by Charles Grant
For the first time in the history of the EU, Germany is the unquestioned leader, and France is number two. Since the financial crisis struck in 2008, the economic inequality between France and Germany has grown. Although regular summits between Angela Merkel and Nicolas Sarkozy maintain the appearance of parity, France's higher levels of debt and public spending, its lower level of exports, its less well capitalised banks and its rising borrowing costs vis-à-vis Germany have forced it to accept German leadership on economic policy.
Last week I talked to officials in Paris about the eurozone crisis. The franker among them admit that on many of the key arguments – should the eurozone be run according to strict rules that minimise the scope for political discretion, should there be a treaty change, should the European Central Bank (ECB) intervene massively to support governments in trouble, and so on – German views have prevailed.
French officials fret about the sustainability of the euro. Their analysis is similar to that of the Anglo-Saxons: they worry that the German medicine being applied to the eurozone ignores the importance of demand and growth, and that few German policy-makers understand financial markets. But unlike the Anglo-Saxons, they think it better not to lecture the Germans in public on what they should do. The French think that the Germans will probably do what it takes to preserve the single currency, in the end. But several officials expressed the concern that, by the time the Germans decide to move, it may be too late to save the euro.
The French are reticent about the German plan to change the EU treaties. They assume that a new treaty will have to be preceded by a convention, as was the constitutional treaty. But when the convention – consisting of MEPs and national parliamentarians, as well as governments – meets, can the Germans ensure that it discusses only the euro, rather than every subject under the sun? Then there is the difficulty of ratifying a new treaty. The Irish, for example, would have to hold a referendum and in their current mood would probably vote no. But the French are going along with treaty change, because they hope that a new treaty with strict rules on government borrowing will make it easier for the Germans to change their current policies on the euro. In the short term that means accepting that the ECB should become a lender of last resort to eurozone governments.
In the forthcoming treaty negotiations, the French want to balance the German emphasis on budgetary discipline with some distinctively French thinking. Officials talk of treaty articles on economic growth and the co-ordination of macro-economic policy, tax rates and labour market rules. They also want to amend Article 136 of the Treaty on the Functioning of the European Union, which allows the eurozone countries to adopt new rules on budgetary discipline. The French want to broaden the scope of that article, beyond the Germanic preoccupation with budgets.
The French hope that the new treaty will pave the way for eurobonds, but know that collective eurozone borrowing only makes sense once budgetary policy has been centralised, which will take several years. In the meantime the French think that the eurozone needs a European Monetary Fund (EMF) to support countries in trouble. An EMF would, like the IMF, lend to countries that cannot borrow commercially, and set conditions. It would also lend preventively to countries that might face problems. It could be based on the European Stability Mechanism, the bail-out fund that is currently under construction.
Many parts of the French government would be happy to see an EMF become a rival source of expertise and power to the European Commission, though the Trésor has doubts about such duplication. France would like an EMF to take decisions by majority vote, so that it could move quickly and not worry about, say, a potential Slovak veto. But the Germans generally prefer unanimous decision-making on bail-outs.
The UK is in bad odour in Paris. Public lectures from David Cameron on what the eurozone should do have gone down badly (even though the French share much of his analysis). The French think the UK hypocritical: it says it cares about the single market but then wants special protection for the City in any new treaty – which as far as the French are concerned would be opting out of the single market. Would the French accept a special deal for the City in a new treaty? "Not if it erodes the concept of majority voting", said one official.
Like the Germans, the French say that if the UK asks for too many treaty opt-outs, they will go for a treaty that covers only the eurozone, or only countries in the euro plus those which plan to join it. The Germans are keen for the treaty to cover all 27 member-states, if possible, to make it easier for the Commission and European Court of Justice (ECJ) to discipline miscreants; the French, always sympathetic to the idea of a core Europe, are more relaxed about a treaty for fewer than 27. French officials disagree on whether it would be feasible for a eurozone treaty of 17 or 17+ to give the Commission and the ECJ a significant role. But they are all reluctant to see the ECJ involved in fining governments that breach eurozone rules.
At the moment, France and Germany are both hostile to the Commission but the French are even keener to minimise its role in managing the euro. They question its professional competence and worry about commissioners from non-euro countries voting on sanctions against, say, France. Paris wants such commissioners excluded from decisions on eurozone governance. The Elysée and the Matignon (the prime minister's office) are more negative about the Commission than the Quai d’Orsai or the Trésor – which think the Commission has a useful role to play in applying the recently adopted laws on budget discipline and eurozone imbalances.
But they are all critical of President José Manuel Barroso for his alleged "lack of vision". The French accuse the Commission of being invisible during the crisis and of not taking enough initiatives – though one official admitted that if it had been more active France would have complained. Among the criticisms I heard last week were that the Commission should have done more during the last decade to warn of the Irish and Spanish economies overheating; that it has pushed ahead with an EU-Mercosur trade accord, though this will harm French farmers and Mercosur has not offered reciprocity; and that although in July the EU asked the Commission to set up a task force to help Greece speed up reform, the task force did not start work till October.
François Hollande, the Socialist presidential candidate, has not yet said much of note on the eurozone crisis or the future of the EU. But he comes from the pragmatic, broadly pro-European wing of his party and his line on the EU is unlikely to be very different from that of Sarkozy. In fact Marine Le Pen, the leader of the Front National, brackets the Gaullists and Socialists together, saying that they are both - unlike her - for globalisation, the EU, the euro and immigration ( Marine Le Pen and the rise of populism). She is also an unremitting critic of the EU’s 'undemocratic' nature.
French policy-makers know that with national budgets likely to come under greater eurozone control, they will need to have an answer to those who claim that the EU is undemocratic. There is no love for the European Parliament in Paris. But officials talk of giving national parliaments a role in eurozone governance. They support Joschka Fischer's idea for a new committee of national parliamentarians to hold eurozone institutions to account.
The French government worries about Le Pen – who is currently polling between16 and 21 per cent. In past presidential elections the Front National has scored better than the polls predicted. If the euro crisis worsens, and requires France to adopt painful austerity measures, Le Pen's implacable hostility to the single currency could earn her extra votes. She could get through to the second round of the presidential election in May 2012, as her father did in 2002, though she could not win. The presidential election is unlikely to change the broad thrust of France's EU policy, but the euro crisis and the increasingly dominant role of Germany could push the French people in a eurosceptic direction.
Wednesday, November 30, 2011
Tuesday, November 29, 2011
The curious case of German leadership
By Katinka Barysch
Some of Germany’s European partners accuse Chancellor Angela Merkel of refusing, or failing, to lead properly in the euro crisis. Many Germans agree with that analysis and call for Merkel to guide the rescue efforts with a firmer hand and more vision. Just as many, however, think that Germany is actually leading well, and that this is not sufficiently acknowledged. As one opposition politician put it to me during a recent Berlin visit: “Germany is expected to lead, and if we do, we are criticised as arrogant – unless it’s in line with what others want.” I learnt that the way many Germans define leadership differs from the views that seem to prevail in other EU countries.
Recent remarks by Volker Kauder, head of the parliamentary faction of Merkel’s CDU (and the CSU), that Europe was now “speaking German” were crude – and treated as such by much of the German media. But the sentiment behind that statement is quite common. Many in the government say that leadership consists of spreading Germany’s ‘stability culture’ throughout Europe. They point to the fact that Greece is implementing reforms that were unthinkable until recently, that Italy is now run by a man who praises the strengths of the German model and that Nicolas Sarkozy is trying to get re-elected as president by promising to cut the French budget.
The Germans say they do not want to be the ones who impose austerity and reforms on their neighbours. They clearly do not enjoy being unpopular. And the experience of reunification has shown them how hard it is to salvage an ailing economy (in that case the eastern Länder) even if you can impose your own laws and practices. Merkel’s government therefore wants to construct new eurozone rules and institutions – but in a way that spreads and enforces a German vision of a ‘stability union’. (On how Germany should handle the euro crisis see 'Why stricter rules threaten the eurozone'.)
Accordingly, the German debate has shifted since the summer. The early debate had been focused on crisis management and blaming profligate South Europeans. Most Germans were spooked by the impression that market pressures were forcing their government into one U-turn after another. Opposition leader Frank-Walter Steinmeier liked to quip about ‘Merkel’s law’: the more fiercely Merkel rules something out, the more certain one can be that it will happen in the end.
In the last couple of months, the German debate has started addressing broader questions about the future of the euro and the EU. Political leaders are queuing up to make big European speeches. Now that the government talks about new treaties and institutions it looks more in charge. Politically, the strategy is working: almost two-thirds of Germans now approve of Merkel’s management of the euro crisis, up from 45 per cent in October.
However, the government’s vision for Europe is limited so far: a few ‘surgical’ amendments to the EU treaty to introduce automatic sanctions, take fiscal rule-breakers to the European Court of Justice and allow Brussels to intervene in the budgets of countries that ask for bail-outs. While Germany appears happy for the EU to curtail the sovereignty of countries that spend too much, it is reluctant to accept new constraints itself. During a recent Euro Group meeting, Finance Minister Wolfgang Schäuble obtained written assurances from his counterparts that the reprimands and sanctions of the new ‘imbalances procedure’ would apply only to countries with deficits, not those with surpluses. Spain in particular had called for more ‘symmetric adjustment’. Even economically literate Germans tend to react to such calls with simplistic statements such as “you cannot ask us to reduce our competitiveness and exports” or “we cannot increase our wages artificially to suit the eurozone because we also compete globally”.
A Germany in leadership mode would acknowledge that more German demand would help its troubled neighbours to export their way out of recession and that there are all manner of reforms (some of which the government is working on or contemplating) that can boost the German economy without ‘reducing competitiveness’. Here, Germany would do well to shed its Mittelstandsdenken (the conservative, inward-focused thinking deeply engrained in Germany’s small and mid-sized companies) and start behaving like a large country whose actions impact on the eurozone as a whole. (See also 'Why Germany is not a model for the eurozone'.)
One area, however, in which Germany will not lead is monetary policy. Observers from abroad often call on Merkel “to allow the European Central Bank to buy more Italian and Spanish bonds”. It is true that a majority of Germans is against the central bank buying government debt, mainly because they fear that ‘free money’ will allow South European countries to carry on borrowing, without implementing reforms and austerity.
However, most Germans do not think that they run monetary policy in Europe. They believe in central bank independence. There is no doubt that the ECB operates in a political environment that is substantially shaped by the German debate. But the idea that there could be a direct chain of command from the chancellery to the ECB or even the Bundesbank would be alien to most Germans.
In the eyes of most of the policy people I spoke to in Berlin, ECB bond-buying is dangerous, wrong, illegal … and inevitable. They know that the German political system cannot quickly come up with the sums that would be needed to finance Italy’s borrowing needs for any considerable length of time. First, Germany’s post-war political system was constructed specifically to prevent rash decision-making and strong leadership; a slow-moving, consensus-oriented political culture has developed as a result. Second, recent debates about bail-out laws have shown growing political opposition to committing more funds, in particular in Merkel’s own coalition. Any attempt to fill a ‘big bazooka’ bail-out vehicle with German taxpayers’ money could lead to political paralysis and early elections.
That only leaves the ECB. Berlin policy-makers shrug off the fact that Germany is routinely outvoted on the ECB board (votes are usually 17 against four). One person close to Chancellor Merkel said he wished the ECB was less hesitant in its bond-buying programme: “They should just announce that they stand ready to buy all Italian bonds, provided certain conditions are fulfilled.” Another told me it was “sad” that the Bundesbank and its boss, Jens Weidmann, were so dogmatic. But German leaders are very careful not to criticise central bankers openly and in public. (On what the ECB should do see 'The ECB must stand behind the euro'.)
No German government will instruct the ECB to “buy more bonds”. One government advisor says this would only prompt the ECB to defend its independence: “The more political calls there are for ECB intervention, the harder it gets for them to do what needs to be done.” Perhaps it is also time for German leaders to acknowledge that their routine statements about the wrongs of debt monetisation unsettle the markets, and just let the ECB get on with the job of stabilising the eurozone.
Some of Germany’s European partners accuse Chancellor Angela Merkel of refusing, or failing, to lead properly in the euro crisis. Many Germans agree with that analysis and call for Merkel to guide the rescue efforts with a firmer hand and more vision. Just as many, however, think that Germany is actually leading well, and that this is not sufficiently acknowledged. As one opposition politician put it to me during a recent Berlin visit: “Germany is expected to lead, and if we do, we are criticised as arrogant – unless it’s in line with what others want.” I learnt that the way many Germans define leadership differs from the views that seem to prevail in other EU countries.
Recent remarks by Volker Kauder, head of the parliamentary faction of Merkel’s CDU (and the CSU), that Europe was now “speaking German” were crude – and treated as such by much of the German media. But the sentiment behind that statement is quite common. Many in the government say that leadership consists of spreading Germany’s ‘stability culture’ throughout Europe. They point to the fact that Greece is implementing reforms that were unthinkable until recently, that Italy is now run by a man who praises the strengths of the German model and that Nicolas Sarkozy is trying to get re-elected as president by promising to cut the French budget.
The Germans say they do not want to be the ones who impose austerity and reforms on their neighbours. They clearly do not enjoy being unpopular. And the experience of reunification has shown them how hard it is to salvage an ailing economy (in that case the eastern Länder) even if you can impose your own laws and practices. Merkel’s government therefore wants to construct new eurozone rules and institutions – but in a way that spreads and enforces a German vision of a ‘stability union’. (On how Germany should handle the euro crisis see 'Why stricter rules threaten the eurozone'.)
Accordingly, the German debate has shifted since the summer. The early debate had been focused on crisis management and blaming profligate South Europeans. Most Germans were spooked by the impression that market pressures were forcing their government into one U-turn after another. Opposition leader Frank-Walter Steinmeier liked to quip about ‘Merkel’s law’: the more fiercely Merkel rules something out, the more certain one can be that it will happen in the end.
In the last couple of months, the German debate has started addressing broader questions about the future of the euro and the EU. Political leaders are queuing up to make big European speeches. Now that the government talks about new treaties and institutions it looks more in charge. Politically, the strategy is working: almost two-thirds of Germans now approve of Merkel’s management of the euro crisis, up from 45 per cent in October.
However, the government’s vision for Europe is limited so far: a few ‘surgical’ amendments to the EU treaty to introduce automatic sanctions, take fiscal rule-breakers to the European Court of Justice and allow Brussels to intervene in the budgets of countries that ask for bail-outs. While Germany appears happy for the EU to curtail the sovereignty of countries that spend too much, it is reluctant to accept new constraints itself. During a recent Euro Group meeting, Finance Minister Wolfgang Schäuble obtained written assurances from his counterparts that the reprimands and sanctions of the new ‘imbalances procedure’ would apply only to countries with deficits, not those with surpluses. Spain in particular had called for more ‘symmetric adjustment’. Even economically literate Germans tend to react to such calls with simplistic statements such as “you cannot ask us to reduce our competitiveness and exports” or “we cannot increase our wages artificially to suit the eurozone because we also compete globally”.
A Germany in leadership mode would acknowledge that more German demand would help its troubled neighbours to export their way out of recession and that there are all manner of reforms (some of which the government is working on or contemplating) that can boost the German economy without ‘reducing competitiveness’. Here, Germany would do well to shed its Mittelstandsdenken (the conservative, inward-focused thinking deeply engrained in Germany’s small and mid-sized companies) and start behaving like a large country whose actions impact on the eurozone as a whole. (See also 'Why Germany is not a model for the eurozone'.)
One area, however, in which Germany will not lead is monetary policy. Observers from abroad often call on Merkel “to allow the European Central Bank to buy more Italian and Spanish bonds”. It is true that a majority of Germans is against the central bank buying government debt, mainly because they fear that ‘free money’ will allow South European countries to carry on borrowing, without implementing reforms and austerity.
However, most Germans do not think that they run monetary policy in Europe. They believe in central bank independence. There is no doubt that the ECB operates in a political environment that is substantially shaped by the German debate. But the idea that there could be a direct chain of command from the chancellery to the ECB or even the Bundesbank would be alien to most Germans.
In the eyes of most of the policy people I spoke to in Berlin, ECB bond-buying is dangerous, wrong, illegal … and inevitable. They know that the German political system cannot quickly come up with the sums that would be needed to finance Italy’s borrowing needs for any considerable length of time. First, Germany’s post-war political system was constructed specifically to prevent rash decision-making and strong leadership; a slow-moving, consensus-oriented political culture has developed as a result. Second, recent debates about bail-out laws have shown growing political opposition to committing more funds, in particular in Merkel’s own coalition. Any attempt to fill a ‘big bazooka’ bail-out vehicle with German taxpayers’ money could lead to political paralysis and early elections.
That only leaves the ECB. Berlin policy-makers shrug off the fact that Germany is routinely outvoted on the ECB board (votes are usually 17 against four). One person close to Chancellor Merkel said he wished the ECB was less hesitant in its bond-buying programme: “They should just announce that they stand ready to buy all Italian bonds, provided certain conditions are fulfilled.” Another told me it was “sad” that the Bundesbank and its boss, Jens Weidmann, were so dogmatic. But German leaders are very careful not to criticise central bankers openly and in public. (On what the ECB should do see 'The ECB must stand behind the euro'.)
No German government will instruct the ECB to “buy more bonds”. One government advisor says this would only prompt the ECB to defend its independence: “The more political calls there are for ECB intervention, the harder it gets for them to do what needs to be done.” Perhaps it is also time for German leaders to acknowledge that their routine statements about the wrongs of debt monetisation unsettle the markets, and just let the ECB get on with the job of stabilising the eurozone.
Monday, November 21, 2011
The eurozone and the US: A tale of two currency zones
by Philip Whyte
Europeans think it is all very unfair. They point out that, in aggregate, the eurozone is in no worse an economic position than the US: its public finances are in better shape than the US’s, and its overall level of private sector debt is actually lower. Yet for the past two years, financial markets have picked on the eurozone with increasing ferocity. In moments of bemused irritation, weary European policy-makers often complain about the baneful influence and biases of the Anglo-Saxon media, or the stubborn irrationality of financial markets. They would do better to reflect on why the eurozone faces an existential crisis while the US does not. The answer is that the two are very different monetary unions.
To start with, the eurozone is a much more decentralised monetary union than the US. The eurozone has no federal budget to speak of. Its closest proxy, the EU budget, is miniscule by comparison (at just 1 per cent of GDP) and cannot in any case go into deficit. Transfer payments are paid out of the EU budget, but these are not, strictly, welfare-related (the main recipients are special interest groups such as farmers). For all intents and purposes, the euro is a currency shared by fiscally independent countries. The upshot is that many things which happen at federal level in the US – deficit-financing, debt issuance, welfare payments, bank deposit protection, and so on – take place at national level in the eurozone.
Sitting atop the eurozone’s fiscally decentralised structure is a central bank which (for political, doctrinal and other reasons) is a more cautious institution than the US Federal Reserve, with a narrower understanding of its function. The European Central Bank (ECB) was deliberately designed as a successor to the German Bundesbank. The result is that it is more inflation-averse than the US Fed, and more reluctant to practice anything that might smack of ‘monetary financing’ (like acting as a lender of last resort to governments). In extremis, the ECB has implemented government bond purchase programmes. However, it has done so half-heartedly, and has always made a point of advertising its aversion to doing so.
So the US is a fully-fledged federation with a relatively flexible central bank, while the eurozone is a fiscally decentralised confederation with a conservative and limited purpose central bank. These differences are critical to understanding why the eurozone is the focus of market turmoil and the US is not. The crux is that the eurozone’s constituents interact very differently with each other than do those of the US: Germany does not stand in relation to Spain the way that Texas does to New Jersey, or eurozone countries in relation to the ECB the way that US states do to the Fed. The structure of the eurozone creates a whole host of problems that do not arise in a fully-fledged federation such as the US. Consider just three.
First, because they do not monopolise control of the currency in which they issue their debt, some countries are treated as if they have issued it in a foreign currency: this explains why Spain is paying 5 percentage points more than the UK to issue 10-year debt, even though its public finances are in no worse shape. Second, unlike the US, the eurozone lacks a joint fiscal backstop to the banking sector: this is why Ireland was plunged into a sovereign debt crisis, but the state of Delaware (where AIG is incorporated) was not. Third, banks and individual states interact differently: in the US, confidence in banks is not affected by the fiscal position of the state in which they are incorporated, but in the eurozone it is.
The eurozone’s structure, therefore, makes it a more fragile monetary union than the US. As a fiscally decentralised monetary union, it is vulnerable to the emergence of vicious ‘death spirals’ in some of its members. These spirals are driven by negative feed-back loops, in which worries about bank and sovereign solvency feed on and amplify each other. So far, eurozone policy-makers have done nothing to fix the structure that gives rise to these deadly spirals. Instead, they have preserved the structure, but made it more rigid. The eurozone remains a fiscally decentralised currency bloc, with a Germanic central bank. The only change is that member-states are now subject to tighter (and more pro-cyclical) fiscal rules.
The German government does not accept that the eurozone is institutionally flawed. It argues that the cause of the crisis is overwhelmingly behavioural, not institutional. The road to salvation is not to deepen integration by establishing a common bank deposit protection scheme or issuing debt jointly (which would increase moral hazard). It is to stop errant conduct. Ever since the crisis broke out, the German mantra has been fiscal consolidation and structural reforms. The underlying assumption is that the eurozone will be fine if it can turn itself economically into a larger version of Germany: countries that consolidate their public finances and reform their economies will end up with German borrowing costs.
It is not hard to see why many Germans find this account so compelling. It speaks to the very real sacrifices that many have made in recent years (for the past decade, German workers’ wages have barely increased in real terms). It suggests that the eurozone need not become the ‘transfer union’ of German nightmares. And it is supported by undeniable evidence of turpitude elsewhere: there is no doubt that Greece mismanaged its public finances, or that countries in southern Europe (and elsewhere) did too little to reform their economies. But what the German narrative does not explain is why the eurozone has proved so much less stable than the US, even though some of its underlying problems are no worse.
The extreme polarisation of government bond yields inside the eurozone does not represent a vote of confidence in the German economy, but a total loss of confidence in the very future of the eurozone. What the financial markets have cottoned on to is the fact that the euro is a post-national currency shared by countries that remain more attached to their fiscal sovereignty than they care to admit. The problem, in other words, is not financial, but political. The eurozone does not need financial assistance from China (or anyone else). It needs its leaders to do something that few have a democratic mandate to do – that is, pool their fiscal resources. Financial markets, for their part, are simply drawing their own conclusions.
Philip Whyte is a senior research fellow at the Centre for European Reform.
Europeans think it is all very unfair. They point out that, in aggregate, the eurozone is in no worse an economic position than the US: its public finances are in better shape than the US’s, and its overall level of private sector debt is actually lower. Yet for the past two years, financial markets have picked on the eurozone with increasing ferocity. In moments of bemused irritation, weary European policy-makers often complain about the baneful influence and biases of the Anglo-Saxon media, or the stubborn irrationality of financial markets. They would do better to reflect on why the eurozone faces an existential crisis while the US does not. The answer is that the two are very different monetary unions.
To start with, the eurozone is a much more decentralised monetary union than the US. The eurozone has no federal budget to speak of. Its closest proxy, the EU budget, is miniscule by comparison (at just 1 per cent of GDP) and cannot in any case go into deficit. Transfer payments are paid out of the EU budget, but these are not, strictly, welfare-related (the main recipients are special interest groups such as farmers). For all intents and purposes, the euro is a currency shared by fiscally independent countries. The upshot is that many things which happen at federal level in the US – deficit-financing, debt issuance, welfare payments, bank deposit protection, and so on – take place at national level in the eurozone.
Sitting atop the eurozone’s fiscally decentralised structure is a central bank which (for political, doctrinal and other reasons) is a more cautious institution than the US Federal Reserve, with a narrower understanding of its function. The European Central Bank (ECB) was deliberately designed as a successor to the German Bundesbank. The result is that it is more inflation-averse than the US Fed, and more reluctant to practice anything that might smack of ‘monetary financing’ (like acting as a lender of last resort to governments). In extremis, the ECB has implemented government bond purchase programmes. However, it has done so half-heartedly, and has always made a point of advertising its aversion to doing so.
So the US is a fully-fledged federation with a relatively flexible central bank, while the eurozone is a fiscally decentralised confederation with a conservative and limited purpose central bank. These differences are critical to understanding why the eurozone is the focus of market turmoil and the US is not. The crux is that the eurozone’s constituents interact very differently with each other than do those of the US: Germany does not stand in relation to Spain the way that Texas does to New Jersey, or eurozone countries in relation to the ECB the way that US states do to the Fed. The structure of the eurozone creates a whole host of problems that do not arise in a fully-fledged federation such as the US. Consider just three.
First, because they do not monopolise control of the currency in which they issue their debt, some countries are treated as if they have issued it in a foreign currency: this explains why Spain is paying 5 percentage points more than the UK to issue 10-year debt, even though its public finances are in no worse shape. Second, unlike the US, the eurozone lacks a joint fiscal backstop to the banking sector: this is why Ireland was plunged into a sovereign debt crisis, but the state of Delaware (where AIG is incorporated) was not. Third, banks and individual states interact differently: in the US, confidence in banks is not affected by the fiscal position of the state in which they are incorporated, but in the eurozone it is.
The eurozone’s structure, therefore, makes it a more fragile monetary union than the US. As a fiscally decentralised monetary union, it is vulnerable to the emergence of vicious ‘death spirals’ in some of its members. These spirals are driven by negative feed-back loops, in which worries about bank and sovereign solvency feed on and amplify each other. So far, eurozone policy-makers have done nothing to fix the structure that gives rise to these deadly spirals. Instead, they have preserved the structure, but made it more rigid. The eurozone remains a fiscally decentralised currency bloc, with a Germanic central bank. The only change is that member-states are now subject to tighter (and more pro-cyclical) fiscal rules.
The German government does not accept that the eurozone is institutionally flawed. It argues that the cause of the crisis is overwhelmingly behavioural, not institutional. The road to salvation is not to deepen integration by establishing a common bank deposit protection scheme or issuing debt jointly (which would increase moral hazard). It is to stop errant conduct. Ever since the crisis broke out, the German mantra has been fiscal consolidation and structural reforms. The underlying assumption is that the eurozone will be fine if it can turn itself economically into a larger version of Germany: countries that consolidate their public finances and reform their economies will end up with German borrowing costs.
It is not hard to see why many Germans find this account so compelling. It speaks to the very real sacrifices that many have made in recent years (for the past decade, German workers’ wages have barely increased in real terms). It suggests that the eurozone need not become the ‘transfer union’ of German nightmares. And it is supported by undeniable evidence of turpitude elsewhere: there is no doubt that Greece mismanaged its public finances, or that countries in southern Europe (and elsewhere) did too little to reform their economies. But what the German narrative does not explain is why the eurozone has proved so much less stable than the US, even though some of its underlying problems are no worse.
The extreme polarisation of government bond yields inside the eurozone does not represent a vote of confidence in the German economy, but a total loss of confidence in the very future of the eurozone. What the financial markets have cottoned on to is the fact that the euro is a post-national currency shared by countries that remain more attached to their fiscal sovereignty than they care to admit. The problem, in other words, is not financial, but political. The eurozone does not need financial assistance from China (or anyone else). It needs its leaders to do something that few have a democratic mandate to do – that is, pool their fiscal resources. Financial markets, for their part, are simply drawing their own conclusions.
Philip Whyte is a senior research fellow at the Centre for European Reform.
Tuesday, November 01, 2011
Governments need incentives to pool and share militaries
by Tomas Valasek
Since the financial crisis began in 2008, EU countries have cut military spending by an amount equivalent to the entire annual defence budget of Germany, Europe's third largest. While the prospects for an economic upturn are dim, the need for credible militaries remains strong – all the more so because the US is signalling that it may not lead future operations in and around Europe. The EU has been urging its member-states to seek defence savings in collaboration. EU officials frequently stress that member-states have no option other than to 'pool and share' their militaries: to make a more common use of training and support facilities, to buy equipment together and to form joint units. Unless such savings measures are taken, the defence cuts will undermine Europe’s ability to respond to future crises on its periphery and beyond.
But what makes obvious sense to experts and officials looks very different to national defence ministers. In most European countries the public care little about defence and will not hold governments responsible for how defence budgets are spent.
From a government point of view, collaboration carries real political costs because opposition politicians and journalists will accuse the ministers of undermining national sovereignty by creating interdependencies with other militaries. Collaboration often takes years to put in place and yields rewards only long after its architects have left office. Initially, it may also cost more than it saves. And defence ministers have little guarantee that any savings which their decisions generate will flow back to the defence budget; often the treasuries take the spoils. So unsurprisingly, many European defence ministers choose the politically safer route of inaction.
The EU is right to want the member-states' militaries to work together. But its approach needs to start with the recognition that defence ministers will need new incentives to do so.
Some help is already on offer. The EU, via its European Defence Agency (EDA), has recently formed a senior expert group, composed of mostly retired high-level officers. They are travelling around Europe sounding out governments on their plans to pool and share and urging them to try harder. The experts should also make it a priority to identify the obstacles to collaboration in each country, and to collect lessons on how countries have been able to overcome national reservations.
The EDA’s planned study on the financial benefits of military collaboration will also be helpful: little hard data exists on potential savings, and a credible risks and benefits analysis would give proponents of pooling and sharing an additional argument against the sceptics. So would another planned EDA study on the depth of past and probable future cuts to European defence budgets. Similar reports, such as the one recently produced by the German Stiftung Wissenschaft und Politik, make for a sobering read and implicitly help build the case for closer collaboration.
More could be done: the EU institutions could help governments identify strategies that generate maximum savings while entailing minimal losses of national sovereignty. The Netherlands and Belgium point the way: they have completely pooled the maintenance and training of crews for their navies' vessels, but they have kept the actual fleets under separate national ownership. They thus reap the financial benefits of collaboration (because they no longer duplicate schools and repair docks) while preserving the right to deploy the vessels where each government sees fit. The report by EDA's senior experts should highlight such successful collaborative strategies and the EDA should make certain that these are widely distributed. Not all defence ministers will read the experts' conclusions so perhaps follow-up visits by the experts - this time to spread lessons learned on pooling and sharing -- may be in order. And because ministers come and go, the EDA should also make sure its experts speak to the armaments and defence policy directors.
As its next step, the EDA should help defence ministers obtain assurances that savings generated through collaboration will be reinvested in defence. While each EU country has a somewhat different way to fund defence, some ideas might find universal application. For example, the French pay for defence through a five-year, legally binding budget allocation. This could be tweaked to allow the defence ministries to keep any savings generated during the life of the budget framework. In Slovakia, the government has pledged to take past reforms into account when cutting the budgets of line ministries in the future. Departments that found savings will have their budgets cut less dramatically than those that have not reformed. Other governments will want to pursue other solutions - the key point here is that defence ministers must feel that they will be able to reap the benefits of pooling and sharing; that they will see a reward for taking political risks.
Lastly, the EDA should explore whether governments can be offered direct financial incentives to pool and share. NATO has long recognised that if its member-states are to connect their militaries, they need help covering the costs directly related to building the physical links. So the alliance created a centralised pool of money, into which all allies pay and which reimburses governments for 'networking' costs, such as the upgrades that were needed at Central European airfields and ports so that they could fuel and communicate with West European aircraft and ships.
Pooling and sharing also essentially requires states to build a network, which entails initial outlays even though it saves money later on. For example, if two countries merge their military colleges, they will need to shut down some facilities and pay some of the personnel a severance fee. The prospect of such initial outlays may well discourage co-operation. So the EDA should sound out its members about the possibility of creating a 'pooling and sharing fund' to reimburse the costs that result when governments choose to enter into military collaboration. Alternatively, because most EU countries are also members of NATO, they could agree to use NATO's fund to encourage pooling and sharing. However, the fund would first have to be expanded (in recent years it has run low on money) and its mandate broadened from funding infrastructure upgrades to include other costs such as severance payments or clean-up of disused military facilities.
There may well be additional ways to entice the governments to pool and share. The EU institutions should make it their priority to identify such incentives and apply them as much as possible. Pooling and sharing may make eminent economic and military sense, but they are fraught with sensitivities and political dangers. The national governments will need all the help and encouragement they can get.
Tomas Valasek is director of foreign policy and defence
Since the financial crisis began in 2008, EU countries have cut military spending by an amount equivalent to the entire annual defence budget of Germany, Europe's third largest. While the prospects for an economic upturn are dim, the need for credible militaries remains strong – all the more so because the US is signalling that it may not lead future operations in and around Europe. The EU has been urging its member-states to seek defence savings in collaboration. EU officials frequently stress that member-states have no option other than to 'pool and share' their militaries: to make a more common use of training and support facilities, to buy equipment together and to form joint units. Unless such savings measures are taken, the defence cuts will undermine Europe’s ability to respond to future crises on its periphery and beyond.
But what makes obvious sense to experts and officials looks very different to national defence ministers. In most European countries the public care little about defence and will not hold governments responsible for how defence budgets are spent.
From a government point of view, collaboration carries real political costs because opposition politicians and journalists will accuse the ministers of undermining national sovereignty by creating interdependencies with other militaries. Collaboration often takes years to put in place and yields rewards only long after its architects have left office. Initially, it may also cost more than it saves. And defence ministers have little guarantee that any savings which their decisions generate will flow back to the defence budget; often the treasuries take the spoils. So unsurprisingly, many European defence ministers choose the politically safer route of inaction.
The EU is right to want the member-states' militaries to work together. But its approach needs to start with the recognition that defence ministers will need new incentives to do so.
Some help is already on offer. The EU, via its European Defence Agency (EDA), has recently formed a senior expert group, composed of mostly retired high-level officers. They are travelling around Europe sounding out governments on their plans to pool and share and urging them to try harder. The experts should also make it a priority to identify the obstacles to collaboration in each country, and to collect lessons on how countries have been able to overcome national reservations.
The EDA’s planned study on the financial benefits of military collaboration will also be helpful: little hard data exists on potential savings, and a credible risks and benefits analysis would give proponents of pooling and sharing an additional argument against the sceptics. So would another planned EDA study on the depth of past and probable future cuts to European defence budgets. Similar reports, such as the one recently produced by the German Stiftung Wissenschaft und Politik, make for a sobering read and implicitly help build the case for closer collaboration.
More could be done: the EU institutions could help governments identify strategies that generate maximum savings while entailing minimal losses of national sovereignty. The Netherlands and Belgium point the way: they have completely pooled the maintenance and training of crews for their navies' vessels, but they have kept the actual fleets under separate national ownership. They thus reap the financial benefits of collaboration (because they no longer duplicate schools and repair docks) while preserving the right to deploy the vessels where each government sees fit. The report by EDA's senior experts should highlight such successful collaborative strategies and the EDA should make certain that these are widely distributed. Not all defence ministers will read the experts' conclusions so perhaps follow-up visits by the experts - this time to spread lessons learned on pooling and sharing -- may be in order. And because ministers come and go, the EDA should also make sure its experts speak to the armaments and defence policy directors.
As its next step, the EDA should help defence ministers obtain assurances that savings generated through collaboration will be reinvested in defence. While each EU country has a somewhat different way to fund defence, some ideas might find universal application. For example, the French pay for defence through a five-year, legally binding budget allocation. This could be tweaked to allow the defence ministries to keep any savings generated during the life of the budget framework. In Slovakia, the government has pledged to take past reforms into account when cutting the budgets of line ministries in the future. Departments that found savings will have their budgets cut less dramatically than those that have not reformed. Other governments will want to pursue other solutions - the key point here is that defence ministers must feel that they will be able to reap the benefits of pooling and sharing; that they will see a reward for taking political risks.
Lastly, the EDA should explore whether governments can be offered direct financial incentives to pool and share. NATO has long recognised that if its member-states are to connect their militaries, they need help covering the costs directly related to building the physical links. So the alliance created a centralised pool of money, into which all allies pay and which reimburses governments for 'networking' costs, such as the upgrades that were needed at Central European airfields and ports so that they could fuel and communicate with West European aircraft and ships.
Pooling and sharing also essentially requires states to build a network, which entails initial outlays even though it saves money later on. For example, if two countries merge their military colleges, they will need to shut down some facilities and pay some of the personnel a severance fee. The prospect of such initial outlays may well discourage co-operation. So the EDA should sound out its members about the possibility of creating a 'pooling and sharing fund' to reimburse the costs that result when governments choose to enter into military collaboration. Alternatively, because most EU countries are also members of NATO, they could agree to use NATO's fund to encourage pooling and sharing. However, the fund would first have to be expanded (in recent years it has run low on money) and its mandate broadened from funding infrastructure upgrades to include other costs such as severance payments or clean-up of disused military facilities.
There may well be additional ways to entice the governments to pool and share. The EU institutions should make it their priority to identify such incentives and apply them as much as possible. Pooling and sharing may make eminent economic and military sense, but they are fraught with sensitivities and political dangers. The national governments will need all the help and encouragement they can get.
Tomas Valasek is director of foreign policy and defence
Monday, October 17, 2011
Global trade imbalances threaten free trade
by Simon Tilford
The developed world’s slide into recession threatens an outbreak of protectionism. Unlike in 2008, governments now have few tools with which to combat a renewed economic downturn, which raises the likelihood of it developing into a slump. If so, protectionist pressure is certain to build. The country that moves first to erect trade barriers will no doubt take the blame for the resulting damage to the trading system. But the real villains will be the countries that skew their exchange policies, tax systems and industrial structures to gain export advantage. The irony is that the countries that are most dependent on free trade – those that produce more than they consume – are the biggest obstacle to a sustained recovery in the global economy. They need to change course before it is too late: all will suffer if countries move to erect new trade barriers, but the surplus economies will suffer most.
Surplus country governments regularly exhort deficit countries to pay-down debt, save more and ‘live within their means’. But the real problem facing the global economy is an acute lack of aggregate demand. The world is awash with savings, but there is a dearth of profitable investment opportunities, which in turn reflects the weakness of consumption. The answer is not therefore for everybody to save more. This will be disastrous: it will further depress consumption and hence investment, and aggravate fiscal problems. If countries with big trade deficits (and correspondingly high levels of indebtedness) are to save more, surplus countries (those that live within their means) will have to save less and spend more.
The weakness of domestic demand in the US, UK and across much of the eurozone is hitting global demand hard, but there is nothing to offset it. The big surplus countries – Germany, China and Japan – are not taking any steps to offset the contraction in demand elsewhere. Such a state of affairs is fraught with risk. If the world is to continue enjoying the benefits of global trade and finance, the global imbalances have to be unwound.
What are trade imbalances? A country’s trade balance is a reflection of what it spends minus what it produces. In surplus countries income exceeds their spending, so they lend the difference to countries where spending exceeds income, accumulating international assets in the process. Deficit countries are the flipside of this. They spend more than their income, borrowing from surplus countries to cover the difference, in the process accumulating international liabilities or debts. Export-led growth in surplus countries feeds (and is dependent on) debt-led growth in deficit countries. It is impossible for all countries to run surpluses, just as it is impossible for all to run deficits.
Are trade imbalances sustainable? Trade imbalances and the accompanying capital flows between countries are not necessarily a problem. Fast-ageing wealthy societies tend to have excess savings and it makes sense to invest these in countries where domestic savings are insufficient to meet investment needs. Historically, this typically meant investing money in rapidly developing emerging markets. So long as current-account deficits remain modest and economies invest the corresponding capital inflows in ways that boost productivity growth, such imbalances are sustainable. But the imbalances we see today are of a different character. First, they are much bigger. The most egregious is that between China and the US, where still poor China is running a huge trade surplus with the US. Many of the other imbalances are between countries of broadly similar levels of economic development, such as those between members of the eurozone, or that between Japan and the US.
Imbalances of this scale and nature are far from benign. First, they lead to destabilising capital flows between economies. For example, the global financial crises of 2007 and the subsequent eurozone crisis were basically the result of capital flows between countries. Over-leveraged banks amplified the problem, but the underlying cause was outflows of capital from economies with excess savings in search of higher returns. Much as in the surplus economies themselves, the US, UK and the members of the eurozone that attracted large-scale capital inflows struggled to find productive uses for them: rather than boosting productivity, the inflows pumped up asset prices and encouraged excessive household borrowing.
The imbalances survived both crises, and are now growing again from an already high level. This is clearly unsustainable. Unlike in the run-up to the financial crisis, the current situation has nothing do with excess demand in the deficit countries, but is taking place against a backdrop of stagnation and falling living standards in these economies. Households and firms in the deficit countries are saving more, but there has been no offsetting decline in private sector savings in the surplus countries. Against this kind of economic backdrop, trade deficits constitute a major drag on economic activity as they drain demand and employment, forcing governments to step-in and fill the gap by running big fiscal deficits. The external demand upon which the surplus countries depend relies implicitly on unsustainable fiscal policies in the deficit countries.
How can imbalances be reduced? The deficit countries need a combination of higher net exports (export minus imports) and higher net savings (domestic savings minus domestic investment), while the surplus countries require the reverse. Put another way, the deficit countries need to get over their dependence on debt, surplus countries their addiction to exports. Deficit countries need more domestic savings and surplus countries more consumption.
Structural changes in both the surplus and deficit countries can clearly contribute to the necessary adjustments. Countries where expenditure lags output, such as Germany and Japan, could take steps to reverse the decline in wages and salaries as a proportion of national income. This would boost consumption, encourage more investment, and hence lower their corporate sectors’ excess savings. For its part, China could discourage excess savings by reducing subsidies to its corporate sector, which is sitting on very large sums of cash. The Chinese authorities could also improve the country’s social safety net and hence lower households’ precautionary savings. However, such adjustments will take time, and time is in short supply. The only way to facilitate rapid adjustment is through shifts in relative prices.
There are three ways of bringing about these movements in prices, or shifts in countries’ so-called ‘real exchange rates’. The fate of the international trading system could depend on which is chosen. First, domestic prices can fall in the deficit countries. This comes about through declining costs and prices, as wages are cut and governments pursue fiscal austerity. Higher unemployment encourages households to save more, and the price of imported goods rise relative to domestically-produced ones.
This is basically what is being attempted in the eurozone. Trade imbalances are to be addressed by deflation in the deficit countries. Policy across the eurozone as a whole has a strongly deflationary bias, as much in the surplus economies as the deficit ones. This implies very weak economic growth, falls in prices (relative to the outside world) and higher unemployment. It also implies higher savings as governments tighten fiscal policy, companies sit on cash rather than investing it and fearful households boost their savings and rein in consumption. The risk is that the deficit countries’ debt burdens will increase further (as the value of their debts grow, while their incomes fall), exacerbating their fiscal problems and undermining their ability to pay their creditors. Far from taking up some of strain from the Americans, the eurozone is trying to run a big surplus with the rest of the world, adding to trade tensions.
Given how indebted the deficit countries are (in terms of public and private debt) rebalancing needs to take place through a combination of movements in nominal exchange rates (where possible) and somewhat higher inflation in the surplus countries. Very low interest rates and quantitative easing in the US is pushing up inflation in countries with currencies linked to the dollar – first and foremost China. The US has little option but to continue pumping dollars into its financial system, in order to compensate for the drag on its economy from the trade balance, and some of this money will continue to leak out to China. However, concerned at the rise in inflation, the Chinese authorities are taking robust steps to slow their economy by clamping down on the amount state-owned banks can lend. Easily the least damaging adjustment in the eurozone would be through higher inflation in Germany. But there is little sign of this. And if there were, the European Central Bank would raise interest rates.
Finally, changes in relative prices can be brought about by movements in nominal exchange rates. For example, the Chinese could allow the renminbi to rise against the dollar or Germany could withdraw from the eurozone and reintroduce the D-mark, which would then appreciate sharply in value. Movements in nominal exchange rates offer by far the least damaging route to the needed rebalancing. It would avoid deflation in the deficit countries or inflation in the surplus ones.
The Chinese government is somewhat schizophrenic about the potential impact of renminbi revaluation. On the one hand it maintains that it would not make any difference, because the deficits in countries like America reflect the latter’s lack of savings, which would not be affected by an appreciation of the Chinese currency. On the other hand, it argues that a stronger renminbi would hit the Chinese economy hard and be disastrous for global economic growth. In short, the Chinese government is dependent on the others running up debt, but at the same time condemns them for doing so. Movements in nominal exchange rates may yet be the mechanism by which the German trade surplus is cut. The current eurozone strategy of deflation in the deficit economies rather than reflation in Germany threatens to force economies out of the currency union. This would open the way for a rebalancing of the German economy, but at enormous political and economic cost to Europe.
Surplus country governments, notably the Chinese and German ones, often warn of the risks of protectionism. They fail to make the connection between the structures of their economies and the trade deficits (and rising indebtedness) of others. As a result, they are the real threat to the international trading order. If the US cannot rebalance its economy and get it growing sustainably, there is a real risk it will opt for protectionism. Other countries with big trade deficits could quickly follow suit. The resulting rebalancing would be brutal for the surplus countries, and many of the benefits of global trade and finance would be lost. To prevent this, the G20 needs to agree a global strategy to rebalance demand. This would require the surplus economies to acknowledge that they are part of the problem and to develop strategies to reduce their export dependence.
Simon Tilford is chief economist at the Centre for European Reform.
The developed world’s slide into recession threatens an outbreak of protectionism. Unlike in 2008, governments now have few tools with which to combat a renewed economic downturn, which raises the likelihood of it developing into a slump. If so, protectionist pressure is certain to build. The country that moves first to erect trade barriers will no doubt take the blame for the resulting damage to the trading system. But the real villains will be the countries that skew their exchange policies, tax systems and industrial structures to gain export advantage. The irony is that the countries that are most dependent on free trade – those that produce more than they consume – are the biggest obstacle to a sustained recovery in the global economy. They need to change course before it is too late: all will suffer if countries move to erect new trade barriers, but the surplus economies will suffer most.
Surplus country governments regularly exhort deficit countries to pay-down debt, save more and ‘live within their means’. But the real problem facing the global economy is an acute lack of aggregate demand. The world is awash with savings, but there is a dearth of profitable investment opportunities, which in turn reflects the weakness of consumption. The answer is not therefore for everybody to save more. This will be disastrous: it will further depress consumption and hence investment, and aggravate fiscal problems. If countries with big trade deficits (and correspondingly high levels of indebtedness) are to save more, surplus countries (those that live within their means) will have to save less and spend more.
The weakness of domestic demand in the US, UK and across much of the eurozone is hitting global demand hard, but there is nothing to offset it. The big surplus countries – Germany, China and Japan – are not taking any steps to offset the contraction in demand elsewhere. Such a state of affairs is fraught with risk. If the world is to continue enjoying the benefits of global trade and finance, the global imbalances have to be unwound.
What are trade imbalances? A country’s trade balance is a reflection of what it spends minus what it produces. In surplus countries income exceeds their spending, so they lend the difference to countries where spending exceeds income, accumulating international assets in the process. Deficit countries are the flipside of this. They spend more than their income, borrowing from surplus countries to cover the difference, in the process accumulating international liabilities or debts. Export-led growth in surplus countries feeds (and is dependent on) debt-led growth in deficit countries. It is impossible for all countries to run surpluses, just as it is impossible for all to run deficits.
Are trade imbalances sustainable? Trade imbalances and the accompanying capital flows between countries are not necessarily a problem. Fast-ageing wealthy societies tend to have excess savings and it makes sense to invest these in countries where domestic savings are insufficient to meet investment needs. Historically, this typically meant investing money in rapidly developing emerging markets. So long as current-account deficits remain modest and economies invest the corresponding capital inflows in ways that boost productivity growth, such imbalances are sustainable. But the imbalances we see today are of a different character. First, they are much bigger. The most egregious is that between China and the US, where still poor China is running a huge trade surplus with the US. Many of the other imbalances are between countries of broadly similar levels of economic development, such as those between members of the eurozone, or that between Japan and the US.
Imbalances of this scale and nature are far from benign. First, they lead to destabilising capital flows between economies. For example, the global financial crises of 2007 and the subsequent eurozone crisis were basically the result of capital flows between countries. Over-leveraged banks amplified the problem, but the underlying cause was outflows of capital from economies with excess savings in search of higher returns. Much as in the surplus economies themselves, the US, UK and the members of the eurozone that attracted large-scale capital inflows struggled to find productive uses for them: rather than boosting productivity, the inflows pumped up asset prices and encouraged excessive household borrowing.
The imbalances survived both crises, and are now growing again from an already high level. This is clearly unsustainable. Unlike in the run-up to the financial crisis, the current situation has nothing do with excess demand in the deficit countries, but is taking place against a backdrop of stagnation and falling living standards in these economies. Households and firms in the deficit countries are saving more, but there has been no offsetting decline in private sector savings in the surplus countries. Against this kind of economic backdrop, trade deficits constitute a major drag on economic activity as they drain demand and employment, forcing governments to step-in and fill the gap by running big fiscal deficits. The external demand upon which the surplus countries depend relies implicitly on unsustainable fiscal policies in the deficit countries.
How can imbalances be reduced? The deficit countries need a combination of higher net exports (export minus imports) and higher net savings (domestic savings minus domestic investment), while the surplus countries require the reverse. Put another way, the deficit countries need to get over their dependence on debt, surplus countries their addiction to exports. Deficit countries need more domestic savings and surplus countries more consumption.
Structural changes in both the surplus and deficit countries can clearly contribute to the necessary adjustments. Countries where expenditure lags output, such as Germany and Japan, could take steps to reverse the decline in wages and salaries as a proportion of national income. This would boost consumption, encourage more investment, and hence lower their corporate sectors’ excess savings. For its part, China could discourage excess savings by reducing subsidies to its corporate sector, which is sitting on very large sums of cash. The Chinese authorities could also improve the country’s social safety net and hence lower households’ precautionary savings. However, such adjustments will take time, and time is in short supply. The only way to facilitate rapid adjustment is through shifts in relative prices.
There are three ways of bringing about these movements in prices, or shifts in countries’ so-called ‘real exchange rates’. The fate of the international trading system could depend on which is chosen. First, domestic prices can fall in the deficit countries. This comes about through declining costs and prices, as wages are cut and governments pursue fiscal austerity. Higher unemployment encourages households to save more, and the price of imported goods rise relative to domestically-produced ones.
This is basically what is being attempted in the eurozone. Trade imbalances are to be addressed by deflation in the deficit countries. Policy across the eurozone as a whole has a strongly deflationary bias, as much in the surplus economies as the deficit ones. This implies very weak economic growth, falls in prices (relative to the outside world) and higher unemployment. It also implies higher savings as governments tighten fiscal policy, companies sit on cash rather than investing it and fearful households boost their savings and rein in consumption. The risk is that the deficit countries’ debt burdens will increase further (as the value of their debts grow, while their incomes fall), exacerbating their fiscal problems and undermining their ability to pay their creditors. Far from taking up some of strain from the Americans, the eurozone is trying to run a big surplus with the rest of the world, adding to trade tensions.
Given how indebted the deficit countries are (in terms of public and private debt) rebalancing needs to take place through a combination of movements in nominal exchange rates (where possible) and somewhat higher inflation in the surplus countries. Very low interest rates and quantitative easing in the US is pushing up inflation in countries with currencies linked to the dollar – first and foremost China. The US has little option but to continue pumping dollars into its financial system, in order to compensate for the drag on its economy from the trade balance, and some of this money will continue to leak out to China. However, concerned at the rise in inflation, the Chinese authorities are taking robust steps to slow their economy by clamping down on the amount state-owned banks can lend. Easily the least damaging adjustment in the eurozone would be through higher inflation in Germany. But there is little sign of this. And if there were, the European Central Bank would raise interest rates.
Finally, changes in relative prices can be brought about by movements in nominal exchange rates. For example, the Chinese could allow the renminbi to rise against the dollar or Germany could withdraw from the eurozone and reintroduce the D-mark, which would then appreciate sharply in value. Movements in nominal exchange rates offer by far the least damaging route to the needed rebalancing. It would avoid deflation in the deficit countries or inflation in the surplus ones.
The Chinese government is somewhat schizophrenic about the potential impact of renminbi revaluation. On the one hand it maintains that it would not make any difference, because the deficits in countries like America reflect the latter’s lack of savings, which would not be affected by an appreciation of the Chinese currency. On the other hand, it argues that a stronger renminbi would hit the Chinese economy hard and be disastrous for global economic growth. In short, the Chinese government is dependent on the others running up debt, but at the same time condemns them for doing so. Movements in nominal exchange rates may yet be the mechanism by which the German trade surplus is cut. The current eurozone strategy of deflation in the deficit economies rather than reflation in Germany threatens to force economies out of the currency union. This would open the way for a rebalancing of the German economy, but at enormous political and economic cost to Europe.
Surplus country governments, notably the Chinese and German ones, often warn of the risks of protectionism. They fail to make the connection between the structures of their economies and the trade deficits (and rising indebtedness) of others. As a result, they are the real threat to the international trading order. If the US cannot rebalance its economy and get it growing sustainably, there is a real risk it will opt for protectionism. Other countries with big trade deficits could quickly follow suit. The resulting rebalancing would be brutal for the surplus countries, and many of the benefits of global trade and finance would be lost. To prevent this, the G20 needs to agree a global strategy to rebalance demand. This would require the surplus economies to acknowledge that they are part of the problem and to develop strategies to reduce their export dependence.
Simon Tilford is chief economist at the Centre for European Reform.
Tuesday, October 11, 2011
Britain, the City and the EU: A triangle of suspicion
by Philip Whyte
After years of mutual suspicion, Britain and its EU partners seemed in early 2009 to be converging in an area of policy where they had often been at odds – financial regulation. The Turner Review, Britain’s official report into the financial crisis, accepted that ‘light touch’ regulation had failed, and recognised that the UK would have to accept greater supervisory integration at EU level if the single market in financial services was to survive. Fast-forward two years, and it is hard not to be struck by a paradox. The UK has abandoned its ‘light touch’ regulatory regime and signed up to greater supervisory integration at EU level. Yet far from narrowing, the Channel looks as wide as ever. So what went wrong?
Part of the answer is to be found in continental Europe. Since the financial crisis, politicians in Germany and France have seen it as their task to bring Britain and the City of London to heel. France’s President Sarkozy has spoken of the “death of unregulated Anglo-Saxon finance”, while Chancellor Merkel has declared that Germany will no longer be dictated to by the City of London. The eurozone debt crisis has only reinforced continental suspicions of Britain and the City, because politicians in Berlin, Paris and elsewhere view both as a threat to the euro’s existence. They think that the City is home to ‘speculators’ who are bent on destroying the euro; and they believe that it marches to the tune of a eurosceptic government and a local media that is hostile to, and ignorant of, the EU.
Suspicions of the ‘Anglo-Saxon world’ explain at least some of the measures which have emerged from the EU’s machinery. The directive on alternative investment funds was a response to longstanding Franco-German concerns about the power exercised by hedge funds in London and New York. Likewise, more recent proposals to introduce a tax on financial transactions reflect an enduring ambition by some governments to curb ‘speculative activity’ in the world’s largest financial centres. Since the UK is disproportionately affected by such measures, it has unsurprisingly showed less enthusiasm for them than other EU member-states. Inevitably, this has made the UK looking like the country of old: that is, isolated and fighting to dilute EU initiatives targeting the financial sector.
From London’s perspective, all of this can seem a bit galling. The problem is not just that some EU measures have been the product of continental politicians playing to their domestic galleries, or that they affect Britain more than other EU countries. It is that some governments have tried to occupy the moral high ground while doing less than the UK in areas of greater importance. A case in point is the recapitalisation of banks – a crucial task since 2008, but one where a number of EU countries have (until very recently at least) been guilty of a combination of denial, foot-dragging and obfuscation. Seen from the UK, the reluctance of certain EU governments to tackle the weakness of their banking systems bears more responsibility for the eurozone crisis than speculators in the City of London.
None of this is to say that the UK has reverted to its traditional role as an uncritical defender of the interests of the City. If there ever was an identity of interest between the British government and the City, this is no longer the case. These days, the City is a ‘national champion’ that attracts the hostility rather than the respect of the general public. The UK realises that it has a comparative advantage in a sector that imposes large costs on society when things go wrong. The principal thrust of policy since 2008 has therefore been to try and reduce the vast contingent liability that the financial system places on British taxpayers. This was the main rationale of the Vickers Commission, which recommended that UK banks should keep their retail operations separate from their investment banking ones.
Few detached observers can seriously doubt that Britain’s era of ‘light touch’ regulation is over. The UK does not need to be cajoled by other EU countries into regulating banks and the City. It has implemented reforms before similar measures were even proposed at EU level (sparking European grumbles about British unilateralism); and in some areas (such as the structural separation of retail and investment banking activities), it intends to go further than other EU countries can countenance. The City’s future, it follows, is being decided by decisions in London as much as those in Brussels: hedge funds have relocated abroad in response to the perceived deterioration of Britain’s tax environment, while large UK banks have periodically threatened to follow suit in response to the Vickers reforms.
But if political rhetoric is anything to go by, perceptions in other member-states have yet to adjust to this new reality. In many quarters, the UK continues to be portrayed at best as a recalcitrant country that has failed to learn the lessons of the global financial crisis, at worst as a hostile force that wishes to protect the interests of ‘speculators’ and the City the better to destroy the eurozone. Quite why the UK would benefit from the collapse of the eurozone – an event that, as the British government has repeatedly made clear, would be catastrophic for the UK economy – is not entirely clear. But lurid assumptions about the ‘Anglo-Saxon’ world are still a remarkably familiar background factor across Europe, shaping how many politicians think about financial regulation and the eurozone crisis.
The truth of the matter is this. There is no question that the UK is more ambivalent about the financial sector and the City than it has been in the past. But the UK does not believe that this justifies ill-conceived and costly initiatives that reflect political grandstanding in other EU countries; or, for that matter, that this gives carte blanche to other countries to drive financial activity away from London. Other EU countries have a justifiable interest in what happens in the City. It is less clear that they have legitimate grounds for pushing old hobby horses that win political points at home, do little to promote financial stability, yet inflict disproportionate costs on the UK (as host to Europe’s largest financial centre). The EU’s recently-proposed financial transactions tax looks like a case in point.
Philip Whyte is a senior research fellow
After years of mutual suspicion, Britain and its EU partners seemed in early 2009 to be converging in an area of policy where they had often been at odds – financial regulation. The Turner Review, Britain’s official report into the financial crisis, accepted that ‘light touch’ regulation had failed, and recognised that the UK would have to accept greater supervisory integration at EU level if the single market in financial services was to survive. Fast-forward two years, and it is hard not to be struck by a paradox. The UK has abandoned its ‘light touch’ regulatory regime and signed up to greater supervisory integration at EU level. Yet far from narrowing, the Channel looks as wide as ever. So what went wrong?
Part of the answer is to be found in continental Europe. Since the financial crisis, politicians in Germany and France have seen it as their task to bring Britain and the City of London to heel. France’s President Sarkozy has spoken of the “death of unregulated Anglo-Saxon finance”, while Chancellor Merkel has declared that Germany will no longer be dictated to by the City of London. The eurozone debt crisis has only reinforced continental suspicions of Britain and the City, because politicians in Berlin, Paris and elsewhere view both as a threat to the euro’s existence. They think that the City is home to ‘speculators’ who are bent on destroying the euro; and they believe that it marches to the tune of a eurosceptic government and a local media that is hostile to, and ignorant of, the EU.
Suspicions of the ‘Anglo-Saxon world’ explain at least some of the measures which have emerged from the EU’s machinery. The directive on alternative investment funds was a response to longstanding Franco-German concerns about the power exercised by hedge funds in London and New York. Likewise, more recent proposals to introduce a tax on financial transactions reflect an enduring ambition by some governments to curb ‘speculative activity’ in the world’s largest financial centres. Since the UK is disproportionately affected by such measures, it has unsurprisingly showed less enthusiasm for them than other EU member-states. Inevitably, this has made the UK looking like the country of old: that is, isolated and fighting to dilute EU initiatives targeting the financial sector.
From London’s perspective, all of this can seem a bit galling. The problem is not just that some EU measures have been the product of continental politicians playing to their domestic galleries, or that they affect Britain more than other EU countries. It is that some governments have tried to occupy the moral high ground while doing less than the UK in areas of greater importance. A case in point is the recapitalisation of banks – a crucial task since 2008, but one where a number of EU countries have (until very recently at least) been guilty of a combination of denial, foot-dragging and obfuscation. Seen from the UK, the reluctance of certain EU governments to tackle the weakness of their banking systems bears more responsibility for the eurozone crisis than speculators in the City of London.
None of this is to say that the UK has reverted to its traditional role as an uncritical defender of the interests of the City. If there ever was an identity of interest between the British government and the City, this is no longer the case. These days, the City is a ‘national champion’ that attracts the hostility rather than the respect of the general public. The UK realises that it has a comparative advantage in a sector that imposes large costs on society when things go wrong. The principal thrust of policy since 2008 has therefore been to try and reduce the vast contingent liability that the financial system places on British taxpayers. This was the main rationale of the Vickers Commission, which recommended that UK banks should keep their retail operations separate from their investment banking ones.
Few detached observers can seriously doubt that Britain’s era of ‘light touch’ regulation is over. The UK does not need to be cajoled by other EU countries into regulating banks and the City. It has implemented reforms before similar measures were even proposed at EU level (sparking European grumbles about British unilateralism); and in some areas (such as the structural separation of retail and investment banking activities), it intends to go further than other EU countries can countenance. The City’s future, it follows, is being decided by decisions in London as much as those in Brussels: hedge funds have relocated abroad in response to the perceived deterioration of Britain’s tax environment, while large UK banks have periodically threatened to follow suit in response to the Vickers reforms.
But if political rhetoric is anything to go by, perceptions in other member-states have yet to adjust to this new reality. In many quarters, the UK continues to be portrayed at best as a recalcitrant country that has failed to learn the lessons of the global financial crisis, at worst as a hostile force that wishes to protect the interests of ‘speculators’ and the City the better to destroy the eurozone. Quite why the UK would benefit from the collapse of the eurozone – an event that, as the British government has repeatedly made clear, would be catastrophic for the UK economy – is not entirely clear. But lurid assumptions about the ‘Anglo-Saxon’ world are still a remarkably familiar background factor across Europe, shaping how many politicians think about financial regulation and the eurozone crisis.
The truth of the matter is this. There is no question that the UK is more ambivalent about the financial sector and the City than it has been in the past. But the UK does not believe that this justifies ill-conceived and costly initiatives that reflect political grandstanding in other EU countries; or, for that matter, that this gives carte blanche to other countries to drive financial activity away from London. Other EU countries have a justifiable interest in what happens in the City. It is less clear that they have legitimate grounds for pushing old hobby horses that win political points at home, do little to promote financial stability, yet inflict disproportionate costs on the UK (as host to Europe’s largest financial centre). The EU’s recently-proposed financial transactions tax looks like a case in point.
Philip Whyte is a senior research fellow
Monday, October 03, 2011
Eurozone crisis: Higher inflation is part of the answer
by Simon Tilford
The biggest challenge facing the eurozone is how to generate economic growth. Whatever its leaders agree in terms of fiscal targets and surveillance will achieve little in the absence of growth. Excessively restrictive fiscal policy is clearly one obstacle to such growth, but the European Central Bank’s obsession with inflation is another. Of course the central bank must guard against excessive inflation, but it is a big problem when its fear of inflation blinds it to the much more serious threats confronting the eurozone economy. Indeed, somewhat higher inflation may be part of the solution to the crisis facing Europe. If policy continues to be directed at ensuring inflation of "below, but close to 2 per cent", countries such as Spain and Italy will struggle to regain competitiveness within the eurozone and their debt burdens will be unsustainable.
The Bundesbank's legacy is clearly visible in the ECB's official strategy. The central bank's interpretation of price stability means it has the most restrictive target or 'reference value' of price stability of any major central bank. Given that many eurozone countries have historically been prone to high inflation, the ECB’s determination to build a reputation for guaranteeing price stability is understandable. Officials from the bank never tire of saying that ensuring low inflation is the best contribution the ECB can make to economic growth. Price stability is important, of course. But a reference value of under 2 per cent and no accompanying mandate to ensure an adequate level of economic activity (such as that faced by the US Federal Reserve) is too restrictive. It is damaging in a number of ways for a currency union such as the eurozone.
First, it increases the risk that interest rates will be raised in response to temporary shocks – such as higher oil prices – that do not threaten medium-term price stability. This was illustrated by the ECB's decision to raise interest rates in July 2008, when the eurozone economy was already contracting. Perhaps more egregious was its decision to raise interest rates in July 2011, despite strong evidence of a slowing economy, against the backdrop of a deepening sovereign debt and banking sector crisis, and in the face of very restrictive fiscal policy across the currency union. The ECB’s decision to raise rates despite these headwinds raises serious concerns over its mandate. The central bank is unlikely to cut interest rates at this week’s meeting because eurozone inflation currently stands at 3 per cent. This is largely because of higher energy prices whose impact on the consumer prices index will weaken sharply from early next year.
Second, an inflation target of below, but close to 2 per cent leaves very little room for adjustment within the currency union. Since countries such as Spain and Italy cannot devalue, they can only improve their 'competitiveness' by cutting their costs relative to Germany. Such a strategy will lead to deflation and debt traps unless German inflation rises more quickly than the current projections of around 1.5 per cent per annum. The eurozone would be better off with a symmetrical eurozone inflation target of 3 per cent with the inflation rate allowed to deviate by no more than 1 percentage point in either direction. Such a target would make it much easier for a member-state to hold its inflation rate (and wage growth) below the eurozone average without risking economic stagnation and deflation.
Although a target of under 2 per cent might have been appropriate for the Bundesbank, it is ill-suited to the eurozone. Unlike Germany, the eurozone is a largely closed economy (exports account for a similar proportion of GDP as they do in US) and hence cannot rely to anywhere near the same extent as Germany on exports to close the gap between output and expenditure. The currency union as a whole cannot expect to export its way out of trouble – it needs robust growth in domestic demand.
If the ECB had to take economic activity into account, not only would eurozone interest rates be lower, but the central bank would also be pumping money directly into the eurozone economy. Much like the US Fed, the Bank of Japan and the Bank of England – all of whom like the ECB face economies struggling with the aftermath of financial crises and the associated collapse in aggregate demand – the ECB would be engaged in so-called quantitative easing (QE), the unsterilised purchasing of government debt and other assets. By bringing down public and private borrowing costs and boosting the volume of credit, QE could strengthen economic activity and guard against the risk of deflation.
Supporters of the ECB's current mandate would no doubt argue that the Fed's dual target of inflation and employment has caused it to pump up one bubble after another. The Fed is forced to sacrifice the principle of sound money on the altar of short-term pump-priming. The result is an unbalanced US economy, excessive debt, and a world awash with dollars. This, in turn, puts downward pressure on the US currency, threatening international monetary stability. But this is a largely self-serving analysis. Had the Fed not kept interest rates very low and pumped money into its economy, the world would have had an even bigger problem: the US economy would have slumped, and its trade balance swung into surplus.
The eurozone is essentially trying to ensure monetary stability in Europe at the cost of higher debt elsewhere: the crisis strategy for the currency union is for everyone to save more, and spend less – to 'live within their means'. This implies the eurozone running a huge trade surplus with the rest of the world. But this will not be possible. East Asia is pursuing a similar strategy to the eurozone. And the US economy is simply too indebted and not big enough to act as the consumer of last resort for both East Asia and Europe.
The ECB should not be responsible for setting its own mandate. One option would be to transfer responsibility for this to the Euro Group, which would agree decisions by qualified majority. Such a move would not necessarily require a new treaty; a unanimous decision in the Council could be enough. Unfortunately, there is no chance of this happening. Reforms of eurozone governance will not include reform of the ECB since several eurozone governments, not least the German one, are steadfastly opposed to such a move.
This leaves the currency bloc vulnerable to slump and on-going crisis. Fiscal policy is highly contractionary. The monetary policy stance is restrictive, given the depth of the economic weakness. The currency union as a whole cannot export its way out of trouble. Structural reforms should help to boost growth in the medium to long term. But such reforms need to be accompanied by investment if they are to deliver on their potential and with demand so weak investment will be thin on the ground. It is beholden on those governments that oppose greater monetary stimulus to explain how the eurozone economy is to grow and how the necessary adjustment in price and labour costs between the participating economies are to be made.
Simon Tilford is chief economist at the Centre for European Reform.
The biggest challenge facing the eurozone is how to generate economic growth. Whatever its leaders agree in terms of fiscal targets and surveillance will achieve little in the absence of growth. Excessively restrictive fiscal policy is clearly one obstacle to such growth, but the European Central Bank’s obsession with inflation is another. Of course the central bank must guard against excessive inflation, but it is a big problem when its fear of inflation blinds it to the much more serious threats confronting the eurozone economy. Indeed, somewhat higher inflation may be part of the solution to the crisis facing Europe. If policy continues to be directed at ensuring inflation of "below, but close to 2 per cent", countries such as Spain and Italy will struggle to regain competitiveness within the eurozone and their debt burdens will be unsustainable.
The Bundesbank's legacy is clearly visible in the ECB's official strategy. The central bank's interpretation of price stability means it has the most restrictive target or 'reference value' of price stability of any major central bank. Given that many eurozone countries have historically been prone to high inflation, the ECB’s determination to build a reputation for guaranteeing price stability is understandable. Officials from the bank never tire of saying that ensuring low inflation is the best contribution the ECB can make to economic growth. Price stability is important, of course. But a reference value of under 2 per cent and no accompanying mandate to ensure an adequate level of economic activity (such as that faced by the US Federal Reserve) is too restrictive. It is damaging in a number of ways for a currency union such as the eurozone.
First, it increases the risk that interest rates will be raised in response to temporary shocks – such as higher oil prices – that do not threaten medium-term price stability. This was illustrated by the ECB's decision to raise interest rates in July 2008, when the eurozone economy was already contracting. Perhaps more egregious was its decision to raise interest rates in July 2011, despite strong evidence of a slowing economy, against the backdrop of a deepening sovereign debt and banking sector crisis, and in the face of very restrictive fiscal policy across the currency union. The ECB’s decision to raise rates despite these headwinds raises serious concerns over its mandate. The central bank is unlikely to cut interest rates at this week’s meeting because eurozone inflation currently stands at 3 per cent. This is largely because of higher energy prices whose impact on the consumer prices index will weaken sharply from early next year.
Second, an inflation target of below, but close to 2 per cent leaves very little room for adjustment within the currency union. Since countries such as Spain and Italy cannot devalue, they can only improve their 'competitiveness' by cutting their costs relative to Germany. Such a strategy will lead to deflation and debt traps unless German inflation rises more quickly than the current projections of around 1.5 per cent per annum. The eurozone would be better off with a symmetrical eurozone inflation target of 3 per cent with the inflation rate allowed to deviate by no more than 1 percentage point in either direction. Such a target would make it much easier for a member-state to hold its inflation rate (and wage growth) below the eurozone average without risking economic stagnation and deflation.
Although a target of under 2 per cent might have been appropriate for the Bundesbank, it is ill-suited to the eurozone. Unlike Germany, the eurozone is a largely closed economy (exports account for a similar proportion of GDP as they do in US) and hence cannot rely to anywhere near the same extent as Germany on exports to close the gap between output and expenditure. The currency union as a whole cannot expect to export its way out of trouble – it needs robust growth in domestic demand.
If the ECB had to take economic activity into account, not only would eurozone interest rates be lower, but the central bank would also be pumping money directly into the eurozone economy. Much like the US Fed, the Bank of Japan and the Bank of England – all of whom like the ECB face economies struggling with the aftermath of financial crises and the associated collapse in aggregate demand – the ECB would be engaged in so-called quantitative easing (QE), the unsterilised purchasing of government debt and other assets. By bringing down public and private borrowing costs and boosting the volume of credit, QE could strengthen economic activity and guard against the risk of deflation.
Supporters of the ECB's current mandate would no doubt argue that the Fed's dual target of inflation and employment has caused it to pump up one bubble after another. The Fed is forced to sacrifice the principle of sound money on the altar of short-term pump-priming. The result is an unbalanced US economy, excessive debt, and a world awash with dollars. This, in turn, puts downward pressure on the US currency, threatening international monetary stability. But this is a largely self-serving analysis. Had the Fed not kept interest rates very low and pumped money into its economy, the world would have had an even bigger problem: the US economy would have slumped, and its trade balance swung into surplus.
The eurozone is essentially trying to ensure monetary stability in Europe at the cost of higher debt elsewhere: the crisis strategy for the currency union is for everyone to save more, and spend less – to 'live within their means'. This implies the eurozone running a huge trade surplus with the rest of the world. But this will not be possible. East Asia is pursuing a similar strategy to the eurozone. And the US economy is simply too indebted and not big enough to act as the consumer of last resort for both East Asia and Europe.
The ECB should not be responsible for setting its own mandate. One option would be to transfer responsibility for this to the Euro Group, which would agree decisions by qualified majority. Such a move would not necessarily require a new treaty; a unanimous decision in the Council could be enough. Unfortunately, there is no chance of this happening. Reforms of eurozone governance will not include reform of the ECB since several eurozone governments, not least the German one, are steadfastly opposed to such a move.
This leaves the currency bloc vulnerable to slump and on-going crisis. Fiscal policy is highly contractionary. The monetary policy stance is restrictive, given the depth of the economic weakness. The currency union as a whole cannot export its way out of trouble. Structural reforms should help to boost growth in the medium to long term. But such reforms need to be accompanied by investment if they are to deliver on their potential and with demand so weak investment will be thin on the ground. It is beholden on those governments that oppose greater monetary stimulus to explain how the eurozone economy is to grow and how the necessary adjustment in price and labour costs between the participating economies are to be made.
Simon Tilford is chief economist at the Centre for European Reform.
Monday, September 19, 2011
The euro: Reaching the endgame?
by Simon Tilford
Eurozone policy-makers, especially German and Dutch ones, have been unable to rise above hubris and moral posturing, leaving the eurozone with very little ammunition to confront the coming financial storm. They have stubbornly dug in their feet, preferring to deepen the crisis than to admit their mistakes. This makes a fracturing of the eurozone almost inevitable. And it will not simply be Greece (and possibly Portugal) leaving, as some German and Dutch policy-makers appear to think. This is wilfully naive. This threat goes right up to and includes France. A ‘core’ could be very small indeed, comprising just Germany, the Netherlands, Austria, Finland and Luxembourg. France and Germany would no longer share a currency.
The eurozone has opted to deny itself the policy tools to deal with the crisis: there will be no debt mutualisation, even one accompanied by tight fiscal rules; the European Central Bank (ECB) will not be permitted to exercise the full range of lender of last resort functions (for example, to buy unlimited volumes of sovereign debt or other financial assets); there will be no co-ordinated recapitalisation of eurozone banks; and economic policy will be driven by faith, not reason (leading eurozone policy-makers believe that unco-ordinated, simultaneous cuts in public spending allied to tax increases, will boost household and business confidence). This is the kind of thinking that caused economic slump in the 1930s, and with it the rise of political extremism.
Debt mutualisation: September’s ruling by Germany’s Constitutional Court has thrown a further obstacle in the way of the issuance of eurobonds, but the political obstacles to such a move were already formidable. A move to fiscal union cannot be pushed through under the radar (in time-honoured EU tradition) but has to be sanctioned democratically. Because of the way various eurozone governments (especially the German and Dutch ones) have characterised the eurozone crisis – as a battle between the virtuous and the venal, between those countries that keep to the rules and those that break them – it will be nigh-impossible to win democratic consent for a debt union in these countries.
Lender of last resort: The ECB is highly unlikely to be permitted to carry out the full range of lender of last resort functions to eurozone sovereigns and banks. It will not, for example, be free to step in and buy unlimited amounts of government debt in order to demonstrate to investors that their fears over insolvency are unfounded. The resignations of both Juergen Stark and Axel Weber (the German chief economist at the ECB and the head of Bundesbank respectively) in protest at the ECB’s buying of the government debt of hard-hit member-states, demonstrates that much of the German policy establishment would prefer the crisis to run its course rather than compromise on their philosophical positions. Had the ECB not stepped in to purchase Spanish and Italian bonds over the summer of 2011, both countries’ borrowing costs would have continued to balloon, almost certainly causing interrelated sovereign and banking sector crises, calling into question the future of the single currency.
Far from laying the way open for a more activist ECB strategy aimed at reassuring investors that the central banks stand behind the sovereign debt of eurozone economies, the departure of Mr Stark confirms the breach with Germany and threatens to paralyse the ECB. In extremis, the European Financial Stability Fund (EFSF) and its successor, the European Stability Mechanism (ESM), will be able to buy some sovereign debt and inject some funds into the banks, but nowhere near enough to cope with an interrelated sovereign and banking sector crisis. Any attempt at a properly activist strategy will prompt a stand-off with Germany. The outcome of such a stand-off cannot be predicted, but it is unlikely to involve Germany backing-down (at least, not far enough) and the ECB could not risk pushing ahead in the teeth of German opposition.
Bank recapitalisation: The dual failure to agree debt mutualisation or allow the ECB to act in the interests of the whole eurozone rather than just its creditor economies would be less critical if eurozone governments were moving to recapitalise their banks, so that they were better placed to cope with the coming debt defaults. Eurozone policy-makers had hoped that a rebound in economic growth and moves to postpone defaults would give eurozone banks time to strengthen their balance sheets. But with the eurozone economy having almost certainly fallen back into recession, this strategy is untenable. Despite an unfolding banking crisis – some bank shares have already fallen by more than in the 2008 financial crisis – there is no plan to make Europe’s banks bullet proof. August’s call by Christine Lagarde (the former French finance minister and now head of the IMF) for the forced recapitalisation of eurozone banks was airily dismissed across the eurozone. But it would be much cheaper to address the problem now than try to pick up the pieces later.
Growth-orientated economic policy: Finally, eurozone macroeconomic policy is being driven by a belief in the confidence fairy. Eurozone policy-makers, from German finance minister, Wolfgang Schaeuble, to ECB president, Jean-Claude Trichet, queue up to argue that fiscal austerity, even if pursued by all member-states simultaneously, will not be contractionary, let alone risk destroying the euro. According to this belief, fiscal austerity will boost household and business confidence by reassuring households and businesses that government finances are sustainable, leading to a recovery in consumption and investment. But they are unable to cite any historical precedent in support of this belief, which appears to boil down to little more than faith. There are, of course, examples of fiscal austerity preceding economic growth, but they all include currency devaluation and/or big cuts in interest rates. Neither option is open to eurozone economies. Unsurprisingly, household and business confidence is crumbling rapidly across the currency union, depressing economic activity, and with it the likelihood of governments meeting their fiscal targets.
On current policy trends, a series of sovereign and banking defaults are unavoidable. Does this mean that dissolution of the eurozone is inevitable? Almost certainly, yes. On current policy trends, much of the eurozone faces depression and deflation. The ECB and EFSF will not be able to keep a lid on bond yields, with the result that countries will face unsustainably high borrowing costs and default. This, in turn, will cripple these countries’ banking sectors, but they will be unable to raise the funds needed to recapitalise them. Stuck in a vicious deflationary circle, unable to borrow on affordable terms, and subject to quixotic and counter-productive fiscal and other rules for what support they do get from the EFSF and ECB, political support for continued membership will drain away. Faced with a choice between permanent slump and rising debt burdens (as falling GDP and deflation leads to inexorable increases in debt), countries will elect to quit the currency union. At least this way they will be able to print money, recapitalise their banks and escape deflation. Once Spain or Italy opt for this, the dissolution of the eurozone will be unstoppable. Investors will not wear French participation in a core euro: the country has weak public finances and a sizeable external deficit. Participation in the core would imply a potentially huge real currency appreciation and a corresponding collapse in economic activity. Investors will calculate that the wage cuts (to restore competitiveness) and cuts in public spending (to rein in the fiscal deficit) would be politically unsustainable. In short, France will effectively be in the same position as Italy and Spain are at present.
Such contentions are met with derision and incredulity across much of the eurozone. Otherwise rational people talk about something ‘coming up’ or express confidence that policy-makers ‘will never let that happen’. The political investment in the project is just too great for this to happen, they argue, usually accompanying this assertion with accusations that Anglo-Saxons are hopelessly wedded to the world of the nation-state and just do not understand that Europe has moved beyond such primitive attachments. Such assertions sit very uneasily with events over the last two years. The euro crisis has spun out of control because eurozone governments are unwilling to acknowledge that their policies have an impact on other member-states, and that this requires a measure of solidarity. Indeed, if there is one thing this crisis has shown, it is that the nation-state is alive and kicking in the eurozone.
Simon Tilford is chief economist at the CER.
Eurozone policy-makers, especially German and Dutch ones, have been unable to rise above hubris and moral posturing, leaving the eurozone with very little ammunition to confront the coming financial storm. They have stubbornly dug in their feet, preferring to deepen the crisis than to admit their mistakes. This makes a fracturing of the eurozone almost inevitable. And it will not simply be Greece (and possibly Portugal) leaving, as some German and Dutch policy-makers appear to think. This is wilfully naive. This threat goes right up to and includes France. A ‘core’ could be very small indeed, comprising just Germany, the Netherlands, Austria, Finland and Luxembourg. France and Germany would no longer share a currency.
The eurozone has opted to deny itself the policy tools to deal with the crisis: there will be no debt mutualisation, even one accompanied by tight fiscal rules; the European Central Bank (ECB) will not be permitted to exercise the full range of lender of last resort functions (for example, to buy unlimited volumes of sovereign debt or other financial assets); there will be no co-ordinated recapitalisation of eurozone banks; and economic policy will be driven by faith, not reason (leading eurozone policy-makers believe that unco-ordinated, simultaneous cuts in public spending allied to tax increases, will boost household and business confidence). This is the kind of thinking that caused economic slump in the 1930s, and with it the rise of political extremism.
Debt mutualisation: September’s ruling by Germany’s Constitutional Court has thrown a further obstacle in the way of the issuance of eurobonds, but the political obstacles to such a move were already formidable. A move to fiscal union cannot be pushed through under the radar (in time-honoured EU tradition) but has to be sanctioned democratically. Because of the way various eurozone governments (especially the German and Dutch ones) have characterised the eurozone crisis – as a battle between the virtuous and the venal, between those countries that keep to the rules and those that break them – it will be nigh-impossible to win democratic consent for a debt union in these countries.
Lender of last resort: The ECB is highly unlikely to be permitted to carry out the full range of lender of last resort functions to eurozone sovereigns and banks. It will not, for example, be free to step in and buy unlimited amounts of government debt in order to demonstrate to investors that their fears over insolvency are unfounded. The resignations of both Juergen Stark and Axel Weber (the German chief economist at the ECB and the head of Bundesbank respectively) in protest at the ECB’s buying of the government debt of hard-hit member-states, demonstrates that much of the German policy establishment would prefer the crisis to run its course rather than compromise on their philosophical positions. Had the ECB not stepped in to purchase Spanish and Italian bonds over the summer of 2011, both countries’ borrowing costs would have continued to balloon, almost certainly causing interrelated sovereign and banking sector crises, calling into question the future of the single currency.
Far from laying the way open for a more activist ECB strategy aimed at reassuring investors that the central banks stand behind the sovereign debt of eurozone economies, the departure of Mr Stark confirms the breach with Germany and threatens to paralyse the ECB. In extremis, the European Financial Stability Fund (EFSF) and its successor, the European Stability Mechanism (ESM), will be able to buy some sovereign debt and inject some funds into the banks, but nowhere near enough to cope with an interrelated sovereign and banking sector crisis. Any attempt at a properly activist strategy will prompt a stand-off with Germany. The outcome of such a stand-off cannot be predicted, but it is unlikely to involve Germany backing-down (at least, not far enough) and the ECB could not risk pushing ahead in the teeth of German opposition.
Bank recapitalisation: The dual failure to agree debt mutualisation or allow the ECB to act in the interests of the whole eurozone rather than just its creditor economies would be less critical if eurozone governments were moving to recapitalise their banks, so that they were better placed to cope with the coming debt defaults. Eurozone policy-makers had hoped that a rebound in economic growth and moves to postpone defaults would give eurozone banks time to strengthen their balance sheets. But with the eurozone economy having almost certainly fallen back into recession, this strategy is untenable. Despite an unfolding banking crisis – some bank shares have already fallen by more than in the 2008 financial crisis – there is no plan to make Europe’s banks bullet proof. August’s call by Christine Lagarde (the former French finance minister and now head of the IMF) for the forced recapitalisation of eurozone banks was airily dismissed across the eurozone. But it would be much cheaper to address the problem now than try to pick up the pieces later.
Growth-orientated economic policy: Finally, eurozone macroeconomic policy is being driven by a belief in the confidence fairy. Eurozone policy-makers, from German finance minister, Wolfgang Schaeuble, to ECB president, Jean-Claude Trichet, queue up to argue that fiscal austerity, even if pursued by all member-states simultaneously, will not be contractionary, let alone risk destroying the euro. According to this belief, fiscal austerity will boost household and business confidence by reassuring households and businesses that government finances are sustainable, leading to a recovery in consumption and investment. But they are unable to cite any historical precedent in support of this belief, which appears to boil down to little more than faith. There are, of course, examples of fiscal austerity preceding economic growth, but they all include currency devaluation and/or big cuts in interest rates. Neither option is open to eurozone economies. Unsurprisingly, household and business confidence is crumbling rapidly across the currency union, depressing economic activity, and with it the likelihood of governments meeting their fiscal targets.
On current policy trends, a series of sovereign and banking defaults are unavoidable. Does this mean that dissolution of the eurozone is inevitable? Almost certainly, yes. On current policy trends, much of the eurozone faces depression and deflation. The ECB and EFSF will not be able to keep a lid on bond yields, with the result that countries will face unsustainably high borrowing costs and default. This, in turn, will cripple these countries’ banking sectors, but they will be unable to raise the funds needed to recapitalise them. Stuck in a vicious deflationary circle, unable to borrow on affordable terms, and subject to quixotic and counter-productive fiscal and other rules for what support they do get from the EFSF and ECB, political support for continued membership will drain away. Faced with a choice between permanent slump and rising debt burdens (as falling GDP and deflation leads to inexorable increases in debt), countries will elect to quit the currency union. At least this way they will be able to print money, recapitalise their banks and escape deflation. Once Spain or Italy opt for this, the dissolution of the eurozone will be unstoppable. Investors will not wear French participation in a core euro: the country has weak public finances and a sizeable external deficit. Participation in the core would imply a potentially huge real currency appreciation and a corresponding collapse in economic activity. Investors will calculate that the wage cuts (to restore competitiveness) and cuts in public spending (to rein in the fiscal deficit) would be politically unsustainable. In short, France will effectively be in the same position as Italy and Spain are at present.
Such contentions are met with derision and incredulity across much of the eurozone. Otherwise rational people talk about something ‘coming up’ or express confidence that policy-makers ‘will never let that happen’. The political investment in the project is just too great for this to happen, they argue, usually accompanying this assertion with accusations that Anglo-Saxons are hopelessly wedded to the world of the nation-state and just do not understand that Europe has moved beyond such primitive attachments. Such assertions sit very uneasily with events over the last two years. The euro crisis has spun out of control because eurozone governments are unwilling to acknowledge that their policies have an impact on other member-states, and that this requires a measure of solidarity. Indeed, if there is one thing this crisis has shown, it is that the nation-state is alive and kicking in the eurozone.
Simon Tilford is chief economist at the CER.
Friday, August 26, 2011
What Libya says about future NATO operations
by Tomas Valasek
Libya has been a difficult war for NATO. It has shown the alliance divided: only eight out of 28 allies sent combat forces. Some of them ran out of ammunition and Italy withdrew its aircraft carrier in the midst of the conflict because the government needed to cut expenses. The Americans’ frustration with European performance boiled over in June, when the then-secretary of defence Robert Gates warned that NATO faced a ‘dim and dismal’ future.
Yet critics of NATO’s performance are missing a bigger story: in Libya, the Europeans have for the first time responded to Washington’s calls to assume more responsibility for their neighbourhood. In complete contrast to the Balkans in the 1990s, they have taken decisive military action. As a result, the United States could take a back seat while the Europeans have absorbed most of the risks and costs of the ultimately successful war. This should be cause for cautious optimism about NATO.
Libya is an unheralded triumph for US diplomacy. One of Washington’s consistent aims has been to convince its allies to relieve the US military burden. In Libya, the US at last did what it had long threatened to do: the Obama administration, never too keen on the intervention in the first place, turned over most operations to allies shortly after the war’s initial stage, which had been led by US forces.
The US’s policy has had the desired effect on Europe: it has energised the key allies. French and British air forces, along with other European, Canadian and Middle Eastern colleagues, have performed the majority of the bombing raids since early weeks of the six-month war. In a sense, Libya is the antithesis to Europe’s failure to act in Bosnia. When bloodshed in the Balkans broke out in the 1990s, senior politicians on the continent hailed the ‘hour of Europe’, when an economic power would become a security player. But key European capitals could not summon the political will to use force, and, embarrassingly, it fell mostly to the US to end the civil war in Bosnia. In Libya, European governments acted swiftly, and helped the rebels win the war. In the process, the allies established a new division of labour for NATO operations on Europe’s borders, which should be encouraged and developed further.
This is not to say that all is well in NATO. Germany’s refusal to support the mission is worrying; Europe’s diplomacy and military operations in Libya lacked the punch they would have had with the continent’s largest country on board. Money is also a concern. The new division of labour inside NATO can only work if European governments continue to invest in their militaries. They are failing to do this: over the past few years, European countries have cut defence budgets dramatically. The Libyan conflict has done little to change the trend: the fiscal crisis is ensnaring more governments each month, prompting deeper and deeper cuts in government expenses including defence. On present trends, the Europeans may well lose the ability to mount another Libya-style operation in the future.
However, as a recent CER essay points out, there are things that the governments in Europe can do to avoid such outcome: from getting rid of legacy Cold War equipment to buying new weapons jointly and integrating their exercise ranges, maintenance facilities and military academies. There is evidence that the Europeans are moving in the right direction – the French and the British recently agreed to share the costs of building and maintaining nuclear weapons; they also plan to buy missiles and drones together in the future. More governments are exploring other ideas for collaboration, and the Dutch and the Belgians as well as the Nordic countries have been doing so for several years. These measures will not completely offset the impact of budget cuts but they may soften the blow until the fiscal situation in Europe improves.
For their part, the American military leaders need to challenge overly negative assumptions about the alliance in the United States. The success of US efforts to delegate responsibility to Europe has gone almost completely unappreciated in Washington’s political discourse, whose focus has been on European military failings. This damages the image of NATO in the US, with potentially serious consequences. The US-European defence relationship can only work if the Americans continue to see the alliance as useful for their own security. And this should not be taken for granted: as time passes, politicians and the military in the US tend to be less and less informed by the experience of the Cold War, and less inclined to view Europe as their default partner. Undue criticism of allies’ military shortcomings only accelerates the de-Europeanisation of US foreign policy.
Encouragingly, the message from Washington has changed in recent days, with the new secretary of defence, Leon Panetta, praising NATO’s operation as an example of international cooperation. The success in Tripoli, along with the new-found will in London, Paris and other European capitals to assume greater responsibility for the security in its own neighbourhood, ought to give the Americans more reasons for optimism.
Tomas Valasek is director of foreign policy and defence at the CER.
Libya has been a difficult war for NATO. It has shown the alliance divided: only eight out of 28 allies sent combat forces. Some of them ran out of ammunition and Italy withdrew its aircraft carrier in the midst of the conflict because the government needed to cut expenses. The Americans’ frustration with European performance boiled over in June, when the then-secretary of defence Robert Gates warned that NATO faced a ‘dim and dismal’ future.
Yet critics of NATO’s performance are missing a bigger story: in Libya, the Europeans have for the first time responded to Washington’s calls to assume more responsibility for their neighbourhood. In complete contrast to the Balkans in the 1990s, they have taken decisive military action. As a result, the United States could take a back seat while the Europeans have absorbed most of the risks and costs of the ultimately successful war. This should be cause for cautious optimism about NATO.
Libya is an unheralded triumph for US diplomacy. One of Washington’s consistent aims has been to convince its allies to relieve the US military burden. In Libya, the US at last did what it had long threatened to do: the Obama administration, never too keen on the intervention in the first place, turned over most operations to allies shortly after the war’s initial stage, which had been led by US forces.
The US’s policy has had the desired effect on Europe: it has energised the key allies. French and British air forces, along with other European, Canadian and Middle Eastern colleagues, have performed the majority of the bombing raids since early weeks of the six-month war. In a sense, Libya is the antithesis to Europe’s failure to act in Bosnia. When bloodshed in the Balkans broke out in the 1990s, senior politicians on the continent hailed the ‘hour of Europe’, when an economic power would become a security player. But key European capitals could not summon the political will to use force, and, embarrassingly, it fell mostly to the US to end the civil war in Bosnia. In Libya, European governments acted swiftly, and helped the rebels win the war. In the process, the allies established a new division of labour for NATO operations on Europe’s borders, which should be encouraged and developed further.
This is not to say that all is well in NATO. Germany’s refusal to support the mission is worrying; Europe’s diplomacy and military operations in Libya lacked the punch they would have had with the continent’s largest country on board. Money is also a concern. The new division of labour inside NATO can only work if European governments continue to invest in their militaries. They are failing to do this: over the past few years, European countries have cut defence budgets dramatically. The Libyan conflict has done little to change the trend: the fiscal crisis is ensnaring more governments each month, prompting deeper and deeper cuts in government expenses including defence. On present trends, the Europeans may well lose the ability to mount another Libya-style operation in the future.
However, as a recent CER essay points out, there are things that the governments in Europe can do to avoid such outcome: from getting rid of legacy Cold War equipment to buying new weapons jointly and integrating their exercise ranges, maintenance facilities and military academies. There is evidence that the Europeans are moving in the right direction – the French and the British recently agreed to share the costs of building and maintaining nuclear weapons; they also plan to buy missiles and drones together in the future. More governments are exploring other ideas for collaboration, and the Dutch and the Belgians as well as the Nordic countries have been doing so for several years. These measures will not completely offset the impact of budget cuts but they may soften the blow until the fiscal situation in Europe improves.
For their part, the American military leaders need to challenge overly negative assumptions about the alliance in the United States. The success of US efforts to delegate responsibility to Europe has gone almost completely unappreciated in Washington’s political discourse, whose focus has been on European military failings. This damages the image of NATO in the US, with potentially serious consequences. The US-European defence relationship can only work if the Americans continue to see the alliance as useful for their own security. And this should not be taken for granted: as time passes, politicians and the military in the US tend to be less and less informed by the experience of the Cold War, and less inclined to view Europe as their default partner. Undue criticism of allies’ military shortcomings only accelerates the de-Europeanisation of US foreign policy.
Encouragingly, the message from Washington has changed in recent days, with the new secretary of defence, Leon Panetta, praising NATO’s operation as an example of international cooperation. The success in Tripoli, along with the new-found will in London, Paris and other European capitals to assume greater responsibility for the security in its own neighbourhood, ought to give the Americans more reasons for optimism.
Tomas Valasek is director of foreign policy and defence at the CER.
Thursday, August 25, 2011
The US and the EU should support the Palestinian bid for UN membership
by Clara Marina O'Donnell
For months, the US and the EU have tried to discourage the Palestinians from asking the UN to recognise the state of Palestine. On both sides of the Atlantic, governments are concerned that the UN bid will exacerbate the conflict with Israel. But so far, American and European efforts have failed. Instead Washington and its EU counterparts should exploit the Palestinian initiative. If framed constructively, UN recognition could actually strengthen the prospects for peace.
Since spring, Palestinian President Mahmoud Abbas has been planning to ask the UN to recognise a state of Palestine based on the 1967 borders, and grant it UN membership in September. Abbas is portraying the initiative as part of a campaign of non-violent protests against Israel, designed to make headway towards a two-state solution at a time when peace talks have stalled.
The UN bid is very popular amongst the Palestinian population and it has gained support from numerous countries, including those in the Arab League. But the US and several EU governments worry that UN recognition would only make peace harder to achieve. Israel is already threatening to sever all assistance and contact with the Palestinian authorities out of concern that they will use recognition to pursue claims against Israel at the International Court of Justice. Furthermore, emboldened Palestinian grass roots movements and Israeli settlers might try to reclaim land from each other in the West Bank, triggering unrest and potentially violence.
The Obama administration has already publicly declared that it will oppose any UN resolution recognising a Palestinian state. This would prevent the Palestinians from obtaining the UN Security Council’s endorsement – required for UN membership. But they could still ask the General Assembly to recognise them and give Palestine the status of a UN observer state.
As a result Washington and the Europeans have been trying to re-launch peace talks in an attempt to entice the Palestinians to drop their bid for recognition. But this approach is not working. A special meeting of the Quartet (a group set up to support the peace process, made up of the US, the EU, Russia and the UN) in July failed to reach any conclusions, never mind convince Palestinians and Israelis to restart negotiations. In early August, according to some press reports, Israeli Prime Minister Benjamin Netanyahu agreed to negotiate with the Palestinians on the basis of the 1967 ceasefire lines. In light of Netanyahu’s long standing opposition to the idea, this would be a significant breakthrough. But the Palestinians have so far rejected the offer because Netanyahu – whom Palestinians suspect is still not truly committed to negotiations – would only hold such talks if they recognised Israel as a Jewish state.
Instead of opposing the UN bid, Washington and its European partners should use the Palestinian initiative to strengthen their efforts to re-launch peace talks. The US and the EU should inform the Palestinians that they will support a request for UN membership so long as the Palestinians ask the UN to recognise a state of Palestine whose borders broadly resemble those of 1967; they commit themselves to resolving outstanding disputes with Israel through negotiations (including the exact demarcation of borders); and they extend their executive control over the territory only through agreement with Israel.
Such a resolution would curtail the risks envisaged by Israel and others about UN recognition. It would reaffirm the primacy of negotiations as the way to solve the conflict. And by eliminating legal ambiguities about who controls Palestinian territory, it would reduce the scope for Palestinian and Israeli popular protests. In addition, when presented under such terms, UN recognition could help address some of the obstacles which have stalled the peace process in recent years. It would ensure that the Arab world, while undergoing a major upheaval, endorsed the concept of a two-state solution. And it would force the militant group Hamas, which is still in control of Gaza and has so far been disdainful of the UN effort, to either endorse it or lose support amongst the Palestinian people.
It is unusual for the UN to grant membership to a state with such extensive caveats. And many of the challenges which have blighted peace talks in the past are set to remain. Nevertheless Abbas’ initiative could offer the best platform to re-launch negotiations between Israelis and Palestinians. And at a time when violence is flaring up around Gaza and the Israeli-Egyptian border, the US and the EU must do their utmost to ensure that the Palestinian UN bid does not trigger further instability.
Clara Marina O'Donnell is a research fellow at the Centre for European Reform.
For months, the US and the EU have tried to discourage the Palestinians from asking the UN to recognise the state of Palestine. On both sides of the Atlantic, governments are concerned that the UN bid will exacerbate the conflict with Israel. But so far, American and European efforts have failed. Instead Washington and its EU counterparts should exploit the Palestinian initiative. If framed constructively, UN recognition could actually strengthen the prospects for peace.
Since spring, Palestinian President Mahmoud Abbas has been planning to ask the UN to recognise a state of Palestine based on the 1967 borders, and grant it UN membership in September. Abbas is portraying the initiative as part of a campaign of non-violent protests against Israel, designed to make headway towards a two-state solution at a time when peace talks have stalled.
The UN bid is very popular amongst the Palestinian population and it has gained support from numerous countries, including those in the Arab League. But the US and several EU governments worry that UN recognition would only make peace harder to achieve. Israel is already threatening to sever all assistance and contact with the Palestinian authorities out of concern that they will use recognition to pursue claims against Israel at the International Court of Justice. Furthermore, emboldened Palestinian grass roots movements and Israeli settlers might try to reclaim land from each other in the West Bank, triggering unrest and potentially violence.
The Obama administration has already publicly declared that it will oppose any UN resolution recognising a Palestinian state. This would prevent the Palestinians from obtaining the UN Security Council’s endorsement – required for UN membership. But they could still ask the General Assembly to recognise them and give Palestine the status of a UN observer state.
As a result Washington and the Europeans have been trying to re-launch peace talks in an attempt to entice the Palestinians to drop their bid for recognition. But this approach is not working. A special meeting of the Quartet (a group set up to support the peace process, made up of the US, the EU, Russia and the UN) in July failed to reach any conclusions, never mind convince Palestinians and Israelis to restart negotiations. In early August, according to some press reports, Israeli Prime Minister Benjamin Netanyahu agreed to negotiate with the Palestinians on the basis of the 1967 ceasefire lines. In light of Netanyahu’s long standing opposition to the idea, this would be a significant breakthrough. But the Palestinians have so far rejected the offer because Netanyahu – whom Palestinians suspect is still not truly committed to negotiations – would only hold such talks if they recognised Israel as a Jewish state.
Instead of opposing the UN bid, Washington and its European partners should use the Palestinian initiative to strengthen their efforts to re-launch peace talks. The US and the EU should inform the Palestinians that they will support a request for UN membership so long as the Palestinians ask the UN to recognise a state of Palestine whose borders broadly resemble those of 1967; they commit themselves to resolving outstanding disputes with Israel through negotiations (including the exact demarcation of borders); and they extend their executive control over the territory only through agreement with Israel.
Such a resolution would curtail the risks envisaged by Israel and others about UN recognition. It would reaffirm the primacy of negotiations as the way to solve the conflict. And by eliminating legal ambiguities about who controls Palestinian territory, it would reduce the scope for Palestinian and Israeli popular protests. In addition, when presented under such terms, UN recognition could help address some of the obstacles which have stalled the peace process in recent years. It would ensure that the Arab world, while undergoing a major upheaval, endorsed the concept of a two-state solution. And it would force the militant group Hamas, which is still in control of Gaza and has so far been disdainful of the UN effort, to either endorse it or lose support amongst the Palestinian people.
It is unusual for the UN to grant membership to a state with such extensive caveats. And many of the challenges which have blighted peace talks in the past are set to remain. Nevertheless Abbas’ initiative could offer the best platform to re-launch negotiations between Israelis and Palestinians. And at a time when violence is flaring up around Gaza and the Israeli-Egyptian border, the US and the EU must do their utmost to ensure that the Palestinian UN bid does not trigger further instability.
Clara Marina O'Donnell is a research fellow at the Centre for European Reform.
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