Friday, March 11, 2016

Time for a regime change in Frankfurt

In recent years, the European Central Bank’s (ECB) monetary policy has been half of what is necessary, two years late. To get eurozone inflation back to its ‘close to 2 per cent’ target, the ECB needs to be much bolder.
The ECB’s meeting on March 10th is shaping up to be one of its most anticipated. Inflation remains far below target and market expectations of future inflation have hardened at very low levels, indicating that investors have lost confidence in the ECB’s ability to fulfil its mandate. The eurozone’s anaemic economic recovery is faltering, which will put further downward pressure on prices, while the weakening world economy will not provide the external stimulus that the ECB hoped for. The central bank needs to be bold and make it clear it will do everything required to raise inflation. Unfortunately, it is likely to err on side of caution, as it has in the past, damaging eurozone growth prospects and calling into question the sustainability of many member-states’ debt burdens.

The eurozone is not alone among developed economies in experiencing a structural growth slowdown in the rate of economic growth or in grappling with excessively low inflation (see Chart 1). But the currency union does have an especially acute structural growth problem: it has only just recovered its pre-crisis size, a far worse performance than other developed economies, including Japan. The eurozone had hoped to piggy-back on strong global demand, but this source of cyclical stimulus is drying up as growth in the global economy weakens and the value of world trade shrinks. The ECB had also hoped that the euro would weaken sufficiently to raise inflation by boosting import prices. But the euro is stronger than the ECB would like, as the prospect of interest rate rises has receded in the US and UK, reducing the attractiveness of the dollar and sterling. And growth in emerging markets has slowed, putting their currencies under pressure.

Chart 1: Headline and core inflation in the Eurozone
Note: Core inflation measures consumer price inflation (HICP) without energy and unprocessed food, two very volatile (and in the case of energy, globally-determined) prices.

Weak economic growth is not the only reason for very low inflation in the eurozone. This also reflects the steep fall in oil and other commodity prices, but even stripping out these effects, inflation is far too low: core inflation, which excludes energy and food prices, has been stable at around below 1 per cent (and hence at around half the ECB’s inflation target) for more than two years (see chart). The persistent weakness of inflation is being reflected in lower wage settlements, raising the prospect of a vicious cycle of weak wage growth begetting low inflation and in turn low expectations of future inflation.

The ECB shares quite a bit of the blame for this daunting state of affairs. It has persistently been too optimistic about the outlook for eurozone growth and hence the outlook for inflation. As a result, it was too slow to cut interest rates, and allowed speculation that they could rise at any point. The central bank did eventually launch a major programme of quantitative easing (QE) involving the purchase of a huge quantity of government debt. In the process, it kept a lid on government borrowing costs. But this has not shifted expectations of future inflation, partly because investors are unconvinced that the bank will not reverse monetary stimulus by selling government bonds as soon as inflation picks up a bit. In short, investors do not believe the ECB will do everything possible to meet its inflation target.

The ECB is not entirely to blame for excessively low inflation: the eurozone requires a big fiscal expansion as well as monetary stimulus. Governments should be exploiting unprecedentedly low borrowing costs to step up public investment, boosting demand and growth potential. However, the ECB has consistently argued against fiscal expansion, at least in the absence of a fiscal union. The central bank has moderated its position a little recently, arguing for ‘growth-friendly’ fiscal consolidation, and some board members have even argued that countries with fiscal space to boost spending should use it. But it is opposed to a major eurozone fiscal stimulus.

The ECB has three measures at its disposal to boost growth and inflation. The first is to use the policies it is deploying – the ECB’s main interest rates and QE – more aggressively. For example, it could lower the rate at which banks deposit their reserves at the central bank further into negative territory, from currently -0.3 per cent to -0.75 per cent (the rate prevailing in Switzerland) or even -1.25 per cent (as in Sweden). The ECB could also apply negative interest rates to the loans it extends to banks; the current rate stands at 0.05 per cent. Switzerland and Sweden have already pushed these rates below zero.

Such negative rates would make it less attractive to hold euros and assets denominated in euros. This, in turn, should weaken the single currency –helping eurozone exporters – and drive up inflation. If banks passed on their lower cost of funding to businesses, business investment would become cheaper to finance. Negative interest rates are controversial: they could increase pressure on European banks, which may be reluctant to charge customers for making deposits with them. However, forcing banks to put pressure on large depositors to put their money to better use is welcome. And experience from other countries shows that banks pass on part of their lower rates to customers.

The ECB’s second option is to expand its QE programme (currently €60 billion monthly); broaden its scope to include corporate bonds, bank bonds or even equities; and make it longer – it is due to end in March 2017. The aim of the programme is to lower government funding costs to allow looser fiscal policy, and to lower longer-term interest rates, and hence the cost of borrowing for  businesses.
But neither negative rates nor more QE will lift inflation and growth if the ECB does not concurrently change expectations about the future course of monetary policy. Low interest rates alone will not lead to more investment if investors expect economic activity and hence inflation to remain weak. Inflation will rise only if consumers and investors expect that income and output will rise. The ECB needs to convince investors that it will allow inflation to overshoot the 2 per cent target for a while to make up for the period when it failed to meet its target.
How can the ECB – a conservative central bank – credibly commit to be ‘irresponsible’? It needs to engineer a regime change in monetary policy-making. Two steps are necessary. First, the ECB needs to come clean about its failure to act in a timely and bold enough fashion in the past. The ECB cannot credibly claim to investors, banks and consumers that it has changed unless it puts its past behind it.
Second, the ECB needs to make the overshooting of inflation central to its target. Currently, the ECB targets the rate of change in inflation over the medium term. A period of below-target inflation does not automatically lead the ECB to target higher inflation in order to make up for it. The ECB should commit to a price-level target, promising to reach 2 per cent on average over a rolling period of five years. A period of lower inflation would automatically require higher inflation in the future.

Would a regime change to shift expectations, negative rates and an expanded programme of QE succeed in bringing eurozone inflation back to target? Probably not. After all, the first piece of advice to a central bank in the ECB’s situation is: do not start from here. It is difficult to push a structurally weak economy of the size of the eurozone out of a cycle of low growth and low inflation, especially when external demand is too weak to generate any export-led growth.

The eurozone needs a major fiscal stimulus in order to boost consumption and investment, but eurozone governments are not about to agree on one. However, the ECB could go beyond what any central bank has so far contemplated doing, and hand out cash directly to citizens: so-called helicopter drops. This would almost certainly boost consumption, and help lift inflation. It would legally be difficult for the ECB to implement such a policy, but not impossible.

Alas, the ECB is only willing to consider small changes to rates and its QE programme. The most likely outcome of Thursday’s meeting is a gradual cut in the deposit rate, plus a limited extension of QE. When these measures fail to drive up inflation, there will be another gradual change in policy – but no regime change that is so crucial to changing expectations about the future path of inflation. The ECB will only consider helicopter drops once there is absolutely no alternative, and only then if all other major central banks have already tried them. As a result, the ECB will continue to fail in its duty to ensure an adequate level of inflation across the currency union.

Simon Tilford is deputy director and Christian Odendahl is chief economist at the Centre for European Reform.

Monday, February 29, 2016

The refugee crisis: Fixing Schengen is not enough

Solving the problems of the Schengen area will not stop Europe’s refugee crisis. This is a foreign policy crisis with domestic spill-over; it has to be solved abroad as well as at home.

In January, the European Commission gave Greece three months to improve its border controls, and process refugees and migrants more effectively, or face suspension from the borderless Schengen area. Border controls have been reinstated by six of the 26 Schengen states (Austria, France, Denmark, Germany, Norway and Sweden). Hungary built a fence last year to keep out migrants arriving from Serbia. EU ministers are discussing whether to suspend the Schengen arrangements for up to two years.

The EU is looking inwards for solutions to its problems when it should also be looking outwards. The refugee crisis is not merely the consequence of Schengen’s deficiencies. Governments are overwhelmed by the sheer numbers of immigrants, and even with better migration and border security policies they would struggle to control the multitudes making the short voyage from Turkey to the Greek islands. Once refugees make it to Greece’s territorial waters, they become Europe’s problem. 

There are certainly many economic migrants coming to Europe to seek their fortunes, but the majority of those travelling to the Greek islands and Italy over the past year have been genuine refugees.

The EU needs a new strategy to deal with the area beyond its borders to the south and south-east. The arc of countries from Turkey to Morocco should be part of Europe’s protection against the consequences of instability further afield, but is in fact contributing to the problems. The EU has to think afresh about how to reduce the flow of people before they reach the Mediterranean coast. If it only concentrates on making its external border controls more effective, it will be sticking its thumb in the garden hose instead of turning off the tap.
SyriaAccording to the UN refugee agency, 55 per cent of those arriving in Greece over the past 12 months have been Syrian refugees. They will not stop leaving Syria until the country begins to return to stability. That is a very distant prospect. Since the conflict started in 2011, EU member-states have been unable to agree on what to do, beyond backing UN efforts. They wanted Syrian president Bashar al-Assad replaced, but would not intervene decisively to force him out. They wanted the moderate opposition forces to succeed, but would not train and equip them militarily. They wanted Daesh defeated, but would not deploy ground forces to do that. They criticise Russian airstrikes but do nothing to deter them.

President Vladimir Putin of Russia has clearer objectives in Syria: to defeat the moderate opposition, and then to present the West with a choice between Assad and Daesh. That will result in the victory of Assad. Meanwhile Russian bombs continue to strike civilian targets including hospitals, leading to Western fears that Putin may be deliberately worsening the refugee crisis to contribute to the destabilisation of Europe. The fall of Aleppo – a stronghold of anti-Assad forces – could lead to hundreds of thousands more refugees.

Alternative futures look as bad: Saudi Arabia has threatened to send ground forces to Syria, while Turkey is increasingly being drawn into the conflict as it fights Kurdish militias. Will Ankara and Riyadh intervene more heavily to prevent Assad’s victory, or pursue more limited objectives? In either case, their involvement will not lead to quick solutions.

There are no good options in Syria. The conflict has already produced almost 12 million refugees and internally displaced persons (IDPs). The West could support a no-fly zone inside Syria, in which Syrians could live safely, as German Chancellor Angela Merkel suggested on February 15th. But such a step would now entail a military confrontation with Russia. However awful Russia’s bombing campaign, it seems clear that neither Europeans nor the US are ready to risk war to save Syrian civilians.

The least risky choice for the EU would be an enormous increase in its aid to Jordan, Lebanon and Turkey, making education and jobs available to refugees, enabling them to stay in the region for the long term. The London conference on supporting Syria and the region on February 4th pledged around €10 billion over the period to 2020 – around €160 per refugee or IDP per year. That is clearly inadequate. 

TurkeyIf Syrian refugees are to be stopped before they can reach Europe, Turkey’s role will be vital. In November, the EU reached an agreement with President Recep Tayyip Erdo─čan: in return for €3 billion to support refugee camps in Turkey, and commitments to move forward with visa liberalisation, Ankara is expected to contain the flow of people, and take back asylum seekers who arrive in Greece from Turkey. The problem is that the deal is not working; more than 2,000 people a day are making their way across the Aegean, despite the winter conditions. NATO has decided to mount patrols in the Aegean to track and deter people smugglers, though it is not yet clear how the operation will work or how it will link to EU efforts.

Politically, Turkey has the EU over a barrel: the overwhelming priority for the EU is to prevent refugees reaching Greece, and it is prepared to offer all sorts of inducements to Turkey to help (even though it is unclear whether Ankara is actually capable of shutting down the flow of people). Instead of focusing exclusively on the refugee camps, the EU should also pay for an EU-operated asylum processing centre in Turkey. That should select which people do, and which do not, have a legitimate basis to apply for refugee status in Europe, allowing the authorities to return failed asylum seekers to their home country. Those that qualify could then travel to the EU safely, without having to rely on people smugglers and avoid risking a perilous journey only to be turned away. The EU must also ensure that those asylum seekers awaiting a decision are kept in humane conditions. But this plan will come at a cost: the Turkish government may insist on concessions in the EU accession talks, which some member-states are reluctant to offer.

Libya If the problem of the Turkish route could be solved, that would still leave North Africa, and especially Libya. Before Syrians overwhelmed the Greek islands in 2015, most of the EU’s attention was focused on people crossing the Mediterranean from Libya. Though the numbers have declined from last summer, last month 6,000 migrants arrived in Italy; most embarked from Libya’s coast. Libya has no national government, few if any functioning institutions and a vast desert hinterland in which people smugglers can circulate freely.

As in Syria, the EU has hoped that the UN would find a political solution to the country’s problems; new national institutions could then control law and order and put an end to people smuggling. Although the UN-brokered Libyan Political Accord was signed on December 17th 2015, the government established to implement the accord remains confined to a hotel in neighbouring Tunisia. The growing presence of Daesh is also a challenge for Libya’s beleaguered authorities.

Once migrants set sail from Libya, they are the EU’s problem, de facto if not de jure. They cannot be pushed back to Libya; nor can they be left to die at sea if their ships sink. Last summer the EU launched the maritime mission now called ‘Operation Sophia’. Its objective is to stop migrant smuggling from Libya. Among other things, the EU wants to apprehend smugglers before their ships leave port. That phase has not yet started, but can only be successful if the EU has eyes and ears on the ground in Libya. With the consent of the legally-recognised (if ineffective) Libyan authorities, the EU should consider a civil-military mission, with sufficient air mobility and intelligence assets, to track and disrupt smuggling networks in Libya. This mission would undoubtedly be demanding; but the alternative is for the EU to continue providing a taxi service to Italy for those who cannot get there under their own power.

Further south still, as part of its work on a new security strategy, the EU needs to review how its development policies can contribute to stopping the flow of economic migrants and preventing people-smuggling from sub-Saharan Africa.

Schengen reformEven if the EU succeeds in cutting the numbers of refugees and irregular migrants reaching its territory, some will get in. As a forthcoming policy brief by Camino Mortera-Martinez will explain, the Schengen countries’ most pressing need is to reform the Dublin system governing asylum seekers. Under that system the first EU country the refugee enters is responsible for processing the asylum application. Greece and Italy have found it impossible to cope with the numbers of people arriving, and the system has allowed transit countries, such as Hungary, to take measures to stop asylum seekers travelling further north.

The ‘quota’ system adopted by the Council of Ministers in September sought to distribute asylum seekers across all Schengen countries. The system has failed so far, not least because the centres designed to process and relocate refugees (so-called ‘hotspots’ in Italy and Greece) are not functioning: some of them have not been built yet, and those that have are not yet dealing with migrants properly. Greece claims that it does not have the money or staff to make the centres work. The Commission and the member-states blame the Greek authorities for ‘serious shortcomings’ in the way Athens manages Schengen’s external borders. For the hotspots to function, all sides need to do more: Greek authorities should do a better job in staffing them, and work with Frontex ‒ the EU’s border agency ‒ and other member-states on the ground. Other member-states have only provided two-thirds of the 775 border guards requested by Frontex in October; they need to do more. The European Commission should provide more cash to build and equip the hotspots.

To increase pressure on Athens, the EU is now considering sealing the Greek border with Macedonia. The idea is to pile up refugees in Greece so that the situation becomes so serious that Greek authorities would have no option but to step up their game. The Commission also believes that doing so would leave other member-states no choice but to take in their promised share of refugees.
This is a dangerous idea: Greece’s febrile politics do not need inflaming, and no one factored in the cost of a migrant surge to last summer’s Greek bailout deal. It is also misguided: shutting the border with Macedonia would not disrupt smuggling networks. It would only change the routes they use. As long as there is a demand for people smuggling, organised crime will provide a supply.

Scapegoating Greece would also be hypocritical. Other governments are not living up to their commitments to relocate 160,000 asylum seekers: so far fewer than 0.4 per cent have been moved. Member-states must take in their share of refugees.

Schengen is under fire and is unfairly blamed for social tensions, alienation and even terrorism. Despite its imperfections, the borderless area within Europe is one of the great achievements of the EU. EU countries have become closer trading partners thanks to Schengen, and labour mobility has increased. For many European citizens, passport-free travel around the continent is one of the EU’s most important and recognisable accomplishments. It would be a great mistake for EU leaders to erect borders again, only to find that in solving nothing they jeopardise the EU’s future.

Ian Bond is director of foreign policy, Rem Korteweg is a senior research fellow and Camino Mortera-Martinez is a research fellow at the Centre for European Reform.

Deal done: Now for the hard work

David Cameron did better than expected at the marathon Brussels summit. But his package of reforms will sway few voters, so he must now make the case for the EU itself.

Once David Cameron had won the May 2015 general election, and announced an EU referendum before the end of 2017, he was always going to find it hard to fulfil his pledge to achieve significant reforms to the Union. The final phase of the British renegotiation proved particularly tortuous. But on the night of February 19th a deal emerged and there will now be a referendum on EU membership on June 23rd. Why did Cameron struggle to win major reforms? What are the most significant changes that he has achieved? And how should he try to win the referendum campaign?

The other 27 countries in the club are confronted by huge problems, notably the near-collapse of the borderless Schengen area and the continuation of serious economic problems in much of the eurozone. And then the British came along with a form of blackmail: they said that if they were not given a series of minor, mostly technical reforms, that were either not a priority for other countries or cut against their interests, the UK’s EU referendum could well be lost. This tactic has not exactly endeared Britain to its partners.

In 2013, when Cameron announced his plans for a renegotiation and a referendum, he believed that the other Europeans would need a new treaty to sort out the euro’s problems, and that would give the UK leverage to extract concessions. At the time the CER warned that there probably would not be a new treaty and we turned out to be right. The lack of treaty change has weakened Cameron’s hand. His only leverage has been that no government wants the British to leave – though some have been more willing than others to make an effort to help keep them in.

In the end Cameron had to fight extremely hard to achieve his reforms, many of which come in the form of a legally-binding decision of the heads of state and government. One reason why some leaders proved so unwilling to give the British what they wanted was the fear of contagion: if the British got a special deal on say, the words on ‘ever closer union’ or cuts to migrants’ benefits, others might ask for the same thing. Most leaders, like Cameron, had to contend with difficult domestic politics, which encouraged them to resist some of his demands. And at points in the negotiation leaders tried to bring in side-deals: for example the Greeks threatened to block the British package unless they were reassured that the EU would not close their border with Macedonia before a special summit on migration in March.

The sheer number of states in the EU makes it hard for compromises to be forged. So does the absence of serious leaders. Both Donald Tusk, the president of the European Council, and Jean-Claude Juncker, the Commission president, worked hard and with determination to help achieve a British deal. But neither has the stature or authority to browbeat prime ministers to compromise on national interests for the sake of satisfying the British.

The one national leader who is pre-eminent is Angela Merkel, the German chancellor, who for the past ten years has dominated EU summits. However, she is not the force she was. Her unilateral open-door policy towards refugees has weakened her at home and angered many other EU governments. Throughout the renegotiation she has sought to help David Cameron but a few years ago she would have had greater authority to cajole recalcitrant leaders into making quick compromises with the British.

Given all these difficulties, the details of the deal were very much at the upper end of what Cameron could have hoped to achieve. His biggest victory was two minor curbs to migrants’ access to benefits. The UK will be able to pull an ‘emergency brake’ to reduce in-work benefits, like tax credits and housing benefits, paid to future EU migrants. New migrants will not be able to claim such benefits from day one of residence, and the amount they receive will slowly grow over four years, after which they will be treated identically to a British worker. The British had originally demanded a complete ban on all in-work benefits for four years, but the EU’s lawyers said that this would too obviously violate the treaties’ principle of non-discrimination. This emergency brake will operate for seven years, not permanently, as Cameron had originally hoped.

There are still some risks to this reform: the European Parliament may quibble over the details, because establishing the brake requires EU legislation. And the brake is on the edge of what is legally permissible under the treaties, since workers of different countries will be treated differently. Cameron did not succeed in cementing this reform through a promise of future treaty change, so it will be open to challenge in the European Court of Justice. Officials in London and Brussels expect that at some point a case will be brought against this brake. But the fact that this reform has been blessed by the heads of state and government means that it is highly likely to endure.

The second benefit curb – to child benefits – is not the full ban on payments of child benefit to workers whose children live abroad that Cameron had desired. All member-states will be allowed to index child benefit payments to the standard of living in the member-state where the child lives. This will only apply to new migrants until 2020, when indexation can be extended to all migrants with children living elsewhere in the Union. But given the hostility of Central and Eastern European countries to this reform – they are especially unhappy that all Western European states can index the benefit, rather than just Britain – Cameron can chalk this up as a win. (This reform, like the benefits brake, will require EU legislation, as will a third, relatively uncontroversial change, which will constrain the ability of EU migrants to bring in spouses from non-EU countries.)

The UK did win a promise that two other reforms will be embedded in the treaties when they are next changed. First, if Britain or another non-euro country considers that new financial rules driven by eurozone countries could damage its interests (for example, in the City of London), it will be able to pull another sort of ‘emergency brake’ to force those rules to be debated by all 28 ministers in the Council of Ministers and subsequently, if necessary, by the heads of government. This is a delaying mechanism, not a veto – the French and German governments were determined that Britain should not be able to block whatever eurozone governments think they need to do to ensure the currency’s health and survival. But the brake does offer the British a chance to build alliances at a political level against regulation that they think is inimical to their interests. Cameron won the right for only one country to be able to pull the brake.
Some bitter arguments with the French ended with the text giving the British some limited scope to have financial rules that are different from those of the eurozone, but not in ways that could destabilise the currency union. The deal also makes clear that the eurozone may not discriminate against members of the single market, and that non-euro countries will not participate in eurozone bailouts.

The second promise of treaty change is over ‘ever closer union’, the phrase in the current treaties that so annoys British eurosceptics. The text says that Britain has a “specific situation” under the treaties and “is not committed to further political integration”, and this will go into the next treaty change. During the summit, Belgium strongly opposed the possibility that other countries might gain a similar dispensation, and in the end the words made clear that this can only apply to Britain. The new wording will allow Cameron to say that Britain is not being dragged into a federalising EU, though the practical implications in the long term remain unclear.

The other parts of the deal were far less contentious, and so were relatively easily agreed. If 55 per cent of the votes allocated to national parliaments are cast against a draft EU law, the Council will scrap it unless the Commission amends the law to take on board the parliaments’ objections. The Germans were among those who opposed this ‘red card procedure’ but let it go through as they considered that it would be impractical for the parliaments to concert their efforts very often.

The text also points to new initiatives on deregulation. A declaration from the Commission promises a new mechanism to review the body of existing EU law for compliance with the principles subsidiarity and proportionality, and to report annually on which laws should be culled. There is some vague language in the summit’s declaration on extending the single market and brokering more free trade deals.

In all, then, the package is a collection of modest reforms that set out some principles for achieving a more competitive European economy, clarifying the relationship between the eurozone and the member-states outside the monetary union, curbing migrants’ access to welfare a little, giving national parliaments a small stake in EU law-making and spelling out that Britain has a special status within the EU. It will be hard for Cameron to claim that this is transformational, and the deal is unlikely to persuade many Tory MPs to switch from Out, or fence-sitting, to In. Downing Street had assumed that two key Tories – Michael Gove, the justice secretary, and Boris Johnson, the mayor of London – would come round to Remain. However, as soon as the deal was done, Michael Gove announced that he would campaign for Out. Johnson is still on the fence. He is popular with the public, and might provide the figurehead that the Leave campaign badly needs.

Cameron’s approach to the renegotiation has made it more difficult for him to campaign convincingly in the referendum. Until very recently he was often a strong critic of the EU. His government suppressed messages that might have helped assuage public suspicions of the EU, for fear of annoying eurosceptics. For example, Downing St deliberately chose not to publicise the government’s own review of EU competences, which concluded – in 32 detailed and serious reports, published in 2013 and 2014 – that almost all the powers exercised by the EU were broadly beneficial to Britain.

Cameron appeared to see himself as a kind of alchemist, who could turn lead into gold. He described the EU as pretty awful but implied that he would succeed in transforming it with his reforms. The prime minister now faces an awkward pivot, from EU-critic to enthusiast for In. His position would be easier if his line had been: “For all its faults, the EU is good for Britain, and with my reforms we can improve it in several important ways”. As it is, the tortuous negotiations have reinforced the perception that the EU is cumbersome and very hard to reform. In a Union of 28, Britain, though still one of the more influential member-states, cannot dictate terms and relies on other member-states falling into line.

What Cameron needs to do now is to move the public debate on from the merits of his reforms to the bigger issue of how the EU benefits Britain. His most recent public statements suggest that he sees this point very clearly. He should describe how the EU has changed for the better in recent decades and argue that it can continue to do so.

Britain has often stood at the forefront of reforming and improving the EU – while managing to stay outside its biggest failure, the single currency. Britain was one of the leading advocates of eastward enlargement, which has successfully tied Central and Eastern Europe to the West. It also brought prosperity to Poland, which in 1990 had similar living standards to Ukraine in 1990 but is now more than four times richer. The single market, which the UK has championed, has boosted trade and investment flows between member-states. The EU has opened its markets to countries outside Europe, reducing its trade-weighted average tariff from 5 per cent in 1990 to 1 per cent in 2013, and signed a host of free trade agreements (including, in recent years, with countries like Canada, Vietnam, Singapore and South Korea).

Cameron needs to keep highlighting the EU’s achievements in security, too. The European Arrest Warrant, introduced in 2004, allows criminals and terrorists to be swiftly extradited across European frontiers. The EU’s foreign policy institutions have helped bring about successes: brokering a settlement between Serbia and Kosovo, negotiating with Iran to limit its nuclear programme, lifting sanctions on Burma in return for the generals holding free elections, and imposing stringent sanctions on Russia because of its military adventures in Ukraine (Russia wants the sanctions lifted, which may explain why the fighting has been relatively quiet for the past six months).

David Cameron should repeat the message he used in the last general election campaign, when he stressed the need for security and continuity over the unknown and untested, and in the last few days he has started to do so. Brexit would be a major geopolitical event with consequences that are impossible to foresee with great certainty. The UK would be leaving the most comprehensive free trade area in the world, and the extent of the economic damage is unknowable, not least because nobody knows what the terms of the divorce would be. The Scottish nationalists would certainly use Brexit to push for another independence referendum, and might prevail at the second attempt. Britain would find it harder to exert itself on the continent and to influence the troubled European neighbourhood. Cameron’s best chance of success is to shift the debate onto more lofty terrain, away from arguments about banking safeguards and migrants’ benefits towards a contest over how to secure Britain’s interests in Europe and the rest of the world.

Charles Grant is director and John Springford is a senior research fellow at the Centre for European Reform.

Would an 'independent' Britain want to join the single market?

Three economic rules mean that Britain would seek to join the EU’s single market if it were not already a member.

Both sides of Britain’s EU debate claim the mantle of free-traders. Pro-Europeans emphasise the potential loss of access to the single market if Britain quits the EU. Outers point to the EU’s declining share of world trade, and the opportunities that might arise from signing free trade agreements with countries outside Europe, without having to find consensus with 27 other states. A central question in the campaign has become: ‘Would Brexit boost or depress Britain’s international trade?’

One way to answer the question is to imagine that Britain has no trade agreements with other countries, including the EU. Which countries should be the first port of call for its trade negotiators? Three principles would guide its choice: gravity, comparative advantage, and the ‘dynamic’ gains from trade. Together, they suggest that, if it were developing a trade strategy from scratch, Britain would be straight on the phone to Brussels.
Principle 1: Gravity
In the 1960s, Dutch economist Jan Tinbergen discovered that there was a close analogy between Newtonian physics and trade flows. He was inspired by Isaac Newton’s law of universal gravitation:  that the gravitational force between two objects is proportional to their mass and the distance between them. Tinbergen’s insight was that trade flows between two big economies were larger than between two small ones. But trade was larger between neighbouring countries than those that were distant from one another. This is intuitive – it costs less to ship goods between neighbouring countries, and the value of trade between big economies will always be higher than between small ones, simply because large economies suck in more imports.

In its 2014 report on the economics of Brexit the Centre for European Reform put together a gravity model, and found that this principle held with Britain’s trade with the rest of the EU. For every percentage point increase in a country’s distance from Britain, Britain’s trade with that country fell by 0.6 per cent. And for every percentage point increase in a country’s GDP, Britain’s trade with that country grew by 2.5 per cent. Consider Table 1. If the EU buys just under half of British total exports, but its economy comprises just 18 per cent of world GDP, why does Britain trade so much with it? The answer lies in the proximity of EU member-states – on average, they are only 1,200 kilometres away from Britain. Meanwhile, the OECD members that are not in the EU – the US, Japan, Australia and so forth – are far more distant, on average, which explains why Britain exports far less to them than to the EU. Of course, other factors explain why Britain exports less to the ‘BRICS’ emerging economies (Brazil, Russia, India, China and South Africa), despite the fact that they make up more of the world economy than the rest of the OECD. Mainly, it is because their GDP per capita is lower – poorer countries are less likely to buy Britain’s expensive, high value-added exports than richer ones.
Table 1.
If Britain were to start trade negotiations from scratch, its first priority should be to reduce the cost of trade with large economies, and its second to cut trade barriers with nearby countries. According to the gravity principle, then, which of the EU, the US or China would Britain choose to organise a free trade agreement with? The answer is, of course, the EU, because every reduction in trade costs achieved with that bloc is worth more than with the US or China, because Britain naturally exports more to rich countries that are on its doorstep.

Principle 2: Comparative advantage
Over the last four decades, the principle of comparative advantage has driven the global division of labour. After he came to power in 1978, Deng Xiaoping’s reforms allowed China to use its comparative advantage in low-value added manufacturing. Other developing economies followed. This process enriched Britain’s consumers: electronic goods, toys, clothes and steel became much cheaper in real terms. And over time, labour and capital were redeployed to more productive sectors of the British economy, raising incomes further. Together, these two effects made Britain richer.
However, trade with poorer countries is not without cost. It makes Chinese and British people richer on average, but the scars of deindustrialisation are still visible in Britain’s unbalanced economy, with higher unemployment rates and lower productivity continuing to blight the UK’s northern cities. As manufacturing and industrial work dried up, many poorer people moved into low-paid services work. Productivity growth in low value-added services sectors has been slower than in manufacturing. These trends have contributed to the ‘hollowing out’ of the British labour market, with more low- and high-paid jobs being created than those which provide middling earnings.

The benefits of such trade are skewed toward the rich, and the costs are locally and socially concentrated. The economic scars from plant closures – the industrial churn that is the process by which trade raises productivity – can be felt for decades. That does not mean that an independent Britain should eschew a trade agreement with China – but it does suggest that agreements with richer countries should be its priority.

Principle 3: ‘Dynamic’ gains from trade
After the 2008 crash, Britain’s productivity plunged and then stagnated. It had been catching up with US levels over the preceding decades, but after six years of weak growth, the UK’s output per worker is now a quarter lower than the US. Thus Britain’s trade strategy should make productivity growth its ultimate aim.

Higher trade and investment with developed economies are more likely to raise productivity than with poorer ones. This is because of a fact that is often lost on politicians and the public alike – that the biggest gains from trade come not from exports but from imports. Imports boost competition in the domestic economy, which raises the incentive for domestic firms to make productivity-enhancing investments.

Indeed, more imports and inward investment, especially from rich countries, can raise the rate of economic growth, and this process is known as the dynamic gains from trade. Two economists, Nauro Campos and Fabrizio Coricelli, recently pointed out that UK trade with the EU is largely ‘intra-industry’ – that is, competition between companies in the same industry. This is the opposite of comparative advantage, by which countries specialise in different sectors. Imports from more productive EU firms encourages their British competitors to raise productivity and spend more on research and development in order to keep a foothold in the market. The constant pressure of competition from more productive overseas companies raises productivity growth – not just productivity levels. For its part, trade driven by comparative advantage reduces the cost of imports and encourages labour and capital to shift to more productive sectors of the economy. But this effect is one-off – once a British steel mill has been closed and its workers and capital have been redeployed, that’s it: there has been a one-time boost to Britain’s total income.

Outside the EU, Britain could unilaterally and fully open its markets to the US, Japan, Australia and the EU in order to take advantage of those dynamic gains. But without unimpeded access to the EU market, foreign direct investment (FDI) would be lower. Such investment is a major source of dynamic gains, and is to a degree dependent on EU membership. The UK has been the largest recipient of FDI in the EU because it offers a bridgehead to European markets. And, since the UK cannot control what tariff and other barriers the rest of the EU would impose on the country after withdrawal, foreign investment would be at risk: Nissan, whose Sunderland factory now produces more cars per year than Italy, has plants elsewhere in the EU, and higher trade costs would prompt it to expand production inside the single market.

These rules of trade economics give our imaginary trade negotiators a clear order of priorities. First, seek to open markets with more productive, rich countries. Second, seek to open markets with countries that are nearby. Measures to boost exports with distant emerging economies come third. Were it not already a member of the EU’s single market, Britain might seek to join it, especially if the EU’s putative free trade agreements with the US and Japan come to fruition. Sadly, if Britain wanted single market membership without joining the euro or Schengen, the EU would probably force it to join the European Economic Area, like Norway or Iceland, and not become a full member of the club. Then it would have next-to-no say over the single market’s rules. The underlying principles of trade point to an obvious answer to the referendum question: Britain should remain in the EU.

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