Wednesday, December 23, 2009

The EU must learn from its mistakes over the past decade

by Hugo Brady

The EU needs new thinking. After eight years of stop-start negotiations, the Union finally has a new rulebook, the Lisbon treaty, which entered into force earlier this month. The member-states are waiting for a new European Commission and a new European Council president to take office early next year. But, despite Europeans’ shared anxieties about economic growth, government debt, the stability of the euro, immigration and the environment, there is not yet a clear sense of what the EU’s priorities for the next five years should or will be.

Given the global recession, many assume that the EU’s next ‘big idea’ will have an economic focus. Mario Monti, a former competition commissioner, has already proposed that EU countries should quicken their recovery from the crisis by opening up trade in services in exchange for a deal on harmonising tax bases. Others expect a new initiative on climate change – like a European carbon bank – or tighter rules on deficit spending to prevent the risk of default in the euro area.

But those thinking seriously about the EU’s future would do better to use the dying days of the decade to consider carefully the Union's mistakes and failures over the last ten years – before they chart ambitious new courses. The EU was neither sclerotic nor paralysed during the years 2000-09. It successfully rolled out a single currency, expanded to 27 members, established the world’s first functioning carbon trading scheme, deployed its first military missions and agreed a common arrest warrant to tackle cross-border crime. Nonetheless, the member-states would be wise to acknowledge several key failures from the same period:

• The EU spent most of the decade following the will o' the wisp of a grand constitution, to the detriment of its reputation both within the Union and in the outside world. That the Union repeated the exercise of treaty-writing so soon after a similarly troubling experience with the Treaty of Nice reveals a weakness for introspection which should be resisted in future. Let us hope that the innovations to EU business brought in by the Lisbon treaty will justify the time and effort spent on it.

• The premature accession of Bulgaria and Romania to the Union in 2007 damaged the credibility of EU enlargement, due to persistent problems with corruption and organised crime in these countries. Now that they are full EU members, reform of public administration and the judiciary has slowed.

• The EU made a similar error in allowing the accession of Cyprus in 2004. In doing so, the member-states removed probably the only international leverage that could have helped to push the island's territorial conflict to resolution. Since then the Cypriot government has unabashedly used its EU veto to complicate the Union’s ties with Turkey and NATO. Both of those relationships are critical for the Union's geopolitical standing.

• The EU spent most of the decade trying to convince key global players like the US or China that it is an emerging actor in a multipolar world. Yet it has been unable to overcome internal divisions over its relations with Russia, energy policy and reform of European representation in international organisations. Even the Union's jealously guarded image as a global leader on climate change is exaggerated (the final deal at the Copenhagen climate change summit was crafted in the absence of the EU). Unless the member-states find a way of summoning the political will to forge common positions on sensitive issues like, for example, how to handle meeting the Dalai Lama, the Europeans will continue to play ping pong while the rest of the world plays chess.

• The EU was wrong to lump together its external policies towards non-EU countries in the Mediterranean and Eastern Europe in the so-called European neighbourhood policy. Within a few years that policy error had to be tacitly acknowledged with the decision to create both a 'Union for the Mediterranean' and an 'Eastern Partnership'. But both these initiatives still suffer from a lack of substance.

• The EU's agreement on a lacklustre 'services directive' in 2005 was a missed opportunity to boost intra-European trade in services and thus help complete the single market. If the EU had been able to agree on something like the original ‘Bolkestein directive’ – before member-states and the European Parliament watered it down – the ability of the eurozone to withstand economic shocks like the current recession would have been greatly strengthened.

• In 2005, the member-states failed to find the political courage to reform the EU's budget and have so far reneged on a commitment to engage in a serious review of how the Union's annual expenditure of €120 billion should best be allocated. This is despite the Sapir report, commissioned by the European Commission, which described the EU's budget as “an historical relic”, in which “expenditures, revenues and procedures are all inconsistent with the present and future state of EU integration.”

• The EU's Court of Auditors declined to sign off its accounts at any point throughout the decade, mostly due to irregularities in how funds are dispersed within the member-states. This, plus a number of scandals over expenses paid to MEPs, have damaged the EU's credibility with taxpayers. Any future increase in the size of the EU's budget would be politically untenable without demonstrable reform.

The Irish historian and former diplomat, Conor Cruise O'Brien, famously said of the UN that the institution was prized by its member governments because of its “proven capacity to fail, and to be seen to fail.” To avoid a similar fate – that of a powerless body towards which its member-states push intractable problems – the EU must use the period 2010-15 to demonstrate that it can learn from the failures outlined above, correct them where possible, and avoid their repeat at all costs.

Governments and EU officials looking to the future should also reflect on the wisdom of reflections by Ralf Dahrendorf, a German-born British peer, who died earlier this year after a unique life committed to bringing Europeans closer together:

“All too often, today’s European Union forces its supporters to apologise for its strange ways: towards democrats for its bureaucratic opaqueness, towards free traders for its protectionism, towards applicants for membership for its apparent lack of a sense of urgency, and towards trading partners elsewhere, notably in the poorer parts of the world, for its crude and at times destructive pursuit of self interest. If such apologies continue to be necessary, support will wane and eventually vanish. European reform is imperative if the European Union is to survive.” *

A fine mission for the EU in the years ahead would be to ensure that these words – written in 1996 – do not ring true in 2015.

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

* Why Europe Matters: A personal view, Ralf Dahrendorf, CER essay, 1996.

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

Friday, December 18, 2009

Gazprom’s uncertain outlook

by Katinka Barysch

Many people in the EU tend to see Gazprom as a mighty giant that uses energy as a political tool on behalf of the Kremlin. They say that Russia has leverage because it controls 40 per cent of the EU’s gas imports. They fear that Gazprom may again cut gas flows to Ukraine this winter. They should think again. Realities on the international gas market have changed. Gazprom faces almost unprecedented uncertainty. It should therefore be keener on stable energy relations and co-operative customers. There may be an opening for a revived EU-Russia energy dialogue.

Gazprom’s energy strategy, and its political swagger, were predicated on the assumption that gas demand in the EU – by far the company’s most lucrative market – would continue growing. But in 2009, European gas demand fell for the first time ever. In the short term, this may even have suited Gazprom. Many analysts had warned that Russia may be unable to fulfil its export obligations from 2011 onwards because it does not invest enough in developing new gas fields in Yamal and Shtokman. Russia’s ability to supply is now more in line with gas demand.

In the medium term, however, the outlook for the gas market is foggy. For a company that must ponder multi-billion dollar investments to prevent an impending output decline, sits on a $40 billion debt pile and faces tougher competition, this is an uncomfortable position to be in.

The sluggish global economy will cap energy demand at a time when technology has opened up entirely new possibilities for producers. In 2009, output of so-called unconventional gas (gas coming from rock formations) in the US has risen so fast that the US has mothballed its LNG terminals. LNG tankers from Qatar started sailing to Europe instead. The additional supplies have depressed prices in the ‘spot’ market for short-term gas contracts. Spot gas became very cheap compared with piped gas from Russia or Algeria, which is tied to the oil price with a lag. European companies bought more supplies on the spot market and Gazprom lost out.

If the price gap persists, the big European companies, such as E.On, Gaz de France or ENI, will want to renegotiate their long-term ‘take or pay’ contracts with Gazprom. Russia, so far, wants none of it. If the Europeans buy less than the minimum amount fixed in these agreements, Gazprom can charge them a fine. But if spot prices are sufficiently low, that may still make business sense.

It is not only slow global growth and new technology that are causing uncertainty for Gazprom. So are the EU’s climate change targets and its emerging diversification strategy.

The gas industry argues, somewhat optimistically, that tougher CO2 targets will play in its favour as EU countries are forced to shut down polluting coal plants. Energy experts are not so sure. If the EU is to achieve both its target to increase energy efficiency (by 20 per cent by 2020) and boost the share of renewables to 20 per cent, the role of gas in the energy mix will have to shrink. At the same time, the Europeans are debating how to diversify their gas supplies away from Russia, to minimise the risk of further gas crises like the ones in 2006 and 2009. Many in Europe ridicule the EU-backed Nabucco pipeline as a pipe dream. But Gazprom has taken it sufficiently seriously to move ahead with its €20 billion South Stream pipeline that would compete with Nabucco for both Caspian gas reserves and South East Europe’s fast-growing energy markets. Austria is the latest country that appears to have switched sides from Nabucco to South Stream.

Pipeline competition, disputes over long-term contracts and uncertainty over both supply and demand make for an antagonistic energy relationship. Neither the EU nor Russia can want this.

The EU’s energy majors will want to wiggle out of their inflexible 30-year agreements but without endangering their working relationship with Gazprom. Some of them have upstream interests in the exploitation of Russian oil and gas fields. Some are involved in multi-billion euro joint pipeline projects with Russia. Long-term contracts will remain important for EU-Russia energy ties, but perhaps without the outdated practice of linking gas prices to those of oil.

Pipeline competition is souring the political climate in Europe. The EU and Russia should discuss whether Nabucco and South Stream might be merged. Russia will need western capital and know-how to develop difficult new gas fields. The EU wants Russia to sign up to joint principles on energy sector investment and transit, especially after Moscow recently withdrew its signature from the Energy Charter Treaty. Russia seeks European help to make its hugely wasteful industrial and power sectors more energy efficient. The EU wants Moscow to adopt greener policies.

These issues, and plenty more, could fill a reinvigorated EU-Russia energy dialogue with substance. Gazprom’s weakened position may bring Moscow to the negotiating table in a more compromising and constructive mood. Progress on energy co-operation could help dissolve the gridlock in EU-Russia relations.

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

Monday, December 14, 2009

Rocky road back to growth

by Simon Tilford

There is no doubt that governments had to take exceptional steps in response to the financial crisis. Without such unprecedented action, many economies would have slipped into slump and probably deflation. With both public and private debt levels so high, deflation would have been crippling. But the point is approaching where stimulus and other monetary measures could become counter-productive. New asset price bubbles are inflating and there are signs of a return to excessive risk-taking in the financial markets. Fiscal positions are now terribly weak in many European countries. Deficit spending on this scale risks depressing rather than simulating economies, if investors lose faith in the sustainability of countries' fiscal positions and borrowing costs rise.

However, although there is no option but to start exiting soon, no-one should be under any illusions about the economic outlook. The short to medium-term looks bleak. Banking crises are typically followed by deep downturns and sluggish recoveries. This is no exception. Investment risks being held back by enfeebled banks. It is imperative that losses are disclosed and banks recapitalised. This is happening too slowly. Household borrowing is already high in many member-states and this will inevitably constrain private consumption. Cuts in public spending will soon be a drag on economic growth across most of Europe. Nor will external demand come to the rescue, not least because the euro looks set for a period of serious overvaluation.

Over the medium to long-term, the only way of bringing about sustainable economic expansion in Europe will be by boosting productivity growth and increasing employment rates. This demands markets that combine high skills and flexibility. Some European countries have one or the other; some neither; very few both. It demands an improved climate for innovation. A genuinely single market for high-tech products and pan-European capital markets would help high-tech firms to expand. Governments also need to increase public support of both pure and applied research as well as product development. Europe needs to learn from the US, where public procurement of one sort of another has made to the fostering of new technologies. Europe needs more, not less, competition. Without it, resources will be slow to move from underperforming or declining sectors to faster-growing, higher-tech ones. Finally, the financial system needs to allocate capital to those that can employ it most productively. The last few years suggest that financial markets are a long way from being perfect at doing this. But they are surely still better than governments.

However, governments will find it hard to implement many of these measures. One of the most striking trends of recent years has been rising inequality. Falling demand for unskilled labour is one reason for this. However, there is more to it. The rewards of economic growth have been accruing disproportionately to the rich rather than to skilled labour in general. Board-room pay is still rising rapidly across Europe, inflating wage differentials. This is not just a trend specific to the financial sector problem and it is certainly not confined to member-states that are considered to be 'economically-liberal'. Moreover, to a greater or lesser extent, governments have also had to step-in to bail-out the financial sector, and hence in the process some of the most highly rewarded people in Europe.

These developments threaten to be poisonous for the political economy of reform. Governments will have to do a number of things if they are to succeed in restoring order to public finances and in pushing through further reforms of labour and product markets. They will have to ensure that the burden of public spending cuts and tax increases is borne equitably. They must do a much better job of demonstrating how greater EU integration and reform benefits the average worker. And they will have to address the issue of excessive pay, both in public and private sectors. If they fail to address these problems, they will have a hard time cutting spending and pushing through tax increases. And they will struggle to pass anything that looks like a 'supply-side reform'.

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

Wednesday, November 25, 2009

Last hooray for the EU on Iran?

by Tomas Valasek

When the EU's first 'foreign minister', Cathy Ashton, starts work on December 1st, she will find Iran on top of her 'to do' pile. Earlier this week, Tehran turned down a proposal from the International Atomic Energy Agency (IAEA) that would have seen a large part of the country's stock of uranium moved out of the country for further enrichment. Barring a last-minute change of heart in Tehran, the US, UK, France and Germany will soon move to tighten UN sanctions on Iran. This could set the scene for a confrontation with Russia and China, which are unconvinced that tough sanctions would work.

It will fall to Ashton to try to get Iran to reconsider. The country's government has not rejected the IAEA proposals outright; it has offered a counter-proposal, which US and European officials deem unacceptable. The Iranians may simply be buying time but there is a small hope that they are open to compromise. Before the UN Security Council imposes further sanctions, the EU needs to be absolutely sure that Iran does not want a deal.

The trouble is that the chances of a negotiating breakthrough with Iran, never high, have diminished since the fraudulent elections in Iran in June 2009 and their bloody aftermath. For the past five months, the country has been mired in twin crises: one within the regime (a band of clerics versus the former Revolutionary Guard commanders grouped around President Mahmoud Ahmadinejad) and another one between the regime and the people. The government appears to have become dysfunctional. Tehran wavered for weeks over the recent Western proposals before rejecting them. It is not obvious that in a country as unstable as Iran is today, any centre of power has the courage to push for a compromise with the West (though some Iran watchers have warned that Tehran could be faking indecision while it buys time to develop further its nuclear programme).

It had been hoped that Barack Obama's entry into the nuclear talks would strengthen the EU's negotiating hand. In the past Iran had made clear to EU diplomats that it would not accept any agreement that did not involve the US. But Obama's charm offensive has had a limited effect. True, it “empowered advocates of engagement inside Iran and transferred the onus of co-operation from the US to Iran”, one Iran expert told a recent gathering of foreign policy thinkers and officials convened by the CER and other think-tanks in Stockholm. Obama's efforts have also made it more likely that Russia will support sanctions. But even after the US had joined the Iran talks and Obama had offered “dialogue without preconditions”, Tehran decided to reject the recent IAEA package.

High Representative Ashton and other western diplomats have few effective tools left to pressure Iran into changing its position, so the world's attention is shifting towards negotiating a new sanctions regime. The EU used to be divided on further sanctions, with France and the UK strongly in favour and Germany more sceptical. But Chancellor Angela Merkel's recent tough language on Iran (in a speech to a joint session of the US Congress) suggests that the new centre right-liberal coalition views sanctions more favourably (this was confirmed by senior German diplomats at the Stockholm event).

The key critics of tighter sanctions are Russia and China, whose top officials have argued on many occasions not only that sanctions would fail to stop Iran's nuclear programme, but also that they would boost the position of radicals within the country. They are right that sanctions are a very blunt instrument. Tougher sanctions almost certainly would strengthen the Revolutionary Guards' stranglehold on the economy and thus, paradoxically, empower the most authoritarian of Iranian political forces and set back the cause of Iran's liberalisation. Sanctions could also prompt Iran to kick out the IAEA inspectors who monitor Iran's nuclear facilities; this would leave the world blind to Iranian nuclear intentions.

But the case for sanctions, on balance, seems somewhat stronger. They discourage other states in the region from following Iran down the nuclear path, and they give the US and - crucially - Israel an alternative to the use of force. Existing sanctions have worked to the extent that they have deprived Iran of some needed technology; the centrifuges used to enrich uranium are said to be crashing frequently. And contrary to what Russia and China say, precedents suggest that sanctions can, under the right circumstances, bring weapons programmes to halt. As one US participant at the Stockholm meeting pointed out, “sanctions against Iraq in the 1990s and early 2000s worked so well that they made the invasion of that country completely unnecessary”. It transpired after the war that Iraq had given up its nuclear and biological programmes years before the US invasion, in large part because it could not obtain the necessary technology.

The two European members of the UN Security Council, France and the UK, along with Germany and the US, will lead negotiations at the UN on further sanctions. But Ashton will still have an important role to play. Sanctions are not meant to replace talks but to complement them; the idea is to inflict hurt on Iran's economy and political classes in order to get the government to accept nuclear proposals from the IAEA. So Cathy Ashton, like Javier Solana before her, will be expected to keep up talks with Iran while the UN debates sanctions, and after the UNSC agrees a new regime. The UNSC is likely to do so: President Dmitri Medvedev has hinted that Russia will swallow somewhat tougher sanctions, while China rarely vetoes UNSC resolutions alone (unless they concern Tibet or Taiwan).

But one wonders if this is the EU's last hooray on Iran. If the combination of sanctions and talks fail, the remaining options would seem to leave little room for EU diplomacy. If Israel strikes Iran's nuclear facilities, Tehran will certainly call off the EU-led talks. The other choice before the world is to start preparing for a nuclear Iran. A strategy of containment would require western governments to focus on making Iran's neighbours feel secure, so as to discourage them from building nuclear weapons themselves. But this will almost certainly be a job mainly for the US, rather than the EU. So while Baroness Ashton will spend a lot of time on Iran at the beginning of her term, the EU may gradually lose its leading role.

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

Wednesday, November 11, 2009

What Eastern Europe can learn from the crisis

by Katinka Barysch

It is 20 years since the Berlin Wall crumbled and political and economic freedom started spreading through Eastern Europe. Today, however, the region is mired in deep recession. The global economic and financial crisis has hit the Central and East European countries (CEECs) harder than any other emerging market region. In February 2009, I asked whether the savage downturn would make the new EU member-states question their entire transition model of trade opening, financial integration and EU-conforming reforms (‘New Europe and the economic crisis’ This has not happened. Dire predictions did not come true: financial systems did not collapse, the steep fall in exports and industrial output has bottomed out and there has been no mass social unrest. Most people, inside and outside the region, seem to agree that the CEECs need to recalibrate their growth model, rather than ditch it. The crisis may harbour some valuable lessons on how to go forward after 20 years of transition.

The fact that the CEECs had sold almost their entire banking sectors to big finance houses from Austria, Belgium, Germany, Italy or Sweden turned out to be a mixed blessing. During the boom years, financial integration did help the CEECs to grow faster (which is not true of all emerging market regions). When the crisis hit, West European banks did not withdraw all funding from their CEE subsidiaries overnight or let them go bankrupt, as many had feared. These subsidiaries did stop lending, as their parent banks scrambled to rebuild capital – but so did local banks.

There were no big banking crises in Eastern Europe. The hastily assembled ‘Vienna initiative’ – a club consisting of pan-European banks, the regulators of the countries in which they operate and international organisations such as the EU and the World Bank – helped to prevent a run for the exit that could have resulted in financial meltdown. The €25 billion put up by three multilateral lenders in support of ailing CEE banks also helped.

The EBRD, in its latest ‘Transition Report’, claims that countries with a higher share of foreign bank ownership did relatively better in the crisis than those with shaky local institutions that relied on short-term liquidity from abroad. However, the EBRD report also admits that the presence of foreign banks fuelled unsustainable credit booms and brought shoddy lending practices to the CEECs, such as giving mortgages in euros or Swiss francs to people without thorough credit checks.

The crisis showed that home country supervision – the basic principle of EU financial market integration – needs to be improved. The authorities of say, Sweden and Austria, did not pay enough attention to what their banks were getting up to in Latvia or Hungary. Some economists think that this will change now that Swedish and Austrian taxpayers are footing the bills for bank bail-outs abroad. But others argue that only stronger cross-border banking regulation and supervision can prevent similar trouble in the future. At the same time, the governments and regulators of the CEE host countries need to work harder to strengthen local capital markets. For example, unhedged foreign-currency denominated loans are a lousy idea as long as exchange rates are not irrevocably fixed.

Eastern Europe’s exceptional openness to trade was a blessing while global growth was strong. But it also left the region vulnerable. No fiscal stimulus programme would have been big enough to compensate for the collapse of eurozone demand in countries where exports typically account for 50 to 80 per cent of GDP. What is more, the crisis highlighted that some of the new EU members had focused rather too much on one industrial sector – cars. Around half of export revenues and up to 20 per cent of value added is generated by the automotive industry in the Central European countries.

Several car factories in CEECs shut down in late 2008 and early 2009. For a while it looked as if the new members might be the losers from a subsidy race among the bigger, richer EU countries. In the end, however, countries such as the Czech Republic and Slovakia benefited from the scrappage schemes that Germany, Austria, France and other West European countries implemented to boost domestic demand. Single market rules held: these schemes did not discriminate in favour of vehicles made at home. The WIIW, a Vienna economic research outfit, even claims that those CEECs that rely most on exports of machinery and cars have suffered milder contractions.

Most countries are now phasing out their ‘cash for clunkers’ schemes, which will translate into lower demand for vehicles made in Eastern Europe. In the medium term, the need to cut costs and overcapacity in this sector worldwide could work in the CEECs' favour as the big car makers will continue to relocate production to countries with low unit labour costs.

Nevertheless, the economic crisis has served as a reminder that the CEECs need to diversify their industrial structures. Wedged between a high-tech Western Europe and a low-cost Far East, there is only one way to go for the CEECs: move up the value chain. To do this, these countries need to improve their education and training systems, make their markets work better and encourage innovation and entrepreneurship.

Such reforms are needed more urgently than ever now that global competition for capital and markets has become fiercer. The EBRD, which tracks economic change across Eastern Europe, finds that there have been few instances of reforms unravelling since the onset of the crisis; but it also finds that there has been little noticeable progress towards better-functioning market economies. So far, populism has been contained in Eastern Europe. But with lay-offs still rising fast, and governments too cash-strapped to do much about it, the elections due in many CEECs in 2010 and 2011 could result in governments promising protection rather than explaining the need for economic change. The risk remains that the CEECs will draw the wrong lessons from the crisis and endanger the economic success of the last 20 years of transition.

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

Wednesday, November 04, 2009

Is Turkey Iran's friend?

by Katinka Barysch

Is Turkey really Iran’s “friend”, as Recep Tayyip Erdogan claimed in a recent interview with the Guardian newspaper? Erdogan’s visit last week to Tehran suggests so. He met not only President Mahmoud Ahmadinejad but also Supreme Leader Ayatollah Ali Khamenei, a rare honour. He announced plans for energy and commercial co-operation with Iran and defended the country’s right to civilian nuclear power, calling its energy programme “peaceful” and “humanitarian”. Ahmadinejad, meanwhile, thanked Erdogan for his critical stance on Israel.

Policymakers in the West are getting worried that Turkey’s growing ties with Iran – by lessening that country’s sense of isolation – may frustrate diplomatic efforts to prevent Tehran from building a nuclear bomb.

Turkey’s official line is that it fully supports international efforts to persuade Iran to stop its enrichment programme, backed by the threat of tougher sanctions. The Turkish government claims that it is using closer ties with Iran to pass on tough messages to the leadership there. However, Turkish political leaders and high officials have been very cautious in their public pronouncements about Iran. “Iran does not accept it is building a weapon”, Erdogan is quoted as saying by the Guardian. “They are working on nuclear power for the purposes of energy only."

Erdogan has often mentioned Iran in the same sentence as Israel, perhaps implying that if one country in the Middle East has nuclear weapons it might be unfair to prevent other ones from building them too. Following his Tehran trip, he referred to western pressure on Iran as ‘arrogant’ because it came from countries that themselves had nuclear weapons. It would be preferable, he said, to have a nuclear-free Middle East and a nuclear-free world.

Turkey’s rather friendly stance on Iran may be understandable and acceptable at a time when the West’s diplomatic efforts are making at least some progress. But what if current negotiations fail? Would Turkey support the tougher sanctions that the US and most EU countries are threatening?

When asked this question, a top Turkish diplomat (at a recent EDAM roundtable in Bodrum) was evasive: “We would have to first see the content of the resolution. And we would have to make sure that we bring Russia and China on board.” This answer implies that Turkey may support sanctions in the (unlikely) event that they are backed by the United Nations Security Council but not if they are unilaterally imposed by the Americans and the Europeans. Another Turkish diplomat (at the ‘Istanbul Forum’, a big conference focusing on Turkey and the Middle East in October) summed up Turkey’s stance on Iran’s nuclear programme as “diplomacy, more diplomacy and even more diplomacy”.

Many Turks fear the impact of tougher on their own economy. Turks say that the 1999 sanctions against Iraq resulted in the loss of what had then been their second most important trading relationship, and that European sanctions on Serbia in the 1990s cut off one of Turkey’s most important transport artery to the EU.

Trade between Turkey and Iran has been growing fast in recent years, to reach an estimated $ 6 billion in 2008. Politicians from both sides say they want to see that figure double or even triple over the next 5-10 years. Iran is also Turkey’s second biggest gas supplier after Russia. Many Turks think that Iranian gas will be essential if Turkey is to fulfil its ambition of becoming a regional energy hub. Further sanctions would therefore harm Turkey’s economic interests. Already, US pressure forced Turkey to put on ice a $3.5 billion investment deal in the Iranian gas sector signed in 2007 – although Erdogan confirmed that Turkey still wanted to go ahead with such energy deals during his recent Tehran visit.

More importantly, perhaps, Turkish support for tougher sanctions would end the recent rapprochement between Tehran and Ankara and could even lead to retaliation. “We have no choice but to have good relations with our big neighbours”, explained one Turkish parliamentarian at the Istanbul Forum. “This conviction stood behind our decision in 2003 not to allow the Americans to march into Iraq from our territory. We knew we would have to live with Iraq afterwards, no matter what the outcome of the war.”

The Erdogan government values its relationship with Iran as part of its ‘zero problem’ neighbourhood policy. Having been more or less isolated in the region only 20 years ago, Turkey now has flourishing political and trade links with most of its immediate neighbours, as well as many countries of the Middle East, the Caucasus and Central Asia. There are even plans to open the border to Armenia, closed since 1993. Ankara is proud that it is one of the few countries that ‘talks to everyone’. This strategy has entailed links with Hamas and, more recently, visa-free travel and trade liberalisation with Syria.

Iran is one of Turkey’s most important neighbours and therefore crucial for the perceived success of the ‘zero problem’ strategy. Turkish politicians like to point out that the current Turkish-Iranian border dates back to 1639 and that the two countries have not been at war since. Since the implosion of Iraq, the two countries have worked together more closely on security issues, in particular to prevent Kurdish separatism and terrorism, which threatens both countries.

As ties with Iran thicken, Turks see the country’s nuclear programme as less of a threat. A third of Turks now think that a nuclear armed Iran would be acceptable, according to the latest Transatlantic Trends survey from the German Marshall Fund. Two years ago, the share was half that, at 17 per cent. In the US, only 5 per cent say they could live with a nuclear armed Iran. Turkish leaders hardly ever say explicitly whether they consider a possible Iranian bomb as a threat. When asked whether he was worried about such a prospect, one official at the EDAM roundtable responded: “We are under Nato’s nuclear umbrella.”

This apparent confidence, however, hides some deep-seated anxiety and mistrust. Turkey and Iran may not have been to war with each other for centuries, but they are natural rivals in a volatile region. Arguably, much of Turkey’s recent regional diplomacy has been designed to contain Iran’s growing influence, from Turkish efforts to help stabilise Iraq to building closer links with Syria. Neither the Americans nor the Iranians took up Ankara’s offer to mediate between the two, preferring to deal with each other directly. At the Istanbul Forum – which devoted a lot of time to discussing Iran – not a single Iranian official showed up.

Many Turks fear that a nuclear armed Iran would change the regional balance of power and trigger an arms race in this unstable part of the world. One Turkish politician, when asked what Turkey would do if efforts to stop the Iranian weapons programme failed, said: “We will have to build our own bomb.” It is statements like this that make some people suspect that the reason why Turkey is now starting its own nuclear programme is not only to improve energy security but also to be prepared in case of a nuclear arms race in the Middle East.

Turkish officials deny this categorically. They insist that their country needs nuclear power to satisfy fast-growing energy demand, reduce reliance on imported gas and cut CO2 emissions. Moreover, it could take Turkey a decade to build up a nuclear capacity. Already, the first tender to build a nuclear plant is being reviewed after only one company (from Russia) submitted a bid.

Meanwhile, Turkey is in talks with Washington about buying a missile defence system against short and medium-range missiles. The claim of Turkey’s foreign minister, Ahmet Davutoglu, that this system would have “nothing to do with Iran or any other country” just begs the question.

Turkey’s ambiguous stance towards Iran is symptomatic of the difficulties that Turkey faces in trying to combine its growing regional ties with its traditional orientation towards the West. As a long-standing NATO member and a country negotiating for EU membership, Turkey is expected to align itself with the US and Europe – or at least not do anything that undermines the West’s political objectives in the Middle East. As a regional power, Turkey will want to act independently and avoid antagonising its neighbours. It is not clear how long Ankara will be able to avoid tough choices.

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

Tuesday, October 20, 2009

President Lamy?

by Hugo Brady

EU leaders are racking their brains to come up with candidates for the future presidency of the European Council. The job, to be created by the nearly-ratified Lisbon treaty, will replace a system whereby the EU is 'led' by a different national leader every six months. Instead, the Union will have a full-time consensus builder who will also represent the EU to foreign heads of state, for a maximum five-year term. The man or woman who gets the job is banned from holding national office, but the assumption is that potential incumbents need to have served as a president or prime minister in a past life.

Strangely, suitable candidates are proving elusive, even though the post has the potential to be both prestigious and influential. Of those names that have been touted so far, some – like the former British prime minister, Tony Blair – are divisive figures that would inevitably bring much political baggage to the office. Others – like Jan Peter Balkenende, the current Dutch prime minister – are agreeable to most, but uninspiring. They lack the profile and international standing that is needed if the post is to be more than merely ceremonial.

In early 2008, I tried to imagine the qualities the successful candidate for European Council president should have, in a mock job advert published in CER's bi-monthly bulletin:

"As the first person to hold this post, you will enjoy enormous scope to shape its future potential. Second-rate candidates need not apply. You should be a formidable communicator, highly capable but not overly assertive. You need to be firm but conciliatory. Modesty would be an asset. Although this position offers prestige and influence, power and perks will be limited. With only a handful of staff and no presidential cavalcade, the job will resemble that of the UN secretary-general rather than that of US president. Beyond your right to assemble us for emergency meetings, your formal powers will be limited. We are counting on your ability to set the agenda and forge consensus through persuasion and quiet charisma."

('Applicants sought for EU council president', CER bulletin, April/May 2008).

These are virtuous attributes indeed but, even in the rarefied corps of past and present European leaders, they are hard to find. Moreover, the job appears to require its holder to be a walking paradox: charismatic but modest, highly effective but non-intimidating, a consensus builder but also a decision-maker. Most ex-leaders of national governments would struggle to adjust to the limitations and requirements of such a position. That is one reason why candidates are so scarce.

Hence the member-states would find more suitable candidates if they widened their search beyond former heads of government to heads of international organisations, former European Commissioners with a distinguished record and, perhaps, even prominent figures from the world of business with an international profile. Some potentials might be Dominique Strauss-Kahn, (although it is probably more important that he stay in his current position as head of the IMF), or Chris Patten, a former EU commissioner for external relations.

In an ideal world, the most promising candidate from the non-leaders category would probably be Pascal Lamy, the current head of the World Trade Organisation. Judged against the criteria quoted above, Lamy emerges as a front-runner for a number of reasons. First, as the current head of a complex but indispensible organisation that operates by consensus and moves at a slow pace, Lamy could argue that he has done this sort of work before. Second, he has no political baggage of the sort that would identify him as a tool of one particular camp of member-states or another. A French socialist who supports free trade, Lamy would be a prime candidate to bring the Union together on many issues, especially on further steps to hasten economic recovery.

Also, whilst chief of staff for Jacques Delors, a former president of the European Commission, Lamy was a highly effective consensus builder who managed to thrive amid often spectacular political infighting. That is a quality that would stand him in good stead in the power-sharing triumvirate established by the Lisbon treaty, where the Council President's responsibilities rub up against those of the president of the European Commission and a newly powerful High Representative for Foreign Policy.

Opponents could argue that Lamy has no foreign policy experience on big picture issues like the Middle East peace process or Iran's nuclear programme. But trade – along with enlargement – has long been the EU's most important foreign policy tool, and Lamy is a former EU trade commissioner. Furthermore, rising powers like China or India will sit up and take notice if the head of the WTO were to depart suddenly to take up the European Council job.

I have no idea if Lamy is interested in the EU presidency, or whether he would be willing to leave the WTO were it offered to him. But the member-states will have a bigger, better field of candidates to choose from if they can let go of the idea that the first incumbent - so important to the future success of the position - must first have been a member of their own club.

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

Thursday, October 08, 2009

Greece: Nowhere to hide

by Simon Tilford

The Greek economy is on a very dangerous course. Unless the government takes steps to boost productivity and strengthen public finances, Greece faces a bleak future. Many Greeks appear to believe that membership of the euro insulates their country from the threat of financial crisis. This is mistaken. Membership may free the country from the threat of a currency crisis, but not from a fiscal crisis.

Eurozone membership requires considerable discipline. The reason is obvious. A country that loses trade competitiveness within the currency union can only regain it by ensuring its costs rise less quickly than the rest of the eurozone. In short, it must engineer a real depreciation within economic and monetary union (EMU). It cannot rely on devaluation to restore competitiveness.

Costs can be held down by wage freezes, although this risks depressing domestic demand and exacerbating the weakness of the fiscal position. Only stronger productivity offers the chance of regaining competitiveness without hitting domestic demand and bringing on a fiscal crisis. Higher productivity requires reforms of labour markets and the opening of the domestic economy to more competition.

Greece only has a small window of opportunity. The government deficit is on course to exceed 8% of GDP this year – this despite the Greek economy having only just entered recession. With the economy set to contract next year and stagnate the following year, the debt to GDP ratio will rise dramatically. The IMF estimates that it will jump to 134% by 2014. In reality, it looks like being much higher than this. And once the deficit reaches such a level it is hard to prevent it rising further because of the rising burden of interest payments.

Greece cannot finance deficits of this size domestically. It has to attract funding from abroad. This will become increasingly difficult if investors believe that the economy will be stuck in a cycle of very weak economic growth and rising public debt. Investors will lose faith in the ability of the Greek government to service its debts.

Many Greeks appear to believe that the eurozone as a whole would step in to prevent a debt crisis. They are probably right, but this would not be cost free. Assistance would be provided only in return for a commitment to reform the economy and cut public spending. It would make much more sense to take steps now rather than having to take more painful steps later.

The election result suggests that there is little stomach for reform in Greece. But Greece has no choice but to reform. Delay will only make the eventual medicine more bitter.

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

Friday, October 02, 2009

The Czechs will probably ratify the Lisbon treaty this year

by Charles Grant

Any prediction about the timing of the Czech Republic’s ratification of the Lisbon treaty must be heavily qualified; politics in Prague are so complex and opaque that many Czechs find it hard to understand what is going on. But having just spent a couple of days talking to politicians and officials in Prague, I think it likely that the Czechs will ratify this year.

The republic’s maverick president, Vaclav Klaus – who shares the passion of his idol, Margaret Thatcher, for free markets and bashing Brussels – is doing his best to delay the ratification of the Lisbon treaty. Last year a group of eurosceptic senators allied to Klaus challenged the treaty in the constitutional court, with six specific complaints about the document. After seven months the court approved the treaty and earlier this year the parliament voted for it, but Klaus has delayed signing the law of ratification. On September 29th the eurosceptic senators mounted a second challenge to the treaty in the constitutional court, thereby giving Klaus a good reason not to sign.

If the Irish approve the treaty in their October 2nd referendum, Poland’s president, Lech Kaczynski, is likely to sign his country’s law of ratification. The Czech Republic would then be the only EU member-state not to have ratified the document.

The general view in Prague is that the court, based in the Moravian town of Brno, will once again approve the treaty. It is an independent institution and nobody thinks its judges are particularly eurosceptic. But how quickly will it rule? Klaus has admitted receiving a hand-written letter from David Cameron, the leader of the British Conservatives, apparently stating that they are with the Czech president in his fight against the treaty. If Klaus can delay his signature till the Conservatives take office in Britain – after the general election that is due by next June – Cameron will hold a referendum on the treaty. The result would almost certainly be a No, and that would be the end of the Lisbon treaty.

Nobody knows how long the court will take to consider the treaty. Although it took only ten days to rule on a recent case concerning early parliamentary elections (the court insisted that the current parliament continue to the end of its term), it will need to give a full and considered response to the new challenge to the Lisbon treaty. However, one senior figure I spoke to was confident that the ruling would be “in weeks not months”. The case for a quick ruling is that the court has already spent time on the treaty, dealing with last year’s case, and that “the court does not exist in a political vacuum”. The judges understand, apparently, that there is much at stake for the whole of Europe. The chairman of the court has said that he and his judges will prioritise this case and that other matters will be put on hold. The predominant view of people I spoke to was that the court would rule by Christmas.

But could Klaus’s friends in the Senate seek to delay the treaty further, by mounting a third legal challenge? The leader of the eurosceptic senators, Jiri Oberfalzer, is reported to have said that they would not do so. Oberfalzer has also said it is unlikely that the president himself would start a new case before the court. Indeed, at a recent dinner of leaders of the Visegrad countries (the Czech Republic, Hungary, Poland and Slovakia), Klaus apparently said that ratification was like a train in motion that could not be stopped.

So long as Klaus jibs at signing the ratification, he will face mounting pressure from other EU governments. And he may face threats from France and/or Germany. In Paris there is talk of punishing the Czech Republic for delaying ratification, for example by making sure the next Czech commissioner gets a non-job or by blocking Czech participation in international bodies. In the Commission and the European Parliament some people say that the Czechs could lose their commissioner altogether: if the next Commission has to be appointed under the rules of the Nice treaty – so that the number of the commissioners must be less than the number of member-states – the Czechs should be the ones to lose out.

That kind of threat would probably be counter-productive. Klaus is famously stubborn and is never happier than when standing up for a little country against bullying by big member-states. Czech officials worry that France’s president, Nicolas Sarkozy – renowned for his impulsive comments – could put his foot in it with a stinging attack on the Czechs.

It would be wiser to let the Czech people themselves put pressure on their president. Klaus is out of tune with Czech public opinion, which is predominantly in favour of the Lisbon treaty. All the main parties except for the Communists support the treaty. The recent decision of President Barack Obama to scrap plans for an anti-missile radar in the Czech republic has weakened the hand of those Czech politicians who argue that the American alliance is more important than European integration. Indeed, since the US decision on missile defence there has been more talk in Prague of boosting the EU’s role in defence. The best course of action for Europe’s leaders is to wait patiently for the court to rule and keep their fingers crossed.

Charles Grant is director of the Centre for European Reform.

Tuesday, September 29, 2009

Westerwelle for finance minister

by Katinka Barysch

Guido Westerwelle is the undisputed winner of Sunday’s election in Germany. His Liberal Democratic Party (FDP) attracted almost 15 per cent of the vote, its highest share ever. Angela Merkel will remain chancellor although her Christian Democratic Union (CDU) did slightly worse than in the 2005 election. The FDP’s gains allow Merkel to discard the cumbersome ‘grand coalition’ with the Social Democrats and start negotiating a deal with the more likeminded Liberals.

The haggling about posts and policies is likely to be swift this time, with Merkel promising to have her new cabinet in place in a couple of weeks. Traditionally, the leader of the junior coalition partner becomes foreign minister (and vice chancellor). So Westerwelle is almost certain to succeed SPD-leader Frank-Walter Steinmeier in the foreign ministry.

Since taking over as FDP leader eight years ago, Westerwelle has worked hard to make his party appeal more to young voters and those fed up with the two big Volksparteien, the SDP and the CDU. Sunday’s result shows that he has been successful. But party political manoeuvring and a relentless quest for media attention have not left him much time to travel the world.

His public statements about foreign policy have often been a little vague and sometimes contradictory. He has argued for continuity in German foreign policy, promising that there would be no sharp breaks with most of Steinmeier’s positions. As a strong Atlanticist he was critical of George W Bush’s war on terror but has applauded Barack Obama, in particular for his moves on disarmament. He has spoken out against Germany sending more troops to Afghanistan, or letting them fight in the south, but he wants Berlin to live up to its promises to train more Afghan policemen. He is a firm believer in the benefits of European integration, especially the single market, and he thinks Germany should pay more attention to the smaller EU members. But the smalls will not like his suggestion that European integration should become more flexible, allowing sub-groups of member-states to go ahead with particular policies. He says EU accession negotiations with Turkey should continue, which will put him at loggerheads with those in the CDU (and its smaller sister party, the CSU) who want to offer Turkey a privileged partnership. He has sometimes sounded rather conciliatory on Russia. But he also advocates keeping Germany’s nuclear power stations running beyond 2022, to make the country less dependent on Russian gas.

Westerwelle does not have a lot of experience with foreign policy and his public statements on international issues so far do not add up to a coherent Weltanschauung. That does not mean that he would not make a good foreign minister. Joschka Fischer had limited international credentials before he became foreign minister of the SPD / Green Party coalition in 1998. He turned out to be an effective and principled international operator. Like all foreign ministers before him, he quickly became one of Germany’s most popular politicians.

It is not Westerwelle (or Fischer or Steinmeier) that is the problem. It is the tradition of giving the foreign ministry to the leader of the junior coalition partner. Westerwelle may or may not agree with Merkel on foreign policy. He has little choice but to use his new job to sharpen his party’s profile. The SPD did so dismally in Sunday’s election partly because, after four years in the grand coalition, voters struggle to tell what it stands for. The lesson for the FDP will be to chart an independent course, especially after 11 years in opposition. It should: in economics, not in foreign policy.

Since the foreign minister and the chancellor always come from different parties, all vital foreign policy dossiers (relations with the US, Russia, China and so on) land directly on the chancellor’s desk. Not content with being in charge of secondary issues, Germany’s foreign ministers have often developed their own stance on the big issues of the day. Contradictory public statements and competing diplomatic initiatives have sometimes been the result. Such incoherence in foreign policy mattered little before reunification, when Germany’s low-key foreign policy mainly consisted of supporting European integration and the transatlantic alliance. But today, Germany claims international leadership and is expected to adopt regional and global responsibilities. Today, German foreign policy should not be a matter of coalition squabbles. Therefore, the foreign minister should come from Merkel’s own party.

Westerwelle should move into the finance ministry instead. While the foreign policy part of the FDP’s manifesto is weak, it has strong positions on economic policy: it advocates open markets, less stringent hiring and firing rules, an effective competition policy, help for small enterprises and, most importantly, lower and simpler taxes. Westerwelle insists that he will not sign a coalition agreement that does not contain tax reform. But he also knows that with € 1.6 trillion in public debt and a new law mandating a zero deficit by 2016, there is not much room for fiscal manoeuvre. The temptation to leave this balancing act to someone else and instead enjoy the international limelight will be strong. But if Westerwelle is serious about tax reform, he should install himself in the finance ministry and see it through as best he can. By helping to tackle some of Germany’s economic weaknesses, Westerwelle may even add more to his country’s international standing and credibility than by being its chief diplomat.

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

Tuesday, September 22, 2009

Talk of ‘exit’ is premature

by Simon Tilford

The governor of the Bank of England (BoE), Mervyn King, has had a mixed financial crisis. He assumed that financial stability flowed from monetary stability – which we now know is not the case – and was very slow to recognize the extent of the crisis. He has also taken the UK into unchartered waters with the embrace of so-called quantitative easing (QE). QE involves the electronic creation of new money by the central bank in the form of purchases of government and private sector bonds. QE aims to drive down long-term interest rates and encourage bank lending. The BoE has now spent around £150bn, in the process buying not far short of a quarter of the UK’s entire outstanding stock of government debt. It is far from clear whether QE will work. It is possible that the banks will simply sit on the cash rather than lending it, as they did in the early 1990s when the Bank of Japan employed a similar strategy. But King is right to argue that dramatic action is warranted by the economic outlook, which is much worse (and not just in the UK) than the general consensus.

The BoE governor has repeatedly warned that commentators and economists are not paying sufficient attention to the difference between ‘growth and levels’, and that the threat of inflation is extremely remote. He is clearly right. A couple of quarters of modest economic growth following peak-to-trough contractions of around 5 per cent is neither here nor there. It certainly does not represent a return to business as usual. Of course, it is positive that the recession is over. But that the economy has been stabilized at all has been the result of massive monetary and fiscal stimulus. The underlying dynamic remains very weak. On most growth projections it will take the EU economy several years to return to pre-crisis levels of GDP.

No sooner has the recession ended than we are being overwhelmed with talk of a rapid bounceback in economic growth and hence for the need to craft ‘exit strategies’ to prevent an upsurge of inflation. This ignores what has happened. The gap between what we can produce and what we do produce is now enormous. With consumption and investment set to remain very weak, it will take many years to close this gap. To talk of exit strategies in such a situation is dangerous and potentially deflationary. It is going to feel like a recession for many years. Demand for labour will take a long time to recover, not only because it will take time to recoup the lost output but because labour productivity will also rise over this period. Fewer workers will be needed to produce a given amount of output. The result threatens to be mass unemployment. The outlook for investment is also very poor. The combination of excess capacity and undercapitalised banks will conspire to keep investment weak for quite some time.

Of course there are mighty long-term fiscal challenges facing most EU economies. If bond investors start to believe that governments have lost control of their public finances, long-term interest rates will rise, hitting growth. But a premature exit would do more harm than good, as it would almost certainly derail the recovery, in the process weakening fiscal positions. If no-one else is willing to spend, then the state has to. Any country exiting before a self-sustaining recovery has taken hold will essentially be guilty of free-riding on the demand being generated by deficit spending elsewhere. Germany has already indicated that it intends to tighten fiscal policy steadily following the election and is now constitutionally obliged to reduce its fiscal deficit to 0.35% of GDP by 2016. Such a move will only work if others keep spending and Germany can rely on rebuilding its trade surplus for economic growth. This is a zero-sum game. If everyone behaves in this way, the impact on Europe’s economy will be dire.

Similarly, a premature move to raise interest rates in an effort to head off a largely imaginary inflation bogeyman would risk scuppering the recovery by increasing the cost of capital and boosting the already excessive strength of the euro. The European economy needs very low interest rates for an extended period of time to keep capital cheap and to stimulate activity to close the output gap. The risk of snuffing out the recovery now (in the process exacerbating the weakness of public finances) is far greater than a spike in inflation later on. Stagnation and debt deflation pose greater risks to the European economy than inflation.

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

Thursday, September 10, 2009

The dangers of Karzai’s re-election

by Tomas Valasek

The final result of the Afghan election may not be known until the end of September, but it looks as if President Hamid Karzai will have done well enough to avoid a second round of voting. This is causing dismay in some western capitals, where some senior figures now view Karzai as a key obstacle to Afghanistan’s reconstruction. If he stays in power, people in many European countries are likely to become increasingly disenchanted with the ‘mission impossible’ that their soldiers are undertaking, and that would increase the probability of European forces being withdrawn.

A senior UK diplomat recently described the problems posed by Karzai’s government for western attempts to reconstruct Afghanistan. “Our game plan is to use foreign troops to create enough breathing room for the Afghan government to assert its authority throughout the country,” he said. “But if the government whose authority we help to assert is widely viewed as corrupt and incompetent, we have no chance of succeeding.”

Karzai’s government has earned its inglorious reputation for several reasons. Washington suspects that some of its top officials are involved in the drug trade, including the president’s brother, Ahmed Wali Karzai, as well as the defence minister, Karzai’s running mate and the potential future vice-president, Mohammad Fahim. Corruption extends downwards through the bureaucracy. Western troops say that many Afghan policemen steal valuables during searches of houses. Local leaders complain they have very little effort from the Kabul government to rebuild roads or resuscitate the economy; it is the western governments and NGOs that deliver the little progress that there is.

In his early years as president, Karzai offered hope for a new future and was genuinely popular. In 2005, 83 per cent of Afghans approved of president Karzai and 80 per cent approved of the national government overall. Today those figures have dropped to 52 and 49 per cent, respectively. Those are still solid numbers that some western leaders would envy. But the support has been on a constant slide for the past four years because more and more Afghans have given up hope that the current government will deliver stability or prosperity.

The US, the UK and other key troop-contributing governments worry that a Karzai victory heavily tainted by allegations of fraud will further disappoint the Afghans and embolden the Taliban. And in the western countries that send the troops his re-election could also fatally undermine public support for the mission. The latest opinion polls show that about two-thirds of Britons want UK troops out of the country – not only because of rising casualties, but also because of the perception that Afghan politicians are using their authority, which rests on the support of western troops, for self-enrichment.

The US, for now, has little choice but to stay put. The US public is as fidgety as that in Britain but President Obama has made success in Afghanistan a key plank of his foreign policy and he will not want to give up so soon. The US may send more troops if General Stanley McChrystal, the commander of US and NATO forces in Afghanistan, requests reinforcements.

The situation is different in other NATO allies. The Dutch are scheduled to leave next year, and the Canadians say they will withdraw in 2011, though NATO is working hard to get both governments to change their mind. That may prove impossible unless events in Afghanistan give the public some reason to believe that NATO is managing to turn around its flagging mission. Even the British presence cannot be taken as guaranteed, if public support for it continues to slide.

The prospect of European troops departing brings two risks. One is to the security of Afghanistan itself. Together, the UK, Canada and the Netherlands supply the bulk of the troops that keep a semblance of order in three of the volatile southern provinces (though the US is reinforcing its presence in the south). NATO and the EU are busy training new Afghan soldiers and police to replace the western troops. But on the evidence of the past few years, the central government is unlikely to have enough properly trained replacements to take over from the Europeans anytime soon. Some local Afghan leaders say that if the Europeans withdraw in the next year or two, they will leave the country too, or strike deals with the Taliban. Either way, the government in Kabul would lose out. The second risk is to NATO itself. Why should Washington take the alliance seriously if it finds itself manning the ramparts in Afghanistan alone?

To prevent European support for the war in Afghanistan from collapsing, the governments need to take two steps. First, those capitals that have done little to drum up public support for the mission need to step up. In the UK, Prime Minister Gordon Brown gave a major ‘why we fight’ speech on September 4th. More effort of this sort is needed. Second, assuming that Karzai is declared the victor, the West needs to find ways of making clear to is government that it needs to do more to fight corruption. This could include withholding EU and national aid from the most corrupt parts of the Afghan government.

Getting the Kabul government to change its ways will not be easy: when the US special representative, Richard Holbrooke, recently suggested that Afghanistan might have to deal with complaints of ballot-rigging by holding a second round of elections, Karzai walked out of the meeting; he later told a French newspaper that the US wanted him to be more “docile”. But the European governments and Washington are right to try. The government in Kabul and its western partners need to find ways of changing the perception that the Karzai government is failing, or public pressure may force European troops to withdraw sooner than is good for the country.

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

Friday, August 07, 2009

Anglo-Saxons and hedge funds: Culprits or scapegoats?

by Philip Whyte

Disasters often provoke unseemly bouts of finger-pointing. This has certainly been true of the global financial crisis. In the Anglo-Saxon world, libertarians have blamed it on governments, and governments on ‘bankers’. But in continental Europe, many blame Anglo-Saxons for their supposed reluctance to regulate financial markets. The crisis, they believe, would never have happened if the British and the Americans had regulated and supervised their financial sectors like the French and the Germans. On this view, the UK needs to change, notably by clamping down on hedge funds. Does this narrative stack up? Or have some Europeans just turned Anglo-Saxons and hedge funds into their scapegoats of choice?

Tirades against Anglo-Saxons long predated the crisis, but they have gathered in intensity since it began. In the run-up to the G20 summit in April, Luxembourg’s prime minister, Jean-Claude Juncker, stated that this crisis “started in the US. The Anglo-Saxon world has always refused to add the dose of regulation which financial markets needed.” At the end of the same summit, the French President, Nicolas Sarkozy, announced the death of “unregulated Anglo-Saxon finance”. And in July, Germany’s chancellor, Angela Merkel, told a political meeting in Nuremberg that “with us, dear friends, Wall Street or the City of London won’t dictate again how money should be made, only to let others pick up the bill.”

In any analysis of the causes of the crisis, the UK and the US clearly deserve a share of the blame. They tolerated unsustainable domestic credit booms which wreaked havoc on themselves and the rest of the world. But they were hardly the only countries to experience credit-fuelled housing booms. Denmark, France, Ireland and Spain did too. Nor were they the only countries which allowed ‘shadow banking’ entities to proliferate and banks’ exposures to complex financial instruments to grow. It was a funding crisis at two ‘special investment vehicles’ (SIVs) that brought the regulated German bank, IKB, to its knees. And German banks built massive exposures to collateralised debt obligations (CDOs).

What of hedge funds? Listen to French and German leaders, and you would think that hedge funds were central to the financial crisis. France and Germany have leaned on the European Commission to propose a directive that would regulate hedge funds; they have criticised the Commission’s resulting legislative proposal as too weak; and they have accused the British of dragging their heels. France and Germany are not entirely wrong: the example of Long Term Capital Management in 1998 shows that some hedge funds can pose a threat to financial stability. Even so, it is hard to avoid the conclusion that France and Germany have used the crisis as an opportunity to advance one of their hobby horses.

Both the EU’s de Larosière report and the UK’s Turner review agree that hedge funds did not cause the global financial crisis. They did not drive the growth in sub-prime lending. They did not cause house prices to fall. And they did not force regulated banks (such as Germany’s Hypo Real Estate) to hold CDOs on their balance sheets. So it is quite wrong to imply, as some French and German politicians do, that the crisis would not have occurred if hedge funds had been more tightly regulated. It is also wrong to suggest that the British are reluctant to regulate hedge funds. The British government has accepted the Turner review’s recommendation that “regulation should focus on economic substance, not legal form”.

The Turner and de Larosière reports point to a broad, technocratic cross-Channel consensus on the causes of the financial crisis and the lessons to be learned. Does it matter if this is not reflected in political rhetoric? Yes, for two reasons. First, political obsessions can often drag policy in undesirable directions. (Remember that when Germany chaired the G7 in the months leading up to the crisis in 2007, it was so fixated with regulating hedge funds that it was blind to what turned out to be the central problem: the excessive leverage and effective under-capitalisation of the regulated banking sector). Second, rhetoric can poison negotiations unnecessarily, making agreement more difficult to reach.

Populist broadsides against Anglo-Saxons and hedge funds are unlikely to help the prospect of pan-European regulatory reform. If French and German politicians are not careful, the scenario which they paint of a recalcitrant Britain at odds with the rest of Europe could become a self-fulfilling prophesy. It is no secret that sections of Britain’s media and political class are primed to detect sinister motives in anything emanating from Europe. More often than not, such fears are just paranoid fantasy. But for once, the British may be forgiven if they conclude that France and Germany are exploiting the crisis to promote some of their longstanding objectives and to weaken London’s position as a financial centre.

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

Monday, July 27, 2009

Can Europeans share a common security culture?

by Clara Marina O'Donnell

European countries have long declared their ambition to turn the EU into a global player in security – in order to tackle common threats and strengthen their voice on the global stage. But they still cannot agree on the main threats to their security or the best way to tackle them. Their views are so diverse that it is a wonder EU countries have managed to agree on any common action at all. But member-states need to strengthen their efforts to develop a common approach to security if the EU is to become a serious player.

For the past two decades, the EU has been developing a profile in foreign and security policy. It has agreed common security strategies, deployed over 20 peacekeeping and crisis management missions, led negotiations with Iran on the latter’s nuclear programme and negotiated a ceasefire to the Russia-Georgia war. However, as was brought into focus at a recent EUISS seminar, EU countries do not always share the same threat perceptions, or agree how these should be tackled.

Some European countries, such as Ireland and Austria, do not believe they face any serious ‘hard’ threats. Others fear for their territorial integrity, including the Baltics, Poland and the Czech Republic. Greeks and Cypriots worry mainly about the prospect of renewed military conflict with Turkey. So while Cyprus is still partly militarily occupied and Greek and Turkish military aircraft tail each other on a daily basis, the Viennese worry mainly about the level of burglaries in their city.

While the UK considers the threat of transnational terrorism as the most pressing threat to Europe as a whole, and a key priority to be tackled at home and abroad, most other countries feel largely unaffected. Russia is seen as a close partner to some countries, including Italy and Germany, while the Baltic states see it as an existential threat. Some member-states believe it is important to have a global outlook on security, in particular France and the UK, while others, such as Malta, believe their main security challenge is managing migration flows.

Different views also exist on how to tackle security threats. For many member-states a UN mandate is essential in order to participate in a military mission abroad, while for others, like the UK, it is only desirable. Some believe the US and NATO are cornerstones of their security (in particular the UK and the eastern countries), while others view NATO with suspicion – and resent the UK for having sided with the US during the war in Iraq. Some EU member-states have long traditions of intervention in conflicts across the world and accept the possibility of casualties within their armed forces, in particular France and the UK. Others are averse to the use of military force, most notably Germany.

Various member-states (Sweden, Austria, Finland and Ireland) have a long history of neutrality and are grappling to make their stance compatible with growing EU co-operation in security and defence (Ireland is finding it the hardest to accept EU defence co-operation. Due to public concern, it will have its military neutrality enshrined in an EU treaty for the first time if the Lisbon treaty comes into force). For their part, the UK and France are insistent on the need to develop expeditionary capabilities to allow the EU to fulfil its ambitions abroad. Some member-states, such as Sweden, have transformed their military forces, but many others have so far resisted.

In light of their very different histories, traditions and cultures, it is no mean achievement that EU countries have agreed to work together to provide peacekeeping and crisis management to conflicts zones in need, and to cooperate on wider security issues such as Iran and the Arab-Israeli conflict. In addition, with time the EU is likely to become further involved in security, by tackling ‘soft’ threats (such as protective measures against cyber attacks), or certain aspects of ‘hard’ threats (such as monitoring the cross-border transfer of dangerous products which could be used in chemical or biological attacks).

But member-states’ different interests and approaches limit the EU’s effectiveness as an external actor, as demonstrated by the difficulties in finding helicopters for the EU’s peacekeeping mission to Chad, the UK’s refusal to send a battlegroup to the Democratic Republic of Congo in 2008, or the difficulties the EU has in agreeing a common position on Russia or energy security.

Perhaps the biggest problem for the EU is the division between its western and eastern members. While many member-states feel they cannot trust their partners to guarantee their security (within the EU or NATO), it is difficult to talk of a common security culture. If threat perceptions within eastern European countries worsened, their anxieties could define their foreign policies, hampering the EU’s work at home and abroad (and NATO). For the EU and NATO to remain credible security providers to their members, and for the EU to become a serious player in global security, European countries must overcome the current mistrust and strengthen their efforts to develop a stronger common strategic culture.

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

Tuesday, July 21, 2009

Carl Bildt and the cost of speaking plainly

by Charles Grant

Carl Bildt is better known throughout the world than most of his fellow EU foreign ministers – and many of the prime ministers, too. That is not only because he has held some senior jobs (prime minister of Sweden, and Balkan envoy for both the United Nations and the EU), but also because he is actively engaged in, and knowledgeable about, a wide range of international issues.

Someone with Bildt’s skills and experience should be the front-runner to become the EU’s new High Representative – in effect its foreign policy chief – if, as is likely, the Lisbon treaty is finally implemented at the end of this year. That treaty would merge the roles currently played by Javier Solana, the current High Representative, and Benita Ferrero-Waldner, the commissioner for external relations, into a single post at the head of a new ‘external action service’ – an embryonic EU foreign ministry.

But Bildt’s chances of being appointed High Representative are slim. This is because he tends to say what he thinks and that is not always wise in politics or diplomacy. His frank and trenchant opinions appeal to think-tankers and journalists but not always to other foreign ministers. Some of them find his confidence and cleverness, and the length of his contact book, irritating. And sometimes he conducts his own solo diplomacy, particularly when Balkan problems hot up, which can be frustrating for the country holding the EU presidency.

I must declare an interest. Carl Bildt sat on the advisory board of the Centre for European Reform until he became Swedish foreign minister in October 2006, and still attends many CER conferences. He is very much a ‘think-tankers’ foreign minister’: he likes to argue and ask questions, and he brims with ideas. He also works very hard at his job: most weekends, this youthful-looking 60-year old is at some conference or other, debating the most pressing foreign policy issues of the day. And if he is not at a conference he is on a diplomatic mission or at a summit.

His critics view Bildt as an arrogant Mr Know-it-all. But in many ways he is modest. He takes the time to speak to people who are not ‘important’, like secretaries and conference organisers, and not all politicians do that. Furthermore, most politicians will only attend a conference if they are given a speaking slot. They go to give their speech and are not particularly interested in hearing what others have to say. But Bildt is not like that. Every six months the CER and other think-tanks organise a roundtable that brings together European and American diplomats and thinkers. Bildt always turns up, even though he seldom has a speaking slot. He sits at the back taking notes, because he is genuinely interested to hear what other experts have to say.

If Bildt was serious about running for the job of High Representative he would have manoeuvred to win the support of France and Germany. But he has not done that, with the result that both Berlin and Paris are likely to block his candidacy. Germany takes the view that the EU should maintain friendly relations with Russia. So in August 2008, when Russia invaded Georgia, the Germans disapproved of Bildt’s comparison of the Russian justification for the attack on Georgia to Adolf Hitler's rationale for invading parts of Central Europe – namely the need to protect a minority. Bildt’s comment was indeed over-the-top and unwise. In fact he has a good network of contacts inside Russia, including some of those in positions of power. Nevertheless as far as several EU governments are concerned, Bildt is simply too confrontational towards Russia.

France is an even bigger problem for Bildt. Just before the recent European elections he gave an interview to Le Figaro in which he contradicted the view of President Nicolas Sarkozy that Turkey is not in Europe. “If we judge Cyprus to be in Europe, although it is as in island along Syria's shores, it is hard not to consider that Turkey is in Europe," Bildt said. That interview made Sarkozy angry and he cancelled a visit to Stockholm. To make matters worse, Bildt does not speak French fluently.

Bildt has also been implicitly critical of Sarkozy’s protectionist rhetoric – he is a true believer in free markets, free trade and the ‘Lisbon agenda’ of economic reform. You know where you are with Bildt – he is a strong backer of human rights in authoritarian countries and he believes that the countries of Eastern Europe should be free to choose their own destinies. He is also an unstinting Atlanticist; if the decision was left to him, Sweden would join NATO. Bildt’s experience in Bosnia has made him passionate about the protection of minorities. At the end of the war in Sri Lanka, when government forces were killing many Tamil civilians, he tried to fly to Colombo to make his point to the country’s leaders. But he was refused a visa.

Many EU foreign ministers would probably prefer a High Representative in the mould of Javier Solana, the incumbent. The Spaniard’s style of operating is the opposite of Bildt’s: he avoids direct confrontations with people, preferring to build a consensus through discreet personal diplomacy. The ideal High Representative would be a figure who combined Bildt’s rigorous thinking and grand strategic vision with Solana’s subtle manner and feline operating skills. But there is probably no such person.

Charles Grant is director of the Cente for European Reform

Friday, July 10, 2009

Iran, elections, and nuclear weapons

by Tomas Valasek

What the future holds for Iran's theocratic regime is hard to read. True, the government has ensured its own survival by suppressing last month's protests there with brutal force. President Mahmoud Ahmadinejad will remain in power despite a contested election. But the authority of the regime has suffered. The president has lost legitimacy in the eyes of millions of Iranians. The country's supreme leader, Ayatollah Ali Khamenei, who urged force against the protestors, has lost much of his popularity. The events of June 2009 could turn out to be the beginning of a deeper challenge to the Islamic republic: Iran observers point out that the country's 1979 revolution was preceded by a long build up of low-level agitation.

What is clear is that the violence around the presidential election bodes ill for western diplomacy to end Iran's nuclear ambitions, in at least two ways. First, Barack Obama will be under pressure to rethink the offer of 'engagement grounded in mutual respect', which he extended to the government in Iran in April 2009. On the other hand, the US will now find it easier to convince the Europeans to toughen the sanctions regime on Iran, thanks to Tehran's heavy-handiness.

Iran's nuclear programme is run directly by the country's supreme leader, not the president. The recent political turmoil will have had little effect on it. Even if the challenger, Mir Hossein Mousavi had won the presidency, Iran would have almost certainly continued to enrich uranium. Mousavi said during the campaign that he would not abandon "Iran's right to nuclear technology". Some Iran watchers have speculated that Mousavi would build enrichment facilities but not nuclear weapons, lest he put Iran in even deeper isolation. In reality, the president's views have little bearing on the nature of the nuclear project.

The West has long been worried that Iran is building a nuclear bomb, or at least acquiring all the necessary ingredients. However the more immediate concern now is the prospect of an Israeli military strike on Iran. US officials say they fear that Israel may try to destroy Iran's nuclear facilities this autumn, before Russia delivers a batch of modern anti-aircraft missiles recently purchased by the Iranian regime.

To prevent Iran from acquiring nuclear weapons – and to keep Israel from attacking – Barack Obama launched a new diplomatic push in April 2009. He has promised to join the European-led talks with the government in Tehran. US negotiators are rumoured to be considering dropping a key western condition for the talks, namely that Iran shut down its enrichment programme before the negotiations start. Obama also recorded a video statement to the Iranian people, in which he has offered a partnership between the US and Iran. The idea was to win the Iranian regime's goodwill by showing it the respect it craves, and to spur the Iranians into pressuring the leadership to pursue a less confrontational line with the US.

The second pillar of the US strategy has worked very well. While most Iranians support the nuclear programme, many of the young ones are increasingly frustrated with the country's pariah status. Mir Hossein Mousavi, surged ahead in the polls after he accused president Ahmadinejad of leading Iran into the 'indignity' of international isolation.

But Mousavi failed to win – or was prevented from winning – and the post-election protests have undermined the overall strategy. Iran cannot negotiate because the government is 'too busy locking people up', said one EU official working on the Iran dossier. If Ahmadinejad and Khamenei do fully consolidate power, this will create another headache for the West: how can Barack Obama speak to a regime which has likely rigged elections and brutally suppressed democratic protests? Obama is already under fire for being "soft" and "naive" regarding Iran. Admiral Michael Mullen, the chairman of the US Joint Chiefs of Staff, recently urged him to take a harsher line, noting that Iran's nuclear programme was progressing whatever the domestic situation there. Even if Obama starts talks with Tehran, he may feel compelled to satisfy Mullen, and others, by employing tougher rethoric. This would likely cause the talks to collapse prematurely.

If, as is likely, engagement does not generate a generous response from Tehran, the US will want to tighten existing sanctions on Iran. Some governments like the German and Italian ones, have been known to be sceptical about the need for further sanctions; the Italian foreign minister published an article in early June calling for the West to be nice to Iran. But the violence in Tehran has made the doubters more inclined to penalise the Iranian government, EU officials say.

However, fresh UN sanctions may be blocked by Russia, and possibly China. Both are members of the UN Security Council and oppose a harsher line on Iran. If the US and the EU apply unilateral sanctions, these will be less effective. Meanwhile, Israel may decide to attack, or Iran may race to acquire a full nuclear weapon. So the furore over Iran's presidential election – by throwing up new obstacles to diplomacy – has made the job of resolving tensions over its nuclear programme harder. That may prove the deadliest legacy of the events of the last few weeks.

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

Friday, July 03, 2009

Russia: A tale of two crises

by Katinka Barysch

Russia’s economy has been hit hard by a triple whammy of capital outflows, collapsing oil prices and falling global demand. In the first three months of the year, output was down by 10 per cent compared with a year earlier. The retail boom that had fuelled growth in recent years has turned into a slump. The output of the manufacturing sector is contracting at a rate of over 20 per cent year on year. Construction is in deep recession. The current-account surplus has melted away.

However, the latest economic indicators suggest that the economic contraction is at least slowing. The oil price has recovered to over $70 a barrel. Surveys show that credit conditions are easing and managers are a bit less gloomy. Capital outflows have slowed. So has inflation, which has allowed the central bank to finally cut rates. International reserves, although down from 2008 peaks, still stand at $410 billion. The government is making plans for recapitalising some of the country’s banks.

Investors still remember the rapid, V-shaped recovery that followed Russia’s last financial crash in 1998. In the following nine years, the Russian economy grew by an average of 7 per cent a year. Will Russia be able to pull out of trouble this quickly again?

On the plus side, Russia’s government finances are in incomparably better shape than they were ten years ago. Back then, it was short-term public borrowing that triggered the crisis, ultimately forcing the government into default. Since then, the budget has shown a healthy surplus, allowing the government to stash away $140 billion in a reserve fund. So although revenue has collapsed (half of it comes from the oil and gas sector), the authorities have room for fiscal manoeuvre. Public spending will also have a bigger impact on the economy, simply because the Russian state is much bigger than it used to be (federal budget revenue was 13 per cent of GDP back in 1998, today it is over 20 per cent, according to Erik Berglőf from the European Bank of Reconstruction and Development).

Also, in 1998 the Russian economy had only just returned to growth, following years of severe post-transition recession. Now, after ten years of uninterrupted expansion, fewer Russians are living hand to mouth and many should be able to draw on savings to tide them over the most difficult period.

However, there are also reasons to expect the current crisis to be more severe and drawn-out. The 1998 crisis mainly affected emerging markets. This time, the recession is global, which means that no country will be able to export its way out of trouble. (Russia exports mainly raw materials, as well as some metals, timber and heavy industrial goods. But it is the collapse in demand for non-oil exports, such as steel products, that is causing the most trouble since these are often produced in isolated one-industry towns.)

Depressed global demand also means that the rally in oil prices is likely to be short-lived. After 1998, the oil price climbed steadily from around $10 a barrel to a peak of $140 last summer. Many forecasters expect oil prices to linger around $50-60 this year and next – not disastrously low but not enough to fuel a strong Russian recovery either. Moreover, Russia’s economy today is much more dependent on oil and gas sales than it was in 1998. Back then, oil and gas sales accounted for 44 per cent of export revenue, now the share is over two-thirds. Many manufacturing and services industries are directly or indirectly linked to the resource sector.

Perhaps the biggest difference lies in the role of banking and borrowing. Although both crises originated in the financial sector, in 1998 this sector was still so small that its collapse barely affected the wider economy. Then, credit to firms and households stood at 9 per cent of GDP; today it is over 40 per cent.

In recent years, much more of that borrowing came from abroad so the drying up of global liquidity in 2008 hit Russia hard. The World Bank estimates that in 1998-99, the reversal in foreign capital flows amounted to less than 2 per cent of Russian GDP. In 2008-09, it was close to 12 per cent of GDP.

Domestic banks cannot take up the slack because a rising share of bad loans will constrain their ability to start lending again. The health of the banking sector is difficult to assess. Official numbers show that the share of non-performing loans has climbed from 1 per cent at the start of the year to 4 per cent today. Given the sorry state of Russian industries, this is still an implausibly low number. Independent assessments put the share of bad loans at anywhere between 10 and 20 per cent.

As a result of these factors, the Russian economy is likely to take longer to come out if its slump than it did ten years ago. The World Bank predicts a contraction of almost 8 per cent this year, but some forecasters thinks even this is too optimistic and they question whether Russia will be able to make even timid recovery in 2010. Most economists agree that Russia stands little or no chance of returning to the 7-8 per cent growth rate that it enjoyed before the crisis struck

The big question is what the changed growth outlook will mean for Russia’s internal stability and the government’s willingness to implement economic reforms. In 1998 Russians expected very little from their leaders in Moscow. They were positively surprised when the Putin administration after 2000 started to implement some useful reforms, such as simplifying the tax system and cleaning up regulations.

Since then, Putin’s muscular rhetoric, combined with Alexei Kudrin’s sound macro-economic management, have raised expectations. The people that took to the streets in Russian cities in recent weeks and months did not so much protest against government policies as demand government help. The government could react either by getting serious about modernising and diversifying the economy. Or it could resort to economic nationalism and populist spending increases. So far, there is more evidence of the latter than the former. Prime Minister Putin has personally instructed companies to clear wage arrears and criticised shops for overcharging struggling families. On June 29th, he told the managers of Russia’s biggest banks that they should not go on summer holiday before they have significantly increased lending to the corporate sector (he even gave them a numerical target of $16 billion). With this kind of crises response, Russia’s growth prospects could end up being lower not only in the short term, but for many years to come.

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

Thursday, June 25, 2009

Britain’s eurosceptics need to come clean

by Simon Tilford

Britain’s media and political class have a right to be sceptical about the EU, even hostile to it. But they also have an obligation to be honest about the economic implications of a retreat from full membership of the Union. Their failure to do so is dishonest and poses a serious risk to Britain’s prosperity. A newly ‘emancipated’ Britain would not remain part of the EU’s single market, at least not on the terms the eurosceptics claim. In fact, a retreat would achieve nothing but impotence. It would not reduce the regulatory and compliance costs facing UK business and it would end our ability to shape the EU’s single market.

Those calling for a renegotiation of the EU’s Lisbon treaty, or of the UK’s relationship with the EU more generally, ignore that this would inevitably lead to at best semi-detached membership of the EU, and more probably divorce. Eurosceptics appear to believe that a Britain outside the EU would remain part of the single market, but that it would be freed from the need to abide by EU regulation. In short, Britain could enjoy all the benefits of access to the single market but none of the costs.

This is incoherent. To remain a full member of the single market, British firms would have to abide by all its rules and regulations. A Britain that opted to withdraw from the EU would have no say over the drawing up of those rules and regulations. British interests would not be represented in Brussels and Britain would not be able to stymie regulatory drives that threaten UK prosperity. In short, British business would experience the worst of all worlds.

British manufacturers might not suffer too badly. Britain would have no say over EU product standards, which British firms would nevertheless have to comply with in order to sell their products in the EU. Nor would the costs of producing for the UK market fall – it would make no sense for British firms to make one set of products for the British market and another for the rest of Europe. But merchandise markets are at least already open. The real threat for the UK lies elsewhere.

Britain is by far the biggest exporter of commercial services in the EU. As such, it has a very strong interest in opening markets for those services. But a Britain that has no say over the future of the single market will not be able to use its influence to push for service sector liberalisation. It will not be able to challenge the self-serving idea put forward by other member-states that a single market in merchandise goods is one thing, but open markets in services are somehow beyond the pale. Nor will it be able to ensure that regulation of service industries is not inimical to the interests of British business. This would be a major own-goal.

One only has to look at the financial services industry to see the risks. If British-based providers of financial services wanted to do business in the single market, they would have to abide by whatever regulations the rest of the EU dreamt up. These would certainly be more restrictive in the absence of British involvement. At a time when other EU governments see an opportunity to cut London down to size, would it really make sense to be a bystander? How would Britain thwart the rather heavy-handed attack on the private equity and hedge fund industries operating in the EU if it had no seat at the table?

Britain needs to step up its involvement in the EU, not leave the playing field in a huff. It needs to strive to ensure that EU financial regulation is – as far as possible – proportionate and reconcilable with the UK approach. More generally, it needs to make common cause with other economically liberal member-states to ensure that the EU evolves in a direction that serves British interests.

Britain’s conversation about its relationship with the EU is devoid of the pragmatism and empiricism with which it is traditionally associated. Some British eurosceptics genuinely believe that the UK can have its cake and eat it. That it could reduce the cost of EU membership while retaining all the existing and potential benefits. Others know exactly what they are doing. Their ultimate objective is for Britain to withdraw from the EU. This is a perfectly defensible aim, but those for whom this is the objective need to explain how it would be in the UK’s strategic and commercial interests.

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