Will the euro crisis lead to the break-up of EU member-states?

Last month over a million Catalonians marched for independence in Barcelona. Opinion polls say that support in the province for separation from Spain has doubled since the economic crisis started – and some polls put it at over 50 per cent. The Economist sees a clear link with the economic crisis, noting recently: "Whereas one-third of Catalans are convinced separatists, many others are simply enraged by their tax money propping up poorer regions." Meanwhile in Belgium, Bart de Wever's nationalist New Flemish Alliance did well in Flanders' local elections, and de Wever has become mayor of Antwerp. Like Catalan separatists, the Flemish dislike subsidising their poorer neighbours in Wallonia.  The two events seem to suggest a trend. But while bailouts and the austerity that stems from the euro crisis are making central governments unpopular throughout Europe, Spain's and Belgium's woes may be a poor predictor of developments elsewhere.

The growing support for independence in Catalonia is only partly driven by the crisis. Jordi Vaquer of the Barcelona Centre for International Affairs notes that the Partido Popular's (PP) return to power in Madrid in 2012 bears some responsibility for the surge of pro-independence sentiment in Catalonia. The conservative PP blames Spain's budgetary woes on the provinces' profligacy (they represent 40 per cent of total public spending in Spain). The Madrid government has set out to tighten control over the regions' finances. Many in Catalonia think the PP is using the crisis as an excuse to pursue their longstanding agenda of curbing regional autonomy. They note that Spain's economic woes are mainly the result of excessive private sector borrowing, over which the provinces have had no control.

Pro-independence sentiment in Spain and other parts of Europe has also grown stronger because some separatist parties have grown more adept at selling their message. The New Flemish Alliance (NVA) is a much smoother party than the hard-right Flemish Interest, who NVA replaced as the standard-bearer for independence. In Edinburgh, Alex Salmond of the Scottish National Party (SNP) has proven to be a capable leader, who has governed competently during his five-and-a-half years in power (Scotland has enjoyed considerable autonomy since the 1998 devolution of some powers from London to Edinburgh). In an effort to showcase his party's new moderation, he recently persuaded it to ditch its longstanding policy of withdrawal from NATO. Both de Wever and Salmond say they would keep a common army with their southern neighbours. The success of these moderate, articulate nationalists in some parts of Europe has boosted the appeal of pro-independence movements elsewhere. "Previously, voters in Catalonia saw separatism as something that dictators in the former Soviet Union and Yugoslavia did. Now it has become difficult to brush aside nationalists as crazies," Vaquer observes. 

But while the Flemish and Scottish pro-independence parties have learned not to scare voters, the appeal of nationalism in other parts of the EU has waned. The Slovaks elected a parliament in 2012 that for the first time in the country's 20-year history does not include the Hungary-bashing Slovak National Party (voters have grown wary of infighting in its top ranks, and of its leader's penchant for yachts and jets). A mildly-separatist party of ethnic Hungarians in Slovakia has also lost its place in the parliament in the same election; another mostly Hungarian party that openly favours good relations with the central government in Bratislava has taken its place. Politics in Europe remains deeply local – and while nationalist leaders in Spain or Flanders have being doing well, others have fallen victim to their own hubris or incompetence.

In 2014 the Scots may dampen separatist spirits in Europe. Earlier this month, the SNP agreed with the London government to hold a referendum on Scottish independence in the autumn of that year. However, a recent Ipsos MORI poll shows that only 35 per cent of those who plan to vote will opt for separation from Britain. If the Scottish referendum on independence fails, nationalist movements like those in Catalonia or the Basque country may find their case weakened (though the Scottish nationalists may make progress with their demands for greater autonomy from the central government).

In Scotland, ironically, the euro crisis has proved very damaging to the cause of independence. In the past the SNP said that an independent Scotland would join the euro. In current circumstances that policy would not be a vote winner. So the SNP’s new line is to favour independence but keep the pound. But if there is one thing that the euro crisis has taught people, it is that currency unions do not work without some sort of fiscal union. A separate Scotland that used the pound would have to accept the constraints of a 'fiscal compact' with the remainder of the United Kingdom. So it would not be as free from London’s dictat as many Scots would wish.

There is little doubt that austerity measures have generated anger against political classes everywhere in Europe. In Spain, this protest takes the form of demonstrations against the 'Madrid elites', from which pro-independence movements benefit. In the future, similar conditions may exist in other parts of Europe, such as Italy or France, so events in Catalonia or Flanders bear watching. But it would be too simple to extrapolate from them that other countries will go the way of Spain or Belgium. The grievances that drive pro-independence movements differ from country to country. And so does the quality of local political elites, both on the pro-independence side and among the central governments, which have the job of addressing the grievances that fuel separatism.

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

Alice in euroland: What political union for the single currency?

"When I use a word," Humpty Dumpty said, "it means just what I choose it to mean – neither more nor less." 
"The question is," said Alice, "whether you can make words mean so many different things." 
"The question is," said Humpty Dumpty, "which is to be master – that’s all." 
(Lewis Carroll, Through the Looking Glass, Chapter 6)

The underlying purpose of the ‘European project’ has always been clearer than its ultimate destination. Its purpose – to escape a traumatic past disfigured by dictatorship and war – has never been particularly contentious (what sane European would want a return to that?). But the same cannot be said of the EU’s final destination. For much of its history, the EU has hidden behind the foggy ambiguity of its aspiration to build an “ever closer union among the peoples of Europe”. The trouble is that this worthy aspiration has always meant very different things to different people. Those of a minimalist disposition, often to be found among the British, have usually understood it to mean little more than the removal of cross-border barriers to the free movement of goods, services, capital and people. Those of a more ambitious bent, more often to be found in continental Europe, have seen the ultimate goal of the project to be some sort of ‘political union’ (however understood).

The eurozone crisis has once again exposed the gulf between British and continental visions of the EU. But it has done a lot more. It has also forced European leaders to speak a little less airily about ‘political union’ than they have become accustomed to in the past. All agree that the single currency must be embedded in a real ‘political union’ if it is to survive. But they are being forced to define their terms. Roughly speaking, two schools of thought have emerged. One (mostly northern European) school thinks that the crisis resulted from errant behaviour. For it, political union means tighter rules, more strictly enforced. The second school believes that the architecture of the eurozone is flawed. For it, political union means transferring a number of critical responsibilities from national to European level. If the first school frets about moral hazard, the second worries about a dearth of solidarity. The first school emphasises collective discipline, the second mutual burden-sharing.

Which of the two schools has the better story to tell? Although Greece is a convincing poster child for the first school, the balance of evidence weighs heavily in favour of the second. To start with, compliance with rules before 2008 turned out to be a poor predictor of countries’ subsequent plight. Like Mark Twain’s stories, the eurozone had its good little boys to whom bad things happened and its naughty boys who prospered. (Ireland never broke the fiscal rules before 2008 but is now in a slump, while Germany did and is not.) Second, despite having lower levels of debt in aggregate, it is the eurozone, not the US, which has been in the eye of the storm – strong evidence that it is the eurozone’s architecture, rather than the behaviour of its constituents, which is to blame. Third, the more the principle of collective responsibility has been asserted, the worse the eurozone’s plight has become: efforts to instill discipline have signally failed to restore confidence in the eurozone.

The symptoms of this failure are numerous. Financial markets within the union have fragmented as private-sector capital has drained out of countries in the ‘periphery’. Long-term borrowing costs inside the union have become unsustainably polarised, pushing systemically important countries such as Spain and Italy perilously close to insolvency. Target 2 balances within the European System of Central Banks have ballooned as public-sector capital flows have replaced private ones. Countries experiencing private-sector capital flight have been forced to pursue self-defeating policies of fiscal austerity. Sound banks domiciled in countries with stressed sovereigns have become vulnerable to depositor flight. And so on. The countries under strain partly have themselves to blame. But they are also victims of the eurozone’s structure: Spain’s borrowing costs are vastly higher than those of euro ‘outs’ such as the UK, even though Spain’s public finances are in no worse shape.

European policy-makers have been slow to accept that the eurozone’s institutional configuration makes it structurally unstable. But in June 2012, the so-called ‘Gang of Four’ – a group consisting of the presidents of the European Council (Herman Van Rompuy), the European Commission (Jose-Manuel Barroso), the European Central Bank (Mario Draghi) and the Eurogroup (Jean-Claude Juncker) – submitted an important plan to set the eurozone on a more stable long-term footing. It marked an important departure, because its focus shifted to correcting the eurozone’s architectural flaws rather than the behaviour of its members. The policy areas covered – banking supervision, resolution regimes, deposit protection – may have been dry and technical. But the plan was deeply political. It proposed that the stabilisation of the eurozone required key functions to be moved from national level to European level. It was, in other words, a plan to federalise the eurozone.

Why is the federalisation of certain functions necessary to restore confidence in the eurozone? The answer is not that the tasks concerned will necessarily be carried out more competently at European level (the reverse may even be the case). It is that the existence of federal powers and instruments is both a symbol and a guarantee of member-states’ commitment to the union. The reason the eurozone faces an existential crisis while the US does not is not the result of a financial market conspiracy orchestrated by Anglo-Saxons (as some Europeans darkly claim). It is that the eurozone’s decentralised configuration raises doubts about individual states’ commitment to the union. Unlike in the eurozone, bank failures in the US did not push any of the constituent states (such as Delaware) into insolvency, because the associated costs were mutualised. No one thinks that the parlous state of California’s public finances will result in its exit from the US (unlike, say, Greece from the eurozone).
  
A currency union embedded in a fiscally decentralised confederation, it turns out, has been a highly unstable arrangement (particularly in the aftermath of a financial crisis). The adoption of new rules that constrain national sovereignty have not really helped to restore confidence or stability. Indeed, as new rules have proliferated, the eurozone has come to look less like a single currency and more like a rigid fixed exchange rate system on life support. For much of the past two years, redenomination risk has stalked the eurozone. So the Gang of Four is right. The eurozone needs a degree of federalisation to persuade investors and depositors that its members are committed to the currency union’s integrity and survival. Far from being some obscure technocratic fix, a banking union is better understood as an essential pillar of the sort of political union that the eurozone needs if it is to endure and prosper. The question, then, is whether the member-states now accept this.

The answer is that they are still split. The recent report by EU foreign ministers on the future of Europe (the ‘Westerwelle report’) hinted at a number of unresolved arguments between confederal and federal visions of Europe. A striking feature of the report was the number of reservations placed by certain member-states on the proposals of the Gang of Four. On the subject of a banking union, for example, the report said that “some members of the group underlined the importance of a common deposit protection scheme and of a restructuring and resolution scheme”. By implication, other member-states still think that such steps are unnecessary. Indeed, the impression created by the Westerwelle report is that there is more agreement among member-states about the need to develop the foreign policy than the economic dimension of political union. If this is what EU leaders end up doing, they risk creating a Potemkin village rather than a political union that stabilises the eurozone.

Alice’s question to Humpty Dumpty was spot on. Words can be made to mean very different things. Since the onset of the eurozone crisis, two meanings of political union have done battle. The first has emphasised collective discipline, or the need for rules that bind member-states. This is the language of confederalism. The other has emphasised mutualisation, or the need for solidarity and common institutions. This is the language of federalism. For much of the past two years, the language of confederalism has dominated: reforms have focused on improving behaviour rather than on fixing the eurozone’s flawed structure. But a more federal language is starting to emerge. There is more acceptance now than there was two years ago that rules may be necessary to curb moral hazard, but that they are insufficient to eliminate redenomination risk (and so restore confidence in the eurozone’s stability). This view, however, is still far from being universally shared by the member-states

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

Hollande, the Germans and political union

Before becoming French president, Franҫois Hollande did not appear to take much interest in the EU. However, in his youth he was a protégé of Jacques Delors, the French left’s great European, and his instincts seem to be broadly pro-EU. Hollande’s arrival in the Elysée has not led to dramatic changes in France’s EU policy, but a new approach is emerging. Compared with Nicolas Sarkozy, Hollande is less hostile to EU institutions, more willing to work closely with the southern European member-states and, most crucial of all, keener to demonstrate that France does not slavishly follow German wishes.

Hollande knows very well that a strong Franco-German relationship is indispensable to sorting out the problems of the eurozone in particular and the EU in general. But, as officials in the Elysée, the finance ministry and the foreign ministry made clear during recent conversations, Hollande wants a more balanced Franco-German relationship.

These officials emphasise that the ‘Deauville’ model of Paris-Berlin relations has been scrapped. At the Franco-German summit in Deauville in October 2010, Chancellor Angela Merkel made Nicolas Sarkozy, the then French president, accept the principle that private-sector holders of sovereign bonds of countries needing a bail-out should suffer losses. At an EU summit a few days later, the ‘Merkozy’ duo imposed that principle on their fellow leaders, who feared that its adoption would destabilise sovereign bond markets (which is exactly what happened).  At many other summits, too, Merkel and Sarkozy set the agenda or delayed decisions while they consulted each other. This upset other member-states and the EU institutions.

Hollande understands what drove Sarkozy towards followership vis-à-vis Merkel: for several years the German economy had out-performed France’s – notably on unit labour costs, employment, export performance and growth – so that the relationship had become unbalanced.

Hollande has therefore sought to strengthen France’s position relative to Germany in a number of ways. One is to consult other countries – especially Italy and Spain – and the European Commission on key issues. Sarkozy avoided getting too close to ‘problem’ member-states, lest the financial markets associate France with southern Europe. But Hollande does not have that hang-up. At his first summit, when he lined up with Italy’s Mario Monti and Spain’s Mariano Rajoy, the Germans were not amused, but they have now – according to the French – seen that a more inclusive system of leadership is in their interests. Hollande’s officials claim that he has not been and will not be so crude as to try and put together a bloc to counter Germany.

Hollande’s second way of strengthening French influence is to retain the austere fiscal targets that he inherited, notably by limiting the budget deficit to 3 per cent of GDP in 2013. Some government officials believe that this and the budgetary targets adopted by other EU governments – partly because of German pressure – are excessive and counter-productive. They nevertheless say that France needs to stick to 3 per cent in order to win credibility in Berlin. They think that as long as economic growth this year holds up to the predicted 0.8 per cent, the target is feasible. Although the current emphasis is on shrinking the budget deficit through tax rises, in future years spending cuts will predominate, officials say.

The third way of raising France’s standing is to improve the country’s competitiveness. Outside France, the president and his ministers are not perceived as being particularly committed to structural economic reform. During the presidential election campaign, Hollande avoided the subject. But some of the key officials in Paris say that the government is determined to reduce unit labour costs and to reform labour markets. If the current negotiations between the social partners on labour market reform break down, they say, the government will legislate. Many previous French governments have declared their commitment to such reforms, only to back down in the face of street protests. But Hollande’s people are adamant that he will stand firm – and it is arguable that over the past 30 years, Socialist governments have reformed more boldly than Gaullist governments.

Having got off to a rocky start with Merkel – who refused to meet him before the French presidential election – Hollande now has a good working relationship with her, his advisers say. Although personalities matter much less than interests in Franco-German relations, this pair may end up with a more affable relationship than Merkel and Sarkozy had. The dour Merkel, who likes to move slowly and cautiously, and the mercurial Sarkozy, who is impatient and partial to bold initiatives, were not natural soul-mates. Hollande, however, tends to be soft-spoken and a consensus builder – as is Merkel.

French officials claim that Hollande helped to persuade Germany’s leaders to shift their thinking on the euro crisis. For example, Merkel and Wolfgang Schäuble, her finance minister, have rallied behind Mario Draghi, the president of the European Central Bank (ECB), and his scheme to intervene in bond markets to lower the borrowing costs of peripheral countries (but the French worry that Jens Weidmann, the Bundesbank president who opposes the scheme, is winning the public relations battle inside Germany). The German government has also made clear that – like France – it wants Greece to stay in the euro, for fear of the consequences of its departure.

But many tensions remain between Paris and Berlin. The French support the Commission’s proposals for an EU-wide system of bank supervision that would cover all Europe’s banks; the Germans want only the largest, cross-border banks to be covered – apparently oblivious to the fact that many of the problems in European banking emerged in small or medium-sized banks. Germany seems to want to slow down an agreement on EU banking supervision, although the European Stability Mechanism (the permanent bail-out fund that will soon be operational) cannot help banks in difficulty until the new supervisory regime is in place. Furthermore, the German government is counselling Spain not to activate the Draghi mechanism to intervene in bond markets, perhaps because it fears a vote in the Bundestag; the French believe that the mechanism must be used soon, lest the financial markets cease to believe in its potency.

On longer-term issues of eurozone governance, too, there is a huge distance between Paris and Berlin. The French worry about the incoherence of the way the eurozone is managed – nobody is in charge, and governments do not know what different leaders have said to each other. They want the Eurogroup (the regular meetings of eurozone finance ministers) to provide some of the missing leadership by appointing a full-time president and by introducing majority voting. But some Germans worry that a stronger Eurogroup could erode the independence of the ECB.

The French think that, because they have swallowed the painful medicine of the fiscal compact – that they will soon ratify – and thus given away some of their cherished budgetary sovereignty, Germany should be keener to discuss ‘eurobonds’ (the mutualisation of European debt), pan-European bank deposit insurance and a bank resolution regime. But Germany still says no to those ideas, since they would cost it money.

Another broad disagreement is over the woolly concept of ‘political union’, which is moving up the EU’s agenda. On September 12th, José Manuel Barroso, the Commission president, called for a “federation of nation-states” when he spoke to the European Parliament. He promised proposals for a new EU treaty before the 2014 European elections.

In Berlin, there is much talk of ‘more Europe’, treaty change and political union. Indeed, a reflection group led by Guido Westerwelle, the German foreign minister – with the participation of eight other foreign ministries – published a report on September 17th on Europe’s future. This proposed classic federalist solutions to the EU’s problems: majority voting on foreign policy, a stronger role for the High Representative for foreign policy, a European army, an elected Commission president, a stronger European Parliament and a new system for ratifying treaties (to prevent small countries holding back everybody else). Many of the report’s proposals would require treaty change. However, several ministers taking part in the Westerwelle group have dissociated themselves from certain proposals, and some of the governments not involved have reacted coolly.

In Paris there is no enthusiasm for the concept of political union. Although France was involved in the Westerwelle group – sending a junior minister, rather than the foreign minister – some French officials talk disdainfully of it. “When the EU is in crisis, the Germans have a Pavlovian reaction and call for political union, without really meaning it,” said one. Another opined that Merkel did not support many of the ideas in the Westerwelle report and that the Germans did not know what they wanted from treaty change (in many other capitals, too, there is scepticism about Merkel’s commitment to the report).

The negotiation of a major new EU treaty would have to be preceded by a convention on the future of Europe (“a nightmare”, in the words of one French official) and followed by ratification in every member-state, with some holding referendums. The French are in no hurry to re-open institutional questions. In the words of one key official: “The EU spent the last decade dealing with treaty changes and institutions, when it should have been worrying about the ‘Lisbon agenda’ [on competitiveness] and the flaws in eurozone governance”. The EU’s priority, the French believe, should be fixing the euro: the 17 that use it should agree on whatever arrangements are necessary, and then allow others that wish to join the euro to participate later.

Some French officials think they can postpone a major new EU treaty for two or three years. But others, notably in the finance ministry, are less hostile to treaty change; they know that neither a stronger Eurogroup nor EU-wide deposit insurance can be established under the current treaties.

Despite their wariness of political union, French officials are thinking about the future of EU institutions. They recognise that the increasing centralisation of decision-making on eurozone issues creates a greater need for democracy and accountability at eurozone level. Some officials talk of a new body of national parliamentarians and MEPs that could approve key appointments and hold to account eurozone decision-makers such as the Eurogroup president, or the ECB body that will be responsible for bank supervision. That idea is similar to a recommendation in the Westerwelle report, as is the view of many French officials that MEPs from countries outside the euro should not be allowed to vote on euro issues.

In general, the people around Hollande and finance minister Pierre Moscovici are less inter-governmentalist than were Sarkozy’s advisers. Some of them view the European Parliament quite sympathetically, though they do not think that in its current form it can play much of a role in eurozone governance. They are less keen than Sarkozy was to give national parliamentarians a role in EU decision-making. They criticise the Commission less viciously than Sarkozy’s people, though they complain about the quality of its leadership and its tendency to interfere on little things that should be left to member-states. They accept, albeit reluctantly, that the Commission must play a role in supervising the economic and budgetary policies of eurozone member-states. Hollande’s relatively communautaire approach puts him closer to traditional German thinking than to Gaullist thinking.

So far, Hollande’s new approach to Germany – working closely with it, but not following slavishly – seems to have been moderately successful. But in the long run, if he wants French influence in the EU to approach that of Germany, he will have to deliver on his promise to boost the competitiveness of the French economy.

Charles Grant is director of the Centre for European Reform

Time for a European Civil Liberties Union?

Today's EU faces retreat on several fronts. One is a possible break-up of the euro with unknowable consequences for the single market and the Union itself. Another is the apparent decay of the rule of law, democracy or media freedoms in certain member-states. Bulgaria, the Czech Republic, Hungary, Lithuania, Romania and Slovakia all show some symptoms of the latter, according to Freedom House, an NGO watchdog for democracy and civil liberties worldwide.

The EU's institutions have tried to react to such developments. The European Commission is taking Hungary to court over the plan by the prime minister, Viktor Orbán, to weaken the independence of the judiciary there. During the summer, José Manuel Barroso, president of the Commission, intervened to stop an arbitrary attempt by Romania's prime minster to remove his president, Traian Basescu, from power. And neither Romania nor neighbouring Bulgaria are likely to join the Schengen passport-free travel zone until their political and judicial cultures approach something resembling the EU norm.

The EU can shepherd its wayward democracies only so long as their governments risk losing power and status by being labelled second class members. In the past, this desire to stay at, or travel towards, 'the heart of Europe' gave EU membership a transformative power, especially over those countries which joined from 2004 onwards. Most have better records at implementing EU legislation than some long-standing members.

Now the eurozone crisis threatens to chip away at this benign influence. The Union may segregate into a top tier of tightly-integrated euro area countries and an outer rim of ten or so non-members. (Only five of those countries which joined after 2004 currently use the euro.) Despite a treaty obligation on new members to join, eurozone creditor countries are not keen to admit countries with poor governance records for fear of having another Greece in the club. Governments which feel condemned to be permanent outsiders, or which do not wish to adopt the euro while the crisis endures, are likely to feel less bound by the constraints of EU membership.

Hence other influences must be brought to bear to help copper-fasten the peaceful transition of central and eastern Europe to capitalist democracy and the rule of law. The region lacks the self-sustaining popular narratives that characterise the confident democratic traditions of Western Europe. Britain has its 'history of British liberty'; France, its self-image as 'the mother of human rights'; and Germany is rightly proud of the 'never again' protections enshrined in its Basic Law. By contrast, the countries of central and eastern Europe spent most of modern history under various forms of totalitarianism. (An honourable exception is democratic Czechoslovakia between 1918-1938.) This makes them vulnerable to a return of the political strongmen.

NGOs and other observers hope that Europe's courts can help prevent any such scenario. For example, the European Court of Justice (ECJ) in Luxembourg is gradually transforming itself from a tribunal that deals mainly with regulatory and EU staffing matters to more fundamental issues of rights and civil liberties. Its judges are getting to grips with the Charter of Fundamental Rights – made legally binding with the passage of the Lisbon treaty – and deliberating more on civil liberties as their writ expands to migration and security questions.

There are hazards in relying too much on judicial solutions, however. First, legal deliberations take time, and delays due to huge backlogs of cases can put effective justice out of reach for those seeking protection from corrupt or malicious regimes. In 2011, over 150,000 cases awaited a decision from the European Court of Human Rights in Strasbourg, a non-EU institution connected to the Council of Europe. The ECJ fears that its own caseload is also set to become unwieldy due to its expanded jurisdiction under Lisbon. Its president has called for an increase in the number of its serving judges.

Second, ordinary people struggle to access European courts. The European Court of Human Rights is only supposed to be a 'last resort': plaintiffs must have already tried and failed to get justice in national courts. (This rule is likely to be applied more strictly following reforms announced earlier this year.) And - except in very rare cases - citizens or civil society organisations cannot directly petition the ECJ at all. Access to the Luxembourg court is normally restricted to EU governments, institutions, or businesses impacted by the Union's regulatory decisions. Even if the ECJ investigates a breach of the Charter by a particular member-state, it cannot make the government in question desist from such behaviour while the facts of the case are established. This contrasts with the powers of the Strasbourg Court. (See this interesting paper from the Centre for European Policy Studies.)

More broadly, 'government by judges' is a precarious way to protect democracy or resolve political crises such as the recent shenanigans in Romania. No judiciary can protect and uphold rights indefinitely in the absence of a healthy political culture where civil liberties and independent checks on executive power are uncontested. One idea to aid the development of such a culture throughout the EU would be the establishment by liberal activists of a European Civil Liberties Union (ECLU). This could be modelled to some extent on the American Civil Liberties Union (ACLU), founded in the 1920s primarily to protect the right to free speech in the US. One of main goals of an ECLU should be to capture the spirit of the region's glorious emergence from communism after 1989 through a mix of grassroots activism, litigation, educational initiatives and public awareness-raising.

A central ECLU office might receive EU funding but its national chapters would mostly depend on volunteer efforts, philanthropy and membership drives organised by university associations and others. (The ACLU has some 500,000 members and a budget of over $100 million.) In some cases, there will be no need to establish new national organisations from scratch: existing bodies performing democratic watchdog functions could receive the organisation's support if they feel the need.

ECLU chapters could co-ordinate their activities across the region and share resources such as legal and campaigning expertise. They should act as a counterweight to a 'domino effect' in the region where political strongmen in one country are encouraged by the success of fellow travellers elsewhere. An annual plenary meeting of all European chapters could be held each October 2nd, the anniversary of the drafting of the Charter.

In time, an ECLU could expand anywhere there was a need to open a local chapter or support a pre-existing organisation. Western Europe has plenty of foibles of its own: the treatment of migrants in Italy, the rise of hate crime in Greece and the weakened state of civil liberties in some countries due to disproportionate counter-terrorism measures. But its first priority should be central and eastern Europe – a region where the rule of law cannot yet be taken for granted – as the EU itself goes through fundamental change.

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

How seriously can investors take Draghi’s assurances?

ECB president, Mario Draghi, has repeatedly claimed that the central bank will do everything necessary to save the euro. Nothing has been formally agreed yet, but the ECB is expected to announce a new government bond-buying programme following next week’s meeting of its Governing Council. To have a significant impact on Italian and Spanish borrowing costs, the latest effort must be big enough to dispel the convertibility risk that lies behind the extreme polarisation of government bond yields across the eurozone: investors are loath to hold Spanish and Italian debt because they fear that the two countries’ membership of the currency union might be unsustainable. Unfortunately, the ECB is highly unlikely to do enough to convince investors that membership is unequivocally forever, not least because the Bundesbank opposes any open-ended commitment to cap borrowing costs.

Spain, Italy and the periphery of the eurozone face unprecedentedly high real borrowing costs, which are preventing a recovery in investment and hence economic growth. Without a return to growth, they will fail to dispel investor fears over the sustainability of their public finances and the solvency of their banking sectors. The Italian and Spanish governments argue that their high borrowing costs largely reflect convertibility risks and that the ECB should do as much as necessary to address these fears. The eurozone’s members that currently benefit from exceptionally low borrowing costs – Germany, Austria, Finland, the Netherlands and to a lesser extent France – maintain that very high Italian and Spanish borrowing costs largely reflect these countries’ failure to reform their economies and strengthen their public finances. There is merit in both these positions, but much more to the Spanish and Italian argument than the opposing one.

Opponents of open-ended ECB action argue that Italian and Spanish borrowing costs are not actually that high. Interest rates have just returned to levels seen in the run-up to the introduction of the euro, when investors distinguished properly between the countries that now share the euro. High borrowing costs are needed to focus minds and instil discipline. Were the ECB to take aggressive action to bring down borrowing costs, it would create so-called moral hazard; countries would be free to delay reforms in the knowledge that they will not be punished for it by having to pay high borrowing costs. According to this argument, it is a positive development that investors are now differentiating so strongly between the risks of lending to various governments. After all, the failure to do so in the run-up to the crisis contributed to the under-pricing of risk across the eurozone and reduced pressure on governments to reform their economies.

In nominal terms Italian and Spanish borrowing are indeed comparable to the levels of the late 1990s. But it is real cost of capital (that is, adjusted for inflation), that is crucial, and not the nominal cost. Both countries face much higher real borrowing costs than they did in the run-up to their adoption of the euro. Moreover, it is erroneous to compare the present with the late 1990s. Italy and Spain are at very different points of the economic cycle now than they were then. In the late 1990s both economies were growing, in the Spanish case rapidly, whereas now they face slump and mounting risk of deflation. Countries facing depressions and rapidly weakening inflation typically face very low borrowing costs: investors invest in government bonds for a want of profitable alternatives. This is what we see in the UK and US; borrowing costs remain at all-times low despite the extreme weakness of both countries’ public finances and poor growth prospects. Investors certainly need to differentiate between eurozone governments, in order to ensure that risk is correctly priced. The Italian and Spanish authorities acknowledge this. But the current spread between the yield on German government debt and that of the Italian and Spanish governments wildly exceeds what is required to make sure investors differentiate appropriately.

The polarisation of borrowing costs has politically explosive distributional effects: Germany is borrowing and refinancing its existing debt at artificially low interest rates. According to the German Institute for the World Economy, investor flight from the government debt markets of the eurozone’s struggling members to Germany has already saved the German government almost €70bn. Other countries face ruinously high borrowing costs, which are simultaneously increasing the scale of their reform challenges and narrowing their political scope to make the necessary reforms. The longer Italian and Spanish borrowing costs remain at such elevated levels, the greater the economic damage to those economies will be and the harder it will become for the two countries’ governments to shore up the necessary political support for further reforms.

Why have government borrowing costs across the eurozone diverged so much? The principal reason for the size of the spread between the periphery and Germany is convertibility risk. Investors believe that there is a chance that Italy and Spain will ultimately be forced out of the currency union and are thus demanding a hefty premium to insure against this eventuality. This feeds the convertibility risk by weakening countries’ fiscal positions and raising private sector borrowing costs (government bond yields set the cost of capital for the private sector). With private and public consumption in both Italy and Spain set to remain depressed for years to come, economic recovery requires stronger investment and exports. But borrowing costs are crippling and credit scarce. In a vicious cycle, the steep fall in the value of Italian and Spanish banks’ holding of government debt, combined with mounting bad debts as a result of recessions made worse by punitive borrowing costs, are forcing the banks to further rein in business lending. 

The ECB’s latest programme of bond purchases will be big enough to ensure that Mario Draghi does not lose face. But it will not be big enough to dispel convertibility risk and hence demonstrate its credibility as a lender of last resort. And it is this credibility problem, rather than the relative ‘credibility’ or otherwise of member-states policies, that is the principal reason for the unsustainably high borrowing costs faced by Italy and Spain.

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

Will a new German constitution save the euro?

If the Social Democrats win next year’s general election in Germany, they will ask voters to adopt a new constitution in a referendum. The new document, so they plan, would remove the legal fetters that currently prevent Chancellor Angela Merkel agreeing to eurobonds or joint deposit guarantees. Not only the Social Democratic Party (SPD), also politicians from Merkel’s ruling coalition are now speaking out in favour of a referendum. Some analysts are rejoicing that Berlin is finally preparing the ground for the fiscal union that will save the euro. But this is Germany, where policymaking is complex and slow. The debate about a new constitution might sap political energies without contributing much to the stability of the single currency.

German politicians mean different things when they talk about a euro-related referendum. Sigmar Gabriel and his fellow leaders of the SPD say they want voters’ consent to a eurozone fiscal union that involves not only debt mutualisation but also joint budget-planning, harmonised tax rates and tough financial regulation. Some pro-European MPs in Merkel’s own Christian Democratic Union (CDU) agree on the need for a new constitution. But many others insist that the current document leaves enough leeway for euro rescue measures. Some CDU politicians use talk about a referendum mainly as a warning shot to the constitutional court: if you judges continue constraining Merkel’s euro policies, a new constitution will restore power to elected politicians. Finance Minister Wolfgang Schäuble predicts that a constitutional referendum will happen “quicker than I would have expected a couple of months ago”. But he does not say what it would entail.

Horst Seehofer, leader of the traditionally euro-wary Christian Social Union (CSU), the CDU’s smaller Bavarian sister party, wants a referendum each time the EU assumes new powers, bails out a struggling member or admits new countries. And he probably hopes voters will say no to these. Foreign Minister Guido Westerwelle from the Free Democratic Party (FDP, another coalition member), contemplates not a German but a Europe-wide referendum on euro rescue measures. All parties are spooked by the recent successes of the Pirate party which campaigns for more country-wide referendums.

Even if Germany’s politicians could agree on a referendum strategy, this would not be a quick fix to save the euro.

Germans are having this debate right now because the constitutional court has indicated that EU integration could not go much further on the basis of the current constitution. Stricter budgetary oversight from Brussels, as envisaged by the fiscal compact, could be problematic. Eurobonds or any other kind of unlimited liability involved in a fiscal or banking union would be incompatible with the constitution. These would undermine Germany’s statehood and democracy by constraining parliament. If politicians cannot promise different fiscal policies, voters are deprived of a real choice and democracy suffers.

These constraints cannot be removed easily because the German constitution contains an ‘eternity clause’ (Article 79) that sets in stone certain principles, notably democracy, federalism and the market economy. No parliamentary majority and no referendum can alter these principles. Hence, the only way for Germany to accede to a fiscal union is to convene a constitutional assembly, work out a new constitution and put it to a referendum.

Some lawyers say this could be done quickly: only the eternity clause and the one detailing how Germany transfers powers to international organisations (Article 23) need to be tweaked. But more likely the constitutional assembly would be inundated with calls for more extensive social rights, a reform of federalism and a new voting system, to name but a few. “This would be an extremely long process”, predicts a constitutional expert.

Nor is it assured that Germans would vote yes in the ensuing referendum. Eurosceptics will argue that the new constitution will lead Germany into the dreaded transfer union, characterised by permanent money flows from Germany to the eurozone’s South. And even if a new constitution was adopted, who says there would be a political majority for eurobonds? Most Germans are against debt mutualisation even if it comes with tough budgetary oversight, according to a recent Emnid poll. Even among SPD voters, less than 40 per cent are in favour. “It’s not that if we had a new constitutional clause we would just wave through debt mutualisation”, says one CDU advisor.

And there is a last hurdle: Germany might adopt a plan for fiscal union only to be blocked by Austria, Finland or the Netherlands. After all, this is not really a debate about the German constitution but the future shape of Europe.

Nevertheless, the constitutional debate will continue because it suits both the opposition and the government. The SPD seeks to sharpen its political profile ahead of the 2013 election. It has so far loyally supported Merkel’s euro policies in parliament. Now many voters complain that they no longer know what the SDP stands for. The SDP is trying to change that, not by blocking Merkel’s policies but by going beyond them.

The CDU also gains from the constitutional debate. The opposition accuses Merkel of lacking a blueprint for the euro, of reacting to market panics, and of recklessly putting taxpayers’ money at risk without delivering more European integration. By talking about a new pro-European constitution, the government looks like it has a plan while it can put off hard decisions until after the 2013 election.

Now all eyes are on the constitutional court again. On September 12th the judges will issue a preliminary verdict on the European Stability Mechanism and the fiscal compact. They are unlikely to strike them down. But they will define conditions for making the ESM and the compact compatible with the constitution.

Some constitutional experts expect that the court will use the occasion to pronounce on what a process of constitutional renewal might look like. Others think that the court will shy away from encouraging such a process and instead widen the government’s room for manoeuvre within the current basic law.

Whatever the court does, the debate about a new, pro-European constitution will hot up this autumn. But do not be fooled: Germany is still a very long way from agreeing to eurobonds.

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

Burma: An EU foreign policy success

Disunity is bad but pluralism is good. The story of EU policy on Burma illustrates this point. Disunity is normal: sovereign states with varied histories and traditions might be expected to disagree. The remarkable thing is that in the end, on Burma as on much else, the EU manages to achieve a common policy. The policy may even be better for being the product of disagreement and debate. Unfortunately the EU tends to do its disagreeing in public but when it reaches a sensible consensus often conceals the fact.

On Burma the disagreements start with the name. EU documents refer to Burma/Myanmar. Can one really have a policy on a country when one cannot agree on the name?

This disagreement is in fact not so unreasonable. On one side is the argument that if the UN, its neighbours and some people in the country call it Myanmar, the EU should follow suit.  But the argument on the other side is also strong: an early act of the State Law and Order Restoration Council (SLORC), one of the nastier manifestations of the military in its 50-year term of office, was to change the official name in English to Myanmar. The SLORC claimed that this name had the advantage of including minorities not from the predominant Bamar (or Burman) ethnic group. But this argument is largely false since ‘Burma’ is in fact a colloquial form of ‘Myanmar’ and the one the British rulers opted for. Furthermore, Aung San Suu Kyi and her supporters gave the name political significance by refusing to follow the SLORC’s decree. The lady now uses Myanmar when speaking the Burmese (or Myanmar) language, thereby offending some of her supporters, but insists on using Burma in English, thereby offending some generals. Too much energy has been wasted on this rather unimportant issue.

On the more critical issue of sanctions there are respectable cases to be made both for and against. Let us leave aside the EU’s visa bans and asset freezes on members of the regime, which have certainly discomforted those targeted. The arguments against broad sanctions are that they corrupt and distort an economy; they impoverish people; they often create illegal trade from which the primary beneficiaries are those in power; and they provide a convenient alibi for the government’s own economic mismanagement. If sanctions bite, the intention is that they will hurt people and thus encourage them to overthrow the government through elections or revolution.  That makes them particularly ineffective when dealing with military regimes. Besides, it is contact, not isolation that brings about change. Trade leads to more extensive relations with other countries; it opens countries up, eventually creating the middle class that is essential for democracy.

But there are also valid arguments on the other side. The damage done to the Burmese economy by EU sanctions has always been small compared with the damage inflicted by the military government. Spending on health and education has been minimal, while the defence budget as a proportion of GDP – officially 4.9 per cent, though the true figure is certainly much higher – surpasses that of any other country in the Association of South-East Asia Nations (Indonesia and the Philippines both spend 1 per cent, Malaysia and Thailand 1.5 per cent, Vietnam 2.5 per cent and Singapore 3.6 per cent, according to the International Institute for Strategic Studies). 

The sanctions did have one powerful effect, namely, to signal to European companies that the Burmese regime was unacceptable, and that they should stay away. Almost universally, they took this advice. The sanctions also gave moral support to the opposition, thousands of whose members have been beaten and locked up.
The arguments of those who opposed sanctions nevertheless had an impact on what the EU did. Its sanctions were designed to limit direct damage to the livelihoods of ordinary Burmese. They were selective and targeted on the extractive industries – mainly timber and gem stones – where the military and their cronies are dominant (though the sanctions’ effectiveness was impaired by some of these goods being rebadged and exported via Thailand).
The EU matched sanctions with a commitment to provide humanitarian support, not just at the time of cyclone Nargis in 2008, but on a continuing basis, with an emphasis on health and rural poverty. The US chose a very different path, applying an enormous and complex web of sanctions to Burma, similar to those in force against Iran. The US blocked World Bank lending and cut off Burmese banks from the international financial system. Congressional restrictions obliged the Global Fund (which ran programmes to fight malaria, tuberculosis and AIDS) to pull out of Burma in 2005. The EU led a consortium to replace the work of the Global Fund. In sympathy with those who argued against having anything to do with the Burmese regime, the EU ran all its programmes through NGOs.
Western sanctions were probably not the main cause of the thaw in Burma. When authoritarian regimes decide upon profound reform, foreign pressure may be a factor but is often less important than the ambitions of key leaders. Mikhail Gorbachev pursued glasnost and perestroika because he was a communist patriot.  In South Africa, F W de Klerk saw that his country had no future with apartheid. U Thein Sein, who became Burma’s president in March 2011, appears to be a man who wants the best for his country, and who knows that he cannot tackle poverty and under-development without first engaging in political reform and reconnecting Burma to the world.

Perhaps change would have happened without sanctions. But if so it would have happened differently. It is hard to imagine that representatives of the National League for Democracy (the NLD, the party led by Aung San Suu Kyi) would have spent hours in the Ministry of the Interior going through lists of political prisoners if their release had not been one of the conditions for suspending sanctions. And would the NLD have even been there at all? It was always an EU demand that all political forces should participate in the political process. That was code for Aung San Suu Kyi and the NLD, as well as Burma’s too-often forgotten ethnic minorities.

Then there is the China factor. Burma’s leaders were becoming worried about not only their economic dependency on China – a major trading partner and source of investment – but also their reliance on its diplomatic protection in international organisations. They wanted to balance the ties to Beijing with closer ties to the West, and that required reforms that would persuade the EU and the US to remove sanctions.

As it turns out, Western sanctions provided not only the opposition with a card it could play, but also reformists within the government. A government trying to reform cannot easily show benefits to sceptical conservatives, at least in the early stages. But greater respect from foreign powers – Hillary Clinton, David Cameron and Catherine Ashton have been among the recent visitors – and the removal of sanctions are visible rewards that a government can point to when it is fighting difficult internal battles.

In the case of Burma the opposition has been a cause worth supporting. Not only Aung San Suu Kyi herself, but also her supporters are fully committed to democracy and the rule of law. She has shown that she is ready to compromise – contrary to the propaganda persistently put about by the regime. Her approach to the government, the constitution and the parliament has involved many compromises. And on the question of sanctions, she and her party have, understandably, been somewhat ambiguous. She believes that Burma has a long way to go before it is free and democratic, and she has not called for the US to end all sanctions. But she has gone along with the EU’s suspension of sanctions and favours responsible foreign investment to create jobs.

On certain points, such as corruption and the fair conduct of elections, Aung San Suu Kyi remains immovable. This should be welcome; too many countries in Asia have become accustomed to a kind of semi-democracy, in which elections are held but are not particularly fair, in which the rule of law functions but not in quite the same way if you have friends in high places, and in which corruption is a part of the system. It is good that for once that a senior political figure in Asia is supporting high standards. If the Burmese are lucky, eventually she will prevail – and hopefully set an example to other Asian countries.

The Burmese government’s announcement this month that it is scrapping press censorship suggests that it is still bent on reform. But in June, violence between the Muslim Rohingya minority and Buddhists in the western province of Rakhine left dozens dead and nearly a hundred thousand homeless. Burma’s leadership continues to ignore the basic rights of Rohingyas. The opposition says too little about their plight – and some of its leaders have even questioned whether the Rohingyas belong in Burma. Several other ethnic conflicts continue to fester in various corners of the country. Further EU development aid should be conditional not only on continuing progress on human rights, but also on the regime seeking to achieve reconciliation with the ethnic groups.

The EU can offer its own expertise – from countries such as Spain – in building political structures that accommodate minorities. The EU should also encourage the army to retreat from political life, while recognising that this process will inevitably be slow. In Turkey the army has spent more than 50 years – with many ups and downs – gradually relaxing its grip on the political system. One suspects that Egypt’s generals will continue to control large swathes of that country’s economy for several years to come.

This year the EU has, to its credit, stepped up aid and opened an office in Rangoon. Its policy on Burma has looked a bit messy: in the past, pursuing sanctions but not across the board, and giving aid but not working with the government; and now, suspending rather than lifting sanctions while not insisting that every single political prisoner should first be released – while continuing to press the case of those who remain. Messy is what you expect when 27 countries debate and compromise. But the common line forged by the EU has helped to change Burma for the better.

Charles Grant is director of the Centre for European Reform.

The Commission should stand firm on Iceland’s accession negotiations

Iceland is the world’s longest running democracy. At a time when some member-states are struggling with democracy in the face of economic crisis, and the European institutions are still being criticised for a democratic deficit, Iceland would therefore be a valuable and welcome member of the club. Iceland also has much to teach the EU about energy policy: it generates three quarters of its electricity from hydroelectricity, and the rest from geothermal plants. All of its heat comes from geothermal.  However, the European Commission should remain firm on its negotiating demands on fishing and whaling.

Iceland applied to join the EU in 2009, in the aftermath of its banking crisis. The island saw EU membership as a source of stability and economic recovery. Out of the 35 negotiating chapters, 18 have been opened. Ten of these have been provisionally completed. Enlargement Commissioner Stefan Füle hopes that accession negotiations will be completed in 2013 – though the most difficult chapters, on agriculture, environment and fisheries, have not been negotiated yet.  As a member of the European Economic Area (EEA) and Schengen, Iceland has already adopted two-thirds of the acquis.

Iceland’s accession bid has quite broad support among member-states. The main obstacle to its accession is that Icelanders themselves are likely to reject it. Once negotiations are completed, Icelanders will vote in a referendum on whether or not to join the EU. Polls suggest that only around a quarter support EU membership, with over half against and around a fifth undecided. The level of support for membership has fallen since negotiations began in 2009. This is in part because Iceland’s economy has recovered from the serious 2008 banking and debt crises, and is now growing at over four per cent per year. And EU membership is no longer seen as a source of stability.  But support for membership has also fallen because of the European Commission’s perceived (by Icelanders) unfairness towards Iceland over the Icesave  settlement and the current “mackerel war”. And the totemic issue of whaling remains to be confronted.

Icesave was an online facility run by the Icelandic bank Landsbanki between 2006 and 2008. It gained over 300,000 customers in the UK, and over 125,000 in the Netherlands. But in 2008 Landsbanki was placed into receivership. The British and Dutch governments argue that the Icelandic government is obliged to pay at least €20,000 to each depositor, and that Icelandic and foreign depositors must be treated in the same way. Reykjavik disagrees. It argues that, had the restructured bank been obliged to bear the full cost of the debt, it would have had a negative equity of €2.6 billion, which would have had to be paid by Icelandic taxpayers.

Half the Icesave debt to depositors has now been repaid. The EFTA Court will hear legal argument about the remainder on September 18th.  The time for negotiation over Icesave has passed, since the matter is now before a court. So the key negotiating issues are fishing and whaling. The European Commission should remain firm on these issues. It would be counter-productive to lower existing EU standards to attract a new member. If this firmness leads to Iceland voting no in a referendum, so be it.

Fishing has always been a bone of contention between Iceland and other European countries. The Common Fisheries Policy is not included in the EEA, so Iceland can set its own policy. The fishing industry provides 40 per cent of Iceland’s export earnings, and eight per cent of employment on the island.  The current dispute focuses on mackerel. Iceland has increased its annual quota for mackerel catch enormously – from 2,000 tonnes to 146,000 tonnes. Reykjavik argues that this is sustainable because climate change is resulting in more mackerel in its waters. The Commission disagrees, and argues that Iceland’s quota is 36 per cent higher than it should be to be sustainable. Ireland, France, Portugal and Spain are demanding sanctions. The Commission has threatened to block Icelandic ships from unloading mackerel at EU ports.

The EU and Ice­land (plus the Far­oe Islands and Nor­way) will meet in Lon­don in Sep­tem­ber to try to reach agreement.  Some movement by the Commission, to defuse the argument and avoid conflict, would be understandable. But the Commission should not move much. It should continue to base its position on its scientific estimate of a sustainable catch.

On whaling, the Commission should not move at all. In 2006 Iceland resumed commercial whaling of fin whales and minke whales. Thus it joined Norway in defying the international moratorium on commercial whaling.  Iceland has always caught some minke whales for “scientific research”.  So the 2006 decision made little practical difference on minke – it simply represented Iceland becoming more open about its reasons for whaling. But it did represent a restart of fin whale hunting. Fin whales are an endangered species. Iceland maintains that there are enough fin whales in Icelandic waters for a small catch to be sustainable. This may or may not be correct, but is anyway not relevant to EU negotiations. EU law prevents the killing of any whales, even those which (like minke) are relatively numerous.  EU law is based partly on the need to protect biological diversity, but partly also on the need to prevent animal suffering.  Being killed by harpoons is a particularly painful, and often slow, way for an animal to die.

By no means all Icelanders favour whaling. Whale watching is an important part of their tourism industry – and increased tourism is one of the drivers of economic recovery. Yet some Icelanders argue that whaling is an important part of their culture and tradition. Culture is important, and European integration must respect most cultural traditions. But not all, and not those which involve cruelty. Iceland has an impressive culture –and has produced some of the world’s greatest literature. So it ought to be possible, in the twenty-first century, for Icelanders to separate their cultural heritage from whaling. If this is not possible, EU membership should also not be possible.

In any case, the ongoing dispute about Icesave and the Icelandic economic recovery may well result in Iceland voting no to EU membership, whatever concessions the Commission has offered on fish and whales. The EU should not lower its standards whatever the rewards. To lower them and get no reward would be particularly unwise.

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

Can 'good Italy' triumph over 'bad Italy'?

The key battles for the survival of the euro will be fought in Italy more than anywhere else. Mario Monti’s technocratic government is struggling to push through sufficient reforms to convince financial markets that economic growth will return and thus erode the country’s mountain of public debt. Unless EU institutions intervene in government bond markets to lower the country’s cost of borrowing, Italy may soon be frozen out of those markets. The EU’s bail-out funds may just have enough money to provide Spain’s financing needs for the next few years, but they would then have no spare capacity to save the larger Italian economy. So Italy’s inability to borrow could lead to the euro unravelling – unless the Germans suddenly agree to bigger bail-out funds or the mutualisation of eurozone debt.

When the euro was conceived, more than 20 years ago, many economists thought the Italian economy ill-suited to take part. Then Italy’s reformist governments in the 1990s did just enough to convince the EU’s leading member-states that it should be allowed into the single currency. But after the launch of the euro in 1999, with Silvio Berlusconi prime minister for much of the time, reform more or less stopped.

Bill Emmott’s new book, ‘Good Italy, Bad Italy: why Italy must conquer its demons to face the future’ (Yale University Press), provides an excellent account of what is rotten in the state of Italy. When editor of The Economist, in 2001, Emmott started to run a series of investigative stories that exposed Berlusconi’s questionable financial dealings. One cover proclaimed: “Why Silvio Berlusconi is unfit to lead Italy”. The Italian prime minister, unamused, complained of an “E-Communist plot” against himself, pointed out that Emmott looked like Lenin and launched two libel actions that The Economist fought and won (though one of these is still subject to appeal).

Emmott’s book is particularly good on the sorry story of the Italian economy. Only Haiti and Zimbabwe grew more slowly in the period 2000-10. He describes how archaic labour market rules that prevent employers of more than 15 people from firing workers have kept companies small and thus damaged productivity. The lack of competition in the economy is a major cause of Italy’s service firms being inefficient. As a result, businesses pay more than they should for logistics, information and communications technology, marketing, transport and legal advice. There are 290 lawyers for every 100,000 Italian citizens, compared with just 22 in Britain. Emmott explains how an ageing population, unmeritocratic universities, low levels of foreign direct investment and the high level of public debt (over 120 per cent of GDP) depress the economy. Meanwhile a black economy amounting to 20-25 per cent of GDP weakens the state.

Emmott defines ‘Bad Italy’ as “the urge to seek power in order to use it for self-interested purposes, to amass power to reward friends, family, bag-carriers and sexual partners regardless of merit or ability, and by doing so to build clans and other networks that are beholden to you, and that live by enriching themselves at the expense of others, by closing doors rather than opening them, by excluding rather than including…This sort of selfishness involves a special and even wilfully destructive disregard for a wider community or, especially, national interests, institutions, laws and values.”

The roots of Bad Italy are embedded in the political system and the nature of Italian society. Emmott’s descriptions of these are not as profound as his economic analysis. He does not say a great deal about the centre-left, which held power from 1995-2001 and again from 2006-08 but reformed very little (though its record is somewhat better than that of the centre-right). He might have examined why the Italian centre-left is so weak and fragmented, compared with that in Britain, France or Germany. However, Emmott is good on the nefarious influence of the Catholic Church on politics: for many years it supported Berlusconi because of his stance on gay marriage and in vitro fertilisation – and because he exempted Church property from taxation.

Emmott could have focused more on the many vested interests that profit from the current system and have been so successful in blocking reform. But he implies that they can be overcome because half the book is about ‘Good Italy’, the Italy that draws its strength from civil society, promotes vigorous entrepreneurialism and thinks globally. One of the book’s merits is to point out that Bad Italy is not synonymous with the south of the country, nor Good Italy with the north. Emmott takes the reader on a tour of success stories, to ‘Addiopizzo’, an anti-mafia NGO in Sicily; the Tecnam sports aircraft manufacturer near Naples; the Brunello Cucinelli cashmere clothing company near Perugia; Rainbow, a world-beating maker of animated children’s cartoons near Ancona; the Slow Food movement in Turin; and well-known firms such as Luxottica (sunglasses) in Milan and Ferrero (chocolates) in the Langhe region of Piedmont.

Emmott shows that energetic companies, usually led by brilliant individuals, can beat the system and succeed. He sets out a list of reforms that Mario Monti – or the next prime minister – should seek to achieve, to tilt the system in favour of Good Italy. But he does not attempt to say how a reformist government should seek to overcome the vested interests of Bad Italy, or why Good Italy will ultimately triumph.

Mario Monti, a brilliant economist and the incarnation of the hopes of Good Italy, would surely agree with Emmott’s analysis. But his government is embattled. Within Italy, trade unions, professional associations and other conservative lobbies have diluted many of Monti’s reforms. In democratic countries, the most able governments find it hard to introduce structural economic reforms, even when economies are growing; the losers feel the pain immediately while the benefits take years to emerge. When an economy is shrinking – as is the case in Italy, partly because of excessively tight fiscal policies across the EU – it is almost impossible to implement structural reforms.

Monti’s noble efforts to reform Italy may have come too late. Bad Italy is extraordinarily resilient. Even if Monti’s government survives until the elections that are due in spring 2013, the entrenched power of Bad Italy may yet force Italy out of the euro. And if Italy and the other southerners quit, the EU’s leaders may find it hard to convince financial markets that France – which though a much stronger economy than Italy, suffers from some of the same ailments – can stay in the euro.

Charles Grant is director of the Centre for European Reform.

A similar article appears in the August 2012 edition of the Literary Review.

What Central Europe thinks of Britain and why

Britain's Conservative Party is committed to repatriating powers from the EU. On July 12th, Foreign Secretary William Hague launched a review of the EU's competences. This would, he told Parliament, be an "audit of…where competence lies, how the EU's competences, whether exclusive, shared or supporting, are used, and what that means for our national interest." Many Conservatives expect this audit to prepare the ground for a manifesto commitment to renegotiate the terms of Britain's EU membership. They hope that Britain can obtain opt-outs in areas such as financial services, judicial co-operation, employment, migration, regional policy or fisheries. They argue that Britain's partners will wish to change the EU treaties to cope with the eurozone crisis, and that Britain can trade off the repatriation of powers in return for its signature.

However, any British opt-out would require the unanimous agreement of every other member-state. Conversations with diplomats from Central Europe suggest that there is very little goodwill towards London, even among its formerly stalwart allies.

The Central Europeans see the UK as an important partner. When David Cameron circulated a letter in February 2012 outlining single market reforms that would revive the European economy, five of the eleven co-signatories came from Central Europe, with Germany and France the notable absentees. The new member-states sided with London against Paris and Berlin over the Iraq war, and the UK shares their desire to bring more Balkan countries into the EU – again, against much scepticism from many continental countries.

And yet the UK cannot count on all Central Europeans to support its demand for opt-outs from EU legislation. This is for two reasons: Germany has become the central focus of the region’s foreign policies, and Britain has come to be seen by other member-states as taking advantage of the common currency's existential troubles to defend its narrow interests.

Germany is by far the largest investor in Central Europe, and its economy is deeply embedded in the wider region. When I asked a former finance minister from Central Europe to predict his country's growth rate, he replied "take Germany’s number and add one percentage point". Most Central European governments also assume that there is a possibility of the eurozone fracturing and losing some of its member-states. If and when it happens, they want to remain a part of the Berlin-led economic core. London will be of little help in such a crisis – it is too far away, has too few investments in Central Europe, and wants to have less and less to do with the EU in general. So the new member-states (and others in similar situations such as Denmark or the Netherlands) will have few reasons for wanting to spend political capital on supporting UK demands for exemptions from EU legislation, especially if Germany opposes them (and senior officials in Berlin take a hard line in opposing British attempts to repatriate powers).

Furthermore, the UK offers nothing in return (it is not contributing to the eurozone bailout fund) and Britain’s exemptions may adversely affect other countries’ economies. They fear, for example, that if the UK relaxes social protection for workers (a key Conservative demand), businesses elsewhere in Europe will migrate to the UK. "London is engaging in 'beggar-thy-neighbour' tactics", one official from Central Europe told me (though France and others say the same of the new member-states' low corporate tax rate). In December 2011 Britain threatened to veto the proposed ‘fiscal compact’ to secure an opt-out from rules governing financial services. But the tactic misfired – the rest of the EU minus the Czech Republic agreed to form the compact anyway; they did so outside existing EU treaties and without Britain. Any future banking or fiscal union will almost certainly be organised in a similar way, a Baltic diplomat told me, because the UK and the Czech Republic – and possibly others – do not want closer integration. This leaves London without any good means to pressure others to secure its opt-outs. "The rest of the EU now knows that it is possible to isolate Britain, and they are more willing than ever to do so. It is not clear that Britain realises that", the official said.

Nothing has hurt Britain's image elsewhere in Europe more than the perception that London is failing to help to end the crisis and – worse – that the UK is taking advantage of others' woes. A Polish official told me that during the December 2011 negotiations London lobbied Warsaw to stay out of the fiscal compact. Its creation is a key part of the member-states’ efforts to stop the run on their sovereign debt. The fact that Britain not only decided against joining it but sought to discourage other non-euro countries from doing so – presumably to avoid being isolated – has been seen by many as an act of remarkable ill will. According to a senior Baltic official "Britain is a nuisance; it imposes an additional burden on us of having to go around it, complicating negotiations". This is not entirely fair: British proposals on how to stimulate economic growth, which many Central European governments signed, are among the most thoughtful of such contributions. But European diplomats think that London puts a lot more energy into demanding special deals for itself than solving the crisis.

The Central European officials I interviewed sounded genuinely regretful of Britain's growing estrangement from the EU – there was no sense of 'good riddance' or gloating. But Britain’s likely demands for opt-outs from EU policies will have very little support from them (with the possible exception of the Czech Republic). A dangerous situation has emerged. Even though the government in London seems likely to attempt to unpick some of its ties, rather than sever them all, it risks rejection. And would a bruised UK want to remain in the EU? The Central Europeans fear that Britain may drop out in anger, in effect leaving the EU by accident rather than by design. But, as one Polish official acknowledged "as long as the eurozone is a mess, Britain will not want to be shackled to a sinking ship. We need to sort out our banks and economies first, thus giving London the reason to stay".

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