Time for a regime change in Frankfurt

In recent years, the European Central Bank’s (ECB) monetary policy has been half of what is necessary, two years late. To get eurozone inflation back to its ‘close to 2 per cent’ target, the ECB needs to be much bolder.
The ECB’s meeting on March 10th is shaping up to be one of its most anticipated. Inflation remains far below target and market expectations of future inflation have hardened at very low levels, indicating that investors have lost confidence in the ECB’s ability to fulfil its mandate. The eurozone’s anaemic economic recovery is faltering, which will put further downward pressure on prices, while the weakening world economy will not provide the external stimulus that the ECB hoped for. The central bank needs to be bold and make it clear it will do everything required to raise inflation. Unfortunately, it is likely to err on side of caution, as it has in the past, damaging eurozone growth prospects and calling into question the sustainability of many member-states’ debt burdens.

The eurozone is not alone among developed economies in experiencing a structural growth slowdown in the rate of economic growth or in grappling with excessively low inflation (see Chart 1). But the currency union does have an especially acute structural growth problem: it has only just recovered its pre-crisis size, a far worse performance than other developed economies, including Japan. The eurozone had hoped to piggy-back on strong global demand, but this source of cyclical stimulus is drying up as growth in the global economy weakens and the value of world trade shrinks. The ECB had also hoped that the euro would weaken sufficiently to raise inflation by boosting import prices. But the euro is stronger than the ECB would like, as the prospect of interest rate rises has receded in the US and UK, reducing the attractiveness of the dollar and sterling. And growth in emerging markets has slowed, putting their currencies under pressure.


Chart 1: Headline and core inflation in the Eurozone

Note: Core inflation measures consumer price inflation (HICP) without energy and unprocessed food, two very volatile (and in the case of energy, globally-determined) prices.

Weak economic growth is not the only reason for very low inflation in the eurozone. This also reflects the steep fall in oil and other commodity prices, but even stripping out these effects, inflation is far too low: core inflation, which excludes energy and food prices, has been stable at around below 1 per cent (and hence at around half the ECB’s inflation target) for more than two years (see chart). The persistent weakness of inflation is being reflected in lower wage settlements, raising the prospect of a vicious cycle of weak wage growth begetting low inflation and in turn low expectations of future inflation.

The ECB shares quite a bit of the blame for this daunting state of affairs. It has persistently been too optimistic about the outlook for eurozone growth and hence the outlook for inflation. As a result, it was too slow to cut interest rates, and allowed speculation that they could rise at any point. The central bank did eventually launch a major programme of quantitative easing (QE) involving the purchase of a huge quantity of government debt. In the process, it kept a lid on government borrowing costs. But this has not shifted expectations of future inflation, partly because investors are unconvinced that the bank will not reverse monetary stimulus by selling government bonds as soon as inflation picks up a bit. In short, investors do not believe the ECB will do everything possible to meet its inflation target.

The ECB is not entirely to blame for excessively low inflation: the eurozone requires a big fiscal expansion as well as monetary stimulus. Governments should be exploiting unprecedentedly low borrowing costs to step up public investment, boosting demand and growth potential. However, the ECB has consistently argued against fiscal expansion, at least in the absence of a fiscal union. The central bank has moderated its position a little recently, arguing for ‘growth-friendly’ fiscal consolidation, and some board members have even argued that countries with fiscal space to boost spending should use it. But it is opposed to a major eurozone fiscal stimulus.

The ECB has three measures at its disposal to boost growth and inflation. The first is to use the policies it is deploying – the ECB’s main interest rates and QE – more aggressively. For example, it could lower the rate at which banks deposit their reserves at the central bank further into negative territory, from currently -0.3 per cent to -0.75 per cent (the rate prevailing in Switzerland) or even -1.25 per cent (as in Sweden). The ECB could also apply negative interest rates to the loans it extends to banks; the current rate stands at 0.05 per cent. Switzerland and Sweden have already pushed these rates below zero.

Such negative rates would make it less attractive to hold euros and assets denominated in euros. This, in turn, should weaken the single currency –helping eurozone exporters – and drive up inflation. If banks passed on their lower cost of funding to businesses, business investment would become cheaper to finance. Negative interest rates are controversial: they could increase pressure on European banks, which may be reluctant to charge customers for making deposits with them. However, forcing banks to put pressure on large depositors to put their money to better use is welcome. And experience from other countries shows that banks pass on part of their lower rates to customers.

The ECB’s second option is to expand its QE programme (currently €60 billion monthly); broaden its scope to include corporate bonds, bank bonds or even equities; and make it longer – it is due to end in March 2017. The aim of the programme is to lower government funding costs to allow looser fiscal policy, and to lower longer-term interest rates, and hence the cost of borrowing for  businesses.
But neither negative rates nor more QE will lift inflation and growth if the ECB does not concurrently change expectations about the future course of monetary policy. Low interest rates alone will not lead to more investment if investors expect economic activity and hence inflation to remain weak. Inflation will rise only if consumers and investors expect that income and output will rise. The ECB needs to convince investors that it will allow inflation to overshoot the 2 per cent target for a while to make up for the period when it failed to meet its target.

How can the ECB – a conservative central bank – credibly commit to be ‘irresponsible’? It needs to engineer a regime change in monetary policy-making. Two steps are necessary. First, the ECB needs to come clean about its failure to act in a timely and bold enough fashion in the past. The ECB cannot credibly claim to investors, banks and consumers that it has changed unless it puts its past behind it.
Second, the ECB needs to make the overshooting of inflation central to its target. Currently, the ECB targets the rate of change in inflation over the medium term. A period of below-target inflation does not automatically lead the ECB to target higher inflation in order to make up for it. The ECB should commit to a price-level target, promising to reach 2 per cent on average over a rolling period of five years. A period of lower inflation would automatically require higher inflation in the future.

Would a regime change to shift expectations, negative rates and an expanded programme of QE succeed in bringing eurozone inflation back to target? Probably not. After all, the first piece of advice to a central bank in the ECB’s situation is: do not start from here. It is difficult to push a structurally weak economy of the size of the eurozone out of a cycle of low growth and low inflation, especially when external demand is too weak to generate any export-led growth.

The eurozone needs a major fiscal stimulus in order to boost consumption and investment, but eurozone governments are not about to agree on one. However, the ECB could go beyond what any central bank has so far contemplated doing, and hand out cash directly to citizens: so-called helicopter drops. This would almost certainly boost consumption, and help lift inflation. It would legally be difficult for the ECB to implement such a policy, but not impossible.

Alas, the ECB is only willing to consider small changes to rates and its QE programme. The most likely outcome of Thursday’s meeting is a gradual cut in the deposit rate, plus a limited extension of QE. When these measures fail to drive up inflation, there will be another gradual change in policy – but no regime change that is so crucial to changing expectations about the future path of inflation. The ECB will only consider helicopter drops once there is absolutely no alternative, and only then if all other major central banks have already tried them. As a result, the ECB will continue to fail in its duty to ensure an adequate level of inflation across the currency union.

Simon Tilford is deputy director and Christian Odendahl is chief economist at the Centre for European Reform.

The refugee crisis: Fixing Schengen is not enough

Solving the problems of the Schengen area will not stop Europe’s refugee crisis. This is a foreign policy crisis with domestic spill-over; it has to be solved abroad as well as at home.

In January, the European Commission gave Greece three months to improve its border controls, and process refugees and migrants more effectively, or face suspension from the borderless Schengen area. Border controls have been reinstated by six of the 26 Schengen states (Austria, France, Denmark, Germany, Norway and Sweden). Hungary built a fence last year to keep out migrants arriving from Serbia. EU ministers are discussing whether to suspend the Schengen arrangements for up to two years.

The EU is looking inwards for solutions to its problems when it should also be looking outwards. The refugee crisis is not merely the consequence of Schengen’s deficiencies. Governments are overwhelmed by the sheer numbers of immigrants, and even with better migration and border security policies they would struggle to control the multitudes making the short voyage from Turkey to the Greek islands. Once refugees make it to Greece’s territorial waters, they become Europe’s problem. 

There are certainly many economic migrants coming to Europe to seek their fortunes, but the majority of those travelling to the Greek islands and Italy over the past year have been genuine refugees.

The EU needs a new strategy to deal with the area beyond its borders to the south and south-east. The arc of countries from Turkey to Morocco should be part of Europe’s protection against the consequences of instability further afield, but is in fact contributing to the problems. The EU has to think afresh about how to reduce the flow of people before they reach the Mediterranean coast. If it only concentrates on making its external border controls more effective, it will be sticking its thumb in the garden hose instead of turning off the tap.

SyriaAccording to the UN refugee agency, 55 per cent of those arriving in Greece over the past 12 months have been Syrian refugees. They will not stop leaving Syria until the country begins to return to stability. That is a very distant prospect. Since the conflict started in 2011, EU member-states have been unable to agree on what to do, beyond backing UN efforts. They wanted Syrian president Bashar al-Assad replaced, but would not intervene decisively to force him out. They wanted the moderate opposition forces to succeed, but would not train and equip them militarily. They wanted Daesh defeated, but would not deploy ground forces to do that. They criticise Russian airstrikes but do nothing to deter them.

President Vladimir Putin of Russia has clearer objectives in Syria: to defeat the moderate opposition, and then to present the West with a choice between Assad and Daesh. That will result in the victory of Assad. Meanwhile Russian bombs continue to strike civilian targets including hospitals, leading to Western fears that Putin may be deliberately worsening the refugee crisis to contribute to the destabilisation of Europe. The fall of Aleppo – a stronghold of anti-Assad forces – could lead to hundreds of thousands more refugees.

Alternative futures look as bad: Saudi Arabia has threatened to send ground forces to Syria, while Turkey is increasingly being drawn into the conflict as it fights Kurdish militias. Will Ankara and Riyadh intervene more heavily to prevent Assad’s victory, or pursue more limited objectives? In either case, their involvement will not lead to quick solutions.

There are no good options in Syria. The conflict has already produced almost 12 million refugees and internally displaced persons (IDPs). The West could support a no-fly zone inside Syria, in which Syrians could live safely, as German Chancellor Angela Merkel suggested on February 15th. But such a step would now entail a military confrontation with Russia. However awful Russia’s bombing campaign, it seems clear that neither Europeans nor the US are ready to risk war to save Syrian civilians.

The least risky choice for the EU would be an enormous increase in its aid to Jordan, Lebanon and Turkey, making education and jobs available to refugees, enabling them to stay in the region for the long term. The London conference on supporting Syria and the region on February 4th pledged around €10 billion over the period to 2020 – around €160 per refugee or IDP per year. That is clearly inadequate. 

TurkeyIf Syrian refugees are to be stopped before they can reach Europe, Turkey’s role will be vital. In November, the EU reached an agreement with President Recep Tayyip Erdoğan: in return for €3 billion to support refugee camps in Turkey, and commitments to move forward with visa liberalisation, Ankara is expected to contain the flow of people, and take back asylum seekers who arrive in Greece from Turkey. The problem is that the deal is not working; more than 2,000 people a day are making their way across the Aegean, despite the winter conditions. NATO has decided to mount patrols in the Aegean to track and deter people smugglers, though it is not yet clear how the operation will work or how it will link to EU efforts.

Politically, Turkey has the EU over a barrel: the overwhelming priority for the EU is to prevent refugees reaching Greece, and it is prepared to offer all sorts of inducements to Turkey to help (even though it is unclear whether Ankara is actually capable of shutting down the flow of people). Instead of focusing exclusively on the refugee camps, the EU should also pay for an EU-operated asylum processing centre in Turkey. That should select which people do, and which do not, have a legitimate basis to apply for refugee status in Europe, allowing the authorities to return failed asylum seekers to their home country. Those that qualify could then travel to the EU safely, without having to rely on people smugglers and avoid risking a perilous journey only to be turned away. The EU must also ensure that those asylum seekers awaiting a decision are kept in humane conditions. But this plan will come at a cost: the Turkish government may insist on concessions in the EU accession talks, which some member-states are reluctant to offer.

Libya If the problem of the Turkish route could be solved, that would still leave North Africa, and especially Libya. Before Syrians overwhelmed the Greek islands in 2015, most of the EU’s attention was focused on people crossing the Mediterranean from Libya. Though the numbers have declined from last summer, last month 6,000 migrants arrived in Italy; most embarked from Libya’s coast. Libya has no national government, few if any functioning institutions and a vast desert hinterland in which people smugglers can circulate freely.

As in Syria, the EU has hoped that the UN would find a political solution to the country’s problems; new national institutions could then control law and order and put an end to people smuggling. Although the UN-brokered Libyan Political Accord was signed on December 17th 2015, the government established to implement the accord remains confined to a hotel in neighbouring Tunisia. The growing presence of Daesh is also a challenge for Libya’s beleaguered authorities.

Once migrants set sail from Libya, they are the EU’s problem, de facto if not de jure. They cannot be pushed back to Libya; nor can they be left to die at sea if their ships sink. Last summer the EU launched the maritime mission now called ‘Operation Sophia’. Its objective is to stop migrant smuggling from Libya. Among other things, the EU wants to apprehend smugglers before their ships leave port. That phase has not yet started, but can only be successful if the EU has eyes and ears on the ground in Libya. With the consent of the legally-recognised (if ineffective) Libyan authorities, the EU should consider a civil-military mission, with sufficient air mobility and intelligence assets, to track and disrupt smuggling networks in Libya. This mission would undoubtedly be demanding; but the alternative is for the EU to continue providing a taxi service to Italy for those who cannot get there under their own power.

The #EU can't go on providing a taxi service to Italy for migrants from Libya #refugeecrisis

Further south still, as part of its work on a new security strategy, the EU needs to review how its development policies can contribute to stopping the flow of economic migrants and preventing people-smuggling from sub-Saharan Africa.

Schengen reformEven if the EU succeeds in cutting the numbers of refugees and irregular migrants reaching its territory, some will get in. As a forthcoming policy brief by Camino Mortera-Martinez will explain, the Schengen countries’ most pressing need is to reform the Dublin system governing asylum seekers. Under that system the first EU country the refugee enters is responsible for processing the asylum application. Greece and Italy have found it impossible to cope with the numbers of people arriving, and the system has allowed transit countries, such as Hungary, to take measures to stop asylum seekers travelling further north.

The ‘quota’ system adopted by the Council of Ministers in September sought to distribute asylum seekers across all Schengen countries. The system has failed so far, not least because the centres designed to process and relocate refugees (so-called ‘hotspots’ in Italy and Greece) are not functioning: some of them have not been built yet, and those that have are not yet dealing with migrants properly. Greece claims that it does not have the money or staff to make the centres work. The Commission and the member-states blame the Greek authorities for ‘serious shortcomings’ in the way Athens manages Schengen’s external borders. For the hotspots to function, all sides need to do more: Greek authorities should do a better job in staffing them, and work with Frontex ‒ the EU’s border agency ‒ and other member-states on the ground. Other member-states have only provided two-thirds of the 775 border guards requested by Frontex in October; they need to do more. The European Commission should provide more cash to build and equip the hotspots.

To increase pressure on Athens, the EU is now considering sealing the Greek border with Macedonia. The idea is to pile up refugees in Greece so that the situation becomes so serious that Greek authorities would have no option but to step up their game. The Commission also believes that doing so would leave other member-states no choice but to take in their promised share of refugees.
This is a dangerous idea: Greece’s febrile politics do not need inflaming, and no one factored in the cost of a migrant surge to last summer’s Greek bailout deal. It is also misguided: shutting the border with Macedonia would not disrupt smuggling networks. It would only change the routes they use. As long as there is a demand for people smuggling, organised crime will provide a supply.

Scapegoating Greece would also be hypocritical. Other governments are not living up to their commitments to relocate 160,000 asylum seekers: so far fewer than 0.4 per cent have been moved. Member-states must take in their share of refugees.

Schengen is under fire and is unfairly blamed for social tensions, alienation and even terrorism. Despite its imperfections, the borderless area within Europe is one of the great achievements of the EU. EU countries have become closer trading partners thanks to Schengen, and labour mobility has increased. For many European citizens, passport-free travel around the continent is one of the EU’s most important and recognisable accomplishments. It would be a great mistake for EU leaders to erect borders again, only to find that in solving nothing they jeopardise the EU’s future.

Ian Bond is director of foreign policy, Rem Korteweg is a senior research fellow and Camino Mortera-Martinez is a research fellow at the Centre for European Reform.

Deal done: Now for the hard work

David Cameron did better than expected at the marathon Brussels summit. But his package of reforms will sway few voters, so he must now make the case for the EU itself.

Once David Cameron had won the May 2015 general election, and announced an EU referendum before the end of 2017, he was always going to find it hard to fulfil his pledge to achieve significant reforms to the Union. The final phase of the British renegotiation proved particularly tortuous. But on the night of February 19th a deal emerged and there will now be a referendum on EU membership on June 23rd. Why did Cameron struggle to win major reforms? What are the most significant changes that he has achieved? And how should he try to win the referendum campaign?

The other 27 countries in the club are confronted by huge problems, notably the near-collapse of the borderless Schengen area and the continuation of serious economic problems in much of the eurozone. And then the British came along with a form of blackmail: they said that if they were not given a series of minor, mostly technical reforms, that were either not a priority for other countries or cut against their interests, the UK’s EU referendum could well be lost. This tactic has not exactly endeared Britain to its partners.

In 2013, when Cameron announced his plans for a renegotiation and a referendum, he believed that the other Europeans would need a new treaty to sort out the euro’s problems, and that would give the UK leverage to extract concessions. At the time the CER warned that there probably would not be a new treaty and we turned out to be right. The lack of treaty change has weakened Cameron’s hand. His only leverage has been that no government wants the British to leave – though some have been more willing than others to make an effort to help keep them in.

In light of the difficulties the #EUCO deal is at the upper end of what Cameron could have hoped for

In the end Cameron had to fight extremely hard to achieve his reforms, many of which come in the form of a legally-binding decision of the heads of state and government. One reason why some leaders proved so unwilling to give the British what they wanted was the fear of contagion: if the British got a special deal on say, the words on ‘ever closer union’ or cuts to migrants’ benefits, others might ask for the same thing. Most leaders, like Cameron, had to contend with difficult domestic politics, which encouraged them to resist some of his demands. And at points in the negotiation leaders tried to bring in side-deals: for example the Greeks threatened to block the British package unless they were reassured that the EU would not close their border with Macedonia before a special summit on migration in March.

The sheer number of states in the EU makes it hard for compromises to be forged. So does the absence of serious leaders. Both Donald Tusk, the president of the European Council, and Jean-Claude Juncker, the Commission president, worked hard and with determination to help achieve a British deal. But neither has the stature or authority to browbeat prime ministers to compromise on national interests for the sake of satisfying the British.

The one national leader who is pre-eminent is Angela Merkel, the German chancellor, who for the past ten years has dominated EU summits. However, she is not the force she was. Her unilateral open-door policy towards refugees has weakened her at home and angered many other EU governments. Throughout the renegotiation she has sought to help David Cameron but a few years ago she would have had greater authority to cajole recalcitrant leaders into making quick compromises with the British.

Given all these difficulties, the details of the deal were very much at the upper end of what Cameron could have hoped to achieve. His biggest victory was two minor curbs to migrants’ access to benefits. The UK will be able to pull an ‘emergency brake’ to reduce in-work benefits, like tax credits and housing benefits, paid to future EU migrants. New migrants will not be able to claim such benefits from day one of residence, and the amount they receive will slowly grow over four years, after which they will be treated identically to a British worker. The British had originally demanded a complete ban on all in-work benefits for four years, but the EU’s lawyers said that this would too obviously violate the treaties’ principle of non-discrimination. This emergency brake will operate for seven years, not permanently, as Cameron had originally hoped.

There are still some risks to this reform: the European Parliament may quibble over the details, because establishing the brake requires EU legislation. And the brake is on the edge of what is legally permissible under the treaties, since workers of different countries will be treated differently. Cameron did not succeed in cementing this reform through a promise of future treaty change, so it will be open to challenge in the European Court of Justice. Officials in London and Brussels expect that at some point a case will be brought against this brake. But the fact that this reform has been blessed by the heads of state and government means that it is highly likely to endure.

The second benefit curb – to child benefits – is not the full ban on payments of child benefit to workers whose children live abroad that Cameron had desired. All member-states will be allowed to index child benefit payments to the standard of living in the member-state where the child lives. This will only apply to new migrants until 2020, when indexation can be extended to all migrants with children living elsewhere in the Union. But given the hostility of Central and Eastern European countries to this reform – they are especially unhappy that all Western European states can index the benefit, rather than just Britain – Cameron can chalk this up as a win. (This reform, like the benefits brake, will require EU legislation, as will a third, relatively uncontroversial change, which will constrain the ability of EU migrants to bring in spouses from non-EU countries.)

The UK did win a promise that two other reforms will be embedded in the treaties when they are next changed. First, if Britain or another non-euro country considers that new financial rules driven by eurozone countries could damage its interests (for example, in the City of London), it will be able to pull another sort of ‘emergency brake’ to force those rules to be debated by all 28 ministers in the Council of Ministers and subsequently, if necessary, by the heads of government. This is a delaying mechanism, not a veto – the French and German governments were determined that Britain should not be able to block whatever eurozone governments think they need to do to ensure the currency’s health and survival. But the brake does offer the British a chance to build alliances at a political level against regulation that they think is inimical to their interests. Cameron won the right for only one country to be able to pull the brake.

Some bitter arguments with the French ended with the text giving the British some limited scope to have financial rules that are different from those of the eurozone, but not in ways that could destabilise the currency union. The deal also makes clear that the eurozone may not discriminate against members of the single market, and that non-euro countries will not participate in eurozone bailouts.

The second promise of treaty change is over ‘ever closer union’, the phrase in the current treaties that so annoys British eurosceptics. The text says that Britain has a “specific situation” under the treaties and “is not committed to further political integration”, and this will go into the next treaty change. During the summit, Belgium strongly opposed the possibility that other countries might gain a similar dispensation, and in the end the words made clear that this can only apply to Britain. The new wording will allow Cameron to say that Britain is not being dragged into a federalising EU, though the practical implications in the long term remain unclear.

The other parts of the deal were far less contentious, and so were relatively easily agreed. If 55 per cent of the votes allocated to national parliaments are cast against a draft EU law, the Council will scrap it unless the Commission amends the law to take on board the parliaments’ objections. The Germans were among those who opposed this ‘red card procedure’ but let it go through as they considered that it would be impractical for the parliaments to concert their efforts very often.

The text also points to new initiatives on deregulation. A declaration from the Commission promises a new mechanism to review the body of existing EU law for compliance with the principles subsidiarity and proportionality, and to report annually on which laws should be culled. There is some vague language in the summit’s declaration on extending the single market and brokering more free trade deals.

In all, then, the package is a collection of modest reforms that set out some principles for achieving a more competitive European economy, clarifying the relationship between the eurozone and the member-states outside the monetary union, curbing migrants’ access to welfare a little, giving national parliaments a small stake in EU law-making and spelling out that Britain has a special status within the EU. It will be hard for Cameron to claim that this is transformational, and the deal is unlikely to persuade many Tory MPs to switch from Out, or fence-sitting, to In. Downing Street had assumed that two key Tories – Michael Gove, the justice secretary, and Boris Johnson, the mayor of London – would come round to Remain. However, as soon as the deal was done, Michael Gove announced that he would campaign for Out. Johnson is still on the fence. He is popular with the public, and might provide the figurehead that the Leave campaign badly needs.

Cameron’s approach to the renegotiation has made it more difficult for him to campaign convincingly in the referendum. Until very recently he was often a strong critic of the EU. His government suppressed messages that might have helped assuage public suspicions of the EU, for fear of annoying eurosceptics. For example, Downing St deliberately chose not to publicise the government’s own review of EU competences, which concluded – in 32 detailed and serious reports, published in 2013 and 2014 – that almost all the powers exercised by the EU were broadly beneficial to Britain.

Cameron appeared to see himself as a kind of alchemist, who could turn lead into gold. He described the EU as pretty awful but implied that he would succeed in transforming it with his reforms. The prime minister now faces an awkward pivot, from EU-critic to enthusiast for In. His position would be easier if his line had been: “For all its faults, the EU is good for Britain, and with my reforms we can improve it in several important ways”. As it is, the tortuous negotiations have reinforced the perception that the EU is cumbersome and very hard to reform. In a Union of 28, Britain, though still one of the more influential member-states, cannot dictate terms and relies on other member-states falling into line.

What Cameron needs to do now is to move the public debate on from the merits of his reforms to the bigger issue of how the EU benefits Britain. His most recent public statements suggest that he sees this point very clearly. He should describe how the EU has changed for the better in recent decades and argue that it can continue to do so.

Britain has often stood at the forefront of reforming and improving the EU – while managing to stay outside its biggest failure, the single currency. Britain was one of the leading advocates of eastward enlargement, which has successfully tied Central and Eastern Europe to the West. It also brought prosperity to Poland, which in 1990 had similar living standards to Ukraine in 1990 but is now more than four times richer. The single market, which the UK has championed, has boosted trade and investment flows between member-states. The EU has opened its markets to countries outside Europe, reducing its trade-weighted average tariff from 5 per cent in 1990 to 1 per cent in 2013, and signed a host of free trade agreements (including, in recent years, with countries like Canada, Vietnam, Singapore and South Korea).

Cameron needs to keep highlighting the EU’s achievements in security, too. The European Arrest Warrant, introduced in 2004, allows criminals and terrorists to be swiftly extradited across European frontiers. The EU’s foreign policy institutions have helped bring about successes: brokering a settlement between Serbia and Kosovo, negotiating with Iran to limit its nuclear programme, lifting sanctions on Burma in return for the generals holding free elections, and imposing stringent sanctions on Russia because of its military adventures in Ukraine (Russia wants the sanctions lifted, which may explain why the fighting has been relatively quiet for the past six months).

David Cameron should repeat the message he used in the last general election campaign, when he stressed the need for security and continuity over the unknown and untested, and in the last few days he has started to do so. Brexit would be a major geopolitical event with consequences that are impossible to foresee with great certainty. The UK would be leaving the most comprehensive free trade area in the world, and the extent of the economic damage is unknowable, not least because nobody knows what the terms of the divorce would be. The Scottish nationalists would certainly use Brexit to push for another independence referendum, and might prevail at the second attempt. Britain would find it harder to exert itself on the continent and to influence the troubled European neighbourhood. Cameron’s best chance of success is to shift the debate onto more lofty terrain, away from arguments about banking safeguards and migrants’ benefits towards a contest over how to secure Britain’s interests in Europe and the rest of the world.

Charles Grant is director and John Springford is a senior research fellow at the Centre for European Reform.

Would an 'independent' Britain want to join the single market?

Three economic rules mean that Britain would seek to join the EU’s single market if it were not already a member.

Both sides of Britain’s EU debate claim the mantle of free-traders. Pro-Europeans emphasise the potential loss of access to the single market if Britain quits the EU. Outers point to the EU’s declining share of world trade, and the opportunities that might arise from signing free trade agreements with countries outside Europe, without having to find consensus with 27 other states. A central question in the campaign has become: ‘Would Brexit boost or depress Britain’s international trade?’

One way to answer the question is to imagine that Britain has no trade agreements with other countries, including the EU. Which countries should be the first port of call for its trade negotiators? Three principles would guide its choice: gravity, comparative advantage, and the ‘dynamic’ gains from trade. Together, they suggest that, if it were developing a trade strategy from scratch, Britain would be straight on the phone to Brussels.

Principle 1: Gravity
In the 1960s, Dutch economist Jan Tinbergen discovered that there was a close analogy between Newtonian physics and trade flows. He was inspired by Isaac Newton’s law of universal gravitation:  that the gravitational force between two objects is proportional to their mass and the distance between them. Tinbergen’s insight was that trade flows between two big economies were larger than between two small ones. But trade was larger between neighbouring countries than those that were distant from one another. This is intuitive – it costs less to ship goods between neighbouring countries, and the value of trade between big economies will always be higher than between small ones, simply because large economies suck in more imports.

In its 2014 report on the economics of Brexit the Centre for European Reform put together a gravity model, and found that this principle held with Britain’s trade with the rest of the EU. For every percentage point increase in a country’s distance from Britain, Britain’s trade with that country fell by 0.6 per cent. And for every percentage point increase in a country’s GDP, Britain’s trade with that country grew by 2.5 per cent. Consider Table 1. If the EU buys just under half of British total exports, but its economy comprises just 18 per cent of world GDP, why does Britain trade so much with it? The answer lies in the proximity of EU member-states – on average, they are only 1,200 kilometres away from Britain. Meanwhile, the OECD members that are not in the EU – the US, Japan, Australia and so forth – are far more distant, on average, which explains why Britain exports far less to them than to the EU. Of course, other factors explain why Britain exports less to the ‘BRICS’ emerging economies (Brazil, Russia, India, China and South Africa), despite the fact that they make up more of the world economy than the rest of the OECD. Mainly, it is because their GDP per capita is lower – poorer countries are less likely to buy Britain’s expensive, high value-added exports than richer ones.
Table 1.

If Britain were to start trade negotiations from scratch, its first priority should be to reduce the cost of trade with large economies, and its second to cut trade barriers with nearby countries. According to the gravity principle, then, which of the EU, the US or China would Britain choose to organise a free trade agreement with? The answer is, of course, the EU, because every reduction in trade costs achieved with that bloc is worth more than with the US or China, because Britain naturally exports more to rich countries that are on its doorstep.

Principle 2: Comparative advantage
Over the last four decades, the principle of comparative advantage has driven the global division of labour. After he came to power in 1978, Deng Xiaoping’s reforms allowed China to use its comparative advantage in low-value added manufacturing. Other developing economies followed. This process enriched Britain’s consumers: electronic goods, toys, clothes and steel became much cheaper in real terms. And over time, labour and capital were redeployed to more productive sectors of the British economy, raising incomes further. Together, these two effects made Britain richer.
However, trade with poorer countries is not without cost. It makes Chinese and British people richer on average, but the scars of deindustrialisation are still visible in Britain’s unbalanced economy, with higher unemployment rates and lower productivity continuing to blight the UK’s northern cities. As manufacturing and industrial work dried up, many poorer people moved into low-paid services work. Productivity growth in low value-added services sectors has been slower than in manufacturing. These trends have contributed to the ‘hollowing out’ of the British labour market, with more low- and high-paid jobs being created than those which provide middling earnings.

The benefits of such trade are skewed toward the rich, and the costs are locally and socially concentrated. The economic scars from plant closures – the industrial churn that is the process by which trade raises productivity – can be felt for decades. That does not mean that an independent Britain should eschew a trade agreement with China – but it does suggest that agreements with richer countries should be its priority.

Principle 3: ‘Dynamic’ gains from trade
After the 2008 crash, Britain’s productivity plunged and then stagnated. It had been catching up with US levels over the preceding decades, but after six years of weak growth, the UK’s output per worker is now a quarter lower than the US. Thus Britain’s trade strategy should make productivity growth its ultimate aim.

Higher trade and investment with developed economies are more likely to raise productivity than with poorer ones. This is because of a fact that is often lost on politicians and the public alike – that the biggest gains from trade come not from exports but from imports. Imports boost competition in the domestic economy, which raises the incentive for domestic firms to make productivity-enhancing investments.

Indeed, more imports and inward investment, especially from rich countries, can raise the rate of economic growth, and this process is known as the dynamic gains from trade. Two economists, Nauro Campos and Fabrizio Coricelli, recently pointed out that UK trade with the EU is largely ‘intra-industry’ – that is, competition between companies in the same industry. This is the opposite of comparative advantage, by which countries specialise in different sectors. Imports from more productive EU firms encourages their British competitors to raise productivity and spend more on research and development in order to keep a foothold in the market. The constant pressure of competition from more productive overseas companies raises productivity growth – not just productivity levels. For its part, trade driven by comparative advantage reduces the cost of imports and encourages labour and capital to shift to more productive sectors of the economy. But this effect is one-off – once a British steel mill has been closed and its workers and capital have been redeployed, that’s it: there has been a one-time boost to Britain’s total income.

Outside the EU, Britain could unilaterally and fully open its markets to the US, Japan, Australia and the EU in order to take advantage of those dynamic gains. But without unimpeded access to the EU market, foreign direct investment (FDI) would be lower. Such investment is a major source of dynamic gains, and is to a degree dependent on EU membership. The UK has been the largest recipient of FDI in the EU because it offers a bridgehead to European markets. And, since the UK cannot control what tariff and other barriers the rest of the EU would impose on the country after withdrawal, foreign investment would be at risk: Nissan, whose Sunderland factory now produces more cars per year than Italy, has plants elsewhere in the EU, and higher trade costs would prompt it to expand production inside the single market.

These rules of trade economics give our imaginary trade negotiators a clear order of priorities. First, seek to open markets with more productive, rich countries. Second, seek to open markets with countries that are nearby. Measures to boost exports with distant emerging economies come third. Were it not already a member of the EU’s single market, Britain might seek to join it, especially if the EU’s putative free trade agreements with the US and Japan come to fruition. Sadly, if Britain wanted single market membership without joining the euro or Schengen, the EU would probably force it to join the European Economic Area, like Norway or Iceland, and not become a full member of the club. Then it would have next-to-no say over the single market’s rules. The underlying principles of trade point to an obvious answer to the referendum question: Britain should remain in the EU.

John Springford is a senior research fellow at the Centre for European Reform.

China’s European charm offensive: Silk Road or Silk Rope?

The UK should not imagine that Chinese President Xi Jinping’s October visit means it now has a 'special relationship' with China. The visit was just part of a Chinese charm offensive aimed at the EU. 

Xi Jinping’s state visit to the UK from October 20th-23rd had every possible element of flattery and friendship. The Chancellor of the Exchequer, George Osborne, said before the visit that the UK was China’s “best partner in the West”. Xi told a joint session of Parliament that China and the UK were becoming “an interdependent community of entwined interests”.

China has not, however, singled out the UK for special favours. Chart 1 shows that (even though the UK's trade with China has increased significantly in recent years) Britain is still far from being China’s most important economic partner in Europe.

Chart 1. China's leading EU trade partners, 2013

China is cultivating many European countries: since September 1st 2015, Chinese leaders have met senior representatives of more than 20 EU member-states, as well as at least four European commissioners. That outstrips the amount of senior contact between the US and its European partners over the same period. 

Since Sept 1, #Chinese leaders have met senior representatives of more than 20 #EU member-states

Part of China’s motivation is clearly economic. The EU is China’s largest trading partner (and China is the EU’s second largest trading partner after the US). After decades of fast growth, trade has stagnated since the eurozone crisis began in 2010 (Chart 2). Although Beijing wants its future economic growth to be founded upon domestic consumption more than investment and exports, Chinese experts privately admit that the restructuring needed for this would cause economic dislocation, threatening political stability; better to find new markets or increase exports to existing ones.

Chart 2: EU-China total trade

The search for markets also motivates Xi Jinping’s signature ‘One Belt, One Road’ (OBOR) initiative – designed to create the infrastructure for new land and sea routes between China and Europe (the ‘Silk Road Economic Belt’ and the ‘Maritime Silk Road’ respectively). Large infrastructure projects – whether railways in Central Asia or port facilities around the Indian Ocean – would help China deal with over-production of steel and other products without closing plants and creating unemployment.  

According to a recent report by the Mercator Institute for China Studies and Rhodium Group, China’s annual investment in EU member-states went from virtually zero in the mid-2000s to €14 billion in 2014, with the stock of investment reaching €46 billion. The report projects that the pace of investment will continue to increase. For the EU, the prospect of China investing some of its $3.5 trillion foreign currency reserves in European infrastructure is extremely attractive. The EU-China Summit in Brussels in June agreed to "support synergies" between the Investment Plan for Europe (also known as the Juncker Plan) and OBOR. The Juncker Plan is intended to generate investments of €315 billion over three years, including in infrastructure; China envisages the Asia Infrastructure Investment Bank (AIIB) having $100 billion to put into OBOR-related projects, and has set up a separate $40 billion Silk Road Fund to invest in businesses along the route. The two sides subsequently agreed that the European Commission, the European Investment Bank (EIB) and the Silk Road Fund would identify by December how exactly China could co-operate with the Juncker Plan. 

Potentially, economic co-operation between Europe and China on Silk Road projects could indeed be "all-win", as Chinese leaders describe it. Transit times for goods and agricultural products could be shortened. Central Asian states that have developed little (the hydrocarbon sector aside) since independence from the Soviet Union in 1991 could be connected to global markets. And Europe itself could use Chinese money to boost growth.

The question is whether OBOR is a purely economic project, or has geopolitical overtones. The Chinese are certainly at pains to deny that they have ulterior motives in promoting OBOR. But not everyone is convinced. 

Beijing has sought to allay Russian fears that the Chinese are making a move into Moscow's back-yard. When they met in Moscow in May, Russian President Vladimir Putin and Xi Jinping agreed to co-ordinate the Silk Road Economic Belt and the Russian-led Eurasian Economic Union (whose members include Armenia, Belarus, Kazakhstan and Kyrgyzstan, with Tajikistan to come shortly) – even if neither the Russians nor the Chinese know how exactly to merge two very different concepts. For China, however, a good relationship with Russia is important primarily because it removes a potential obstacle on the road to Europe. 

For at least some Chinese officials, the relationship with Europe is seen through the prism of China’s competition with the US: European participation in the AIIB is a good thing not only because European countries will contribute to the bank’s capital, but because they defied US opposition to join it. The fact that the UK was the first to break ranks, risking its ‘special relationship’ with the US to win a ‘golden era’ with China, may be seen in Beijing as a significant victory. And the OBOR initiative, which China claims will include 65 countries with a total population of 4.4 billion, may have two other benefits for China. 

First, it may serve as a partial counterweight to two US-promoted free trade agreements, the Trans-Pacific Partnership (TPP – 12 countries, 800 million people) and the Transatlantic Trade and Investment Partnership (TTIP – the EU and the US, 820 million people). TPP and TTIP are designed in part to ensure that Western countries rather than China set future global trade standards. If China embeds itself in the economies of members of TTIP or the TPP, it can encourage those countries to look after China’s interests.

Second, it may reduce the incentives for Europe to stand up to China over its claim to the South China Sea: if goods can be transported from East Asia to Europe in larger quantities and more quickly by land than by sea, the importance of the South China Sea to Europe as a trade route would shrink. And then, why put the relationship with Beijing at risk for little practical advantage?

More broadly, China can play member-states off against each other (the Chinese have told countries from Latvia to Spain that they can host the European terminus of the Silk Road), or against the US, to gain international influence. American officials may now admit privately that the US was wrong to try to persuade its European partners not to join the AIIB; but some Europeans regret that the UK chose to move first and on its own to sign up to the Chinese plan, rather than in co-ordination with the rest of the EU. In so doing, the UK gained bilaterally but weakened Europe’s ability to extract concessions from China on the AIIB’s standards of governance and transparency. 

Beijing uses the lure of economic co-operation to discourage European criticism of China's human rights record. Perhaps the scale of Germany’s economic relationship with China means that Beijing cannot object when the Germans raise their concerns; during her visit to Beijing in October, Merkel held a private meeting with human rights activists and dissidents. But China makes life difficult for other European countries when they take too much interest in human rights (relations with Norway have not recovered from the award of the Nobel Peace Prize to the dissident Liu Xiaobo in 2010). Those who prioritise commercial interests, on the other hand, are rewarded: the Chinese state media praised Osborne for not confronting China over human rights, and Cameron was able to claim that up to £40 billion of trade and investment deals had been done as a result of Xi Jinping's visit. 

No use @eu_eeas & @EU_Commission delivering tough msgs to #China if member-states undermine #EU line

The EU needs a strategy to benefit from China's economic strength without losing sight of Europe's interests and values: 

• The most important thing is to have a unified European policy towards China, which takes account of the EU's interest in preserving the global order and principles like freedom of navigation. It is pointless for the European External Action Service and the Commission to deliver tough messages, if individual member-states undermine the EU line in order to gain commercial advantage. Germany shows that it is possible to deliver unpalatable messages to China, as long as the trading relationship is important enough to Beijing; and the collective EU trading relationship is the most important of all.
• The Commission and the European External Action Service should ensure that they have a coherent approach to the OBOR initiative, ideally with one senior figure looking at both its technical aspects and geopolitical implications.
• Europe needs to remember that China is not its only partner in the region. Countries like Japan, South Korea and Vietnam are also important, politically and economically, and have their own interests; the EU should weigh these against its desire to gain Chinese approval and economic benefits.
• The EU should make clear to China that European interests in the South China Sea go beyond free passage for European shipping; the principles of maritime law at stake there have global implications. The EU is right to stay neutral on the substance of claims, but it should back the Philippines in saying that an international tribunal is the right body to adjudicate between claimants.
• The EU should offer advice to ASEAN on practical matters like maritime surveillance and fisheries management in the region, as a way of removing some of the sources of possible clashes.
• China and its neighbours need a multilateral dialogue on the South China Sea. The EU should build on the precedent of the Asia-Europe foreign ministers’ meeting in Luxembourg on November 5th and 6th, where EU ministers discussed the South China Sea in private with counterparts from all the littoral states, including China. 
• The EU should revive efforts to co-ordinate policy towards China with the US. Then-US Secretary of State Hilary Clinton and then-EU High Representative for foreign policy Catherine Ashton issued a statement on the Asia-Pacific region in 2012, setting out a number of shared objectives and calling for regular high-level dialogue; but there has been little subsequent follow-up. The interests of Washington and Brussels will not always coincide, but often they will, whether it is on protection of intellectual property rights, compliance with WTO standards or freedom of navigation. 
• The EU should make sure that it focuses on getting China to meet European standards of economic governance and investment protection, rather than relaxing its standards to attract the Chinese to Europe: no Chinese company should be able to flout EU rules in the way that the Russian gas company Gazprom was able to for many years.

No #Chinese company shld be able to flout #EU rules in the way that #Gazprom was able to for years

The UK should not start acting as China's champion in Europe; but it should pay attention when Xi says that the UK "as an important member of the EU" should play "a more positive and constructive role" in the development of EU-China relations; if the US and China are both urging the UK to remain an active EU member, they must have good reasons. As a state with global political, security and economic interests, Britain should work with partners (particularly Germany, still the member-state with the greatest clout in Beijing) to build a more coherent EU policy towards China. An economic Silk Road between China and Europe could be a boon to both; but the EU should avoid being politically bound to China with a silk rope.

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

Merkel after Paris

In spite of speculation that the German chancellor’s refugee policies may be her downfall, Merkel’s relatively open and liberal stance on refugees makes it easier for her to respond robustly to the attacks in France through security and foreign policy. 

For years, Angela Merkel’s personal popularity ratings have been stratospheric and her Christian Democratic bloc (CDU/CSU) has had a robust lead in opinion polls. But during the refugee crisis, Merkel’s relatively open stance has led to her approval ratings dropping to their lowest level since 2011. Meanwhile the increasingly far-right party Alternative für Deutschland (AfD) has gained in popularity. The terrorist attacks in Paris on November 13th have predictably provoked more criticism of Merkel’s refugee policies. But it would be premature to call time on the Merkel era. The combination of her open rhetoric and harsh measures to limit illegal immigration is allowing the CDU/CSU to maintain its hold over the political centre ground. Polling indicates that support for the Christian Democrats is stabilising, as voters faced with a security crisis rally around their leader. Merkel’s position as party leader and chancellor is not in danger.

In August, 45 per cent of Germans saw more advantages than disadvantages from immigration. This number dropped to 35 per cent in September and has since stayed stable at around that level (37 per cent in November). In light of these figures and weakening poll numbers, sceptics evoke a historical analogy. They recall that former Social Democrat chancellor Gerhard Schröder fell as a result of a reform package to liberalise the labour market that incited rebellion in his party, leading to the rise of the new The Left party. Merkel is looking at a similar rebellion over her policy towards refugees, they say. They point to angry voices on the CDU/CSU’s right wing, who no longer feel represented by their party leader, and to the rise of the AfD.

Up until now, the Christian Democrats have successfully prevented the emergence of a mainstream party to their right for three reasons. First, the CDU and its Bavarian sister party CSU is a broad coalition, with the CSU’s leaders traditionally allaying the anxieties of Germany’s more conservative voters (whether Bavarian or not), while the chancellor has held the centre ground. A few rebelling members of parliament, within limits, is part of this strategy. Even today, 86 per cent of CDU/CSU members are happy with Merkel as chancellor, and 81 per cent want her to run again in 2017. 

Second, party discipline has always been strong in these parties, because they have often prioritised power over ideological purity or costly leadership quarrels. Third, right-wing populist parties have attracted xenophobes, anti-Semites, and nationalists, which quickly taints their brand in a Germany wary of its past. 

But the CDU/CSU faces new challenges. It needs to cover an even wider spectrum than in the past: the middle ground of German politics is more liberal, while far-right voters feel less constrained by the country’s past. Forty-three per cent of Germans see the country’s Willkommenskultur (welcome culture) as too politically correct, according to a poll, and feel they cannot openly express their concerns about the refugee crisis. Such sentiments are a fertile breeding ground for populist parties that claim to be giving a voice to ‘concerned citizens’. The increasingly far-right party AfD has won supporters – enough to win seats in the Bundestag if elections were held today – after transforming itself from  an anti-euro party into an increasingly far-right, nationalist and anti-refugee party. After the terrorist attacks in Paris, polling by the conservative Insa Institute put the AfD as Germany’s third-strongest party for the first time, at more than 10 per cent. 

But AfD cannot threaten Merkel without restraining the xenophobic rhetoric of some of its regional leaders, which is proving difficult. Moreover, even if the AfD entered the Bundestag, it could not seriously harm the CDU/CSU’s prospect of retaining power, nor Merkel’s chances of being re-elected chancellor in 2017. As long as Merkel keeps to the centre ground, the arithmetic of German politics favours the CDU/CSU: the AfD would reduce the relative share of the left parties (SPD, The Greens and The Left) in the Bundestag, making Merkel’s party even more indispensable for any governing coalition. 

The chancellor’s stance on refugees has been less impetuous than many have claimed. Merkel’s approach has been rooted in her usual crisis management strategy. She develops her policies cautiously over time – waiting for a public consensus to form, weighing her political options, and working towards a solution that keeps her in power. As the refugee crisis unfolded, the chancellor initially remained on the sidelines of the debate and only chose to ‘be bold’ when a Willkommenskultur materialised throughout Germany. If she had insisted on traditionally conservative and restrictive policies, she would have vacated the centre ground to the SPD and The Greens. Instead, she integrated many of the more left-wing policies on refugees into a Christian-conservative narrative. This strategy has served her well in the past, on issues such as the introduction of a minimum wage or withdrawal from nuclear power. 

#Merkel has integrated left-wing policies on #refugees into a Christian-conservative narrative

Polls show that the German population’s biggest concerns about refugees are linked to the economic and fiscal impact, followed by worries over heightened competition in the housing market and the influence of Islam in Germany. Merkel knows that Germany has the economic strength to cope with the additional costs of integrating refugees, as a study by DIW, a think-tank, has recently confirmed. Germany is running a budget surplus so it can easily finance expenses such as housing for refugees, as even the fiscally-conservative Bundesbank has recently argued. Moreover, in the current European economic situation of low demand and low inflation, additional spending by Germany is a welcome stimulus. Over the medium term, if Germany manages to integrate refugees into the labour market, its demographic problems could be partially mitigated. 

Merkel’s main objective at the moment is to demonstrate that she is in control. Her relatively open and liberal stance on refugees makes it easier for her to respond robustly to the attacks in France through security and foreign policy. Germany had already implemented tougher rules on refugees, including faster deportation, in October. After Paris, Merkel is aiming for resettlements of refugees currently living in or passing through Turkey according to a specific allocation key. In exchange, Ankara would promise to block refugees outside of that quota from coming to Europe. This policy allows Merkel to limit immigration without imposing an absolute cap that would be difficult to uphold.

#Merkel's liberal stance on refugees makes it easier for her to respond robustly to the #ParisAttacks

In foreign policy, her first step was to offer financial and political incentives to Ankara to help reduce the flow of Syrian refugees. At the G20 summit in Antalya, two days after the attacks in Paris, the chancellor stressed the importance of securing Europe’s external borders and Turkey’s crucial role in the process. Her policy has contributed to the EU turning a blind eye to Turkey’s human rights record – in particular recent attacks on the freedom of the press – and to re-energising Turkey’s accession process. Tougher security policies in Germany, or even German involvement in the war against Daesh, could follow – while the chancellor maintains her open and liberal rhetoric on refugees.

Merkel retains the support of a large part of Germany’s political spectrum. A recent poll found that 60 per cent of Germans believe that no other politician in Germany could do a better job of steering the country through the refugee crisis and responding to the threat of terrorism. She still has room to further tighten policies on refugees, while being more assertive on security and foreign policy. Merkel looks like remaining the EU’s dominant political figure for some time to come.

Christian Odendahl is chief economist and Sophia Besch is the Clara Marina O'Donnell fellow at the Centre for European Reform.

Terrorism in Paris: Aux armes, citoyens?

Western indecision in Syria has allowed Daesh to grow strong, and enabled it to attack Europe. The Western response must be resolute abroad, and subtle at home, if it is to defeat Islamist extremism.

Sometimes an event occurs that should create clarity of purpose and lucidity of priorities. The Paris attacks are such an event. The tragedy must galvanise European and international support for a co-ordinated offensive against Daesh. Yet questions remain about how best to deal with terrorism at home.

France has seen terrorism’s face before: most recently in January, when Charlie Hebdo and a Jewish supermarket were the targets. But never, in modern times, has the soul of France been so thoroughly penetrated. French president Francois Hollande called the terrorist attacks in Paris on November 13th “an act of war” by Daesh, the so-called ‘Islamic State’ terrorist organisation. And France’s first reaction has been war-like: the French air force launched heavy bombing raids on Raqqa, the headquarters of Daesh in Syria, on November 15th. That may bring some satisfaction, though it will not solve the problem of Islamist terrorism in Europe.

Since the start of the campaign against Daesh in September 2014, European governments have believed they could dislodge the ‘Islamic State’ from its sanctuary in Iraq and Syria through airstrikes. Yet Daesh has remained able to plot attacks abroad, attract recruits and gain millions of dollars selling oil. In the past month alone, Daesh has claimed, or is believed to have been behind, successful attacks in Ankara, the Sinai, Beirut and now Paris. This should now focus the attention of governments in the West and elsewhere.

Hollande’s rhetoric is reminiscent of George W Bush’s declaration of a ‘global war on terror’ against Al Qaeda after the 9/11 attacks in 2001. Daesh, in contrast to Al Qaeda in 2001, resembles a state in that it holds territory, which can be conquered. The priority should be to destroy the safe haven Daesh has in Iraq and Syria.

In his speech before the joint session of parliament on November 16th, Hollande told his defence minister to invoke article 42.7 of the Treaty on European Union. This ‘solidarity clause’ obliges other member-states to offer aid “by all the means in their power” in response to an armed attack. The clause has never been invoked before, and so its impact remains to be seen, though an EU military intervention is not likely. At the least, the clause forces traditionally neutral EU member-states, like Austria and Finland, to assist. Additionally, its invocation acknowledges that the EU has an important role to play in the battle against Daesh, especially within Europe’s borders. France would also have every right to invoke NATO’s article 5 — which would declare that it has been the subject of an armed attack, calling on its allies to help it. However, Hollande appears to prefer working through a coalition of the willing, rather than bringing NATO in. NATO’s presence in Syria might complicate any co-operation with Russia. Hollande is also seeking a UN Security Council resolution. If it explicitly mandates the use of force, it would be an additional rallying cry for a broad coalition.

Western airstrikes limited to Iraqi territory have so far been practically useless #ParisAttacks 

Airstrikes, particularly limited to Iraqi territory as many European airstrikes are, have been practically useless. Air power by itself rarely wins wars. If the West can find reliable allies who can fight on the ground (including Kurdish forces, despite Turkish concerns), it should help them to do so. Yet the fight may require Western ‘boots on the ground’. The United States has already decided to send up to 50 Special Forces to fight Daesh. European governments should follow suit.

The lessons of past interventions in Afghanistan, Iraq and Libya are not that the West should never intervene militarily, but that it should not start a war without a plan for the day after. In Syria and Iraq, the day after has to include a political process to end the conflicts that have created the governance vacuum, which Daesh has filled. The difficulty of doing so, of course, should not be under-estimated.

After the #ParisAttacks #Putin may argue that Assad is the answer in Syria. He is not.

Russia’s president Vladimir Putin may argue that Syria’s president Bashar al-Assad is the answer in Syria. He is not. Indeed, Assad has done his best to ensure that Daesh is the only opponent left on the battlefield: Syrian and Russian forces have struck against other groups fighting Assad much more often than against Daesh. Though perhaps not immediately, Assad will have to make way to allow Syria to move towards a more peaceful future. In its response, the West will have to work with many countries that have ulterior motives in Syria, including Russia, Turkey and Saudi Arabia.

Europe must not be taken in by Putin’s suggestion that the West, Russia and Assad are now all on the same side in fighting against terrorism. Putin’s game in Syria is cynical. However, the presence of Russian forces in Syria means that the West has no choice but to co-ordinate with Russia, at least to ensure that Western and Russian aircraft stay out of each other’s way.

Europe must work with Turkey’s president Recep Erdogan: despite European concerns about increased authoritarianism in Turkey, the recent attack in Ankara suggests a convergence of interests to fight Daesh. Western governments have to convince Turkey not to undermine the relatively successful Kurdish fight against Daesh for fear of strengthening Kurdish separatists in Turkey. Aside from the military campaign against Daesh, Europe’s external borders must be better secured, for which Turkey’s co-operation is crucial.

The West also has to reconsider its relationship with Saudi Arabia: many of the most disturbing aspects of Daesh’s behaviour in Iraq and Syria reflect Riyadh’s regional propagation of its intolerant, fundamentalist Wahhabist ideology, including through Saudi-funded mosques and Islamic schools in Western countries. Saudi efforts to stop Daesh and its ideology have so far been half-hearted, as it chooses to prioritise fighting against Iranian-backed rebels in Yemen instead.

Despite the semblance of statehood, Daesh is also a network, and its offshoots have already emerged elsewhere across the Middle East. Assuming it can be defeated in Iraq and Syria, Daesh could well metastasise in Libya, Nigeria, Sinai, Afghanistan or elsewhere in the Levant. Still, it is better to disrupt Daesh and keep it on the run, than allow the benefits of a profitable sanctuary to accrue. This means Europe should prepare for a prolonged fight against the group.

#EU governments must balance the use of force abroad & the rule of law at home #ParisAttacks

European governments must balance the use of force abroad and the need to keep working within the framework of the rule of law at home. Daesh wants Western governments to over-react, thereby polarising communities and mobilising new recruits. Instead, Europe must avoid clamping down hard on Muslim communities. Though politicians like Marine Le Pen, Nigel Farage and Geert Wilders will call for de facto anti-Muslim measures, Europe must stay true to its liberal and tolerant values. Police and security services should respond strongly to populist vigilantes and extremists who may step up violent attacks against Muslim targets.

One of the terrorists that attacked Paris on Friday left a fake Syrian passport behind. He had allegedly used it to enter the EU through Greece. This could well have been a planned move to reignite the already heated debate on Europe’s asylum policies — why would a terrorist leave a passport behind? European governments should not fall into Daesh’s trap by responding with knee-jerk reactions such as closing borders (though border controls may be necessary temporarily, to pursue and apprehend the suspects of the attacks). A ‘fortress Europe’ aimed at keeping out predominantly Muslim refugees would fuel the narrative of European Christians oppressing and fighting against Muslims.

More to the point, closing borders would give a false sense of security. There has always been a risk that jihadists may enter the EU posing as refugees. Identifying and stopping them demands adequate registering and fingerprinting on their arrival in the EU, and intelligence sharing among the 28 member-states, not a closing of the borders. In fact, many European plots have involved terrorists from Western countries. Some members of Daesh are jihadists with French, Belgian or British passports, returning from conflict zones (such as Syria) to strike in their home countries. To close the borders would do nothing to stop them: international law prohibits a country from denying entry to its own nationals — and if they are not spotted and put under surveillance by intelligence services, they can continue their activities unhindered from within their home countries. Others have not even left the country: Daesh propaganda ‘instructs’ its acolytes around the world to carry out attacks in its name.

Like many criminal organisations, Daesh mainly relies on difficult-to-trace internet communications which defy national borders. Instead of seeking false security in national isolation, more — and better — European intelligence and law enforcement co-operation is needed. To that end, the European Parliament should speed up an agreement on the use of passenger data for terrorist investigations (a directive that it has blocked for over four years, over privacy concerns). The EU should also overcome its problems with the US in the field of data sharing and co-ordinate with Washington to get access to US intelligence, including its no-fly lists, which includes known terrorists.

The attacks in Paris show that the Schengen agreements, and particularly the Schengen Information System (SIS) ‒ a database used by European governments to track persons of interest – are still not functioning properly. The SIS could be used in combination with other databases (such as Eurodac, which contains fingerprints of asylum seekers) to verify the identity of those arriving in Europe. The European Parliament has been reluctant to allow the interconnection of several databases for fears of privacy intrusion. It is now time for the Parliament to drop some of these claims and realise that such intelligence may benefit the EU as a whole: should a Schengen crisis emerge, it would challenge the EU project in its entirety. Europe should not dismantle Schengen, but improve it, by processing refugees more effectively, deploying many more border guards at Europe’s outer borders and improving information sharing among the member-states. These measures will be costly and take time to implement. But the EU can no longer accept an external border where massive inflows of third country nationals are dealt with in places which barely have electricity — such as the ‘processing centre’ on the Greek island Leros, where the allegedly fake refugee (on his way to carry-out the suicide attack in Paris) was fingerprinted.

But even if the EU had taken all these steps, the attacks might still not have been prevented. 14 years after 9/11, European governments remain unable to control the drivers of radicalisation in second- and third-generation Western Muslims. That leaves one, burning question: why have European citizens become so attracted to Daesh’s ideology that they are willing to kill, kill themselves and be killed, in its name? That is the clarity we still desperately seek.

Camino Mortera-Martinez is a research fellow and Brussels representative and Rem Korteweg is a senior research fellow at the Centre for European Reform.

In-work benefits for EU migrants: How the British government dug itself into a hole

The UK could make both Britons and EU migrants wait four years before having access to in-work benefits, but the ECJ might still rule it illegal.

Today, David Cameron gave a speech and sent a letter to Donald Tusk, the European Council president, setting out his EU reform demands. Most of the reforms are not surprising, and compromise is achievable. But Cameron appears to be upping the ante on his key demand that is most difficult to achieve: that immigrants from the EU should be denied in-work benefits, such as tax credits and housing benefit, for four years.

#Cameron appears to be upping the ante on his key demand that is most difficult to achieve #CHspeech

The speech was accompanied by some new statistics claiming that 43 per cent of EU migrants receive a UK benefit in the first four years of residence in the country. The 43 per cent figure is surprisingly high, and is based upon administrative data, which is not available to the general public. By contrast, data from the official, publicly available Labour Force Survey, puts the figure at 21 per cent in the first quarter of 2015. The government has made the decision to continue to push for the four-year demand, despite the fact that it would require treaty change, unless similar measures were applied to Britons.

The Centre for European Reform has repeatedly argued that the four-year demand was discriminatory and violated the EU’s treaties. In December 2014, shortly after Cameron’s speech announcing the demand, Camino Mortera-Martinez pointed out that article 45 of the Treaty on the Functioning of the European Union (TFEU) forbids discrimination against workers “as regards employment, remuneration and other conditions of work and employment”. Tax credit payments are dependent on workers’ hours and income, and whether they have children, so restricting them would amount to discrimination between Britons’ and EU immigrants’ income from the same job.

CER has repeatedly argued that the 4-year demand was discriminatory & violated EU treaties #EUref

In May 2015, I noted that this discrimination could be quite large: the new universal credit, which will lump together housing benefit and tax credits, would more than double the income of the average central and east European migrant with a child in the UK. Withdrawing in-work benefits from migrants would lead to many British workers receiving higher incomes than EU immigrants for doing the same job. This is a violation of a founding principle of the EU – that workers and companies should be free to do business anywhere in the single market without discrimination. Would Britain accept the French government applying different income tax rates to French nationals and Britons living in France? No. Discrimination through tax credits amounts to the same thing.

Then why is David Cameron proposing it? At the time of his migration speech, the political context was challenging for No. 10: public hostility to immigration was increasing, and the rise of UKIP fed Tory fears that the party would deprive the Conservatives of a majority at the 2015 election. Cameron wanted ideas that would take the heat out of the migration issue. Open Europe, a think-tank with close links to the Conservatives, came up with one. Damian Chalmers, a professor of EU law at the London School of Economics, and Open Europe’s Stephen Booth, called for a three year pause before EU migrants could access most benefits, to be enshrined in EU law through a new directive. (‘Directives’ are secondary EU legislation that must not conflict with the underlying EU treaties.) They said this had a legal basis, because articles 20 and 21 of the TFEU say the Council of Ministers can make secondary laws on welfare, which seems to suggest that the treaties do not have the final word on the issue. But, as the University of Essex professor Steve Peers wrote at the time, this is true for migrants who do not work in their host state. For those who do work, discrimination is not allowed in the treaties, and secondary laws are only permitted when they accord with TFEU’s article 46, which allows only “measures required to bring about freedom of movement for workers”, not measures that restrict it.

At the time of Cameron’s speech, many Conservatives were demanding quotas to limit the number of EU migrants. Indeed, late drafts of the speech included this demand – despite the fact that it was evidently incompatible with the EU treaties or what Britain’s partners would accept. At the last minute, Angela Merkel, the German chancellor, helped to persuade Cameron to abandon quotas. So Cameron took up Open Europe’s proposal – which they had marketed as a way to “save free movement” by, it was hoped, making the issue less toxic for British voters.

As a result, the four-year waiting period for in-work benefits went into the Conservatives’ election manifesto. Of all the British government’s demands in its EU renegotiation, this is the only one that looks unachievable. One suggestion, floated by government sources in August, might be to act unilaterally, and make a domestic policy change: stop EU migrants from getting in-work benefits for four years as well as Britons between the ages of 18 and 22. On the face of it, this idea might solve the government’s difficulties, but in reality, it is still legally problematic. Since migrants from the EU tend to be older than 22, and more likely to have children than British 18-22 year-olds, the ECJ might rule that the policy amounted to de facto discrimination.

The government may find it somewhat easier to reform rules on out-of-work benefits, payments of child benefit overseas and the right of people from countries joining the EU to work in other member-states, as my colleague Charles Grant explains in his recent analysis of Cameron’s demands. But Cameron has been very specific about what he wants on in-work benefits and his government is now in a difficult position. Free movement is the EU policy that British voters most dislike. Other EU governments, however, will not amend the treaties to accommodate the British. For some, such as Poland, this is because it would be directly against their national interest, and for many, it is because they view the principle of non-discrimination as a central plank of the single market. If treaty change to make discrimination between EU workers legal were put on the table, countries more hostile than the UK to free trade might demand discrimination in other areas – between national and foreign companies, for example – and the single market process could go into reverse.

The only out of #Cameron’s in-work benefits trap is to remove benefits from Britons & #EUmigrants

As my late colleague Philip Whyte put it: “The reality is that the EU keeps its members ‘honest’ by anchoring their behaviour”. The EU limits protectionism by enforcing a body of laws – laws which may not violate treaty principles. Any changes to that fundamental principle of the single market will always be very difficult to make. It appears that the only way out is to withdraw benefits from young Britons as well as EU migrants, and hope that the ECJ rules in favour of the reform.

John Springford is a senior research fellow at the Centre for European Reform.

25 years on: How the euro's architects erred

A quarter of a century after the euro’s conception, the flaws in its design have become apparent. EU leaders have fixed some of them but the euro needs better policies in order to be a successful currency.

It is almost 25 years since European finance ministers, meeting in Rome in December 1990, launched an ‘inter-governmental conference’ on Economic and Monetary Union (EMU). Their work emerged a year later as the Treaty of Maastricht, which set out a roadmap for creating what became the euro.
At that time I was a journalist in Brussels, interviewing many of those involved in the conception of the euro. Most of them assumed that the euro would encourage trade and investment across frontiers, thereby deepening the single market and boosting competition. They thought that an independent European Central Bank (ECB) would keep inflation and interest rates low, encouraging investment and job creation. They were also convinced that the euro would strengthen the political bonds between the European nations.

The euro has in fact delivered real benefits to some of its members, particularly in northern Europe. But since 2010, the euro’s difficulties have forced its supporters to challenge some of their assumptions: the eurozone has under-performed compared with other advanced economies (its output is still below pre-crisis levels); high unemployment in southern Europe has contributed to the rise of populist parties; and countless acrimonious emergency summits have pitted north against south, or more recently, against just Greece. Even in Britain, which has no plans to join the euro, its problems have tarnished the EU’s reputation.

A quarter of a century on, it is worth taking stock of what went wrong with EMU and what its future holds. Were its architects driven by political priorities, at the expense of economic fundamentals? What were the biggest flaws in their plans? And are today’s EU leaders doing enough to save the project?

Nowadays, many people view the euro as the child of a Franco-German bargain over German unification that had little to do with economics. However, EMU was initially an economic project, spurred by the success of the single market programme that Jacques Delors, the president of the European Commission, had launched in 1985.

In 1987 a seminal report by Tommaso Padoa-Schioppa, an Italian economist, had a profound effect on Delors. Padoa-Schioppa predicted that the imminent liberalisation of capital controls, a key part of the single market programme, would destabilise the Exchange Rate Mechanism (ERM) that then linked most EU currencies. He argued that of the three objectives of a stable ERM, free movement of capital and national autonomy on monetary policy, only two were possible at the same time.

Delors feared that if the ERM fell apart – as it very nearly did in 1993 – the single market would be threatened: gyrating currencies could provoke the return of protectionist barriers. He concluded that national monetary policies would have to go and persuaded Chancellor Helmut Kohl of the case for monetary union. In June 1988 the European Council asked Delors to chair a committee of central bank governors that would draw up a plan for EMU. A year later EU leaders endorsed the Delors report – before anyone thought the Berlin Wall might fall.

At the end of that year, when the two halves of Germany were starting to move together, Franҫois Mitterrand, France’s president, made EMU unstoppable: he told Kohl that he would not support reunification unless Germany gave up the Deutschmark (which was very popular with most Germans). The Delors report, amended to reflect German concerns, became the basis of the Maastricht treaty’s provisions on EMU.

Monetary union was driven by the politics not only of reunification but also of the ERM, which had evolved into a German-led system of semi-fixed exchange rates. Realignments of currencies were rare, and whenever the Bundesbank shifted interest rates, for the sake of the German economy, the other central banks in the ERM had to follow suit immediately. France and the other countries, finding this German hegemony unacceptable, saw EMU as a means of curbing it. Yet ironically the euro has now become, to a considerable extent, a means for Germany to cajole the rest of the eurozone to adopt its preferred economic policies.

Design flaws of the #EMU: 1st the #EZ has lacked a system for making fiscal policy counter-cyclical

With hindsight, the plans for EMU had at least five serious design flaws. First, the eurozone has lacked a system for making fiscal policy counter-cyclical. When growing, economies need fiscal discipline, but in recession they need freedom to borrow. Lack of discipline has proved to be a particular problem in Greece. During the Maastricht negotiations, German finance minister Theo Waigel insisted on binding rules on budget deficits, with the prospect of fines for governments that borrowed more than 3 per cent of GDP. A strange alliance of Delors and Norman Lamont, the British finance minister, argued that binding rules would in practice be unenforceable. Lamont trusted financial markets to discipline a country that over-borrowed, by demanding a higher rate of interest. Delors said that a country in difficulties would need credits from the EU, which would then impose conditions, including budget cuts. But they lost the argument.

Waigel was right that the markets were fallible: not believing in the Maastricht treaty’s no-bail-out rule, they went on lending to Greece at almost the same interest rate as they lent to Germany, until 2010. But Delors and Lamont were correct that binding rules were unenforceable; France and Germany first broke the 3 per cent rule in 2003 and many others have done so since.

A second problem is that the plans for monetary union lacked provisions for a ‘banking union’, which is now recognised as an essential component. EMU’s parents failed to foresee that the euro would engender a cross-border intermingling of bank assets and liabilities, with the result that if a large bank or a sovereign government wobbles, the reverberations may destabilise banking systems across the EU. A bank bail-out may affect creditors in several countries and lead to difficult questions on who should pay. Nor did the parents foresee the danger of ‘doom loops’: if a bank holds a lot of debt of its own government, which then in a crisis has to bail out the bank, a vicious circle may destabilise both. Such problems emerged after the financial crisis of 2008, which spurred the eurozone to create a ‘single supervisory mechanism’ and a ‘single resolution mechanism’ – including a small recapitalisation fund – for its banks.

Third, EMU’s architects should have created a lender of last resort – one that, in a crisis of confidence, could stabilise financial markets by lending to governments. In 2012, when there was a danger that the markets would tear apart the euro, the ECB plugged the gap by announcing a scheme known as OMT for buying sovereign bonds. This calmed the markets without being used. Also in 2012, governments set up the European Stability Mechanism (ESM), a €500 billion bail-out fund, which has provided credits to countries in difficulty. And in 2014 the ECB added ‘quantitative easing’ to its armoury, a bond-buying scheme for curbing deflation.

A fourth omission was the absence of any means to ensure that eurozone members adopted structural economic reforms, to prevent their economies diverging. The Maastricht treaty set convergence criteria as conditions for joining the single currency, but those covered only public debt, budget deficits, inflation and exchange rate stability (Delors lost the argument for an unemployment criterion).

At the time, the case for adopting economic rather than financial convergence criteria did not appear strong. The peripheral EU economies were growing faster than those of the core; some of them, including Italy, were enacting painful economic reforms in order to show their fitness for the euro; many people assumed that, since the southern countries would no longer be able to restore competiveness by devaluing, they would have no choice but reform; and the Commission’s own analysis suggested that poorer countries would benefit most from EMU, since their inflation and interest rates would drop rapidly.

And that is what appeared to be happening, at least in the early 2000s, as Greece, Ireland and Spain enjoyed credit-fuelled booms. But these obscured and in some ways worsened the growing divergence of competitiveness between the eurozone’s core and periphery. While the biggest problems have been in the south, France and even the fairly successful Germany have often ignored the Commission’s strictures on reform (Germany still suffers from over-regulated services markets and France from an inflexible labour market).

Flowing from this fourth problem was a fifth: too many countries joined the club too quickly. Karl Otto Pӧhl, the Bundesbank president during the Maastricht negotiations, expressed doubts about letting in the southern Europeans. So did Wolfgang Schäuble, now Germany’s finance minister, who as a senior parliamentarian in 1994 co-authored a paper calling for a group of core countries (but not Italy) to proceed with a single currency and federalism. They were right that several southern economies were not strong enough to flourish in EMU. But such concerns were cast aside in order to satisfy leaders who did not want their countries excluded from this grand prestige project.

Given these design flaws, the euro’s problems in recent years are hardly surprising. But eurozone leaders have taken important steps to make EMU work better, building the ESM, the banking union and OMT. They have done enough to preserve the euro but not to ensure economic growth across the entire monetary union.

An unholy alliance of federalists and eurosceptics argues that only the radical centralisation of economic decision-making in the eurozone’s institutions can ensure its long-term prosperity. But this will not happen in the foreseeable future. There is not enough trust among governments or agreement on what needs doing, and electorates will not support the transfer of substantial new powers to supranational institutions. But in any case the federalists and eurosceptics are mistaken. Though the mutualisation of eurozone sovereign debts or a mechanism for transferring money from north to south would be desirable, such revolutionary steps are not essential. The eurozone can in fact flourish with better policies.

The excessive, German-driven austerity imposed on the peripheral countries – which has led to deflation, shrinking economies and growing debt burdens – needs to be softened (and has already been somewhat softened over the past year). Countries such as Greece, Italy and France need to speed up structural reform. In Greece, public debts are unsustainable and need to be partially written off. In the long run, both the ESM and the bank recapitalisation fund will need more resources. And, crucially, Germany needs to rebalance its own economy: with an extraordinary current account surplus of over 7 per cent of GDP, stemming from low levels of investment and weak domestic consumption, it should be doing much more to generate growth at home and elsewhere in Europe.
When EMU was designed, many Germans feared it would turn into a French-led enterprise, pursuing un-Germanic policies. They need not have worried. The economic weakness of France, the diminished stature of the Commission, the introversion of Britain and the strength of the German economy have combined to leave Berlin in charge.

My biggest worry for the #euro's future is the intellectual isolation of #Germany’s financial elite

My biggest worry for the future of the euro is the intellectual isolation of much of Germany’s financial elite from the rest of the world. The problem is not so much that German policy-makers are wrong on everything – for example they are right that structural reform is essential and that Keynesians can over-prioritise the short term – but rather that some of them think they have little to learn from others. I have heard senior German figures speak of Southern European, French or Anglo-Saxon economic analysis contemptuously. I have also heard them refuse to consider the eurozone’s overall fiscal stance, while insisting that the German, French and Italian economies be treated as separate entities.

What the eurozone needs are not federal institutions – desirable though they might be – so much as a Germany that is more sensitive to its partners’ needs, less arrogant in dealing with them, more open to others’ economic thinking, and more willing to acknowledge that the eurozone economies all affect each other.

Charles Grant is director of the Centre for European Reform. An earlier version of this article appeared in Chatham House’s The World Today, October-November 2015.