Needed: a Franco-German concordat

Like many other EU summits over the past two years, the European Council meeting in Brussels on June 28th and 29th has been billed as a ‘last chance’ to save the euro. With the situation in Greece, Spain and Italy causing alarm, EU leaders should present a credible plan to convince financial markets that they are serious about saving the euro. They are unlikely to do so. Although there will probably be other last chances, time is starting to run out. Unless France and Germany can soon agree on a grand bargain, disaster may loom.

Not only France but also Italy, Spain, the European Commission, the IMF and the Obama administration are urging Germany to accept ‘eurobonds’ (collective eurozone borrowing), bigger bail-out funds that can intervene in sovereign bond markets and a ‘banking union’ that would include common deposit insurance and bank recapitalisation schemes. For now, however, Chancellor Angela Merkel is not budging.

According to one EU official who has worked closely with Merkel, she reacts badly when other governments ‘gang up’ against her: recent public criticism from François Hollande, the French president, and Mario Monti, the Italian prime minister, has only made her more stubborn. But the official points out that since the euro crisis began she has carried out several U-turns (for example, by agreeing to set up bail-out funds). She has also told fellow EU leaders in private that the euro is in Germany’s national interest and that if, in a crisis, new measures are required, she will take them. What she will not do is spell out in public the steps she is prepared to take, lest that encourage other governments to relax their efforts to curb budget deficits and enact reforms.

When Merkel says that she will do whatever it takes to save the euro she is presumably sincere. But in a crisis would she be able to move quickly enough? She faces severe domestic political constraints. Many Bundestag members oppose greater generosity to southern Europe. In that they reflect German public opinion, which is becoming more hostile to bail-outs. Furthermore, Germany’s constitutional court could block further transfers of power to the European Union. Most of the eurobond schemes that have been mooted would be incompatible with Germany’s current constitution. The German constitution can be changed if two thirds of Bundestag members vote for an amendment. However, if Merkel required the votes of the opposition Social Democratic Party (SPD) to change the constitution, her coalition government would probably collapse.

Not unreasonably, most Germans are reluctant to support schemes such as eurobonds unless other eurozone countries are willing to submit their economic policies to more control by EU institutions. Otherwise the southern Europeans could borrow cheaply via eurobonds and then spend freely. Monti and Mariano Rajoy, the Spanish prime minister, are willing to accept more EU control. But Hollande has not yet indicated that he is willing to do so. Many senior figures in French politics, including the foreign minister, Laurent Fabius, oppose transferring more powers to the European Commission.

Hollande’s current policies are making it hard for Germany to change its stance on the euro. He appears allergic to the kinds of structural economic reform that would boost France’s waning competitiveness, such as deregulating labour markets (he is lowering the pension age while other European governments are raising it). He says he is committed to a budget deficit of 3 per cent next year – which would mean a restrictive fiscal policy – but has so far announced no spending cuts and several spending increases. State spending is 56 per cent of GDP (the highest in the EU after Denmark) and growing. A swathe of new taxes on business is likely to discourage investment and thus stunt economic growth. For the time being, Hollande appears no more willing than Nicolas Sarkozy was to give the EU a bigger say over French budgetary policy.

The story of the euro, like that of the EU itself, is one of Franco-German bargaining. The current disconnect between Paris and Berlin is destabilising the euro. In the long run the euro is not sustainable without a grand bargain between France and Germany. Germany will need to accept the principle of eurobonds, some sort of banking union, softer budgetary targets for the countries in difficulty, and the writing off of more of those countries’ debts. In return France and the other euro countries will have to swallow both structural reforms that would enhance productivity, and greater EU sway over budgets and other economic policies.

At the moment such a grand bargain is impossible, and not only because Paris and Berlin are far apart on policy. Merkel and Hollande do not trust each other. The history of Franco-German relations suggests that even when two leaders initially get on badly (think of Jacques Chirac and Gerhard Schröder, or Nicolas Sarkozy and Angela Merkel) they eventually find a way of working together.

However, the financial markets may not wait. The next eurozone crisis could be imminent, perhaps provoked by a bank run in Spain or Italy, or those countries having to pay so much to borrow that they are effectively frozen out of the bond markets. Those who wish the euro well must hope that in an emergency, Merkel and Holland will overcome their differences, act decisively and bring along the other leaders with them.

But the intrusion of democracy could spoil the best efforts to salvage the euro. In the Netherlands, parties that oppose austerity at home as well as more money for bail-outs could win September’s general election. Monti’s government of technocrats, increasingly unpopular in Italy, could fall long before the elections that are due next spring. Within the past few days both Wolfgang Schaüble, the German finance minister, and Sigmar Gabriel, the SPD leader, have said that big changes such as eurobonds could well require a referendum in Germany.

Many things can go wrong, but if France and Germany work together the euro has a sporting chance of survival. The EU institutions can play a role in bringing them together. Ever since the euro crisis began, the Commission, in particular, has been marginalised from some of the decision-making on the most important issues. The gravity of the current situation presents an opportunity for the institutions to reclaim some intellectual leadership. The ‘four presidents' report’, published on June 25th, shows that they are trying to do so.

Written by the presidents of the Commission, European Central Bank, Eurogroup and European Council – with Herman Van Rompuy, president of the European Council, in the lead – the report sketches a way forward on banking, fiscal and economic union. It calls for common systems for banking supervision, deposit insurance and bank resolution. It also suggests more EU control over national budgets and levels of debt, alongside tentative steps towards debt mutualisation (it mentions short-term ‘eurobills’ and a ‘debt redemption fund’, kinds of eurobond that may be compatible with the German constitution).

The four presidents’ report offers EU leaders a sensible roadmap for their future work. However, Merkel’s response, expressed to law-makers in Berlin on June 26th, was to say that she did not expect to see eurobonds in her lifetime. She is, in the words of the EU official quoted at the start of this piece, “practising brinkmanship, which of course entails the risk that one falls into the abyss”.

Parts of this article are based on a piece that appeared on the Guardian website on June 25th 2012.

Charles Grant is director of the Centre for European Reform.

Germany's own goal: Why Berlin's sense of invulnerability will be its undoing

Countries around the world fear that Europe's handling of the eurozone crisis will cause a global slump. But in Germany, the currency union's biggest economy, there is a curious sense of invulnerability. For many Germans, including many senior policy-makers, the crisis seems to be someone else's problem. Indeed, some even believe that Germany would be better off without the euro. Merkel's obduracy is widely credited with striking a blow for Germany's national interests. The German government and media portray demands that Germany accept debt mutualisation or a banking sector union as a call for German charity or benevolence. Such reforms are rarely, if ever, seen as being in Germany's self-interest, but rather an imposition on the country. This is puzzling, because Germany is much more vulnerable than German policy-makers appear to believe. And Germany’s strategy for dealing with the crisis is maximising, not minimising, the risks to the country’s economic and political interests.

What explains this sense of invulnerability? Is the German economy really so strong that it can sail through an EU slump and a renewed global crisis? The German economy has certainly bounced back stronger than most of the rest of the Europe. Over the four years to the first quarter of 2012, the economy grew by 1 per cent. This hardly qualifies as the Wirtschaftswunder it is sometimes portrayed as in Germany (and is a worse performance than the US), but is considerably better than the EU or eurozone average. Germany's labour market has also performed strongly. Unemployment has fallen steadily, contrasting sharply with surging joblessness in France, Italy and Spain. German youth unemployment is at a 20 year low. This partly reflects demographics – the number of Germans coming of working age each year has fallen steeply due to the country’s persistently low birth-rate. But demand for labour has also held up well.

However, Germany's export dependence remains as pronounced as ever. The country's current account surplus has fallen but not significantly so: after peaking at 7.4 per cent of GDP in 2007 it was still equal to 5.7 per cent in 2011. Over the four years to the first quarter of 2012, domestic demand rose by 2 per cent, and hence outpaced growth in overall GDP. However, this was largely down to a steep fall in exports in 2009. Since then the contribution of net exports (exports minus imports) to economic growth has been positive: growth in domestic demand has lagged that of the economy as a whole. Moreover, stripping out government consumption – which has risen relatively strongly – domestic demand increased by just 1 per cent over the last four years. And growth in government consumption has now slowed sharply.

But what of the argument that Germany is no longer so dependent on the eurozone because of growing trade with the rest of the world? The eurozone accounted for 39 per cent of German exports in 2011, down from 43 per cent in 2007; the EU's share fell from 63 per cent to 59 per cent over this period. Put another way, exports to the EU are still equivalent to over 25 per cent of German GDP. And Germany exported 10 times as much to the EU in 2011 as it did to China. What of the country's trade surplus with the rest of EU? The surpluses with the EU have fallen from the highs reached in 2007. In 2007, trade with the rest of the eurozone accounted for 60 per cent of Germany's overall trade surplus and the EU for over 80 per cent. By 2011 these proportions had fallen to 40 per cent and 55 per cent respectively.

Germany has not rebalanced decisively towards domestic demand and remains highly dependent on trade with the rest of Europe. What of Germany's foreign investments? Almost two-thirds of Germany's total foreign assets (equivalent to around 200 per cent of GDP) are denominated in euro. Two-thirds of the country's stock of foreign direct investment (FDI) is in eurozone countries. The value of these assets is already being depressed by the crisis and would fall dramatically if the currency union collapses. And then there is the Bundesbank's exposure to other eurozone central banks. As capital flight from the struggling member-states has got underway, banks in these economies have become dependent on funds from their central banks, which have turned to the Bundesbank for financing. At the end of 2006 the difference between the Bundesbank's claims on other eurozone central banks and the latter's claims on the German central bank was negligible, but by May 2012 stood at €700bn. This will not pose problems so long as the euro system holds together, but it is far from clear what would happen if it falls apart.

Record low government borrowing costs have fuelled Germany's sense of invulnerability. Investors have pulled out of struggling eurozone economies in favour of German bunds, pushing yields down to unprecedentedly low levels. But there are signs that this is now changing as Germany's burgeoning exposure to the rest of the eurozone raises fears for the country's own fiscal stability. A declining group of countries are being called upon to underwrite ever larger sums of money, eroding their own creditworthiness. For example, a full bail-out of Spain would further erode confidence in Italy which would have to underwrite 23 per cent of the funds or around €100bn (on the assumption that a Spanish bail-out totalled around €400bn). This, in turn, would increase the likelihood of Italy itself needing a bail-out. At this point, only Germany, France, the Benelux, Austria and Finland would be in a position to underwrite bail-out funds. As a result, France's share of a bail-out of Italy would be around 35 per cent of the total, and would inevitably prompt a steep rise in French borrowing costs. Indeed, there is real risk that France would not be able to underwrite its share, leaving German (and a group of small economies) back-stopping the whole edifice. With each new country forced to seek a bail-out from the EU's rescue funds, the more vulnerable Germany becomes.

The current strategy for dealing with the eurozone crisis is largely a German one. But far from limiting the risks to Germany, it is maximising them. The German economy is not immune to the economic slump enveloping a growing swath of Europe. One country after another will need bailing out, with Germany ultimately providing the back-stop. Much of this debt will not be repaid, leading to a dramatic rise in Germany's public indebtedness. Without a mutualisation of risk, the euro will collapse, with devastating implications for German exports (to EU and non-EU markets alike as a euro collapse would hit the global economy hard), the value of Germany's foreign investments, and the stability of its banking sector. These are just some of the direct economic costs; the political fall-out would be grave for Germany. Isolated and blamed for the collapse, it would be poorly placed to pursue its interests through whatever is left of the EU.

By contrast, the reforms needed to stabilise the eurozone pose far fewer risks to Germany. Debt mutualisation need not be open-ended, so moral hazard could be limited. And it is far from clear that mutualising debt would boost Germany's borrowing costs compared to the current approach, which threatens to undermine the country's creditworthiness without doing anything to address the underlying reasons for the eurozone crisis. The arguments for a banking union are equally compelling. If the eurozone banking crisis is left to fester, banks will collapse, which in turn will hit German banks (and hence German taxpayers) very hard. In return for agreeing to mutualise debt and to introduce a eurozone back-stop to the economy's banking sector, Germany could demand a host of concessions. The political union needed to give legitimacy to these institutional reforms would be cast in Germany's image. Berlin would cement its influence over Europe's economy and its politics but in a benign and hence sustainable fashion.

Five years ago Germany was plagued by self-doubt and even self-flagellation. Now the political debate, media coverage and national mood generally are marked by hubris and self-righteousness. Germany's strength is exaggerated and its weaknesses downplayed. The German authorities are underestimating how much they have to lose from the eurozone crisis and the damage it is inflicting on the European economy as a whole. Germany should agree to big institutional reforms of the currency union, not out of charity, but as a way of containing the risks to itself. A deepening crisis, culminating in defaults, a rupturing of the eurozone and most probably the single market are all but inevitable under the current strategy. This will not only do huge economic damage to Germany but leave the country isolated and mistrusted by a region from which it derives its strength. With the German economy slowing rapidly and investors starting to question the safety of German debt, it is possible the country will change course. But at present it appears that Germany is not for turning.

Simon Tilford is chief economist at the Centre for European Reform

The EU must fight corruption and defend the rule of law

The fight against corruption and national maladministration is currently very much on the minds of policy-makers in Brussels. This is because the eurozone crisis and concerns over the rule of law in newer EU members, including Bulgaria and Romania, make clear an embarrassing truth about European integration. The EU is a joint law-making body, single currency area and common travel zone where countries have often very different attitudes towards public accountability, quality of administration and the prevention of graft.

Corruption and the weakness of national institutions is a scourge right across central, eastern and southern Europe, according to a recent report by Transparency International (TI). The report measured the ‘national integrity’ of 25 EU countries, finding that “Greece, Italy, Portugal and Spain have serious deficits in public sector accountability and deep-rooted problems of inefficiency, malpractice and corruption, which are neither sufficiently controlled nor sanctioned.” In addition, TI reports that positive progress towards reform in newer member-states has slowed, and in some cases reversed, since accession, particularly in the Czech Republic, Hungary and Slovakia. But Bulgaria and Romania remain the most corrupt.

Hitherto, officials accepted divergences in governing standards in the EU as an unalterable fact of life, and certainly too difficult to address in the ultra-politically correct world of ministerial meetings and diplomatic working groups. But now the mismatch between national administrations in ethics and efficiency is one of the most salient political problems obstructing efforts to stabilise the euro, calm tensions within the Schengen area of passport-free travel and restore the popularity of EU enlargement in older member-states.

Poor public administration in Greece – in terms of its budgetary reporting and refugee protection – is partly responsible for that country’s tenuous position within both the euro and the Schengen areas. In Bulgaria and Romania, corruption and low judicial standards remain a serious source of concern five years after accession to the Union, damaging both countries’ chances of joining Schengen as well as the credibility of the EU enlargement process. And in Hungary, the government of Viktor Orban seems determined to limit the freedom of the press and the independence of the judiciary and the central bank, a nod towards authoritarianism hardly becoming an EU member-state. (See the 2012 report on media freedom and the rule of law in Hungary, by Freedom House, an NGO.)

 

What – if anything – can be done to address such issues at European level? The EU has the ‘Copenhagen criteria’, under which candidates for membership must have functioning market economies, observe the rule of law and respect human rights. However, the European Commission’s leverage to police these conditions mostly evaporates after the candidate joins the EU and gains equality of status with other members. If a country later crosses the threshold from merely corrupt and inefficient to despotic government, the EU’s treaties allow for other member-states to suspend its voting rights. But this is seen as a ‘nuclear’ option by European governments, designed as a deterrent rather than a tool, given the implications involved for national sovereignty.

The Commission thinks that it can at least improve efforts to fight graft with a new ‘EU anti-corruption report’ to be published every two years from 2013. (Its officials estimate that corruption costs member-states collectively around €120 billion a year.) Rather than rank countries in order of their relative virtue, as Transparency International does (see its annual ‘Corruption Perceptions Index’), the Commission will focus instead on issues such as public procurement where widespread corruption negatively impacts the single market. The reports will not name and shame specific countries. Nor are any sanctions envisaged for those national administrations which fail to address persistent problems. Such initiatives are worthy but lack teeth.

What the EU really needs is an ex post means to ensure that member countries would still pass the Copenhagen criteria if they were to re-apply for membership. In July, the Commission will report on how much progress Bulgaria and Romania have made in efforts to counter corruption, reform their judiciaries and tackle organised crime. This is the so-called ‘co-operation and verification mechanism’ (CVM) that the two countries undertook to follow in return for EU membership. Politicians in Bucharest and Sofia now chafe at being singled out for special treatment amongst their EU counterparts and would dearly love to see the CVM discontinued after its five-year anniversary next month. This is despite the fact that both countries have failed to deliver fully on solemn promises of reform that they made in 2007.

Instead, EU leaders should agree in principle that any member found to be in persistent breach of the Union’s commitment to the rule of law and good governance could be subject to a CVM, rather than a suspension of voting rights. If a majority of EU countries agree, the definition of such a breach could include instances where corruption or maladministration has threatened the stability of the euro or Schengen areas. And, unlike the current situation with Bulgaria and Romania, the Commission should be able to impose sanctions – such as the suspension of EU funds – when countries refuse to discuss problems or make progress towards meeting certain benchmarks. Officials should include this idea in proposals for a new ‘political union’ currently being drawn up to stabilise the eurozone.

Governments – whatever their fears for the euro or free movement – are likely to take a dim view of further Commission interference in an area where national sensitivities could hardly run higher. Furthermore, a country's level of tolerance for corruption and poor administrative practices is deeply engrained in its culture, history and legal traditions. Real progress is dependent on a cultural shift in what is popularly deemed as acceptable behaviour in businesses, courts or the government in the country in question. Such change takes time and bureaucratic sanctions imposed by the EU can play only a complementary role.

Nevertheless, it is equally unlikely that voters will accept closer political union without stronger EU tools to monitor the performance of public administrations and address concerns over corruption and low judicial standards in existing and future members.

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

Some sorts of austerity are better than others

Governments in the eurozone's periphery are pursuing a scorched earth fiscal strategy. Distressed governments may not be able to afford a fiscal stimulus or even a delayed consolidation, partly because of the size of their deficits and partly because they do not fully control the currency in which that debt is issued. In the absence of transfers from the eurozone's creditor nations, governments in the periphery are cutting every area of spending indiscriminately. Pro-growth investments in infrastructure and education are being slashed alongside consumption, like welfare payments. This is no way to build 'competitiveness', as Germany insists they must.

Public investment has a high 'multiplier' – economics jargon for extra growth generated by government spending. Most economists calculate that the infrastructure spending multiplier is greater than one, which means that for every €1 spent, more than €1 of economic activity will accrue. Some studies put the figure as high as two. The education spending multiplier is harder to calculate, but according to the OECD, people who complete university earn 11 per cent more a year on average than those who only have secondary education. Those who finish high school earn 9 per cent more than those who drop out. This suggests that government education spending provides a sizeable 'bang for a buck' over time. The initial investment will be more than repaid through higher tax receipts and lower welfare spending. 

In Spain, the state's investment in infrastructure averaged 3.8 per cent of GDP in the decade before the financial crisis. Over the last three years it has slashed this share to 2.8 per cent – and the 2012 budget foresees this falling to just 1.8 per cent. Advocates of austerity argue that the country already has excellent transport infrastructure (much of it linking up housing developments that are now moribund). They are right that further transport infrastructure spending in Spain may do little to boost activity over the longer-term, even if it provided a quick stimulus. But investment in education would. Half of Spain's youth drop out of high school before 18, have fewer marketable skills, and so impose massive claims on the taxpayer in the form of unemployment benefits later in life. Yet Spain is cutting the federal education budget by a fifth this year. 

This pattern is being repeated across the periphery. Portugal, Italy and Ireland have cut infrastructure spending by 0.4, 0.5 and 0.7 per cent of GDP respectively over the last two years, and are planning to go further. Italy and Portugal are reducing educational expenditure at all levels; Ireland is making small cuts to the schools budget but larger ones to spending on higher education. 

Is there a better way to consolidate the public finances without damaging growth, both in the short term and the long term? The UK's Social Market Foundation, and the International Monetary Fund, have recently suggested that Britain use the 'balanced budget multiplier', and cut areas of spending with low multipliers and recycle the money into investment. The UK fell into recession in the first quarter of 2012, partly because the government had slashed investment, which led to a fall in construction spending. Using the balanced budget multiplier ensures that austerity's impact on short-term output is as small as possible, and helps to encourage growth in the long term, as investments encourage private sector activity. This approach could be applied in the eurozone periphery: while immediate austerity is impossible to avoid without more help from the core, the periphery should seek to cut back further on low-growth areas of spending and hold investment steady, or increase it for a clearly defined period of time.

But what areas of spending should they cut? The area of government activity which has the lowest multiplier is the incentives which governments provide to encourage people to save more. By offering tax relief on direct contributions to private pension and saving pots, government money gets funnelled into consumption that will take place far in the future. This reduces demand in the short-term, as government money that could be spent now is spent later. Every government in the eurozone's periphery makes pension contributions tax-free up to certain limits, and then taxes pension income when workers retire and their pot is drawn down. Governments could switch this around: contributions could be taxed, and pension income made tax free. Alternatively, they could lower the amount that people can save without being taxed.

Other areas with low multipliers, such as welfare payments to middle class households (like child benefits) could also be considered. The reason is that people on higher incomes tend to save more of their income, so cash transfers to them have a low multiplier. The cash saved could then be recycled into public investment, which boosts economic growth.

The measures outlined here would not, of themselves, be sufficient to spur a marked recovery in demand. But as an approach to austerity – which is probably unavoidable in the periphery to some degree, given the way the eurozone is currently configured – it would be far less damaging to growth than the current policy of indiscriminate cuts. 

Such an approach should satisfy bond markets. Investors are unsure whether austerity is the only route out of the crisis, or whether it is self-defeating. If peripheral countries relax austerity, they risk investor flight and unaffordable bond yields, or they risk losing access to bail-out money from the Troika – the ECB, European Commission and IMF. Germany obsesses about moral hazard and governance. But if the periphery's governments demonstrate their political will to cut transfers and government consumption, and commit themselves to holding public investment steady, they could be considered worthier beneficiaries of German aid.

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

NATO ponders austerity and US 'pivot'

When NATO heads of state meet in Chicago this Sunday and Monday, two key worries will be on their minds. In a departure from the past six decades, the US has come to style itself as a Pacific, rather than Atlantic, power. And the Europeans are busy plundering their defence budgets in order to cope with the economic crisis. Any one of those two events alone would have a dramatic effect on how the alliance works. Taken together, they risk pushing NATO into irrelevance.

The CER recently explored NATO's future in a new report, 'All alone? What US retrenchment means for Europe and NATO'. It concluded that the US 'pivot' away from Europe towards Asia will remain in place irrespective of who wins the presidency in November. Because the US is cutting defence budgets too, the Pentagon will conserve resources. And the United States sees few threats emanating from Europe; it also regards the remaining ones, such as the frozen conflicts in the former Soviet republics, as matters for diplomacy, not arms. NATO has also lost some of its military utility to the US. The Americans have invested far more than the Europeans in their armed forces, and have greatly improved their ability to strike quickly and across long distances. The US military has less need for help from European allies, and finds it increasingly difficult to assign them meaningful roles in joint operations.

In principle, the Europeans ought to be buying new weapons to fill the gap created by the reduced US role in European security.  But the US demand for Europe to do more for its defence has come at the worst possible time: Europe is in the midst of an economic crisis, and the allies, instead of buying more weapons, are busy cutting defence budgets to stave off defaults. The UK will be without aircraft carriers for a decade, Spain seems ready to mothball its only remaining one, while Denmark has abandoned submarines and the Netherlands has ditched its tank forces.

This will have a three-fold impact on NATO. Firstly, the Pentagon is cutting two of its four brigades in Europe. While the US is not reconsidering its obligation to come to its allies' defence, the reduction will extend the timelines on which military enforcements can be rushed there. This will delay the actual moment at which the US comes to the continent's defence, and shifts more of the burden for common defence onto the Europeans.

Secondly, in operations fought not in self-defence but on behalf of causes such as human rights, the US will not necessarily lead. The Libya war established a new operating principle: there, the US handed the command to France and the UK after destroying Gaddafi's air defences. From now on, America will sometimes behave like any other ally, sitting out some of NATO’s wars, and doing just enough to help other operations to succeed.

Thirdly, NATO may well fight fewer wars in the future. The Europeans lack some of the hardware such as spying and targeting 'drones' and precision bombs, which are crucial to making wars swift and relatively safe for allies and civilians. If NATO is to fight wars without American help, conflicts will take longer, cause more unintended civilian casualties, and more lives on the NATO side. The European allies, with exceptions such as the UK and France, are already reluctant to fight today's wars. They will grow even more skittish if human and political costs of future conflicts increase. In practice, this means that some future crises similar to those in Kosovo or Bosnia in the 1990s may go unanswered.

Given the confluence of budget cuts and US rebalancing, NATO ought to give serious consideration to reducing its ambitions. Its militaries aspire to be able to fight two major wars and six minor ones simultaneously, which does not seem very credible. To stem further loss of military power, the European allies also need to try much harder to squeeze efficiencies out of collaboration. As a forthcoming CER policy brief notes, governments can buy more power for less money by getting rid of unneeded equipment, merging their defence colleges, sharing training grounds, or buying and maintaining future generations of weapons together ('Smart but too cautious: How NATO can improve its fight against defence austerity', out in May 2012). At Chicago, the alliance will take the first steps by announcing that NATO countries are to jointly finance a new fleet of spying drones. More such projects are needed: the US pivot and European budget cuts have left the alliance undermanned and underpowered, and collaboration is one of the few good solutions the allies have at their disposal.

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

How Hollande should handle Merkel

The election of François Hollande as French president has excited some of those who blame Germany’s emphasis on fiscal austerity for many of the eurozone’s ills. Hollande has promised to refocus EU policies on growth and employment. Countries such as Greece, Portugal, Spain and Italy – their recessions aggravated by the EU’s insistence that they shrink their budget deficits – would welcome a new approach. Even Marios Draghi and Monti, respectively president of the European Central Bank and prime minister of Italy, and both economically conservative, have called for growth initiatives. But can Hollande – as he prepares for his first ever meeting with Chancellor Angela Merkel – really make a difference? He might, but only if he handles Merkel with great diplomatic dexterity.

Many commentators have interpreted Hollande’s victory on May 6^th, alongside the defeat of the established parties in Greece on the same day, as part of a Europe-wide revolt against austerity. However, France has not yet experienced painful austerity. And Hollande has promised to match President Nicolas Sarkozy’s target of bringing the budget deficit down to 3 per cent of GDP next year, and also to balance the budget by 2017, a year later than Sarkozy had promised.

Opinion polls showed that more voters trusted Sarkozy than Hollande on economic policy, but the election was about much more than economics. Many French people felt strong antipathy towards Sarkozy’s character and what they considered to be his un-presidential and undignified style. He also lost because the right is badly divided. There is a natural right-wing majority in France – which is why in the first round of voting the right won more than half the votes. The centre-right Gaullists always find it difficult to deal with the far-right National Front, but this year that difficulty was compounded by Marine Le Pen’s success in rebranding her party as more moderate than it was in her father’s day. This enabled her to win 18 per cent in the first round of voting. Le Pen’s refusal to endorse Sarkozy for the second round meant that only half of her voters switched to him.

However, Hollande did campaign on a policy of ‘renegotiating’ the EU’s recently-agreed and German-driven fiscal compact – which seeks to impose budgetary discipline – to take account of the need for jobs and growth. In most EU capitals, including Berlin, politicians are now calling for an EU ‘growth strategy’. German officials met Hollande’s advisers before the presidential election and told them that Merkel would not reopen the fiscal compact. But they said that Germany could support some of Hollande’s ideas – including enlarging the European Investment Bank’s capital base by €10 billion, targeting unspent EU structural funds on infrastructure and introducing a financial transaction tax (FTT). The Germans are divided on whether to back Hollande’s idea for EU ‘project bonds’ (the European Commission is already working on a scheme to boost infrastructure investment with such bonds). But none of these initiatives would increase economic growth significantly – and not even its advocates claim that an FTT would create jobs.

Hollande’s prescriptions for the European Central Bank – that its mandate should not focus only on inflation, and that it should lend directly to governments – are unacceptable to Berlin. Another difficulty for Hollande is that the Germans – and many others, including the two Marios – think a growth strategy must include structural reforms that would boost productivity and thus competitiveness, even though such reforms seldom deliver growth immediately. Hollande appears to be as allergic to structural reform as most of his compatriots. His election speeches called for growth to be boosted through public spending on infrastructure and through investment in new technologies – and explicitly ruled out deregulation and liberalisation. He seems oblivious to the fact that France’s very high non-wage costs of employment are one cause of relatively high unemployment (10 per cent, against 6.8 per cent in Germany).

Some of Hollande’s election rhetoric implied that he wants a complete reversal of the EU’s austerity-based strategy for dealing with the eurozone crisis. Many of his supporters on the French left expect him to join the Greek leftists who denounce Greece’s bail-out package, and other so-called Keynesian forces across the EU, to dethrone Angela Merkel from her dominance of EU policy-making.

But if Hollande tried to gang up with, say, Italy and Spain, to force Germany into a complete U-turn, he would fail. A crude Keynesian approach would achieve very little: some EU governments have borrowed excessively, need to curb their deficits and cannot spend their way out of recession. Furthermore, France has much less clout in the EU than Germany. The financial crisis and the euro crisis have highlighted the vulnerabilities of the French economy: its waning competitiveness means that its share of world export markets has fallen – by 20 per cent from 2005 to 2010 – while its public debt and borrowing costs have been rising.

This weakness meant that when the euro crisis began, Sarkozy decided to follow the Germans on the broad lines of their eurozone strategy, but to haggle over the details. He probably should have fought the Germans harder over some of their proposals for the eurozone crisis. But because Germany is the biggest contributor to the EU budget and to the bail-out funds, and the strongest EU economy, its views cannot be ignored (as President François Mitterrand discovered when he went for reflation in one country in 1981 – at a time when the economic imbalance between France and Germany was less pronounced than today). In any case, Germany has eurozone allies in its emphasis on austerity, such as Austria, Estonia, Finland, Slovakia and Slovenia, and to some degree the Netherlands.

Nevertheless, Hollande has every right to tell Merkel that the strategy into which Germany has pushed the EU needs amending: by imposing too-rapid reductions of budget deficits on problem countries, it is decreasing their ability to repay their debts. According to the IMF, the ratio of gross public debt to GDP in Spain, Italy, Ireland and Portugal will rise every year between 2008 and 2013. The EU’s strategy is also stimulating waves of political populism, extremism and anti-EU sentiment in many parts of the Union.

The French and German bureaucratic machines put enormous pressure on their respective governments to forge compromises on difficult issues. Hollande probably has enough sense to try to work with the Germans rather than against them. That will mean accepting and ratifying the fiscal compact that the Germans care so much about. He may also have to accept at least modest doses of structural reform. He would then be in a strong position to ask the Germans to be flexible in other areas.

Hollande should prioritise two initiatives. One would be to give the problem countries a greater number of years in which to cut deficits and reach fiscal targets. In Greece, the steepness of the spending cuts has made output fall so fast – GDP is almost 20 per cent below where it was five years ago – that the debt burden has become unsustainable. The deficit reduction targets that Spain has had to adopt – more than 5 per cent of GDP from 2011 to 2013 – may have a similarly harmful effect. There is a fine line to be drawn between two lax an approach, which allows governments to postpone painful choices on spending, and may lead the markets to lose confidence in their ability to repay debts; and excessive austerity, which may smother so much economic activity that markets lose confidence in governments’ ability to repay debts. But Hollande should give a clear message to Merkel that spending cuts are being imposed too quickly in some countries.

Might the Germans be flexible on this point? Two days before the second round of the French presidential election, I was in Berlin talking to government officials. They were obdurate in saying that deficit reduction targets should not be and would not be relaxed. However, most EU governments, the Commission and the IMF believe that the problem countries need to be given longer periods to reduce deficits. Merkel will find it hard to resist them all.

A second priority for Hollande should be to encourage Germany’s leaders to facilitate a rebalancing of their economy. If Germany invested more, consumed more and imported more, it would help to reduce the imbalance between its massive current account surplus and the current account deficits in Southern Europe. For an economy of its great size, Germany has unusually low levels of consumption. If one tells Germans that the structure of their economy is contributing to the eurozone’s ills, they generally don’t like it. They also tend to say that a government cannot have much influence on whether citizens choose to spend or save.

But the good news is that the German economy seems to be doing a bit of rebalancing of its own accord. Investment is increasing. Consumption has risen over recent years (though, until recently, less than overall growth). A report from the IMF this month foresaw the possibility of domestic demand leading a German recovery. Imports from the eurozone are rising – for example there has been surge of wine imports from Spain. According to the Federal Statistical Office, Germany’s trade surplus with the rest of the eurozone in the 12 months to the end of March 2012, of €62 billion, was 29 per cent down from the previous 12 months (though some economists believe these figures are unreliable).

Even better, Germany’s leaders seem to have – finally – woken up to the need for rebalancing. Jens Weidmann, the Bundesbank president, has said that Germany might have to tolerate inflation that was a little higher than the eurozone average. Wolfgang Schaüble, the finance minister, has said that higher wages for German workers could help to combat eurozone imbalances. It had hitherto been a taboo for government ministers to comment on wage settlements.

If Germany experienced higher domestic demand and wage inflation, South European countries could more easily export their way out of recession. Hollande should urge the German government to encourage these trends, for example by cutting VAT and telling employers that it is relatively relaxed about wage inflation.

The political crisis in Greece makes it urgent for Merkel and Hollande to find a modus vivendi. They should tell the Greeks that if they wish to stay in the euro they cannot avoid austerity and structural reform. But to raise the Greeks’ morale the EU will have to relax Greece’s deficit reduction targets, write off much more Greek debt and think more imaginatively about how to encourage external investment in Greece. Merkel will find such policies harder to embrace than Hollande. If Greece moves towards exiting the euro, the EU will have to focus on ensuring that contagion does not affect other member-states. The EU would then need to enlarge its bail-out funds and prepare other emergency measures. Once again, Hollande’s role will be to work with other EU leaders in nudging the Germans to be flexible.

 

If the Germans spurn such efforts they will risk sacrificing not only their special relationship with France but also many of the achievements of 60 years of European integration. Until recently, many German leaders seemed disconcertingly certain that their policies for dealing with the eurozone crisis were absolutely right. Now some of them understand that at least some of their policies are not working. Hollande and other EU leaders need to explain to them that an inflexible Germany risks becoming isolated.

Charles Grant is director of the Centre for European Reform.

Germany’s choice: Higher inflation or sovereign defaults

The battle lines are hardening. More and more eurozone governments are calling for the ECB to loosen monetary policy, for example by directly purchasing government debt in an attempt to bring down borrowing costs and arrest their slide into slump. For its part, the German government and the Bundesbank are calling for the ECB to exit the currently loose strategy, fearing a surge of inflation in Germany. But higher German inflation is the inevitable flipside of a strategy that places the full cost of adjustment on the struggling economies. It is also indispensable if the crisis-hit economies are to rebalance and avoid insolvency. Higher inflation presents formidable political challenges for Germany, but the alternative is a wave of national defaults, culminating in either a fully-fledged transfer union or a collapse of the currency union.

Germany’s strategy for dealing with the eurozone – fiscal austerity and internal devaluations across the south of the currency union – can only work if economic activity strengthens (and prices rise) elsewhere in the currency union. The struggling members of the eurozone (a group that is steadily increasing in size) are trying to regain price competitiveness by reducing their costs relative to the rest of the eurozone, and attempting to reduce public indebtedness by pursuing aggressively pro-cyclical fiscal policies. The result has been a collapse of inflation in Greece, Ireland and Portugal and rapidly weakening inflation pressures in Spain and Italy, as they slide into depression.

The ECB targets inflation of ‘close to but under 2 per cent’ for the eurozone as a whole. Assuming inflation falls to zero in Spain, Italy and the peripheral trio, and averages around 2 per cent in France and the Benelux trio (it is unlikely to be any stronger given the headwinds facing these economies), it follows that inflation in Germany (plus Austria and Finland) will need to rise to around 4 per cent. The German economy’s growth prospects are not as strong as many believe, with the OECD, the European Commission and the IMF forecasting only modest growth over the next few years. However, the IMF estimates that the German economy is running at close to (or even above) capacity. The country’s so-called output gap (the difference between the actual output of an economy and the output it could achieve at full capacity) is zero and its trend rate of growth (the rate of expansion consistent with stable inflation) is low.

The current monetary stance is certainly too lose for Germany given these capacity constraints. Assuming that the German economy is not derailed by the slump across much of Europe (an admittedly large assumption), German inflation will start to rise relative to the rest of the eurozone. If the ECB treats Germany like any other eurozone economy, it will hold eurozone interest rates at their current levels (or even cut them) irrespective of the level of German inflation, as long as eurozone inflation as a whole remains on target. After all, the ECB was sanguine about above average Irish or Spanish inflation in the run up to the crisis.

In reality, it is a moot point whether the ECB would allow German inflation to run to 4 per cent. Germany is considered the anchor of the monetary union. Many at the ECB (and not just those from Germany and core countries closely aligned with it) believe that higher inflation in Germany would constitute a loss of price stability, threatening the credibility of the euro. ECB members will also be aware of the threat that higher German inflation could pose to the legitimacy of the euro in Germany. The German government won over sceptical Germans to the euro by promising that the ECB would deliver the same degree of ‘price stability’ as the Bundesbank. The Bundesbank and the German government would resent much higher German inflation. A sharp rise in German prices would almost certainly harden German opposition to other reforms of eurozone governance, not least any form of debt mutualisation.

But assuming the ECB does treat Germany like any other eurozone economy, what would happen? Germany could try to tighten fiscal policy further in an attempt to offset the very weak monetary stance. But it is unlikely to be any more successful than the Spanish or the Irish were in nullifying the impact of inappropriately loose monetary policy. Negative real interest rates in Germany would stimulate economic activity in Germany, increase the demand for labour and push-up wages. Higher German prices and wages would help facilitate the necessary adjustments in price competitiveness between the eurozone economies: the peripheral countries would be able to reduce their wage costs relative to German ones without having to cut nominal wages. German costs would rise relative to the rest of the currency union, removing one of the obstacles to a return to economic growth (and debt sustainability) across the south of the eurozone. This is how adjustment takes place within a currency union, and was how Germany managed to engineer such a large real depreciation (or ‘internal’ devaluation) in the first place – against a backdrop of robust inflation elsewhere in the currency union. Any attempt to permanently lock-in the competitiveness gains will simply perpetuate the crisis.

In a welcome intervention, the German finance minister, Wolfgang Schaüble, recently argued that German wages should rise more quickly than in the other eurozone economies as this would help the needed rebalancing within the eurozone. But such a recognition has yet to permeate official thinking as a whole, and has not really reached the Bundesbank. There are signs that the Bundesbank accepts that German inflation will need to exceed the eurozone average, but certainly no acknowlegement that the differential needs to be very substantial. The Germans are proud of the ‘competitiveness’ eked out within the eurozone. Indeed, they continue to argue that every other member-state can pursue the same strategy as them.

Germany faces a difficult choice: either it accepts higher inflation and risks the German electorate’s confidence in the euro, or it paves the way for a wave of defaults culminating in either a fully-fledged transfer union or the collapse of the euro.

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

Why France is threatening to leave Schengen

Nicolas Sarkozy appears ready to send the EU's Schengen area to the guillotine in order to win re-election to the French presidency. Last week, Claude Guéant, France's minister for the interior, was despatched to a meeting of his EU counterparts in Luxembourg with a stark warning: Schengen's common border – which stretches from the Baltic to the Mediterranean to the Aegean – must be secure by the end of 2012. Otherwise, France will leave the 26-country passport-free zone, or so says Sarkozy on the stump. 

Guéant's move seems like crude electioneering to most observers. Marine Le Pen, the anti-immigration, anti-EU leader of the National Front, won 18 per cent of the vote in the first round of France's presidential election. Sarkozy must poach a sizable chunk of these votes in order to beat socialist rival, François Hollande, in the run-off on May 6th. Furthermore, although Guéant complained to his ministerial colleagues that 400,000 people enter the Schengen area illegally each year, this figure must be seen in context: the passport-free zone benefits some 650 million legitimate travellers annually.

Yet France's ultimatum is about more than simple pandering to the far-right. French scepticism of the Schengen project goes right back to its inception in 1995, when border controls were first abolished between the original five members: the Benelux three, France and Germany. If Germany gave up its beloved deutschmark in the cause of European integration, France sacrificed sole control over its own borders and reluctantly accepted the free movement of people between EU member-states. Whereas Germany was able to ensure that the European Central Bank reflected its own economic orthodoxy, France had no such means to export its traditions of robust border security to countries guarding the new external frontier. Hence its authorities initially refused to drop border controls after 1995, citing smuggling at the Belgian border and a row with the Netherlands over its liberal drugs policy, to the general consternation of fellow Schengen members.

The Schengen area does have common rules on borders and visas that detail the standards its members must maintain in their border checks and consular procedures. But such stipulations are purely technical in nature and deliberately limited in scope. For example, Schengen countries have only recently agreed to harmonise the background information required from travellers applying for a visa in their consulates abroad. Their governments are highly unlikely to be able to agree anything like a coherent immigration or common security policy in the short-term.

Schengen members are reviewed once every five years for their compliance with the basic technical requirements by teams of border guards and police from their peers, led by the EU presidency. These inspections produce 'recommendations' for improvements to be made but there is very little to force the country in question to follow them up. Greece has completed two such peer reviews and received reams of recommendations since joining Schengen in 2000. But Frontex – the EU's border agency – still reported in early 2012 that the country will remain the largest source of illegal entry to the passport-free zone until at least 2013, with illegal entries remaining as high as 50,000 per year. See http://frontex.europa.eu/assets/Publications/Risk_Analysis/Annual_Risk_Analysis_2012.pdf

Such figures are based only on the number of migrants caught trying to cross the border: the total number of detected and undetected illegal entries is higher.

The net result of all this is that France views the Schengen area very much the way Britain sees its membership of the EU. The French feel trapped inside a club in which they claim higher standards than others while having little faith that fellow members can be kept even to the minimalist rules to which they have signed up. That is why Sarkozy hoodwinked his Italian counterpart, Silvio Berlusconi, into pushing for a review of the Schengen regime in April 2011, after Tunisian migrants began to reach France over its open border with Italy following the unrest of the Arab spring.*

Currently, Schengen members can re-introduce border checks for up to 30 days if either public security or 'order' is at stake, without asking permission of other members or the European Commission. The latter condition is defined quite strictly in EU law: countries usually only invoke it to ensure the security of major events like international sporting tournaments or political summits. (Switzerland, one of Schengen's four non-EU members, invokes the clause annually to maintain security at the World Economic Forum in Davos, for example.) But, if the Greeks are going to permit 50,000 illegal entries to their – and, potentially, French – territory each year, France feels entitled to argue that Schengen's border code should include a third condition for the unilateral re-introduction of border controls: large-scale illegal immigration.

The European Commission has the job of ensuring that Europe's borders remain as open as possible to trade and the free movement of people. Cecilia Malmström, the EU Commissioner for Home Affairs, fears that France's proposed new exemption would result in a tit-for-tat retaliatory imposition of border controls across the passport-free zone. Instead, she has proposed that countries may re-instate border checks but only if the border code is also amended to give the Commission the right to approve specific incidences lasting longer than five days.

However, Guéant, backed up by Germany, Austria and others, made clear last week that Schengen governments consider the latter idea an unconscionable – and opportunistic – power grab. Never before has the Commission had the power to stop a country guarding its own borders. This doomed attempt to establish a confederal arrangement for managing Schengen exposes the contradiction facing the passport-free zone: governments want more control over their own but also over other countries' border decisions simultaneously. (French authorities are dismissive of inspections by EU-led teams evaluating their own implementation of Schengen rules but expect countries like Greece to fall into line.) At the same time, Commission officials must beware of over-reaching: a world of difference exists between winning formal legal powers over a sensitive area of policy and having the moral authority to intervene in national decisions on immigration and security.

 

France's problems with the Schengen area were there before Sarkozy, and they will remain after he leaves office. So there must be a re-think if the current tensions within the passport-free zone are to ease. One preliminary idea is for Malmström to take a zero-tolerance approach to non-compliance with the existing border and visa codes (as well as EU rules on the security of passports) by bringing countries to the European Court of Justice for minor infractions. That would help convince other members that the passport-free zone is a club where those who do not play by the rules are swiftly taken to task. “France is attached to Schengen, but to a Schengen that works”, said Michel Barnier, then France's Europe minister, in 1995. Given that other members – even Schengen's biggest supporter, Germany –  seem to be losing patience with the current system's imperfections, the Commission needs to put this sentiment at the core of any further attempts at reform.

* For a fuller analysis of the politics of the Schengen area, please see the CER report: Saving Schengen: How to protect passport-freetravel in Europe

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

Governance reforms have left the euro's flawed structure intact

Eurozone policy-makers often complain that they are not given enough credit for all the changes they have pushed through since the Greek sovereign debt crisis broke out. It is an understandable reaction. Since 2010, they have presided over a major overhaul of the eurozone’s governance framework. They have adopted a ‘Euro Plus Pact’, which commits countries to pushing through supply-side reforms; a ‘Six-Pack’, which strengthens the old Stability and Growth Pact and adds a new framework for monitoring economic imbalances; and a ‘Fiscal Stability Treaty’ (or ‘compact’), which requires member-states to implement balanced budget rules into their national law. In addition, they have created a bail-out fund (or firewall) to provide liquidity assistance to distressed sovereigns.

European leaders are right on one point: most of these changes would have seemed inconceivable only two years ago. More doubtful, however, is their claim that the changes represent a major step towards greater fiscal union. True, the new framework implies substantial new constraints on sovereignty (as several member-states have already found out). But in a more fundamental sense, the eurozone’s essential character remains unchanged. It is still what it was when it was originally launched: a currency which is embedded in a fiscally decentralised confederation, rather than a fully-fledged federation (such as the US). The thrust of all the reforms has been to reaffirm the eurozone as a rules-based currency union. The animating principle remains collective responsibility, rather than solidarity.

Consider what the eurozone still lacks compared with, say, the US. It has no federal budget for macroeconomic stabilisation: the EU budget is too small (at 1 per cent of GDP) and it cannot in any case go into deficit. Individual states are separately, not jointly, responsible for backstopping the banking system – unlike in the US. And the eurozone lacks a federal agency that issues government debt for the currency union as a whole. In other words, after all the repair work that has been carried out since 2010, the eurozone’s basic institutional configuration remains what it was before the crisis broke out. Because its member-states are reluctant to share the costs of a common currency, critical functions that are performed at the federal level in the US are undertaken at national level in the eurozone.

If the past two years have taught us anything, it is that the eurozone’s fiscally decentralised structure makes it a fundamentally unstable construct. One reason is that because the member-states do not monopolise the currency in which they issue their debt, the bond markets may treat the fiscally weaker among them as if they had issued it in a foreign currency. Another reason is that banks and states interact very differently in a fiscally decentralised currency union than they do in a federal one. Thus, in the US, the fiscal position of an individual state has no bearing on depositors’ confidence in a bank that is incorporated in that state; in the eurozone it does. Equally, banks in the US pose no direct threat to the solvency of the state in which they are incorporated; in the eurozone they do.

If one accepts that the eurozone is unstable because it is structurally flawed, what does this mean for its future? An optimistic case would go something like this. The US did not become a fiscally integrated monetary union overnight; we should not expect the eurozone to do so either. The elaborate system of rules on which Germany has insisted is necessary to establish a pan-European ‘stability culture’. Once that culture has been established, greater fiscal integration will be possible. In the meantime, embryonic federal institutions are slowly emerging. The eurozone’s bail-out fund could be viewed as a nascent debt agency. And the European Supervisory Authorities that were set up in 2011 could develop into a unified banking supervisory system with common fiscal resources to rescue and recapitalise banks.

A more pessimistic reading is that the focus on rules conceals deep-rooted opposition to the very prospect of fiscal union. One sign of this opposition is the European Central Bank’s emergence as the eurozone’s leading (but still largely covert) cross-border financier. Another sign is the IMF’s involvement in the bail-outs of Greece, Ireland and Portugal (it is unprecedented for the IMF to provide support to the sub-units of an entity that, like the eurozone, is running a current-account surplus). A third sign is the institutional sequence which the eurozone has followed: whereas in the US the federal assumption of state debts preceded the adoption of balanced budget rules by the states, in the eurozone balanced budget rules for the member-states have come first and the rest has yet to follow.

At best, then, the eurozone is in a state of institutional limbo. It has acquired some of the form, but little of the substance of a proper fiscal union. For the time being, the assumption (or hope) is that the eurozone will extricate itself from the crisis – and become a more stable arrangement over the long term – if it ‘Europeanises’ German discipline. Among creditor countries, the hope is not that collective discipline will make fiscal union (properly conceived) possible, but unnecessary. But they under-estimate the peculiar vulnerabilities to which the eurozone’s fiscally decentralised structure exposes its indebted members: not only are the latter particularly vulnerable to ‘sudden stops’ in private-sector capital flows, but they are also condemned to pursuing self-defeating economic policies.

In the end, it is the politics of the eurozone crisis that make its economics intractable – not the other way round. At root, the eurozone is in crisis because most voters still think of themselves as nationals first and Europeans second. The eurozone’s fiscally decentralised structure simply reflects the fact that solidarity is weaker across European borders than it is within them. The upshot is that EU leaders do not have a democratic mandate to complete the currency union. Their political commitment to the euro remains strong. They will do all they can to prevent the eurozone breaking apart, and will probably succeed. But it is harder to see how a European demos (and hence more stable currency zone) can emerge from the economic pain and mounting cross-border resentment that current policies are causing.

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

Energy efficiency: Made in Denmark, exportable to the rest of the EU?

Denmark uses energy more efficiently than any other EU member-state. Successive governments have implemented ambitious and consistent policies on energy efficiency since the oil shocks of the 1970s. As a result, Denmark today only uses 60 per cent of the energy per unit of GDP of the EU average. Thus it was no surprise when in January the new Danish presidency of the EU’s Council of Ministers identified a draft ‘energy efficiency directive’ as one of its priorities for its six-month term. But Copenhagen’s efforts look unlikely to lead to agreement before the end of June, when the Danish presidency ends. Several member-states, including Germany and France, are trying to weaken key aspects of the draft directive. The Danish government’s desire to oversee agreement on the ‘energy efficiency directive’ is understandable. But a ‘lowest common denominator’ agreement would be worth little. It would be better for Copenhagen to stick to most of the Commission’s proposals, and remind its partners that in the long run these reforms would save them billions of euros. Where necessary, Denmark could point to its own experience to underline the point.

Failure to take firm action on energy efficiency would be bad news for the European economy. The Commission’s proposals are sensible, shifting the emphasis away from overall medium- and long-term targets – of which the EU has too many – towards annual obligations and specific actions which EU governments will have to take. Philip Lowe, EU director general for energy policy, correctly points out that using energy more efficiently would reduce the cost of importing energy, which was €400 billion in 2011, and create hundreds of thousands of new jobs. The EU has a non-binding target to become 20 per cent more energy efficient, compared to the predicted ‘business as usual’ trend, by 2020. At present it has only become nine per cent more efficient. Lowe argues that the extra energy used under the scenario without greater energy efficiency would cost member-states at least €34 billion by 2020. Such counterfactual calculations are not precise, but it is clear that failure to act on energy efficiency will cost the EU many billions – hard to justify under any circumstances, but even more so when finances are stretched.

The Commission has proposed two annual obligations. First, member-states should renovate at least 3 per cent of the large public buildings in their country. Second, energy retailers should take action to deliver 1.5 per cent energy saving among their clients.

Both these proposals are modest and achievable, and are essential to delivering substantial energy savings. Yet several member states, led by Germany and France, are trying to weaken them substantially. The obligation to renovate public buildings would, as well as delivering energy savings, put governments in a position of leading by example, as the Commission has pointed out. But some governments are trying to reduce this obligation to cover only properties owned and occupied by central government, which would significantly dampen the intended impact of the proposed reform. The Presidency should stick to the Commission’s approach on this issue.

On the energy retailers’ obligation, Austria is arguing that action taken since 2005 should be taken into account. This is a valid point. Retailers who have taken action to get their clients to use energy more efficiently will find it harder to make efficiency improvements in the future – unless they get substantial numbers of new clients – because the ‘low hanging fruit’ has already been picked. Clients’ buildings will have been insulated, inefficient boilers replaced, and so on. So there is scope for compromise with the member-states on this issue.

However, Poland and Sweden are seeking to cut the annual savings obligation from 1.5 per cent to 1.2 per cent. This would substantially reduce the impact of the obligation, and should be strenuously resisted by the Danes and other member-states.

Some governments, led by France, are also arguing that some of the energy sold by retailers to Emissions Trading System (ETS) sectors should be excluded from the requirement on retailers. This would not be a sensible approach. The ETS, the EU’s cap-and-trade scheme for greenhouse gases, has had little impact on energy efficiency so far, and with prices at around €7 per tonne of carbon dioxide will have even less impact in future unless the system is strengthened. (At the time of the last amendment to the ETS directive in 2009, prices of around €30 per tonne were anticipated.) Progress on energy efficiency could lead to a further fall in the carbon price unless the overall cap was lowered, as less energy being used would mean lower emissions from key sectors, including the power sector, so lower demand for allowances. The draft ‘energy efficiency directive’ does include proposals to withdraw (or ‘set aside’, to use the Brussels jargon) a number of allowances in response to energy efficiency measures, so that energy savings do not lead to further falls in allowance prices.

A recent report from the academic network Climate Strategies argues correctly that set aside is a necessary step to prevent further reductions in allowance prices, but will not deliver price stability or predictability. Stability and predictability are needed in order to attract investment into energy efficiency and low-carbon energy supply sectors. Nor will set aside increase the ETS price significantly. So set aside is not sufficient. But it is a necessary first step, and should be included in the ‘energy efficiency directive’.

France is also resisting the Commission proposal that most new power stations should capture and use the heat created when fuel is burnt to generate electricity (an approach called combined heat and power, or ‘co-generation’). France’s opposition is presumably due to its desire to keep the cost of new nuclear power stations down. The French get over three-quarters of their electricity from nuclear power. Nuclear power stations create heat, which can be used in buildings or industrial facilities. Switzerland got 7.5 per cent of its heat from nuclear power stations in 2009. Within the EU, Slovakia got over 5 per cent of its heat from nuclear stations in 2009. Hungary and the Czech Republic also use nuclear heat. But in the EU’s main nuclear players, such as France and the UK, the heat is simply expelled into rivers and seas.

Combined heat and power becomes a more usable technology when a country has installed a district heating system, to transport the heat to homes and factories. In the Nordic countries heat produced in this manner is transported up to a hundred kilometres. A small amount of heat is lost en route, but since it would otherwise just have been pumped into the atmosphere or the seas, this does not represent wastage. Denmark installed extensive district heating networks in the late 1970s and 1980s, and now tops the European league of combined heat and power as a proportion of total energy generated. So whatever the Danish government does to try and get agreement on energy efficiency before the end of June, and whatever its temptation to act as chairman of the Council rather than leader, it should remain firm in support of the Commission proposal on combined heat and power.

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