The US-Russia reset is over

Can the ‘reset’ between Washington and Moscow survive Vladimir Putin’s return to the Russian presidency in May? That is a question I posed to many people on a recent trip to Moscow. Opinions differed, but some of the best-informed analysts and officials expected the reset to fade away.

Vice-President Joe Biden first used the term at the Munich Security Conference in February 2009, when he said that it was time to press the reset button in the US-Russia relationship. Barack Obama and Dmitri Medvedev, both recently elected as presidents of their respective countries, took up the challenge, and the climate between Moscow and Washington improved.

The reset brought considerable benefits to both sides. Moscow obtained an agreement on co-operation on civil nuclear power technology, help with its WTO membership application and an implicit understanding that the US would not directly challenge Russia’s key interests in its own backyard (for example, in Ukraine). The US benefited from Moscow allowing men and supplies for the NATO mission in Afghanistan to pass through Russia. Moscow refused to deliver S-300 surface-to-air missiles to Iran and in June 2010 agreed to more UN Security Council sanctions against that country. Both parties were happy to sign the New Start agreement that will reduce their strategic nuclear arsenals.

The warm personal chemistry between Medvedev and Obama contributed to the reset’s success. For example, their interventions sorted out some of the difficulties in the negotiation of the New Start agreement. And in March 2011, Medvedev’s decision not to veto UNSC Resolution 1973 – a decision opposed by Putin and much of the Russian security establishment – gave the US and its allies legal cover to intervene militarily in Libya.

Prime Minister Putin, who has remained the pre-eminent figure in Moscow during the Medvedev presidency, never used the word but allowed the reset to happen. The prospects for its continuation, however, look bleak. Putin has a less benign view of the US than Medvedev. During the recent presidential election campaign, Putin resorted to tough anti-American rhetoric, accusing opposition demonstrators of being paid by the US. He wrote an essay on Russian foreign policy, published in February in Moskovskie Novosti, which accused the US of promoting human rights and supporting humanitarian interventions simply to advance its own commercial and geopolitical interests. Those who have heard him talk in private say that Putin’s suspicion and mistrust of the US is genuine, rather than mere electoral rhetoric.

Arguments over human rights are likely to cause further strains in the relationship. Within Russia, NGOs funded by Western foundations or governments are facing new forms of harassment. The appointment of Mike McFaul – a longstanding advocate of democracy-promotion – as ambassador in Moscow has fuelled suspicions of US intentions. McFaul has been vilified in the Russian media for meeting representatives of NGOs. All this is likely to lead to more American criticism of Russia, fuelling more paranoia about Western plans to undermine Putin’s regime, and so on.

Another thorny issue is missile defence. Much of the Russian security establishment appears to believe that America’s plans for missile defence are aimed at Russia – though in Washington those working on missile defence say that Iran is the rationale (a handful of American thinkers also see China as a reason for investing in missile defence). Russian strategists are attached to the concept of ‘mutually-assured destruction’ and worry that American missile defence would necessitate a rethinking of that Cold War principle. Medvedev has threatened to respond to the US systems by deploying cruise missiles to Kaliningrad and building Russian missile defence systems.

However, some senior Russians do not view American plans for missile defence as a threat, at least until the early 2020s, when the US says it will deploy more sophisticated interceptors. But even then, some of these Russians acknowledge, the number of interceptors that the US intends to deploy could not significantly stymie Russia’s ability to rain nuclear missiles on the US. According to these Russians, the loud barks from the security establishment are an attempt to set red lines and warn the Americans that they should take Russia’s interests into account as they develop their system.

Syria and Iran are causing great strains. Russian strategists view the turmoil in the Middle East almost exclusively in terms of a conflict between Iran, on the one hand, and Saudi Arabia and the US on the other. Syria is not only Iran’s ally but also Russia’s best friend in the region. Russia has friendlier relations with Iran than with Saudi Arabia. The Russian government believes that geopolitics will drive the US to use force against not only Iran but also Bashar al-Assad’s regime in Syria. Most Russians believe that only ill will come of the Arab spring: the likely result in many countries, they predict, will be fundamentalist Islamist regimes backed by Saudi Arabia.

Putin is ardently opposed to any kind of humanitarian intervention in Syria. This position seems to be based partly on principle – the Russians are even more firmly attached than the Chinese to absolute state sovereignty. Their belief that the West abused the terms of UNSC Resolution 1973 to justify striking Libya has reinforced their hostility to Western intervention anywhere else. Their position is also based on realpolitik: Syria buys a lot of Russian arms, provides Russia with a naval base and helps to prevent US-Saudi dominance in the Middle East.

One subject that has fostered co-operation between Washington and Moscow is Afghanistan. Putin views the US presence in the country as a bulwark against the spread of Islamist fundamentalism. Russia and the US work together on counter-narcotics operations. But even on Afghanistan there are tensions: Moscow opposes both Washington’s schemes to retain military bases after its troops depart in 2014, and its plans to encourage the Afghan economy to integrate with those of Central Asia, on the grounds that they will increase America’s sway in the region. In any case, the Russians believe that once US troops leave the country, the Americans will have fewer reasons to co-operate with Moscow (though Washington still hopes that the two sides will be able to work together on counter-narcotics and counter-terrorism programmes).

In purely electoral terms, Obama is unlikely to suffer from a cooler relationship with the Russian leadership. His Republican challengers have attacked him for being soft on Russia. If Mitt Romney won the presidency, US-Russia relations would probably face a frosty period. If Obama won, though the reset of recent years would be unlikely to continue, both he and Putin would see good reasons to stop the relationship turning hostile. Russia’s seat on the UNSC means that the US needs its help in tackling Iran and other problems in the Middle East. And Russia knows that stormy relations with the West could damage its efforts to modernise its economy.

Russia also wants to avoid becoming too dependent on China, a country with which it currently enjoys good relations but that it mistrusts. For the time being, however, Putin appears to view US hegemony as a bigger danger than the rise of Chinese power. As he wrote in Moskovskie Novosti, he sees the emergence of the BRICS grouping (Brazil, Russia, India, China and South Africa) as geopolitically significant. “We have to co-ordinate more closely on foreign policy matters and work together more closely at the UN…When BRICS is really up and running, its impact on the world economy and politics will be considerable.” Whether the BRICS will ever be cohesive enough make such an impact is debatable. But Putin clearly has faith in the potential of the BRICS to constrain US power.

Charles Grant is director of the Centre for European Reform.

Tackling the scourge of youth unemployment

A fifth of young people in the EU are not in employment, education or training – a measure tagged with the ungainly acronym ‘NEET’. The problem is not confined to the usual suspects, like Spain (49 per cent) or Italy (29 per cent). Nearly a quarter of people under 25 are jobless or not in education in France, Sweden and the UK. Politicians are sounding the alarm. The EU’s Employment Commissioner, László Andor, recently stated that “without decisive action at EU and national level” we will create a “lost generation”. French president Nicolas Sarkozy condemns a “vicious cycle” of worklessness and deteriorating skills.

Are governments’ fears justified? The ‘NEET’ measure is not very accurate. It lumps together recent graduates, who face much shorter periods of unemployment than the low-skilled, with those who leave school at 16 with no qualifications and who may struggle to find work for the rest of their lives. Overall, young workers tend to be unemployed for shorter periods than older ones. And on average they have more family resources to rely upon than older unemployed people: many can live at home, and be bankrolled by their parents.

However, there is no doubt that prospects look bleak for Europe’s youth. They have fewer marketable skills than older workers on average, and hence find it hardest to get work in periods of high unemployment, not least because redundant workers with more skills ‘trade down’ to lower paid jobs. As Europe’s economic stagnation continues – it is already into its fourth year with no end in sight – more people will join the ranks of the long-term unemployed. The longer someone is out of work, the harder it is to get them back in: they lose motivation; they lose the skills they have through lack of use; and they are more likely to succumb to mental illness, alcoholism and drugs, and crime.

Politicians are right to demand that something must be done. But what? The best way to deal with unemployment is to get economies growing again. Easing up on the pace of fiscal austerity would alleviate pressures on labour markets. But governments have turned their backs on this solution.

Instead, many are continuing to deploy cheap policies that are unlikely to work in a downturn. In recent years, governments have turned to ‘work first’ policies to try to get workers to supply their labour, or employers to demand it, or both. The UK, for example, has started to demand that unemployed people do work experience or subsidised work in exchange for welfare benefits. But the evidence from a similar programme in Germany suggests that this approach raises average employment prospects only marginally, and actually reduces it for people aged under 25.

France has raised the percentage of young people large firms must employ if they want to avoid a penalty tax, while Spain is offering tax breaks to small enterprises to take on young people. Such schemes are unlikely to help much: they are limited to particular sizes of companies, in order to keep the costs low for the taxpayer, and so will only lead to jobs for a fraction of the jobless youth. Moreover, they have unintended side-effects. For example, firms have an incentive to switch older workers for younger ones, which will make no difference to the overall unemployment rate. France’s penalty tax may make firms less productive, by forcing them to take on more low-skilled young people. More importantly, ‘work first’ policies are ineffective in tackling cyclical unemployment, when demand for labour is depressed. When cyclical unemployment is high, there are more applicants than jobs, and pushing people to supply their labour while trying to coax or force employers to hire them will not work.

The best way to tackle youth unemployment in a slump is to invest in people’s skills. Investment in skills does two helpful things: it removes some young people from the labour market, making it easier for others to get jobs, and it improves the stock of skills the economy can draw on once demand recovers, which can help boost growth.

Participation rates in vocational training and university education among 18 to 24 year olds are low in many of the European countries struggling with youth unemployment. Between 40 and 43 per cent of young people in the UK, France, Spain and Portugal are in some form of education, compared to 53 to 60 per cent in Germany, the Netherlands, Denmark, Norway and Finland. The latter countries have much lower levels of youth unemployment than the European average.

If France boosted the proportion of young people in education and training to 50 per cent, the NEET rate would fall to 16 per cent. This would require the creation of 400,000 places. Such a move would reduce the number of young applicants per job by nearly a third, helping to ease pressure on the youth labour market during the slump.

Improving young people’s skills will also help Europe’s economy to be more productive in the longer term, and reduce structural unemployment. The returns on investment in human capital are very large, on average, which shows that training leads to more productive workers and thus higher wages and more employment. University graduates across the OECD earn €123,000 more than non-graduates over their lifetime, well above the €35,000 cost of their education. People who complete high school or take vocational courses make €43,000 more than those who do not, with the education costing an average of €19,000. A proportion of these extra earnings will eventually flow back into government coffers through higher taxes and reduced unemployment benefits. Furthermore, these costs do not take into account unemployment benefits and other social costs, which make the case for action even more compelling. At present, governments are currently paying vast sums in unemployment benefits, and young people are losing skills and motivation. Ongoing unemployment depletes the economy’s stock of human capital, reducing growth potential.

For countries that cannot or will not risk their public finances, there is an alternative. The cost of education can be passed on to students themselves, with the government providing the finance. This means that the cost of increasing the proportion of young people in either training or education need not endanger the government’s balance sheet directly. The UK may be a model to follow. It has introduced higher tuition fees with upfront loans to cover the costs of both university and vocational qualifications. The loan is repaid through the tax system once graduates and trainees are working and are earning more than a certain wage threshold. There is a low interest rate attached. However, the UK has not increased the number of places available, which is crucial for such a model to act as a safety valve for youth unemployment.

Europe faces a choice. It can continue to fiddle with small-scale, ineffective labour market policies for young people. Or it can invest in their human capital. It should choose the latter. Such a policy would open the way for stronger productivity growth once the current crisis has been overcome. In the interim, it would prevent young people from losing skills and motivation, and joining the ranks of the long-term unemployed. It would also make it easier for those that cannot or will not take up more education and training to find a job.

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

Oh no, Orban clone? The EU ponders Slovak elections

Hungary's Prime Minister Viktor Orban is the leader least beloved by EU governments and institutions. The European Commission thinks him too spendthrift and has launched proceedings against Hungary for breaching rules on budget deficits. The Venice Commission, a constitutional advisory body affiliated with the Council of Europe, has accused the government of amassing too much power and violating human rights. Orban has done little to win friends abroad: he called the European Commmission's action "extremely stupid" and compared the EU to the Soviet Union. So should European governments and officials be concerned that Hungary's neighbour Slovakia has just elected another firebrand, former Prime Minister Robert Fico, to lead its government? Is Orban a sign of a broader trend – is the economic crisis lifting populists to power in Central Europe?

At first glance, the two situations are similar. Much as Orban in Hungary, Fico will exert a dominant influence: SMER won a controlling majority in the Slovak parliament; for the first time in the country's history a one-party government will rule (SMER fell just short of winning enough votes to be able to unilaterally change the constitution). In his previous stint in power, in 2006-2010, Fico's ministers earned a reputation for corruption and poor stewardship of the economy: Slovakia's debt increased by one-third under his rule, and this was only partly due to the crisis (fiscal discipline crumbled even before the economy soured). Relations with the neighbours suffered too: under Fico, the Slovak National Party (SNS) – one of the three members in the prime minister's coalition – openly railed against 'the Hungarian enemy'. Little wonder that media in the region have been alarmed at Fico's return and are warning of 'Orbanisation' of Central Europe.

But on closer inspection, the differences between the two countries' political situations outweigh the similarities. In contrast to Orban's euroscepticism, Fico ran on a platform of turning Slovakia into a responsible EU citizen. This may have been partly a tactical ploy (to implicitly criticise some of the smaller centre-right parties of the outgoing government, which opposed the EU's bailout of Greece). But having made good relations with the EU a centrepiece of his candidacy, Fico seems intent to deliver. In one of his first post-election appearances on TV, the prime minister-designate agreed to be accompanied by the Slovak vice-president of the European Commission, Maroš Šefčovič – this appears to have been a calculated signal to Brussels that Slovakia will take the EU seriously. Fico also nominated the respected Miroslav Lajčák, currently one of the managing directors in the European External Action Service, to the post of foreign minister (which he already held in 2009-10). The odds are that the new government will be broadly supportive of commonly agreed solutions to the economic crisis though not necessarily contributing many ideas of its own – like other smaller new member-states, Slovakia has struggled to formulate original proposals on improving the way the EU works.

There are few signs for now that SMER is planning to build a one-party state, as many suspect Orban of doing in Hungary. Throughout the campaign, Fico stressed 'stability', implicitly rejecting radical reforms, political or otherwise. In keeping with the tradition, the prime minister-designate has offered two deputy chairmanships as well as a number of key committee chairmanships in the parliament to the opposition. Fico said that he would seek no changes to the constitution, which disperses power between the prime minister, parliament and the president. Granted, Fico controls the first two institutions and is friendly with the president. SMER alone also lacks the votes to change the constitution; it would have to ally with one of the centre-right opposition parties. The true test of Fico's tolerance for political diversity may come after 2014, if an opposition candidate wins the presidency. The outgoing but popular Prime Minister Iveta Radičová is rumoured to be considering a run, and if she wins, Fico may be tempted to tinker with the constitution to curb the president's powers. But for now, the prime minister-designate has gone out of his way to demonstrate that he is committed to pluralistic democracy.

As for relations with neighbours, Fico will have the benefit of ruling without the nationalists from the SNS – in fact, their party failed to clear the 5 per cent barrier necessary to enter the parliament, as has the Slovak Hungarian Coalition (SMK), which represents radical Hungarians in Slovakia and is close to Viktor Orban. For the first time in the country's recent history none of the nationalist parties will have deputies in the parliament. Instead, a newish party called Most/Hid ("bridge" in Slovak and Hungarian), which campaigns to improve ties between the two ethnic groups and fielded both Slovak and Hungarian candidates, has won seats in the legislature for the second term in a row. So Fico is well positioned to continue the outgoing government's policy of pursuing good neighbourly relations with Hungary. Whether he will do so is another matter; there is a lot of potential for trouble. The two countries disagree on Budapest's policy of giving passports to ethnic Hungarians living in Slovakia. Viktor Orban has publicly regretted the poor showing of the SMK, arguing that only 'ethnicity-based parties' can represent the interests of Hungarians in Slovakia. His rhetoric could sharpen further: Hungary holds parliamentary elections in 2014 and Orban faces opposition from the ultra-nationalist Jobbik party, which is gathering strength, especially among young voters. Sensible Hungarians worry that the prime minister may move even further to the right to fend off the challenge, which may include criticising the Slovak government's treatment of ethnic Hungarians. How Fico will respond is anyone's guess: in opposition, he has been more critical of Orban than Iveta Radičová, at one point calling Hungary "an extremist country". There is a possibility that Slovak-Hungarian relations will deteriorate amidst tit-for-tat accusations. 

People familiar with the prime minister-designate's thinking say that he wants the respect and recognition of his EU peers, and fears that his past record and Orban's presence across the border will taint him. Whether by agreeing to share some power with the opposition or by selecting respected Eurocrats for ministers, Fico is signalling that he is not Orban, and Slovakia is not Hungary. Despite these positive moves, it is too early to be conclusive: his government has not even formally assumed power yet. Among other things, the new administration will have to cut benefits and raise taxes to comply with the EU's new fiscal compact, so political opposition to SMER is likely to grow – and with it will the temptation to reach for populist rhetoric. The party's shady past may yet catch up with the prime minister-designate: SMER's financial backers will expect lucrative government contracts, so corruption could rise and fiscal discipline falter. But for now, Robert Fico seems intent to demonstrate that he is wiser and more respectable than he was in 2006-2010. And Viktor Orban in Hungary appears not to be a harbinger of a broader trend towards populism in Central Europe but a one-off.

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

Eurozone policy-makers place a big bet

Have eurozone policy-makers finally managed to lance the boil? They can certainly point to lower borrowing costs in Italy and Spain as evidence of stabilisation. Many of them argue that this demonstrates the success of the strategy of fiscal austerity and structural reforms. The more thoughtful among them acknowledge that borrowing costs in Spain and Italy have actually come down because of the ECB’s long-term refinancing operation (LTRO) – it has lent almost unlimited amounts of money in cash to the region's banks at 1 per cent, who in turn have bought Italian and Spanish debts. But they will then argue that this has carved out sufficient breathing space for structural reforms and fiscal austerity programmes to boost confidence and lift economic growth. There is no doubt the ECB has bought the eurozone time, but that time is not being used constructively. And the LTRO is storing up trouble for the future.

The ECB cannot support the banking system (and hence) the bond markets indefinitely. Its balance sheet has risen to close to 30 per cent of eurozone GDP. At some point the ECB will have to reverse its liquidity measures. To do this, the banking systems and bond markets of the struggling eurozone economies will need to have stabilised, and the banks will need to be in a position to start paying back the loans. This will require economic recovery. And here is the rub. Eurozone policy-makers base their confidence in the current strategy on the belief that the private sectors of the hard-hit economies are going to ride to the rescue. Indeed, they believe that austerity and structural reforms will make more households and firms confident to spend and invest. The problem with this analysis is that both households and business are hugely indebted and face a long period of deleveraging and/or face a very unfavourable economic environment. It is far from clear, for example, why already-indebted Spanish firms would suddenly start to invest in the teeth of falling demand. Nor is it clear why households – facing unprecedented unemployment – would increase spending. There is no reason to expect the private sector to pick up the baton.

The experience elsewhere in the eurozone's periphery demonstrates that tightening fiscal policy in the teeth of a recession is very dangerous. It can push highly indebted countries into a spiral that is tough to get out of. Nor are structural reforms any kind of panacea. Too many policy-makers and commentators attribute Greece's difficulties to the Greek authorities' failure to push through sufficient structural reforms over the last two years. This, they argue, has destroyed business confidence and investment in the country. There is no doubting the need for structural reforms in Greece, but the collapse in investment reflects the fact that firms cannot access capital and foreign businesses and banks are now loath to do business with their Greek counterparts because of the risk of default. Despite having pushed through a series of structural reforms over the last two years, Portugal is only a few months behind Greece. Business investment is collapsing and the country remains firmly shut out of the capital markets. Private sector forecasts expect the economy to contract by at least 5 per cent this year, with the economy sliding further into a debt trap.

There is scant reason to expect fiscal austerity to be any less destructive in Spain than in Greece or Portugal. Fiscal austerity of the order required by the EU will simply push the Spanish economy into a slump, which in turn will worsen the debt position of the private sector, amplifying the required amount of deleveraging, and ultimately how much private debt ends up on the state's books. Italy is in a stronger position than Spain, in that the country has much lower levels of private sector indebtedness. But if Spain slides into a depression, Italy will not escape contagion. The country's borrowing costs will remain very high, further weakening its public finances and pushing up borrowing costs for the private sector (public sector borrowing costs are the benchmark for the private sector).

In the circumstances, the Spanish government is absolutely right to spurn EU demands that it cut Spain’s budget deficit from last year's figure of 8.5 per cent of GDP to 4.4 per cent this year. But even the compromise target of 5.3 per cent (falling to 3 per cent in 2013) will undoubtedly prove impossible and result in an even deeper recession than the country already faces. Most forecasters already expect Spanish GDP to contract by 2 per cent this year, implying a big jump in the ratio of public debt to GDP. The current strategy is the worst of both worlds: it does little, if anything, to bring down public deficits but leads to a dramatic worsening of debt trajectories as the volume of debt relative to GDP rises rapidly. In short, it risks a repeat of Greece and Portugal.

Could exports come to the rescue? The solution propagated by 'austerians' is a so-called internal devaluation. Austerity and private sector wage cuts will lower inflation and costs and bring about improved trade competitiveness within the eurozone. This might just about be possible if German inflation were to surge, enabling these peripheral countries to improve their competitiveness without deflating nominal GDP. But this will not be allowed to happen. The ECB will raise rates to ward off the threat of higher inflation in Germany. In the run-up to the financial crisis, the ECB held rates too low for the needs of the eurozone as a whole in an attempt to boost the then ailing German economy, in the process helping to inflate the bubbles in the periphery. The perceived needs of the German economy will almost certainly take precedence again. And for obvious reasons. If the ECB allowed German inflation to surge, political support for euro membership in Germany could disintegrate.

The eurozone crisis is to a large extent an economic growth crisis and the ECB's LTRO does very little to address that. It will not slow the pace of bank deleveraging across the eurozone. It does little to deal with the aftermath of the asset price collapse or of massive misalignments in real exchange rates. Without a return to economic growth, the banks will not keep buying sovereign debt and will not be able to pay back the ECB. Indeed, the LTRO may ultimately make things worse, because it further concentrates risk in the struggling economies. Their banks have had to place decent collateral with the ECB in return for the money they have borrowed. In place of this capital they now have more of their own countries' sovereign debts. So the LTRO could actually worsen the rather poisonous nexus between sovereigns and banks.

The eurozone needs Monti, Rajoy and François Hollande (assuming he wins the upcoming French presidential election) to steer Europe away from the current dangerous course. The Italian and French governments have a strong vested interest in supporting the Spanish government, as a full-blown crisis in Spain would engulf Italy and ultimately France. However, the obstacles to such an alliance are formidable, not least the differences between Monti and Rajoy on the one side and Hollande on a range of economic and social issues. The Italian and Spanish leaders would have to persuade Hollande of the case for market-led reforms. Only then could they hope to overcome German opposition to debt mutualisation. However, much of the French policy elite fears that any open criticism of the German position would undermine the Franco-German alliance, in the process weakening French power and influence in Europe. The problem they face is that their current strategy of managing the eurozone crisis is bringing about the loss of influence they hope to prevent. 

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

Europe’s growth strategy: All supply and no demand

To say that Europe has a growth problem is an understatement. Almost four years since the outbreak of the global financial crisis, only a handful of EU countries (Austria, Belgium, Germany, Slovakia, Sweden and Poland) have seen their economic output return above pre-crisis levels. In all the others, output is still below its peak in 2008 – in some cases dramatically so. Greece, Ireland and Latvia have endured catastrophic declines. But even in Italy, Spain and the UK, where the downturns have been less dramatic, output has already taken longer to return to pre-crisis levels than it did during the Great Depression of the 1930s. If this were not bad enough, many economies contracted in the final quarter of 2011 and will fall back into recession in 2012. How to explain this debacle?

Ask European policy-makers what their growth strategy for the region is, and chances are they will identify two ingredients. First, they will say, countries across the EU must push through structural reforms to improve the supply-side performance of their economies. Labour markets must be reformed; goods and services markets opened to greater competition; spending on research and development boosted; the EU’s single market deepened (notably in areas such as the digital economy); and so on. Second, they will argue, governments must restore confidence and lift ‘animal spirits’ in the private sector by consolidating their public finances. In combination, structural reforms and fiscal austerity will restore the region to long-term ‘competitiveness’, and consequently to economic growth.

The problem with this story is two-fold. The first is that supply-side reforms, though necessary over the medium to long term, are mostly irrelevant in the short term. Few observers doubt that EU countries, particularly those across southern Europe, would be well-advised to take supply-side reforms more seriously than they did under the Lisbon agenda. If they did, their productivity and living standards would rise over the medium to longer run. But to propose such reforms as an answer to Europe’s immediate growth problem is to miss the point: it is to provide a long-term (supply-side) answer to a short-term (demand-side) problem. Deepening the EU’s single market is a perfectly sound idea. But it will do nothing to offset the immediate impact of private-sector ‘deleveraging’ on demand.

If the first prong of Europe’s growth strategy is beside the point in the short term, the second is positively damaging. For the past two years, policy-makers across Europe seem to have persuaded themselves that fiscal consolidation will boost growth. Jean-Claude Trichet, for one, repeatedly dismissed claims that budgetary austerity would depress growth, arguing that “confidence-inspiring measures will foster and not hamper recovery”. Similar claims were made by other policy-makers, inside and outside the eurozone. The trouble is that these assertions had little evidence to support them. As a careful study conducted by the IMF concluded in 2010, “fiscal consolidations typically lower growth in the short term”. In other words, their net effect on demand is contractionary, rather than expansionary.

It is important to be clear about the short-term impact of fiscal policy because several EU countries are now in a very special kind of downturn: they are in ‘balance sheet recessions’. Such recessions are what follow when debt-financed asset price bubbles burst. Since asset prices fall but liabilities do not, households and firms trim spending as they scramble to reduce their debts. In balance sheet recessions, monetary policy loses its potency because households and firms are less inclined to borrow and spend (even with short-term official interest rates close to zero), while banks (which have balance sheet problems of their own) are reluctant to lend. When the financial health of the private sector is so weak, fiscal policy is the only macroeconomic policy instrument left with any kind of traction.

When Lehman Brothers failed, governments across Europe allowed their budget deficits to rise sharply. But the Greek sovereign debt crisis has since persuaded all of them to reverse course. Greece is paying the price for its past profligacy, and every country is desperate to persuade the financial markets that it is not the ‘next Greece’. Austerity is now the order of the day. But synchronised austerity is the opposite of policy co-ordination. And it is self-defeating. Tightening fiscal policy when monetary policy has lost traction depresses GDP more than would otherwise be the case. And when numerous governments are cutting spending at the same time, the contractionary effect on GDP is further magnified. Countries across the EU are cutting their budget deficits, yet still seeing their ratios of debt to GDP worsen.

A key question is whether governments have any choice. Many think they do not. The British government, for example, believes it has avoided Greece’s fate only because of the ambition of its fiscal consolidation plans. The problem with this explanation is that Japan can issue government debt more cheaply than the UK, even though its public finances are weaker than Greece’s. This suggests that the UK could, if it so wished, slow the pace of fiscal consolidation without losing the confidence of the bond markets. But it also suggests that members of the eurozone enjoy no such choice. Because they are not the sole masters of the currency in which they issue their debt, some are effectively being forced to tighten fiscal policy even when, as in Southern Europe, this is economically self-defeating.

The short-term problem for Europe, then, is that demand across much of the region is chronically weak – and that fiscal policy is making matters worse. In balance sheet recessions, when households and firms cut spending and become net savers, governments must step into the breach by borrowing and spending. People who worry about the resulting deterioration of public finances should remember three things. First, large fiscal deficits are merely the counterpart of the increase in net savings among households and firms. Second, in balance sheet recessions fiscal deficits do not ‘crowd out’ private spending. And third, if governments cut spending when the private sector is ‘deleveraging’, activity will contract (unless foreigners come to the rescue by borrowing and spending more themselves).

The case against Europe’s growth strategy, then, is that it is all supply and no demand. There is no question that structural reforms are urgently needed to boost long-term growth. But fiscal policy is being tightened too rapidly. Europe has turned what should have been a marathon into a sprint. Governments are cutting public spending before private-sector balance sheets have been repaired. The result is that the more certain EU countries do to balance their budgets, the more output contracts. Fiscal virtue, in short, has become an economic vice. Not only does it risk pushing economic output in countries such as Spain the way of Greece, Ireland and Latvia. But it also risks discrediting much-needed structural reforms by associating them in voters’ minds with collapsing activity and rising job losses.

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

Pressure and tact are the right response to Victor Orban

Viktor Orban's FIDESZ party won a constitutional majority in the Hungarian parliament two years ago on a promise of purging the country’s politics of the remnants of communism. The prime minister had a point: unlike neighbouring Central European states, Hungary had moved from communism through compromise, not revolution, so many of the old system’s worst traits including rampant tax evasion and addiction to debt have been preserved or worsened. When Orban promised to “complete regime change”, he had the backing of most Hungarians, even if many suspected the prime minister’s political instincts, and worried that he lacked a clear programme and a team with the expertise to reform the country.

Two years later, Orban is in open conflict with his country’s opposition and much of the West. Critics hold him responsible for a series of confusing, counterproductive and sometimes contradictory economic measures, such as the de facto nationalisation of the private pension system. They also suspect him of trying to build a one-party state. The EU, too, is alarmed, and the European Commission initiated court proceedings against Hungary, chiefly over measures that curb the powers of the country’s central bank. But the West should resist the urge to isolate Viktor Orban, as it does with Belarus’ Alexander Lukashenko. Orban has genuine support from the majority of Hungarians, who believe that the country is on the wrong track and needs deep reforms. While many of the prime minister’s steps have been undemocratic, Orban has proven to be a pragmatist, capable of adjusting course. The EU’s goal in Hungary should be to steer his government away from damaging undemocratic ideas towards needed reforms.

Orban inherited a country in terrible economic and political shape. The brief period of reforms of the 1990s improved living standards, brought in foreign investment and generated some growth, but not enough to repair the country’s finances. The Socialist government that immediately preceded Orban's increased debt from 53 per cent to 80 per cent of GDP during eight years in power – this was before the economic crisis, so the growth in debt cannot be attributed to Keynesian measures to stimulate the economy. Shortly after Orban had assumed power, the global economic crisis hit Hungary hard, eroding the value of the forint and plunging thousands of holders of foreign-denominated mortgages into insolvency.

Orban's response, similar to that of other governments west of Hungary, has been to protect the middle classes from the effects of the economic crisis, and to find a better economic model for Hungary. He sees that Europe is in a profound crisis, and is trying to make the economy more 'national', less dependent on outside investment (that is why the prime minister imposed one-off taxes on mostly foreign-owned big banks). In foreign policy terms, Orban sees Hungary as firmly within the EU and the West; he is no Vladimir Putin. The prime minister simply thinks that Hungary needs to be more self-reliant, as the West is facing tremendous challenges. Orban assumes that the EU’s influence – and possibly its borders too – will be shrinking for the foreseeable future, so he is trying to position Hungary for existence in a buffer zone, outside Europe’s core and close to its eastern fringe. He would like to have a stronger Central Europe, but the Poles reserve their time and attention for the Germans and the French and ignore Hungary. Orban, for his part, ignores Slovakia, another natural would-be partner, preferring to act as spokesman to the latter country’s large Hungarian minority rather than a partner to the Slovak government.

The trouble with Orban’s reforms is that, good intentions notwithstanding, many have been wrong-headed. Economic measures such as the de facto nationalisation of private pension funds or ‘windfall’ taxes on banks have scared foreign investors without renewing economic growth or reducing the country’s large debt. Given that the Hungarian economy greatly relies on exports to the rest of the EU, Orban is bound to fail to completely insulate it, and it is probably fruitless to try. Moreover, the prime minister is deliberately shirking from taking the necessary measures, which would be required to make Hungary truly self-reliant. He should be making serious budget cuts to reduce dependence on foreign lenders. But while Orban has made some savings by reducing the number of public servants and the defence budget, most of his energy is spent elsewhere, such as on forcing the banks to allow the middle classes to repay foreign currency-denominate mortgages at rates below market ones.

Besides a dubious list of priorities, Orban also has a profoundly undemocratic tendency to equate his own government and party with the state. FIDESZ thinks and acts like a clan; it is suspicious of other parties and opinions and seeks to minimise the opposition’s input into law-making, using expedited procedures to pass laws even though FIDESZ holds a comfortable two-third majority in parliament. The EU has rightly criticised him for curbing the freedom of media and packing government institutions with party cronies. Critics worry that in addition to finishing the ‘revolution’ by reforming the economy, Orban has also chosen to cement the power of his party, where his control is unquestioned, over democratic institutions.

But the EU and Orban’s domestic opponents need to tread delicately. FIDESZ’s policies are deeply rooted in the Hungarian society, and Orban remains one of the few Hungarian politicians with a vision of how to reform the state, even if it is in parts dangerous. Indeed, while voters have grown dissatisfied with Orban’s conduct, support for the opposition has barely increased. Hungarians are unhappy with the prime minister’s implementation of policies rather than his broad goals. They want Orban to do better, not necessarily to go.

The European Union’s best response to Orban’s excesses is to ‘play the ball, not the man’: to make a principled argument against those policies that deserve criticism, not to attack the prime minister personally. Orban is fundamentally a pragmatist. Behind the bluster hides a man capable of adjusting course, even if he never states so openly. Upon heavy European criticism, Hungary’s constitutional court annulled some provisions of the media and criminal procedure laws, because “certain passages in the laws contravened the constitution and international agreements”. The government also withdrew its controversial law on religion before the Constitutional Court could decide on its legality. The constitution will almost certainly be amended again to avoid a showdown with the European Commission over independence of the Hungarian central bank. Although the FIDESZ public relations machine hailed these changes as great victories, they were above all retreats. And they suggest that Orban will respond to pressure, as long as he is given the possibility and time to ‘save face’. The reverse is also true: the more the EU attacks Orban personally, the more each policy change looks to the Hungarians as a defeat for the prime minister, and the less incentive Orban has to compromise.

EU countries must also take care not to overstate their case lest they fuel nationalism and euro-scepticism in Hungary. The policy of giving passports to Hungarians living outside the country is a good example: some EU countries such as Slovakia (though not the EU institutions) criticised it. They should reconsider. The policy is not necessarily against European law; Romania practices it and Poland has introduced the Polish card for its minority. Until 2005, Slovakia too gave passports to people even if they did not reside in the country.

The EU governments and institutions are right to devote so much time and energy to Hungary: of all EU countries, Hungarian democracy seems most imperilled. The EU’s best way to check Victor Orban’s undemocratic tendencies is through principled and well informed pressure. But it needs to handle Hungary with care: if it attacks Orban personally, the EU risks losing influence over the prime minister, with Hungary sliding into certain isolation and possible poverty. That would be a terrible outcome for the country, its neighbours and the European Union as such.

Balázs Jarábik is associate fellow at FRIDE; he also heads the Kiev office of Pact, Inc., an NGO supporting civil society and media projects in Eastern Europe.

Russia is not completely wrong about Syria

Russia has been roundly criticised for vetoing a draft UN Security Council resolution aimed at stopping the violence in Syria and ousting President Bashar al-Assad. Moscow is reluctant to give up on the al-Assad regime for the moment: it has a direct interest in the survival of the regime, which buys its arms and provides a naval base; it is strongly opposed to Western-led interventions, on principle; it believes that Arab revolutions are likely to lead to takeovers by Islamic fundamentalists; and it is still fuming that, after it refrained from vetoing UN Security Council resolution 1973 on Libya – about the protection of civilians – the West abused the resolution by using it to justify regime change.

However, Russian diplomats concede that change is inevitable if the violence in Syria is to be contained. Russia wants a managed transition that preserves its influence. The draft UNSC resolution called for the confinement of the Syrian army to barracks and endorsed the Arab League plan for al-Assad to hand over power to his vice president prior to the holding of elections. Russian diplomats are right to say that such a resolution would have been unenforceable and, if implemented, would have led to the sudden collapse of the Syrian government without a credible alternative to take its place. Anarchy could have ensued. The Kremlin may be playing realpolitik and taking pride in blocking the West, but it has a point.

Western leaders have been sincere in expressing revulsion at the continued crackdown by the Syrian military upon largely peaceful protestors. But their diplomacy has been ineffective. Preferring to issue ultimatums from afar, they have given up on dialogue with the Syrian regime when there is no other viable alternative.

A number of diplomatic rules have been ignored by Western governments in Syria. First, never rule out force publicly even if you have done so privately. The numbers killed in Syria are beginning to dwarf those murdered by the Gaddafi regime prior to the NATO intervention in Libya. The brave political decision by European leaders to come to the aid of the Libyan people should have reverberated throughout the region, sending a warning to Syria and other dictatorships in the region. The message should have been clear: nothing is off the table if you murder your own people. Instead, from almost the moment the protests in Syria began, Western leaders fell over themselves to tell Syrian President Bashar al-Assad that he had nothing to fear, since military intervention was simply unthinkable no matter what he did. Western diplomats say that this was necessary in order to secure Chinese and Russian support at the United Nations. That is correct, but such assurances could have been provided discreetly, while the regime in Damascus was left to guess about NATO's real intentions.

Second, the main function of an embassy is to act as a liaison with a host government, even one as odious as that in Damascus. The closing of Western embassies has had little effect upon regime behaviour but has blocked channels of communication. Despite ruling out military intervention or the provision of assistance to defectors from Syria's armed forces, Western diplomats have not managed to do much about Syria other than criticise the violence and call on President al-Assad to stand down.

Western leaders have painted themselves into a corner. They have misread the situation on two counts: firstly, they have assumed that the removal of al-Assad is critical towards ending the violence and issued ultimatums to that end. Secondly, they have also over-estimated the weakness of the Syrian regime and the willingness of the military to turn upon its leaders. The President of Syria is no Gaddafi – power is distributed more horizontally among the elite in Syria, and the President's control over the security services is by no means absolute. The removal of al-Assad by itself would not solve much unless accompanied by a broader commitment to reform. Syrian military leaders have now gone too far to turn back. As in Spain at the end of the Franco dictatorship, they will want assurances that a transition will not mean prison or worse for them and their supporters. Moreover, they are not being defeated – on the contrary, defections have so far been minimal and they believe that they have groups such as the Syrian Free Army on the back foot.

Third, do not encourage regime change without any concept of how, and with what means, such a revolution might come about. The West should have learned this lesson after the slaughter of Iraqi Shia rebels who rose up against Saddam Hussein in 1991 – when the insurgents received nothing more than words of support despite expectations of financial aid and military equipment. Also, if political and economic sanctions are to be the exclusive means of weakening the Syrian regime, it is essential that neighbouring countries are on-side. Here the West has put too much faith in the Arab League. The Arab League may have become more vocal, supported by countries such as Saudi Arabia that have long resented Syria's ties with Iran, but it remains incapable of enforcing its resolutions.

The Syrian government knows that Arab League resolutions are toothless, and that they have supporters in key neighbouring Arab countries, notably Prime Minister Nouri al-Maliki in Baghdad and leading figures in the Lebanese government. Economic sanctions may yet prove to be fatal, but like Chinese water torture, they will need time to take effect. Iran is increasing its support while Turkey, after a brief period of sabre-rattling, has gone cool on the idea of military intervention. Damascus also knows that calls by the Qatari government for intervention by an Arab peacekeeping force will come to nothing.

The West should try to rein in efforts by Gulf countries to arm a range of insurgent groups, many of which are deeply mistrusted by important minority groups such as Syria's Kurds and could do significant damage to the credibility of the opposition movement. Syria badly needs a credible shadow government to negotiate with external parties. Until one emerges, Western diplomats should discourage the distribution of weapons to disparate groups feuding for leadership.

Given the enduring strength and resistance of the Syrian regime, and the lack of any immediate military means to weaken it, it is disappointing that Western countries have all but cut off diplomatic contacts with Damascus. The West should re-start diplomatic dialogue with Syria without pre-conditions. In the end an unsavoury deal such as that made with President Ali Abdullah Saleh of Yemen – granting him immunity from prosecution – may be appropriate for key members of the Syrian elite. Western leaders need to grapple with what an acceptable deal could look like. Issuing statements that condemn a regime is easy; but it is tough diplomatic negotiations with the government in Damascus that can best help the Syrian people.

However, there are limits to the role Western diplomacy can play. Although the West can embark on a supportive dialogue, it is now impossible for the West to play a leading role as an intermediary in the conflict. A trusted interlocutor is urgently required to negotiate a credible transition in Syria. Such leadership cannot come from Europe, the United States, the Arab League, or Russia – none of whom are trusted by all sides. UN Secretary General Ban Ki-moon has been content to sit on the side-lines, choosing not to deploy his 'good offices' in the manner of his more courageous predecessors. It is time to appoint a UN Special Representative to engage with the regime and opposition alike. Even if his or her proposals are ultimately rejected by Moscow or Washington, some options are better than none.

Edward Burke is a research fellow at the Centre for European Reform.

France: Why the self-flagellation?

President Sarkozy wants France to become more like Germany. In a recent speech he made 15 positive references to the German economic model. Unlike France, he argued, Germany had reformed its economy and was reaping the rewards in terms of improved competitiveness and superior economic performance. He bemoaned the alleged decline in French industrial prowess and praised Germany’s success at defending its industrial base. Is Sarkozy right to be so critical of French performance? And would it make sense for France to emulate the German model?

Sarkozy is certainly right that Germany is a more industrial economy than France. The share of the French economy accounted for by industrial output is as low as in Britain (a country Sarkozy likes to deride as ‘having no industry’) and lower than the US. Germany’s share of world export markets has also held up remarkably well over the last ten years, whereas France’s has fallen steadily. However, the relative size of a country’s industrial sector has no bearing on its economic success. Just look at Italy, which has a comparably-sized industrial sector to Germany, but which is easily the worst performing large developed economy. Japan also has a very large industrial sector but has stagnated for much of the last 20 years.

France actually has a decent economic record relative to Germany’s. Between 1992 and 2001, France managed annual GDP growth of 2.1 per cent compared to Germany’s 1.6 per cent. Over the subsequent ten years – 2002 to 2011 – both countries grew by (an admittedly poor) 1.1 per cent per year. Although the German economy performed better in 2010 and 2011 than its French counterpart, the two countries’ growth prospects are very similar, at least according to the European Commission, the IMF and the OECD. All three forecast growth of around 0.5 per cent in 2013 and 1.5 per cent in 2013. Perhaps the best measure of economic performance is productivity. Productivity per French worker is somewhat higher than in Germany, while productivity growth averaged 0.7 per year in both countries between 2002 and 2011.

As recently as mid-2008, rates of joblessness were the same in the two countries. But Germany’s labour market performance has been superior to France’s over the last three years. By the end of 2011 the rate of unemployment had fallen below 6 per cent in Germany, whereas it has risen to almost 10 per cent in France. There is a demographic element to this – because of its very low birth-rate Germany has far fewer people entering the labour market than France. But there is clearly something else at play. The so-called Hartz reforms under the previous German government undercut the bargaining power of labour, and succeeded in pricing workers back into employment, albeit often on very low wages. Adjusted for inflation employee wages fell by 2 per cent in 2002-2011, compared with a rise of over 10 per cent in France. This, in turn, had an impact on private consumption. Over the same period, private consumption grew by just 4 per cent in Germany, against 17 per cent in France.

To the extent that Germany has become more ‘competitive’ this reflects wage restraint, not superior productivity growth. Wage restraint (and the resulting weakness of inflation) meant that Germany’s so-called real effective exchange rate within the eurozone fell by 17 per cent between the beginning of 1999 and the third quarter of 2011, making its exports much more price competitive. Over the same period, France’s real effective exchange rate rose by 4.4 per cent. Germany’s internal devaluation contributed to a big divergence in the two countries’ relative trade positions. Whereas ten years ago France and Germany both had small current account surpluses, France is now running a deficit of around 3 per cent of GDP, while Germany is running a surplus of 6 per cent. This is understandably causing anxiety in official circles in France.

France and Germany have similar levels of public debt, at just over 80 per cent of GDP. But France is running a bigger budget deficit. Whereas Germany’s fell to a little over 1 per cent of GDP in 2011 (compared with 4.3 per cent in 2010), France’s stood at 5.7 per cent (down from 7.1 per cent the previous year). There is no doubt that France needs to strengthen its public finances, but it is worth making a couple of points. First, the French government has been more concerned with maintaining growth in domestic demand than its German counterpart. Second, over a third of the difference in the size of the deficits in 2011 was accounted for by much higher levels of public investment in France – 3.2 per cent of GDP compared with 1.7 per cent in Germany (the second-lowest level in the EU).

The French president is right to be worried about France’s economic performance. In common with most of Europe, the country is in a rut. But it is important that the second biggest economy in Europe draws the right lessons from what has happened across the Rhine. France undoubtedly needs to reform its labour market. At present, so-called insiders – those with full-time jobs – enjoy comprehensive rights and generous entitlements. But this acts as a disincentive for firms to hire people on full-time contracts, condemning the young to a precarious existence on temporary contracts. However, Germany’s labour market reforms might not be the best blue-print for France. Germany has only been able to pursue such a strategy because others have not. If France really does attempt to emulate German wage restraint, it could prove a largely zero-sum game, depressing domestic demand in France (and hence across Europe), in the process worsening the eurozone crisis.

There are plenty of things that other EU countries, including France, can learn from Germany. But they need to be clear about what those things are. A large industrial sector and a big trade surplus are not necessarily signs of economic prowess. And for every country running a trade surplus, there has to be one running a deficit. France has its share of weaknesses. But in some important respects the French model – where the economy is largely propelled by domestic demand – holds out better prospects for a return to economic growth across the eurozone than does the German one.

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

Greece's real challenge

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Why France is leaving Afghanistan

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

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

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

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

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

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

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

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

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

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

Edward Burke is a research fellow at the Centre for European Reform.