Friday, June 27, 2014

The eurozone is no place for poor countries

The economic rationale for poorer countries joining the eurozone was that it would hasten economic convergence between themselves and the richer members of the currency union. They would benefit from a stable macroeconomic environment and more trade and inward investment. And Portugal aside, there was some convergence in the early years of the single currency. But this went into reverse in 2008 and by 2013 the poorer members of the currency union were no better off relative to the EU-15 average than they had been in 1999. Worse still, they have been overtaken by a number of the 2004’s EU intake, who in 1999 had been much poorer. Has the euro become a mechanism for divergence? If so, what are the implications for growth across the eurozone as a whole and for the case for joining?

In 1999, Greek and Portuguese per capita GDP were around 70 per cent of the EU-15 average, and Spanish a little over 80 per cent. By 2013, Greek and Portuguese GDP was under 70 per cent of the average. Spain has not done quite as badly, but has been diverging since 2008 (see chart 1). Indeed, far from converging with the richer members of the EU, they have converged with the Central and Eastern European countries which joined the EU in 2004. In 1999, the GDP levels in Poland and Slovakia (a euro member since 2009) were 42 per cent and 43 per cent of the EU-15 average respectively. The Czech Republic’s was just over 60 per cent of the average. By 2013, these figures were 65 per cent, 72 per cent and 75 per cent.

Chart 1: GDP per capita


Source: European Commission

For crude supply-siders, the lack of convergence between members of the eurozone reflects the failure of the poorer member-states to push through reforms of their economies rather than anything to do with the structure of the currency union. This has cost them competitiveness, leading to economic stagnation.

Others maintain that divergence since 2008 is cyclical and will be quickly reversed. According to this view, the South is simply going through what Germany went through in the early 2000s. Interest rates are too high for the periphery in much the same way as they were for Germany between 1999 and 2006; conversely, they are now too low for Germany. Germany will grow more rapidly than the south for the next few years, but that will then reverse as Germany loses competitiveness and finds itself in similar position to that of the periphery now – with an overvalued real exchange rate and excessively tight monetary policy. At that point there will be renewed convergence between rich and poor. The worst that can be said is that the eurozone has amplified business cycles, but not that it has become an obstacle to convergence between rich and poor.

There are problems with both these arguments. First, it is hard to ascertain a correlation between the kinds of structural reforms the Commission is demanding of the South (principally labour market deregulation) and economic growth. Some of the best performing European economies over the last 20 years – notably Sweden and Austria – have relatively highly regulated labour markets. Germany – the benchmark for much of the Commission’s thinking – also has a tightly regulated labour market (notwithstanding 2004’s Hartz IV reforms), at least in regards to permanent workers (see chart 2). There is certainly a case for labour market reforms to address insider/outsider problems and to help young people and those with poor skills into work. But it is important not to exaggerate the economic effects of such reforms.

Chart 2: OECD indicators of employment protection legislation, 2013
(0 = least restrictions, 6 = most restrictions)

Source: OCED

Nor can differences in product market regulation explain the lack of convergence in living standards within the eurozone. First, according to the Organisation for Economic Co-operation and Development (OECD), there has been steady convergence of such regulation among EU member-states. Second, there is no discernible correlation between levels of product market liberalisation and economic growth. For example, Sweden has among the more tightly regulated product markets in the EU, while Germany and Italy score about the same as each other. Greece does rank badly, but only as badly as Sweden did five year earlier (see chart 3).

Chart 3: OECD indicators of product market regulation
(0 = least restrictions, 6 = most restrictions)

Source: OECD

This is not to say that – all other things being equal – competitive product markets will not boost economic performance, only that they can be more than offset by other things such as the wrong macroeconomic policies or misalignments of real exchange rates. The latter can have a big impact on levels of capital stock per employee and labour skills, which are more important in determining economic performance than levels of labour and product regulation. Cuts in education spending, large-scale emigration of young skilled workers and huge falls in business investment have damaged the productive capacity of the eurozone’s poorer economies.

The cyclical argument for the lack of convergence is also weak. There are several differences between Germany’s position in the early years of the euro and the south now. Germany’s period of retrenchment within the euro was essentially over by 2006. Germany’s real effective exchange rate was not seriously overvalued to start with. Germany was aided in its drive to reduce its real exchange rate by inflation being relatively high elsewhere in the eurozone. And, finally, the country was not highly indebted.

By contrast, the retrenchment in the poorer members of the eurozone has already lasted longer than in Germany in the early 2000s, and there is no end in sight for a number of reasons. First, their loss of trade competitiveness relative to the core is far bigger. Second, they are trying to regain competitiveness by holding inflation rates below the eurozone average at a time when inflation is chronically low elsewhere in the eurozone (German inflation is around 1 per cent and forecast to remain low). And third, they have very high levels of debt. Their drive to improve competitiveness is pushing them into deflation, increasing the real value of their debts and making it harder to deleverage.

As a result, overall levels of indebtedness in Greece, Portugal and Spain are still close to their all-time highs. Their levels of private sector debt have fallen, but there has been an offsetting increase in public debt. According to Standard and Poor’s, the so-called leverage ratio (public and private debt as a share of GDP) in Greece, Spain, and Portugal is currently around twice what it was at the beginning of 1999; Italy’s is 35 per cent higher.

Reducing these leverage ratios will be hard. Firms and households will continue to pay down debt for a long time to come, depressing consumption and investment. For their part, poorer eurozone governments risk contributing to the weakness of demand by continuing their drive to consolidate public finances. The result threatens to be weak economic growth and inflation and hence slow deleveraging. This is less a cyclical issue than a semi-permanent state of affairs. Growth in the poorer states will at some point in the future exceed that of the wealthier North, but any convergence is likely to be slow because of the permanent damage done to their growth potential.

A combination of debt write-offs, co-ordinated eurozone fiscal stimulus and a concerted drive by the European Central Bank (ECB) to drive up eurozone inflation could head off this unfavourable outcome. Anything is possible, of course, but all of these things look unlikely. Low borrowing costs have reduced pressure for institutional reforms of the eurozone, even if low bond yields should be ringing alarm bells (reflecting as they do mounting deflationary pressures). The eurozone might agree an investment programme, but a big fiscal stimulus is impossible without rewriting the rules. And there is little chance the ECB is going to morph into a European version of the US Federal Reserve and launch a full-blooded battle against deflation.

The fate of poorer EU-15 members of the eurozone should give prospective eastern and south-eastern EU member-states pause for thought before joining. They should also closely monitor the experience of Slovenia and Slovakia, which joined the single currency in 2007 and 2009 respectively. Slovenia is considerably poorer relative to the EU-15 average than when it joined. Slovakia has performed respectably within the single currency, but its real effective exchange rate has risen steeply relative to its peers (Czech Republic and Poland) and it has slipped into deflation.

For some – Lithuania, for example – joining the euro is about guarding its independence against a revanchist Russia. But the others face a trade-off: join the euro and get a seat at the top table (more and more of the real decisions on economic issues are taken by eurozone countries rather than the EU) in return for a loss of policy autonomy and much increased economic risk. Or reiterate their commitment to join but postpone doing so in the hope that the eurozone is reformed in such a way that it becomes a mechanism for convergence rather than divergence. This is the strategy being successfully pursued by Poland and the Czech Republic. Others would be wise to follow suit.

Simon Tilford is deputy director at the Centre for European Reform.

Wednesday, June 25, 2014

Russia’s gas deal with China: Business is business

Does Russia’s agreement to sell China gas worth $400 billion (€294 billion) over the next 30 years foreshadow a Sino-Russian special relationship, and a geopolitical earthquake that could threaten European gas imports from Russia? Or has Russian president Vladimir Putin mortgaged Russia’s future to China’s goodwill? Gazprom CEO Aleksei Miller called it an “epoch-making event”, but former Russian deputy minister of energy Vladimir Milov said the terms of the deal are “an insulting lesson for Putin”. Two things seem certain: the China deal will give renewed impetus to EU efforts to reduce gas dependency on Russia; and the biggest winners from the contracts signed during Putin’s visit to China on May 20th-21st will be his friends in the energy and construction sectors.

For China, the deal brings mostly advantages. To help tackle its huge pollution problem, China wants to burn more gas and less coal. It also needs to meet growing energy demand. China’s current gas consumption is forecast to more than double by 2020; from 170 billion cubic meters (bcm) to more than 400 bcm. Beijing is developing significant domestic shale gas reserves (BP expects these to supply 22 per cent of total Chinese demand by 2030), but this will not be enough. So China must rely more on imports. It is investing in liquefied natural gas (LNG) terminals (nine are under construction or have been approved), building new pipelines across Central Asia and eyeing offshore fields in contested areas of the South and East China Seas. If international sanctions on Iran are lifted, China will also be first in line to sign gas contracts with Tehran (Iran has the second largest natural gas reserves in the world – after Russia). Russia has now agreed to supply almost 10 per cent of Chinese demand from 2018, and could increase this later to around 15 per cent.

China has driven a hard bargain. It negotiated with Russia for more than ten years before getting the deal it wanted. The exact price remains a commercial secret, but Russian energy minister Aleksandr Novak said that $350 per thousand cubic metres was “close to” the figure. This is below the European average ($380) and well below the average price in East Asia: Japan currently pays $538 for its LNG. The price is above the $280 per thousand cubic metres which China pays for Turkmen gas. But given the pipelines and other infrastructure that still need to be built, and in comparison with Japan’s soaring gas bills, China has negotiated a hefty discount.

On the negative side for China, gas will not flow for at least four years. Meanwhile, China has agreed to pre-pay $25 billion to help fund construction of the pipeline in Russia. Beijing has also accepted a gas price linked to the oil price. This link is being broken elsewhere by downward pressure on global gas prices as a result of increased LNG availability (due to the US shale gas revolution and new production in East Africa, Indonesia and Australia). So Beijing could possibly have held out for an even better deal.

For the Russian government, the pluses and minuses are more finely balanced. On the one hand, Gazprom diversifies its clients: currently 76 per cent of its gas is sold to EU member-states, many of whose economies are still smaller than before the financial crisis. Since the contract with China involves exploiting relatively undeveloped fields, the state-owned company will increase its total production and revenue. It will now have a long-term contract with a rapidly growing economy; and the pipeline will give it scope to export to other parts of East Asia over time. It is a “take or pay” contract (of the kind which the EU is trying to outlaw) so Russia would not lose revenue even in the unlikely event that Beijing no longer wanted or needed to take the contracted amount of Russian gas.

The up-front payment from China will partially offset the costs to Russia of new infrastructure required for the deal. Moscow may also feel that having China as a customer gives Russia more leverage vis-à-vis European customers because of the additional revenue, although Europe will remain by far the biggest importer of Russian gas for the foreseeable future.

On the other hand, the deal is expensive for Moscow. It involves developing two new fields, Chayanda and Kovykta, and building a 4,000 km pipeline through difficult, seismically active terrain to China, at a total cost of $55 billion. By contrast, the costs of field development and existing pipelines to Europe were written off long ago. At a conference on energy strategy on June 4th, Putin said that the state might recapitalise Gazprom to cover its investment in the China deal, using Russia’s gold or foreign exchange reserves, or its wealth fund. This fund is supposedly intended to fill shortfalls in the national pension fund, which is already in deficit. Using the wealth fund to help Gazprom would significantly worsen Russia’s problem of unfunded pension liabilities. To compound this, the Russian finance minister, Anton Siluanov, said that Russia might consider exempting gas for China from the mineral extraction tax, which would cost the Russian treasury around $450 million a year.

Overall, Gazprom may not be able to make a profit from the deal; particularly if increasing availability of alternative gas supplies forces it to lower its prices at some stage (as it has had to do with some of its European contracts). Russia has always had the upper hand in its dealings with European countries, because the pre-existing pipeline system and lack of investment in bringing gas from elsewhere to European markets left Russia as a de facto monopoly supplier to some eastern European countries. But this is now changing: a number of EU member-states have been able to negotiate price reductions from Gazprom by investing in alternatives. Lithuania, for instance, negotiated a 20 per cent reduction in May 2014 following its decision to build an LNG terminal on the Baltic coast. With China, Russia could face a monopsony: in the short term, China is likely to be the sole purchaser for gas from Kovykta and Chayanda, but will have a range of other suppliers, from Turkmenistan to Australia, as well as growing domestic gas production – useful levers if world gas prices fall and Beijing wants to get a better price from Russia. China will be a tougher customer to bargain with than many EU member-states.

For the EU, this deal – coming on the heels of Russia’s Crimea annexation and European sanctions – has reinforced the fear that Russia may ‘turn off the taps’ and divert gas to China to punish Europe. This seems unlikely, given Russia’s financial needs and its interest in maintaining the trust of international capital markets. A politically-motivated cut in gas supplies to Europe (as opposed to Ukraine) would tarnish Russia’s image as a reliable partner. Still, European consumers may be the victims of the escalating gas dispute between Russia and Ukraine; one-third of European gas imports transit Ukraine.

The EU should therefore treat both the Ukraine crisis and the China deal as opportunities to stimulate debate on Europe’s energy security and take steps to wean itself off over-reliance on Russia. At present, six EU countries rely completely on Russia for their gas imports. The EU should act vigorously to shield these member-states from the effects of possible Russian supply cuts, by making it easier to move gas around Europe through bi-directional interconnector pipelines, developing more LNG terminals and importing more gas from non-Russian sources. The Commission has already identified projects to fund in pursuit of these objectives. The EU should further liberalise the European gas market through effective enforcement by the Commission of existing rules on unbundling ownership of production, transmission and retail energy operations; and it should encourage energy efficiency and the development of new energy sources.

One question under consideration is whether the EU should take up Polish Prime Minister Donald Tusk’s suggestion that the EU set up an “Energy Union”, including by creating a single purchaser of gas. Although in theory this would increase Europe’s bargaining power, the Polish proposal is unlikely to be accepted in full: the EU would struggle to predict accurately the energy needs of 28 states for years to come; and many states would be wary of giving the Commission the power to negotiate gas contracts on their behalf. But some elements of the Tusk proposal make a lot of sense: if there was full transparency about the deals European companies make with Gazprom, there would be more opportunity for the Commission to act against market-distorting behaviour, and less chance for Russia to divide and rule in the EU. The Commission has also said that it will consider permitting voluntary collective negotiation of gas contracts by interested countries, which would strengthen the purchasing leverage of those currently most vulnerable to pressure from Gazprom.

For one European country, perhaps, the Russia-China gas deal may be worrying. Russian supplies to China will be nearly equivalent to the amount of gas it sells to Ukraine; 38 bcm and 30 bcm per year respectively. Gazprom cut gas exports to Ukraine on June 16th in a dispute over payment arrears, in parallel with Russia’s efforts to destabilise the country. Together with the South Stream pipeline, which would bring Russian gas to Europe without transiting Ukraine, the deal with China would ultimately allow Moscow to leave Ukraine in the cold without greatly affecting Gazprom’s revenue. But this assumes that by 2018 relations with Ukraine are still as bad as today; and that South Stream gets a green light from the Commission, which is currently uncertain. Under pressure from the Commission, Bulgaria has suspended work on its section of South Stream, but during Putin’s visit to Vienna on June 23rd Austria rejected EU criticism and signed a contract with Russia for construction of the Austrian section of the pipeline.

So what is the geostrategic significance of the deal with China? A Russian-Chinese naval exercise took place during Putin’s visit, suggesting the possibility of closer security ties between Moscow and Beijing. But neither military co-operation nor gas supplies will be enough automatically to create a Sino-Russian ‘special relationship’. While the two countries work together in the UN and relations are generally cordial, there are too many divergent interests for them to become brothers-in-arms. Bilaterally, there is still mistrust in Moscow about China’s influence and long-term goals in the Russian Far East. Russia is also concerned about China’s forays into Central Asia, which Moscow still considers as part of its traditional backyard; the Russian-led Eurasian Economic Union could hinder China’s trade with the region. In China’s backyard, on the other hand, Russia is building closer ties with Vietnam to gain access to the naval port in Cam Ranh Bay at a time when Chinese-Vietnamese tensions are increasing over energy resources in waters claimed by both sides.

Another sign that the deal is less than a geopolitical game-changer is the currency in which the deal will be settled. Fearing further Western sanctions, Russian firms want to move to renminbi-based contracts; instead, at least initially, the gas deal will operate in US dollars and thus not threaten the global position of the greenback (though it is unclear whether the contract allows for a switch of currency in the future).

Finally, one group of people who are likely to benefit, not only from the Gazprom contract with China, but from the many other deals signed during Putin’s visit, are his friends. Someone has to build a 4,000 kilometre pipeline in Russia, and two of the main options are Stroygazmontazh, described by Russian media as Gazprom’s largest contractor and owned by Arkady and Boris Rotenberg, who are both subject to US sanctions; and Stroytransgaz, controlled by Gennadiy Timchenko (also subject to US sanctions). Timchenko is also a major shareholder in several more companies which signed lucrative contracts with China during Putin’s visit.

For China the gas contract looks like a business deal, pure and simple. For the oligarchs involved, it does too. Not for the first time, those close to Putin are likely to do well by doing good for the Motherland.

Ian Bond is director of foreign policy and Rem Korteweg is senior research fellow at the Centre for European Reform.

Monday, June 23, 2014

Why the push to install Juncker is so damaging

If Jean-Claude Juncker is crowned president of the European Commission, it will be a major blow to David Cameron. Britain’s prime minister made a mistake in drawing a red line over the appointment of a federalist politician from a tiny country, who shows little understanding of the crisis of legitimacy facing the EU. But the German (and to a lesser extent) French newspapers have been full of anti-Cameron rhetoric, arguing that this is the latest in a series of British attempts to stymie EU integration; Cameron is beholden to eurosceptics on his right, who cannot be allowed to control the pace of that integration. This is wrongheaded and hypocritical. The battle for Juncker is not a principled fight in defence of democratic accountability, but a combination of power grab by the European Parliament and power-broking by national governments.

Britain is not the one spoiling the federalist party. Cameron and his finance minister, George Osborne, have repeatedly said that the eurozone needs to become more of a federation. They have not tried to stop the eurozone from mutualising more debt or creating a system of transfers between its member-states – both of which would make the currency union more stable. The eurozone member-states themselves decided to carry on with a fiscally decentralised currency union and technocratic central governance without real democratic legitimacy. This is because creditor countries refused to provide the credit needed to make such a system work, and neither they nor debtor countries were willing to accede to the political union that would be needed to run it.

Cameron’s strategic error was more modest: he and his advisors imagined that the process of eurozone integration would be faster than has proved to be the case, and they hoped that, along the way, they could negotiate some reforms of the EU that would make the EU more palatable to British voters. In recent months, they have lowered their ambitions from a broad renegotiation of Britain’s membership to more modest reforms. In his March 16th article in the Sunday Telegraph, Cameron listed his reforms: less red tape; more free trade deals; a longer period before migrants could claim benefits; the removal of “ever closer union” from the EU treaties; and more powers for national parliaments to block EU rules. This is hardly Europe à la carte, or the fundamental transformation of the EU that Cameron and his spokespeople argue it is. This is precisely because they realise that Britain is marginalised, and in no position to dictate terms.

Cameron’s proposed reforms are not in any way inimical to the interests of the eurozone: they are minor tweaks that would allow him to say that he has made the EU more open and liberal. They would have negligible effects on European economic growth – unlike a better system of eurozone governance, which Britain is no obstacle to. Britain shares next to no blame for the economic and political crisis in the EU; responsibility for this lies in the eurozone. Indeed, Britain is one of the innocent bystanders – chronically weak demand in its biggest export market is a major problem for the UK economy. The mishandling of the eurozone crisis has also made it much harder for the British government to counter eurosceptic arguments. And now Britain is unable to influence decisions that have profound implications for the country because those decisions are now the product of trade-offs within the currency union.

Britain’s European strategy is not uniquely driven by its domestic political constraints. Similar calculations are made in all member-states. If German Chancellor, Angela Merkel, does indeed back Juncker it will not be because she considers him the best man for the job, or because she believes that it is the democratic thing to do. It will be because it will create fissures in her grand coalition and draw criticism from the country’s media if she does not. Her coalition partner, the centre-left SPD, meanwhile, is angling for a senior appointment for their European leader, Martin Schulz, in return for backing Juncker. The Socialists in the European Parliament are backing Juncker in an effort to expand the powers of the Parliament. If they were properly accountable they would be concentrating their efforts on fighting for policies their voters favour. Such motivations notwithstanding, the majority of German media and punditry has portrayed the issue as a battle for European integration and democracy against British nationalism, which is absurd.

Merkel’s vacillation over the issue – initially signalling understanding for Cameron’s position and then coming down strongly behind Juncker – may be a sound tactical move in terms of Germany’s domestic politics, but it is bad European politics. Matteo Renzi, the Italian prime minister, is considering signing up to Juncker’s candidacy in the hope that Italy will be allowed to relax austerity. And Juncker is very popular among the smaller countries in the EU because he has been an outspoken advocate of their rights. Some of the small member-states that act as tax havens are keen on him because his home country Luxembourg is a tax haven and Juncker’s federalism does not stretch to clamping down on tax avoidance. None of them are driven by purer, more European motives than the British. Neither is the British public uniquely eurosceptic. Euroscepticism is rising across the EU, especially in France, the Netherlands and among the Nordic countries. For example, confidence in the European Parliament in many member-states is no higher than in the UK. And if the appointment of Juncker had the same toxic connotations in any of these countries as it does in Britain, they would have worked equally hard to thwart his appointment.

The key point about this affair is not whether Cameron’s strategy has been a good one (it has not). The most important aspect is that it has given a brutal demonstration of where power lies in Europe. The message to British politicians is that EU member-states – even those fellow reformers such as the Netherlands and Sweden – would rather risk pushing Britain out of the EU than cause some temporary problems for Merkel. Merkel, in turn, would rather risk making Cameron’s position untenable than temporarily upset her coalition partner or the German media. The UK is not alone in its self-interest, but simply much less adept at cloaking it in pro-European language. If it does end up leaving the EU, the blame will not be Britain’s alone.

The appointment of Juncker would be the wrong way for the EU to respond to the strong showing of eurosceptics and populists at last May’s European Parliament election. It suggests that governments are not listening to their electorates’ concerns, and risks further undermining already very low popular confidence in the Parliament (turnout at the recent election was up just 0.1 per cent on the all-time low of four years ago). If Europe is to address these concerns, governments will have to accept that the current state of affairs is unsustainable. An opportunistic power grab by the Parliament followed by opaque bargaining between governments resulting in the appointment of a Brussels fixer will erode the legitimacy of the EU, not bolster it. Finally, the prospect of exorcising the UK from the EU may feel good to some governments and commentators, but it won’t make it any easier to address Europe’s problems.

Simon Tilford is deputy director and John Springford is senior research fellow at the Centre for European Reform.

Friday, June 13, 2014

More investment, for Germany’s sake

Germany, the biggest economy in Europe and, more importantly, in the eurozone, is being urged to invest more at home. Those that support greater investment argue that it would help to spur a faster recovery in the eurozone and reduce the German current account surplus – lines of argument  that meet resistance from the German public and the country’s policy circles. After all, many Germans feel (rightly or wrongly) that they have done enough for Europe. Luckily, the case for German investment can be based entirely on narrow self-interest: for the sake of its future prosperity, Germany needs to invest more, regardless of whether that helps the rest of the eurozone. Why is Germany not investing more, then? The answer is, as so often, political. But there could be a way to convince the German government to do what is best for Germany – and ultimately for Europe, too.
German investment has been falling steadily over the past two decades, from around 21 per cent of its GDP in the late 1990s to just above 17 per cent now (see chart one). The biggest drop came after 2000, when the German economy slid into a period of low growth and high public deficits. This led both private and public investment to fall: private investment for lack of profitable opportunities, and public investment because of eurozone budgetary constraints.

Chart one: Gross investment as a share of GDP
Source: European Commission / Haver Analytics

By international comparison, this is a low number: The EU15 (roughly the eurozone plus the UK) invested around 20 per cent of GDP in the run-up to crisis. Because of the severe recession in many EU15 countries, this has recently fallen to German levels (but notably not below). Investment in the US and Switzerland has been even higher. But such overall investment figures can only provide a rough guide: they contain construction and equipment, both private and public, each of which needs to be analysed. In addition, intangible investment such as software, R&D and organisational know-how is not included.

Breaking German investment down into its constituent parts reveals that the fall in construction is mostly responsible for the decline in aggregate investment; investment in machinery and equipment has only decreased slightly (see chart two). So does that suggest that German investment is fine? After all, construction investment has not been the wisest use of savings in countries like Spain or Ireland – where much of the money invested was in fact German.

Chart two: German gross investment by type as a share of GDP

Source: European Commission / Haver Analytics

However, by international standards, investment in equipment is also low. While Germany compares well to the US or the EU15 average (see chart three), its real peer group – countries with similarly large manufacturing sectors – invest considerably more: Germany’s manufacturing value added accounts for 22 per cent of GDP, compared to just 10 per cent in France or the UK, and 13 per cent in the US. The relevant comparison group – Japan, Switzerland and Austria with manufacturing sectors contributing similarly to GDP – invest between 1.5 and 4 percentage points of GDP more than Germany in equipment.

Chart three: Gross investment in equipment as a share of GDP

Source: European Commission / Haver Analytics

This investment gap is not compensated for by intangible investment either. On the contrary, such investment in software, R&D and organisational know-how is low compared to countries like the US that have similar levels of investment in equipment. Germany invests more than 5 percentage points of GDP less than the US, and 2.5 percentage points less than the UK or Sweden. Considering both equipment and intangible investment combined, Germany clearly invests too little.

Chart four: Intangible investment as a share of GDP

Source: Carol Corrado, Jonathan Haskel, Cecilia Jona-Lasinio and Massimiliano Iommi (2012) "Intangible Capital and Growth in Advanced Economies: Measurement Methods and Comparative Results" and the associated database; European Commission / Haver Analytics
Public spending on education is not usually considered to be investment. And yet it is clear that, from an economic point of view, education spending is mostly investment in human capital and should be included in investment totals. By international comparison, German public investment in education is very low as a share of GDP. And while the greater number of young people in France, the UK and Sweden explains part of the difference, the difference with Switzerland cannot be explained by demographics; the difference between Germany and Sweden is simply too large to be fully explained by demographic differences, and has been for long.

Chart five: General government expenditure on education as a share of GDP

Source: European Commission / Haver Analytics

Finally, public investment in construction and equipment is also very low – it is actually negative once depreciation is factored in. After all, public capital deteriorates just like private capital: roads get potholes and school equipment breaks. After deducting depreciation of the existing capital, Germany has been investing less than zero in its public infrastructure and equipment for a decade. In essence, Germany has been running down its public capital stock.

Chart six: Net public investment as a share of GDP

Source: European Commission / Haver Analytics

All this leads to the conclusion that Germany has not been investing enough: not in equipment, given its large manufacturing sector, not in R&D and other intangible assets to grow new sectors, not in education or in public infrastructure. This is particularly worrying as the German population is aging quickly, with the median age already close to 47 (up from 40 in 1999) – a high number if compared to Sweden (41.2), the UK (40.4) or the US (37.6). An ageing society needs to invest domestically to make its workers more productive, because these workers will need to support pensioners in the future. Productivity growth is especially important in Germany because its pension system is largely ‘pay-as-you-go’: the young pay for the old. If people had private pensions, in which they built up pension pots for their own use, these could be invested abroad, which would make domestic productivity less of an issue.

What is more, Germany is saving much more than it invests, the result of which is a massive current account surplus of 7 per cent of GDP. Whatever Germany saves beyond what it invests domestically will be invested abroad. But the German banking system, through which most of these savings are intermediated, has not been able to invest this surplus productively. In fact, Germany has lost around €400 billion on its investment abroad since 1999, according to calculations by the German Institute for Economic Research (DIW). In Germany, their research shows, the return on investment – measured by the economic growth per unit of investment – was among the highest in the world over that period of time.

There are essentially two ways for policy-makers in Germany to increase investment. One is to encourage private investment through policies such as predictable energy policies or further liberalisation of services markets, both of which would help. But the biggest impact the government could make is to increase public investment, for a very simple reason: Germany can currently borrow money essentially for free. Interest rates on 10 year government bonds are around 1.4 per cent, which is likely to be below the average inflation rate over the next ten years. This implies that the German government is paid (in real terms) to borrow: the real interest rate is negative. Bonds that mature in 30 years yield 2.3 per cent and hence barely more than the probable inflation over that period of time.

Given that the case for more public investment in Germany is so strong, why is the German government not investing more? There are three reasons. First, the German economy is growing relatively rapidly; the Bundesbank recently upgraded the outlook for 2014 and 2015 to 1.9 and 2 per cent respectively. Germany has little, if any, underutilised capacity and such growth figures are a good deal above Germany’s potential growth, that is, the underlying growth rate around which economies fluctuate. This means that there is currently little need for public investment to stimulate the economy further, from a business cycle perspective. In fact, given that the European Central Bank (ECB) needs to keep rates low to help the rest of the eurozone, there is a danger the German economy might overheat. However, German inflation (a key indicator for a boom) is not projected to rise beyond 2 per cent until 2016, according to Bundesbank estimates. What is more, the risks for the eurozone economy are “to the downside”, as Mario Draghi likes to point out, such that additional public investment would serve as an insurance against a renewed eurozone downturn.

Second, the German constitution contains a fiscal rule known as the ‘debt brake’ that, after a transition period, comes into full effect in 2016. It mandates that the structural balance – the budget balance after the effects of the business cycle have been taken into account – does not exceed 0.35 per cent of GDP. This in effect excludes debt-financed public investment in Germany in the future – a questionable rule to begin with, given the arguments above. However, until 2016 at least, the government has room to go beyond the 0.35 per cent limit and should use this fiscal space. According to KfW, a German state-owned bank, the German government could invest €100 billion more over the next five years (which equals roughly 3.5 per cent of current GDP) without violating the transitional rules of the ‘debt brake’.

Finally, the most important reason why public investment is low is that fiscal consolidation is politically more appealing in Germany than investment: after decades of belt-tightening and fears of ever increasing public debt, a balanced budget is seen as a big accomplishment. This is why the coalition agreement between the two governing parties contains a balanced budget pledge that goes beyond the constitutional debt brake and aims for a faster fiscal consolidation. Unravelling this pledge now, the argument goes, would open a Pandora’s box of government consumption demands and hence not increase investment. Therefore, it is best to keep the lid on it, despite the beneficial effects of more public investment.

The only way to convince the German government to invest more is to emphasize Germany’s gains from such investment rather than Europe’s; to make sure it is politically more profitable than fiscal consolidation; and to ensure that the added fiscal spending really does go into investment rather than public consumption, and preferably sooner rather than later.

One proposal that fulfils all three criteria could lie with German municipalities. First, they are responsible for roughly two thirds of German public investment. Second, they are heavily indebted, some are essentially insolvent, and need help. And third, they are the main stumbling block for dismantling Germany’s local business tax (Gewerbesteuer) – a tax that generates volatile revenues for municipalities; that is uneven both between municipalities and between firms of different types and sizes; and that complicates the German corporate tax system unduly. Wolfgang Schäuble, the German finance minister, has in the past attempted (but failed) to reform municipal finances and to dismantle the Gewerbesteuer. He could offer the municipalities a grand bargain: €133 billion – the total debt of German local governments – in debt relief and investment funding for municipalities in return for a comprehensive reform of municipal finances.

The political benefits of such a deal would be significant and arguably higher than those of fiscal consolidation: removing the municipal business tax is the holy grail of German tax reformers, and municipal spending is an important issue for the public; additional funds would be spend on investment rather than consumption; and the benefits of such investment would accrue visibly to the German public rather than to other European countries. But whatever the details of a deal, convincing the German government to invest more will not be easy.

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

Tuesday, June 03, 2014

Presidential candidates, European federalism and Charles Grant

In a recent CER insight Charles Grant offers a number of criticisms of themes in my book, ‘Turbulent and Mighty Continent: What Future for Europe?’ My basic thesis in the part of the work he criticises is simple. The coming of the euro has created de facto economic federalism at the core of the EU. The eurozone countries have become irrevocably interdependent. New forms of collective economic management simply have to be set up to manage that interdependence – and to cope with the strains and conflicts it has produced. The Union is so far only in the early stages of that process, which will have to involve fiscal mechanisms, and not only a banking union.

Economic federalism, I go on to argue, is not possible in the longer term without political federalism – in some form or other – because otherwise it has no effective legitimacy. The euro may have been set up in the usual EU fashion, as a back-stage deal between a few major states, but the consequence has been to undermine that very way of doing things. The traditional problems of the EU – lack of democratic involvement of the citizenry, and the absence of legitimate political leadership – can no longer be simply swept aside or disregarded. The surge of support for populist parties has its origin in this new situation.

Grant has several objections to this analysis. He doesn’t like talk of federalism, because it means ‘more Europe’. This isn’t something he wants, nor is it supported by the bulk of the electorate. He is not a fan of the European Parliament and he thinks the involvement of that body in the choice of a new president of the Commission is a mistake (he has made this point in a recent CER insight). Grant wishes to stick with the existing inter-governmental system, in which as he puts it, ‘the member-states (who in practice tend to be led by the big ones) should set the agenda and take key decisions.’

‘Politics in Europe’, he says, ‘remains largely national’. ‘Variable geometry’ (the principle that groups of member-states can integrate in particular policy areas, without the involvement of all 28) is the order of the day. Reform should be confined to such strategies as the greater involvement of national parliaments in decisions of European consequence. The euro, he continues, can survive and even prosper with the limited policies that have already been put in place. The antagonisms between North and South can be dealt with by relaxing austerity, encouraging economic reform and the writing off of a certain amount of debt. What Grant offers is more or less a business-as-usual scenario, give or take a bit of tweaking.

I find this analysis deeply unconvincing. The combination and the financial crisis and the travails of the euro have already transformed the political situation in Europe. Tinkering with the status quo is not going to resolve the issues that have to be faced up to. Such an approach recognises neither the scale of the problems to be resolved, nor the emerging forces that have irretrievably altered the political landscape. Largely because of the depth of its difficulties, the EU has become what I call in my book a community of fate. This is signaled by the fact that the EU is in the news almost every day in a way it never was previously – even in that most un-European of European countries, the UK. The challenge for pro-Europeans is to change that negatively charged consciousness into a positive one.

The recent European elections are the first to have been fought in some substantial part on European rather than strictly national issues. The populist parties that have arisen are mostly hostile to the EU and some want to see the end of it altogether. Some have noxious or wholly impractical ideas, or a mixture of the two. In an odd way, however, these parties are doing pro-Europeans a favour – at least if we respond in the right ways. They are helping to create a pan-European political space. Moreover, at least some of the basic issues the populists have forced onto the agenda are all too real. The system Grant seems to approve of – decisions taken by a few large states behind closed doors – is in fact a core part of the EU’s lack of accountability.

The leading candidate from the European Parliament to be the next head of the Commission, Jean-Claude Juncker, has been widely derided as colourless and a member of the establishment. Yet his name is in the frame as a result of a democratic process. If he is rejected as a result of horse-trading behind closed doors, the EU will be reverting to some of its worst traits.

Whatever happens, the involvement of the Parliament in such decisions is clearly no more than a beginning. If the EU is to achieve renewed stability, pro-Europeans simply must think more radically, just as the populists do. I want to see a lot of reform, even if it will take an extended period of time and, yes, ultimately treaty change, to achieve. I want an EU that is more open, democratic and flexible, as well as quick-acting in responding to a world of massive change. Federalism to me is more or less the opposite of what Grant takes it to mean. It is not about the centralisation of power but about finding a balance between effective leadership and democratic accountability. A new system of governance could and should be far more streamlined than the cumbersome and arcane set of practices that exist at the moment.

The eurozone countries should act as an avant-garde, since they can make significant innovations without treaty change. The work of stabilizing the eurozone is far from done – the euro remains vulnerable. For that reason, unlike Grant, I am sympathetic to the programme of far-reaching further reform set out by the Glienicker Group in Germany. As the Group observes, “Europe has structural problems that require structural solutions”. Contrary to what Grant says, there won’t be a great deal of scope for variable geometry, at least in sheer economic terms. I do not in fact argue, as he claims, “that most of the ten EU countries not in the euro will join it soon”. However, the majority of them are in line to sign up at some point and this expectation will inevitably shape their economic policy in a convergent direction.

A battle for the future of Europe will be fought over the next few years. To me the new narrative for the EU among pro-Europeans should be about maximising the benefits of intensifying global interdependence – which, short of catastrophe, is unstoppable – while muting its risks and dangers. I don’t accept that creating a more democratic, cohesive and effective Union means further sacrifices of national sovereignty. The picture is much more complex than this. One cannot give up something that has already been largely lost. Even when acting alone, member-states gain more sovereignty – real power to shape the world – by being part of the EU than they could ever hope to achieve as a disorganised gaggle of separate countries. To be effective in everyday politics, of course, these lofty thoughts must be brought down to earth and integrated with citizens’ concerns, hopes and fears. As the battle to reshape the Union unfolds, let’s take on the arguments of the populists in a direct way. Let’s do so by means of reason and the judicious marshalling of evidence; but let’s throw in a dose of passion too.

Anthony Giddens is a former director of the London School of Economics, a Labour peer and the author of ‘Turbulent and Mighty Continent: What Future for Europe?’.