Thursday, December 18, 2014

EU-Israel relations: Confrontation or co-operation?

For the last decade, relations between the EU and Israel have been strained by tension over the Middle East peace process, but strengthened by intensive scientific and economic co-operation. So far, confrontation has not crowded out collaboration, but with the EU’s decision to get tougher on Israel’s settlements policy, this may change. Both Israel and the EU will need to find a balance between their disagreements over the settlements and the beneficial economic and scientific co-operation. They can take a number of steps in order to achieve this.

The positive aspect of the relationship is not often recognised. Economic and research links between the EU and Israel are strong. In 2013, the value of EU-Israel trade was €29.5 billion (equal to 13.7 per cent of Israel’s GDP), with €12.5 billion imports to the EU and €17 billion exports to Israel. The EU is Israel’s main trading partner, accounting for one-third of its total trade. Large Israeli corporations have sizeable investments in Europe and employ many Europeans, while Israel, despite its small size, is one of Europe’s most important trading partners in the Middle East. It supplies Europe with high-tech products, including software and apps used in most PCs and smartphones, medical devices, chemicals and pharmaceuticals (Israel’s TEVA is one of the most important sources of generic medicines for Europe).

Beyond trade, Israel and the EU have been collaborating in fields such as agriculture, aviation, science and in a wide variety of R&D fields (including nanotechnology, health, environment and communications). Israel participated in the latest EU R&D Framework Programme (FP7) and in June 2014 it joined the EU’s research and innovation programme, Horizon 2020, and will contribute to its budget. Hundreds of leading Israeli institutions have received EU funding for innovative research, in many cases sharing their expertise and knowledge with their European counterparts.

There are also defence ties: Israel conducts joint military exercises with Bulgaria, Greece and Italy, while some EU member states, including Germany, the UK and Italy trade defence goods and services with Israel. In addition, Israel’s intelligence agencies and their European counterparts (among them agencies in the UK and Germany) collaborate closely.

But alongside that co-operation, political tension, rooted in the Israeli-Palestinian conflict, is increasing. Issues such as the political status of Jerusalem, human rights, the humanitarian situation in Gaza and EU funding for left-wing NGOs in Israel have been troublesome.

The EU and Israel also disagree on the timetable for peace. While many European leaders believe that now is the moment to push for an agreement, Israeli politicians often stress the current instability in the Middle East. Moreover, Israelis remember the 2005 withdrawal from Gaza and fear that leaving the West Bank will only lead to a ‘second Gaza’ under Hamas rule or turn it into fertile ground for jihadist movements.

The issue of Israeli settlements in the West Bank undoubtedly casts the longest shadow. European leaders criticise new houses and neighbourhoods built beyond the 1967 borders. They fear that Israel’s actions undermine the territorial integrity of a future Palestinian state, thus making it harder to achieve a two-state solution. Many Israeli politicians, on the other hand, argue that the real obstacle for peace is not the settlements policy but rather the absence of a credible Palestinian partner who is willing to compromise.

Since 2012, the EU’s attitude towards Israeli settlements in the West Bank has become more assertive. This is reflected both in rhetoric and policy. For example, recent statements issued by the European External Action Service (EEAS), say that the settlements “constitute an obstacle to peace” and “question Israel’s commitment to a peaceful negotiated settlement”.

In practical terms, the EU has published strict new guidelines for EU grants, preventing Israeli entities located in the West Bank from receiving EU funding. Additionally, the EU no longer recognises Israeli veterinary services in the West Bank, which in practice prevents the export of dairy and poultry products from settlements to Europe. According to media reports, EU officials are considering applying additional ‘sticks’ in the future if construction continues, among them labelling Israeli products produced in the West Bank and requiring visas from Israeli settlers.

While these European policies are limited in scope, they damage the dialogue between Israel and the EU, especially with a right-wing Israeli government. They may also discourage bilateral co-operation in other areas. Last year’s negotiations on Israel’s participation in the Horizon 2020 programme shows how things can snowball.

During the negotiations, the EU wanted to ensure that European funds would not reach Israeli institutions located in the West Bank, East Jerusalem or the Golan Heights. The Israeli newspaper Haaretz reported that tough meetings took place within the Israeli government; some ministers supported signing the agreement, among them Finance Minister Yair Lapid, while Foreign Minister Avigdor Lieberman and his deputy Ze’ev Elkin argued that Israel should not participate in the programme. They felt that by signing, Israel would de facto acknowledge that the settlements were illegal. For his part, Prime Minister Benjamin Netanyahu raised the possibility of attracting alternative funds from Asia and North America in order to compensate Israeli research institutions.

What started as a discussion about access to Horizon 2020 funds soon became a political argument, creating tensions that had the potential to damage fruitful scientific collaboration. Israel’s academic and research institutions could have lost millions of euros in research grants, as well as access to European knowledge and markets. The EU would have lost one of its most innovative and successful scientific partners.

The Israeli media give more coverage to such disagreements than to co-operation with Europe. Israeli politicians, academics and diplomats have accused the EU of dealing with Israel unfairly, by only pressuring Israel for concessions, and of not understanding the mentality of the Middle East. Furthermore, the increasing number of anti-Semitic incidents across Europe and boycott campaigns in European universities and companies receive significant media attention in Israel. Although these incidents are often condemned by European leaders, they reinforce Israeli mistrust.

The case of Horizon 2020 however, also shows how tensions can be managed. Amid the crisis, prominent Israeli academics, including heads of Israeli universities, members of the Israeli Academy of Sciences and representatives from the Committee of the Council for Higher Education (the state body responsible for distributing higher education funding) repeatedly urged the government to sign the agreement; they were worried about the implications for Israeli research. This pressure eventually paid off. The Israeli government showed some flexibility and a diplomatic agreement was reached: EU regulations will be respected and funding will not flow to settlements, but Israel added an annexe to the agreement stating that it disagrees with the EU’s legal position concerning the settlements.

Other parties can also play a role in calming tensions and preventing future rows about EU policy towards Israeli settlements from damaging collaboration. First, high-tech and medical businesses in Europe and Israel should speak up in times of political friction about the direct benefits they get from a good relationship.

Second, the EU’s representatives have to voice more clearly what they are trying to do. The EU’s guidelines and demands concerning Horizon 2020 were portrayed by some Israeli commentators as part of a ‘European boycott’; but in fact the EU made a legitimate decision not to fund organisations in Israeli settlements in the West Bank, which violate international law. The EU should make clear that, in areas of productive co-operation where there are not the same legal issues, it will do its best to maintain the relationship. It should emphasise the positive contribution that the EU brings to the daily lives of Israelis. For instance, the EU-Israel ‘open sky pact’ reduces the prices of airline tickets for Israelis; its funding for institutions based within the 1967 borders boosts Israeli research and jobs; and the EU-Israel free trade agreement has a positive effect on Israel’s market.

Third, Israeli and European politicians should focus on quieter, pragmatic dialogue, rather than play to the crowd. Member-states, the Commission and the EEAS all have a role to play in managing the relationship and talking frankly about disagreements. Federica Mogherini’s first visit outside Europe as High Representative for Foreign Policy was to Israel and the Palestinian territories. She stated that she intended “to use the Union’s political potential in this region”, which suggests that she plans to continue (or even deepen) the dialogue and the EU’s involvement. Israeli senior politicians should commit to doing the same.

These tools should allow both parties to manage some of the tensions and hostility that have emerged in Israel as a result of the EU’s stance on the settlements. In the long run, however, without meaningful progress in the Middle East peace process, and with more settlements under construction, the EU may be tempted to be tougher. This could translate into more restrictions on Israeli entities located outside the 1967 borders. The longer the status quo remains, the greater the chances of such EU actions. This should be cause for alarm, particularly in Israel. Although the benefits of the relationship are mutual, they are not symmetric; Israel is much more reliant on Europe than vice versa. Turning a deaf ear to Europe’s complaints could be a costly mistake for Israel’s leaders.

Yehuda Ben-Hur Levy is a Clara Marina O'Donnell fellow at the Centre for European Reform.

Tuesday, December 16, 2014

Germany and the eurozone: The view from Paris

On recent visits to Berlin, I have been surprised at how negative people are about France. Key officials regard the country as incapable of controlling spending or enacting serious structural reform. They do not show much understanding of the political constraints that limit President François Hollande’s freedom of action. The officials add that, so long as the mistrust between Berlin and Paris persists, they cannot strike a bargain to strengthen eurozone governance. In any case, they say, there is no urgent need to do so, because – in their view – the eurozone as a whole is not in crisis. There are just specific problems in a few countries like France and Italy, caused by politicians lacking the courage to do what is necessary.

So I went to Paris to discover what the government thinks about Germany and the future of the euro. In Paris there is a sense of urgency about the stagnation of the eurozone (which is likely to grow at less than 1 per cent this year and to do not much better next year), the deflation afflicting parts of it (prices are falling in France) and the negative impact that these problems will have on French growth, job-creation and debt sustainability. Even French officials who are life-long believers in Franco-German amitié admit that the relationship is now ragged and horribly unbalanced: on the big questions, Germany sets the agenda for the eurozone.

Among the questions being considered by the French government are: what is the best way of influencing the Germans; whether the economic thinking in Berlin and Frankfurt may evolve to become less anti-Keynesian; whether the presence of the SPD in the German government could prove helpful; and how eurozone governance should be improved.

There are divisions on how to deal with the Germans. The predominant view is that France has a credibility problem with Berlin. Therefore it should show some results on implementing reforms and controlling spending, before taking on Berlin on eurozone governance. The other view is that the economic situation in France and in the eurozone is so dire that the Germans need to be confronted right away.

Everyone in the government is upset that Commissioner Günter Oettinger in the Financial Times and Chancellor Angela Merkel in the Welt am Sonntag criticised France for neither reforming nor complying with EU budget rules. This finger-wagging reinforces the narrative in France that Hollande and Prime Minister Manuel Valls have to reform to keep Berlin happy – whereas their line is that reform is good for France. Some of those close to Hollande think the criticism unfair, given that, as they see it, France is doing a lot to reform: the Loi Macron promises to deregulate professions, shopping hours and coach services, while the social partners are due to hammer out new labour market rules in January. But others point out that many Socialist deputies – and even some ministers – oppose these reforms for being too libérales and may well succeed in watering them down.

French officials worry about the intellectual gulf that separates the thinking of Germany’s financial and political elite – which emphasises the supply side to the exclusion of demand, and rules rather than macro-economics – from most of the rest of the world. In particular, they worry about the Germans’ reluctance to analyse the eurozone economy as a whole, rather than as a series of national economies; about their indifference to deflation; and about their rejection of the principle that an economy can suffer from a lack of demand that requires a macro-economic stimulus. They lament that so many key officials in the Chancellery and Ministry of Finance are lawyers rather than economists.

The French find the Germans more uncompromising on their economic philosophy than they were a few years ago, and less prepared to accept that they might be wrong (the recent downturn in the German economy has not been harsh enough to prompt many Germans to reconsider their views). Therefore when Germany has to compromise in the EU, for example on budget deficits, it does it out of political necessity, not because it admits to any chinks in its argument. As one official puts it, “the Germans don’t think economically, but judicially and in terms of rules and the rapport de forces”.

This intellectual divergence makes it hard for Berlin and Paris to agree on the next steps for the euro. At a time of supreme German self-confidence, the French are particularly unwilling to contemplate a new treaty or revision of the eurozone rules – because they think the Germans would write them.

Economy Minister Sigmar Gabriel, the SPD leader, has disappointed Paris. Intellectually, he doesn’t follow the hard line of Finance Minister Wolfgang Schäuble on the need for austerity in the eurozone. But he is not prepared to argue for a softer line in public, lest the SPD alienate German voters.

Some French officials credit Gabriel with helping to persuade Schäuble to make a small shift by accepting the case for more investment in Germany. Other officials think they have succeeded in changing the thinking of their opposite numbers in Berlin on the need for more investment at eurozone level. But they recognise that this supposed intellectual shift has not yet led to significant new policies for the eurozone or Germany. The Germans still think structural reform is the only really effective way to revive growth. And they have ensured that Commission President Jean-Claude Juncker’s €315 billion plan to boost investment contains little new money (the idea is to lever €21 billion from the EU budget and the European Investment Bank).

As always, there are frequent gatherings of French and German ministers and officials, but these are not bringing about a meeting of minds. Recently, the four ministers of economy and finance produced a joint paper on the need for more investment in the EU, France and Germany, but it said little that was new. Gabriel and Macron also commissioned Henrik Enderlein and Jean Pisani-Ferry, two eminent economists, to write a report on ‘Reforms, investment and growth: An agenda for France, Germany and Europe’. This called on each country to take a series of steps, for example for the Germans to boost public investment and the French to introduce more flexible labour markets. But the ministers have only weakly endorsed the report, given that its recommendations are controversial, and for now it is not being translated into political action.

October’s European Council asked the ‘three presidents’ (of the Commission, European Council and European Central Bank) to prepare a report on the future of the monetary union. This will put eurozone governance on the agenda in 2015. Given the strained state of the Franco-German relationship, however, there is not much optimism in Paris about what this exercise may achieve. In any case, the French do not currently have a set position on eurozone governance. Nevertheless they are mulling over a number of ideas. These include:

  • Inserting more economic analysis into the EU’s process of vetting national budgets. Officials are vexed that when the Commission recently looked at the French budget, it carried out no analysis on the economic impact of different possible budgets. The decision-making is purely rule-based and political. The French think that the appointment of a high-profile chief economist would help to correct this deficiency in the Commission. Some officials think that the French committee which examines the national budget – looking, for example, at the credibility of forecasts and figures – could serve as an example for a similar committee at EU level. Such a committee could also cover structural reform. The French also want the EU’s budgetary process to take into account the eurozone’s aggregate fiscal stance.
  • Reviving old ideas such as establishing a full-time Eurogroup president and giving the EU a role in national unemployment schemes. As one official put it, “the emphasis should be on carrots, not sticks – so no to Merkel’s reform contracts”. For the past few years the chancellor has been pushing the idea that the Commission should negotiate binding accords with each eurozone member, committing them to structural reform. But the official thought that a similar idea could work if given a positive spin: “Germany won’t agree to counter-cyclical policies at EU level, but why not incentivise structural reform in say Spain with a eurozone contribution to its unemployment benefits?”
  • Producing a ten-year plan for converging the eurozone economies. Like the Maastricht treaty scheme for the euro, this could have three phases, which would help to mobilise support. Politically, this would be an easier sell than Merkel’s contracts. To keep Germany happy, the plan could cover labour markets and the single market in goods and services; to keep France happy, it could cover tax (harmonising corporate tax bases) and social issues (how minimum wages are calculated). The plan could also deal with other prerequisites of growth, such as co-operation on industrial policy, digital markets, energy and R&D. Apparently the Commission is not enthusiastic about this convergence plan, though President Donald Tusk and the ECB are supportive. Some French officials are hopeful that the Germans – aware of the long-term challenges to their own growth model of high exports and low investment and consumption – could back such ideas. 
French officials say it is not clear whether any of this may in the long run need treaty change, though they are adamant that for the time being they will resist attempts to revise the treaties.

The French do not expect the new Commission to be particularly helpful vis-à-vis the Germans. Many of them have a positive view of Jean-Claude Juncker, seeing him as more understanding of their problems than his predecessor, José Manuel Barroso. But they worry that so many of the Commission president’s chief advisers and senior colleagues (such as Valdis Dombrovskis and Jyrki Katainen) are ‘German’ in their thinking. Nobody is yet sure whether Pierre Moscovici, the French Commissioner for Economic and Financial Affairs, will prove influential. French officials are not particularly worried by the prospect of EU fines for their budget deficit; they assume they can go on negotiating with the Commission, making little adjustments to stave off punishment.

There is a lot of unhappiness in Paris about the ECB’s deference to Germany. Officials are frustrated with its inconsistency: it criticises in public the governments which borrow too much, yet although President Mario Draghi believes that Germany should adopt an expansionary fiscal policy, he will not say this unambiguously in public.

Amidst all this gloom, what strategy should the French pursue? They would certainly gain credibility in Berlin if they could show that they were controlling spending and implementing structural reform. But they believe they are caught in a vicious circle: Germany’s austerian policies – for both the EU and Germany – make it harder for France to grow, which worsens the fiscal position and makes painful reform politically more difficult.

The eurozone probably has to face a much deeper crisis before anything gets better. The Germans still believe that either fiscal or monetary easing would remove the pressure on countries like France to reform. But there may come a point when even the fiscal hawks of the German finance ministry have to acknowledge that the eurozone faces systemic difficulties (and not just policy errors in a few member-states). Negative growth and high unemployment, perhaps prompting social unrest, may impact on German thinking. If the current governments in Greece, Spain or Italy – all of which have more or less tolerated Germanic economics – were to collapse, bringing to power politicians opposed to the euro or to the German view of it, Berlin would have to compromise.

Charles Grant is director of the Centre for European Reform.

Thursday, December 04, 2014

Cameron's migration speech and EU law: Can he change the status quo?

On November 28th, David Cameron delivered a long-awaited speech addressing public concerns on EU migration. Its essence was not anti-European: the British prime minister underlined Britain’s long-term commitment to the principle of free movement, as one of the cornerstones of the single market. Having understood that quotas or ‘emergency brakes’ on EU migrants were unacceptable to all Britain’s partners (including German Chancellor Angela Merkel), Cameron pulled back at the last minute from proposing such ideas. He therefore upset hardline Conservative eurosceptics, who knew that if the UK made a cap on EU immigrants its chief negotiating demand, a British exit would become much more likely.

The prime minister’s speech included five proposals:
  • To deport EU job-seekers who have not found work within six months; and to stop such job-seekers accessing ‘universal credit’ (which will incorporate the current job-seeker’s allowance) when it is rolled out from 2015 onwards, for their first four years in Britain.
  • To impose a four-year period before EU migrants have access to in-work benefits like tax credits and housing benefit.
  • To stop workers in one EU member-state collecting child benefit there for children who live in another member-state. 
  • To prevent workers from countries that join the EU from seeking work in the rest of the EU, until these countries’ economies have partially converged with those of the existing members.
  • To make it easier to deport criminals, fraudsters and beggars from other member-states, and to ban their re-entry.

Are these proposals achievable through new EU legislation, or would the Union’s treaties need amendment? And how likely is it that other member-states would agree to the changes?

The principles of free movement and the equal treatment of workers have been enshrined in the treaties, developed through secondary legislation in the form of directives and regulations, and extended by rulings of the European Court of Justice (ECJ). Any new or amended directives or regulations would have to be proposed by the European Commission and adopted by a majority in the Council of Ministers and the European Parliament. Amendments to secondary legislation that do not amount to discrimination between EU citizens and those of the host member-state would not require treaty revision. However, fundamental changes to secondary legislation that affect the principles of free movement and equal treatment would require treaty change and hence the unanimous agreement of 28 member-states. This distinction is crucial for understanding the legal and political feasibility of Cameron’s proposals.

Restricting the rights of job-seekers: The prime minister’s proposals lacked precision. First, he mentioned the possibility of requiring EU citizens to prove that they had a job offer before coming to the UK. This may have been a wish rather than a concrete proposal, but it would in any case be contrary to the treaties and impossible to implement in practice. Later, Cameron said that Britain would seek to deport EU migrants who failed to find a job within six months of entering the country. Other member-states have already considered this. Under EU law, EU citizens need to be working, studying, or self-sufficient in order to live legally in another member-state.

The ECJ, however, has extended some of these rights to job-seekers, so that EU migrants are allowed to live in a member-state if they can prove that they have a genuine chance of getting a job. According to the Court’s case law, member-states are permitted to limit the period for which unsuccessful job-seekers can access unemployment benefits. Therefore, restrictions on job-seekers, if not unconditional (that is to say, if they are not solely based on time limits, but they also take into account the migrant’s personal situation and their chances of  finding a job) may well comply with EU law. They may also find some political support, notably from Western European member-states such as the Netherlands, Austria and Germany.

Cameron also said that he would stop EU migrants who had not yet worked in the UK from accessing the new ‘universal credit’, which will be introduced in 2015 if the Conservatives remain in power. This would mean they would have no access to unemployment benefit at all while looking for work in Britain. The ECJ’s case law has given job-seekers some rights of access to unemployment benefits, when they assist with integration into the host country’s labour market, so this proposal may put the government on collision course with the ECJ.

Limitations on EU migrants’ access to in-work benefits: The Conservatives may find it hard to impose temporary limits on EU migrants accessing in-work benefits: Article 45 of the Treaty on the Functioning of the European Union (TFEU) forbids discrimination against workers “as regards employment, remuneration and other conditions of work and employment”. Restricting migrants’ access to tax credits could amount to discrimination, since they are a condition of work and employment, and so the reform could require treaty change. Even if UK government lawyers managed to convince Brussels that tax credits should not be seen as a condition of work, and rather as social assistance or a tax advantage, a qualifying period would still be contrary to both a 2011 regulation on the freedom of movement for workers and ECJ case law. Reforming this regulation would need a revision of the underlying treaty principles, and hence require treaty change.

Stopping child benefits being paid to children abroad: Under current EU rules, the children of EU parents working in the UK are entitled to receive child benefits from the UK, regardless of where those children live, provided that neither parent works and lives abroad with the children. This rule is part of a 2004 regulation that addresses situations where the children of EU workers do not live with their parents. Several EU governments support reform of this regulation. Nevertheless to stop EU citizens from accessing child benefits in certain circumstances could be considered as discrimination against EU workers – so some would argue that it required treaty change.

Temporary restrictions on workers coming from new member-states: This proposal should be much less problematic: imposing restrictions on workers coming from new member-states until “their economies have converged with the existing member-states”, as Cameron put it, would be legally and politically feasible. Workers from Romania and Bulgaria faced temporary restrictions on their right to free movement for a period of seven years after those countries acceded. Since accession treaties require the unanimous agreement of all member-states, the UK could, if it wished, insist on restrictions that endured until the accession state’s per capita income had reached a certain percentage of the EU average. But this proposal will not make much difference in the short term: no country is due to join the EU in the next five years.

Expulsion and re-entry bans on EU criminals, beggars and fraudsters: On December 1st the UK opted back into 35 measures of police and judicial co-operation (such as the Schengen Information System and the European Arrest Warrant), which help governments to exercise tighter controls over convicted and suspected criminals across the EU. The current migration debate makes the case for opting back into these measures even clearer: the more police and judicial co-operation there is, the more control the UK will have over EU criminals entering the country, including fraudsters. The ‘citizens directive’ allows member-states to expel EU citizens on the grounds of public policy or public security. Member-states can also ban expelled EU citizens from re-entering the country.

The ‘citizens directive’, however, requires a case by case analysis of expulsion and re-entry bans, and offers a system of procedural guarantees to ensure that EU citizens are protected from arbitrary expulsions and expulsions en masse. Article 27 of the directive has incorporated the ECJ’s case law and says that a criminal conviction is not sufficient reason to expel an EU citizen. Furthermore, the grounds for expulsion cannot be “invoked to serve economic ends”. Therefore, the UK, like any other member-state, is allowed to expel EU citizens on the basis of public policy or security, provided that the decision is based on a solid examination of the citizen’s personal circumstances. Indiscriminate expulsions of criminals, fraudsters or beggars are not allowed under EU law and would require legislative change, although probably not a revision of the treaties.

In sum, several of Cameron’s proposals might require treaty change in order to be legally watertight, since they would discriminate against EU workers. Indeed, Cameron himself said that treaty change would be necessary. In particular, imposing temporary restrictions on access to in-work benefits and expelling job-seekers after six months might violate the principles of the free movement of workers and equality of treatment. Banning parents from drawing child benefits for children abroad could also be regarded as an obstacle to the free movement of workers and might require treaty change.

The UK could, however, try to achieve limited reforms to the rules on access to benefits which would be both treaty-compliant and politically attractive to some other governments; for example, limiting the time that job-seekers can stay in the UK when they have failed to prove that they have a real chance of finding employment or that they are actively looking for a job. The UK could certainly impose restrictions on the right of free movement of workers from future accession countries. Britain can exercise more stringent controls on EU criminals entering the country through the effective implementation of the 35 JHA measures the government has just opted back into. The UK does not need to change EU law in order to expel criminals from its territory, since the ‘citizens directive’ already allows for it.

Cameron will still have to contend with the possibility of the European Court of Justice scrutinising secondary legislation that challenges the principle of free movement. The ECJ has in the past sought to extend the rights of EU citizens working or looking for work in other member-states. Amendments to secondary legislation could be quashed by the Court, on the basis of its interpretation of the treaties. That is why in the long run Cameron may need to underpin several of his proposals by treaty change.

Changing the treaties through the normal method – the holding of a convention of MEPs, national parliamentarians and government representatives, followed by an inter-governmental conference (IGC) leading to an unanimous agreement among 28 member-states, each of which then has to ratify the new treaty – would take many years. At the moment virtually no member-state other than Britain has an appetite for treaty change. Many of them fear that parliaments or electorates (in those countries that would need to hold referendums) would reject the changes, given the strength of eurosceptic feeling in much of Europe. Furthermore, the economic situation in the eurozone, though far from healthy, is not so dire that its leaders believe its rules must be revised in a new treaty. Governments are also reticent because they know that embarking on treaty change would be like opening Pandora’s Box: almost every government has demands that it wishes to see fulfilled in a new treaty. There is no chance of getting a major new treaty ratified by Cameron’s self-imposed referendum deadline of 2017.

Could Cameron find a speedier method? Possibly. The ‘simplified procedure’ allows changes to internal policies that do not involve the transfer of competences to the EU. Under this procedure, EU leaders could dispense with the convention and the IGC. But the procedure cannot be activated without a unanimous agreement to do so, and then the new text still has to be agreed unanimously and then ratified by all members. None of which would be quick or easy.

Probably the only sort of ‘treaty change’ that is feasible by 2017 is a political agreement among heads of government to make specific changes in the future. British officials are thinking about emulating the method used to deal with Ireland’s rejection of the Lisbon treaty in the referendum of 2008. A protocol was drawn up, with language that reassured Ireland over the Lisbon treaty’s provisions on abortion, tax and neutrality. These reassurances helped to persuade the Irish to vote Yes in a second referendum – though they had to wait for the Croatian accession treaty, to which the Irish protocol was tied, before the protocol became legally binding.

If the UK aims to change the rules through this kind of ‘post-dated cheque’, it will face many problems. In a referendum campaign in 2017, would voters believe promises of change that depended on other countries ratifying future treaties? Furthermore, the provisions of the Irish protocol were uncontroversial. Any British attempt to push through the revision of EU rules on free movement via a similar protocol – requiring unanimity – would be fraught. Central European governments have already criticised some of Cameron’s ideas, but many in Western and Southern Europe will also oppose attempts to undermine free movement for workers and job-seekers.

If Cameron bangs the table, resorts to Eurosceptic rhetoric and challenges the principle of free movement, he may achieve very little. But if he embarks on a charm offensive in Europe, building alliances and forging friendships with other EU leaders, he may be able to achieve parts of his package.

Camino Mortera-Martinez is a research fellow at the Centre for European Reform.

Tuesday, December 02, 2014

The ECB is not the German central bank

For many years, the debate about whether the European Central Bank (ECB) was too heavily influenced by Germany was confined to academic papers. As of late, it has become the central policy question of the eurozone. Germany is more influential at the ECB than it should be. In fact, Mario Draghi’s penchant for seeking German approval has been his biggest mistake as head of the ECB. He should end it. If he waits until the German public comes around to looser ECB policy, it might be too late, as the seemingly unstoppable fall in inflation and the eurozone’s weak growth prospects show. The Bundesbank, rather than torpedoing reasonable ECB decisions, should throw its weight behind a more expansionary monetary policy and back the ECB.

The ECB was modelled on the German Bundesbank. As a result, it is one of the world’s most politically independent central banks; its mandate is focused narrowly on price stability; it does not take broader economic goals like unemployment into account in the way other central banks, such as the Fed, do; and it is de facto more restricted than other central banks, since controversial measures can lead to complex political and legal struggles, involving 18 (soon to be 19) countries. Its setup and philosophy are therefore ‘German‘, that is, conservative and cautious.

In terms of the ECB’s conduct of monetary policy, it is worth distinguishing between the pre- and post-crisis periods. A wide range of studies have so far failed to establish a firm consensus on the influence of various countries on the ECB during the euro’s first decade. However, most studies have found that the ECB behaved like a multinational central bank, in which each country has a weight proportional to the size of its economy. This gave Germany a higher weight than other countries because it is the largest economy in the eurozone. But it is hard to argue that there was a German bias at the ECB before the crisis.

In the post-crisis period, the ECB has failed to stabilise the economy, and inflation has fallen to just 0.3 per cent. It is tempting to see this as the product of a German bias, because the German economy has suffered least from the ECB’s hesitation to do more. But it is hard to argue that German pressure prevented the ECB from lowering rates faster during the last two years, for example, or managing the inflation expectations of consumers and investors more aggressively. Rather, the ECB’s misjudgement of the economic dynamic in the eurozone prevented a more timely and aggressive stance.

However, now that the ECB has to move further into unconventional territory to correct its previous errors – potentially by buying government bonds – Draghi has taken German resistance into account and delayed quantitative easing (QE). German policy-makers and commentators argue that further monetary easing will not stimulate the eurozone economy much, but risks encouraging excessive risk-taking and asset price bubbles that could breed future crises. They also claim that buying government bonds would lower the pressure on governments to reform, and adjust their economies and budgets.

This raises the question of why German approval is needed at all. In the governing council of the ECB, all relevant monetary policy decisions are taken by simple majority, with the smaller countries having one vote each, and the larger countries traditionally two (because of the additional votes of executive board members). Some of the more fundamental decisions, like recapitalising the ECB, need a two-thirds majority, based on the ECB’s capital shares, but even then Germany has no veto. What is more, there is currently a clear majority for more aggressive ECB action in the council, which Draghi can draw upon whenever he decides that the time is right. Formally, there is no need for German approval, either from Berlin or from the Bundesbank.

Why, then, is Draghi waiting for German approval? There are two possible reasons. First, he might consider it unwise to conduct monetary policy in the face of opposition from the largest eurozone country. There is some merit to this view but it loses validity when the ECB is failing to fulfil its inflation mandate by a wide margin, as it is now. Not only is inflation below the target of 'just below, but close to 2 per cent inflation'; expectations of future inflation have fallen steeply – a source of alarm even to conservative central bankers. Expanding the scope of monetary policy is therefore a matter of urgency, regardless of which country is opposed. It is with good reason that the statute of the ECB is not limited to a narrow definition of monetary policy but allows the purchase of ‘marketable assets’, including government bonds in the secondary market.

In such circumstances, Draghi should not let himself be bullied by the macroeconomic views of a single, if powerful country – views that few share outside Germany. Even the relatively cautious OECD has now come out in favour of further monetary stimulus, and the IMF has been urging the ECB to do more for a while. Given that the Fed and the Bank of England have bought government bonds on a massive scale, the ECB would be well in line with consensus views on monetary policy if it did the same.

The second reason why Draghi might want to get Germany’s backing is that he may fear losing the German government’s consent for the ECB’s other operations, which are not strictly monetary policy. The most important of these, of course, is the OMT programme, which was announced during a panic-driven run on eurozone government bonds in the summer of 2012. The ECB declared that it intended to buy unlimited quantities of these bonds if the panic did not subside – which it then duly did. This programme makes the ECB the implicit guardian of the eurozone as the lender of last resort to governments, but the OMT is in part a fiscal operation. Without the support of Germany, the country with the deepest pockets, the OMT might fail. Draghi therefore does not need the Bundesbank’s support but that of Merkel and the German government – which has backed him on the OMT.

However, Germany’s attitude towards the OMT should not be misunderstood. The German government understood very well that the eurozone might collapse if the ECB did not intervene in the summer of 2012. In fact, one could hear a collective sigh of relief (some say the sound of popping champagne bottles) in Berlin after the ECB took on the de facto role as lender of last resort to sovereigns – despite shrill German press coverage warning against such a step. Regardless of whether the German government approves of further easing of monetary policy, it would still back the OMT. Draghi should therefore not be overly concerned that further, unconventional monetary easing would threaten his role as guardian of the eurozone.

The outstanding legal challenges to the OMT do not change this. Even if the German constitutional court were to forbid the Bundesbank to take part in such a programme in the end – a drastic but conceivable outcome – the basic idea behind the OMT would still survive. The question that the OMT has answered is how far Germany would go to save the eurozone from breakup. Germany has tacitly approved the nuclear option, using the very deep pockets of the ECB as a backstop for government bonds. Even if the legal details of the OMT programme turn out to be tricky, this answer is still the same: Germany and the ECB are determined to avoid a break-up of the eurozone and a panic-driven run on eurozone government bonds. The history of the euro crisis shows that if there is a will, European policy-makers remove the legal roadblocks that might stand in the way. The market will therefore not bet against Germany’s and the ECB’s resolve to keep the eurozone intact.

Waiting for German consent has been Draghi’s biggest mistake in office, since waiting imposes considerable costs. The most important task of a central bank is to keep the expectations of consumers, firms and investors about the future state of the economy on a reasonably optimistic path. Waiting for German approval in the face of a weakening economy undermines these expectations, making the job of lifting expectations that much harder, once the central bank does decide to act. Draghi has wasted precious time – the ECB should have started to act aggressively in spring 2013 – and is now being forced to use controversial measures on a large scale to turn the economy around. Whether those measures will succeed is still uncertain.

Draghi is not the only one to blame, however. The Bundesbank enjoys huge credibility in the German public. It could easily stand publicly behind the ECB and thus foster an environment in which the ECB can act more aggressively, which most economists agree is desperately needed. At the very least, Jens Weidmann, the head of the Bundesbank, needs to stop undermining the ECB in the eyes of the German public. Likewise, Wolfgang Schäuble, Germany’s finance minister, and Angela Merkel should back the ECB openly, and pressure the Bundesbank to do likewise. After all, one reason for the weak state of the eurozone economy is Germany’s reluctance to accept more expansionary fiscal policies in the eurozone and at home.

Christian Odendahl is chief economist at the Centre for European Reform.

Monday, December 01, 2014

Public investment: A modest proposal

Last Wednesday Jean-Claude Juncker, the president of the European Commission, announced his plan to create a €315 billion ‘European Fund for Strategic Investment’ to try to stimulate the European economy. It will take the form of an investment fund; €21 billion will be taken from the EU budget and the European Investment Bank to act as the fund’s capital. This will be used to offer guarantees that will reduce risk for private investors. The hope is that this will stimulate private lending to infrastructure and research and development, and take the value of investment over €300 billion.

That figure looks impressive, but the fund is unlikely to have much impact on growth. This is because it has been designed to avoid any new public borrowing for investment. There is no new public spending – pre-existing funds are being shuffled into the programme. So new spending will have to come as a result of loans from the private sector. Juncker hopes that the capital of the fund can be ‘leveraged’ by 15 times, meaning that the value of private lending will dwarf the public capital that has been committed. This would be double the leverage ratio of the European Stability Mechanism, and infrastructure investments are often more risky than lending to governments, which should reduce private investors’ willingness to lend to the fund. Finally, member-states can inject more capital into the fund if they wish, and these investments will be excluded from their deficit targets under the eurozone’s fiscal rules. But they are unlikely to do so, since the European Investment Bank will pick the projects that will be funded, and so governments’ capital will be mostly used in other member-states.

It may seem pointless to argue for a more sensible investment strategy, since it would require counter-cyclical government investment of the type that the eurozone has repeatedly rejected. But the case for such a strategy is strong. Instead of fiddling with financial engineering, eurozone member-states should simply borrow money directly from the markets and invest it themselves. There is little need for the Commission or European Investment Bank to be involved. Member-states need to co-ordinate on the size of the stimulus – Germany providing some stimulus on its own will not be enough – but they do not need a common instrument to do so. The eurozone is in the last-chance saloon: unless it starts to grow, and unless inflation rises, public sector debt will become uncontrollably large in some member-states. And, counter-intuitively, more public investment would reduce the burden of debt, not raise it.

The eurozone economy has stagnated for three years: in real terms, it is now slightly smaller than it was in the first quarter of 2011, and is still 2 percent below its peak in the first quarter of 2008. Inflation is very low, at 0.4 per cent. Unemployment is stuck above 11 per cent. But policy-makers have done little in response. Mario Draghi, the president of the European Central Bank, has continued to try to improve inflation expectations through talk rather than through action: the ECB is yet to embark on quantitative easing.

Meanwhile, eurozone countries remain committed to fiscal targets (limiting structural budget deficits – the deficit adjusted for the economic cycle – to below 0.5 per cent) that tightly circumscribe their freedom to go for a fiscal stimulus. Fortunately, fiscal policy will contribute a little to growth across the eurozone between 2015 and 2016, as France, Italy and Spain have successfully won more time to comply with these rules (see Chart 1). However, there is no indication that the eurozone is close to launching a meaningful fiscal stimulus.

Chart 1. Eurozone structural government deficits
Source: European Commission/Haver

Member-states should not merely stop digging. The eurozone needs a fiscal boost, alongside more unconventional monetary policy, to kick-start growth and raise inflation. As ever, the biggest obstacle to such a programme is Germany, which has been facing increasingly desperate calls to stimulate the eurozone economy through a programme of public investment at home. It has been running down its infrastructure for over a decade. It can borrow money, essentially for free, since yields on its long-dated debt are lower than expected inflation.

Berlin’s stock response is that a German investment stimulus would do little to boost the eurozone economy as a whole. They point to research that suggests the impact of a German programme of fiscal stimulus on other member-states would be small. According to the ECB, a 1 percentage point increase in German government spending would only boost French GDP by 0.03 per cent.

However, other researchers have shown that the spillover effects would be bigger. In a 2013 paper, Jan in’t Veld, an economist at the European Commission, questioned the method of studies that found little benefit for Germany going it alone. He pointed out that they did not include important factors that would make their models more realistic under current conditions: a far larger proportion of households than usual lack access to credit, for example, and the ECB’s interest rates are effectively at zero. When these factors were included in the model, the spillovers were higher, at between 0.2 per cent for France, Italy and Spain, rising to 0.3 per cent for Ireland. The IMF found that the effect would be of a similar size. This suggests that a German stimulus would have a moderate impact on output in other countries, and is worth pursuing for both domestic reasons and for the benefit of the eurozone as a whole.

However, as the Oxford University economist Simon Wren-Lewis notes, a fiscal stimulus in the eurozone would be more beneficial the more countries participated in it. To understand why, consider the effect on GDP of the eurozone’s co-ordinated austerity programmes since 2010. In’t Veld found this effect to have been very large. In Germany, Ireland and the rest of the eurozone ‘core’ of Belgium, the Netherlands, Austria and Finland, simultaneous austerity more than doubled the impact on output compared to austerity pursued alone. In France, Italy and Spain – larger economies that are slightly less open to trade  – the impact was around 40 per cent bigger. Why is that the case? Austerity leaks into other member-states, since it reduces demand for other eurozone member-states’ exports. If a member-state cuts its deficit alone, reducing demand for imports, that reduced demand is shared across its trading partners, which makes the effects fairly modest. But if every country imposes austerity at the same time, the effect on imports is much larger. The obvious lesson is that simultaneous fiscal stimulus (as opposed to rectitude) will have much larger effects on output than if Germany acted alone.

Many in Frankfurt, Berlin and Brussels argue that any co-ordinated stimulus beyond the core would be far too risky, since the ‘periphery’ cannot afford to take on more debt. But the ECB, through its ‘Outright Monetary Transactions’ programme, has reduced the risk that a country might be forced to leave the eurozone, at least for now. It has promised to act as a lender of last resort to eurozone governments – which brings the eurozone into line with other developed countries – and as a result, borrowing costs for governments have fallen. Chart 2 shows the average interest rate on existing stocks of government debt. Government borrowing costs have fallen rapidly since 2012, with Italy and Spain’s average debt service costs as low as Germany’s were in 2009. These countries do not face a funding crisis.

Chart 2. Average interest rate on stock of existing debt
Source: ECB

Now that the ECB has given the eurozone the chance to pursue a broad-based fiscal stimulus, it should use it. The most sensible thing to do would be to invest in energy, transport, digital networks and other forms of infrastructure. Public spending in these areas has a high ‘multiplier’ – meaning that it raises GDP by more than tax cuts or other forms of spending. This is because little of the money is saved, as with tax cuts. Moreover, government investment leads to higher levels of private investment. A new road linking businesses and consumers, or employers and workers, will create economic activity.

There is not a shortage of things to invest in, especially in Italy and Germany. The quality of Italian infrastructure is far lower than its competitors: the IMF gives it 3.9 out of 7 compared to France’s 6.4. The quality of Germany’s infrastructure is high, but has been falling steadily since 2006 – especially its roads, which are now at the G7 average.

The case for increased infrastructure spending in Spain and France is less obvious: France has sensibly maintained its infrastructure spending, unlike other countries, and has the best infrastructure in the G7. Spain invested too much in physical infrastructure in the boom years. However, investment in human capital might be a replacement. But both countries have higher youth unemployment than the OECD average, and the quality of vocational and tertiary education for young people who have done poorly at high school in both France and Spain is bad.

In its latest World Economic Outlook, the IMF calculated that the multiplier on debt-financed government investment in developed economies, under the prevailing depressed economic conditions, would be so large that:
  • a 1 percentage point of GDP increase in public investment would raise output by 2 per cent in the short term, rising to 3 per cent in the long term, as the supply capacity of the economy expanded; 
  • and such a stimulus would reduce public debt by 1.6 percentage points for a ‘high efficiency’ investment programme – which means investments that bring in higher taxes – and by 0.6 percentage points for a ‘low efficiency’ one.
The stumbling block is the eurozone’s fiscal rules. Earlier this month, France and Italy demanded more time to meet them – even, in Italy’s case, demanding a small stimulus in the short-term. For its part, the Commission insisted that they cut their deficits, but by less than it had originally demanded.

This exercise in haggling makes one thing clear: that the eurozone’s fiscal rules have not been abandoned, as some commentators suggest. They may not be followed to the letter, but, unless member-states insist that the rules are abandoned or reformed, a sensible counter-cyclical fiscal policy will not be forthcoming.

There are two ways to reform the rules to make them less pro-cyclical. The first would be to cite the Stability and Growth Pact’s ‘exceptional circumstances’ clause, which allows member-states to breach the 3 per cent limit on budget deficits in “periods of severe economic downturn for the euro area or the EU as a whole.” The current depressed state of the eurozone econmy surely counts as such a period. A more radical option – and therefore one that is more unpalatable for the eurozone’s creditor countries – would be to supplement the existing fiscal rules with a ‘golden rule’, which would allow governments to borrow to invest over the economic cycle. This would remove investment from the eurozone’s fiscal framework altogether. This should have been the case from the start, since, under the current framework, public investment has been slashed more than other forms of spending, despite its high multiplier.

This modest proposal, which is founded in economic theory and evidence, will no doubt be ignored or rebuffed by the austerians, as though it were akin to Jonathan Swift’s proposal three centuries ago (that the problem of an Irish famine could be solved by parents eating their children). The problem is that, unless the eurozone treats ‘lowflation’ as the emergency that it is, debt restructuring will eventually become inevitable. But, unless Germany joins the rest of the eurozone core and the ECB in doing all they can to raise growth and inflation, the effort will fail. This is the tragedy of the eurozone: its member-states are bound together, and can only escape with the help of Berlin, Frankfurt and Brussels. That help is unlikely to be forthcoming. But it does not weaken the case for public investment, as part of a broader attempt to pull the eurozone economy off the rocks.

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

Thursday, November 27, 2014

What should an energy union cover?

The events of the last year, and in particular the risk that the fighting in Ukraine could jeopardise Russian energy supplies to Europe, have highlighted the absence of a co-ordinated European energy policy. Donald Tusk, the incoming president of the European Council, has talked of the need for an ‘energy union’. What kind of policy co-ordination should European leaders undertake?

The basic facts are clear. The European Union is importing an increasing proportion of its energy, as output from mature oil and gas fields in the North Sea declines. Oil can be bought on the international market, but the EU has become dependent on imports of Russian gas, which now meet a quarter of our daily consumption. The gas reaches Europe through a series of pipelines, two of which run through Ukraine.

Securing gas supplies is not, of course, the only issue at stake in the European energy market. There are Europe-wide targets to reduce emissions, improve efficiency and increase the share of renewables, which were recently extended to 2030. The European Union also aims to keep energy affordable. However, European competence in the area of energy is limited. There is no common energy policy and the pattern of supply and demand is the product of 28 distinct national policies. So what might an energy union mean and how might it advance the three goals of security, cost competitiveness and environmental protection?

It is important to start with a dose of realism. Countries’ choices about energy supply often transcend rational economic calculations. Attitudes to one form of supply or another can owe more to emotion and history than to economics. No European directive is going to make Germany reverse its decision to close its nuclear power stations by 2022, or remove the overwhelming opposition to the technology of ‘fracking’, which can produce oil and gas from shale rocks, in France and Bulgaria. Nor are we likely to see common European energy prices, not least because energy taxation is such an important source of national government revenue. In the UK 80 per cent of the price of every litre of petrol goes to the government in taxes.

In addition, different countries hold different natural resources, and widely varying requirements for imports. The United Kingdom is still a significant producer of oil and gas, even if the volumes have fallen. Poland is still a major coal producer. Many of the other countries in Central and Eastern Europe have limited local energy supplies and rely on imports, often imports of gas and electricity from Russia. Donald Tusk, when Polish prime minister, argued that Europe should create a single buyer to match the market power of Russian exporters. But the pattern of trade across Europe is too complex for that. If the European Union created another centralised structure, it would not change that reality.

An energy union will therefore have limitations but could still be valuable. In at least three ways, a rational co-ordination of policy could give us all a more secure, cleaner and lower-cost energy supply system.

The first role is to link what we have already. Most of the energy systems across Europe, along with patterns of ownership and regulation, remain strictly national in scope. The most recent European Council set an objective that, by 2030, 15 per cent of the installed electricity production should be linked across borders. The scale of the aspiration seems limited compared to the potential. Last May the European Commission published a long list of potential projects that could usefully develop cross-border links. These included physical projects such as linking the southern Italian grid to the north of the country and onward, or a link over the Pyrenees between Spain and France. Under a working energy union, such links should be the norm rather than the exception.

An integrated distribution network, combined with a diversity of sources of supply, is clearly the most effective means of achieving energy security. If we had that, European countries could continue to trade with Russia – if it made economic and political sense – but would know that, if things did go wrong, alternative sources of gas and alternative pipeline networks were always available.

The second role is to establish a new pan-European grid with the capacity to transmit power across the continent from multiple sources. A so-called ‘super grid’ would enhance security but also enable us to better use power from areas in surplus. It cannot be efficient or cost effective for every one of the 28 member-states to maintain their capacity at the level necessary to meet peak demand. A super grid, which has in the past been backed by the German government, could be built step by step, starting with the plans for a new grid around the North Sea. A super grid would help to open markets to competition and to keep prices down. If European leaders are really serious about the notion of using infrastructure investment to drive economic recovery, a modernised grid would be a good place to start.

The third role for an energy union is to invest in the research necessary to transform the system as a whole. The EU’s plans for reducing emissions by means of carbon pricing and emissions trading, conceived six years ago, have not succeeded. The carbon price (the cost of having the right to emit one tonne of carbon dioxide) is proving insufficient to prevent a resurgence of  low cost, but high carbon  coal use. Renewables may be growing in scale – at a high cost – but their benefit in terms of reducing emissions is being offset by increasing use of coal.

An energy union could be a very useful way of focusing collective funds on the important research objective of finding a source of power which is both low cost and low carbon. One option, on which some initial work is being done in the United States, is to find a way of storing electricity efficiently. If successful, that would transform the economics of renewables – allowing much more power generated from the sun and the winds to be captured and used. Effective storage would also remove the problem of intermittency, which at the moment means that expensive back-up systems have to be in place to provide cover when wind and solar are unavailable. Why should Europe, with its extensive scientific base, wait for the US to find the answer?

An energy union should not mean centralisation and uniformity. Different countries will continue to pursue various policies. Such diversity is a good thing, not a problem. The EU’s role should be to enhance security, cost competitiveness and emissions reductions in ways which individual countries cannot achieve on their own.

Nick Butler
Visiting professor and chair, King's Policy Institute, King's College London

Ukraine after the elections: Democracy and the barrel of a gun

Ukraine has lost control of parts of its industrial heartland, as well as Crimea. The question is whether there will now be a government in Kyiv that can make a success of the rest of the country. There are reasons for concern.

The good news is that most of Ukraine voted for a new parliament on October 26th. Pro-European parties backing President Petro Poroshenko and Prime Minister Arseniy Yatsenyuk won a majority of the 423 seats contested (which excluded occupied areas). More than 900 international observers monitored voting; they described it as "an amply contested election that offered voters real choice". The Russian Foreign Minister, Sergey Lavrov, said grudgingly that the elections seemed to be valid, though not in every part of Ukraine.

The first piece of bad news is that Russian forces and their local proxies did not give Ukrainians in the occupied parts of Donetsk and Luhansk regions the chance to cast a ballot. Instead, on November 2nd the separatists organised sham elections in the self-proclaimed statelets. These polls were criticised by the EU, the US and the Organisation for Security and Co-operation in Europe. The Russian foreign ministry, however, said that Russia respected "the declaration of the will of people in south-eastern Ukraine".

About 15 per cent of the Ukrainian population lives in the areas Russia controls (or used to live there – the UN estimates that the conflict has created over 900,000 refugees or internally-displaced persons). Ukraine, while asserting its territorial integrity de jure, is effectively challenging Russia to take responsibility for these areas: on November 15th, Poroshenko ordered state institutions in the occupied territories, including schools and hospitals, to close, and banks to cease operations. Poroshenko's action is understandable: he could not control what was happening in the area. But he risks consolidating the division between the self-proclaimed Donetsk and Luhansk 'People's Republics' and the rest of Ukraine.

The second piece of bad news is that the potential coalition partners are wrangling over the composition of the government, including which party should fill the important posts of interior minister and finance minister. The president’s 'Petro Poroshenko Bloc' has the most MPs, with the prime minister's 'People's Front' as runner up. Between them they have 214 seats, a narrow parliamentary majority. Important reforms such as devolving powers to the regions will require constitutional changes, for which 300 votes are needed. So coalition talks include three smaller parties (including the far-right 'Radical Party', which argues for Ukraine to have nuclear weapons).

What Ukraine needs, immediately, is a competent government with honest ministers, rather than one designed to divide the spoils among its constituent parties. The coalition parties should sink their differences and install a government based on ability and integrity rather than party affiliation. For most of the last two decades Ukraine was a case study in post-Soviet poor governance. The new government must do better. Fighting the corruption for which Ukraine has been famous will demand both government transparency and effective law enforcement. An EU mission will start work on December 1st on police and judicial reform; the EU should also attach advisers to ministries and agencies to help them combat corruption.

The third problem is a collapsing economy. The European Bank for Reconstruction and Development forecast in September that Ukrainian GDP would fall by 9 per cent this year and a further 3 per cent in 2015; meanwhile inflation will rise from minus 0.3 per cent in 2013 to 11.8 per cent this year. The current account deficit is undergoing a forced correction, from 9.2 per cent of GDP last year to 2.5 per cent in 2014, through a painful contraction in imports. The value of the hryvnia has fallen by almost 50 per cent this year, making imports impossibly expensive.

In theory, the devaluation of the currency should help Ukrainian exporters. Unfortunately, the Russian market, which absorbed around a quarter of Ukraine's exports in 2013, is now effectively closed; and as long as much of Ukraine's heavy industry in the east cannot operate, Ukraine's export potential will be limited.

The Ukrainian government cannot cope without international help. The $17 billion (€14 billion) IMF package and the €11 billion mixture of EU grants and loans agreed earlier in the year are insufficient. Yields on Ukrainian government bonds are over 18 per cent, with investors assuming a high probability of default. A senior American official suggested recently that Ukraine would need an extra $10-15 billion in 2015 alone. The US itself has been niggardly, giving around $1.3 billion in loan guarantees and grants; both Washington and its international partners need to do more for Ukraine to have a chance of succeeding. The EU should not have delayed implementation of its association agreement with Ukraine under Russian pressure. It should now do everything possible to accelerate Ukraine's convergence with EU standards and regulations. Then Ukraine can re-orient its economic ties westwards (as Georgia did, successfully, after its war with Russia in 2008).

Finally, the ceasefire agreed in September has broken down. According to NATO, Russian forces and equipment are again crossing Ukraine's border. The Russians' aim may only be to consolidate their hold, and perhaps straighten out some 'kinks' in the front line (for example by taking the town of Shchastya, home to a power plant supplying almost all the Luhansk region's electricity, or they may intend something more ambitious, such as capturing the port city of Mariupol and the rest of the coastline between there and Crimea (which is proving hard to supply by ship from Russia). Poroshenko has said that Ukraine is prepared for a "scenario of total war" with Russia; but in reality, while Ukrainian forces could certainly inflict large-scale casualties on attacking forces, they could not resist an all-out invasion from better equipped and more numerous Russian forces.

So far, Western leaders have refused to do much to increase Ukraine's military capability, hiding behind the mantra that "there is no military solution" to the conflict, and suggesting that arms supplies might encourage Kyiv to think that there is. But as long as Ukrainian forces are so much weaker than Russian forces, there is indeed a military solution: outright Russian victory. The best way to deter further Russian advances is to help Ukraine with equipment, training and intelligence, so that the domestic political cost of victory for Russia, in casualties incurred, becomes prohibitively high.

'Realist' commentators like Henry Kissinger often assert that Ukraine matters more to Russia than to Europe or the United States. A strong case could be made, however, that the success of Ukraine matters more to the West than it does to Russia. The EU and NATO would be better off with a prosperous, stable nation of 45 million people next door, rather than a corrupt, unstable economic basket-case. The West should be prepared to invest in achieving the right outcomes by both strengthening the government-controlled parts of Ukraine and preventing Russia from further demolishing the country.

Ian Bond
Director of foreign policy, Centre for European Reform

Free movement: Why Britain does not need to change the rules

Now that the European Commission, Germany and other member-states have made clear that they will not accept quotas or ‘emergency brakes’ on EU migrants, British Conservatives are looking again at limiting their access to benefits. As this bulletin went to press, David Cameron was preparing a major speech on the issue. But he will find it very hard to achieve significant changes to the rules on benefits.

A recent ruling of the European Court of Justice (ECJ) in the Dano case seemed to offer encouragement to Britain. The ECJ confirmed the right of the German authorities to refuse unemployment benefits to a Romanian citizen who had no history of work in either country. Many Conservatives hope this means that the EU institutions will not block reforms to reduce EU migrants’ access to welfare. They are probably wrong: the court merely upheld a 2004 directive (the ‘citizens directive’) that already limited migrants’ access to benefits.

Free movement has never been an unconditional right. EU law offers a number of tools to control intra-EU migration and prevent abuse of welfare systems. In the past, the ECJ has tended to expand the scope of free movement rights, particularly for non-active migrants. The Dano ruling may be a sign that the Court is reacting to growing national concerns over free movement and national welfare systems.

The ‘citizens directive’ gives EU citizens the right to live in another member-state for more than three months, but only if they are employed, studying or economically self-sufficient. In the latter two cases, they must have health insurance. Once these conditions are met, EU citizens have the same rights as nationals of the host country. In turn, those migrants who become an “unreasonable  burden” (a term undefined in the directive) on the welfare system of the host country can be denied benefits. Member-states are allowed to expel those EU citizens who do not fulfil the conditions for legal residence.

EU law prohibits flagrant abuses of social security systems. These abuses are, in any case, vanishingly small in number. Neither the CER nor the European Commission can find much evidence of ‘benefit tourism’ in the UK – the idea that migrants head for the UK because of its welfare system. And a new study from University College London has found that immigrants from the EU – including from Central and Eastern Europe – were net contributors to the public purse, a finding that has been replicated in other member-states.

Various Conservative MPs and think-tanks have suggested that benefits should not be granted to EU migrants for a period of two to three years, either by amending existing EU laws or by proposing new ones. But the chances of other member-states and the EU institutions agreeing to such a reform are very low. It might require treaty change, if the denial of in-work benefits were to amount to discrimination between workers from different member-states, which is prohibited by the treaties. If that were the case, such a change would require the unanimous agreement of all 28 member-states.

Even if the UK could find reforms that would not require treaty change, the reform would still need to go through the EU’s legislative procedure.The new or amended legislation would need to be proposed by the Commission and approved by a qualified majority in the Council (at least 15 member-states representing 65 per cent of the European population) and by the European Parliament. In the unlikely event that the UK convinced 14 other member-states to support reform, it would still need to persuade both the European Commission and the Parliament that such a change was needed. Given the lack of evidence supporting the claim that EU migrants are bad for the UK’s economy, and the strong stance taken by the EU institutions in defence of free movement, this would be difficult. Existing EU legal safeguards against the abuse of welfare systems would also weaken the case for reform.

Further limitations to the rights of EU migrants are unnecessary and may well be politically unfeasible at the European level, however popular they would be with some Britons. They are also not in Britain’s interest. There are many retired British citizens living in Spain or France who enjoy free access to healthcare, paid for by their host member-state. If Britain were to push for measures to delay or limit benefits to EU migrants, the UK taxpayer would probably end up bearing the cost of healthcare for British pensioners abroad.

The UK should learn the right lesson from the Dano ruling, and stop blaming Brussels for problems which can and should be solved at the national level. EU laws, which the UK agreed to adopt, allow member-states to prevent abuse of the benefits system. Britain could exercise closer oversight of EU migrants by, for example, establishing a compulsory register for EU citizens. The majority of member-states use such registers to check that EU migrants fulfil the necessary conditions and that they are not a burden on the welfare state. Those not meeting the requirements could be expelled.

Free movement is a cornerstone of the internal market, which the UK has traditionally championed. Hostility to EU migration has become the most salient issue in British politics, despite evidence of its positive economic impact. But ultimately, Britain has to face up to reality: the only way to stop EU migrants entering the country is to leave the EU, with all the economic and geopolitical damage that entails.

Camino Mortera-Martinez
Research fellow, Centre for European Reform

Wednesday, November 26, 2014

Hungary and the West: We need to talk about Viktor

Prime Minister Viktor Orban still dominates Hungary’s political scene, in spite of recent large demonstrations in Budapest. But his political reforms and economic and foreign policies are raising more and more questions abroad as well as at home. If Orban thinks he can ignore such criticism, he is wrong: Hungary's economic development depends on its Western partners.

Worries about Orban’s intentions started soon after his election in 2010, when he quickly consolidated his Fidesz party’s grip on power, and purged political opponents from positions of influence. In 2011, German Chancellor Angela Merkel (among others) criticised measures to control the media; in 2012 the European Commission started infringement proceedings against Hungary for limiting the independence of the Central Bank and the data protection authority, and for compulsorily retiring 274 judges (who were replaced by more Fidesz-friendly figures).

But concerns about Orban have heightened recently as a result of two speeches. His inaugural speech to parliament in May, after his re-election, called for autonomy and 'communal rights' for ethnic Hungarians in neighbouring states, including Ukraine. It upset neighbours like Poland, where Prime Minister Donald Tusk suggested that it sounded too similar to Putin's line on ethnic Russians abroad. Orban’s speech to a gathering of Hungarian students in Romania in July 2014 caused even more trouble. In it, he proclaimed a shift from liberal democracy towards the construction of an “illiberal state" and cited Singapore, China, India, Russia and Turkey as models.

Does the reality of Orban’s policies live up to the rhetoric? Hungarians close to the ruling party argue that the rest of the West listens too much to Orban’s leftist political opponents. They claim that Hungary has been a reliable EU partner, whatever critics say. They point to Hungary’s successful presidency in 2011: it secured Croatian accession to the EU, and laid the foundations for the European Parliament’s involvement in the negotiations on the EU’s long-term budget.

Some foreign experts on Hungary suggest that however alarming the ‘illiberal’ label sounds, what Orban means is merely that the EU’s current approach to tackling the economic crisis is not working; and that the liberal model, which privileges the rights of the individual over the interests of the community, is one of the reasons for its failure. Orban, according to this interpretation, wants to build closer links with economically successful, albeit authoritarian states.

Even Hungarians who do not support Fidesz accept that some of the steps taken reflect a necessary if belated attempt to purge ex-Communists from positions of influence, where they could obstruct change and perpetuate the power of the Cold War-era nomenklatura.

Whether or not Orban’s motives were pure, the effect of his reforms has been to create strongly pro-Fidesz state structures, rather than a politically neutral administration. Murky links between business and politics have developed: in October the US government imposed visa bans on a number of officials, after repeated attempts to get the Hungarian authorities to tackle corrupt practices which favoured Fidesz-linked firms. And Orban has intensified pressure on civil society: in September police raided the Budapest offices of an NGO funded by Norwegian government grants, following Hungarian government allegations that it was funding Fidesz’ political opponents.

Economically, Orban has pursued populist policies, such as trying to reduce the role of foreign investors in key sectors. In September 2014 Deputy Prime Minister Zsolt Semjen said that nationalising the energy sector was the only way to guarantee security of supply for Hungarians, despite ample evidence that liberalising markets would work better. The government has also forced banks to take large losses in order to protect Hungarian borrowers against exchange rate fluctuations, and seems poised to buy up the assets of any banks that leave the Hungarian market as a result. In response, the Commission has expressed concern about Hungary's compliance with rules on state aid.

Orban might be able to thumb his nose at the Commission if his economic policies were a success. But from 2008-2013, Hungary’s GDP grew at the slowest rate in the Visegrad Group (which comprises Hungary, Poland, Slovakia and the Czech Republic and is often referred to as the V4).

The main victims of Orban’s domestic policies may be his own citizens, but his foreign and security policy could damage wider European interests. His statements often hint at a wish to revise Hungary’s borders, established after the First World War, which left Hungarian minorities spread across several neighbouring countries. His implicit encouragement of irredentism worries other countries, particularly Slovakia and Romania which have significant ethnic Hungarian populations. It also complicates co-operation within the V4.

As neighbours of Ukraine, the V4 should have been central to formulating the EU's response to Russia's annexation of Crimea and continued interference in the Donbass. The V4's experience of economic and political transition and of European integration should make them natural mentors for the new authorities in Kyiv. Instead, Orban has contributed to V4 disunity and questioned EU efforts to put pressure on Russia.

One European politician who has known Orban for many years suggests that his cultivation of Putin comes from a mixture of anger at the way other EU leaders treat Hungary and pure opportunism. Whatever the cause, Orban has tied his country closely to Russia, especially in the energy sector. In January 2014 he signed an agreement with Putin on expanding Hungary's Paks nuclear power station; 80 per cent of the project will be financed by a Russian state loan. In July, he restated his support for the South Stream gas pipeline from Russia to Europe (which would bypass Ukraine) – a project which the Commission has said is illegal in its current form.
And in September, after a meeting with Gazprom CEO Aleksei Miller, he halted the re-export to Ukraine of gas bought by Hungary; by doing so, he made Russia's cut of gas supplies to Ukraine more effective.

Though the US has loudly criticised Orban's democratic back-sliding and closeness to Russia, Brussels has more leverage with Hungary than Washington. What can the EU do with this awkward but democratically-elected man? So far, the member-states and the Commission have only grumbled, to little avail. As an organisation often criticised for its own lack of democratic legitimacy, the EU has hesitated to challenge someone who has a large majority in his national parliament.

If the political will to act exists, the EU has two types of tools it can use. First, the Commission can take action against a government which breaks European law and in the process goes against EU values. It allows the Commission to launch infringement proceedings. But such proceedings cannot address cases where a government acts contrary to the EU's values but does not break any specific EU law. In the case of the compulsory retirement of judges, the Commission based its legal action on EU rules against age discrimination in employment; but it had no standing to tackle more fundamental questions of the rule of law and independence of the judiciary. Hungary settled the case by compensating the judges but not reinstating them.

Second, the EU can address democratic shortcomings in a member-state through Article 7 of the Treaty on European Union, which enables the European Council to determine “the existence of a serious and persistent breach of EU values” in a member-state; and to suspend some of its membership rights, including voting rights. The European Council must decide unanimously (minus the country concerned) that a breach has taken place. Other countries would probably want to see evidence of much more serious misbehaviour than anything Orban has yet done before resorting to such a nuclear option.

Article 7 also has a ‘warning mechanism’: four-fifths of the member-states may determine that there is a clear risk of a serious breach of EU values in another member-state. This ‘yellow card’ permits a dialogue with the member-state in question before more radical steps are taken. But member-states are even afraid of using this mechanism. It would fuel debate about whether the EU should be able to interfere in the affairs of a member-state. It could also lead to an East/West split in the Council, if the Central Europeans believed that ‘old’ member-states were using Article 7 against them while overlooking failings in one of their own number. It is worth noting that in 2000, when Austria’s coalition government included the far-right Freedom Party, other member-states introduced political sanctions without using Article 7 that had been introduced by Amsterdam treaty and entered into force in 1999.

Doing nothing about Orban’s policies is not acceptable. He has challenged the EU’s role as the champion of democratic values, which was the basis of past enlargements and is the reason the EU has remained so attractive to countries like Ukraine. Inaction would weaken the EU’s power of example.

Some governments would like a proper debate about Hungary’s behaviour. In 2013 the German, Dutch, Danish and Finnish foreign ministers wrote to the Commission urging it to do more to promote respect for the rule of law in the EU. They proposed various measures to respond to breaches of EU principles that could be deployed before escalating to the use of Article 7. These ranged from political dialogue with the Commission about issues of concern to the suspension of structural funds (currently only possible if a country breaks the EU’s macroeconomic rules).

A majority of member-states have so far blocked proposals to enhance the EU’s role in policing the rule of law. Some, like the UK, fear that strengthening the Commission’s power would play into hands of eurosceptics; others, including in the Baltic States, worry that the EU would interfere with their policies towards national minorities. The General Affairs Council will revert to the issue of the rule of law in December, but there is no guarantee of progress. For the moment, therefore, more informal ways of handling Orban must be found.

The other members of the V4 have an important role to play. Some of them share Orban’s misgivings about sanctions against Russia; but they have developed a ‘brand identity’ as modern, successful European societies, and Orban’s populist nationalism threatens this reputation. They should work behind the scenes to shift Orban back into the liberal, market-oriented European mainstream.

British Prime Minister David Cameron should also speak up. Orban joined Cameron in his unsuccessful efforts to oppose the nomination of Jean-Claude Juncker as Commission President. Cameron’s views on the EU are sometimes compared with those of Orban. But unlike Orban, Cameron has been outspoken about the threat Putin's policies pose to Europe. Nobody has accused Cameron of trying to monopolise state institutions for the Conservative Party. Cameron could suggest that Orban join the UK in trying to reform and strengthen the EU, internally and externally, rather than chasing after illiberal democracies that have their own economic and political problems.

Perhaps the best hope is that other centre-right politicians in Europe can talk Orban round. He has benefited from the support of the European People’s Party (EPP), which unites most of the centre-right parties in the EU, including Fidesz. It is time for leaders like Angela Merkel of Germany or the new Polish Prime Minister, Ewa Kopacz, to remind Orban that almost 80 per cent of Hungary's trade is with other EU member-states, and that his main economic and political partners are still in the West, not in Moscow.

Agata Gostyńska is a research fellow and Ian Bond is director of foreign policy at the Centre for European Reform.

Thursday, November 13, 2014

Iran nuclear talks: Patience is a virtue

When negotiators from Iran and the EU3+3 (France, UK, Germany plus the US, Russia and China) reached an interim agreement in November 2013 restricting Iran's nuclear programme, they set themselves a one-year deadline for sealing a comprehensive, long-term agreement. That deadline expires on November 24th. Now Western governments have to decide whether negotiators should stick with the deadline or extend the talks. They should choose the latter; the current geopolitical context does not favour the West and, in time, low oil prices could force Iran to compromise.

On the face of it, a deal should be within reach. The main point of disagreement is the number of centrifuges – tools for enriching uranium – Iran should be permitted to have. The more it has, the faster it can enrich enough uranium to build a nuclear weapon. US Secretary of State John Kerry has said he wants to ensure Tehran cannot build a bomb in less than one year. So far the Iranian government has built 19,000 centrifuges and says it intends to build at least twice as many. But the US and others want to reduce the number to the low thousands.

Under the November 2013 interim deal, Tehran agreed to suspend its uranium enrichment activities, dilute some of its higher enriched uranium stock and halt work at three nuclear sites. It also agreed to allow increased monitoring by the International Atomic Energy Agency (IAEA), the international nuclear watchdog. In return, the US and the EU, which had restricted Iran’s ability to sell oil and natural gas through a tough sanctions regime, released several billion dollars in Iranian oil proceeds and allowed access to specific goods, including medicine and aircraft spare parts.

The ‘prize’ of a successful negotiation is containing the spread of nuclear weapons in the Middle East. A comprehensive agreement would bring a dose of badly needed good news to the volatile region, and make a US or Israeli military strike unlikely. A deal would show that multilateral diplomacy involving the West and Russia can solve thorny international issues even when relations are tense because of the Ukraine crisis.

Even a comprehensive deal would not make Iran a friend of the West. But it would reduce the level of animosity and offer the prospect of a pragmatic détente. There are a number of regional issues which would benefit from greater co-operation, such as the conflict in Syria, Iraq and the threat from the terrorist group ISIL (the Islamic State in Iraq and the Levant), and the stability of Afghanistan. A deal would also help to revive Iran’s economy, for example by attracting investment into Iran’s energy sector.

Under a comprehensive deal the West may have to tacitly accept that Iran has the technical potential to develop a nuclear weapon. But Iran’s leaders would need to dismantle or roll back parts of the country’s nuclear programme, allow invasive inspections, make credible offers of transparency and accept that sanctions could be reinstated anytime. As economic and geopolitical realities influence the negotiations, Ayatollah Khamenei, Iran’s Supreme Leader – and his president, Hassan Rouhani – may not see the need to compromise enough to achieve a deal.

The US and Europe are using economic sanctions, particularly against Iran’s financial and energy sectors, to extract concessions at the negotiating table. Iran’s economy has suffered as a result: according to the US State Department, it is 25 per cent smaller than it would have been if it had continued to grow at its pre-sanctions rate. The economy has been in recession, Iran cannot market most of its vast energy resources and foreign reserves worth more than $100 billion (€80 billion) are out of Tehran’s reach, mostly locked in Asian banks.

However, Iran has had some success in circumventing the sanctions. According to the Central Bank of Iran, the first quarter’s growth rate was 4.6 per cent over the same quarter in 2013. Unemployment has dropped, and inflation has come down from 45 per cent to 27 per cent. The bank argues that the Iranian economy may recover, even under sanctions. If President Rouhani can deliver growth through negotiated sanctions relief and sanctions busting, he will have less interest in compromising during the nuclear talks.

In 2014, Iran’s national oil company exploited a loophole in the sanctions regime; exports of natural gas condensates – a very light oil – are only partially restricted. The interim agreement caps Iranian crude oil exports at 1 million barrels per day. But according to the International Energy Agency (IEA), in 2014 Iran exceeded the export cap by nearly 400,000 barrels per day ‒ mostly in the form of condensates ‒ adding $3.3 billion to the Iranian treasury.

Iran is also trying to attract the interest of foreign investors. In October, President Rouhani publicly endorsed a business roundtable in London that discussed post-sanctions economic opportunities. Tehran is luring international energy companies to return by offering them more profitable conditions, even though sanctions would only be lifted after a comprehensive deal was reached.

At the same time, cracks are appearing in Europe’s sanctions edifice. A ruling by the European Court of Justice (ECJ) on September 18th, citing procedural mistakes, annulled some of the EU’s restrictive measures against the Central Bank of Iran. On October 7th, another ECJ ruling in favour of Iran’s national tanker company allowed its assets to be unfrozen. While the EU responded by putting the company back on its sanctions list, these rulings suggest more of the sanctions package could be legally unpicked.

Iran may also be decreasingly willing to compromise for geopolitical reasons. US-led efforts to target ISIL are strengthening Iran’s regional influence. ISIL is an adversary of Iran’s allies in Damascus and Baghdad, and the group has targeted Shia communities and their holy sites in Iraq. In response, Iran’s Revolutionary Guard Corps helped prevent the fall of Irbil in August and is training Shia militias. Meanwhile Iran continues to prop up President Bashar al-Assad and offer him military backing through its Lebanese proxy group, Hizbollah.

A rapprochement between the US and Iran seemed possible in the run-up to US airstrikes on ISIL in late August. But Iranian officials have tied co-operation against ISIL to American leniency on Iranian centrifuges. The United States has made the opposite linkage: President Obama reportedly told Ayatollah Khamenei that co-operation against ISIL depended on Iranian nuclear concessions. But Iran has more influence on the ground in Iraq and Syria than the US does, and Obama is under domestic political pressure to deliver results against ISIL, strengthening Iran’s hand in the talks.

The Ukraine crisis could also help Iran’s negotiating position. Western negotiators say that Moscow is not letting the conflict in Ukraine contaminate the talks. But Russian attempts to frustrate Western diplomacy have emerged. In the energy domain, Iran and Russia are competitors. Yet Tehran is flirting with Moscow, hoping to agree on an oil-for-goods swap, which would see Russia importing 500,000 barrels per day from Iran and sending Russian manufacturing and drilling equipment in return. If relations between the West and Russia become more strained, this arrangement could go ahead, undermining the sanctions regime and Iran’s incentive to make a deal.

The oil price is another reason why Russia may not want a deal now and could be advising Iran to hold out. Any nuclear agreement will raise the prospect of more Iranian oil exports, putting downward pressure on the oil price. This would further harm a Russian economy dependent on oil exports and hit by Western sanctions over Ukraine. (The oil-for-goods swap would make sense to Moscow as the agreement would keep Iranian oil off the international market, while Russia would pay in kind, leaving spot oil prices undisturbed).

Although a compromise may be out of reach at present, neither the West nor Iran has an interest in talks breaking down. The Obama administration has invested significant political capital in a deal and sees it as a possible foreign policy legacy. For the majority-Republican US Congress, however, failed negotiations would confirm that the administration's diplomacy needs to be replaced by a more muscular policy of harsher sanctions. A reluctant Obama would face new pressure to put a military option back on the table.

Collapsed negotiations and a tougher US approach would cause splits in the EU3+3. Russia and China would consider bilateral trade and energy deals with Iran, and European companies would push their leaders to take a softer stance on sanctions. The sanctions regime could unravel.

America’s regional allies have been sceptical about the interim agreement from the start. If diplomacy failed and Iran resumed work on its nuclear programme, Israel and Saudi Arabia in particular would take counter-measures. These might range from lobbying Washington to take military action, to (in the case of Israel) launching unilateral military strikes or (in the case of Saudi Arabia) pursuing a nuclear option itself.

For Iran, the collapse of negotiations would put pressure on President Rouhani from hardliners to accelerate a weapons programme. On the economic front, the re-imposition of sanctions, or further measures, would be painful. Politically, Rouhani would have to gamble either that international solidarity would crumble, or that America’s next president would be as willing as Obama to try to do a deal, while facing opposition from Congress and US allies in the Middle East.

So if, as seems likely, the November 24th deadline cannot be met, the interim agreement and the talks should be extended. Initially, this is in the interest of all parties. The Iranians would get the continued benefit of some sanctions relief without having made major concessions, and need not fear a military threat. The Americans and the Europeans would steer away from yet another Middle Eastern conflict and a deal would still be within reach. And Russia could continue to build its commercial ties to Iran, without risking nuclear proliferation along its southern borders.

Looking ahead, an extension should favour the EU3+3. Due to the serendipitous ‘fracking’ revolution, America’s geopolitical clout is growing. US oil is flooding the market (and Saudi Arabia too is keeping the spigot open). In combination with slowing Chinese demand for energy, oil prices are now at their lowest point in four years. The IEA expects growth in oil demand to slow in 2015 and the International Monetary Fund (IMF) has adjusted its growth forecast for China downward. It suggests oil prices will remain down. The oil price at which Iran’s budget is balanced lies between $120 and $130, while the current market price is roughly $75-80. Iran’s economic recovery could be short-lived as low oil prices hurt its bottom line and offset likely gains from sanctions busting. Even a Russian-Iranian oil-for-goods deal would not be sufficient to keep its economy afloat. President Rouhani recently hinted at Iran’s vulnerability to the price slump. The longer it lasts, the more pain it will cause to Iran’s economy. An extension of six more months would allow the oil price to do its work on Iran’s willingness to compromise in the nuclear talks.

A sceptical US Congress could still try to derail an extension by imposing new sanctions on Iran. A two-thirds majority in both the Senate and the House is required to block a presidential veto. The House is strongly opposed to the talks, but Obama should be able to convince enough senators to back an extension.

By designating Catherine Ashton as the EU’s mediator on Iran, after her term as High Representative expired, the EU has signalled it could live with an extension. But the EU and its member-states should ensure that the loopholes in the sanctions regime – for instance on natural gas condensates – are closed, that EU lawyers successfully defend the sanctions regime at the ECJ, and that European companies that circumvent sanctions are fined – something which until now Europe has left to prosecutors in the US.

A deal might still be struck this month, but the odds are that it will not. In that case, Americans and Europeans should use their economic leverage to get a better agreement later.

Rem Korteweg is a senior research fellow at the Centre for European Reform.