreed arrangements for how the ETS will operate until 2020, and total numbers of carbon allowances for each year until then, so some policy-makers and businesses are arguing that it would be wrong to intervene in the market. But the number of allowances were set against a 'business as usual' scenario – and business is anything but usual at present. To rescue the ETS from irrelevance, intervention is essential.

The EU has agreed that the total number of allowances will reduce by 1.74 per cent each year. This annual reduction will continue after 2020. Apart from this, nothing has been agreed about how the ETS will operate after 2020.

Caps for the years 2021 to 2030 need to be set soon, and the annual rate of reduction increased above 1.74 per cent. But given the track record of ETS price fluctuations, even a greatly improved ETS is unlikely to provide an adequate post-2020 policy framework to give businesses and investors confidence.

So the third priority for EU climate and energy policy in 2012 should be to set out a strategy for 2020-30. At the press conference launching the Energy Roadmap 2015, energy commissioner Günther Oettinger called for an immediate discussion on targets for renewables by 2030, with a decision in two years' time. Targets are less important than policies, but can play a useful role. The roadmap states, correctly, that the 2020 renewables target has given investors greater confidence.

So the EU should give priority to three steps in 2012: adopting the energy efficiency directive, operating a reserve price for ETS auctions and setting a 2030 renewable energy target. Given the eurozone crisis, there is a danger that climate and energy issues will slip down the EU's agenda. But the Danish government, which holds the EU presidency in the first half of 2012, has made clear its intention to prevent this happening. It believes that strong climate and energy policies will boost 'green growth'.

The Danish climate and energy minister, Martin Lidegaard, has said that "every euro spent on energy efficiency will go to ensuring European jobs. Every euro spent on oil imports will go out of Europe". He has acknowledged that the current ETS price is "not sustainable" but not said what he will do about it.

Denmark has an excellent story to tell on climate and energy policy. Since the late 1970s, in response to the oil shocks of that decade, it has vigorously pursued energy efficiency and renewable energy. Denmark has the lowest energy intensity (energy used per unit of GDP) of any member-state. Over 20 per cent of its electricity comes from wind farms. There is a cross-party consensus on climate and energy issues.

Before she became commissioner for climate action, Connie Hedegaard was Danish minister for climate and energy. So despite the eurozone crisis, the treaty negotiations and the inevitable arguments over the multiannual financial framework, we can expect the Danish presidency to remind EU institutions not to neglect climate and energy policies.

Stephen Tindale is an associate fellow at the Centre for European Reform.

The UK-EU split: The impact on Central Europe

2011-12-13T16:35:00.001Z

By Tomas Valasek

The UK decision to boycott the new EU treaty removed an important liberal economic voice from the centre of European decision-making. This has left like-minded EU countries, including most of the Central European states, in a far weaker position to resist the etatist tendencies of France and (to a lesser extent) Germany - all the more so because Britain's actions have also shifted power in the EU from small to big states.

I spent the weekend at a Central European ‘strategy forum’ organised by the Slovak Atlantic Commission and attended by senior officials from the Czech Republic, Hungary and Slovakia. The economic crisis and last week's summit dominated the debates. The prevailing sentiment was one of disappointment that the new 'fiscal union' will operate on an intergovernmental basis: because the UK vetoed a new EU treaty the rest of the member-states will now set up a club outside existing EU rules. This weakens the role of common institutions such as the European Commission (in which each country has one member). The smaller countries prefer strong European institutions because they help balance the power of big member-states such as Germany and France. Germany wanted to work through the EU institutions too but France prefers a new club, seeing it as a way to undo the 2004 enlargement. The UK veto played into Nicolas Sarkozy’s hands, and cemented the dominant role of Germany and France in the new fiscal union, to the alarm of the Central Europeans. "We are being presented with decisions on which we have minimum influence", one official said at the event in Slovakia.

The new balance of power in Europe raises several worrying possibilities. The first is that the inner core will continue to shrink. This is because the perception of a Franco-German diktat is feeding a populist backlash in smaller countries. Voters in Central Europe but also in Finland or the Netherlands are alarmed by a lack of influence over their own affairs and turning to Eurosceptic parties. The Central Europeans worry that this might eventually cost them membership in the fiscal union: "The more excluded we are, the more difficult we find it to pursue sensible policies, and this in turn gives France more reasons to kick us out altogether", one participant observed.

The second key concern for the Central Europeans is that France and Germany may try to expand the remit of the core group beyond issues such as national budgets and deficits to include taxes or labour standards, as Nicolas Sarkozy's and Angela Merkel's joint letter from before the summit sets out. This presents a direct threat to the Central European economic model built on low taxes and investor-friendly laws. In particular, the French desire to harmonise some tax rates might remove one of the Central European economies' competitive advantages. I have heard a prime minister of one country in the region argue that "the freedom to set our own tax levels is an existential issue, for which we are willing to leave the core". If Paris and Berlin agree to unify tax rates, the EU's fiscal union could quickly lose more countries – as it is, the Czech and Hungarian governments asked for more time to assess whether they want to join in the first place.

In theory, the Central Europeans can veto any move to harmonise tax rates because it requires unanimity. In practice, smaller countries need the support of others to resist the pressure from the big countries. In the past, the UK could be counted on to fight alongside the Central Europeans to keep decisions on taxes and social issues in the hands of the capitals. But at the summit, London has managed to "drive itself towards the edges of European politics", one Central European ambassador said at the event in Slovakia. The remark was offered with regret, not glee. On social issues, taxation or the single market, the Visegrad countries are firmly in the UK, not Franco-German, camp. But they have little sympathy for David Cameron, who is seen as having brought the isolation on himself, and blamed for weakening common institutions and thus reducing the power of smaller states.

Another priority which the Central Europeans share with the UK is economic growth and a wish to rebalance Germany's one-sided insistence on fiscal austerity with measures to boost the European economies. At the Central European strategy forum, some think-tank participants argued that governments in the region should join forces with London to launch a drive to cut red tape and expand the EU's single market into new realms such as services and digital economy. The UK had proposed similar measures a few months ago, to little avail. A new joint initiative, in addition to boosting growth, would have the added benefit of underlining that decisions on issues such as single market, labour standards and tax rates are for the 27 to decide, not the core.

But the government officials present at the event showed little interest in the idea. Privately, they say that Britain has become toxic by association; that ideas which it sponsors will be resisted on principle, not on merit. And for governments that share London's liberal view on the economy, that is a depressing conclusion.

Britain on the edge of Europe

2011-12-09T18:05:00.000Z

By Charles Grant

The outcome of the Brussels summit on December 8th and 9th is a disaster for the UK and also threatens the integrity of the single market. For more than 50 years, a fundamental principle of Britain’s foreign policy has been to be present when EU bodies take decisions, so that it can influence the outcome. David Cameron, the prime minister, has abandoned that policy. Britain will not take part in a new fiscal compact that most other EU countries will join.

France and Germany have persuaded the other eurozone countries that treaty changes are needed to enshrine stricter budget policies and closer economic policy co-ordination. The new procedures would apply only to countries in the euro. Most member-states wanted to enact those reforms through amending the existing EU treaties. That would ensure that countries in the euro, and those outside, would be subject to a single set of rules and institutions.

But Britain blocked that deal, pushing France, Germany and most other member-states to proceed with a new treaty, to sit alongside the EU treaties. The new treaty may face difficulties: the Irish may hold a referendum on it and could easily vote no. But Paris and Berlin are determined to press ahead with the fiscal compact and if the Irish vote against it they are likely to find themselves excluded.

Cameron blocked a treaty for all 27 because he could not obtain agreement on a protocol to protect the City of London. This protocol demanded a switch from majority voting to unanimous decision-making on a number of issues that matter for the City, including the extension of the powers of EU regulatory authorities, and rules that prevent national governments from imposing stricter requirements on bank capital.

Cameron was right to seek to protect the interests of Britain’s hugely important financial services industry. Most financial regulations are decided by qualified majority vote, and there is a risk that new EU rules could damage this vital national interest. However, Britain has never yet been outvoted on a significant piece of EU financial regulation. If Cameron had been prepared to compromise on his demands, he might have been able to secure a deal.

But France’s president, Nicolas Sarkozy, was annoyed by Britain’s demand for special treatment, and had no desire to do the City favours; indeed, after the summit he said that a lack of regulation of financial markets was responsible for many of the current problems. Other heads of government found Britain’s demands and the way it presented them unreasonable. They also complained about the lack of British diplomacy: the British Treasury took its time to draft the protocol and did not present it to the Council of Ministers legal service until the day before the summit. The British made no effort to sell the protocol to most of the member-states. In short, there was little goodwill towards Cameron.

As far as I can gather, the UK government’s position stiffened between the morning of December 7th and the evening of December 8th. At the start of that period, Cameron seemed to want a deal, as his article in The Times indicated. But then loud rumblings from Conservative eurosceptic backbenchers – and calls for a referendum from two cabinet ministers and London Mayor Boris Johnson – made the Conservative leadership reluctant to show flexibility. Some senior Conservatives worried that if the government accepted a new EU treaty it would struggle to push it through Parliament. Many Tories would have rebelled and it probably would have passed – if at all – only with Labour’s support, thereby humiliating Cameron. That is why some senior figures in the government did not want a deal in Brussels.

But Britain’s so-called veto – which has not stopped anything from happening – seems likely to damage its interests. For a start, the government failed to achieve any sort of protection for the City. The countries taking part in the new arrangements (between 23 and 26 member-states are likely to adopt them) will meet regularly and discuss economic policy. They are also bound to talk about single market issues such as financial regulation. In theory, single market matters will still be settled by all 27. In practice, the countries in the new club are likely to caucus and pre-determine the results of EU votes on single market rules – whether they concern the City or other matters.

In the new arrangements, the Commission and the European Court of Justice will almost certainly play a diminished role. That is because France and Germany, the dominant countries in the fiscal compact, are hostile to the Commission and favour a more ‘inter-governmental’ Europe. To the extent that these institutions are weaker, they will be less able to do their job of defending the single market and ensuring that all member-states are treated fairly.

Some British eurosceptics seem to imagine that the new club will not be allowed to use EU institutions without Britain’s permission. There are likely to be complicated law-suits, but if most member-states want the Commission and the Court to play a role in the fiscal compact, these institutions will play a role. The institutions will have to try and reconcile two sets of rules and procedures, which will make it harder for them to do their job of policing the market.

What if the eurozone countries want to harmonise banking regulations, which they may need to do in order to ensure the success of the euro? Britain would not support a centralised system of banking regulation, but could easily be outvoted. Rules on banking regulation, like other single market issues, will remain subject to qualified majority voting among the 27. But if Britain wants to win votes, it will need allies.

I can never recall Britain being so friendless in the EU. Countries that might be sympathetic to the UK, such as Denmark, the Netherlands, Poland and Sweden, have grown impatient with the Cameron government. They have always wanted Britain to be influential in Europe, to balance the power of France and Germany. They would have much preferred all 27 countries to stay together. Britain’s self-exclusion has left them disappointed. Many of the smaller member-states are unhappy: when EU institutions weaken, they are more likely to be pushed around by France and Germany.

Since it joined the EU in 1973, Britain’s impact on the EU has been positive in many ways. It has pushed for legislation to bring about the single market. Together with France, it invented EU defence policy and it has contributed a lot to EU external policies, in areas such as the Balkans, Iran and climate diplomacy. It has helped to maintain the EU’s Atlanticist orientation. It has encouraged the EU to look outwards and see globalisation more as an opportunity than as a threat. With Britain’s voice diminished, the EU is less likely to deepen the single market and more likely to be inward-looking.

It is conceivable that a different British government could seek to reverse this disastrous opt-out. More likely, Britain will continue on a path towards isolation, perhaps even leaving the EU itself.

EU summit: Enough to save the euro?

2011-12-09T17:06:00.000Z

by Simon Tilford

The UK’s decision to marginalise itself by vetoing a new EU-27 treaty has dominated the post-summit media coverage. And for good reason – it could prove a big step towards UK withdrawal from the EU. However, the bigger question is whether the agreement reached at the summit will do anything to address the fundamentals of the euro crisis.

Unfortunately, the news on this point is just as bad. This summit will go down as yet another missed opportunity. Despite rhetoric to the contrary, the summit suggests that policy-makers have not yet taken on board the seriousness of the eurozone’s predicament. There was no agreement to close any of the institutional gaps in the eurozone, such as the lack of either a real fiscal union or a pan-eurozone backstop to the banking sector. There was no agreement to boost the firepower of the European Financial Stability Fund (EFSF), while the move to beef up the IMF’s finances fall far short of what is needed. As a result, there is little to prevent a further deepening of the crisis.

What has been agreed falls far short of a ‘fiscal union’. There will be no joint debt issuance, no shared budget, and no mechanism to transfer monies between the participating countries. Essentially, the agreement hard-wires pro-cyclical fiscal austerity into the institutional framework of the eurozone, with no quid quo pro in terms of a commitment to move gradually to debt mutualisation. It is little more than a revamped version of the EU’s existing Stability and Growth Pact. The market reaction has been less than euphoric – bond spreads have jumped sharply. Italian yields have risen back to close to 7 per cent.

This is unsurprising. Fiscal austerity alone will not solve the crisis. Indeed it has become part of the crisis. Such a strategy has already failed in Greece and Portugal and it threatens to make a bad situation in Spain and Italy even worse. What the eurozone needs is economic growth, and this agreement further worsens the outlook for that. The eurozone economy is facing a deep recession, and mounting signs of a credit crunch across much of its southern flank, as capital flight gains momentum. To adhere doggedly to a crisis strategy centred on the single pillar of fiscal austerity risks causing a further erosion of investor confidence.

But does the agreement at least give the Germans cover to back more substantive solutions to the crisis, such as debt mutualisation? So far, there is little indication of any thaw in the German opposition to debt mutualisation (‘eurobonds’), but a tough fiscal regime could potentially make it easier for the German government to accept, in principle, the case for eurobonds. The problem is that the longer the crisis goes on, the riskier eurobonds become for Germany economically and hence politically: the bigger the crisis, the larger the impact debt mutualisation would have on Germany’s own borrowing costs, and the larger the obstacles the government would face in trying to sell eurobonds to voters.

And does the agreement provide sufficient cover for the ECB to step up its buying of struggling eurozone countries’ government bonds?
The ECB has stepped up support for the eurozone’s battered banking sector. For example, the ECB has increased liquidity support for the banks: among other measures, banks will be able to borrow from the ECB on longer maturities. But there is no indication that the ECB will dramatically increase its bond buying or set targets for member-states’ borrowing costs. There was apparently strong opposition on the ECB’s governing council to the provision of additional support to the banking sector. For the time being it seems unlikely that the governing council will sanction the scale of bond-buying needed to dispel fears of default. The bank certainly could not intervene indefinitely, anyway. ECB action would need to be accompanied by institutional reforms, in particular a move to mutualise debt. In the absence of that, large-scale bond buying would quickly erode the ECB’s credibility.

The eurozone appears to be little nearer to striking the ‘grand bargain’ needed to secure the future of the single currency. Germany continues to believe that investor confidence can be won back through the imposition of legal regulations. But stability cannot be achieved through regulation. At a time when the European economy faces an acute risk of depression, the eurozone still has no economic growth strategy. Eurozone governments also failed to agree to set aside more money for the EFSF and all the indications are that the ECB will remain cautious.

So the summit has failed to bring any short-term reassurance to investors and done nothing to close any of the eurozone’s institutional gaps. It has set the scene for a new and even more dangerous phase of the crisis. Politics might still come to rescue of the single currency, but the omens are not good.

The French learn followership

2011-11-30T18:19:00.001Z

by Charles Grant

For the first time in the history of the EU, Germany is the unquestioned leader, and France is number two. Since the financial crisis struck in 2008, the economic inequality between France and Germany has grown. Although regular summits between Angela Merkel and Nicolas Sarkozy maintain the appearance of parity, France's higher levels of debt and public spending, its lower level of exports, its less well capitalised banks and its rising borrowing costs vis-à-vis Germany have forced it to accept German leadership on economic policy.

Last week I talked to officials in Paris about the eurozone crisis. The franker among them admit that on many of the key arguments – should the eurozone be run according to strict rules that minimise the scope for political discretion, should there be a treaty change, should the European Central Bank (ECB) intervene massively to support governments in trouble, and so on – German views have prevailed.

French officials fret about the sustainability of the euro. Their analysis is similar to that of the Anglo-Saxons: they worry that the German medicine being applied to the eurozone ignores the importance of demand and growth, and that few German policy-makers understand financial markets. But unlike the Anglo-Saxons, they think it better not to lecture the Germans in public on what they should do. The French think that the Germans will probably do what it takes to preserve the single currency, in the end. But several officials expressed the concern that, by the time the Germans decide to move, it may be too late to save the euro.

The French are reticent about the German plan to change the EU treaties. They assume that a new treaty will have to be preceded by a convention, as was the constitutional treaty. But when the convention – consisting of MEPs and national parliamentarians, as well as governments – meets, can the Germans ensure that it discusses only the euro, rather than every subject under the sun? Then there is the difficulty of ratifying a new treaty. The Irish, for example, would have to hold a referendum and in their current mood would probably vote no. But the French are going along with treaty change, because they hope that a new treaty with strict rules on government borrowing will make it easier for the Germans to change their current policies on the euro. In the short term that means accepting that the ECB should become a lender of last resort to eurozone governments.

In the forthcoming treaty negotiations, the French want to balance the German emphasis on budgetary discipline with some distinctively French thinking. Officials talk of treaty articles on economic growth and the co-ordination of macro-economic policy, tax rates and labour market rules. They also want to amend Article 136 of the Treaty on the Functioning of the European Union, which allows the eurozone countries to adopt new rules on budgetary discipline. The French want to broaden the scope of that article, beyond the Germanic preoccupation with budgets.

The French hope that the new treaty will pave the way for eurobonds, but know that collective eurozone borrowing only makes sense once budgetary policy has been centralised, which will take several years. In the meantime the French think that the eurozone needs a European Monetary Fund (EMF) to support countries in trouble. An EMF would, like the IMF, lend to countries that cannot borrow commercially, and set conditions. It would also lend preventively to countries that might face problems. It could be based on the European Stability Mechanism, the bail-out fund that is currently under construction.

Many parts of the French government would be happy to see an EMF become a rival source of expertise and power to the European Commission, though the Trésor has doubts about such duplication. France would like an EMF to take decisions by majority vote, so that it could move quickly and not worry about, say, a potential Slovak veto. But the Germans generally prefer unanimous decision-making on bail-outs.

The UK is in bad odour in Paris. Public lectures from David Cameron on what the eurozone should do have gone down badly (even though the French share much of his analysis). The French think the UK hypocritical: it says it cares about the single market but then wants special protection for the City in any new treaty – which as far as the French are concerned would be opting out of the single market. Would the French accept a special deal for the City in a new treaty? "Not if it erodes the concept of majority voting", said one official.

Like the Germans, the French say that if the UK asks for too many treaty opt-outs, they will go for a treaty that covers only the eurozone, or only countries in the euro plus those which plan to join it. The Germans are keen for the treaty to cover all 27 member-states, if possible, to make it easier for the Commission and European Court of Justice (ECJ) to discipline miscreants; the French, always sympathetic to the idea of a core Europe, are more relaxed about a treaty for fewer than 27. French officials disagree on whether it would be feasible for a eurozone treaty of 17 or 17+ to give the Commission and the ECJ a significant role. But they are all reluctant to see the ECJ involved in fining governments that breach eurozone rules.

At the moment, France and Germany are both hostile to the Commission but the French are even keener to minimise its role in managing the euro. They question its professional competence and worry about commissioners from non-euro countries voting on sanctions against, say, France. Paris wants such commissioners excluded from decisions on eurozone governance. The Elysée and the Matignon (the prime minister's office) are more negative about the Commission than the Quai d’Orsai or the Trésor – which think the Commission has a useful role to play in applying the recently adopted laws on budget discipline and eurozone imbalances.

But they are all critical of President José Manuel Barroso for his alleged "lack of vision". The French accuse the Commission of being invisible during the crisis and of not taking enough initiatives – though one official admitted that if it had been more active France would have complained. Among the criticisms I heard last week were that the Commission should have done more during the last decade to warn of the Irish and Spanish economies overheating; that it has pushed ahead with an EU-Mercosur trade accord, though this will harm French farmers and Mercosur has not offered reciprocity; and that although in July the EU asked the Commission to set up a task force to help Greece speed up reform, the task force did not start work till October.

François Hollande, the Socialist presidential candidate, has not yet said much of note on the eurozone crisis or the future of the EU. But he comes from the pragmatic, broadly pro-European wing of his party and his line on the EU is unlikely to be very different from that of Sarkozy. In fact Marine Le Pen, the leader of the Front National, brackets the Gaullists and Socialists together, saying that they are both - unlike her - for globalisation, the EU, the euro and immigration ( Marine Le Pen and the rise of populism). She is also an unremitting critic of the EU’s 'undemocratic' nature.

French policy-makers know that with national budgets likely to come under greater eurozone control, they will need to have an answer to those who claim that the EU is undemocratic. There is no love for the European Parliament in Paris. But officials talk of giving national parliaments a role in eurozone governance. They support Joschka Fischer's idea for a new committee of national parliamentarians to hold eurozone institutions to account.

The French government worries about Le Pen – who is currently polling between16 and 21 per cent. In past presidential elections the Front National has scored better than the polls predicted. If the euro crisis worsens, and requires France to adopt painful austerity measures, Le Pen's implacable hostility to the single currency could earn her extra votes. She could get through to the second round of the presidential election in May 2012, as her father did in 2002, though she could not win. The presidential election is unlikely to change the broad thrust of France's EU policy, but the euro crisis and the increasingly dominant role of Germany could push the French people in a eurosceptic direction.

The curious case of German leadership

2011-11-29T14:30:00.001Z

By Katinka Barysch

Some of Germany’s European partners accuse Chancellor Angela Merkel of refusing, or failing, to lead properly in the euro crisis. Many Germans agree with that analysis and call for Merkel to guide the rescue efforts with a firmer hand and more vision. Just as many, however, think that Germany is actually leading well, and that this is not sufficiently acknowledged. As one opposition politician put it to me during a recent Berlin visit: “Germany is expected to lead, and if we do, we are criticised as arrogant – unless it’s in line with what others want.” I learnt that the way many Germans define leadership differs from the views that seem to prevail in other EU countries.

Recent remarks by Volker Kauder, head of the parliamentary faction of Merkel’s CDU (and the CSU), that Europe was now “speaking German” were crude – and treated as such by much of the German media. But the sentiment behind that statement is quite common. Many in the government say that leadership consists of spreading Germany’s ‘stability culture’ throughout Europe. They point to the fact that Greece is implementing reforms that were unthinkable until recently, that Italy is now run by a man who praises the strengths of the German model and that Nicolas Sarkozy is trying to get re-elected as president by promising to cut the French budget.

The Germans say they do not want to be the ones who impose austerity and reforms on their neighbours. They clearly do not enjoy being unpopular. And the experience of reunification has shown them how hard it is to salvage an ailing economy (in that case the eastern Länder) even if you can impose your own laws and practices. Merkel’s government therefore wants to construct new eurozone rules and institutions – but in a way that spreads and enforces a German vision of a ‘stability union’. (On how Germany should handle the euro crisis see 'Why stricter rules threaten the eurozone'.)

Accordingly, the German debate has shifted since the summer. The early debate had been focused on crisis management and blaming profligate South Europeans. Most Germans were spooked by the impression that market pressures were forcing their government into one U-turn after another. Opposition leader Frank-Walter Steinmeier liked to quip about ‘Merkel’s law’: the more fiercely Merkel rules something out, the more certain one can be that it will happen in the end.

In the last couple of months, the German debate has started addressing broader questions about the future of the euro and the EU. Political leaders are queuing up to make big European speeches. Now that the government talks about new treaties and institutions it looks more in charge. Politically, the strategy is working: almost two-thirds of Germans now approve of Merkel’s management of the euro crisis, up from 45 per cent in October.

However, the government’s vision for Europe is limited so far: a few ‘surgical’ amendments to the EU treaty to introduce automatic sanctions, take fiscal rule-breakers to the European Court of Justice and allow Brussels to intervene in the budgets of countries that ask for bail-outs. While Germany appears happy for the EU to curtail the sovereignty of countries that spend too much, it is reluctant to accept new constraints itself. During a recent Euro Group meeting, Finance Minister Wolfgang Schäuble obtained written assurances from his counterparts that the reprimands and sanctions of the new ‘imbalances procedure’ would apply only to countries with deficits, not those with surpluses. Spain in particular had called for more ‘symmetric adjustment’. Even economically literate Germans tend to react to such calls with simplistic statements such as “you cannot ask us to reduce our competitiveness and exports” or “we cannot increase our wages artificially to suit the eurozone because we also compete globally”.

A Germany in leadership mode would acknowledge that more German demand would help its troubled neighbours to export their way out of recession and that there are all manner of reforms (some of which the government is working on or contemplating) that can boost the German economy without ‘reducing competitiveness’. Here, Germany would do well to shed its Mittelstandsdenken (the conservative, inward-focused thinking deeply engrained in Germany’s small and mid-sized companies) and start behaving like a large country whose actions impact on the eurozone as a whole. (See also 'Why Germany is not a model for the eurozone'.)

One area, however, in which Germany will not lead is monetary policy. Observers from abroad often call on Merkel “to allow the European Central Bank to buy more Italian and Spanish bonds”. It is true that a majority of Germans is against the central bank buying government debt, mainly because they fear that ‘free money’ will allow South European countries to carry on borrowing, without implementing reforms and austerity.

However, most Germans do not think that they run monetary policy in Europe. They believe in central bank independence. There is no doubt that the ECB operates in a political environment that is substantially shaped by the German debate. But the idea that there could be a direct chain of command from the chancellery to the ECB or even the Bundesbank would be alien to most Germans.

In the eyes of most of the policy people I spoke to in Berlin, ECB bond-buying is dangerous, wrong, illegal … and inevitable. They know that the German political system cannot quickly come up with the sums that would be needed to finance Italy’s borrowing needs for any considerable length of time. First, Germany’s post-war political system was constructed specifically to prevent rash decision-making and strong leadership; a slow-moving, consensus-oriented political culture has developed as a result. Second, recent debates about bail-out laws have shown growing political opposition to committing more funds, in particular in Merkel’s own coalition. Any attempt to fill a ‘big bazooka’ bail-out vehicle with German taxpayers’ money could lead to political paralysis and early elections.

That only leaves the ECB. Berlin policy-makers shrug off the fact that Germany is routinely outvoted on the ECB board (votes are usually 17 against four). One person close to Chancellor Merkel said he wished the ECB was less hesitant in its bond-buying programme: “They should just announce that they stand ready to buy all Italian bonds, provided certain conditions are fulfilled.” Another told me it was “sad” that the Bundesbank and its boss, Jens Weidmann, were so dogmatic. But German leaders are very careful not to criticise central bankers openly and in public. (On what the ECB should do see 'The ECB must stand behind the euro'.)

No German government will instruct the ECB to “buy more bonds”. One government advisor says this would only prompt the ECB to defend its independence: “The more political calls there are for ECB intervention, the harder it gets for them to do what needs to be done.” Perhaps it is also time for German leaders to acknowledge that their routine statements about the wrongs of debt monetisation unsettle the markets, and just let the ECB get on with the job of stabilising the eurozone.

The eurozone and the US: A tale of two currency zones

2011-11-21T14:06:00.001Z

by Philip Whyte

Europeans think it is all very unfair. They point out that, in aggregate, the eurozone is in no worse an economic position than the US: its public finances are in better shape than the US’s, and its overall level of private sector debt is actually lower. Yet for the past two years, financial markets have picked on the eurozone with increasing ferocity. In moments of bemused irritation, weary European policy-makers often complain about the baneful influence and biases of the Anglo-Saxon media, or the stubborn irrationality of financial markets. They would do better to reflect on why the eurozone faces an existential crisis while the US does not. The answer is that the two are very different monetary unions.

To start with, the eurozone is a much more decentralised monetary union than the US. The eurozone has no federal budget to speak of. Its closest proxy, the EU budget, is miniscule by comparison (at just 1 per cent of GDP) and cannot in any case go into deficit. Transfer payments are paid out of the EU budget, but these are not, strictly, welfare-related (the main recipients are special interest groups such as farmers). For all intents and purposes, the euro is a currency shared by fiscally independent countries. The upshot is that many things which happen at federal level in the US – deficit-financing, debt issuance, welfare payments, bank deposit protection, and so on – take place at national level in the eurozone.

Sitting atop the eurozone’s fiscally decentralised structure is a central bank which (for political, doctrinal and other reasons) is a more cautious institution than the US Federal Reserve, with a narrower understanding of its function. The European Central Bank (ECB) was deliberately designed as a successor to the German Bundesbank. The result is that it is more inflation-averse than the US Fed, and more reluctant to practice anything that might smack of ‘monetary financing’ (like acting as a lender of last resort to governments). In extremis, the ECB has implemented government bond purchase programmes. However, it has done so half-heartedly, and has always made a point of advertising its aversion to doing so.

So the US is a fully-fledged federation with a relatively flexible central bank, while the eurozone is a fiscally decentralised confederation with a conservative and limited purpose central bank. These differences are critical to understanding why the eurozone is the focus of market turmoil and the US is not. The crux is that the eurozone’s constituents interact very differently with each other than do those of the US: Germany does not stand in relation to Spain the way that Texas does to New Jersey, or eurozone countries in relation to the ECB the way that US states do to the Fed. The structure of the eurozone creates a whole host of problems that do not arise in a fully-fledged federation such as the US. Consider just three.

First, because they do not monopolise control of the currency in which they issue their debt, some countries are treated as if they have issued it in a foreign currency: this explains why Spain is paying 5 percentage points more than the UK to issue 10-year debt, even though its public finances are in no worse shape. Second, unlike the US, the eurozone lacks a joint fiscal backstop to the banking sector: this is why Ireland was plunged into a sovereign debt crisis, but the state of Delaware (where AIG is incorporated) was not. Third, banks and individual states interact differently: in the US, confidence in banks is not affected by the fiscal position of the state in which they are incorporated, but in the eurozone it is.

The eurozone’s structure, therefore, makes it a more fragile monetary union than the US. As a fiscally decentralised monetary union, it is vulnerable to the emergence of vicious ‘death spirals’ in some of its members. These spirals are driven by negative feed-back loops, in which worries about bank and sovereign solvency feed on and amplify each other. So far, eurozone policy-makers have done nothing to fix the structure that gives rise to these deadly spirals. Instead, they have preserved the structure, but made it more rigid. The eurozone remains a fiscally decentralised currency bloc, with a Germanic central bank. The only change is that member-states are now subject to tighter (and more pro-cyclical) fiscal rules.

The German government does not accept that the eurozone is institutionally flawed. It argues that the cause of the crisis is overwhelmingly behavioural, not institutional. The road to salvation is not to deepen integration by establishing a common bank deposit protection scheme or issuing debt jointly (which would increase moral hazard). It is to stop errant conduct. Ever since the crisis broke out, the German mantra has been fiscal consolidation and structural reforms. The underlying assumption is that the eurozone will be fine if it can turn itself economically into a larger version of Germany: countries that consolidate their public finances and reform their economies will end up with German borrowing costs.

It is not hard to see why many Germans find this account so compelling. It speaks to the very real sacrifices that many have made in recent years (for the past decade, German workers’ wages have barely increased in real terms). It suggests that the eurozone need not become the ‘transfer union’ of German nightmares. And it is supported by undeniable evidence of turpitude elsewhere: there is no doubt that Greece mismanaged its public finances, or that countries in southern Europe (and elsewhere) did too little to reform their economies. But what the German narrative does not explain is why the eurozone has proved so much less stable than the US, even though some of its underlying problems are no worse.

The extreme polarisation of government bond yields inside the eurozone does not represent a vote of confidence in the German economy, but a total loss of confidence in the very future of the eurozone. What the financial markets have cottoned on to is the fact that the euro is a post-national currency shared by countries that remain more attached to their fiscal sovereignty than they care to admit. The problem, in other words, is not financial, but political. The eurozone does not need financial assistance from China (or anyone else). It needs its leaders to do something that few have a democratic mandate to do – that is, pool their fiscal resources. Financial markets, for their part, are simply drawing their own conclusions.

Philip Whyte is a senior research fellow at the Centre for European Reform.

Governments need incentives to pool and share militaries

2011-11-01T13:11:00.001Z

by Tomas Valasek

Since the financial crisis began in 2008, EU countries have cut military spending by an amount equivalent to the entire annual defence budget of Germany, Europe's third largest. While the prospects for an economic upturn are dim, the need for credible militaries remains strong – all the more so because the US is signalling that it may not lead future operations in and around Europe. The EU has been urging its member-states to seek defence savings in collaboration. EU officials frequently stress that member-states have no option other than to 'pool and share' their militaries: to make a more common use of training and support facilities, to buy equipment together and to form joint units. Unless such savings measures are taken, the defence cuts will undermine Europe’s ability to respond to future crises on its periphery and beyond.

But what makes obvious sense to experts and officials looks very different to national defence ministers. In most European countries the public care little about defence and will not hold governments responsible for how defence budgets are spent.

From a government point of view, collaboration carries real political costs because opposition politicians and journalists will accuse the ministers of undermining national sovereignty by creating interdependencies with other militaries. Collaboration often takes years to put in place and yields rewards only long after its architects have left office. Initially, it may also cost more than it saves. And defence ministers have little guarantee that any savings which their decisions generate will flow back to the defence budget; often the treasuries take the spoils. So unsurprisingly, many European defence ministers choose the politically safer route of inaction.

The EU is right to want the member-states' militaries to work together. But its approach needs to start with the recognition that defence ministers will need new incentives to do so.

Some help is already on offer. The EU, via its European Defence Agency (EDA), has recently formed a senior expert group, composed of mostly retired high-level officers. They are travelling around Europe sounding out governments on their plans to pool and share and urging them to try harder. The experts should also make it a priority to identify the obstacles to collaboration in each country, and to collect lessons on how countries have been able to overcome national reservations.

The EDA’s planned study on the financial benefits of military collaboration will also be helpful: little hard data exists on potential savings, and a credible risks and benefits analysis would give proponents of pooling and sharing an additional argument against the sceptics. So would another planned EDA study on the depth of past and probable future cuts to European defence budgets. Similar reports, such as the one recently produced by the German Stiftung Wissenschaft und Politik, make for a sobering read and implicitly help build the case for closer collaboration.

More could be done: the EU institutions could help governments identify strategies that generate maximum savings while entailing minimal losses of national sovereignty. The Netherlands and Belgium point the way: they have completely pooled the maintenance and training of crews for their navies' vessels, but they have kept the actual fleets under separate national ownership. They thus reap the financial benefits of collaboration (because they no longer duplicate schools and repair docks) while preserving the right to deploy the vessels where each government sees fit. The report by EDA's senior experts should highlight such successful collaborative strategies and the EDA should make certain that these are widely distributed. Not all defence ministers will read the experts' conclusions so perhaps follow-up visits by the experts - this time to spread lessons learned on pooling and sharing -- may be in order. And because ministers come and go, the EDA should also make sure its experts speak to the armaments and defence policy directors.

As its next step, the EDA should help defence ministers obtain assurances that savings generated through collaboration will be reinvested in defence. While each EU country has a somewhat different way to fund defence, some ideas might find universal application. For example, the French pay for defence through a five-year, legally binding budget allocation. This could be tweaked to allow the defence ministries to keep any savings generated during the life of the budget framework. In Slovakia, the government has pledged to take past reforms into account when cutting the budgets of line ministries in the future. Departments that found savings will have their budgets cut less dramatically than those that have not reformed. Other governments will want to pursue other solutions - the key point here is that defence ministers must feel that they will be able to reap the benefits of pooling and sharing; that they will see a reward for taking political risks.

Lastly, the EDA should explore whether governments can be offered direct financial incentives to pool and share. NATO has long recognised that if its member-states are to connect their militaries, they need help covering the costs directly related to building the physical links. So the alliance created a centralised pool of money, into which all allies pay and which reimburses governments for 'networking' costs, such as the upgrades that were needed at Central European airfields and ports so that they could fuel and communicate with West European aircraft and ships.

Pooling and sharing also essentially requires states to build a network, which entails initial outlays even though it saves money later on. For example, if two countries merge their military colleges, they will need to shut down some facilities and pay some of the personnel a severance fee. The prospect of such initial outlays may well discourage co-operation. So the EDA should sound out its members about the possibility of creating a 'pooling and sharing fund' to reimburse the costs that result when governments choose to enter into military collaboration. Alternatively, because most EU countries are also members of NATO, they could agree to use NATO's fund to encourage pooling and sharing. However, the fund would first have to be expanded (in recent years it has run low on money) and its mandate broadened from funding infrastructure upgrades to include other costs such as severance payments or clean-up of disused military facilities.

There may well be additional ways to entice the governments to pool and share. The EU institutions should make it their priority to identify such incentives and apply them as much as possible. Pooling and sharing may make eminent economic and military sense, but they are fraught with sensitivities and political dangers. The national governments will need all the help and encouragement they can get.

Tomas Valasek is director of foreign policy and defence

Global trade imbalances threaten free trade

2011-10-17T07:48:00.003Z

by Simon Tilford

The developed world’s slide into recession threatens an outbreak of protectionism. Unlike in 2008, governments now have few tools with which to combat a renewed economic downturn, which raises the likelihood of it developing into a slump. If so, protectionist pressure is certain to build. The country that moves first to erect trade barriers will no doubt take the blame for the resulting damage to the trading system. But the real villains will be the countries that skew their exchange policies, tax systems and industrial structures to gain export advantage. The irony is that the countries that are most dependent on free trade – those that produce more than they consume – are the biggest obstacle to a sustained recovery in the global economy. They need to change course before it is too late: all will suffer if countries move to erect new trade barriers, but the surplus economies will suffer most.

Surplus country governments regularly exhort deficit countries to pay-down debt, save more and ‘live within their means’. But the real problem facing the global economy is an acute lack of aggregate demand. The world is awash with savings, but there is a dearth of profitable investment opportunities, which in turn reflects the weakness of consumption. The answer is not therefore for everybody to save more. This will be disastrous: it will further depress consumption and hence investment, and aggravate fiscal problems. If countries with big trade deficits (and correspondingly high levels of indebtedness) are to save more, surplus countries (those that live within their means) will have to save less and spend more.

The weakness of domestic demand in the US, UK and across much of the eurozone is hitting global demand hard, but there is nothing to offset it. The big surplus countries – Germany, China and Japan – are not taking any steps to offset the contraction in demand elsewhere. Such a state of affairs is fraught with risk. If the world is to continue enjoying the benefits of global trade and finance, the global imbalances have to be unwound.

What are trade imbalances? A country’s trade balance is a reflection of what it spends minus what it produces. In surplus countries income exceeds their spending, so they lend the difference to countries where spending exceeds income, accumulating international assets in the process. Deficit countries are the flipside of this. They spend more than their income, borrowing from surplus countries to cover the difference, in the process accumulating international liabilities or debts. Export-led growth in surplus countries feeds (and is dependent on) debt-led growth in deficit countries. It is impossible for all countries to run surpluses, just as it is impossible for all to run deficits.

Are trade imbalances sustainable? Trade imbalances and the accompanying capital flows between countries are not necessarily a problem. Fast-ageing wealthy societies tend to have excess savings and it makes sense to invest these in countries where domestic savings are insufficient to meet investment needs. Historically, this typically meant investing money in rapidly developing emerging markets. So long as current-account deficits remain modest and economies invest the corresponding capital inflows in ways that boost productivity growth, such imbalances are sustainable. But the imbalances we see today are of a different character. First, they are much bigger. The most egregious is that between China and the US, where still poor China is running a huge trade surplus with the US. Many of the other imbalances are between countries of broadly similar levels of economic development, such as those between members of the eurozone, or that between Japan and the US.

Imbalances of this scale and nature are far from benign. First, they lead to destabilising capital flows between economies. For example, the global financial crises of 2007 and the subsequent eurozone crisis were basically the result of capital flows between countries. Over-leveraged banks amplified the problem, but the underlying cause was outflows of capital from economies with excess savings in search of higher returns. Much as in the surplus economies themselves, the US, UK and the members of the eurozone that attracted large-scale capital inflows struggled to find productive uses for them: rather than boosting productivity, the inflows pumped up asset prices and encouraged excessive household borrowing.

The imbalances survived both crises, and are now growing again from an already high level. This is clearly unsustainable. Unlike in the run-up to the financial crisis, the current situation has nothing do with excess demand in the deficit countries, but is taking place against a backdrop of stagnation and falling living standards in these economies. Households and firms in the deficit countries are saving more, but there has been no offsetting decline in private sector savings in the surplus countries. Against this kind of economic backdrop, trade deficits constitute a major drag on economic activity as they drain demand and employment, forcing governments to step-in and fill the gap by running big fiscal deficits. The external demand upon which the surplus countries depend relies implicitly on unsustainable fiscal policies in the deficit countries.

How can imbalances be reduced? The deficit countries need a combination of higher net exports (export minus imports) and higher net savings (domestic savings minus domestic investment), while the surplus countries require the reverse. Put another way, the deficit countries need to get over their dependence on debt, surplus countries their addiction to exports. Deficit countries need more domestic savings and surplus countries more consumption.

Structural changes in both the surplus and deficit countries can clearly contribute to the necessary adjustments. Countries where expenditure lags output, such as Germany and Japan, could take steps to reverse the decline in wages and salaries as a proportion of national income. This would boost consumption, encourage more investment, and hence lower their corporate sectors’ excess savings. For its part, China could discourage excess savings by reducing subsidies to its corporate sector, which is sitting on very large sums of cash. The Chinese authorities could also improve the country’s social safety net and hence lower households’ precautionary savings. However, such adjustments will take time, and time is in short supply. The only way to facilitate rapid adjustment is through shifts in relative prices.

There are three ways of bringing about these movements in prices, or shifts in countries’ so-called ‘real exchange rates’. The fate of the international trading system could depend on which is chosen. First, domestic prices can fall in the deficit countries. This comes about through declining costs and prices, as wages are cut and governments pursue fiscal austerity. Higher unemployment encourages households to save more, and the price of imported goods rise relative to domestically-produced ones.

This is basically what is being attempted in the eurozone. Trade imbalances are to be addressed by deflation in the deficit countries. Policy across the eurozone as a whole has a strongly deflationary bias, as much in the surplus economies as the deficit ones. This implies very weak economic growth, falls in prices (relative to the outside world) and higher unemployment. It also implies higher savings as governments tighten fiscal policy, companies sit on cash rather than investing it and fearful households boost their savings and rein in consumption. The risk is that the deficit countries’ debt burdens will increase further (as the value of their debts grow, while their incomes fall), exacerbating their fiscal problems and undermining their ability to pay their creditors. Far from taking up some of strain from the Americans, the eurozone is trying to run a big surplus with the rest of the world, adding to trade tensions.

Given how indebted the deficit countries are (in terms of public and private debt) rebalancing needs to take place through a combination of movements in nominal exchange rates (where possible) and somewhat higher inflation in the surplus countries. Very low interest rates and quantitative easing in the US is pushing up inflation in countries with currencies linked to the dollar – first and foremost China. The US has little option but to continue pumping dollars into its financial system, in order to compensate for the drag on its economy from the trade balance, and some of this money will continue to leak out to China. However, concerned at the rise in inflation, the Chinese authorities are taking robust steps to slow their economy by clamping down on the amount state-owned banks can lend. Easily the least damaging adjustment in the eurozone would be through higher inflation in Germany. But there is little sign of this. And if there were, the European Central Bank would raise interest rates.

Finally, changes in relative prices can be brought about by movements in nominal exchange rates. For example, the Chinese could allow the renminbi to rise against the dollar or Germany could withdraw from the eurozone and reintroduce the D-mark, which would then appreciate sharply in value. Movements in nominal exchange rates offer by far the least damaging route to the needed rebalancing. It would avoid deflation in the deficit countries or inflation in the surplus ones.

The Chinese government is somewhat schizophrenic about the potential impact of renminbi revaluation. On the one hand it maintains that it would not make any difference, because the deficits in countries like America reflect the latter’s lack of savings, which would not be affected by an appreciation of the Chinese currency. On the other hand, it argues that a stronger renminbi would hit the Chinese economy hard and be disastrous for global economic growth. In short, the Chinese government is dependent on the others running up debt, but at the same time condemns them for doing so. Movements in nominal exchange rates may yet be the mechanism by which the German trade surplus is cut. The current eurozone strategy of deflation in the deficit economies rather than reflation in Germany threatens to force economies out of the currency union. This would open the way for a rebalancing of the German economy, but at enormous political and economic cost to Europe.

Surplus country governments, notably the Chinese and German ones, often warn of the risks of protectionism. They fail to make the connection between the structures of their economies and the trade deficits (and rising indebtedness) of others. As a result, they are the real threat to the international trading order. If the US cannot rebalance its economy and get it growing sustainably, there is a real risk it will opt for protectionism. Other countries with big trade deficits could quickly follow suit. The resulting rebalancing would be brutal for the surplus countries, and many of the benefits of global trade and finance would be lost. To prevent this, the G20 needs to agree a global strategy to rebalance demand. This would require the surplus economies to acknowledge that they are part of the problem and to develop strategies to reduce their export dependence.

Simon Tilford is chief economist at the Centre for European Reform.

Britain, the City and the EU: A triangle of suspicion

2011-10-11T14:48:00.002Z

by Philip Whyte

After years of mutual suspicion, Britain and its EU partners seemed in early 2009 to be converging in an area of policy where they had often been at odds – financial regulation. The Turner Review, Britain’s official report into the financial crisis, accepted that ‘light touch’ regulation had failed, and recognised that the UK would have to accept greater supervisory integration at EU level if the single market in financial services was to survive. Fast-forward two years, and it is hard not to be struck by a paradox. The UK has abandoned its ‘light touch’ regulatory regime and signed up to greater supervisory integration at EU level. Yet far from narrowing, the Channel looks as wide as ever. So what went wrong?

Part of the answer is to be found in continental Europe. Since the financial crisis, politicians in Germany and France have seen it as their task to bring Britain and the City of London to heel. France’s President Sarkozy has spoken of the “death of unregulated Anglo-Saxon finance”, while Chancellor Merkel has declared that Germany will no longer be dictated to by the City of London. The eurozone debt crisis has only reinforced continental suspicions of Britain and the City, because politicians in Berlin, Paris and elsewhere view both as a threat to the euro’s existence. They think that the City is home to ‘speculators’ who are bent on destroying the euro; and they believe that it marches to the tune of a eurosceptic government and a local media that is hostile to, and ignorant of, the EU.

Suspicions of the ‘Anglo-Saxon world’ explain at least some of the measures which have emerged from the EU’s machinery. The directive on alternative investment funds was a response to longstanding Franco-German concerns about the power exercised by hedge funds in London and New York. Likewise, more recent proposals to introduce a tax on financial transactions reflect an enduring ambition by some governments to curb ‘speculative activity’ in the world’s largest financial centres. Since the UK is disproportionately affected by such measures, it has unsurprisingly showed less enthusiasm for them than other EU member-states. Inevitably, this has made the UK looking like the country of old: that is, isolated and fighting to dilute EU initiatives targeting the financial sector.

From London’s perspective, all of this can seem a bit galling. The problem is not just that some EU measures have been the product of continental politicians playing to their domestic galleries, or that they affect Britain more than other EU countries. It is that some governments have tried to occupy the moral high ground while doing less than the UK in areas of greater importance. A case in point is the recapitalisation of banks – a crucial task since 2008, but one where a number of EU countries have (until very recently at least) been guilty of a combination of denial, foot-dragging and obfuscation. Seen from the UK, the reluctance of certain EU governments to tackle the weakness of their banking systems bears more responsibility for the eurozone crisis than speculators in the City of London.

None of this is to say that the UK has reverted to its traditional role as an uncritical defender of the interests of the City. If there ever was an identity of interest between the British government and the City, this is no longer the case. These days, the City is a ‘national champion’ that attracts the hostility rather than the respect of the general public. The UK realises that it has a comparative advantage in a sector that imposes large costs on society when things go wrong. The principal thrust of policy since 2008 has therefore been to try and reduce the vast contingent liability that the financial system places on British taxpayers. This was the main rationale of the Vickers Commission, which recommended that UK banks should keep their retail operations separate from their investment banking ones.

Few detached observers can seriously doubt that Britain’s era of ‘light touch’ regulation is over. The UK does not need to be cajoled by other EU countries into regulating banks and the City. It has implemented reforms before similar measures were even proposed at EU level (sparking European grumbles about British unilateralism); and in some areas (such as the structural separation of retail and investment banking activities), it intends to go further than other EU countries can countenance. The City’s future, it follows, is being decided by decisions in London as much as those in Brussels: hedge funds have relocated abroad in response to the perceived deterioration of Britain’s tax environment, while large UK banks have periodically threatened to follow suit in response to the Vickers reforms.

But if political rhetoric is anything to go by, perceptions in other member-states have yet to adjust to this new reality. In many quarters, the UK continues to be portrayed at best as a recalcitrant country that has failed to learn the lessons of the global financial crisis, at worst as a hostile force that wishes to protect the interests of ‘speculators’ and the City the better to destroy the eurozone. Quite why the UK would benefit from the collapse of the eurozone – an event that, as the British government has repeatedly made clear, would be catastrophic for the UK economy – is not entirely clear. But lurid assumptions about the ‘Anglo-Saxon’ world are still a remarkably familiar background factor across Europe, shaping how many politicians think about financial regulation and the eurozone crisis.

The truth of the matter is this. There is no question that the UK is more ambivalent about the financial sector and the City than it has been in the past. But the UK does not believe that this justifies ill-conceived and costly initiatives that reflect political grandstanding in other EU countries; or, for that matter, that this gives carte blanche to other countries to drive financial activity away from London. Other EU countries have a justifiable interest in what happens in the City. It is less clear that they have legitimate grounds for pushing old hobby horses that win political points at home, do little to promote financial stability, yet inflict disproportionate costs on the UK (as host to Europe’s largest financial centre). The EU’s recently-proposed financial transactions tax looks like a case in point.

Philip Whyte is a senior research fellow

Eurozone crisis: Higher inflation is part of the answer

2011-10-03T10:50:00.001Z

by Simon Tilford

The biggest challenge facing the eurozone is how to generate economic growth. Whatever its leaders agree in terms of fiscal targets and surveillance will achieve little in the absence of growth. Excessively restrictive fiscal policy is clearly one obstacle to such growth, but the European Central Bank’s obsession with inflation is another. Of course the central bank must guard against excessive inflation, but it is a big problem when its fear of inflation blinds it to the much more serious threats confronting the eurozone economy. Indeed, somewhat higher inflation may be part of the solution to the crisis facing Europe. If policy continues to be directed at ensuring inflation of "below, but close to 2 per cent", countries such as Spain and Italy will struggle to regain competitiveness within the eurozone and their debt burdens will be unsustainable.

The Bundesbank's legacy is clearly visible in the ECB's official strategy. The central bank's interpretation of price stability means it has the most restrictive target or 'reference value' of price stability of any major central bank. Given that many eurozone countries have historically been prone to high inflation, the ECB’s determination to build a reputation for guaranteeing price stability is understandable. Officials from the bank never tire of saying that ensuring low inflation is the best contribution the ECB can make to economic growth. Price stability is important, of course. But a reference value of under 2 per cent and no accompanying mandate to ensure an adequate level of economic activity (such as that faced by the US Federal Reserve) is too restrictive. It is damaging in a number of ways for a currency union such as the eurozone.

First, it increases the risk that interest rates will be raised in response to temporary shocks – such as higher oil prices – that do not threaten medium-term price stability. This was illustrated by the ECB's decision to raise interest rates in July 2008, when the eurozone economy was already contracting. Perhaps more egregious was its decision to raise interest rates in July 2011, despite strong evidence of a slowing economy, against the backdrop of a deepening sovereign debt and banking sector crisis, and in the face of very restrictive fiscal policy across the currency union. The ECB’s decision to raise rates despite these headwinds raises serious concerns over its mandate. The central bank is unlikely to cut interest rates at this week’s meeting because eurozone inflation currently stands at 3 per cent. This is largely because of higher energy prices whose impact on the consumer prices index will weaken sharply from early next year.

Second, an inflation target of below, but close to 2 per cent leaves very little room for adjustment within the currency union. Since countries such as Spain and Italy cannot devalue, they can only improve their 'competitiveness' by cutting their costs relative to Germany. Such a strategy will lead to deflation and debt traps unless German inflation rises more quickly than the current projections of around 1.5 per cent per annum. The eurozone would be better off with a symmetrical eurozone inflation target of 3 per cent with the inflation rate allowed to deviate by no more than 1 percentage point in either direction. Such a target would make it much easier for a member-state to hold its inflation rate (and wage growth) below the eurozone average without risking economic stagnation and deflation.

Although a target of under 2 per cent might have been appropriate for the Bundesbank, it is ill-suited to the eurozone. Unlike Germany, the eurozone is a largely closed economy (exports account for a similar proportion of GDP as they do in US) and hence cannot rely to anywhere near the same extent as Germany on exports to close the gap between output and expenditure. The currency union as a whole cannot expect to export its way out of trouble – it needs robust growth in domestic demand.

If the ECB had to take economic activity into account, not only would eurozone interest rates be lower, but the central bank would also be pumping money directly into the eurozone economy. Much like the US Fed, the Bank of Japan and the Bank of England – all of whom like the ECB face economies struggling with the aftermath of financial crises and the associated collapse in aggregate demand – the ECB would be engaged in so-called quantitative easing (QE), the unsterilised purchasing of government debt and other assets. By bringing down public and private borrowing costs and boosting the volume of credit, QE could strengthen economic activity and guard against the risk of deflation.

Supporters of the ECB's current mandate would no doubt argue that the Fed's dual target of inflation and employment has caused it to pump up one bubble after another. The Fed is forced to sacrifice the principle of sound money on the altar of short-term pump-priming. The result is an unbalanced US economy, excessive debt, and a world awash with dollars. This, in turn, puts downward pressure on the US currency, threatening international monetary stability. But this is a largely self-serving analysis. Had the Fed not kept interest rates very low and pumped money into its economy, the world would have had an even bigger problem: the US economy would have slumped, and its trade balance swung into surplus.

The eurozone is essentially trying to ensure monetary stability in Europe at the cost of higher debt elsewhere: the crisis strategy for the currency union is for everyone to save more, and spend less – to 'live within their means'. This implies the eurozone running a huge trade surplus with the rest of the world. But this will not be possible. East Asia is pursuing a similar strategy to the eurozone. And the US economy is simply too indebted and not big enough to act as the consumer of last resort for both East Asia and Europe.

The ECB should not be responsible for setting its own mandate. One option would be to transfer responsibility for this to the Euro Group, which would agree decisions by qualified majority. Such a move would not necessarily require a new treaty; a unanimous decision in the Council could be enough. Unfortunately, there is no chance of this happening. Reforms of eurozone governance will not include reform of the ECB since several eurozone governments, not least the German one, are steadfastly opposed to such a move.

This leaves the currency bloc vulnerable to slump and on-going crisis. Fiscal policy is highly contractionary. The monetary policy stance is restrictive, given the depth of the economic weakness. The currency union as a whole cannot export its way out of trouble. Structural reforms should help to boost growth in the medium to long term. But such reforms need to be accompanied by investment if they are to deliver on their potential and with demand so weak investment will be thin on the ground. It is beholden on those governments that oppose greater monetary stimulus to explain how the eurozone economy is to grow and how the necessary adjustment in price and labour costs between the participating economies are to be made.

Simon Tilford is chief economist at the Centre for European Reform.

The euro: Reaching the endgame?

2011-09-19T09:24:00.001Z

by Simon Tilford

Eurozone policy-makers, especially German and Dutch ones, have been unable to rise above hubris and moral posturing, leaving the eurozone with very little ammunition to confront the coming financial storm. They have stubbornly dug in their feet, preferring to deepen the crisis than to admit their mistakes. This makes a fracturing of the eurozone almost inevitable. And it will not simply be Greece (and possibly Portugal) leaving, as some German and Dutch policy-makers appear to think. This is wilfully naive. This threat goes right up to and includes France. A ‘core’ could be very small indeed, comprising just Germany, the Netherlands, Austria, Finland and Luxembourg. France and Germany would no longer share a currency.

The eurozone has opted to deny itself the policy tools to deal with the crisis: there will be no debt mutualisation, even one accompanied by tight fiscal rules; the European Central Bank (ECB) will not be permitted to exercise the full range of lender of last resort functions (for example, to buy unlimited volumes of sovereign debt or other financial assets); there will be no co-ordinated recapitalisation of eurozone banks; and economic policy will be driven by faith, not reason (leading eurozone policy-makers believe that unco-ordinated, simultaneous cuts in public spending allied to tax increases, will boost household and business confidence). This is the kind of thinking that caused economic slump in the 1930s, and with it the rise of political extremism.

Debt mutualisation: September’s ruling by Germany’s Constitutional Court has thrown a further obstacle in the way of the issuance of eurobonds, but the political obstacles to such a move were already formidable. A move to fiscal union cannot be pushed through under the radar (in time-honoured EU tradition) but has to be sanctioned democratically. Because of the way various eurozone governments (especially the German and Dutch ones) have characterised the eurozone crisis – as a battle between the virtuous and the venal, between those countries that keep to the rules and those that break them – it will be nigh-impossible to win democratic consent for a debt union in these countries.

Lender of last resort: The ECB is highly unlikely to be permitted to carry out the full range of lender of last resort functions to eurozone sovereigns and banks. It will not, for example, be free to step in and buy unlimited amounts of government debt in order to demonstrate to investors that their fears over insolvency are unfounded. The resignations of both Juergen Stark and Axel Weber (the German chief economist at the ECB and the head of Bundesbank respectively) in protest at the ECB’s buying of the government debt of hard-hit member-states, demonstrates that much of the German policy establishment would prefer the crisis to run its course rather than compromise on their philosophical positions. Had the ECB not stepped in to purchase Spanish and Italian bonds over the summer of 2011, both countries’ borrowing costs would have continued to balloon, almost certainly causing interrelated sovereign and banking sector crises, calling into question the future of the single currency.

Far from laying the way open for a more activist ECB strategy aimed at reassuring investors that the central banks stand behind the sovereign debt of eurozone economies, the departure of Mr Stark confirms the breach with Germany and threatens to paralyse the ECB. In extremis, the European Financial Stability Fund (EFSF) and its successor, the European Stability Mechanism (ESM), will be able to buy some sovereign debt and inject some funds into the banks, but nowhere near enough to cope with an interrelated sovereign and banking sector crisis. Any attempt at a properly activist strategy will prompt a stand-off with Germany. The outcome of such a stand-off cannot be predicted, but it is unlikely to involve Germany backing-down (at least, not far enough) and the ECB could not risk pushing ahead in the teeth of German opposition.

Bank recapitalisation: The dual failure to agree debt mutualisation or allow the ECB to act in the interests of the whole eurozone rather than just its creditor economies would be less critical if eurozone governments were moving to recapitalise their banks, so that they were better placed to cope with the coming debt defaults. Eurozone policy-makers had hoped that a rebound in economic growth and moves to postpone defaults would give eurozone banks time to strengthen their balance sheets. But with the eurozone economy having almost certainly fallen back into recession, this strategy is untenable. Despite an unfolding banking crisis – some bank shares have already fallen by more than in the 2008 financial crisis – there is no plan to make Europe’s banks bullet proof. August’s call by Christine Lagarde (the former French finance minister and now head of the IMF) for the forced recapitalisation of eurozone banks was airily dismissed across the eurozone. But it would be much cheaper to address the problem now than try to pick up the pieces later.

Growth-orientated economic policy: Finally, eurozone macroeconomic policy is being driven by a belief in the confidence fairy. Eurozone policy-makers, from German finance minister, Wolfgang Schaeuble, to ECB president, Jean-Claude Trichet, queue up to argue that fiscal austerity, even if pursued by all member-states simultaneously, will not be contractionary, let alone risk destroying the euro. According to this belief, fiscal austerity will boost household and business confidence by reassuring households and businesses that government finances are sustainable, leading to a recovery in consumption and investment. But they are unable to cite any historical precedent in support of this belief, which appears to boil down to little more than faith. There are, of course, examples of fiscal austerity preceding economic growth, but they all include currency devaluation and/or big cuts in interest rates. Neither option is open to eurozone economies. Unsurprisingly, household and business confidence is crumbling rapidly across the currency union, depressing economic activity, and with it the likelihood of governments meeting their fiscal targets.

On current policy trends, a series of sovereign and banking defaults are unavoidable. Does this mean that dissolution of the eurozone is inevitable? Almost certainly, yes. On current policy trends, much of the eurozone faces depression and deflation. The ECB and EFSF will not be able to keep a lid on bond yields, with the result that countries will face unsustainably high borrowing costs and default. This, in turn, will cripple these countries’ banking sectors, but they will be unable to raise the funds needed to recapitalise them. Stuck in a vicious deflationary circle, unable to borrow on affordable terms, and subject to quixotic and counter-productive fiscal and other rules for what support they do get from the EFSF and ECB, political support for continued membership will drain away. Faced with a choice between permanent slump and rising debt burdens (as falling GDP and deflation leads to inexorable increases in debt), countries will elect to quit the currency union. At least this way they will be able to print money, recapitalise their banks and escape deflation. Once Spain or Italy opt for this, the dissolution of the eurozone will be unstoppable. Investors will not wear French participation in a core euro: the country has weak public finances and a sizeable external deficit. Participation in the core would imply a potentially huge real currency appreciation and a corresponding collapse in economic activity. Investors will calculate that the wage cuts (to restore competitiveness) and cuts in public spending (to rein in the fiscal deficit) would be politically unsustainable. In short, France will effectively be in the same position as Italy and Spain are at present.

Such contentions are met with derision and incredulity across much of the eurozone. Otherwise rational people talk about something ‘coming up’ or express confidence that policy-makers ‘will never let that happen’. The political investment in the project is just too great for this to happen, they argue, usually accompanying this assertion with accusations that Anglo-Saxons are hopelessly wedded to the world of the nation-state and just do not understand that Europe has moved beyond such primitive attachments. Such assertions sit very uneasily with events over the last two years. The euro crisis has spun out of control because eurozone governments are unwilling to acknowledge that their policies have an impact on other member-states, and that this requires a measure of solidarity. Indeed, if there is one thing this crisis has shown, it is that the nation-state is alive and kicking in the eurozone.

Simon Tilford is chief economist at the CER.

What Libya says about future NATO operations

2011-08-26T08:30:00.004Z

by Tomas Valasek

Libya has been a difficult war for NATO. It has shown the alliance divided: only eight out of 28 allies sent combat forces. Some of them ran out of ammunition and Italy withdrew its aircraft carrier in the midst of the conflict because the government needed to cut expenses. The Americans’ frustration with European performance boiled over in June, when the then-secretary of defence Robert Gates warned that NATO faced a ‘dim and dismal’ future.

Yet critics of NATO’s performance are missing a bigger story: in Libya, the Europeans have for the first time responded to Washington’s calls to assume more responsibility for their neighbourhood. In complete contrast to the Balkans in the 1990s, they have taken decisive military action. As a result, the United States could take a back seat while the Europeans have absorbed most of the risks and costs of the ultimately successful war. This should be cause for cautious optimism about NATO.

Libya is an unheralded triumph for US diplomacy. One of Washington’s consistent aims has been to convince its allies to relieve the US military burden. In Libya, the US at last did what it had long threatened to do: the Obama administration, never too keen on the intervention in the first place, turned over most operations to allies shortly after the war’s initial stage, which had been led by US forces.

The US’s policy has had the desired effect on Europe: it has energised the key allies. French and British air forces, along with other European, Canadian and Middle Eastern colleagues, have performed the majority of the bombing raids since early weeks of the six-month war. In a sense, Libya is the antithesis to Europe’s failure to act in Bosnia. When bloodshed in the Balkans broke out in the 1990s, senior politicians on the continent hailed the ‘hour of Europe’, when an economic power would become a security player. But key European capitals could not summon the political will to use force, and, embarrassingly, it fell mostly to the US to end the civil war in Bosnia. In Libya, European governments acted swiftly, and helped the rebels win the war. In the process, the allies established a new division of labour for NATO operations on Europe’s borders, which should be encouraged and developed further.

This is not to say that all is well in NATO. Germany’s refusal to support the mission is worrying; Europe’s diplomacy and military operations in Libya lacked the punch they would have had with the continent’s largest country on board. Money is also a concern. The new division of labour inside NATO can only work if European governments continue to invest in their militaries. They are failing to do this: over the past few years, European countries have cut defence budgets dramatically. The Libyan conflict has done little to change the trend: the fiscal crisis is ensnaring more governments each month, prompting deeper and deeper cuts in government expenses including defence. On present trends, the Europeans may well lose the ability to mount another Libya-style operation in the future.

However, as a recent CER essay points out, there are things that the governments in Europe can do to avoid such outcome: from getting rid of legacy Cold War equipment to buying new weapons jointly and integrating their exercise ranges, maintenance facilities and military academies. There is evidence that the Europeans are moving in the right direction – the French and the British recently agreed to share the costs of building and maintaining nuclear weapons; they also plan to buy missiles and drones together in the future. More governments are exploring other ideas for collaboration, and the Dutch and the Belgians as well as the Nordic countries have been doing so for several years. These measures will not completely offset the impact of budget cuts but they may soften the blow until the fiscal situation in Europe improves.

For their part, the American military leaders need to challenge overly negative assumptions about the alliance in the United States. The success of US efforts to delegate responsibility to Europe has gone almost completely unappreciated in Washington’s political discourse, whose focus has been on European military failings. This damages the image of NATO in the US, with potentially serious consequences. The US-European defence relationship can only work if the Americans continue to see the alliance as useful for their own security. And this should not be taken for granted: as time passes, politicians and the military in the US tend to be less and less informed by the experience of the Cold War, and less inclined to view Europe as their default partner. Undue criticism of allies’ military shortcomings only accelerates the de-Europeanisation of US foreign policy.

Encouragingly, the message from Washington has changed in recent days, with the new secretary of defence, Leon Panetta, praising NATO’s operation as an example of international cooperation. The success in Tripoli, along with the new-found will in London, Paris and other European capitals to assume greater responsibility for the security in its own neighbourhood, ought to give the Americans more reasons for optimism.

Tomas Valasek is director of foreign policy and defence at the CER.

The US and the EU should support the Palestinian bid for UN membership

2011-08-25T14:57:00.001Z

by Clara Marina O'Donnell

For months, the US and the EU have tried to discourage the Palestinians from asking the UN to recognise the state of Palestine. On both sides of the Atlantic, governments are concerned that the UN bid will exacerbate the conflict with Israel. But so far, American and European efforts have failed. Instead Washington and its EU counterparts should exploit the Palestinian initiative. If framed constructively, UN recognition could actually strengthen the prospects for peace.

Since spring, Palestinian President Mahmoud Abbas has been planning to ask the UN to recognise a state of Palestine based on the 1967 borders, and grant it UN membership in September. Abbas is portraying the initiative as part of a campaign of non-violent protests against Israel, designed to make headway towards a two-state solution at a time when peace talks have stalled.

The UN bid is very popular amongst the Palestinian population and it has gained support from numerous countries, including those in the Arab League. But the US and several EU governments worry that UN recognition would only make peace harder to achieve. Israel is already threatening to sever all assistance and contact with the Palestinian authorities out of concern that they will use recognition to pursue claims against Israel at the International Court of Justice. Furthermore, emboldened Palestinian grass roots movements and Israeli settlers might try to reclaim land from each other in the West Bank, triggering unrest and potentially violence.

The Obama administration has already publicly declared that it will oppose any UN resolution recognising a Palestinian state. This would prevent the Palestinians from obtaining the UN Security Council’s endorsement – required for UN membership. But they could still ask the General Assembly to recognise them and give Palestine the status of a UN observer state.

As a result Washington and the Europeans have been trying to re-launch peace talks in an attempt to entice the Palestinians to drop their bid for recognition. But this approach is not working. A special meeting of the Quartet (a group set up to support the peace process, made up of the US, the EU, Russia and the UN) in July failed to reach any conclusions, never mind convince Palestinians and Israelis to restart negotiations. In early August, according to some press reports, Israeli Prime Minister Benjamin Netanyahu agreed to negotiate with the Palestinians on the basis of the 1967 ceasefire lines. In light of Netanyahu’s long standing opposition to the idea, this would be a significant breakthrough. But the Palestinians have so far rejected the offer because Netanyahu – whom Palestinians suspect is still not truly committed to negotiations – would only hold such talks if they recognised Israel as a Jewish state.

Instead of opposing the UN bid, Washington and its European partners should use the Palestinian initiative to strengthen their efforts to re-launch peace talks. The US and the EU should inform the Palestinians that they will support a request for UN membership so long as the Palestinians ask the UN to recognise a state of Palestine whose borders broadly resemble those of 1967; they commit themselves to resolving outstanding disputes with Israel through negotiations (including the exact demarcation of borders); and they extend their executive control over the territory only through agreement with Israel.

Such a resolution would curtail the risks envisaged by Israel and others about UN recognition. It would reaffirm the primacy of negotiations as the way to solve the conflict. And by eliminating legal ambiguities about who controls Palestinian territory, it would reduce the scope for Palestinian and Israeli popular protests. In addition, when presented under such terms, UN recognition could help address some of the obstacles which have stalled the peace process in recent years. It would ensure that the Arab world, while undergoing a major upheaval, endorsed the concept of a two-state solution. And it would force the militant group Hamas, which is still in control of Gaza and has so far been disdainful of the UN effort, to either endorse it or lose support amongst the Palestinian people.

It is unusual for the UN to grant membership to a state with such extensive caveats. And many of the challenges which have blighted peace talks in the past are set to remain. Nevertheless Abbas’ initiative could offer the best platform to re-launch negotiations between Israelis and Palestinians. And at a time when violence is flaring up around Gaza and the Israeli-Egyptian border, the US and the EU must do their utmost to ensure that the Palestinian UN bid does not trigger further instability.

Clara Marina O'Donnell is a research fellow at the Centre for European Reform.

Race to the bottom

2011-08-24T07:39:00.000Z

by Tomas Valasek

For decades, European countries cut defence budgets with little worry. The United States kept enough troops on the continent to deter all potential enemies, almost irrespective of how small European militaries became. But the US contingent has been steadily shrinking, and the pace of this downsizing now seems certain to accelerate because of the economic crisis. The Europeans should be worried – yet they will probably respond by hastening their own defence cuts.

The July 31st agreement under which US Congress increased the ceiling for national debt cuts defence spending by $350 billion over the next ten years, White House calculations say. However, the deal also calls for a joint committee of six Democrats and six Republicans to find ways to decrease the deficit by another $1.5 trillion. The lion’s share of those reductions is certain to come in the form of expenditure cuts (as opposed to tax increases). And these further cuts – even if spread across government departments – will include significant reductions in the Pentagon budget, beyond the $350 billion that it is already scheduled to lose. Military spending now consumes more than 20 per cent of the total federal budget (for comparison, in the UK the figure is 6 per cent). Assuming that the joint committee makes roughly proportional cuts among government departments, the Pentagon will lose another $250 billion; this would put total reductions in military spending at $600 billion over ten years.

There is also the possibility that members of the committee will fail to agree, which would be even worse for the US military. Under the borrowing agreement, such a failure would lead to an automatic imposition of a $1.2 trillion cut in government spending, half of which would come straight from the Pentagon’s budget (for accounting reasons, the final amount would be slightly less than half: $534 billion). Including the $350 billion in cuts agreed last week, total loss to US defence spending over the next ten years could thus reach nearly $900 billion. The Republicans have been traditionally supportive of defence spending so in theory they have strong reasons to work with the Democrats on averting such draconian cuts to the military. But Democrats want further deficit reduction to include tax increases, which the Republicans oppose. And the ‘new’ Republican party is considerably less pro-defence than it used to be in the days of John McCain and Bob Dole; its top priority now is deficit reduction. If Democrats insist on tax raises, there is a chance that Republican members of the joint committee would rather choose an impasse, even if this led to deep defence cuts.

Whether the final amount is $600 billion or close to $900 billion, reductions of such magnitudewill have considerable impact on contractors and allies around the globe. One mitigating factor is that the cuts will be calculated on the basis of future projected spending (which was scheduled to rise) rather than current spending. Also, after 13 straight years of increases, the defence budget has reached a monumental $530 billion in fiscal year 2011 (not including another $160 billion allocated specifically for the wars in Iraq and Afghanistan). However, much of this amount is committed to manpower and benefits. Military healthcare alone consumes around $50 billion a year, and Congress is unlikely to agree to reduce it before the 2012 elections. The brunt of the newly ordered cuts will therefore fall on relatively few budget categories. Research is likely to suffer (because it can be cut with little immediately visible impact) and so is procurement (because some new weapons have incurred controversial cost overruns).

Importantly for America’s allies, many of the cuts will lead to closure of overseas bases. These have no political constituency in the United States, and thus no defenders in Congress, which will have to approve cuts. Europe is certain to suffer disproportionately in any future base closures. The continent is not high on the Defense Department’s list of priorities and it is seen as relatively free from danger. The allies have capable militaries, which, the Pentagon believes, should be able to assure security of Europe’s periphery (in places such as Libya) with little US help.

Even before the latest cuts, in April 2011, the Obama administration ordered the withdrawal of one of the four remaining US brigade combat teams (BCTs) from Europe. This was a less dramatic reduction than the one that George Bush’s government initially ordered in 2004 – then, the Pentagon decided to cut half the BCTs but subsequently put the decision on hold because they were needed in Afghanistan. In reducing the cut to just on BCT in 2011, the Pentagon cited the need to assure allies (mainly in Central Europe) that Washington remains committed to their defence. But it now seems very probable that the Defense Department, under pressure to save money, will withdraw the second BCT after all.

Many US military facilities in Western Europe are in danger. Their number has gradually dwindled as the US reduced forces from the Cold War average of 311,000 to fewer than 80,000 today. Many more will now be closed. The US military sees the smaller bases in particular as a source of relatively easy savings. While installations such as the large US military hospital in Landshut, Germany are likely to fare well, the 700-strong US Air Force base in Lajes, Portugal, will probably go. Non-essential facilities such as the George C Marshall Center in Germany (a school for military officers, mainly from Eastern Europe and Asia) are also vulnerable.

These departures are certain to be unpopular with local governments around Europe, some of which will suffer a double or triple setback. In addition to expected US base closures, NATO and national governments have also been cutting budgets and forces. Portugal, which will probably lose Lajes, had recently seen NATO decide to close its ‘Joint Force Command’ near Lisbon. Germany plans to close many of its own bases to save money; it now stands to lose some of the US ones as well. The closures will cause tensions among local and national governments but the impact on transatlantic relations will be limited – because virtually all allied capitals are reducing forces, none will be in a position to complain. But the US and European militaries will lose some of the existing opportunities to train together. And the loss of schools such as the George C Marshall Center would deprive the allies of the ability to win the hearts and minds of young officers in dangerous parts of the world such as South Caucasus and Central Asia.

With cuts to US defence budget looming, the US will also forgo its ability to pressurise the Europeans against reductions in their own spending. Apparently at the first meeting between Leon Panetta, the new Pentagon chief, and Liam Fox, the UK defence secretary, the two swapped lessons on how to cut budgets with least political pain. A year ago the US defence secretary would have sought to restrain the UK from cutting in the first place.

There is a real danger that cuts on one end of the Atlantic will encourage more cuts on the other end, thus degrading NATO’s credibility. While some of the bases that the United States is thinking of closing may well be redundant, NATO defence guarantees will lose their meaning unless the allies maintain a certain minimum number of forces and military installations. In theory, the Europeans should be responding to US force cuts by studying whether NATO is close to reaching this threshold, and whether they need to augment their forces to replace the departing US ones. But the opposite is likely to happen: without US pressure, many European governments will feel freer than ever to reduce military spending and forces. This may yet turn out to be the most significant and corrosive legacy of current US budgets cuts for allied security.

Tomas Valasek is director of foreign policy and defence at the Centre for European Reform.

Eurozone crisis: Can contagion to Italy be arrested?

2011-08-05T08:51:00.001Z

by Philip Whyte

Ever since the EU and the IMF ‘bailed out’ Greece in May last year, the eurozone has fought a desperate rear-guard battle to stem contagion to other countries – with little success. Ireland and Portugal have since been bailed out, and Cyprus could be next. The most disquieting development, however, has been incipient contagion to larger economies like Spain and Italy. Unless this contagion is arrested, the eurozone could face a potentially terminal crisis. For the past year, the Spanish government has been battling valiantly to persuade financial markets that it will not be the next domino in the chain. But the change in sentiment towards Italy has been more recent – and is perhaps more alarming. What explains it?

Until early July, Italy had just about convinced the financial markets that it was not the ‘next Greece’. A cynic might justifiably wonder why. The country’s structural problems, after all, are as profound as they are well-known. It has a rapidly ageing population. Its ratio of public debt to GDP is the second highest in the eurozone (after Greece). Productivity has barely risen over the past decade. Rising wages have consequently pushed up unit labour costs, eroding the country’s trade competitiveness. Governance, moreover, is notoriously weak: because of the dysfunctional nature of the political system, few eurozone countries have done less in recent years to improve the supply-side performance of their economy.

Given these longstanding weaknesses, why did sentiment towards Italy not sour earlier? Until recently, Italy was thought to have several advantages over other countries in the eurozone’s troubled geographical periphery. Unlike Ireland and Spain, it did not experience a domestic credit boom in the run-up to the global financial crisis. Private sector balance sheets are therefore stronger: households are not over-indebted, and Italian banks fared well in recent stress tests. Italy, moreover, has been running smaller budget deficits than Greece or Portugal; in 2011, it is expected to run a primary budget surplus. Unlike in Greece and Portugal, budget deficits did not seem to pose a threat to Italy’s public debt sustainability.

Since July, however, market sentiment has changed alarmingly. At the time of writing, the yield on 10-year Italian government bonds stands at 6.12% – up from 4.73% at the end of June (and from 3.73% in October 2010). The spread over German bunds, which had fallen to almost zero in 2008, has now widened to 370 basis points. As in Greece, heightened perceptions of sovereign risk are hitting sentiment towards Italian banks (which have large exposures to their home country’s sovereign debt). Even banks that fared well in the EU’s recent stress tests have not been spared: the share prices of all Italian banks have taken a pummelling. Why has sentiment towards Italy soured so dramatically over the past month?

It is tempting to pin all the blame on political infighting and paralysis. It certainly does not help that the government is hamstrung by a small majority in parliament, or that relations between the prime minister and the finance minister are poor. Nor does it help that Silvio Berlusconi seems more inclined to use the office of prime minister to advance his private interests than the public one. But it is not as if these factors became apparent only in early July. Besides, Spain, whose government has shown greater focus and determination than Italy’s over the past year, has also experienced rising borrowing costs. So a strong political commitment to reform is necessary to restore confidence in Italy. But it may not be sufficient.

To see why, consider Japan – a country that displays many of the same ills as Italy. Like Italy, Japan has a rapidly ageing population. It also suffers from political paralysis and low economic growth. Japan’s public finances, moreover, are in much worse shape than Italy’s: its ratio of public debt to GDP is almost twice as large as Italy’s, and it is set to run a bigger budget deficit in 2011. If the recent spike in Italian government bond yields was solely driven by market fears about political stasis, low growth, weak public finances and a dearth of economic reforms, one might have expected Japanese bond yields to have risen in tandem with Italy’s. Yet they have fallen: 10-year Japanese bonds now yield just 1.2%.

Why have two countries with similar problems experienced such contrasting fortunes? Beleaguered European politicians may be tempted to blame market irrationality. A more plausible explanation is that less creditworthy sovereign issuers are more fragile inside a monetary union than outside, as they issue debt in a currency over which they have little control. The emerging framework for dealing with stressed sovereigns in the eurozone has heightened perceptions of fragility. A sovereign can only remain solvent if markets are confident that a ‘credit event’ is not in prospect. That confidence has weakened in the eurozone because ‘bail outs’ are increasingly seen as a prelude to, rather than a means of avoiding, a default.

The result is that bond yields inside the eurozone have become increasingly polarised between the weak and the strong. Italy could certainly do much to restore market confidence in the long-term sustainability of its public debt by enacting reforms that raise the economy’s long-term rate of growth. But it is illusory to believe that the country’s borrowing costs can be restored to more sustainable levels by action in Italy alone. The fate of Italy – and, by extension, the eurozone – is likely to be determined as much as by decisions in Berlin and Brussels as by those in Rome. It is becoming harder to see how the polarisation of yields within the eurozone can be reversed unless European leaders adopt a common Eurobond.

Philip Whyte is a senior research fellow at the Centre for European Reform.

Why the eurozone needs debt mutualisation

2011-07-28T10:59:00.000Z

by Simon Tilford

The institutional weaknesses of the eurozone have been laid bare. The attempt to run a common monetary policy without a common treasury has failed. Investors do not know what they are buying when they purchase an Italian bond – is it backstopped by Germany or not? The best credit must stand behind the rest, or bear runs, such as those that have derailed Greece, Ireland and Portugal and which threaten to do the same to Italy and Spain, are inevitable. Debt mutualisation alone will not save the euro, but without it the eurozone is unlikely to survive intact.

The eurozone’s July 21st summit was a small step forward. Leaders agreed to lower interest rates on loans made by the European Financial Stability Fund (EFSF) and they recognised that Greece’s debt burden is unsustainable. But this fell far short of what is needed to arrest the deepening crisis in the currency union. Borrowing costs remain unsustainably high for many eurozone economies, and not just those in the periphery. For example, the economic growth potential of Spain and Italy has fallen to as little as 1 per cent, but their borrowing costs exceed 6 per cent. By contrast, German sovereign yields have fallen sharply, lowering the public and private sectors’ borrowing costs. This is a recipe for further economic divergence and insolvency, not the urgently required convergence.

To prevent this, the eurozone has to have a ‘risk-free’ interest rate. The struggling economies need lower borrowing costs, or they will suffocate economically (and political support for eurozone membership will evaporate). Only the mutualisation of debt issuance will generate the low (risk-free) interest rate needed to enable them to put their public finances on a sound footing and lay the basis for a return to economic growth.

All eurozone countries should therefore finance debt by issuing bonds which would be jointly guaranteed by all member-states. The obvious problem with eurobonds is moral hazard: how to prevent fiscally irresponsible countries free-riding on the credit-worthiness of other member-states. This is the understandable fear of countries such as Germany and the Netherlands.

A possible solution to the problem of moral hazard would be for member-states to issue debt as eurobonds up to a certain level – for example, 60 per cent of GDP – but be individually responsible for any debt above it. This would give countries with high levels of public debt an incentive to consolidate their public finances. Had the eurozone introduced such a system from the outset, it could well have worked. But it is too late for that now. For a number of economies, the additional borrowing would simply be too expensive. A better solution would be for a new, independent fiscal body to establish borrowing targets for each member-state and for a European debt agency to issue eurobonds (up to a certain level) on behalf of the member-states.

How would these rules be designed? A dogmatic target of budgetary balance four years hence irrespective of a country’s position in the economic cycle would achieve little: targets are meaningless if they are impossible to implement. These fiscal rules would have to be set with reference to the cyclically-adjusted fiscal position for each member-state. The OECD already produces estimates for these. Member-states will have to be permitted to run deficits when their cyclical positions demand it. Inappropriately pro-cyclical fiscal policies and ruinous interest rates would depress economic activity and with it the investment needed to boost productivity.

Careful thought would need to be given to the composition of the new fiscal body. A board of 17 people, one from each eurozone economy, would be unwieldy, and unlikely to win the support of the eurozone’s principal creditor countries. At the same time, a board dominated by the creditor countries would be unlikely to win the backing of the debtor countries. A board of nine economists, from the big eurozone economies, the European Commission, the ECB and the OECD might form a good basis.

The eurozone, of course, has a poor record of enforcing fiscal rules. To ensure that there is no repeat of this failure, there would have to be strong penalties for non-compliance. If a country deviated from its fiscal targets, it would not be allowed to borrow the additional funds at the risk-free rate. Instead, it would have to borrow under its own rating, which in the case of the fiscally weaker countries would be more expensive. To provide additional incentives to abide by the borrowing rules, the ECB could refuse to accept debt issued under national ratings as collateral. Alternatively, a new EU financial regulator could handicap own country bonds by requiring banks holding them to set aside more capital.

Fiscal rules of the type envisaged (and a new body to enforce them) would not necessarily require a treaty change. But various creditor countries rightly fear that the adoption of eurobonds will push up their borrowing costs and constitute a transfer union. Opponents of eurobonds may eventually come around to seeing them as the least bad option. The risk is that by the time they do, it could be too late to save the euro from a partial break-up: what could work if adopted promptly could be ineffective in six months’ time.

Opponents need to be persuaded as soon as possible that this is the least costly option for them. Eurobonds would certainly be a cheaper option for core countries than the underwriting of loans to struggling member-states, which essentially involves throwing good money after bad: they will book large losses on these EFSF loans. These losses will only increase if, as seems possible, some of the countries currently in receipt of EFSF loans end up having to leave the eurozone and default on their debt.

Simon Tilford is chief economist at the Centre for European Reform.

Marine Le Pen and the rise of populism

2011-07-20T10:11:00.000Z

By Charles Grant

Since becoming leader of France’s Front National in January, Marine Le Pen has started to shift her party away from the far right. She has not only dropped the overt racism and Islamophobia of her father but also adopted hard-left economic policies. “Left and right don’t mean anything anymore – both left and right are for the EU, the euro, free trade and immigration,” she said when opposing me in a recent dinner debate on the future of Europe in Paris. “For 30 years, left and right have been the same; the real fracture is now between those who support globalisation and nationalists.”

The debate – organised by The KitSon, a Paris think-tank – was off-the-record. But I can repeat some of her comments, since they echoed what she had already said on-the-record elsewhere. She is a tall, strong-looking woman and an effective debater. She speaks pithily and sometimes with humour.

She presents her party as a nationalist force – in British terms, the United Kingdom Independence Party rather than the British National Party. In its hostility to the EU and to immigration, the Front National has much in common with Austria’s Freedom Party, the Danish Peoples’ Party, the True Finns, the Sweden Democrats and Geert Wilders’ Party for Freedom in the Netherlands. Populist, illiberal parties are flourishing in the most sophisticated, liberal societies of Northern Europe.

Although Le Pen is changing her party’s brand, she is no Gianfranco Fini: he led his party away from neo-fascism towards the pro-European centre of Italian politics. Le Pen’s European policies remain extreme: she urges France to leave not only the euro but also the EU. Her economic platform is one of national economic autarky: she wants to protect France from globalisation by erecting high tariff barriers. Her economic platform is in fact quite close to that of Jean-Pierre Chevènement, the veteran anti-European and former Socialist minister. Earlier this month she appealed to Chevènement to work with her – but he rebuffed her advances.

Le Pen’s line on the euro and the EU may be extreme, but given the mess that Europe is in, her views may not cost her votes among those who want to kick the Paris and Brussels elites for their (apparent) complacency, smugness and incompetence. She wants France to leave the euro so that it can devalue and become more competitive. While China and the US benefit from being able to devalue, she said, the eurozone suffers from low economic growth. “To save the euro we are asking the Greeks to make huge sacrifices through austerity, and soon we will ask the same of people elsewhere, even in France. The euro will lead to war.”

When I responded that devaluation would destroy the French people’s purchasing power, she said that only ‘BCBGs’ (short for bon chic bon genre, that is to say the fashionable middle class) would complain about devaluation; they buy the foreign goods and holidays that would cost more, whereas most poor people buy things made in France (a point that is highly debatable).

She complained about sovereignty draining away to Brussels and said that we live in a Union Soviétique Européenne. The EU represents the interests of big financial groups, she said, and encourages immigration in order to put downward pressure on salaries. She said that her country needs a French agricultural policy, rather than a Common Agricultural Policy, since the CAP was giving too much aid to Central Europeans.

“The EU has been built on Anglo-Saxon principles of everything being available to be bought or sold.” Ultra-liberals run the EU, she said, and will not let the French protect their industries. “Without protection we cannot be competitive against China, since we don’t want to work 20 hours a day.”

When I said that rather than trying to compete directly with China, France should go up market and produce goods and services that the Chinese cannot, she argued that they could now beat France in any industry – as they were doing by building high-speed trains. I responded by praising the prowess of France’s world-beating companies in areas such as luxury goods, agribusiness, energy and aerospace – so she joked that the best proponents of Sarkozyism came from Britain.

The obvious critique of her line on the EU is that France, on its own, is rather small compared to China and other emerging powers, and that it therefore needs the EU to amplify its voice in the world. But she had no truck with that argument, saying that France on its own had a big voice. “I am a gaullienne, and the general would be horrified to see the EU today…I want an association of sovereign nation-states; that would allow us to influence Russia and the wider world.” And when I suggested that the EU had the merit of constraining German power, she said Germany already dominated the EU. “When Germany has a constitutional problem, we change the EU treaty; but if France has a problem, we have to change our constitution.”

Le Pen wants France to leave NATO. When I pointed out that France would then have to raise defence spending enormously, in order to enjoy a comparable level of security to that provided by NATO today, she was unfazed. “We are not Botswana, if we want to play a big role in defence we can, and in any case defence spending is good for the economy.”

During two hours of debate she said nothing that sounded racist. The closest she came was this: “I am not against immigration, France has always accepted foreigners. But it should not lead to lower salaries. And in employment we should prioritise jobs for français de souche.” That could be translated as people of French stock.

I think Le Pen is right when she says that the main political divide in Europe is between nationalists and globalisers. But the solutions that she offers to complex problems are far too simple. Her language resonates with the common man: she is on the side of the little people against foreigners, international bureaucrats and big capitalists. And her economic nationalism goes down particularly well in France, a country that is probably more hostile to globalisation than any other European country.

But there are obvious gaps in Le Pen’s thinking. She has nothing to say about global governance, or what to do about transnational threats such as organised crime, climate change, proliferation or international terrorism. And she would be a more effective critic of globalisation if she acknowledged that in certain respects France does nicely from it. When I told her that France benefited hugely from foreign direct investment – it gets more FDI than any other country in Europe – and that French companies did very well from investing in other member-states, like Britain, she had very little to say.

Opinion polls suggest that Marine Le Pen has a good chance of getting into the second round of the May 2012 presidential election – as Jean-Marie Le Pen did when he won more votes than the Socialists’ Lionel Jospin in 2002. According to some polls, the second round would pit the Socialist candidate – almost certain to be either François Hollande or Martine Aubry – against Le Pen. Of course, she would not win the second round. As in 2002, the centre-left and the centre-right would combine to keep out a Le Pen – only reinforcing her view that Sarkozy and the Socialists are the same. But in any case, I do not think she is serious about exercising power, at least for now. If she was serious, she would have to start compromising on some of her economic and international policies, and she shows no signs of doing so.

But even without formally winning office, she – like her equivalents in Austria, Denmark, Finland, the Netherlands and Sweden – is shaping the political debate in her country. Politicians on the centre-right have toughened their line on immigration, lest the Front National steal too many of their votes. And very few French politicians on the centre-right – or the centre-left – have a good word to say about the EU.

Charles Grant is director of the Centre for European Reform

The new EU budget: A missed opportunity

2011-07-11T13:14:00.001Z

by Stephen Tindale

The European Commission published its proposals for the 2014-2020 EU budget at the end of June. The British media were incensed about proposals for new ‘EU taxes’, a planned nominal rise in EU budget spending at a time of austerity and alleged threats to the British rebate. However, rather than focusing on the British net balance, the Cameron government should make a strong and constructive case for thorough budget reform. The Commission’s proposals are a missed opportunity.

In a joint letter from last December, the British, German, French, Dutch and Finnish governments demanded that the next ‘Multiannual Financial Framework’ (MFF) for 2014-20 should keep total EU spending at 2013 levels in real terms. The European Parliament hit back in June 2011, demanding a budget increase of at least 5 per cent. The Commission’s proposal states, somewhat lamely, that it has “sought to strike the right balance between ambition and realism” and suggests to cap spending at 1 per cent of EU GDP as in the past while moving (or keeping) some spending items outside the official budget framework. If only the ‘on budget’ spending is counted, the Commission’s proposals are in line with the five member states’ demands, but if the ‘off budget’ money is included the Commission has sided with the Parliament. At 2 per cent of total EU public spending, the EU budget is “stuck between being so small as to be economically irrelevant and big enough to harbour shock horror stories”, in the words of one former British negotiator (quotes are from a recent CER seminar on “Reworking the EU budget”).

However, it is not so much the overall size of the budget that matters but whether EU money is spent on political priorities in a way that adds value. The Commission’s proposals more or less perpetuate the budget priorities of the 2007-13 MFF. While this will please most member-states, it will hardly help the EU to address new challenges such as innovation and research, fighting climate change, dealing with the euro crisis and migration or helping the democratic and economic transition in Eastern Europe and Northern Africa.

The two biggest spending blocks in the 2014-20 MFF will remain the same: structural (or cohesion) funds for regional developments and the common agricultural policy (CAP), with both receiving around 36 per cent of total EU budget spending (although cohesion funds would for the first time be slightly bigger than the CAP).

In theory, cohesion policy is a good example of what European co-operation should be all about: redistributing income and wealth from richer parts of Europe to poorer parts. However, the structural funds are still allocated in a way that even regions in the richest member-states get money. Economists (and some Commission officials) have long advocated to focus cohesion money on the poorer member-states, perhaps those with a GDP of less than 90 per cent of the EU average. Instead, the rich countries insist that their budget contributions get ‘recycled’ via Brussels back to their own less advantaged regions. Many politicians claim that such transfers are needed for political legitimacy and fairness. Surely there are better ways to ensure that richer countries benefit from the EU budget, such as spending on innovation.

The Commission proposals are similarly timid when it comes to the CAP. Not only does spending so much EU money on farmers make little sense as the share of Europeans working the land continues to decline. But the CAP even fails on its own account: too much money now goes to the biggest land-owners. With food prices near all-time high, this EU budget would have been the perfect opportunity for radical CAP reform. “Even the Americans are reducing farm support”, explains one British food producer, “if we do not reform the CAP now, then when?”. The Commission should have proposed phasing out the ‘single farm payment’ (income support that goes to all farmers) while maintaining rural development spending. There should also be a gradual shift towards more national co-financing.

With a much-reduced CAP and re-focused cohesion funds, the EU budget could increasingly go towards issues that the EU declares a priority.

Climate change is one such priority. According to the Commission, EU expenditure for climate programmes will rise to at least 20 per cent of the total – but it gives no details on how it plans to achieve this. Rather than making aspirational statements, the Commission should have made concrete proposals.

Another area that should get more money is external affairs. Only
€100 billion are earmarked in the Commission’s proposal. Although the biggest increase is foreseen for neighbourhood policies, the money will not be enough for the EU to implement its ambitious new neighbourhood policy that it started drawing up in the wake of the Arab spring. Similarly, the €8.7 billion foreseen for dealing with migration is inadequate for a European immigration policy that would help to save the Schengen area of free movement.

The EU should also spend more on its economic priorities. Allocated amounts for R&D and innovation are supposed to rise from €55 billion in the last MFF to €80 billion in 2014-20. This is welcome but still inadequate for a continent whose future prosperity will depend on staying at the technological frontier. For the first time, the EU budget will contain a sizeable pot of money for infrastructure investments: the €40 billion of the new ‘connecting Europe facility’ are supposed to attract a multiple in public (for example from the European Investment Bank) and private investments (perhaps from pension funds) to improve European transport, energy and communications infrastructure. However, about half of the €40 billion will go to transport infrastructure – an area where waste has been a big problem in the past. The money would be better spent on information and communication technology in the EU’s less developed countries and on constructing an EU-wide energy market and preparing for the addition of large amounts of renewables to the European power sector.

Alas, the chances that the 27 EU governments will agree on radical budget reform before 2014 are slim. European budget talks are always heated but today’s political environment is particularly toxic. First, most EU nations are in the process of pushing through painful budget cuts at home and want the Commission to do the same (to its credit, the Commission suggests to cut its staff by 5 per cent but since administration accounts for only 6 per cent of total EU spending, this will be largely symbolic). Second, the Lisbon treaty has given the European Parliament new powers over the budget process, which – if recent moves are anything to go by – it will use to push for higher spending. “The European Parliament is full of spokespeople for individual policy interests whose demands will add up to more than the available budget money”, predicts one British journalist.

Third, the euro crisis has left many people in the richer EU countries opposed to any kind transfers to poorer countries. The grants earmarked for cohesion in the EU budget are peanuts compared with the loan guarantees in the rescue packages put together for Greece, Ireland and Portugal. Yet in the minds of many Europeans, these blend into one. In particular Germany, traditionally the ‘paymaster’ of Europe, will be in no mood to throw in extra billions to lubricate a compromise on the EU budget. Finally, with presidential elections due in France next year, the chances that Paris will move on CAP reform are slim. In London, meanwhile, Prime Minister Cameron will be under heavy pressure from his eurosceptic party base to retain the British rebate and keep budget spending low. A bilateral deal whereby France keeps its farm payments while Britain retains its rebates would allow for a compromise but spell the death knell for EU budget reform.

The Commission has added further fuel to the political fire by making some bold proposals for new ‘own resources’, EU jargon for money that the Union collects directly for the EU budget, for example from customs duties or sugar levies. The Commission now wants member-states to discuss whether the EU could raise money from a new VAT levy and from a financial transaction tax. A German diplomat calls the proposals simply “not acceptable” while a British one dismisses them as an “amusing distraction”. A financial transaction tax would impact heavily on the UK – disproportionately so in the view of the UK government. Since any new own resources need unanimity among the 27 governments, the chances of the Commission’s proposal making it into the new MFF are close to zero.

The Commission’s proposals succeed in trying to please as many political masters as possible. The price that Brussels has paid for this is an unambitious, backward looking budget package. A European Union that must deal with a public finance crisis, an unstable neighbourhood, diminishing legitimacy and declining global competitiveness must do better. And David Cameron should provide the leadership. France has a presidential election in 2012, and Germany a federal election in 2013, so President Sarkozy and Chancellor Merkel are boxed in by the demands of electioneering. UK foreign secretary William Hague – no fan of Brussels – has said that the EU should do more to control climate change. So the British government should argue that significantly more should be spent on climate control, and significantly less on the CAP, and that if genuine budget reform is on the table, the UK rebate is up for re-negotiation.

Stephen Tindale is an associate fellow at the Centre for European Reform.

Financial regulation: Britain the perennial outlier?

2011-06-20T13:14:00.000Z

by Philip Whyte

Back in 2007, when the Labour government had abolished the business cycle and the City of London was booming, British policy-makers liked to vaunt the merits of ‘light touch’ regulation. Given the scale of British hubris in the run-up to the worst financial crisis since the Great Depression, the country’s EU partners can be forgiven for feeling a certain amount of Schadenfreude. Less justifiable, however, is the sense of vindication that has often accompanied it. Many European politicians have liked to give the impression that the financial crisis would not have happened if ‘Anglo-Saxons’ had regulated and supervised financial markets as strictly as Europeans; and that the task following the crisis is for Europeans to make sure that recalcitrant Anglo-Saxons are finally made to do so.

There are at least two reasons why this narrative is misplaced. The first is that Europe was not an innocent spectator in the run-up to the financial crisis, but an active participant in its genesis. Many European banks were as highly leveraged as Anglo-American ones (and vastly more so than hedge funds). Their lending standards deteriorated every bit as dramatically. And many enthusiastically underwrote or invested in exotic asset-backed securities like collateralised debt obligations (CDOs). (European banks’ voracious appetite for high-yielding securities with AAA-ratings was one factor that drove the growth in the market for CDOs). It does not necessarily follow, then, that the crisis would have been averted if regulatory and supervisory regimes in the Anglo-American world had been ‘more European’.

The second reason is that it ignores just how far the climate in Britain has changed since the crisis. Britain has not had to be bullied into abandoning its ‘light touch’ regime; it has done so of its own will. Changes to its regulatory and supervisory regime have been so wide-ranging that the UK is now at the strict end of the EU spectrum. For example, senior policy-makers, from the governor of the Bank of England to the chairman of the Financial Services Authority, have argued that EU rules on bank capital should be stronger, not weaker, than the Basel III accords. And the government has recently said that it will follow the recommendations of the Vickers Commission and ring-fence retail banking operations from investment banking ones – a move no other EU country is contemplating.

What does it matter if European politicians believe that the post-crisis task is to whip Anglo-Saxons into shape? Isn’t the belief harmless? Indeed, if it helps to rectify the problems that the crisis exposed, doesn’t it do more good than harm? Not necessarily. To start with, it risks creating needless friction between Britain and its EU partners. As host to Europe’s largest financial centre, the UK is disproportionately affected by some of the measures that the EU adopts – the recent Alternative Investment Fund Managers (AIFM) directive being a case in point. As other measures wind their way through the EU’s legislative pipeline and the recently-established European Supervisory Authorities bed down, it is in no one’s interest for EU initiatives to be seen in Britain as gratuitous attacks on the City of London.

Just as seriously, the popular European pass-time of bashing Anglo-Saxons diverts attention away from problems elsewhere in the EU. Consider Germany. In 2009, the country’s chancellor, Angela Merkel, told members of her party that they would no longer be dictated to by the City of London. Since then, her government has shown a striking reluctance to come clean about the weakened state of Germany’s own banks. This is why Germany played an active part in watering down stress tests for EU banks in 2010, and why it fought a rear-guard action to try and dilute the new Basel accords on capital adequacy. Seen from outside, Germany has appeared strangely reluctant to accept one of the central lessons of the financial crisis: that banks should hold more and better quality capital.

However absurd British paeans to light touch regulation seem now, there was more in common between Britain and the rest of Europe in the run-up to the financial crisis than is often recognised. Politicians, however, rarely find it easy to own up to failings at home. There was a brief moment in 2008 when the British government tried to pin all the blame for the financial crisis on events in the US – a claim that was hard to sustain given the carbon-copy, debt-fuelled boom that the UK went through. Unlike Britain, Germany never experienced a domestic credit-fuelled boom. This may explain why German politicians have found it easier to claim (and perhaps even believe) that they were the victims of shortcomings abroad, and why they have been slow to confront the problems at German banks.

Europe’s landscape, in short, has changed since the financial crisis. Britain is increasingly nervous about the huge contingent liabilities to which the country’s large financial sector exposes domestic taxpayers. It does not want to become Reykjavik-on-Thames. It is calling for tougher rules than even longstanding critics of light touch regulation are prepared to contemplate. The future of the City of London, it follows, will be influenced as much by the new climate in London as by the old one in Brussels (more hedge funds have left London in response to changes in the British tax system than because of the adoption of the EU’s AIFM directive). Critics will argue that Britain is as unilateralist as ever – and hence remains a European outlier. But if it is, it is in a very different sense from in 2007.

Philip Whyte is a senior research fellow at the Centre for European Reform.

EU ministers tackle defence austerity

2011-06-01T08:10:00.003Z

by Tomas Valasek

How do you do more with less? The EU defence ministers agreed last week that the way to limit the impact of the economic crisis on their defence budgets lies in more co-operation. In a joint statement, they called for more military 'pooling and sharing': joint development and procurement of weapons, and partial integration of European militaries. EU member-states have trialled such ideas before but with limited success. Deep co-operation remains highly sensitive: governments are reluctant to build joint units because this may require them to share decisions on how and when to use them. The ministers' conclusions are correspondingly cautious: they call for a “structured” and “long-term” approach while offering few specific guidelines. It need not be this way: past pooling and sharing attempts offer plenty of lessons on what makes military collaboration successful.

In a recent CER report,['Surviving austerity: The case for a new approach to EU military collaboration', May 2011, http://www.cer.org.uk/pdf/rp_981.pdf]. I suggested ways for European countries to avoid past mistakes. Partial military integration works best when participating countries have similar strategic cultures, a high level of mutual trust, comparable attitudes to defence industry, and relatively low corruption in defence procurement. It also helps if countries are roughly similar in size, and serious about defence matters: that is, they are willing to use their armed forces and keen to maintain their ability to fight for future contingencies.

Several conclusions for EU defence ministers flow from these observations. Since many factors have to align for pooling and sharing to succeed, future defence integration will remain an exception rather than the rule. The conditions listed above only occur in some – and not necessarily geographically connected – parts of Europe. Hence, the idea that EU defence could begin around a single core group, the emergence of which would encourage others to join in a ‘snowballing’ effect, seems unrealistic. Future events may well prod European militaries to create a single, coherent military force. But no such outcome is foreseeable currently given widely varying levels of threat perception, political interest and military cultures across the Union.

The report also recommends that rather than pursuing ‘permanent structured co-operation’, the focus of EU countries and institutions should be on encouraging the formation of several “islands of co-operation” along regional lines, where members partly integrate their militaries. Some of these islands are already well established. The Benelux countries have had much success with pooling and sharing forces. The Nordic states are moving in this direction, as are France and the UK, which have recently concluded a bilateral treaty on defence co-operation. The recent EU defence ministers' communiqué makes a nod to the islands of co-operation idea by stating that multinational co-operation should also take place on a regional basis.

The EU's ability to nudge member-states towards such co-operation will be limited: the capitals will want a final say on with whom to partner, and to what end and depth. But this is not so say that there is nothing that the EU can do; in fact, European institutions have already been helpful. Their key role lies in spreading lessons learned in one region to the rest of Europe. The European Defence Agency, which EU countries set up to facilitate collaboration, has been collecting data on past and current examples of pooling and sharing; it should also catalogue why some have succeeded better than others. The EU military staff, which advises the EU high representative, has conducted a similar but forward-looking exercise: it collected information on what military skills or facilities the member-states are willing to pool and share. It should now use the data to highlight opportunities for collaboration.

The EU can also give member-states incentives to enter into permanent collaboration. Its best tool is the EU 'battlegroups': multinational, 1,500-strong units that are prepared, on a six-month basis, to deploy rapidly in and around Europe. While their primary raison d’être has been to give the EU the ability to quickly respond to crises, it was also hoped that the battlegroups would encourage governments to build permanent joint units. But on this last count, the experiment has disappointed: countries come together for six months, but then go their own separate ways. The EU should adopt recent Polish proposals that the battlegroups should always be composed of the same states, and that they should be on rotation on a predictable schedule, for example every three years. This would give the member-states reasons to maintain close long-term co-operation with partners in the battlegroup, and possibly to pool their units on a permanent basis, not just for the duration of the rotation.

Pooling and sharing will never compensate for inadequate defence budgets: when average spending in Europe, as percentage of GDP, drops by half – as it has over the past two decades – militaries will inevitably suffer. The EU member-states will almost certainly do 'less with less' rather than 'more with less'. However, properly applied, pooling and sharing can partly offset the impact of lower budgets. So while EU countries will still lose some of their military power to budget cuts, they will be better off with pooling and sharing than without.

Tomas Valsek is director of foreign policy and defence at the Centre for European Reform.

Press freedom – the new accession criterion?

2011-05-16T07:33:00.001Z

by Katinka Barysch

Countries that want to join the EU need to show that their democracies work well. However, press freedom – a key ingredient of any pluralist democracy – is under threat in most of the countries that are now queuing for accession. Independent newspapers and broadcasters are being squeezed out of the market. Critical journalists are being sacked, beaten or locked up. Without curious and courageous journalists, crime and cronyism flourish, public debate is stunted and politicians feel unaccountable. The EU could do more to protect media freedom in the Western Balkans and Turkey.

The erosion of press freedom has been most striking in Turkey recently. A shocking 50-60 journalists are now in jail (depending on who does the counting), mostly accused of plotting to overthrow the government or split the country. Some 10,000 lawsuits are pending against writers and broadcasters. Many journalists suspect that their phones are tapped and their e-mails read. Fear and suspicion pervade the media. In the press freedom ranking of Reporters without Borders, a Paris-based NGO, Turkey has dropped to 138th place, behind Iraq and only just ahead of Russia.

The situation in the Western Balkan countries is similarly worrying. Scores of journalists have been beaten up or intimidated. A couple have lost their lives, with their killers usually going unpunished. Some of Serbia's and Croatia's best-known journalists now live with constant police protection. Many of their colleagues prefer self-censorship to a life in fear or unemployment.

The problems that the region's newspapers, radio stations and TV broadcasters grapple with are complex. Direct state censorship is arguably the least of their problems. Pressure is indirect and comes from various sides. Money is a huge constraint, especially in the small, fragmented Balkan media markets. The economic crisis that started in 2008 has led to painful losses of advertising revenue. Media companies have sacked staff and dumbed down their coverage. Investigative journalism is becoming a luxury.

Some media bosses would not want their journalists to snoop around too much anyway. Conflicts of interests are rife: although ownership structures are often obscure, it is clear that many newspapers and TV stations form part of bigger business empires. Owners fear that they will lose lucrative public contracts or other favours from politicians if their journalists write about government corruption or crime. Others are using their media outlets blatantly to promote their own interests. Albania, with fewer inhabitants than Berlin, has 25 daily newspapers. Most of them are controlled by local mini-tycoons wrestling for influence. In such an environment, journalists are little more than PR writers.

West Europeans can usually rely on well-funded public service broadcasters for information. But trying to build a local version of the BBC is not the solution for South East Europe. In most Balkan countries, public TV stations function more like "ministries for propaganda", says Remzi Lani of the Albanian Media Institute. Their coverage is neither independent nor balanced. In the Western Balkans, a legacy of ethnic hatred and fervent nationalism makes for a toxic media landscape. In Turkey, the press mirrors the political schism between the mildly Islamist AK government and its Kemalist opponents.

"Governments need to stop seeing the media as their private property", warns Dunja Mijatovic, the OSCE’s Media Freedom Representative. Some observers hope that internet bloggers and other forms of 'citizen journalism' could fill the gap between self-serving commercial media and politicised public ones. However, most web publications do not generate income to pay for investigative journalism. And governments are clamping down on the internet as well. The Turkish government has blocked an estimated 12,000 websites to date. It is now planning to make 'filters' compulsory to prevent Turks from viewing websites that contain pornography. Access to sites containing one or more of 138 'prohibited' words (including puzzling items such as skirt, homemade and Haydar) would be blocked automatically.

The European Commission, in charge of monitoring accession countries' compliance with civil liberties and democratic standards, is getting seriously worried. It has repeatedly flagged up the deteriorating media environment in its annual assessments of accession preparations. Yet the situation keeps getting worse. To help it figure out what to do, the Commission gathered over 450 journalists and activists from the Western Balkans and Turkey in Brussels on May 6th. Many of them were seething with frustration: "The Europeans are hypocrites. They say they worry about journalism in our countries. But they still support our governments", said one editor.

The EU has been shy to put pressure on accession country governments. First, the EU's own record on media freedom is not flawless, with Hungary's new restrictive media law and Silvio Berlusconi's grip on Italy’s television the most frequently cited examples. Second, the EU has only a limited role in the media sector. There is, for example, a directive telling member-states not to discriminate against media outlets from other EU countries. But on the whole, the acquis in this area is thin and rules are made by national governments or by self-regulatory bodies.

To its credit, the Commission is becoming more outspoken, in particular in response to the most recent arrests of journalists in Turkey. Enlargement Commissioner Stefan Fule is also thinking about singling out press freedom as a more explicit benchmark for accession. At the moment, it is just one of the many items assessed under the criterion of a 'functioning democracy' (the other accession criteria concern market economics and the implementation of EU law).

The Commission could also do more to monitor the broader environment in which journalists in Turkey and the Western Balkans operate. While the accession countries usually have nice-sounding laws on media freedom, these are often not implemented properly. Other laws, covering defamation, anti-terrorism, taxation or public procurement, have been used to prosecute journalists and bankrupt or disadvantage their employers. The Commission has a remit to push accession countries to reform their judiciaries and improve the wider business environment for media outlets. It should use it forcefully.

In addition, the Commission should ask accession countries to make media ownership more transparent and clamp down on conflicts of interest. It should work out benchmarks against which the region's fledgling self-regulatory bodies can be measured. It could join other donors in funding training for investigative journalists or support for independent news websites.

Most importantly, the EU and its member-states have to become more vocal about their concerns. Past attempts to put pressure on the governments of Turkey and some Balkan countries through silent diplomacy have not worked. "Our politicians are liars", says Saso Ordanoski, an editor from Macedonia. "They will promise anything unless they are exposed to public scrutiny."

Katinka Barysch is deputy director of the Centre for European Reform.

Debt restructuring will not end the euro crisis

2011-05-09T15:26:00.002Z

by Simon Tilford

Even as the ink is still drying on Portugal’s EU/IMF ‘bail-out’ agreement, it is becoming clear that Greece’s 2010 bail-out has failed to improve the sustainability of its public finances. There are even rumours (strenuously denied) that the German government has drawn up plans for a Greek withdrawal from the currency union. Far from improving access to the financial markets, the support packages for Greece and Ireland (which succumbed to a bail-out of its own in December 2010) have left these countries facing record borrowing costs. The reasons for this are by now well-rehearsed. The markets do not believe that the struggling euro countries are going to grow rapidly enough to service their debts. By increasing their debts further, the bail-outs have made investors even more sceptical. The outlook for Portugal is similar, notwithstanding the slightly less draconian terms of its agreement.

All three countries will eventually have to restructure their debts. Initially, the EU will no doubt try and get away with ‘soft’ restructurings, involving a combination of longer maturities and lower interest rates. But this will not work and by 2013 there will be no viable alternative to ‘hard’ restructurings (default) comprising debt write-downs of 50 per cent or more. Unfortunately, in the case of Greece and Portugal at least, even this will not guarantee continued membership of the euro.

Debt restructuring of this scale will be messy and fraught with risks. The eurozone will have to inject capital into the banks of peripheral countries, which have huge holdings of their respective governments’ debts. Banks based elsewhere in the eurozone that have large exposures to peripheral country debt will have to raise capital from private investors or from their governments. However, by the time the EU gets around to a ‘hard’ debt restructuring in 2013, public bodies (EU governments, the ECB and the IMF) will have assumed at least half of the private sector’s exposure to the public debt of the defaulting countries. In order to prevent debt restructuring from causing a flight from government debt markets across the rest of the eurozone, the ECB will have to stand ready to provide liquidity and, if necessary, purchase government bonds. The ECB itself will have to book huge losses on the money it lent to banks in the defaulting countries. But assuming all this can be achieved without a systemic financial crisis, what then? Will such a debt restructuring/default solve the crisis?

Cutting the debt burdens of the peripheral states will only go so far to resolving their problems. After all, interest payments on their outstanding public debt account for a relatively small (albeit quickly rising) proportion of their budget deficits. Reducing the cost of servicing the outstanding stock of public debt by 50-60 per cent would obviously improve the long-term sustainability of these countries' fiscal positions. But unless the defaulting countries can engineer a return to economic growth, they will continue to struggle to tap the capital markets on anything but prohibitively expensive terms. Of the three peripheral economies, only Ireland stands a good chance of convincing investors of its solvency.

Assuming Ireland’s public debt is written down by around 50 per cent in 2013 (when its debt-to-GDP ratio will have climbed to around 120 per cent of GDP) its debt ratio would be a manageable looking 60 per cent. However, in all likelihood it will also still have a huge budget deficit, which will require on-going budget austerity. In Ireland’s case investors will probably calculate that the Irish economy will be strong enough to weather continued austerity. Ireland is now running a current-account surplus – so it is not dependent on foreign borrowing to finance the deficit and the foreign balance is not a drag on its economy. There will be no return to Celtic Tiger rates of expansion, but the country’s export sector is competitive. Exports should perform relatively strongly, holding out the promise of decent economic growth. As a result, Ireland could regain access to financial markets relatively quickly following a ‘hard’ debt restructuring.

What about Greece and Portugal? In both cases the picture is bleaker. Assuming that the ratio of Greek debt rises to over 160 per cent of GDP before the EU finally pushes ahead with a ‘hard’ restructuring involving a write-down of as much as 60 per cent, the country would have a debt to GDP ratio of 65 per cent. However, investors will be sceptical of the Greek economy’s ability to absorb the cuts needed to bring down the still very large budget deficit. The Greek government will be largely dependent on foreign borrowing to finance the budget deficit: Greece’s current-account deficit has narrowed, but remains very large. Unlike Ireland, Greece will find it very hard to generate the stimulus from exports needed to offset the impact of continued austerity. Exports only account for around 25 per cent of Greek GDP – compared with well over 100 per cent in the Irish case – and Greece does little trade with countries outside the slow-growing EU. Investors will surely bet that they will not get bailed out by taxpayers a second time, and continue to deny Greece market access.

What about Portugal? Portugal has a lower stock of public debt than Greece – at around 95 per cent of GDP – but it has a very sizeable budget deficit, hugely indebted private sector and current account deficit of a comparable size to Greece’s. The combined debt of Portugal’s public and private sectors (excluding debts between banks) is now around 300 per cent of GDP. A chunk of this private sector debt will end up on the government’s books. Under its agreement with the EU and IMF, Portugal has to underwrite €35bn of its banks’ liabilities – equivalent to around 20 per cent of its GDP. But with the Portuguese economy set to contract steeply over the next two years (the EU forecasts falls in GDP of 2 per cent in both 2011 and 2012) the eventual transfer of debt from the private to the public sector is likely to be substantially higher than $35 billion.

If, as seems likely, the ratio of Portugal’s public debt to GDP rises to close to 120 per cent by 2013, a 50 per cent write-down would reduce the debt to around 60 per cent of GDP. But with the fiscal deficit large and export-led growth elusive, investors will remain wary of lending to the Portuguese government. Portugal’s economy is more open than Greece’s, but nowhere near as open as Ireland’s, and does similarly little trade with non-EU markets. Moreover, the country’s principal export market – Spain – faces years of economic stagnation as it grapples with problems not dissimilar to those of Portugal. Portuguese businesses have also experienced a huge loss of trade competitiveness within the eurozone. Added to this, the euro is likely to remain very strong against the dollar as the US Federal Reserve maintains a loose monetary policy and the ECB raises interest rates.

What will then happen? Further bail-outs of Greece and Portugal in the form of loans from the rest of the eurozone are unlikely. Everyone will by then recognise that piling more debt on top of already unsustainable levels makes little sense. This will leave two alternatives: fiscal transfers (the dreaded ‘fiscal union’) or a withdrawal of the affected countries from the currency union. Faced with the possibility of countries leaving the currency union, it is impossible to discount the possibility of a shift to some kind of transfer union. But the politics look formidably difficult. Could there be a negotiated withdrawal from the currency union? It would require action on a number of fronts, including emergency support for the affected countries’ banks and the imposition of temporary capital controls. The quitting countries’ debts would have to be redenominated into their newly introduced (and massively devalued) currencies. The rules stating that any country leaving the currency union would have to quit the EU would also have to be fudged. It is impossible to attach a likelihood to all this happening. But given the obstacles to fiscal transfers between eurozone economies it would be unwise to bet too much money against it.

Simon Tilford is chief economist at the Centre for European Reform.

Can the Arab spring bring peace to the Middle East?

2011-04-21T14:57:00.002Z

by Clara Marina O'Donnell

Many western diplomats and observers argue that the popular uprisings in North Africa and the Middle East reinforce the need for Israelis and Palestinians to return to peace talks. In May, US President Barack Obama and Israeli Prime Minister Benjamin Netanyahu are expected to lay out their views about how the process should be re-started. However, calls for an immediate resumption of negotiations are unrealistic. The political turmoil across the Arab world is making conditions on the ground – already dire – even less conducive to a lasting settlement. Instead, Europeans and Americans should exploit the hiatus created by current regional instability to encourage Palestinians to end their divisions and hold long-overdue elections before October. The EU and the US should also prod Israel to offer the prospect of serious peace talks to whoever wins those elections.

Western diplomats calling for progress in the peace process in response to the upheaval in the Arab world make two arguments. First they point out that Israel could end up with neighbours which are even more hostile to it. There is significant uncertainty about the makeup of the next leadership in Egypt – a key ally of Israel in recent decades. In addition, it cannot be ruled out that regimes in neighbouring countries, such as Syria and Jordan, will fall. In each of these countries, there are groups that are more hostile to Israel than the regimes which have governed in recent years. To limit the scope for conflict, some diplomats argue, Israel should solve its dispute with the Palestinians as soon as possible.

The second argument advanced by western diplomats is that if Israeli and Palestinian leaders do not make progress towards a final negotiated agreement soon, Palestinians in the West Bank might feel emboldened by the popular movements in other Arab countries – and start protesting against Israel or the local Palestinian authorities. In recent years, there have been relatively few protests within the West Bank, governed by moderate President Mahmoud Abbas, either against the Palestinian authorities or Israel. This is in stark contrast to Gaza, which since 2007 has been run by a more radical Palestinian faction, Hamas, and where many militant groups have been protesting violently against Israel, not least through rocket attacks. Some Gazans have already been inspired by the Arab spring, and held marches against Hamas' rule and calling for new elections.

While these arguments are valid, the upheaval across North Africa and the Middle East precludes a diplomatic breakthrough over the next few months. Even before the wave of popular uprisings, the realities on the ground in Israel and the Palestinian Territories stalled the successive diplomatic efforts of the Obama administration (and previously those of the Bush administration): since 2007, the US has been attempting to negotiate a peace deal between the Israeli government and President Abbas. At the same time, Washington, as well as the EU and Israel, have isolated the rulers of Gaza. But Abbas's credibility as a negotiator has been seriously undermined because he has not spoken on behalf of all the Palestinians. To make matters worse, recent Israeli governments have included political parties strongly opposed to negotiating certain key aspects of the peace process – including the withdrawal of illegal settlements in the West Bank or sharing Jerusalem.

The uprisings in Egypt and elsewhere in the region have thrown up two new obstacles: several Arab governments are shaky or in transition, which means they cannot commit to normalising their relations with Israel - a key component of a peace deal for any Israeli government. Second, Hamas is holding out hopes that regional power shifts – in particular the political rise of the Muslim Brotherhood in Egypt - will strengthen their position vis-à-vis President Abbas and his Fatah party. As a result, Hamas is now even less inclined to support peace efforts led by Abbas.

If the US initiates another push for immediate peace talks between Netanyahu and Abbas under current circumstances, they are most likely to flounder. Another diplomatic failure would fuel further disillusionment amongst the Palestinian population. It also risks strengthening calls from the political leadership in the West Bank to secure unilaterally the recognition of the state of Palestine at the UN – which would further complicate eventual peace talks and risk cementing divisions between Gaza and the West Bank.

Instead, over the next few months, the US, the EU and Israel should try to eliminate one of the key obstacles to peace – the lack of a united Palestinian government. Both Fatah and Hamas have repeatedly called for Palestinian reunification over the years, but their mutual antipathy has blighted several reconciliation efforts. However, Abbas has also been held back because Israel has stressed that if the Palestinian President were to form a government of national unity with Hamas, Israel would rule out peace talks. And the US and the EU have threatened to cut off their generous funding to the Palestinian Authority – although the EU has slightly relaxed its position in recent years.

The next deadline for the long-overdue Palestinian presidential and parliamentary elections is October 2011. The US and the EU should encourage Israel to make an offer to the Palestinians: if Palestinians hold elections in both the West Bank and Gaza before October, Israel will be open to peace talks with the resulting united Palestinian government, even if it contains members of Hamas – so long as they no longer resort to violence. In the meantime, Israel could demonstrate its good faith by improving conditions on the ground, notably by halting settlement building and removing further roadblocks in the West Bank.

There is a risk that reuniting the Palestinian factions would weaken President Abbas and Prime Minister Salam Fayyad – two figures who have shown a strong commitment to a peaceful resolution of the conflict and who have succeeded in improving the economy of the West Bank. But it is a risk worth taking, particularly because, according to polling by the Palestinian Center for Policy and Survey Research in March 2011, Abbas would win the presidential election and Fatah would receive 40 per cent of the vote in parliamentary elections (while Hamas would only secure 26 per cent). Even if Hamas were to fare better in the elections, having members of Hamas in a government of national unity would be better than leaving the group in continued isolation: over the nearly four years since Hamas has been in sole control of Gaza, Israeli border closures and military strikes (in response to the sustained rocket attacks) have led to poverty and alienation amongst the population of Gaza. And Hamas and other militant groups have built a significant military arsenal in preparation for another conflict with Israel – in large part with the help of Iran.

The Arab spring makes the continued boycott of Hamas even more problematic. The upheaval in Egypt is giving more room for manoeuvre to militant groups and outside actors - including Iran - within its Sinai region which borders Israel. Moreover, future governments in Egypt, Tunisia and possibly other countries in the region, may well contain Islamist groups. Having to deal with such groups is likely to make it harder for the EU and the US to continue sidelining Hamas.

If Israel, the US and the EU help to reunite the Palestinians over the next few months, they will limit the influence of nefarious groups in and around Gaza. They will incorporate Hamas into the political process at a time when the group has less popular support than moderate Palestinian factions. And importantly, Israelis and Palestinians will be putting themselves in a much stronger position to secure a lasting peace when the turmoil in their neighbourhood starts to settle.

Clara Marina O'Donnell is a research fellow at the Centre for European Reform

The June European Council: Migrants on their minds

2011-04-08T09:07:00.003Z

by Hugo Brady

In June, EU leaders will meet in Brussels for their next quarterly summit chaired by Council President Herman Van Rompuy. Some of them – Britain's David Cameron and France's Nicolas Sarkozy – are currently fighting a war in Libya. Others, like Angela Merkel and Silvio Berlusconi, are facing political upheaval at home. European leaders from both north and south are watching anxiously as the markets continue to pound the euro. But everyone – apart perhaps from the newer members to the east – is worried about immigration. Hence, if events allow, Van Rompuy wants to focus the forthcoming meeting on border control, immigration and refugee policy.

This could easily become a bad tempered, inconclusive affair. First, the summit is supposed to take a broad strategic view of EU immigration and asylum policies. But instability in North Africa will inevitably skew discussion towards the present. Silvio Berlusconi, Italy's prime minister, is adamant that his country needs help to manage a "human tsunami" from Libya and Tunisia. Berlusconi's demands for “solidarity” from fellow EU countries essentially mean their agreement to take in some of the 20,000 or so migrants currently housed in tent camps on the island of Lampedusa and in the mainland region of Puglia. The EU has committed money, a humanitarian mission and border guards from its Frontex border agency. Nonetheless, the Italians want more help. The country’s ‘realist’ immigration policy – heavily reliant on co-operation with dictators such as Muammar Gaddafi and Tunisia’s Ben Ali – is in tatters following EU-supported uprisings.

EU refugee rules say that migrants who claim asylum must be accepted by the first member country they reach. Exceptions can only be made in an emergency if overwhelming numbers suddenly arrive en masse. Although 20,000 is a large number of people, it is nowhere near the influx that followed the 1999 Kosovo war. Then, Albanian Kosovars fled to Western Europe in their hundreds of thousands leading EU governments to provide for some deviation to the first-country-of-arrival rule. Furthermore, several North European countries – including, in this instance, France – typically accept more asylum seekers than Italy, both proportionately and in overall numbers. As it stands, the current situation will not prompt the re-think demanded by Italy, Malta and some other Mediterranean member-states.

Second, European leaders back an EU immigration policy only in so far as it means tighter border controls and more repatriation. To satisfy this demand, the European Commission has proposed giving Frontex more powers and is due to publish in 2012 a raft of legislation intended to upgrade Schengen area border controls with new technology. EU countries have little interest in the Commission’s other ideas to facilitate more legal immigration, however. This was true even when Europe’s economic conditions were favourable and unemployment relatively low. But the creation of more legal migration routes into the EU, like a single European residency permit, would greatly strengthen the Commission's hand in negotiations with neighbouring countries on border checks and the return of unauthorised immigrants.

Third, EU leaders have discussed all of these issues before and achieved little. In 2008, they signed a European 'migration pact' at the urging of France, when summit agendas were still set by a different rotating presidency every six months. The pact declared that the free movement of people between EU countries and the existence of the Schengen area of passport-free travel meant that national immigration policies must also be linked. The text committed all member-states to tighter border controls and more repatriation of immigrants illegally resident on their territories. But – like the Union for the Mediterranean agreed the same year – the pact's confident language and forthright assertions failed to make much difference in practice.

Given that several EU leaders are vulnerable to political challenges at home from the far right, the temptation to push immigration policy upwards to the European level is understandable. But the idea that 'Europe' will help to reduce illegal immigration dramatically is largely an illusion. An EU immigration policy will not of itself drastically decrease the numbers of unskilled migrants arriving on European shores or over-staying tourist visas. Immigration trends are driven by so-called push and pull factors: disparities of wealth, the contrast between instability at home and the high quality of life in Europe, and demand for cheap labour. And even enlightened policies aimed at discouraging emigration from migrants' home countries – trade liberalisation and development aid – tend to produce ambiguous effects. Conditions improve in the poorer country but so too does the mobility of its people and their aspiration for a better life abroad.

With maddening constraints like these, what can Van Rompuy credibly hope to achieve in June? To start with, he can try to steer the talks away from demands for solidarity to a concept he has stressed during the eurozone crisis: mutual responsibility. In the immigration context, this would mean that EU countries need to work together much more pro-actively to prevent future migratory pressures endangering free movement and passport-free travel. One idea would be to create bilateral partnerships between EU countries that struggle to maintain the external border and those that have resources to spare or face less migratory pressure. These partnerships would involve core teams of experts with the relevant skills being seconded to external border countries for long periods. In addition, Van Rompuy could open a debate on whether the creation of a European border guard – EU officials with powers to direct Schengen country border controls – might be necessary.

The EU has four funds for helping member-states to return illegal immigrants, integrate minorities, care for refugees and maintain modern border controls. Taken together, these account for 0.5 per cent (around €550 million) of the EU's annual budget. With inward migration to Europe more likely to rise than fall in the coming years, President Van Rompuy could propose to the assembled leaders that they agree now to double the amount of money allocated to these funds in the next EU multi-annual budget for 2014-2021.

Lastly, Van Rompuy could take forward calls from Germany for the EU to conclude 'mobility partnerships' on immigration with Egypt and Tunisia. These are agreements – managed by the European Commission – whereby some EU countries offer temporary work visas to citizens of a country that, in return, collaborates on border checks and repatriation. Here Van Rompuy could go further and propose that those countries that adhere in practice to UN accords banning the use of torture and providing for refugee protection would be entitled to much more generous terms than those that do not. By encouraging neighbouring countries to treat their own refugees better, the EU would begin to extend the concept of mutual responsibility beyond its own borders. When ready, Libya too should be offered this choice.

The president of the European Council might consider these initiatives too piecemeal to offer to EU leaders as solutions to their immigration worries. They do not amount to a grand European bargain on migration. But, as he watches the black cars pull up in June, Van Rompuy might recall a favourite motto of Pope John 23rd: "See all. Forgive much. Change a little."

Hugo Brady is a senior research fellow at the Centre for European Reform.

Europe's damaging obsession with 'competitiveness'

2011-03-31T16:49:00.000Z

by Simon Tilford

Many European policy-makers and business leaders believe that a country's economic growth prospects depend on its ability to capture a growing share of global markets. Indeed, European policy-makers are obsessed with national 'competitiveness' and genuinely appear to think that prosperity is synonymous with trade surpluses. Of course, imports have to be financed by exports. But the focus on trade competitiveness risks drawing attention away from Europe’s underlying problem, which is very weak productivity growth.

The idea of economic growth being determined by a battle for global market shares in manufactured goods is easy for politicians to grasp and to communicate to their electorates. Countries have little in common with firms, but referring to Deutschland AG, or UK plc, is conceptually attractive and seductively easy. Economies running external surpluses are regarded as 'competitive' irrespective of their productivity or growth performance. The trade balance is seen as a country's 'bottom line', as if countries were firms. The trade balance is nothing of the sort, but is simply the difference between domestic savings and investment or more broadly, between aggregate spending and output.

Governments obsessed with national competitiveness are likely to pursue damaging economic policies. If economic growth is seen as being dependent on the cost competitiveness of exports, governments will focus on things that might make sense for exporters but not for their economies as a whole. A fixation with exports leads to labour market policies aimed at artificially holding down wage growth, which redistributes income from labour to capital and exacerbates inequality. The secular decline in the proportion of national income accounted for by wages and salaries over the last 10 years in nearly every EU economy is a major obstacle to a recovery in private consumption. The flipside of the decline in wage and salaries – a steep rise in the proportion of national income accounted for by corporate profits – has not resulted in booming investment. This is no surprise. An individual firm can cut wages without undermining demand for whatever good or service it produces. But this does not work if all firms attempt this simultaneously. The resulting weakness of overall demand depresses companies' incentives to invest, and with it productivity growth.

In short, cutting the proportion of national income accounted for by wages, accepting a secular rise in inequality and boosting the proportion of national income accounted for by corporate profits is no way to deliver sustainable economic expansion. But it is what happens when governments believe that economic salvation lies in winning a growing share of export markets.

The EU's economic prospects will largely be down to its domestic rate of productivity, not the size of its trade surplus. There is a very strong correlation between growth in labour productivity and economic growth, which holds for countries with trade surpluses as well as those with deficits.

Unfortunately, the data show a remarkable decline in productivity growth across Europe, from around 3.5 per cent annually in the 1970s to barely 1 per cent in the 2000s. And productivity growth has been almost as weak in the eurozone's core as in its troubled periphery. Governments across the region should focus on raising productivity – not just in the most internationally exposed sectors like manufacturing, but in less tradeable sectors such as services too. Service sectors now account for around two-thirds of economic activity. Without stronger productivity across the service sector economic growth will prove elusive.

Why has Europe's productivity performance, with a few notable exceptions been so bad? There are two core problems. The first is inadequate skills levels. Europeans are terrifically complacent about labour skills. Some countries – the Nordics, the Netherlands – do well. The picture elsewhere is patchy at best. Germany has good vocational training, Britain more than its fair share of top universities, France good technical education. Other countries, especially in the south, perform poorly in most areas. The second cause is inadequate competition. In too many sectors, incumbents are protected. This is justified in terms of upholding 'social justice' or defending 'national champions'. What it leads to is so-called rent-seeking; the ability of particular groups in society to extract disproportionate rewards for their work. Where this tendency is strongest, productivity levels are weakest.

Europe's economic growth prospects may be poor. But this has little to do with what is happening elsewhere. Europe’s leaders will find that improving education and throwing open hitherto protected markets is a long and arduous task. But unlike the obsession with 'competitiveness' such reforms will lead Europe onto the path of sustainable growth.

Simon Tilford is chief economist at the Centre for European Reform.

Turkey, the EU and the Mediterranean uprisings

2011-03-16T17:38:00.001Z

by Katinka Barysch

The revolts in Tunisia, Egypt and Libya have brought home to many people that Turkey has become a force to be reckoned with in this region. Turkey enjoys lots of credibility in the Arab world. It has burgeoning trade ties and solid political relations with many Middle Eastern and Mediterranean countries. As the EU scrambles to revamp its own neighbourhood policy, it would do well to work closely with Turkey. Turkey would also gain. Sadly, there is little evidence of such co-operation to date.

Asked at a recent Aspen roundtable in Istanbul whether the EU and Turkey were co-ordinating their responses to the revolts in the Arab world, Ali Babacan, a veteran minister in the Erdogan government, said: "We work a lot with the Americans, like we do on Afghanistan, but not with Europe." The main reason, he said, was that his country's plan to join the EU was going nowhere.

The EU - in acknowledgement of Turkey’s growing international clout - has offered Ankara a foreign policy dialogue outside the accession process. But the dialogue has yet to start in earnest. Most of the interaction between Turkey and the EU still revolves around a largely blocked accession process. Foreign Minister Ahmet Davutoglu - at the same Aspen roundtable - added a second reason why foreign policy co-ordination had been slow to get off the ground. Turkey, he explained, did not bother to work with the EU because the EU's own neighbourhood policy was weak and inconsistent.

Davutoglu and his colleagues in Ankara should reconsider. The uprisings in the Arab world are spurring the EU to rethink its neighbourhood policy (see Charles Grant, 'A new neighbourhood policy for the EU'). They could also wreck Turkey's 'zero problems with the neighbours' approach to its region - which is already in trouble after Turkish attempts to mediate in several regional conflicts failed and Ankara fell out with Israel.

Although today's Turkey likes to see itself as a regional leader, its influence in the Middle East, and even more so in the Maghreb, is still rather fresh and fragile. During the Cold War years, Turkey was largely isolated in its neighbourhood. It clung to its NATO allies while viewing its southern neighbours as sources of Islamic extremism, Kurdish separatism and other potential security threats.

In the 1990s, there were initial attempts to make up with old adversaries like Syria and Iran. These accelerated after the AK party took power in 2002. Turkish mediation efforts, for example between Israel and Syria or Iran and the West, have produced no tangible results. But over the last decade, Turkey has created a web of political, economic and civil society ties with almost all of the countries around its borders. Turkey has scrapped visa requirements for Syrians, Tunisians, Lebanese, Libyans and Moroccans; it is building a free trade zone with various Mediterranean countries; and Turkish traders, builders and bankers are active across the region, as are Turkish business federations and other non-governmental organisations.

Bizarrely, as Kemal Kirisci points out in a recent GMF-IAI paper ('Turkey: Reluctant Mediteranean power'), Turkey's neighbourhood policy has moved from its security-obsessed origins to good old-fashioned European functionalism – the belief that economic integration and lots of low-level exchanges will bring political understanding and stability. The EU's Mediterranean policy has also involved scrapping trade barriers. And it talks about nice things such as democracy and good governance. But in reality it has taken a security-first approach, focusing mainly on fighting terrorism, fundamentalism, and illegal migration.

The revolts in Northern Africa have already forced the EU to think harder about how to help introduce democracy and create economic opportunities in its southern neighbours. Turkey, meanwhile, will probably move security back to the heart of its neighbourhood policy, especially if political upheaval spreads closer to its borders, and if some of the new regimes in the region start quarrelling with Israel or Iran.

Both Turkey and the EU will grapple with finding a balance between the objectives of stability and democracy in their neighbourhood policies. Unlike the EU, Turkey has not in the past claimed to be promoting democracy in the Arab world. Erdogan has managed to gain the admiration of the Arab street - partly through supporting Palestinians and criticising Israel - while at the same time snuggling up to some of the region’s most autocratic rulers, including Colonel Gaddafi, Mahmoud Ahmadinejad and Bashar al-Assad. Erdogan's initial reaction to the Arab uprisings was equally inconsistent. He called on Egypt's President Mubarak to leave and he welcomed Tunisia's move to democracy. But in the case of Libya, Erdogan has been holding out against sanctions and any kind of military intervention. And he has never criticised Ahmadinejad for rigging elections or Assad for clamping down on his opponents. In the new political environment, Turkey's standing in the Arab world will suffer unless its approach to democracy promotion becomes more coherent and consistent.

Turkey's ruling AK party, which itself has some roots in outlawed Islamist forces, has strengthened ties with various Islamist movements in its neighbourhood, including the Muslim Brotherhood in Egypt. The AKP could help turn such movements into electable political parties. However, at a time when the Erdogan government is accused of moving towards religious conservatism and political authoritarianism, collaboration with Islamists elsewhere would scare people inside Turkey and outside. They would ask whether Turkey was trying to promote democracy or Islamism in its foreign relations. Such suspicions would be mitigated if the AKP's ties with Islamists in Egypt and elsewhere were part of an EU-supported democratisation and institution-building programme.

The EU would also benefit greatly from working with Turkey - and not only because Turkey brings valuable regional links and expertise to the table. Having lost much of its kudos by focusing aid and political attentions on various autocratic regimes, the EU could regain soft power by working with Turkey - a country that still enjoys much esteem across the Arab world.

The revamp of respective neighbourhood policies could be an opportunity for the EU and Turkey to get serious about foreign policy co-ordination and thus improve their strained bilateral ties. Co-operation should go beyond political dialogue between Brussels and Ankara and involve business federations, foundations and other non-governmental organisations that can help Mediterranean countries become more stable and prosperous. Without this kind of co-ordination, rivalries and misunderstandings between the EU and Turkey could further undermine their bilateral relationship and the effectiveness of their respective neighbourhood policies.

Katinka Barysch is deputy director of the Centre for European Reform

What cuts in US defence budget will mean for the transatlantic alliance

2011-03-15T12:14:00.001Z

by Tomas Valasek

The US defence budget seems set to fall as Washington begins to restore order in its finances. Spending on the military has reached such heights – $700 billion, or 20 per cent of the US federal budget – that it has become too large for deficit-cutters to ignore. Even traditionally pro-defence Republicans now argue that military expenditures need to be reduced along with other government expenses. Europe, too, will feel the pinch: many of the American soldiers currently based on the continent seem certain to go, and some joint weapons programmes will be cancelled. In case of future crises in Europe, NATO’s and the EU’s ability to respond will be tested. The US will expect Europe to lead but European allies themselves have been reducing forces and budgets.

Congress is poised to cut the White House’s request for defence for the fiscal year (FY) 2011 by $15-$20 billion. That might seem low relative to the $700 billion total but of that amount roughly $160 billion is set aside for operations in Iraq and Afghanistan, and will decrease as those conflicts wind down. And much of the remaining money is tied up in non-discretionary spending such as pensions and healthcare for military personnel (the latter alone costs the Pentagon over $50 billion a year). The brunt of the cuts in FY 2011 will therefore fall on the pool of $200-$300 billion that pays for purchases of new equipment, foreign military assistance, overseas bases and non-core military operations. Money spent abroad will be particularly vulnerable to cuts – more and more Americans say that the US government should look after its own rather than, say, wealthy Europeans (all foreign aid is in for big reductions).

The effect of US defence budget cuts on Europe will be five-fold. First, some of the 80,000 US soldiers left in Europe as assurance to NATO allies will most probably leave; Gates said in January 2011 that “it is clear that we have excess force structure in Europe”. The Balts and others in Europe who continue to fear possible trouble with Russia will wonder whether the US has enough forces ready to defend them. But their unease will be tempered by the many military exercises that the US held in the region last year. In 2010, Washington also successfully lobbied the rest of NATO to draft a defence plan for the Baltic. This was done in order to re-affirm US intent to uphold the alliance’s mutual defence pledge, and it seems to have worked: judging by mood at events such as this month’s GLOBSEC conference in Bratislava, the Balts and other Central Europeans are more at ease with Obama. Besides, as Stephen Flanagan of CSIS, a Washington think-tank, points out, “the 50,000 troops that will stay in Europe would be more than double the US ground presence in South Korea, where there is daily risk of imminent war.” Many of the new allies have been busy cutting defence budget themselves: they say that the fiscal crisis leaves them no choice, but the cuts also suggest that they feel little imminent threat from the East. This will make Washington less reticent about withdrawing troops from Europe.

Second, the military assistance that the US provides to help allies to modernise and re-arm will continue to fall. In the past decade, the US generously funded equipment purchases in Europe, with most money going to the new allies. Low-interest US loans allowed Poland to buy F-16 fighter jets, while Romania purchased C-130 cargo planes with US aid. But in recent years, assistance to countries such as Egypt or Pakistan has taken priority – of the $5.4 billion in 'foreign military financing', which the US set aside for 2011, $4.7 billion will go to Middle East and North Africa. The proportion of the aid going to wealthier and less strategic European countries will be slashed further when, as expected, the overall volume of military assistance falls. In the past, US defence companies would have had a decent shot at thwarting cuts in such assistance: they tend to be its main beneficiaries as most of the money ends up with them in the form of procurement orders. But the mood in the US is changing: Republicans in particular argue that the US government should not be in the business of funding new jobs, and that the best job-creation strategy lies in cutting expenses, thus restoring order in the federal budget. Should military assistance to Europe be slashed, as seems likely, programmes such as Romania’s planned purchase of F-16 fighter jets that are financed with US monies would likely be postponed or cancelled. With defence budgets falling in virtually all NATO countries, there is little hope that European allies would pick up the slack.

Third, US personnel on operations in Europe – in Bosnia-Herzegovina and in Kosovo – will likely be reduced or withdrawn altogether. Because their numbers are low to begin with, the short-term impact will be minimal. Only 20 US soldiers remain in Bosnia in a force that once counted 20,000 American troops. The US has about 800 soldiers left in Kosovo, where the overall NATO force is being reduced from 14,000 to 2,500. Should a new crisis break out in the Balkans, the Pentagon will be able to send more soldiers from bases elsewhere in Europe (primarily Germany). But this reserve force too is being reduced. The downsized Pentagon will be far less willing than in the 1990s to lead military operations in Europe. In the future, Washington will look to its allies to assume main responsibility for dealing with the Balkans and other crises on Europe’s periphery. The defense department’s resistance to a no-fly zone in Libya could be a sign of things to come.

Fourth, those European companies that do business in the US will lose some of their orders – but so will their US competitors. Signs of renewed protectionism have been few so far. While the Pentagon recently chose Boeing over a Franco-German consortium EADS to build a new generation of tanker aircraft, “this is mainly because Boeing’s planes were $2 billion cheaper”, says Andrew Koch, an analyst with Scribe Strategies and Advisors, a Washington consultancy. The European companies have worked hard to erase their US competitors’ advantage: the likes of BAE Systems and EADS pledge to build equipment in the US using American workers, so they are likely to have as many members of Congress on their side as their US counterparts. While competition for US defence contracts will toughen, European companies are not necessarily losing ground to US ones.

Fifth, the future of new weapons funded jointly by the US and its allies is in doubt. Already, the Pentagon has announced that it was pulling out of a US-German-Italian project to build a new generation of medium-range missile defences. This is in large part because the project, MEADS, has suffered technical problems. But the Pentagon, in announcing the decision, also cited financial constraints as a factor. The more the US cuts defence spending, the higher the risk that NATO’s own flagship, continent-wide missile umbrella could be at risk. Announced in November 2010, the system envisions combining future US radars and missiles to be stationed mainly in Central Europe with yet-to-be-developed European sensors and interceptors. But few European governments have come forward pledging money for it. It is not obvious why the US Congress would fund a programme to defend European mainland, which the Europeans themselves are unwilling to support.

Politically, cuts in US defence spending are sure to rankle in Europe. A setback to NATO’s missile defences could be particularly divisive, with new allies lamenting a chance to host US military bases, and with NATO losing one of its key initiatives, which it also has been hoping to use to entice Russia into a closer relationship. The effect of US reductions will be compounded by cuts to military spending in Europe: there is a risk that reductions on one side of the Atlantic will be used to justify corresponding cuts across the sea. NATO remains the most powerful military block in the world but it will lose some of its ability to handle multiple crises simultaneously.

The main challenge for US and European defence communities for the next few years will be to keep NATO’s mutual defence pledge credible: this will require allies to prioritise missions and to hone their ability to diffuse crises before they require deployment of large forces. Even if no such crises occur, the Americans and Europeans will be busy managing the political fallout from cancelled procurement programmes and reduced operations. To minimise damage, the Pentagon should keep allies apprised of its cost-cutting measures. For their part, the Europeans need to co-ordinate better their own reductions in defence budgets, so as to make sure that enough money and resources are left to cover any shortfalls that US cuts will create.

Tomas Valasek is director of foreign policy and defence at the Centre for European Reform.

The EU’s new politics of movement

2011-02-17T15:02:00.003Z

by Hugo Brady

The freedom enjoyed by EU citizens to live and work in each others' countries is a unique liberty. It is the basis around which European governments have tried to build a single border, a compensatory system of co-operation between police, judges and immigration officers and a common refugee policy. But hardening attitudes towards immigration in many countries and widening policy disagreements between governments and the EU's institutions are exposing fault-lines in this structure. As the cracks threaten to widen over the coming months, policy-makers face some tricky dilemmas.

For a start, some EU governments are struggling with the very concept of free movement. The Dutch government – prodded by far-right politician and coalition kingmaker Geert Wilders – recently announced that it wants to renegotiate the free movement directive. At first sight, the Dutch demand does not seem that outrageous: change the law to allow governments to deport EU nationals with criminal records back to their home countries. The problem is that any re-opening of the 2004 directive risks sparking a plethora of demands from France, Italy or Britain to restrict free movement in other ways. The law was also at the centre of last year's spectacular row between the European Commission and France over arbitrary deportations of Roma. Poorer countries like Poland, Hungary or Romania would be livid, leading to a bitter split between east and west and, possibly, north and south.

Second, the Schengen area – the passport-free travel zone that incorporates most countries where free movement applies – is showing signs of strain. The most startling example of this is the partial takeover of Greece's border with Turkey by Frontex, the EU's border agency, due to a spike in illegal arrivals across the Evros river. Schengen is a bit like the euro, where countries share the benefits of a common good but largely trust each other to run a tight ship at home. However Greece already appears to view the Frontex mission as permanent, throwing up questions of moral hazard amid years of under-investment in its border services. With Italy appealing for similar intervention to help with migratory pressures from Tunisia, we could be witnessing the de facto creation of a European border guard. That development will take many EU countries by complete surprise.

Meanwhile, Bulgaria and Romania are adamant that they should join the Schengen area this year. But despite diplomatic bluster from both governments, neither is yet truly ready to cope with the kind of situation currently evident in Greece. For example, the Romanian port of Constanta risks becoming a Baltimore-on-the-Black Sea if traffickers and smugglers operating in the region can access the Schengen area there under current conditions: organised crime and corruption are commonplace. Moreover, Schengen entry is probably the last piece of leverage the EU has left to encourage both countries to cleanse corruption, reform their judiciaries and step up the fight against serious crime, as they solemnly promised to do in 2007. To argue that these issues are irrelevant to the maintenance of a common border is to dwell on niceties: they are all inherently linked to the rule of law.

Third, the EU's common asylum system is broken. Its cornerstone principle – that those fleeing persecution must apply for refugee status in whatever EU country they first reach – has been undermined by a recent judgement of the European Court of Human Rights on sub-standard refugee conditions in Greece.* The court exposed publically what governments and the European Commission already knew: despite the theoretical existence of common asylum rules, EU countries apply these more according to their national administrative traditions than the spirit of European law. Sadly, there is little agreement between Northern Europeans, the Mediterranean member-states or the Commission about what direction reform should take. While the Commission wants to raise standards and create some exceptions to the first-country-of-arrival rule, most governments oppose any liberalisation on the grounds of cost or moral hazard or both. Indeed the Netherlands wants the rules toughened to make it more, not less, difficult to claim refugee status; Sweden has tightened its own system in response to a rise in support for the far-right; and the UK has opted out of most of the new legislation proposed. This matters because no common border can work without an agreed approach to refugees: asylum seekers have special rights under international law to cross national frontiers. And with a fresh refugee crisis brewing in the EU's North African neighbourhood, it is imperative that the current system be replaced with something workable.

Fourth, the EU is about to embark on a complex and difficult debate about the sharing of police data across borders. EU countries have responded to the loss of control over their borders by creating ever more IT systems for sharing information like fingerprints, DNA records and criminal convictions. Later this year, Viviane Reding, the EU's justice commissioner, will unveil a robust new regime for protecting personal privacy in such cases, as well as an overall agreement with the US on data exchanged for the purposes of counter-terrorism and other serious crimes. The problem here is that the Commission is attempting to regulate the exchange of police files for the first time, using new powers under the Lisbon treaty. The issue is full of potential pitfalls. Given the disparity between national regimes for handling police data, an over-zealous proposal from the Commission would set it on a collision course with national security establishments across the EU and possibly provoke fresh tensions with the US. It is also questionable whether – as the Commission intends – a single EU system covering both commercial data and police records is feasible. It is important that information on private citizens shared across borders between police forces with different cultures and levels of professionalism is subject to credible restrictions. So too is the need for law enforcement bodies to work effectively together across borders. The Commission must exercise subtlety and good judgement.

The EU has a new politics of the interior. Failure to address any of the aforementioned issues correctly would undoubtedly have consequences for free movement and passport-free travel given the current political climate in Europe. It is no co-incidence that both France and the Netherlands have already recently attempted to step up police checks at their borders, in contravention of EU rules. As with the original system underpinning fiscal stability in the eurozone, some EU policies to do with border management, refugee protection and police co-operation were poorly designed. Their consequences, flaws and inherent contradictions will trigger much political and diplomatic confrontation in the months ahead. Many will say this is healthy: policies that have hitherto enjoyed years of cozy consensus and relative anonymity are now subject to proper scrutiny and debate. That is true enough. But the battles ahead are not for the faint-hearted.

Hugo Brady is a senior research fellow at the centre for European Reform

* M.S.S. v Belgium and Greece, http://cmiskp.echr.coe.int/tkp197/view.asp?action=html&documentId=880339&portal=hbkm&source=externalbydocnumber&table=F69A27FD8FB86142BF01C1166DEA398649

Eurozone governance and the Berlin consensus

2011-02-11T12:27:00.002Z

by Philip Whyte

A broad consensus appears to have emerged across northern Europe on what ails the eurozone. The region's current predicament, on this view, is the result of fecklessness and irresponsibility in geographically peripheral member-states. Countries in the periphery ran into difficulty because they mismanaged their public finances and lost 'competitiveness'. The road to redemption, on this analysis, is for the peripheral countries to consolidate their public finances and embrace supply-side reforms. The task at EU level is to keep member-states on the straight and narrow by making sure that they comply with the fiscal rules and do what is required to remain 'competitive'. This view, which is having a decisive influence on reforms to the way the eurozone is run, coincides with that of the German government. Let us, then, call it the 'Berlin consensus'.

As an analysis of what ails numerous economies across Europe, the Berlin consensus has much to commend it. There is no question that some countries have mismanaged their public finances. Greece, where governments disguised their profligacy by cooking the data, is the most egregious example. Nor is there any question that many 'peripherals', particularly across Southern Europe, face daunting supply-side challenges: low productivity, high drop-out rates from secondary education, inflexible labour markets, insufficient competition in services markets, rapidly ageing populations and low effective ages of retirement are a toxic brew. All these countries are on unsustainable paths and must push through thoroughgoing economic reforms. Depressingly, their reform efforts have been among the most pedestrian in the EU.

So far, so uncontroversial. Is it right, however, to say that the eurozone would have averted crisis if countries had complied with the Stability and Growth Pact and taken the Lisbon agenda of economic reforms more seriously? Nothing is less certain. France and Germany, which violated the Stability and Growth Pact in 2004, do not face funding difficulties in the government bond markets; Ireland and Spain, which complied with the rules until the crisis broke, do. Nor is it clear that macroeconomic imbalances can be pinned on divergences in national 'competitiveness'. Ireland, a flexible economy that scores highly on many indicators of 'competitiveness', is arguably the most troubled (because the most indebted) country in the eurozone. Italy, which scores worse than Ireland on most indicators of competitiveness, is far less indebted.

The problem with the Berlin consensus is that it does not pay enough attention to the demand-side factors that gave rise to the crisis. The cause of the eurozone's macroeconomic imbalances lay on the demand side. In essence, the problem was that demand grew broadly in line with output at eurozone level, but failed to do so at national level. While demand grew faster than output in the periphery, the reverse was the case in the 'core'. Profligacy in the periphery was funded by thrift in the core. This arrangement suited both sides – for a while. Countries in the periphery enjoyed debt-fuelled booms, while countries like Germany could rely on exports to keep growing (in the face of weak demand at home). Export-led growth in the core and rising indebtedness in the periphery were linked: they were reverse sides of the same coin.

Given the amount of capital that was flooding into the deficit countries, there was always a risk that some of it would be wasted on unproductive investments. And so it was. In Greece, the main agent of waste was the government. But the antics of the government in Greece pale in comparison with those of the private sector elsewhere. In Spain and Ireland, the private sector misallocated capital on a truly epic scale. The agents were over-leveraged banks, in both peripheral and core countries, that funded increasingly speculative investments in the property sector. When the property bubble burst and banks' assets turned sour, the direct and indirect costs blew a hole in the public finance. Ireland's deficits and debt exploded because the government guaranteed the liabilities of highly leveraged banks that were too big for the state to save.

At root, the eurozone crisis boils down to an argument about money. Who should pick up the bill for all the capital that was misallocated in the peripheral countries: feckless borrowers, or reckless lenders? Creditor countries, who are currently in the political driving seat, believe the bill should fall on taxpayers in the deficit countries. But it is not clear that this demand is viable – either economically or politically. Some countries in the periphery are probably insolvent, and the medicine they are currently being prescribed risks pushing them into an ever deeper debt trap. It is hard to see how governments in the periphery can indefinitely push through structural reforms if their economies are contracting and their debt burdens are rising. In the end, therefore, some element of forbearance in the creditor countries appears to be inevitable.

What bearing does all this have for the reform of eurozone governance? First, fiscal consolidation and structural reforms in the periphery may be desirable objectives, but they will not restore the most indebted countries to solvency. Second, extending loans on less than generous terms, as Ireland's partners are doing, will buy time but is unlikely to stave off the inevitable: a default on, or restructuring of, peripheral government debt. Third, it is wrong to portray the eurozone crisis as a problem in the periphery alone. The sovereign debt crisis and the banking crisis are inextricably inter-twined. In the peripheral countries, the link is overt. In the core countries it is suppressed. German banks, for example, are under-capitalised and highly exposed to default in the periphery – a fact that the German government is not keen to discuss.

Since a sovereign debt restructuring in the periphery would have repercussions for the solvency of banks in the core, the eurozone needs a crisis management framework to deal with both eventualities. The eurozone needs to establish a framework for orderly sovereign debt restructuring, which would ensure that private-sector creditors share in the pain. And since sovereign debt restructuring would push some European banks into insolvency, the EU needs to develop plans for dealing with this prospect. Solvent sovereigns in the core, such as Germany, will have to decide whether they want to recapitalise their weaker banks, or allow them to survive in their current vegetative state. And countries across the EU must implement resolution regimes that would allow them to wind up insolvent banks in as orderly a fashion as possible.

Philip Whyte is a senior research fellow at the Centre for European Reform

Ireland’s election and the EU: From poster child to enfant terrible?

2011-01-28T11:44:00.004Z

by Hugo Brady

Ireland will elect a new government on February 25th to replace a discredited administration loathed by most Irish voters. At first sight, it seems unlikely the election will re-open the fundamentals of a bail-out agreed with fellow eurozone members and the IMF last November. The last act of Fianna Fáil, the main party in government since 1997, was to translate the terms of that deal into an initial set of tax hikes and further public spending cuts before leaving office. Nonetheless, the poll – Ireland’s most important for decades – marks a shift in hostility towards the bail-out and the EU in general which its partners would be foolish to ignore.

European benefactors might express shock that Irish attitudes towards the EU have worsened in the wake of the bail-out. To many EU leaders – including José Manuel Barroso, president of the European Commission – they are helping to rescue a country where politicians and regulators, through incompetence or worse, allowed bankers and developers to drive the economy to ruin using other people's money.* That view is correct but cloistered. It takes no account of the part played by the introduction of the euro itself – at a low interest rate hitherto unknown in Ireland – in inflating a runaway property boom. And Ireland's eurozone partners (along with Britain) do expect their money back at a profit, having – they hope – secured the common currency and the unwise investments of their own banks in the process.

Furthermore, the Irish version of events differs sharply from that of its partners, even when adjusted for the natural reluctance of any country to blame itself for its own woes. Most Irish people feel that the rest of the eurozone and European Central Bank imposed a bail-out that their country did not need (Ireland could have limped on until mid-2011 despite its astronomical debts) at an interest rate that it could not afford (5.8 per cent) in an ultimately futile attempt to contain a wider crisis. With a decade of austerity ahead and with no option to default, Ireland's voters gape in disbelief at new demands by continental politicians that it must now raise its low corporation tax rate. By the end of the year, Ireland will have lost 300,000 jobs from a labour market of 2.1 million. The country needs to retain foreign investment as a matter of economic survival.

Perhaps popular disenchantment was always unavoidable, but attitudes amongst Ireland's traditionally pro-EU elites have hardened too. Michael Noonan, the finance spokesperson of Fine Gael – an unambiguously pro-European Christian Democratic party and the one likely to form the bulk of the next government – has characterised the bail-out agreement as being forced on a punch-drunk government by lordly EU and IMF negotiators. Eamon Gilmore, the Irish Labour leader, whose party is likely to secure the finance portfolio in a new coalition, has also demanded a renegotiation of the terms of the agreement, saying the bail-out “clearly won't work. It provides no scope for the Irish economy to grow.”** Even Fianna Fáil – now under a far more effective leader in Micheál Martin, the former foreign affairs minster – will repudiate the agreement in time. And independent commentators in the media and respected think-tanks such as the Economic and Social Research Institute wonder aloud how Ireland will remain a euro country while extricating itself from its current situation.

Irish politics manages to fuse an Italian-style localism, ebullience and idiosyncrasy with the British parliamentary model. Ireland's politicians are usually uninterested in ideology, intensely sensitive to local concerns and poor at strategic thinking, one reason why they were unable to think past the boom. But popular Irish attitudes to national sovereignty closely mirror those of its nearest neighbour. In Britain, euroscepticism became a truly potent political force in the wake of the UK's forced exit from the European Exchange Rate Mechanism in 1992. Since then, pro-Europeans in Britain have dwindled to a small group of progressives. There is every reason to believe that the new generation of Irish politicians entering the scene at this election will view Ireland's difficulties with the euro as the ERM crisis for slow-learners. A flotilla of long-serving parliamentarians are bowing out of politics at this election in favour of younger candidates.

All of this matters doubly because – unlike Britain – Ireland has held a referendum on the future of European integration on average every four or five years since 1987. On the two occasions when Ireland has voted twice on the same treaty, Irish politicians were able to justify this by pointing to the fact that EU membership had been overwhelmingly beneficial to the country. Many voters now recall with bitterness how a desperate government assured them in October 2009 that a second vote on the Lisbon treaty would assist an imminent economic recovery. It will no longer be possible to be so categorial about Ireland's relationship with the EU, also bearing in mind that the country will shortly become a net contributor to the European budget. And the current uncertainty over the fate of the euro itself shows that the EU's constitutional future is by no means settled, as many had hoped when Lisbon was finally ratified.

Make no mistake: it is Ireland's politicians, not the EU, that will rightly be in the firing line on February 25th. But although Ireland may never again be able to serve as an unqualified European success story, the collapse of pro-European sentiment there could well come back to haunt the EU in future. In the 1990s, the IMF learned in Latin America that it is often wise to launch a charm offensive when a new government comes into power in a recipient country undergoing harsh economic adjustment. Ireland's eurozone partners and the ECB would be well advised to follow a similar approach by pre-empting the incoming government's demand for a renegotiation with an offer to lower the interest rate for loans needed to sustain the public finances. In time, the sparing of Irish blushes may save those of many others.

Hugo Brady is a senior research fellow at the Centre for European Reform

* http://www.irishtimes.com/newspaper/breaking/2011/0119/breaking52.html

** http://www.irishtimes.com/newspaper/ireland/2011/0106/1224286876810.html

Can Greece be saved?

2011-01-20T11:35:00.001Z

by Katinka Barysch

Will Greece have to restructure its debt? Among most West European economists and investors, this now seems to be a foregone conclusion. The Greeks themselves are not so sure. During a recent visit to Athens, none of the economists and politicians I spoke to thought that restructuring was inevitable or desirable. The Papandreou government looks determined. But to avoid default, Greece would need two things: economic growth and more help from its European neighbours.

Since Greece negotiated its €110 billion financial assistance package with the EU and the IMF last year, it has cut its government deficit by an impressive 6 per cent of GDP. The government has slashed public salaries and pensions, raised VAT and other taxes, and clamped down on ubiquitous tax evasion. Half a dozen big strikes and the occasional outbreak of street fighting notwithstanding, the Greeks have so far remained rather stoic in the face of this unprecedented belt tightening. Most realise that change is needed and hardship inevitable.

The other reason why Greeks have so far stayed calm is that the worst is yet to come. While civil servants, truckers and some other groups felt immediate pain, the population at large has not yet suffered unbearably. After 15 years of rising salaries, most Greeks can cope with an initial drop in income. Those who lose their job or business can usually rely on a tightly knit family network for support.

Greece, however, is not even half way through its deficit cutting programme. The total need for adjustment is 13-15 per cent of GDP. Cutting the first 20 or 30 per cent out of any budget is relatively easy – especially in a budget that contains as much flab as the Greek one. The public sector is overstaffed and, in many places, overpaid; pension entitlements are generous; although 60 per cent of the population lives in the capital, Greece has over 1,000 municipal administrations and 52 regional ones (a new law will cut those numbers by two-thirds); the country’s 150 public hospitals are accounting-free zones, which has contributed to spiralling healthcare costs; public enterprise such as the railways are black holes for government subsidies.

Once the most glaring inefficiencies have been removed, however, further reductions will get a lot harder. After the fat is gone, the government will have to cut bone. Papandreou needs to perform this operation at a time when the economy is in deep recession: by the end of this year, GDP will have contracted by as much as 10 per cent; unemployment is heading towards 15 per cent; among younger people, one in three is out of work; thousands of businesses are closing down every month.

Even if the government managed to stay on track with its plans for budget consolidation, public debt would continue to rise inexorably, to over 150 per cent of GDP by the end of this year. Greece will only stand a chance of generating the revenue needed to service such high debt if it returns to economic growth, and quickly.

The bad news is that in order to regain its competitiveness Greece will require an internal ‘devaluation’ – a fall in real wages relative to its trading partners. Such wage compression will dampen consumption and could even lead to damaging deflation. And it would not even address the deeper problem that Greece makes few things that people in other countries want to buy. Growth since the 1990s was led by consumption and fuelled by cheap foreign credit. To move to a more sustainable growth model, the country requires higher value-added industries and massive foreign investment. Neither will materialise without very thorough economic and institutional reforms. “In terms of institutions, infrastructure and corruption, Greece looks a bit like a third world country”, sighs one Greek fund manager based in London.

The somewhat better news is that Greece’s economy is so inefficient that a series of straightforward changes could kick-start an economic expansion. “In many sectors, our economy resembles Soviet central planning”, explains Yannis Stournaras, who runs the IOBE institute for economic and industrial research. “If we remove stifling regulation and bureaucracy, the economy’s dynamism will be unbound.” IOBE has calculated that liberalisation of the most heavily shackled sectors and professions would lift output by 10 per cent over four years, and probably more once dynamic, growth-boosting effects are taken into account.

Having implemented a first bout of budget-cutting policies, the Papandreou government is now setting to work on structural reforms. If things go according to plan, some 70 ‘closed shop’ professions, from lawyers to pharmacists and civil engineers, will lose many of their privileges and protections. Hiring and firing workers will get easier across the board. State enterprises will be restructured, downsized and sold off. Red tape for businesses will be cut. New incentives will boost investment in green energy, high-end tourism and other potential growth industries.

These plans are already creating fierce opposition from the highly organised groups that will be directly affected. The two main political parties, but Pasok in particular, rely on the trade unions and professional bodies for their core support. “Attacking the closed-shop professions means civil war within Pasok”, predicts Loukas Tsoukalis, head of Eliamep, a think-tank in Athens. Already, some Pasok MPs are grumbling that the reforms are now going too far, too fast. More strikes are inevitable.

Curiously, Greeks tend to sympathise with the plight of even the most molly-coddled public sector workers and privileged professionals. Faced with rising opposition within his own party and public restiveness, Papandreou’s resolve may yet falter.

Even if it does not, Papandreou will face the immovable object of his own state administration. Structural reforms will only boost growth if they are implemented swiftly and effectively. The chances of this happening are slim. A law going back to the post-dictatorship days makes the dismissal of civil servants illegal; even sacking public sector workers who do not strictly speaking enjoy civil service status is considered politically impossible. Each administration since the 1980s has added ‘its’ people to an already outsized state apparatus, often in return for votes and political support. The result is a public sector that is not only hopelessly bloated (roughly 800,000 out of a workforce of five million) but one that is infused with a sense of entitlement, rather than public duty.

Until and unless growth resumes, Greece will struggle to cope with its stifling debt burden. Greeks hope that the EU will step in again to tide the country over until the economy recovers. Many hope that Germany will drop its opposition to joint eurozone bonds, which would help to lower the interest rate at which Greece borrows and refinances its debt. Others suggest that the EU could ‘front-load’ regional aid to boost Greek investment over the next couple of years.

If no further EU help is forthcoming, or the debt burden proves unsustainable, Greece may yet be forced to negotiate a rescheduling or restructuring with its creditors. Since Greek politicians are loath to consider the default option publicly, this would come as a shock to many ordinary Greeks. Many might be directly affected if (as seems likely) a public debt restructuring triggers a crisis within the Greek banking sector and social security funds. Most Greeks would consider default as a terminal blow to the country’s standing inside the EU.

Greeks have traditionally been very pro-EU, and not only because the country has been one of the biggest recipients of EU structural funds since the 1980s. All political parties, with the exception of the Communists, are in favour of more European integration. Remarkably few Greeks have so far blamed the EU (or the IMF for that matter) for the hardship they are going through – although Germans, and Chancellor Merkel in particular, are deeply unpopular for dithering over the bail-out and lecturing the Greeks about their allegedly lazy and lavish ways.

If Greece was forced to restructure, politicians and public opinion could quickly turn against the EU. “The Greeks would say: We’ve been through pain and austerity, and now you drop us”, predicts Panagiotis Ioakeimidis, professor at Athens university and an EU specialist. Some Greeks fear that after default, Greece’s membership in the euro, and the EU itself, may be questioned. That is why the Greeks will hold out fiercely against any pressure to consider restructuring.

Katinka Barysch is deputy director of the Centre for European Reform

Euro crisis: In defence of investors

2011-01-17T11:36:00.000Z

by Simon Tilford

The eurozone’s fiscal position is better than the US and UK, and the crisis-hit members of the currency union are doing more to strengthen their public finances than either of these countries. So why are borrowing costs so much higher for countries in the eurozone periphery than for Britain and America? Portugal and Greece have lower public deficits than the US, so why do investors fear for their solvency, but not that of the US?

These questions are being put with increasing frustration by eurozone economists, from both the public and private sectors, as well as by policy-makers such as Juergen Stark at the European Central Bank. The inference is that investors are judging countries by different standards. Why else would investors continue to lend to the likes of the ‘profligate’ US and UK, but punish countries whose fundamentals are sounder? Such irrational behaviour by investors, it is argued, is unfairly derailing the hard work being done by governments in the eurozone. Are such frustrations justified?

Investors do appear, superficially at least, to be harsh in their attitude towards the eurozone. As Table 1 below shows, the eurozone's aggregate budget deficit is lower than in the UK or the US; its aggregate debt is marginally higher than in the UK, but lower than in the US; and in struggling Spain, public debt is lower than in both the US and the UK.

But anything more than a very superficial analysis shows why investors are right to be concerned about the eurozone. First, there is no federal eurozone budget, so the aggregate budget deficit is only of so much interest to investors. Second, it is countries’ ability to service their debts going forward that determines the risk premium demanded by investors, and to a large extent this depends on their economic growth prospects. While the crisis-hit eurozone economies have made more progress in reducing their borrowing than did either the UK or US, this has been at the cost of economic stagnation. Third, sovereign investors are not just concerned about public debt, but levels of private indebtedness too. They fear that if economic growth remains very weak, governments will end up being liable for some of the private debt.

Eurozone economic growth was a respectable enough 1.7 per cent in 2010 (see Table 2). This was well below the US, but about the same as the UK. However, the eurozone figures masked huge differences. Germany, which accounts for a third of the currency union’s GDP, expanded by 3.6 per cent, whereas Greece’s economy contracted steeply and a number of others barely grew. Stripping out Germany, eurozone economic growth was actually just 1 per cent in 2010. Indeed, the eurozone is still a long way from returning to its pre-crisis level of economic activity: in the third quarter of 2010 eurozone GDP was still 3.2 per cent lower than in the first quarter of 2008. This was better than the UK but far worse than the US, whose economy was almost 2 per cent larger in the third quarter of 2010 than at the outset of the downturn. Not only is real GDP in some of the struggling economies still way below their pre-crisis peaks, but there is little chance of them returning to pre-crisis levels any time soon.

Are investors right to be so pessimistic about the economic growth prospects of the struggling member-states? Yes, because their prospects of economic recovery rest on a strong rise in exports, but the principal way of bringing this about – real devaluation within the eurozone – threatens economic stagnation and rising debt burdens. Because of their membership of the currency union they cannot devalue their currencies, so must reduce their wages and prices relative to their eurozone counterparts. The problem is that this will depress income and lead to deflationary pressures. This, in turn, will make it hard to bring down deficits on a sustained basis (irrespective of how wrenching fiscal austerity is), and will inflate debt servicing costs. A strategy of deflating back to competitiveness might be do-able for an economy with little or no debt, but for the crisis-hit eurozone economies it is high-risk.

Portugal has combined public and private debt of around 320 per cent of GDP. The Portuguese central bank expects real GDP to contract by 1.3 per cent in 2011, while inflation is unlikely to be much more than 1.5 per cent. This implies stagnant nominal GDP (growth in real GDP and inflation). There was much fanfare this week when Portugal successfully sold a modest quantity of government bonds at a yield of 6.7 per cent, but this is a ruinous rate of interest for an economy with Portugal’s prospects. The picture is somewhat better in Spain (hence investors are demanding less of a premium to lend to the Spanish government). Ireland has managed to execute a major internal devaluation within the eurozone, but at the cost of an unprecedented decline in its nominal GDP and an explosion in the country’s debt burden. With Greece’s stock of public debt at 140 per cent of GDP and its economy contracting rapidly, it is hardly surprising that investors have little appetite for Greek bonds.

But what of the structural reforms being pushed through by these countries? Why are investors not taking more account of these? There is no doubt that Spain, Greece and Portugal are now introducing long overdue reforms of their labour markets. These reforms are obviously welcome, and in the long-term should help to boost productivity growth. But a little perspective is needed. Notwithstanding modest moves to free up the markets for professional services in Greece and Portugal, there is little sign of an aggressive drive to open-up these countries’ domestic sectors to more competition. And without such aggressive liberalisation, productivity growth will remain anaemic. Moreover, there are legitimate doubts over the ability of governments to push through an ongoing programme of unpopular reforms when their economies are caught in a cycle of weak economic growth and rising debt burdens. There needs to be light at the end of the tunnel.

What of debt dynamics in the UK and US? Are they not even worse? Both face daunting fiscal challenges and high levels of household indebtedness. And the US at least relies on foreign investors to finance a significant chunk of its budget deficit. But there are several good reasons for investors to be more relaxed about the solvency of the US (and to a somewhat lesser degree, the UK) than the crisis-hit members of the currency union. Unlike their eurozone counterparts, who must rely on deflation to rebalance their economies, the US and UK can rely on currency depreciation to facilitate the necessary adjustment and boost exports. Currency depreciation and very activist central banks in these two countries also ensures that deflation is unlikely to be problem. In addition, both countries have far more flexible product and labour markets than the southern European countries.

In short, the reason why the US and UK can borrow at much lower rates of interest than the similarly indebted members of the eurozone is that the obstacles to economic growth are lower in Britain and America and threat of deflation and mounting social tensions much less acute. Of course, investors could yet take fright if economic recovery in the two countries peters out and their fiscal deficits remain too high. The UK, more than the US, could certainly find itself in this position. But in such a situation, sterling would fall, encouraged no doubt by a further bout of so-called quantitative easing by the Bank of England. And fortunately for the British government, it largely relies on domestic institutional investors to fund its fiscal deficit; this is not so in the case of the currency union’s strugglers.

Unsustainable macroeconomic policies explain investors’ flight from the sovereign debt of the crisis-hit eurozone economies. Until the eurozone demonstrates how the currency union’s peripheral economies are going to avoid stagnation and debt traps, it will be rational for investors to give their sovereign debt a wide berth.

Simon Tilford is chief economist at the Centre for European Reform.

Reflections on Tommaso Padoa-Schioppa and the euro

2011-01-13T10:37:00.000Z

By Charles Grant

At the end of last year, Europe lost Tommaso Padoa-Schioppa, an eminent central banker and economist, and one of the founding fathers of the euro. As EU leaders struggle to cope with the continuing euro crisis, they would do well do ponder some of Padoa-Schioppa’s insights on the economics of monetary union.

Following Greece and Ireland, Portugal may soon require a rescue from its fellow eurozone members. With the benefit of hindsight it is only too evident that the euro has suffered from design flaws, and that European leaders have mismanaged the currency. Too many countries joined the euro before they were ready. Fiscal discipline has been too lax, though new rules will make it harder for governments to over-borrow. Some eurozone governments did far too little to promote structural reform, and have therefore suffered from inflexible economies and poor productivity; in 2010, Greece, Portugal and Spain belatedly implemented some structural reforms. The penal rates of interest at which Greece, Ireland and Portugal have had to borrow have revealed the need for a bail-out mechanism and a procedure for ensuring the relatively orderly restructuring of sovereign debt (both are on their way). The behaviour of many banks – and not only in Ireland and Spain – has shown that the tighter system of pan-European financial regulation now being put together is sorely needed.

The statesmen who designed the euro have been criticised for putting politics ahead of economics: motivated by the desire to promote European unification, they ignored the economics – or assumed that once the project got underway, the necessary rules for economic governance would somehow fall into place. There is truth in that criticism, but many people have forgotten that economics did play a role in the birth of the euro.

In 1987, Padoa-Schioppa wrote a report explaining that the exchange rate mechanism (ERM) – which limited fluctuations among many European currencies – could not survive the removal of exchange controls that was agreed in that year. He wrote: “The complete liberalisation of capital movements is inconsistent with the present combination of exchange rate stability and the considerable national autonomy in the conduct of monetary policy.” He also argued that the end of the ERM and the return of currency instability would endanger the single market.

This report convinced Jacques Delors, the then president of the European Commission, and other leaders, that moving towards economic and monetary union (EMU) was urgent. So in 1988 EU leaders tasked a committee – which had Delors as its chairman and Padoa-Schioppa as its joint rapporteur – with drawing up plans for EMU. Delors and Padoa-Schioppa got most of what they wanted, though the Germans forced them – reluctantly – to accept the principle of binding rules on budget deficits. Most of the Delors committee’s report ended up in the Maastricht treaty in 1991. The ERM would not have survived the currency crises of 1992 and 1993 – when the capital markets nearly tore it apart – without the momentum towards monetary union.

In 2000, when a member of the executive board of the European Central Bank (ECB), Padoa-Schioppa wrote a brilliant essay for the CER, ‘Europe’s new economic policy constitution’. He complained about the weakness of the arrangements for co-ordinating national fiscal policies, arguing that if the eurozone could develop its own fiscal stance, the ECB could better manage monetary policy and more easily keep down interest rates. He also warned that the eurozone would not work well unless governments made labour markets more flexible; doing so would facilitate “higher non-inflationary growth. This in turn would increase fiscal sustainability on both the income and expenditure sides of the budget.”

Padoa-Schioppa’s death has deprived Europe of a courteous public servant who was utterly committed to European unity. Many of his insights have long-lasting relevance, and not only on labour markets. The EU’s new procedure for a ‘European semester’, involving peer review of national budgets, is a step towards the fiscal co-ordination he called for. Above all, Padoa-Schioppa understood the relevance of the euro to the single market. If the euro disappeared, giving way to competitive devaluations and wild currency swings, there is a serious risk that member-states would either impose tariffs against each other or resort to hidden forms of protectionism. Alternatives to the euro would not look pretty.

Like Padoa-Schioppa, the CER has long argued that a healthy eurozone requires much more thorough economic reform. In the flurry of regulatory and institutional reforms now underway, one of the most serious underlying problems in the eurozone is not being addressed. This is the growing gap in competitiveness between the eurozone’s core in northern Europe, and the southern states. This has led to large current account imbalances within the eurozone, and these have left the southern countries struggling to grow and to pay back debts.

One economist who foresaw that these imbalances would be a problem was the CER’s Simon Tilford, whose remarkably prescient CER report, ‘Will the eurozone crack?’, was published in September 2006. Simon wrote: “The core problem is that membership seems to have reduced pressure on governments to undertake the reforms needed to ensure the currency union is a success. Freed from the risk of a currency crisis and higher debt service costs, Italy [and the other southern countries have] done little to strengthen public finances, make labour markets more flexible or introduce more competition. The result has been declining productivity, inflation above the eurozone average and a sharp decline in competitiveness relative to other members of the eurozone. Unable to devalue its currency, Italy now risks getting caught in a vicious circle of very slow economic growth and rising debt.”

Simon predicted, rightly, that the markets’ inability to distinguish between the debts of different eurozone countries would lead to a damaging lack of fiscal discipline. He also pointed out that Germany’s “de facto competitive devaluation”, through low wage growth, would exacerbate eurozone imbalances. “While this has massively boosted the country’s competitiveness and its exports, it has depressed consumption and investment, causing the country’s trade and current account surpluses to balloon. An economy as big as Germany’s cannot depend indefinitely on exports to drive real GDP growth, without imposing intolerable pressures on other members of EMU.” On the other hand, “a German economy growing under its own steam would boost demand across the eurozone, cushioning the impact of structural reforms, and crucially, make it easier for other member-states to restore their competitiveness without forcing their economies into a prolonged recession.”

One reason to be gloomy about the euro is the intellectual rift that divides European leaders. It is as though the doctors examining the patient do not agree on the diagnosis or the medicine required. At the risk of some generalisation, leaders from Germanic and Nordic cultures believe that stricter fiscal discipline and structural reform will suffice to cure the patient. Those from Latin and Anglo-Saxon cultures think that medicine is necessary but not sufficient: they also focus on the imbalances and the need for the core countries with external surpluses to generate demand in the eurozone.

Despite all the problems, I expect the euro to survive, because the political will of EU leaders – including those in Germany – to do what it takes to preserve the currency remains strong. But political will on its own will not suffice; Europe’s leaders must also listen to economists if they want to put the euro on a truly sustainable footing.

Charles Grant is director of the Centre for European Reform

Has Ukraine lost appetite for reforms?

2010-12-17T15:53:00.002Z

In a study on Ukraine published in October, the CER gave President Viktor Yanukovich credit for passing difficult economic reforms but criticised his efforts to suppress political opposition. Since then, reforms have stalled while the concentration of power in the president's hands has continued unabated.

A recent visit to Kyiv has left me deeply worried. The government continues to amass power. This is in part due to the weakness of the opposition – former leaders of the Orange revolution such as former president Viktor Yushchenko and former prime minister Yulia Tymoshenko are genuinely unpopular with voters, who blame them for disappointing economic performance and failure to move Ukraine closer to the EU. Even so, President Yanukovich seems intent on preventing free and fair elections. The October 31st regional poll was marred by widespread use of government powers to help the ruling Party of Regions. The European Parliament notes in its November 25th resolution that "some parties, such as [Yulia Tymoshenko's] Batkivshchyna, were unable to register their candidates". Phil Gordon, the US assistant secretary of state, said that the United States: "does not believe that those elections met the standards of openness and fairness that applied to the presidential election earlier in the year."

The story is not much better on the economic front. Even in those areas, where progress had been made, the government has started to backpedal. For example, the new public procurement law, which the EU helped to draft earlier this year, is being riddled by exceptions: the country's parliament has exempted work on sites for the 2012 European football championship. The EU has viewed the law as key to countering corruption, and its partial reversal dismayed EU ambassadors in Kyiv. Economists also say that the government cheated to comply with a key requirement from the International Monetary Fund (IMF): in order to cut tax refund arrears it simply stopped accepting claims. The IMF is due to decide this month on whether to disburse further aid to Ukraine.

There has been little progress on reforming the country's all-important gas sector. The government has increased domestic gas prices, which has helped to improve the finances of Naftogaz, the country's monopoly – and perennially insolvent – importer and distributor of gas. But there has been no progress on making the company more efficient and transparent. In September 2010 Ukraine acceded to the EU's 'energy community', which groups countries that pledge to uphold each other's security of supply, on the condition that the government separates Naftogaz's gas transit pipelines from other businesses. The Ukrainian parliament passed legislation in July that had ordered Naftogaz to do just that. But nothing has changed: Naftogaz remains untouched and important secondary legislation – to create an independent regulator, for example – is not even under consideration. Meanwhile, Naftogaz is descending into deeper financial trouble. A court in Ukraine has ordered the company to repay nearly $4 billion to one of Ukraine's most powerful businessmen, Dmytro Firtash, who had sued for damages incurred when the previous government cancelled the services of his company in brokering gas purchases from Russia. It is not obvious that Naftogaz has enough money or gas to reimburse Firtash.

The government recently passed a law that would make it easier to explore oil reserves in the Black Sea. These could in the long run lessen Ukraine's dependence on energy imports from Russia. But to extract the reserves, Ukraine needs foreign expertise. So it is baffling that the government has recently imposed a new 40 per cent duty on imports of refined oil (punishing Shell, a key importer) and increased royalties on gas and oil extracted in Ukraine. Foreign energy majors will have little reason to invest in the country. One representative of a Western energy major says that "there is plenty of gas here, in shale and under sea, but no one will tap it because there is zero confidence among investors that they would ever see their money back." Non-energy companies are treated similarly. Deutsche Telekom and Norway's Telenor wanted to buy Ukraine's national telecommunications operator, Ukrtelecom, but the Kyiv government excluded them from the privatisation on a technicality.

Curiously, while the economic reforms have stuttered, relations with the EU have improved, though from a low point. At an EU-Ukraine summit in November, the parties agreed a 'road map' which may eventually allow the Ukrainians to travel to the EU without visas. Talks on a new 'deep and comprehensive free trade agreement' (DCFTA) have also been resumed, after months of paralysis. When the European Commission had threatened in October to cut off talks altogether, President Yanukovich ordered Prime Minister Mykola Azarov "to make all necessary concessions" to restart negotiations. But the order itself is symptomatic of what is wrong with the relationship: Kyiv only pays attention when talks are about to collapse; even then it takes short-term measures: nothing is being done to assess the economic impact of DCFTA on Ukrainian industries or to encourage the losers to move into new lines of business. This guarantees that some of the country's politically powerful oligarchs will eventually revolt against DCFTA.

The EU has limited tools to press for greater political freedoms and proper economic reforms but it is not powerless. The Ukrainians do care what the EU states and institutions think. They have cheered the European Parliament’s November resolution, in which, for the first time, an EU institution (albeit one without decision-making powers in the matter) says that "Ukraine has the right to apply for membership" (something that the Council of Ministers has been reluctant to say). EU High Representative for Foreign Policy Catherine Ashton and senior national diplomats should speak out more forcefully about the state of democracy in Ukraine. EU governments should also use their influence in the IMF to demand real economic reforms. The IMF loans represent the most important leverage that the European governments and the US have in Ukraine today. The current government in Kyiv is capable of tough choices, but only when it feels real pressure.

Tomas Valasek is director of foreign policy and defence at the Centre for European Reform.

Eurozone: Time for damage limitation

2010-12-09T17:20:00.002Z

by Simon Tilford

Time is running out to prevent the eurozone crisis from imperilling Europe's banking system and with it the integrity of the currency union. It is beholden on policy-makers to minimise the economic (and hence political costs) to the EU. Three things need to happen: the debts of Greece, Ireland and Portugal need to be restructured as soon as possible; the European Commission and the European Central Bank (ECB) need to do everything to make sure that the adjustments facing the other struggling euro economies are realistic; and there needs to be policy co-ordination between the member-states aimed at ensuring balanced economic growth across the currency union. This requires leadership and an honest and better informed debate about the causes of the crisis. Both are in short supply.

The adjustments facing Greece, Ireland or Portugal were always a tall order. Now that borrowing costs have ballooned, those adjustments are impossible. Under no plausible economic growth forecasts will these economies be able to pay back their debts. However, eurozone policy-makers continue to treat the crisis as one of liquidity rather than solvency, providing indebted member-states with loans (at punitive interest rates) but doing nothing to improve their chances of being able to service them. This is the worst of all possible worlds. Investors have taken fright and pushed up the borrowing costs of countries whose debts might otherwise have proved manageable. Far from limiting creditor losses, they risk spiralling out of control. Piling up more debt when solvency (not liquidity) is the issue is self-defeating.

The bail-out of Ireland simply increases that country's already unsustainable levels of debt, while insulating investors. The ECB and the Commission opposed restructuring the debts of the Irish banking sector. Instead, they have argued for ever more implausible degrees of fiscal austerity in return for extending costly loans. Unsurprisingly, the Irish government's borrowing costs remain prohibitively high. A bail-out of Portugal will be similarly ineffective. It will benefit lucky investors, but do nothing to improve Portugal's prospects. The loss of confidence in the eurozone and resulting surge in borrowing costs threatens to draw Spain into the insolvent camp, ultimately requiring a Spanish debt restructuring. This would be catastrophic for Europe's banks and would impose huge fiscal costs.

Of course, restructuring the debts of Greece, Ireland and Portugal will be costly for creditors. But if debt positions are unsustainable the problem needs to be addressed sooner rather than later. Banks based in eurozone members such as France and Germany, as well as in non-eurozone countries such as the UK and US, would suffer big losses on their investments in the defaulting countries. The ECB would also book losses. This would be messy and governments would have to bite the bullet and recapitalise their banks. But it would ultimately prove less damaging to economies such as Ireland, Greece and Portugal, and the currency union as a whole, than persisting on a course that promises an even bigger restructuring (and bigger losses) down the line.

The second part of the strategy would be to ensure that the adjustment process facing Spain and other hard-hit economies is a manageable one. The ECB could help by launching an aggressive programme of government bond purchases. Monies from the European Financial Stability Fund (EFSF) could also be used to tide the countries over until they regain access to the financial markets on affordable terms. But these countries' fiscal programmes will also have to be consistent with a return to decent economic growth. Crucially, cuts in spending on education and infrastructure must be kept to a minimum, as these would further reduce growth potential. Reforms of pension and healthcare systems would go a long way to address investors' concerns about the long-term sustainability of countries' fiscal positions.

The third part of the strategy – rebalancing economic growth in the eurozone – will be the hardest to execute, but is essential if future crises are to be avoided. Governments need to support the Commission's drive to foster closer economic integration and to co-ordinate their policies to ensure that they are compatible with balanced economic growth across the eurozone. Huge current account balances are not consistent with a stable currency union, because one way or another they require massive (and hence politically and economically destabilising) transfers between the participating economies. However, even if trade imbalances are reduced, there will have to be greater fiscal supra-nationalism. This could take the form of a common E-bond, some minimal fiscal union, or ideally a combination of the two. Without some element of fiscal supra-nationalism, the adjustment costs facing countries that cede trade competitiveness within the eurozone will simply be too high.

However unpalatable these measures are to eurozone governments, the European Commission and the ECB, they can all be done if governments can summon the political will. Governments have to explain to their voters why debt relief for Greece, Ireland and Portugal and the resulting injection of public funds into banks is necessary in order to head off far greater costs down the line. They have to summon the political courage to make the case for greater economic integration. A fiscal union can also be fashioned in such a way that limits moral hazard. But all of this requires leadership, not least from Germany. The fact that the alternative – a series of ever larger and ineffective bail-outs, culminating in far bigger defaults and a systemic banking sector crash – is much worse, ought to focus minds. After all, under that scenario the political glue holding the union together could dissolve altogether.

Simon Tilford is chief economist at the Centre for European Reform.

The 'new' Poland and its neighbours

2010-11-29T11:05:00.001Z

by Tomas Valasek

Poland is shedding its 'new member-state' image and is instead trying to join the exclusive club of big EU countries. It is a laudable and so far largely successful goal, but not one without risks. To become a big EU player, Poland needs to continue cultivating its role as a regional leader in Central and Eastern Europe.

Poland is riding high. Whereas all other EU economies slumped last year, Poland's grew by 1.7 per cent. Warsaw has patched up relations with Berlin and Moscow, with noticeable results: German Foreign Minister Guido Westerwelle's first foreign trip was to Warsaw, and Russian politicians handled the tragic plane crash that killed the Polish president and other leaders with unusual tact. Poland's dynamic foreign minister, Radek Sikorski, is all over Europe, dispensing advice on how to reform the EU's neighbourhood policy, democratise Belarus, and revamp NATO's nuclear posture. In a single day alone last month, Russia's Foreign Minister Sergey Lavrov, former US Secretary of State Madeleine Albright, US Assistant Secretary of State Phil Gordon, US Assistant Secretary of Defence Alexander Vershbow and a senior US congressional delegation dropped by Warsaw for separate visits.

The 'new' Poland was born in 2007, when the centre-right government of Prime Minister Donald Tusk replaced the controversial Kaczynski government. Tusk's team decided that Poland was to shed its labels of being reflexively Russophobic, anti-German and Atlanticist – which had led to Warsaw at different points vetoing EU-Russia negotiations and seeking to slow common EU defence policy. Instead, the government briefed Russia on Poland's plans for missile defences (which Moscow felt uneasy about), invited Prime Minister Vladimir Putin to the anniversary of the outbreak of Word War II and launched consultations with Germany on the EU's eastern policy. Warsaw also made common EU defence a priority for its EU presidency in 2011.

Poland's revamped foreign policy has been a great success: along with the country's economic resilience, it has catapulted Poland to a position of prominence in Europe without weakening its bond with the US. Relations with Russia are at their highest point since the end of the Cold War. This transformation has inflated the country's confidence: "We are no longer a playground but a player", boasts one government minister. Poland's view of its place in Europe has been transformed, too. The 'old' Poland was a Central European leader. The 'new' Poland sees itself as a European power on a par with France and Germany. Polish diplomats speak fondly and frequently of a 'Weimar Triangle', in which France, Germany and Poland will discuss matters of European security. In many ways it is already working: Germany's and Poland's foreign ministers wrote a joint paper on strengthening the EU's eastern policy and they went to Minsk together to warn the Belarusian governments against falsifying elections. Diplomats say that lower-level co-operation between German and Polish officials is even more intense.

The Polish-Russian 'reset' has been the most notable result of Warsaw's policy reversal. It started for largely tactical reasons – as a way of boosting Poland's standing in Europe. But Russia's positive response has had an interesting psychological effect. When one speaks to Polish diplomats today they leave the impression that they want the relationship with Russia to look successful almost irrespective of what it delivers because the dialogue with Moscow makes Poland feel relevant and strong. Although most Poles are still wary of Russia, Polish politicians and officials appear more prepared than other Europeans to believe that Russia's 'modernisation partnership' with the EU will transform the country. Polish diplomats also sound less suspicious of Russian intentions, for example in meddling in Central Europe, than most of their EU counterparts.

While Poland has received more attention from West European capitals and improved its ties with Moscow, its links with its immediate neighbours have cooled. Relations with Lithuania are the worst they have been in decades. Diplomats from other 'Visegrad Four' states (Hungary, Czech Republic and Slovakia) grumble that it has become difficult to get their Polish colleagues to focus on regional projects such as new interconnections between oil and gas networks in Central Europe. When the Visegrad countries hold a ministerial meeting, Poland usually sends a deputy to meet with other countries' senior ministers.

This is partly Poland's neighbours' fault; they do not always make attractive partners. Some Central European countries are not serious about defence whereas Poland is a military power and one of a few countries to spend close to the NATO-recommended two per cent of GDP on defence (Hungary and Slovakia are already below, or falling below, the one per cent mark). Others, like the Baltic states, have been reckless with their economies and needed to be bailed out by the IMF, whereas Poland is proudly growing. But Warsaw's relations with new EU members have also cooled because Poland is increasingly adopting a 'big country' mentality. Like the UK, France and Germany, it gives smaller countries less attention than it gives the big ones. Above all, the Poles seem intent on shedding the 'new member' label. A commonly-expressed opinion in Poland is that "the new divisions in Europe are not between the East and West but between the [frugal and responsible] North and the [free-spending and reckless] South". In the eyes of other Central Europeans, Poland appears to be deliberately distancing itself from its traditional friends in the neighbourhood.

This is an understandable instinct; all 'rising powers' grapple with how to balance old friendships with new opportunities for partnership with the big states. But Poland's shift to 'big country' mentality is not without risks. Despite all the notable successes, Poland's new status is still fragile. Germany and France will remain preoccupied with saving the euro for the foreseeable future – an endeavour in which Poland as a non-euro member does not have much of a say. Even in areas where Poland thinks it should play a pivotal role now, it is not always taken seriously. Germany and France held a controversial three-way summit with Russia on European security, much to Poland's dismay (one of the main points of repairing relations with France and Germany was to stop them talking to Russia over Polish heads). Poland's charm offensive also comes at a difficult time: the eurozone crisis has made all EU countries more selfish and tetchy. Poland risks being caught in no-man's land: not yet taken fully seriously by Europe's biggest states but no longer seen by the rest of the new EU countries as a natural leader.

Poland should hedge its bets by simultaneously cultivating links to Germany and France while keeping its old friends close. Paris and Berlin take Warsaw seriously partly because Poland is a regional power: the four Visegrad countries have more votes in the EU's Council of Ministers than the Franco-German duo, and many more when the Baltic states are added. Poland, by virtue of its size and prominence, is the region's natural leader. This gives Warsaw real power in the forthcoming debates such as the one about the next EU budget framework starting in 2014. The more effective Poland becomes at corralling Central European votes, the more likely Paris and Berlin are to seek co-operation with Warsaw.

Tomas Valasek is director of foreign policy and defence at the Centre for European Reform.

Eurozone policy-makers are playing with fire

2010-11-15T17:03:00.001Z

By Simon Tilford

There is an awful inevitability about the latest instalment of the eurozone crisis, which looks highly likely to culminate in Ireland being forced to seek a bailout from the European Financial Stability Fund (EFSF). As soon as German and French leaders raised the spectre of private holders of government bonds incurring losses under a permanent crisis resolution mechanism, borrowing costs for the struggling members of the eurozone were only going to increase. Unless the EU changes track and agrees to make the EFSF permanent and the European Central bank (ECB) steps up its purchases of the hard-hit countries’ government bonds, investors will believe that default is inevitable and demand correspondingly punitive interest rates. Contagion to other member-states will be all but inevitable. If, and when, it reaches Spain, the crisis risks spiralling out of control.

Taken out of context there is obviously merit to the Franco-German proposal. But the timing could not have been more damaging. The defence of the proposal – that existing bonds would not be affected, just those issued after 2013 when the new crisis resolution mechanism would replace the EFSF – is illogical. In 2013, Greece, Ireland, Portugal and whichever other countries are in this group by then will have to pay ruinously high interest rates to borrow money. The EU will then have to choose between launching an open-ended bail-out of the countries in question, or push ahead with a restructuring of their debts. The latter would, of course, leave the current holders of these countries’ debts nursing losses, and explains why investors have taken fright.

Investors are calculating that voters in the fiscally sound member-states would baulk at an open-ended bail-out. They are right to be sceptical as the number of countries that would be strong enough to participate in such a bail-out is worrying small. For example, it is unlikely that Italy could really participate in a major bail-out without investors looking askance at its own position. Italy is not confronted with the aftermath of a housing market crash, but the country has a very high level of public debt (around 115 per cent of GDP) and extremely poor economic growth prospects. Belgium is in a similar position.

Instead of making a bad situation worse the eurozone should concentrate its efforts on debating how the EFSF will be made permanent, ideally as the embryo of some kind of minimal fiscal union. Without a permanent mechanism to support member-states, it is hard to see how order is to be restored to the bond markets. The current strategy of austerity and debt-deflation on the struggling member-states is bankrupt and self-defeating. If these countries were able to devalue it might work by boosting the trade competitiveness of their goods and pushing up inflation, hence reducing the risk of deflation. Similarly, if there was going to be serious action to address trade imbalances within the currency union, they might have a chance of generating export-led growth. As it stands a number of member-states are effectively insolvent and caught in a vicious cycle. The collapse of economic growth has devastated tax revenues, while deflation is pushing up the real value of their debts.

For its part, the ECB should be loosening monetary policy and stepping up its strategy of bond purchases in an effort to save the currency union. But the next move in eurozone interest rates will be up, and the ECB is committed to winding-down its bond purchases. In light of the risk of contagion to other member-states, including Spain, the ECB’s current strategy is much riskier than the potentially inflationary impact of such bond purchases. With much of the eurozone economy stagnant and German growth being driven largely by exports rather than domestic demand, the threat of a surge in inflation is imaginary.

The initially slow and disjointed response of eurozone policy-makers to the eurozone crisis was forgivable. After all, the currency union comprises 16 sovereign governments and there had been no contingency planning for such a crisis. Deciding what to do was never going to be easy. What is less forgivable is that they continue to underestimate the severity of the crisis and what is at stake if they fail to contain it. Instead of questioning the rationality of the investors, eurozone policy-makers need to pay more attention to what is driving market sentiment. The eurozone’s strategy for dealing with the crisis now points to default across the currency union’s periphery. The markets can hardly be blamed for pricing in such a likelihood.

Simon Tilford is chief economist at the Centre for European Reform

Europe dances to Germany's tune

2010-11-03T17:41:00.000Z

by Charles Grant

For much of this year, the response of European leaders to the eurozone crisis has been hesitant and fractious. But when the European Council met in Brussels on October 28th and 29th, the EU appeared to be acting with greater purpose and sense of direction. One reason for this change is that most member-states – including France – are now willing to swallow large doses of German leadership. Chancellor Angela Merkel's influence was evident on the three key issues discussed by the summit: tightening rules on economic governance, setting up a new institution to deal with countries unable to borrow in the markets, and revising the EU treaties. However, Germany’s leadership has also brought problems. One is that Germany's determination to get its way has bruised several smaller states, as well as the Commission and the European Central Bank. Another is that its reluctance to discuss imbalances within the eurozone has prevented the EU from taking serious action to tackle them – though the imbalances have (in the view of many countries) contributed to the euro crisis.

On the first key issue, the summit adopted the report of the task force led by Herman Van Rompuy, the European Council president, on 'Strengthening economic governance in the EU'. The implementation of the report will mean stricter and more automatic punishments for countries that borrow too much, as the Germans – backed by the Austrians, Dutch, Finns and Swedes – have called for. Sensibly, the report says that the EU should focus not only on governments' budget deficits, but also the overall level of debt. The task force also considered the delicate subject of economic imbalances in the eurozone (the Germans do not like being told that their unwillingness to spend, and their current account surplus, contribute to inadequate demand and current account deficits in southern Europe). The report says it is more urgent to tackle imbalances in countries with big current account deficits than those in the surplus countries, but it does propose monitoring of imbalances and disciplinary procedures for all those who fail to act on recommendations to tackle imbalances.

On the second issue, the new institution, EU leaders agreed to establish a 'crisis resolution framework' to replace or supplement the European Financial Stability Facility (EFSF) that they designed last May to support governments unable to borrow in the markets. Merkel has been unwilling to prolong the three-year life of the EFSF, fearing that Germany's constitutional court could declare it in breach of the Maastricht treaty's no-bail out rule (she also knew that giving the EFSF a finite life would increase her leverage in the arguments on eurozone governance). EU leaders have not yet agreed on how the new body will work, but it will probably be a kind of European Monetary Fund that both lends money (with strict conditions attached) and facilitates an orderly restructuring of the debt of countries that cannot repay what they have borrowed.

The Germans say this restructuring should lead to private sector creditors taking a loss, and many governments go along with that. But at the summit Jean-Claude Trichet, the president of the European Central Bank, and the leaders of some southern states – who worry about their ability to borrow – argued against establishing that kind of restructuring mechanism at this stage. It could deter investors from lending to eurozone governments, Trichet argued, and make it even harder for them to service their debts. The Germans responded that tax-payers should not bear all the cost of bail-outs, and that markets should fret about potential losses in order to discipline borrowers. The markets now seem to be doing that job – perhaps too well. Since the summit the cost of borrowing for the southern Europeans has risen to as high as it was before the EFSF was hatched in May (though the governments concerned started to tighten their belts several months ago). The Germans will face stiff opposition on the issue of creditors taking losses. But since they will be responsible for providing the biggest share of any rescue package, they are likely to win the argument.

On the third issue, treaty change, the summit asked Van Rompuy to report back in December on whether the current treaties need to be amended to establish the crisis resolution mechanism. The answer to that question is already clear. For many months the Germans have argued that treaty change was needed to ensure that a new mechanism did not fall foul of their constitutional court. However, most governments – having spent the best part of a decade sorting out the Lisbon treaty – did not want another round of treaty change. Then at the Franco-German summit in Deauville on October 19th, Merkel persuaded France's president, Nicolas Sarkozy, to back treaty change (in return for a modest weakening of some sanction mechanisms). At the European Council most other leaders followed them, if only grudgingly – though Luxembourg's Jean-Claude Juncker and the Commission's José Manuel Barroso argued against treaty change.

The heads of government now seem confident that a small treaty change can be achieved without too much pain. They have reached a tacit understanding to limit the change to the establishment of the new institution, and to rule out any other amendments. The Lisbon treaty contains a 'fast track' procedure that allows the heads of government to agree a change, by unanimity, without the need for a convention (the mix of MPs, MEPs and government representatives that drew up the constitutional treaty that later became the Lisbon treaty) or an inter-governmental conference. But two conditions must be satisfied: the change must not transfer powers to the EU, and it must concern the implementation of EU policies, rather than the fundamentals of the Union. The clause the Germans want should meet those conditions.

The fast-track procedure still requires each member-state to ratify the amendment. The Irish and the Danes seem to think they can avoid referendums. In the Netherlands, the populist Dutch Freedom Party and the left-wing Socialist Party are both threatening to demand a referendum, but they lack a parliamentary majority. In the Czech Republic, President Vaclav Klaus could create problems, as he did by delaying the ratification of the Lisbon treaty. In any case Czech eurosceptics are likely to challenge the amendment in the constitutional court, on the grounds that it gives the EU more power and therefore merits a referendum. Britain will not be affected by the new rules on eurozone governance, since it has an opt-out from treaty provisions on the euro. Nevertheless Conservative eurosceptics want Prime Minister David Cameron to block treaty change until the other member-states grant Britain new opt-outs from the treaties in areas such as social policy. Cameron seems determined to face down the eurosceptics. He will accept the amendment so long as other governments help him constrain the growth of the EU budget. At the moment France, Germany and about half the member-states are backing Britain's efforts to hold the rise in next year’s budget to 2.9 per cent.

The Germans did not get everything they wanted at the summit. There was little support for their scheme to deprive governments that borrow too much of voting rights. They have had to accept the Van Rompuy report's argument that imbalances should be monitored. But the Germans achieved most of their key objectives. France had opposed stricter rules and quasi-automatic penalties for over-borrowed countries, a formal debt restructuring mechanism, and treaty change. But now it has accepted those German priorities – without appearing to get a great deal in return.

Visiting Paris just after the summit, I was struck by the deferential tone of some French officials when they talked of Germany. They noted that Germany is in a supremely self-confident mood because of its export surge to emerging markets. They thought this was not the right time to tell the Germans that their economic model was marred by a low level of domestic demand, and that that was aggravating the eurozone crisis. Much better to suggest gingerly that Germany would benefit from taking specific steps such as increasing investment and spending on R&D, lengthening shopping hours and getting more women into the workforce. Such steps would in the long term help to rebalance the eurozone. These French officials may be right on the tactics of how best to deal with the Germans.

In Paris, some senior figures fret about Germany's seemingly superior economic performance, compared to France and other EU countries, and about its economic structure – very focused on emerging markets – which seems to be diverging from that of its partners. "Will Germany lose interest in the EU?" they ask. For several years the French – and many others – have worried about Germany becoming less 'European' and more focused on the east, for example through its special relationship with Russia.

One French response is to stay close to the Germans in order to retain influence with them. That has been evident in Russia policy: in recent years France has emulated Germany's soft approach towards Moscow (which is not to say that that policy is necessarily wrong). And that response has also been evident on the euro. At the Brussels summit several smaller member-states complained about having to fall in behind deals stitched together by Paris and Berlin. But so long as the French continue to back the Germans on eurozone governance, their partners – and the EU institutions – have little choice but to follow.

Charles Grant is director of the Centre for European Reform

Britain's defence review: Good news for European defence?

2010-10-28T12:26:00.002Z

by Clara Marina O'Donnell

On October 19th, the UK's coalition government published its 'strategic defence and security review' (SDSR), laying out the future shape of Britain's armed forces. As was to be expected at a time of budget austerity, the SDSR foresees significant cuts in military capabilities. But the review also has some good news. The need to save money has made the UK government more willing to move towards long-overdue European co-operation. In addition, the coalition is keen to see the EU play a role in defence, a pragmatism which stands in stark contrast to the eurosceptic views held by the Conservative party before the general election last May.

As part of its plan to reduce the UK's budget deficit, the government has been forced to cut an already overstretched defence budget by 8 per cent in real terms over the next four years. Prime Minister David Cameron has claimed that Britain will continue "punching above its weight" in the decades to come. But, inevitably, the UK's level of ambition has been scaled back.

Britain will no longer be able to maintain a long-term operation of the size that is currently deployed in Afghanistan: while there are nearly 10,000 British troops in Afghanistan today, the maximum size of such operations in future will be around 6,500. The size of large-scale fighting operations will also be cut back – to around two-thirds of the forces that went into Iraq in 2003. The government has also been forced to give up big items of military equipment. Britain will mothball or sell one of the two new aircraft carriers it has committed to build; the UK is also retiring its Harrier fleet of military jets early, leaving the other carrier without any British aircraft for several years.

Extensive cuts in UK defence capabilities risk further weakening the ability of Europeans to contribute to global crises, already poor as a result of years of insufficient and inefficient defence spending across the continent. But at least the British government is showing an unprecedented interest in closer defence co-operation – not only with the US, but also with its European allies. Acknowledging that it can no longer afford to maintain capabilities alone, the government has committed to exploring the possibilities of joint formations for future operations, joint training and maintenance, and even sharing assets or relying on others to provide some military equipment.

Frustrated by the inefficiencies and cost overruns of large multinational programmes, the coalition wants to focus on bilateral co-operation. In particular, the government wants to work more closely with France, which has a similar defence budget and shared military ambitions. Prime Minister Cameron and President Nicolas Sarkozy are expected to announce a series of common defence projects at a bilateral summit in Paris in early November. Now that both France and the UK will rely on only one aircraft carrier each, this should also lead to new avenues for co-operation. Britain has already decided to redesign its remaining carrier so it can be used by French (and US) aircraft.

The coalition government's plan to work more closely with its allies is both positive and long overdue. For decades, Britain and other European countries have wasted a lot of money by duplicating the development of military equipment. Depending on the outcome of the Franco-British summit, the new UK government might go further in promoting the cause of European defence co-operation than any of its predecessors.

But London must invest the same political energy it has devoted to France towards exploring additional savings with other European countries. In the SDSR, the government opens the possibility of closer defence co-operation with Germany, Italy, the Netherlands and Spain. But other countries could also offer niche savings, including Poland and Sweden which have shown a keen interest in improving their military capabilities in recent years. The UK should also actively encourage its European allies to strengthen co-operation amongst themselves. As Britain's own military preparedness diminishes, it has a greater interest in other European countries taking up the slack.

The second piece of good news in the SDSR is the rather constructive attitude of the UK towards EU defence co-operation. Before the general election last spring, key members of the Conservative party – in particular William Hague, now the Foreign Secretary, and Liam Fox, now in charge of defence – voiced serious reservations about EU efforts in defence. Liam Fox worried that federalists within the EU were trying to develop a European army. He openly opposed some of the steps towards a stronger EU foreign policy foreseen in the Lisbon treaty. And he was keen to withdraw the UK from the European Defence Agency, a body which encourages common efforts amongst EU countries in developing defence capabilities.

But since their arrival in government with the Liberal Democrats, the Conservatives have agreed to support the new institutions created by the Lisbon treaty. The coalition has chosen to remain in the European Defence Agency for a trial period of two years. And the SDSR has recognised that while NATO remains the "bedrock of Britain’s defence", an "outward-facing" EU also has a role to play in “promoting security and prosperity”. In the defence review, the government even stresses its support for EU military and civilian missions – as long as they offer good value for money and NATO does not want to intervene.

The new government's stronger focus on value for money in EU missions has already ruffled feathers in Brussels, as the UK has become more critical of EU deployments that it considers are failing to deliver – such as the EU mission in support of security sector reform in Guinea-Bissau (which was ended in September 2010) or the military training mission for Somali security forces. But the coalition's desire to see EU missions deliver a real impact on the ground should be seen as a good thing. Too often EU deployments have been too small to make a lasting contribution to stability, like the police training mission in Afghanistan, or their effectiveness has been damaged by an ambiguous mandate, as was the case at the beginning of the police mission in Bosnia-Herzegovina.

If the UK government is going to oppose missions which it considers are not adding value, it must also be willing to strengthen those missions which are effective. Britain is actually one of the EU countries keen to maintain the EU's military deployment in Bosnia-Herzegovina (which some other member-states want to dismantle). But the UK should go further and, when appropriate, increase the budget of effective EU operations and send more British personnel – notwithstanding the UK's budgetary troubles.

If the coalition strengthens EU missions, it would help reassure EU partners that the UK is not opposed to EU operations out of principle. More importantly, effective EU military and civilian deployments would contribute to one of Britain's key objectives within its SDSR – to strengthen stabilisation and conflict prevention efforts around the world.

At a time when additional defence cuts cannot be precluded down the road, the UK must work closely with its European partners over the next few years – in developing military capabilities and deploying stabilisation and crisis management missions, including through the EU. Only through co-operation now will Britain feel more comfortable to explore even deeper common efforts when the next SDSR takes place in 2015.

Clara Marina O'Donnell is a research fellow at the Centre for European Reform.

What currency wars mean for the eurozone

2010-10-15T10:11:00.000Z

By Simon Tilford

The dollar has now fallen to $1.40 against the euro. This is still below the low of almost $1.60 that it reached in the middle in July 2008, but it represents a steep decline from under $1.20 in early June. Moreover, the US currency is likely to weaken further. The euro has also risen sharply against the British pound in recent weeks. Why is this happening? And what are the implications for the eurozone economy and, in particular, the member-states currently experiencing difficulties funding their government deficits?

The renewed strength of the euro is not down to optimism about the eurozone’s economic prospects. Most forecasters foresee only modest growth in the eurozone economy next year and in 2012. Nor does the appreciation in the value of the single currency reflect receding investor concerns over the solvency of various eurozone economies. The spreads between the German government’s borrowing costs and those of the struggling member-states of currency union remain very high. The reason for the strength of the euro reflects the differing policies of the US Federal Reserve (and the Bank of England) on the one side and the European Central Bank on the other.

The Federal Reserve will almost certainly embark on a further round of so-called quantitative easing before the end of 2010. The Bank of England may follow suit. Quantitative easing involves pumping money into the economy through the purchase of assets (usually government bonds), ostensibly with the aim of boosting credit growth and hence consumption and investment. Both central banks are considering such action because of the failure of their respective economic recoveries to gain traction and their consequent fears that inflation will fall too low. Weak economic growth and low inflation (or worse, deflation) is very dangerous for highly indebted economies, because it makes it much harder to reduce the real value of their debt.

The ECB has taken a different line. Some of its board members believe that they need to tighten monetary policy. The bank has already reined in its policy of providing unlimited liquidity to eurozone banks, with the result that market interest rates have risen sharply. Axel Weber, head of the influential German Bundesbank, has called for an increase in official interest rates and spoken out strongly against any quantitative easing comparable to that under consideration by the Federal Reserve or the Bank of England. The institutions’ contrasting approaches partly reflect philosophical differences – the ECB believes the potential inflationary risks of quantitative easing outweigh the threat of deflation. But the differing economic outlooks of the various eurozone economies are also a factor. For example, the German economy is expanding rapidly, explaining Weber’s call for tighter policy.

The problem for the eurozone is that unorthodox monetary policy such as quantitative easing tends to depress the currencies of the countries whose central banks are engaged in it. The reason is that some of the money issued flows abroad. The weakness of the dollar (and the pound) has led many to question whether the US and UK are engaging in competitive currency devaluations. In short, they stand accused of attempting to bolster their trade competitiveness at others’ expense. Because the ECB has elected to pursue a different monetary policy course and because – unlike East Asians countries such as China, South Korea and even Japan – the ECB does not intervene in the foreign currency markets to hold down the value of the euro, it is the single currency which is bearing the brunt of a weaker dollar.

There is no doubt that the Federal Reserve and the Bank of England are keen to keep their respective currencies weak. It is not hard to see why. For the best part of three decades, both economies have more or less continuously run current account deficits as their domestic savings have fallen short of their investment levels. They now need to close these external imbalances, which are a drag on their economies, and are one reason why both are running such large fiscal deficits. Savings rates in both countries have certainly picked up and investment remains weak, but a rebalancing of their economies remains elusive. Indeed, after narrowing in the immediate aftermath of the financial crisis, the US trade deficit is widening. A major reason for this is that many countries remain wedded to export-led growth and are unwilling or unable to rebalance their economies in favour of domestic demand.

Global imbalances were one of the key drivers of the financial crisis. They led to excessive capital flows into the US and other fast-growing developed economies. These pushed down the cost of capital and encouraged – together with poor management – excess leverage and risk-taking. US attempts to cajole the Chinese and others to pursue more balanced economic growth have largely fallen on deaf ears. By pumping out lots of dollars, the US central bank hopes to make it more costly for countries to hold down their currencies. China will have to buy more dollars if it is to maintain the renminbi’s peg to the US currency. This will be costly because the dollar will ultimately have to fall in value, reducing the value of China’s dollar holdings. Moreover, the inflows of dollars into China will prove destabilising, exacerbating bubbles and pushing up inflation. This, in turn, should make Chinese goods less competitive on the US market. However, it is impossible to say how long it will take before the Chinese and other East Asian governments blink.

In the meantime, the euro is set to remain very strong. This is bad news for the stability of the eurozone. If it persists, the adjustment facing struggling members of the currency union, such as Spain, will be even harder to bring off. Spain requires strong growth in exports to offset the weakness of its domestic economy, and a strong euro will make its goods and services less competitive in export markets outside the currency bloc. But is the eurozone an innocent bystander in all this? The eurozone’s trade with the rest of the world is broadly in balance, and no-one could accuse of the ECB of adopting policies aimed at weakening the euro. However, to an extent, the eurozone economies are reaping what they have sown.

First, Spain is so dependent on exports to the rest of the world to dig itself out if its current hole because the eurozone has failed to take action to address the trade imbalances between member-states of the currency union itself. Spain must close its external deficit without any corresponding obligation on countries such as Germany and the Netherlands to narrow their surpluses. In short, the eurozone is relying on demand generated elsewhere in the world to bail it out. In essence, its strategy to overcome the crisis involves running a trade surplus with the rest of the world. US action to weaken the dollar combined with the mercantilism of East Asian governments makes this all but impossible. Second, the Chinese were not the only ones who were deaf to US calls for action to rebalance the global economy. The German government was instrumental in preventing any discussion of imbalances within the G20, joining the Chinese in arguing that it is for the deficit countries alone to put their houses in order.

The G20’s failure to agree a global strategy to address imbalances leaves the eurozone in a tricky position. At the very least, the ECB should hold off tightening monetary policy, as this would further increase the attractiveness of the euro relative to the dollar. Secondly, it must get serious about removing barriers to stronger domestic demand across the eurozone. There will be no export-led exit from the eurozone crisis. Signs of a pick-up in German domestic demand are positive in this regard, but it remains to be seen how vulnerable this is to a weakening of external demand for German goods.

Simon Tilford is chief economist at the Centre for European Reform

The EU should be much bolder on energy efficiency

2010-10-12T09:42:00.000Z

by Stephen Tindale

The most pain-free way for European governments to fight climate change is to use energy more efficiently. At a recent energy conference hosted by the European Commission, it struck me that the EU still has a poverty of ambition when it comes to energy efficiency. This is hard to fathom at a time when it could alleviate several of the ills currently troubling European governments: unemployment, energy security and climate change.

EU policy and performance in this area has been disappointing to date. In a speech to a conference on EU energy policy on September 30th 2010, energy commissioner Gṻnther Oettinger identified energy efficiency as his “first priority”. However, he then talked mainly about how energy is used by consumers and the importance of improving the insulation of buildings. This is a significant part of the energy equation, but not the only important part of it. The EU must also focus on how energy is produced.

Too much of the debate on climates focuses on targets. The EU has legally binding targets to reduce greenhouse gas emissions by at least 20 per cent (from 1990 levels) by 2020, and to get 20 per cent of energy from renewables by the same date. A third target, energy savings of 20 per cent by 2020, is so far only for for guidance. Oettinger has said that he will decide whether to make this target binding after evaluating progress made towards the voluntary target in 2012. Targets have some value; they lead to greater political and business attention and help secure agreement on specific policies. However, it would be a waste of political and negotiating capital to spend too much time or effort making the target binding. It would be more sensible for governments, businesses and non-governmental organisations to focus instead on specific regulations and on funding.

The Commission is due to publish a new Energy Efficiency Action Plan before the end of 2010. This should identify regulations and funds to deliver improved efficiency, both in energy use and in energy production. The Energy Performance of Buildings Directive, Energy Services Directive and Cogeneration Directive should be strengthened. The Energy Performance of Buildings Directive mandates that all buildings undergoing major renovation will have to meet minimum energy performance requirements, but these are to be set by member-states. Germany already requires that any building undergoing substantial renovation should meet high energy efficiency standards. Sweden has gone further: every time a building is sold or rented out it must meet high efficiency standards. All member-states should follow the Swedish example, and the new Action Plan should require that strong building regulations be met whenever a building is renovated, sold or rented.

The Energy Services Directive is an attempt to get energy companies to act as energy services companies, delivering not just power and heat but also advice to help their consumers use energy more efficiently and so reduce costs. The directive requires energy suppliers to promote energy efficiency to their customers and to expand energy metering. But it is vaguely worded and has no significant regulatory teeth. It should in future require energy companies to give money to organisations which carry out energy efficiency work at no up-front cost to customers.

The third directive to strengthen is the Congeneration Directive. When a fuel is burnt to generate electricity, heat is also produced. Most of the heat from most power stations is simply wasted up chimneys. Additional fuel is then burnt to provide heat for homes and industry. It is quite possible to use the heat from electricity generation for industrial or domestic heating. Cogeneration is a well-established technology which makes obvious economic, energy security and climate sense. Yet in 2007 only 11 per cent of EU electricity and 13 per cent of heat used came from cogeneration plants.

The Cogeneration Directive requires member-states to remove barriers to cogeneration. It allows, but does not require, them to support cogeneration. Some governments have done so, but the leading countries were doing this well before the directive was adopted in 2004, and the directive has not delivered a significant increase in cogeneration Europe-wide. Cogeneration should therefore be made mandatory. Whenever anything is burnt to generate electricity, the heat must be captured and used.
As well as regulation, the EU must focus on funding. Grants will be necessary to expand cogeneration and district heating networks. In 2008 the Commission allocated €4.8 billion of cohesion policy funds to renewables, decentralised energy production (which makes cogeneration much easier) and district heating. It has recently proposed that €115 million of unspent money from the European Economic Recovery Fund to be allocated to energy efficiency. The Commission should go much further. It should propose a substantial increase in energy efficiency funding, using some of the estimated €112 billion that will be raised by auctioning Emissions Trading Scheme permits.

Whatever the Commission does, most of the finance will have to be mobilised nationally. Much of the funding should come via low-interest loans, as has been done successfully in Germany through the publicly-owned KfW bank, resulting in the improvement of more than 1.5 million homes. The Energy Services Directive allows member-states to establish energy efficiency funds, but does not require them to do so, while the Energy Performance of Buildings Directive merely requires them to list existing and proposed financing schemes. These provisions are too weak. Member-states must be required to set up energy efficiency financing schemes.

The EU likes to claim to be a world leader on tackling climate change. It cannot claim any sort of leadership in energy efficiency, but there are some reasons for optimism that 2011 will at last see significant progress. President Herman Van Rompuy has called a summit on energy in February 2011. This will be a good opportunity to make progress on implementing the Energy Efficiency Action Plan. Hungary, which holds the EU presidency for the first half of 2011, has particularly strong reasons to focus on improving existing buildings. Doing so could reduce its annual gas imports by 40 per cent, and prevent up to 2,500 people dying from hypothermia every winter. Poland, which has the presidency in the second half of 2011, has improved residential energy consumption by almost 20 per cent over the last five years by retro-fitting existing buildings.

Progress is no guaranteed, of course. Raising the price of energy through taxation is one way to encourage less consumption, and would also help reduce fiscal deficits, but energy taxation proposals provoke extensive and often effective lobbying by industry and consumer organisations. Public grants don't face opposition, but will be limited by the economic situation. Nevertheless, the Commission does now appear to be serious about energy efficiency. It has estimated that reducing EU energy consumption by 20 per cent by 2020 would reduce the cost of energy imports by €100-150 billion annually, and could create a million new jobs. The means to achieve this 20 per cent reduction are already known, and the technologies are available. Yet under current policies the EU will only reduce consumption by 10 per cent, so the EU will miss out on at least €50 billion a year in cost savings and half a million new jobs. Stronger policies to save more energy must be the top priority for Oettinger and Jose Manuel Barroso for the rest of 2010 and the whole of 2011.

Stephen Tindale is an associate fellow at the Centre for European Reform.

The arguments outlined above will be expanded in a CER policy brief, 'Delivering EU Energy Efficiency', in November 2010.

Divisions remain over euro reform

2010-10-08T10:18:00.001Z

by Katinka Barysch

Europeans agree that the management of the euro must be improved to prevent future crises, or deal with them better if and when they happen. The European Commission is hopeful that it can get all 27 EU countries to agree on a package of reforms it published at the end of September. However, recent conversations in various EU capitals left me with the impression that divisions still run deep on crucial aspects of eurozone reform. Not everyone shares the Germans’ sense of urgency, and there is a risk that complacency sets in before a sustainable new framework has been created.

On September 29th, the European Commission published six draft laws designed to improve the management of the euro. The package foresees earlier and tougher sanctions on countries that break agreed limits on budget deficits and debt levels, new procedures for macro-economic co-ordination to avoid harmful imbalances among EU countries, and a harmonisation of the way EU countries draw up their budgets. The conclusions of Herman Van Rompuy’s taskforce on eurozone governance are expected to go broadly in the same direction. The Commission hopes that the proposed reforms can become law by the summer of 2011 – an ambitious timetable even by the Commission’s own admission.

So far, discussions have mainly taken place among finance ministers, either among 16 of them in the Euro Group or all 27 in Van Rompuy’s taskforce (a slightly enlarged version of Ecofin). Finance ministries tend to welcome strict EU rules, which help them to fend off spending pleas from cabinet colleagues. But the same unity of purpose does not exist among the EU’s heads of state.

In rough terms, the EU countries fall into two camps: a German-led one which puts the emphasis on strict rules and automatic sanctions to enforce discipline; and a French-led group of mainly South European countries that – although aware of the need for fiscal discipline – want more political wiggle-room for economic policy co-ordination that could require an effort also from surplus countries, for example by trying to boost demand.

France’s club Med is weaker than the German stability camp: members such as Greece, Portugal and Spain are in the dock and their voices count for less in the current debate. Italy traditionally punches below its weight in European policy debates; and Rome’s opposition to attaching sanctions not only to excessive deficits but also stubbornly high debt levels is a little too predictable (its own debt being the second highest in the EU).

The German camp looks firmer and stronger. Austria and the Netherlands agree on the need for tough spending limits and sanctions. So do the Nordics, including non-euro countries such as Denmark and Sweden. Most of the Central and East European member-states, having imposed fierce austerity programmes at home, are not afraid of strict rules. “We are Germany’s natural allies in this”, insists one Polish official. “That’s why the Germans are stupid to try and keep the East Europeans out of the euro.”

However, the German-led group is not as cohesive as it appears at first sight. The non-euro countries do not only want stronger rules for the eurozone. They also want to forestall the emergence of a two-tier EU where euro countries closely co-ordinate their economic policies while non-euro ones wait outside the door. The price most non-euro countries are willing to pay for this is to be bound by the tough new rules and even accept financial penalties. However, the EU treaties allow eurozone countries to agree on new measures and sanctions among themselves but not to extend them to non-euro countries. Some in Central Europe now silently hope that the euro reform debate will drag on for so long that they can slip into the euro in the meantime. Poland has added a long-standing demand to the eurozone debate, namely that the costs of pension reform be excluded from budget deficit numbers. Other EU countries could complicate the reform effort with their own idiosyncratic issues. The UK is in the special position that it wants stronger rules for the euro – knowing that another eurozone crisis would harm its exports and finance industry – but under no circumstances does it want to be bound by them.

Although Germany has so far dominated the eurozone reform debate, it still faces an uphill struggle to get all 27 governments to back new rules and penalties. A restive European Parliament will also have a say on some of the proposed changes. The most important condition for creating a consensus on swift eurozone reform is still for France and Germany to reach an agreement. Christine Lagarde, France’s finance minister, and her German counterpart, Wolfgang Schäuble, have put on an admirable show of unity in the euro debates. But it is not always clear in how far they speak on behalf of their bosses at home. Divisions between Germany and France still run deep.

French policy-makers and economists think that the single currency suffers from a design flaw: a lack of economic governance. Closer economic policy co-ordination, including on such things as tax levels and industrial policy, is therefore what the French government is aiming for. Most Germans think that the reason for the current mess is that existing fiscal limits were not applied properly [for the reasons why they should re-think see How to save the euro, by Simon Tilford]. Germans demand stricter rules not only at the EU level but also at the national level. They want other EU countries to emulate Germany’s new constitutional clause, which mandates all future German governments to run balanced budgets from 2016 onwards. Germans do not mind that this clause will give the country’s already mighty constitutional court a direct say in economic management.

Policy-making by judicial decree would be anathema to most French. For them, discretion is the essence of politics, at home and in the eurozone. “Leaders need to be able to lead, especially in a crisis. They should not tie their own hands”, says one of Sarkozy’s economic advisors. The Commission proposals already embody a compromise between Germany and France: the fines proposed by the Commission will bite unless a qualified majority of EU countries votes against them. For many Germans, that still leaves too much room for political cop-outs. For most French, the thought of the Commission deciding something so eminently political as fines is still hard to accept.

Another profound disagreement concerns the idea of bolstering the euro through a permanent crisis resolution mechanism. The Commission omitted this from its September reform package, which is looking only at steps that can be implemented without changing the Lisbon treaty. The Commission, alongside the French, also argues that the EU should first see how its €440 billion safety net (the European Financial Stability Facility) works before it talks about new institutions.

But Berlin is in a hurry. It refuses to contemplate extending the EFSF beyond 2013. And it will accept a permanent rescue fund only if it comes with a bankruptcy procedure for countries that can no longer service their debt. “Without a resolution mechanism, we will have endless bail-outs and no incentives for countries to run a responsible fiscal policy”, warns one German finance ministry official. He speculates whether the EU could use the treaty adjustment that will be necessary for Croatia to join the EU over the next couple of years to set up this new mechanism.

French officials argue that talking about a bankruptcy procedure for countries now would only spook the markets. Generally, the French do not appear to feel the same sense of panic about the fate of the euro that has gripped many Germans. “The euro?” asks one Paris intellectual somewhat tongue in cheek. “France suffers from an identity crisis! It fears about its role in the world, its traditional dominance of Europe, its social model, even its way of life.” While France is concerned about losing its AAA credit rating and being ‘decoupled’ from the German economy, it has been less pro-active in the euro reform debate. Without a sense of urgency, France and Germany are unlikely to make the concerted effort that is still needed to get all EU countries to support a comprehensive reform package. The spectre of an EU lurching from crisis to crisis has not been banished.

Katinka Barysch is deputy director at the Centre for European Reform

Immigration: why Brussels will be blamed

2010-09-27T12:54:00.000Z

By Hugo Brady

Liberal Sweden elects an explicitly anti-immigrant party to parliament for the first time. France's president and the European Commission lacerate each other in public over deportations of Roma. A former German central banker publishes a bestseller warning that immigration is diluting the nation's human stock. And even Britain moves forward with plans to cap economic immigration. The last three weeks have been a startling illustration of how immigration has come to dominate European politics.

At first, the EU seemed only a marginal player in this drama. The European Commission cannot dictate how many immigrants member countries let in, how many refugees they accept or how host societies should integrate newcomers. EU powers over the issuing of work visas are limited. But, as the row between President Sarkozy and Viviane Reding, the EU's justice commissioner, demonstrates, the Union has become a central player in immigration policy, even when governments point to public safety to defend their actions. This is mainly because the Commission is legally obliged to protect the mobility rights of citizens under a 'free movement' directive agreed by governments in 2004. (The law aims to make sure that EU nationals can move to each others' countries without the need for work or residency permits, a commitment originally laid down in the EU's founding treaties.)

This responsibility is unlikely to make the EU any more popular with the public, however. It means EU law limits the powers of national governments to tighten immigration policy in response to popular demand during tough economic times. Britain, for example, will set a cap on the numbers of new immigrants coming to the UK starting next year. But the cap seems largely cosmetic, given that citizens from EU countries will continue to be able to seek work there under free movement rules. Voters tend to value control and security over the freedoms they either do not use or take for granted. And there are a number of reasons to think that – in the febrile political atmosphere created by the 2009 recession - they may begin to regard the EU as part of the problem rather than the solution to immigration challenges.

For starters, EU officials should remember that what they often doctrinally dismiss as merely 'free movement' is immigration in anyone else's language, including Europe's politicians. Tensions over immigrants were evident in Western Europe long before the onset of global recession. And they are bound to continue because the east-west European migration that followed the EU's 2004-2007 enlargement has yet to run its course. Germany and Austria will lift transitional restrictions on the free movement of workers from eight Central and East European countries next year. All EU countries must do the same for Bulgaria and Romania by 2014.

Second, the Commission has plans to toughen up the application of EU rules on asylum seekers over the next two years. It will propose higher standards for the treatment and accommodation of refugees and access to the job market for those who wait a long time for their claims to be heard. But like few other issues, the cost of maintaining asylum seekers touches a very raw nerve, especially in countries that are faced with budgetary austerity. The Sweden Democrats owe their electoral success in part to widespread public concerns over the country's recent generosity to thousands of Iraqi refugees. However high-minded the intention, the cost implications of the Commission's proposals may further erode public support for the EU especially as governments are likely to portray such measures as being imposed by Brussels.

Third – as Commissioner Reding has already made clear in the case of France – she wants EU rules on free movement to be more strictly enforced in every member-state, and is prepared to take miscreant countries to court, if necessary. Reding's zeal to apply the law is laudable: EU rules must be uniformly implemented across the 27 member-states to be effective. However she also risks opening a Pandora's box of national discontent at the wrong time. Several EU countries grumble that the free movement directive is too broad in scope, especially after a 2008 court ruling expanded free movement rights even to non-EU nationals in certain circumstances. Faced with a further ultimatum by Reding, governments might be tempted to support a proposal from Italy to water down the directive and allow governments greater leeway to refuse residency based on economic circumstances or security concerns.

If the Commission refused to table such a draft, it might hand a political platform to far right and eurosceptic forces throughout the EU. On the other hand, the EU's institutions have little choice but to stand firm in the face of pressure to compromise on free movement rights or to ignore their non-implementation. They believe - probably rightly - that if such freedoms were rescinded or weakened now, EU governments would not return to the status quo at a future date. Welcome to Europe's battle over immigration and free movement. Appalled Swedish liberals, a floundering French president and an indignant European commissioner are just the opening salvos.

Hugo Brady is a senior research fellow at the Centre for European Reform.

Observations from Russia

2010-09-23T11:20:00.001Z

By Charles Grant

On a recent trip to Russia, I found that the momentum for reform, very evident last year, has dissipated. The more encouraging news is that Russia’s leaders are trying to be civil to Americans and Europeans. In early September I was in Russia with the Valdai Club, a group of think-tankers, academics and journalists that meets Russian leaders and intellectuals once a year. A year ago, the economic crisis was biting and President Dmitri Medvedev’s schemes for ‘modernisation’ were being taken seriously. There was much talk of shifting the economy away from dependency on natural resources – and also of encouraging manufacturing and service industries, boosting innovation and R&D, and fighting corruption. Some Europeans, and the German government especially, became excited about the prospect of helping Russia to modernise.

On this visit Prime Minister Vladimir Putin was less combative than he had been in previous Valdai meetings. He went through the motions of saying that modernisation mattered, but did not engage on the subject. He talked of the need to avoid sudden changes of direction. Stability is his watchword. A number of factors may explain his relaxed mood. Last year the economy shrunk by about 8 per cent, but this year the oil price is above $70 a barrel and there is solid growth. Ukraine is not going to join NATO and is more or less in the Russian camp (this matters hugely to Russian leaders). Relations with the US are quite good, and there has also been an – entirely unreported – ‘reset’ with China.

One senior Russian official who met the Valdai Club was alarmingly frank. “During the crisis, business was mobilised to change its ways; provincial authorities tried harder to think of improving the business environment. But the economy has suffered from oil going to $70 so rapidly,” he said. “We’d have had more progress on modernisation with a slower rise in the oil price. Now we have complacency.” He said corruption had got worse. He had hoped that last year’s budget cuts would help to squeeze corruption out of the system. But this year the budget had grown again and the “shadow sector” had bounced back, siphoning money out of the economy. “The mind-set [for corruption] has now returned to its pre-crisis level.”

None of the Russian intellectuals on this year’s Valdai trip thought that modernisation would go anywhere. They believe that ‘top down’ efforts to modernise – such as giving Rosnano, a state entity, the money to build a nano-technology industry, or creating a ‘silicon valley’ near Moscow at Skolkovo – will not have much impact without broader political change.

One reason for this pessimism is that the position of Medvedev – who has always been more enthusiastic about modernisation than Putin – seems to have weakened. Conservatives never liked him, but some of them now sneer about him with open contempt. Meanwhile Russian liberals, who used to praise Medvedev, have become disdainful. This is because for all his eloquent talk about modernisation, the rule of law and democracy, he has changed so little. Medvedev has sacked some provincial governors, introduced a little judicial reform, made a start on military reform, and responded to Barack Obama’s initiative by agreeing to a ‘reset’ with the US. And that’s about it. The general assumption in Moscow is that Putin will run for president in 2012. Two terms of six years would then mean Putin staying in charge till 2024.

Some of Putin’s most powerful lieutenants show no enthusiasm for Medvedev’s plans for modernisation. Vladimir Yakunin, who runs Russia’s railways and is close to Putin, argued in a letter to The Economist earlier this month that state capitalism “simply works better” than western models. Russia’s past attempts to “reject all history and tradition, combined with the blind imitation of foreign experience, [had] impeded the country’s political and economic development for 20 years”.

For all the gloom about economic modernisation, Russian foreign policy may offer a slightly happier story. Although the oil price has picked up, the swaggering arrogance of a couple of years ago has not reappeared. Last year’s economic crisis brought Russia’s leaders down to earth with a bump. They saw that the growing disparity between the Russian and Chinese economies will be a serious problem in the long term, and that Russia needs to strengthen its position – economically and politically – by looking west. Hence the reset with the US, modest co-operation with the West on Iran and Afghanistan, the deliberate rapprochement with Poland and the settlement of the maritime border dispute with Norway.

Putin confirmed that the reset between Russia and the US still holds by saying that he found Obama “a deep and profound person whose view of the world coincides with ours”. There has also been an improvement in Moscow’s relations with Beijing. Though unreported in the press, “this is more important than the reset with the US”, according to a senior official in the Russian security establishment.

China and its increasingly assertive leaders have been a source of worry to Russia in recent years. But this year there has been a rapprochement. “We now have a relationship that is strategic, pragmatic and based on equal status,” said the official. Each side has agreed not to play off the other one against the US. And the two governments have reached agreement on some difficult issues, such as building a pipeline to take Siberian oil to China, handling the Iranian nuclear problem and co-operating on civil nuclear power. One minister who met the Valdai Club stressed the importance of integrating the Russian Far East and Siberia into the dynamic Asian economies. He saw China not only as a growing market for Russian raw materials but also as a source of investment in areas such as ships, aerospace and high-tech equipment.

Despite the new modus vivendi with China, deep down Russian leaders still fret about the growth of Chinese power. A new Valdai Club report by a group of Russian thinkers calls for a ‘Union of Europe’, including Russia, the EU, Turkey and Ukraine. The report argues that Russia (with its natural resources) and the EU (with its technology) need to get together in order to prevent a ‘G2 world’ run by the US and China. The report therefore proposes a union that would have supranational institutions and its own treaty, covering not only economics and energy but also foreign and security policy. The implication of the report is that if Russia stays on its own it will become a subsidiary of China. The Union of Europe would also help to further the long-held Russian ambition of drawing European states away from the US.

One minister took a similar line when he met the Valdai Club, saying that in the long term he favoured a single market running from the Atlantic to Vladivostok. The Customs Union that Russia has set up with Belarus and Kazakhstan was a first step to a common economic space and then full integration with the EU. But his westward orientation was rather hesitant. “Don’t try to teach us to be civilised or call us black sheep or we will react badly,” he said. “If you push us away we will want to walk away. For all our problems, we are Europe’s salvation, it needs our new blood. But if you don’t want us we will turn to the more dynamic east.”

Despite the rhetoric about integrating with Europe, few Russians are interested in the nitty-gritty of the EU-Russia relationship; the current talks on a new partnership and co-operation agreement have stalled and nobody in Russia seems bothered. There are two obvious problems with the schemes being floated for union between Russia and the EU. One is that most Europeans will not want a closer union with Russia so long as its political system remains authoritarian. The other is that many people in the EU still look to the US for their security, and would not want to join a union that would inevitably weaken transatlantic bonds.

On current trends neither Russia’s economy nor its political system is likely to undergo serious reform anytime soon. That means that China will continue to pull ahead of Russia economically, while the EU will spurn grandiose schemes for ‘union’.

Charles Grant is director of the Centre for European Reform

Has Germany become Europe's locomotive?

2010-09-02T10:19:00.000Z

By Philip Whyte

The German economy has been growing exceptionally strongly of late. In the second quarter of 2010, it expanded faster than any other economy in the G7 and faster than at any time since the country’s reunification in 1990. Industrial output is surging. The rate of unemployment has been declining for over a year and is now well below the eurozone average (let alone levels in the US). Consumer spending and business investment are picking up – and households and firms are generally less burdened with debt than their counterparts in highly leveraged economies like the UK and the US. Germany, in short, seems to have emerged strongly from the Great Recession. Indeed, some observers think it has entered a self-sustained recovery – and that it is starting to act as Europe’s ‘growth locomotive’.

If this were true, it would be welcome. Over the past decade, Germany has not been a great source of demand for the world or the European economy: in real terms, domestic demand is only about 3 per cent higher now than it was back in 2000. For most of the noughties, Germany was structurally reliant on exports for its economic growth: without debt-fuelled spending elsewhere in the world economy, it would barely have grown at all. So any sign of a sustained recovery in German domestic demand would be good news for the country itself and the rest of the world. Not only would it reduce Germany’s reliance on unsustainable (and hence destabilising) foreign profligacy. It would also allow the eurozone and the world economy to rebalance at a higher level of output and employment than otherwise.

Sadly, it may be premature to conclude that Germany has embarked on a durable, self-sustained recovery that will help to lift growth elsewhere. Much has been made of the scale of Germany’s rebound in the second quarter of 2010. But it needs to be placed in context. Germany resembles a bungee jumper in the spring-back phase. It is rebounding faster than neighbouring France. But this is partly because it fell much further on the way down. The size of Germany’s manufacturing sector has resulted in greater output volatility. Germany was hit disproportionately hard in 2008-09 when manufacturers scrambled to run down stocks, but it has since benefited as the stock cycle has reversed. Even after its recent rebound, however, German output is still lower relative to pre-crisis levels than in France.

Besides, the pattern of the recent upturn casts doubt on the view that Germany is acting as a ‘locomotive’ for other countries. The pick-up in domestic demand in the second quarter of 2010 came after three consecutive quarters in which household consumption fell. As for business investment, it is still a long way below pre-crisis levels. If Germany really had become a locomotive for the rest of the EU, net trade would be exerting a drag on its own economic growth. Yet the reverse is the case: net trade has boosted German GDP growth in three of the past five quarters. True, exports to Asia are making a greater contribution to growth. But Germany’s recovery is doing little to rebalance activity in the EU. Indeed, Germany’s trade surplus with the rest of the EU has risen compared with the first half of 2009.

There is a final reason to be sceptical about the prospect of Europe’s largest economy becoming a locomotive for the rest of the EU: it is not clear that German policy-makers want it to become one. As far as they are concerned, the global financial crisis has discredited profligacy and vindicated German prudence. The lesson of the crisis, they believe, is that countries must learn to live within their means. For them, the direction of change is clear: it is for the erstwhile dissolute to shape up, not for Germany to become more spend-thrift. Any suggestion that Germany needs to adjust tends to be met with bemusement, irritation and contempt. Germany has no lessons to take (least of all from irresponsible Anglo-Saxons). And any attempt to hobble German ‘competitiveness’ will be fiercely resisted.

The hopes currently being vested in Germany may consequently be misplaced. The strength of the country’s recovery is partly an optical illusion created by the depth of the downturn which preceded it. Much of the recovery is being driven by net trade. Domestic demand is still fragile and could weaken as the government’s fiscal stimulus is withdrawn and the stock cycle becomes less favourable. And German policy-makers have yet to be persuaded that it is in their country’s interest to reduce its reliance on export-led growth. In short, Germany is not yet acting as a ‘growth locomotive’ for the rest of Europe. And other EU countries, particularly in the highly indebted geographical periphery, may have to get used to the idea that the region’s largest economy may not be about to become one any time soon.

Philip Whyte is a senior research fellow at the Centre for European Reform

Is China being beastly to foreign investors?

2010-07-30T15:22:00.000Z

by Charles Grant

When I visited China a year ago, I was struck by the strong feeling among many foreign firms there that the business environment was getting tougher. Western businessmen complained, in particular, about discrimination against foreigners. On a recent trip to China, I found a more nuanced situation. In some sectors, notably those where intellectual property (IP) is important, there are growing complaints of unfair treatment. But in other sectors foreign companies are making good money, without grumbling much.

Western business leaders are certainly complaining more loudly than they used to. In July, the Financial Times reported Jeffrey Immelt, the chairman of General Electric, as saying that he was “really worried about China. I am not sure that in the end they want any of us to win, or any of us to be successful.” A few days later Jürgen Hambrecht, the CEO of BASF, told Wen Jiabao, the Chinese prime minister, that foreign firms were being forced to transfer know-how to Chinese companies, in return for market access. Hambrecht told him that this did “not exactly correspond to our views of a partnership”. At the same meeting Peter Löscher, the CEO of Siemens, urged Wen to ensure that foreign firms could compete fairly for government procurement contracts. (Like a lot of western business leaders, Löscher had previously taken the Chinese government’s side, as when he criticised German Chancellor Angela Merkel for meeting the Dalai Lama.)

One government measure that has provoked foreign business leaders is the regulation on ‘indigenous innovation’ that was published last November. This would, if enforced, exclude foreign firms from public procurement contracts unless they agreed to hand over IP. The regulation seems to have been driven by the Chinese Communist Party’s belief that market forces alone will not provide a high-tech economy, and that the state therefore needs to get hold of and control advanced technologies. The EU, the US and many other governments lobbied strongly against the measure.

Whether this regulation will bite remains unclear. The government announced a delay in implementation and Chen Deming, the minister of commerce, said the regulation would not affect firms that could prove they added value in China. Some western business lobbies fear that, despite recent reassurances, the regulation will in the long run take effect. If it is enforced, firms like IBM and Microsoft are likely to cut back on R&D in China. On Capitol Hill, Microsoft is now taking a hard line on IP issues in China; until recently, it tended to sympathise with the Chinese point of view. China can no longer assume that US business leaders will, as a bloc, support its interests in Washington.

A similar shift is evident among some European companies. According to the head of one large German firm in China: “They assume their market is so big, that foreigners will stay, and put up with losing IP. That’s a miscalculation. Most foreign investors think IP is very important and that they have a duty not to hand it over.” He thinks that enforcement of the indigenous innovation regulation would dampen FDI in China. Big western manufacturers would not pull out but would source more components to countries such as Vietnam, Taiwan, Malaysia, Indonesia and Singapore. China’s free trade agreements with these countries now make it easier to supply Chinese factories from them.

Within the past two years, some high-tech foreign firms have had to pay higher rates of tax, while new restrictions on representative offices – each is allowed only three non-Chinese staff – are proving irksome. Foreign firms involved in making wind turbines, such as GE, Siemens and Vestas, are particularly annoyed that, as they see it, procurement rules have been skewed to exclude them from the Chinese market (the largest in the world), to the benefit of local firms.

Two-fifths of European businesses in China surveyed by the EU Chamber of Commerce in June 2010 expected the regulatory environment to worsen in the next two years. The same proportion described the discriminatory application of laws and regulations as a ‘significant’ obstacle. The EU Chamber concluded: “Optimism in the overall economic climate has been dampened dramatically by concerns about regulatory interference and unpredictability in the market.”

Some of the shifting balance of power between foreign investors and the Chinese authorities is the inevitable result of the country’s development. A lot of Chinese companies are now stronger and better-equipped to compete with European or American rivals. Twenty years ago the Chinese needed western capital, skills and technology. Now they need the technology, but they have less need of the skills, and plenty of their own capital.

Another issue for foreign investors is that costs are rising, in part due to labour unrest that has been prevalent in the Pearl River Delta area. The emergence of free trade unions is an important and positive step for the country’s future development, signalling the emergence of a civil society that is not controlled by government or party. But many foreign businesses see the new trade unions merely as a source of growing costs.

Mining companies, energy firms, banks and insurers, among others, still face restrictions on their activities in China. Many of them nevertheless make money. That is the case for Shell and BP, which are significant investors, often through joint ventures, but would like to engage in a wider range of activities than they currently do. In many other sectors, such as retailing, advertising, hotels, pharmaceuticals and cars, companies report they are doing well without too much government interference. For example Tesco finds it easier to open stores than two years ago, as central government permission is no longer required; but Tesco says that Chinese retailers face less hassle from red tape than do foreign ones. WPP is allowed to own 100 per cent of local advertising agencies and says that as a foreign firm it faces no discrimination – except that it pays more tax than local competitors. Car companies are doing particularly well: BMW has doubled sales in China over the past year, and Daimler is forming a joint venture to develop electric vehicles.

Since the spring, the government has made an effort to appear friendly to foreign firms: Premier Wen met foreign business leaders to listen to their complaints; several ministries opened their doors to foreign investors in China and asked how they could help; and in July the government appeared to accept a compromise in its dispute with Google, with the result that Chinese citizens can search uncensored via Hong Kong. Chinese analysts point out that many local authorities still compete for FDI and therefore offer special deals (for example, on tax and utilities) to foreign firms.

When China joined the World Trade Organisation in 2002, it failed to sign the agreement on public procurement that prevents discrimination against foreign firms. In July China made new proposals for acceding to this agreement – but western governments think them inadequate (for example, China is not offering to open up local government procurement). Also in July, Chen Deming wrote in the Financial Times that China is “ever more open to business”. He is right that most of the formal rules applying to foreign investors are less restrictive than they were ten years ago. According to his figures, global FDI fell by nearly 40 per cent in 2009, but only by 2.6 per cent in China.

My conclusion is that China still welcomes FDI, but that it is becoming more insistent on setting the terms. For example, it wants to choose the location for big foreign industrial investments – often in the underdeveloped west of the country, where a lot of foreign firms would rather not go. The Chinese government is probably right to calculate that, for all their grumbling, most foreign firms will stay; China is just too big a market to ignore. In any case, despite the difficulties, many foreign investors in China claim that they are managing to hang on to their IP.

China’s strategy is to exploit foreigners’ desire for access to its markets as a means of gaining their technology. From China’s point of view that is a reasonable policy. If a lot of foreign investors clubbed together to speak with one voice and make credible threats to China, they might persuade its leadership to re-examine that strategy. But neither the big foreign companies in China, nor the European and American governments, are likely to get significantly tougher with China. So do not expect much change in China’s policies towards foreign investors.

Charles Grant is director of the Centre for European Reform

Who is winning Eastern Europe's great game?

2010-07-19T13:53:00.001Z

By Katinka Barysch

The US is withdrawing from the former Soviet space; the European Union struggles to be taken seriously there. Does that leave Russia free to strengthen its influence in the countries around its borders? Not necessarily, for the situation in the region is complex.

Hillary Clinton toured the Caucasus recently to reassure Georgia, Armenia and Azerbaijan that Washington had not abandoned them in its quest to ‘reset’ relations with Russia. Nevertheless, the predominant feeling in those countries is that the US is a lot less interested and engaged than it had been during the presidencies of George W Bush and Bill Clinton. Similarly, many Central Asians feel that the Obama administration pays little attention to them, unless they can serve as launch pads for planes destined for Afghanistan. NATO membership for Ukraine and Georgia is no longer on the cards.

While much of America’s attention has moved elsewhere, the European Union hardly has a foothold in the region. The EU’s neighbourhood policy has proved rather ineffective, and the 2009 ‘Eastern partnership’ has not yet had time to make much of a difference. Ukraine, still smarting that the EU has never offered the prospect of membership, appears to be turning towards Russia. Moldova looks keener than ever to get closer to the EU – with few people in Brussels and other capitals taking notice. The EU’s Central Asia strategy has lacked political backing and consistency. In the Caucasus and Central Asia, the EU is a rather new player and its traditional approach of exporting norms and values as the basis for bilateral relations has not been received well. The fact that the EU’s foreign policy machinery is currently in bureaucratic paralysis does not help.

In theory, US neglect and European weakness could leave Russia free to consolidate what President Medvedev likes to refer to as a ‘sphere of privileged interests’. Russia is certainly trying. But success has been patchy at best.

Although by far the most populous and prosperous country in the region, Russia does not necessarily have the means to project power into the neighbourhood. Its tools looked more formidable before they were actually used. Now some of them have turned out to be blunt.

Russia’s use of military force in Georgia last year backfired when even Moscow’s staunchest allies scrambled to become less reliant on their dangerous-looking big neighbour: Belarus turned to the EU, Armenia started talking to Turkey and not a single one of the former Soviet countries has followed Moscow in recognising the independence of Abkhazia and South Ossetia.

Russia has repeatedly used trade embargoes and other economic means to put pressure on its neighbours, in particular smaller ones where Russia’s own business interests are limited, such as Georgia or Latvia. But there is arguably not a single instance where the use of economic sanctions has got Russia what it wanted. Businesses in the countries affected have reinforced their efforts to find alternative markets and sources of investments, making them less dependent on Russia in the long term. Russia’s strategy of gaining influence through directly controlling local businesses has proven more successful: in Armenia for example, various sectors from banking to transport are dominated by Russian-owned companies. How this will translate into political leverage remains to be seen.

This leaves energy as the most promising tool of Russia’s neighbourhood policy. Russia has used pipeline plans, nuclear projects, gas prices and oil deliveries to get what it wants from its neighbours. But even here, Russia’s success rate is mixed. In Belarus and Ukraine, Russia is making headway towards its aim of gaining control over transit pipelines. The recent standoff between Belarus and Russia over gas prices and transit fees only highlighted Minsk’s lack of options: Lukashenko’s announcement that he would buy gas from Venezuela was little more than symbolic. In Ukraine, Russia managed to use the offer of cheaper gas to get the lease for its Black Sea fleet in Sevastopol extended. It has also successfully pressured Kyiv into at least considering merging parts of the two countries’ gas monopolies, Gazprom and Naftogaz, which would give Moscow effective control over Ukraine’s transit pipelines.

The situation is very different in the Caucasus and Central Asia, where energy producing countries are gaining room for manoeuvre through building stronger links with China, Iran and Turkey. Turkmenistan opened a large gas pipeline to China at the beginning of the year and signed another gas delivery contract with Iran in June. It has invited international oil majors to help build an internal pipeline that could one day deliver Turkmen gas from the massive Yolotan field to the Caspian shores and from there to Europe. It had previously promised to let Russia build the pipeline and buy much of the gas. Azerbaijan has spurned a Russian offer to buy up all the gas from its new Shah Deniz 2 field, instead committing it to Turkey and to European buyers. Russia’s attempts to lock up Caspian gas supplies by foiling pipeline projects such as Nabucco are looking increasingly desperate.

The perceived withdrawal of the US and the ineffectiveness of EU policy in the region has not so far played into Russia’s hands. Russia (like the EU and other players in the region) has had to learn that the former Soviet Union does not constitute a homogenous neighbourhood. There are cocky and cash-rich energy suppliers such as Azerbaijan and Kazakhstan, and there are poor and divided countries such as Moldova and Armenia. Russia can cajole and coerce in one place but it has to plead and please in another. All countries in the region will benefit from being less dependent on Russia, in trade and energy terms as well as in politics. While the US might pay less attention to the region, the EU should redouble its efforts, while also taking more account of the the specific situations of individual countries.

Katinka Barysch is deputy director of the CER

Membership for Russia a step too far for NATO?

2010-07-08T15:50:00.001Z

by Tomas Valasek

There are growing signs that Russia’s relations with NATO are on the mend. Senior Russian thinkers, some close to the government, have been cautiously talking up the possibility of Russia joining the alliance, as have several western officials and think-tanks (including the CER.) While some powerful forces in Russia continue to view NATO as a hostile force, the latest signs from Moscow are encouraging. But even assuming that the more pro-western forces within Russia prevail, membership of NATO will remain at best a long-term goal. In the short and medium term, Russia and NATO need to put considerable effort into reducing mistrust.

A group of prominent Russian thinkers recently invited their western counterparts to talk about the possibility of Russia joining NATO. What prompted this initiative is not obvious, but the atmospherics have clearly changed. Russia is being nicer to its neighbours, while a number of European countries – including those in Central and Eastern Europe – are being nicer to Moscow. NATO has effectively put enlargement on hold. Barack Obama’s ‘reset’ seems to be changing attitudes on all sides. The challenge before Russia and NATO is to try to turn this opportunity into a lasting improvement in relations.

The allies are not of one mind on the subject of Russian membership of the alliance. But conversations with NATO officials and diplomats suggest that NATO could be ready by its November summit to offer Moscow the possibility of joining, if and when the latter meets accession criteria. With additional persuasion – though this is more questionable – NATO may even create a special accession track for Russia, different from the one NATO used for previous candidates, so that Moscow feels that it is being treated like a great power. But the allies’ bottom line is that, one way or another, Moscow will need to adopt many of NATO’s norms, including those on democracy and transparency, before it can become a member.

Those Russians who want to explore the possibility of accession seem to have a different approach in mind. They are looking for a bargain of sorts with NATO. The alliance would promise not to enlarge eastward or arm regimes deemed unfriendly by Russia. Moscow would gain a veto over alliance decisions on matters which may affect Russia. In exchange, NATO would get better co-operation from Russia on things like missile defence or Afghanistan. NATO’s rules or norms do not seem to be a part of the bargain. Tellingly, few Russians use the term ‘membership’ with regard to NATO. They talk either of ‘integration’ or ‘organisational unity’. The former implies that both sides adopt some of the other side’s rules; the latter implies that neither side compromises internally. Either model is distant from what NATO has in mind.

But if membership is not the right thing for NATO and Russia to focus on in the near term, are there other viable ways to improve co-operation in the next few months and years? One Russian speaker at the meeting in Moscow put forth a possible solution. Instead of exploring membership, NATO and Russia should ‘demilitarise’ their relationship. Moscow would stop holding exercises that simulate a war with NATO, like the ‘Zapad’ exercise last year, in which 12,500 Russian and Belorusian troops repelled a fictitious attack from NATO. Russia would also change its strategic documents to make clear that NATO is not a ‘threat’ or ‘danger’. NATO would respond in kind, with no exercises and no new bases near Russia’s borders. If demilitarisation is successful, the theory goes, NATO and Russia would gradually come to view each other as partners. And that could open doors to even closer forms of co-operation in the future.

This is a sensible idea but not without difficulties. For a start, is Russia ready? The government is sending out mixed signals. Besides being nicer to its neighbours lately, Moscow has also launched sweeping defence reforms. These will change the Russian military from a grand force built to fight NATO into a smaller but more agile army better suited for regional conflicts like the one in Chechnya. That is good news for NATO. But only last year the Russian government also agreed a new military doctrine, which calls NATO’s activities the greatest danger to Russian security. So there is presumably a large segment of the Russian establishment that would oppose closer ties with the alliance.

In order to take up demilitarisation, NATO would have to be convinced that Russia is equally serious. Just as important, this initiative would need to win the support of the new allies in Central and Eastern Europe. Some of them feel that NATO has been neglecting the possibility of a conflict in Europe, and they want the alliance to adopt new ‘reassurance’ measures. These would involve, among other things, the creation of a new centre at NATO tasked with keeping an eye on future crises, including those involving Russia.

Some in NATO will argue that ‘reassurance’ would kill the hopes of a rapprochement with Russia, by provoking Moscow. But in fact the opposite is the case: without reassurance NATO will not reach the consensus it needs to offer Russia a new relationship – whether it means demilitarisation or, in the long run, integration. The right approach for NATO is to rebuild trust among the allies through reassurance while striving to reform its relationship with Russia. ‘Demilitarisation’ sounds like a useful idea to explore. The new allies should be supportive: after all, they stand to gain the most should Russia stop rehearsing attacks on Central and Eastern Europe. ‘Demilitarisation’ would be the ultimate reassurance measure.

Tomas Valasek is Director of foreign policy and defence at the Centre for European Reform.

EU JHA co-operation: After Lisbon, reality bites

2010-06-24T10:10:00.000Z

By Hugo Brady

EU policies on policing, justice and immigration were widely expected to take a big leap forward after the ratification of the Lisbon treaty. But interested outsiders should not assume that new powers for the EU’s institutions will translate automatically into more coherent European action in security and migration matters. In fact, the EU’s governments and its institutions face serious challenges in justice and home affairs (JHA) co-operation in the years ahead.

First, JHA policy-making is becoming more fractious and politically divided under the new treaty. Sensitive issues like terrorism or organised crime are now subject to the same rules as the EU's single market, meaning that the European Parliament can amend or block such decisions for the first time. This may not sound very radical. But for the EU's conservative interior and justice ministries – as well as key partners like the US – it is a brave new world.

Take terrorism. Last February, the European Parliament shocked both EU governments and the Obama administration alike by rapidly using its new powers to vote down the so-called Swift agreement. (This arrangement allowed US intelligence services to comb European financial transactions en masse for counter-terror purposes.) The parliament has since signalled that it will also vote down a modified version of the agreement which officials had hoped might soothe concerns over data privacy. Furthermore, EU officials worry that MEPs may reject any new security-related law on principle. There is an urgent need for EU governments and the parliament to find a new modus vivendi that allows them to work together constructively on such matters.

Second, EU countries complain that it is now harder under Lisbon to project a single voice in international fora when law and order and immigration issues are discussed. Officials are currently at a loss to know who takes the lead on terrorism or corruption issues in, say, the UN or OSCE. Is it the EU's six-month rotating presidency, the European Commission or the embryonic external action service? Although the Commission would bitterly oppose such a move, it should be up to the High Representative for foreign policy to decide in future who is best placed to lead the EU's external representation in these areas.

Third, the Commission's justice and security directorate, which has drafted most JHA legislation since 1999, is set to be divided in two. The split – into separate home affairs and justice departments – is largely at the behest of Viviane Reding, the EU's firebrand justice commissioner. Reding wants to use her new directorate to re-balance the JHA policy area which she believes has been hitherto too pro-American and too security-focused.

The decision to split up the Commission's JHA directorate is probably a mistake. Part of its added value in security and migration matters was the ability to bring all the relevant policy elements – policing, justice, immigration – together under one roof. There is also a danger that the split could result in more in-fighting and a loss of shared purpose. Better checks and balances were needed in EU internal security co-operation. But these have now been provided in the guise of a more powerful parliament and the extension of the jurisdiction of the EU's Court of Justice over all JHA legislation.

Lastly, despite new powers under the treaty, there is a dearth of really strong ideas from either the governments or the institutions about how the EU's JHA agenda should develop over the next five years. EU governments have recently agreed both an 82-page list of proposals for improving JHA co-operation (known as the Stockholm programme) and a wide-ranging ‘internal security strategy’. But the fact that these largely lack substance hints that the future of European co-operation on security and migration issues will centre on consolidating existing achievements rather than launching bold new initiatives.

One priority is to safeguard the EU’s Schengen area of passport-free travel. Schengen ranks alongside the euro as one of the EU's most tangible achievements. Like the euro, each Schengen country relies largely on assurances of good faith from others in the club, in this case that the common border is being maintained properly. But not all Schengen members are trusted equally. French police are increasing their spot-checks on cars crossing the border from Spain, for example, while Finnish border guards routinely check passports of non-EU travellers en route from Greece. To make the passport-free zone work properly, EU countries must agree a more transparent system for verifying border standards. They must also ensure that Romania and Bulgaria – both chomping at the bit to join – are not allowed in prematurely until they have carried out thoroughgoing reform of their police and judiciaries.

The gap between rhetoric and reality in the Schengen area should serve as a warning against future hubris. The EU’s new powers in policing, justice and immigration will only be a success if they result in the member-states adopting policies that seriously address current security and migration challenges. We will soon know whether a vague new treaty, a divided Brussels bureaucracy and a truculent European Parliament will help or hinder that ambition.

Hugo Brady is a senior research fellow at the Centre for European Reform.

The eurozone retreats into a beggar-thy-neighbour cul-de-sac

2010-06-15T11:09:00.001Z

by Simon Tilford

Almost every member of the eurozone is rushing to slash public spending. While there is no doubting the scale of the fiscal challenge, the eurozone economy is not strong enough to cope with the contractionary effects of a generalised budgetary tightening. And if the eurozone falls back into recession, there will be no chance of putting public finances on a sustainable footing. Furthermore, excessive austerity in Europe will make it even harder to bring about the necessary rebalancing of the global economy, risking a protectionist backlash in the US. Unfortunately, these risks will receive scant attention when European leaders come together for this week's summit in Brussels.

Eurozone policy-makers appear to believe that fiscal policy has no impact on levels of economic activity, even when private demand is as weak as it is in Europe. Of course, some eurozone economies – Greece, Portugal and Spain, for example – have little option but to cut now. However, those member-states running big trade surpluses with the rest of the currency bloc need to hold off tightening fiscal policy until their domestic economies are growing sustainably. The German government believes it is leading by example in embarking on a severe round of budget cuts. But this is the last thing the eurozone needs at this point and demonstrates an alarming parochialism. The fiscal crisis cannot be solved without economic growth. And the eurozone will only return to decent economic growth if the bloc's surplus economies, in particular Germany, start to consume more.

The German economy is very unbalanced. The weakness of domestic demand (a reflection of an extremely high savings rate and years of eye-watering wage restraint) means the country is running a massive current account surplus with the rest of the eurozone. This surplus is a drag on the eurozone economy. Germany's austerity programme all but guarantees very weak domestic demand in the country and effectively ends any chance of narrowing its trade surplus with the rest of the currency union. But unless this surplus narrows substantially, it will be very hard to get the eurozone economy growing, and all but impossible to address the eurozone's fiscal crisis.

Germany's Chancellor Merkel argues that her government's cuts will make Germany more competitive (and hence boost its export sector). In short, Germany's economic growth strategy is predicated on a further increase in its exports relative to its imports. For a country with a huge external surplus and a relatively sound fiscal position to be cutting public spending at this point is highly irresponsible. Germany is defining its economic policy purely in national terms without consideration for the impact on the sustainability of the common currency or the outlook for the broader international economy.

After years of relying on demand generated elsewhere in Europe, Germany now needs to become a source of it. The country is sending a damaging signal to the financial markets – it does not care about economic growth. No-one should be surprised that bond spreads (the difference in government borrowing costs) within the eurozone have widened sharply since Germany announced its budget plan. Instead of some masochistic rush to see who can cut by most, the eurozone needs a co-ordinated response. Germany, whose borrowing costs have fallen to just 2.5 per cent, should be doing all it can to boost its domestic demand, not depress it further.

The Netherlands' external surplus – relative to the size of its economy – is as large as Germany's, and the Dutch rely even more than the Germans on trade with other eurozone economies. But assuming that the conservative People's Party for Freedom and Democracy (VVD) succeeds in forming a coalition government with Geert Wilders' Freedom Party (PVV) and the centre-right Christian Democratic Appeal (CDA), Holland will adopt the same beggar-thy-neighbour strategy as Germany. It is possible that fiscal austerity and further wage restraint will work for Germany and the Netherlands, on the assumption that their firms can take further market share within the eurozone. But this is a zero-sum game: it is not as if every economy can allow domestic demand to stagnate and rely on exports. One country's surplus is another's deficit. They are banking on being able to export the consequences of their austerity to others.

Nor are the Europeans giving any thought to how their austerity (and neglect of economic growth) will impact on the rest of the world. An uncoordinated and premature fiscal contraction against the backdrop of a stagnant eurozone economy will prove contractionary for the world as a whole. The weakness of economic growth will prevent a rise in eurozone interest rates, which will keep the euro weak and boost the exports of those member-states, such as Germany, that trade a lot internationally. As a result, it will throw a further obstacle in the way of the urgently needed rebalancing of the global economy away from its excessive reliance on the US consumer. This reliance can only be reduced if surplus economies in Europe and Asia consume more, not less.

With China resolutely refusing to reduce its export dependence and Europe retreating into a destructive beggar-thy-neighbour cul-de-sac, it will not be long before protectionist sentiment in the US rises. And this will be understandable, despite the inevitable condemnations by European governments.

Simon Tilford is chief economist at the Centre for European Reform.

Shale gas and EU energy security

2010-06-11T10:46:00.000Z

by Katinka Barysch

Will unconventional gas solve Europe’s energy security problem? Many EU member-states rely a lot on Russian gas; in the case of some Central and East European countries the dependence is total. What if these countries suddenly discovered that they themselves sit on huge gas reserves? They should not hold their breath. Unconventional gas will make a big difference to the EU’s energy security – but perhaps not in the way that shale gas enthusiasts expect.

Unconventional gas (UG) is gas trapped in rock formations. The technology now exists to get this gas out. It involves drilling into the rocks and then blasting in water mixed with chemicals to extract the gas. In the US, the new technology has been a ‘game changer’. US production of shale gas (one form of UG) tripled in 2004-08, allowing America to overtake Russia as the world’s biggest gas producer. The US is now self-sufficient – which has enabled it to mothball its terminals for importing liquefied natural gas (LNG, gas that is frozen to liquid form and transported by tankers).

Is something similar about to happen in Europe? Some energy experts estimate that Europe’s UG reserves could be several times bigger than its conventional gas reserves. The likes of Exxon, Chevron, Shell and ConocoPhilips have already snapped up land plots in places that look promising for UG exploration, most notably in Poland, Sweden and Germany.

Should the EU scrap expensive and complicated diversification plans, such as the proposed Nabucco pipeline to import Caspian gas, and simply wait for the UG boom to happen in Europe? At a recent energy security conference in Vienna, gas experts, geologists and industry representatives urged caution.

* Estimates of European UG reserves are based on geological surveys that were not carried out with UG in mind. Only drilling holes in the ground will show whether the geology is indeed suitable for producing and commercially exploiting UG. So far, there has been very little drilling in Europe. A couple of wells in Hungary have been abandoned as unpromising. In southern Sweden, environmental concerns may make gas extraction impossible irrespective of whether the geology proves suitable. In Poland, the country considered most promising, not a single well has been drilled so far.

* In the US, it was small, technology-savvy energy companies that made the shale gas boom possible. The giant international oil companies have only recently joined the fray by buying up smaller companies with the right technology and know-how. Europe’s energy markets are still dominated by national champions. There are few nimble, innovative players. Expertise and infrastructure for UG development is scarce. Engineers are being flown in from Texas or Pennsylvania. In the whole of Europe, there are only 67 land rigs (the structures used in drilling for UG), compared with thousands in the US.

* US legislation tends to be rather kind to oil and gas companies. For example, the law that regulates the safety of drinking water has an intentional loophole that excludes ‘fracking’, the technology used to blast water and chemicals into rocks. Only now, with the shale gas boom in full swing, are environmental concerns mounting in the US. In Europe, by contrast, exploration starts with these concerns already being widely discussed. UG production needs huge amounts of water and, more importantly, uses chemicals that seep into the ground (usually at a depth of several thousand metres but that could store up problems in later years). Some UG drillings have made the earth shake near-by.

* Big UG sites require lots of space (they consist of scores of rigs close together), as well as new roads, reservoirs and pipelines. Planning restrictions in Europe are often tight, partly because the continent is more densely populated: typically 250-400 people live on each square kilometre in EU countries compared with 80 in the US.

* In the US, whoever owns a plot of land owns the resources beneath it. In EU countries, the resources below surface usually belong to the state. There will be no ‘poor farmers to shale gas millionaires’ stories in Europe. If only big energy companies gain, UG production could be less socially acceptable. Moreover, those companies looking for UG in Europe complain that local regulators and environment ministries have no experience with awarding the necessary licenses. Progress can be frustratingly slow.

* The US shale gas boom happened at a time when gas prices were rising and most analysts predicted steadily growing gas demand for years ahead. The situation is very different now. The European market is over-supplied at the moment, prices on the 'spot' market for short-term gas contracts have fallen significantly, and the medium-term outlook is highly uncertain. “High prices allowed us to make lots of mistakes when building up the US shale gas industry,” says one gas expert. “With depressed prices and demand in Europe, we have to be profitable straight away.” Because of the smaller scale of production and the dearth of infrastructure and expertise, it will probably cost two to three times as much to produce UG in Europe than in the US. So it is not clear whether European UG will be able to compete with LNG and pipeline gas.

Whether and when Europe’s first UG projects will become profitable is still anyone’s guess. One manager who runs a UG project in Poland says that in a best case scenario his company would need around three years to drill exploratory wells, another three to determine whether resources are commercially viable and yet more time to figure out how to get supplies to customers. One person involved in the Swedish exploration says he would expect commercialisation in around ten years.

“In Europe, unconventional gas is not a game changer,” concludes one executive of a big EU gas company. UG will most likely develop in Europe, but a repeat of the US shale gas boom is doubtful. The good news is that regardless of UG developments in Europe, the shale gas boom in the US is changing the global, and European, gas market.

Scores of new LNG terminals are being constructed in the Gulf, Africa and elsewhere. But the US LNG market has disappeared almost overnight. Other than Asia, that only leaves Europe as a destination for rapidly growing amounts of LNG. Already, market prices for LNG have collapsed in Europe, which, in turn, has forced pipeline gas suppliers such as Norway’s Statoil and Russia’s Gazprom to re-negotiate contracts with their biggest European customers. LNG imports mean more competition in a market hitherto dominated by 30-year contracts with fixed volumes and prices linked to the international oil price. That system is crumbling. Gazprom and other suppliers will have to make a bigger effort to be cheap and reliable – and that before even a single molecule of unconventional gas has been produced on the European continent.

Katinka Barysch is deputy director of the Centre for European Reform