What Central Europe thinks of Britain and why

Britain's Conservative Party is committed to repatriating powers from the EU. On July 12th, Foreign Secretary William Hague launched a review of the EU's competences. This would, he told Parliament, be an "audit of…where competence lies, how the EU's competences, whether exclusive, shared or supporting, are used, and what that means for our national interest." Many Conservatives expect this audit to prepare the ground for a manifesto commitment to renegotiate the terms of Britain's EU membership. They hope that Britain can obtain opt-outs in areas such as financial services, judicial co-operation, employment, migration, regional policy or fisheries. They argue that Britain's partners will wish to change the EU treaties to cope with the eurozone crisis, and that Britain can trade off the repatriation of powers in return for its signature.

However, any British opt-out would require the unanimous agreement of every other member-state. Conversations with diplomats from Central Europe suggest that there is very little goodwill towards London, even among its formerly stalwart allies.

The Central Europeans see the UK as an important partner. When David Cameron circulated a letter in February 2012 outlining single market reforms that would revive the European economy, five of the eleven co-signatories came from Central Europe, with Germany and France the notable absentees. The new member-states sided with London against Paris and Berlin over the Iraq war, and the UK shares their desire to bring more Balkan countries into the EU – again, against much scepticism from many continental countries.

And yet the UK cannot count on all Central Europeans to support its demand for opt-outs from EU legislation. This is for two reasons: Germany has become the central focus of the region’s foreign policies, and Britain has come to be seen by other member-states as taking advantage of the common currency's existential troubles to defend its narrow interests.

Germany is by far the largest investor in Central Europe, and its economy is deeply embedded in the wider region. When I asked a former finance minister from Central Europe to predict his country's growth rate, he replied "take Germany’s number and add one percentage point". Most Central European governments also assume that there is a possibility of the eurozone fracturing and losing some of its member-states. If and when it happens, they want to remain a part of the Berlin-led economic core. London will be of little help in such a crisis – it is too far away, has too few investments in Central Europe, and wants to have less and less to do with the EU in general. So the new member-states (and others in similar situations such as Denmark or the Netherlands) will have few reasons for wanting to spend political capital on supporting UK demands for exemptions from EU legislation, especially if Germany opposes them (and senior officials in Berlin take a hard line in opposing British attempts to repatriate powers).

Furthermore, the UK offers nothing in return (it is not contributing to the eurozone bailout fund) and Britain’s exemptions may adversely affect other countries’ economies. They fear, for example, that if the UK relaxes social protection for workers (a key Conservative demand), businesses elsewhere in Europe will migrate to the UK. "London is engaging in 'beggar-thy-neighbour' tactics", one official from Central Europe told me (though France and others say the same of the new member-states' low corporate tax rate). In December 2011 Britain threatened to veto the proposed ‘fiscal compact’ to secure an opt-out from rules governing financial services. But the tactic misfired – the rest of the EU minus the Czech Republic agreed to form the compact anyway; they did so outside existing EU treaties and without Britain. Any future banking or fiscal union will almost certainly be organised in a similar way, a Baltic diplomat told me, because the UK and the Czech Republic – and possibly others – do not want closer integration. This leaves London without any good means to pressure others to secure its opt-outs. "The rest of the EU now knows that it is possible to isolate Britain, and they are more willing than ever to do so. It is not clear that Britain realises that", the official said.

Nothing has hurt Britain's image elsewhere in Europe more than the perception that London is failing to help to end the crisis and – worse – that the UK is taking advantage of others' woes. A Polish official told me that during the December 2011 negotiations London lobbied Warsaw to stay out of the fiscal compact. Its creation is a key part of the member-states’ efforts to stop the run on their sovereign debt. The fact that Britain not only decided against joining it but sought to discourage other non-euro countries from doing so – presumably to avoid being isolated – has been seen by many as an act of remarkable ill will. According to a senior Baltic official "Britain is a nuisance; it imposes an additional burden on us of having to go around it, complicating negotiations". This is not entirely fair: British proposals on how to stimulate economic growth, which many Central European governments signed, are among the most thoughtful of such contributions. But European diplomats think that London puts a lot more energy into demanding special deals for itself than solving the crisis.

The Central European officials I interviewed sounded genuinely regretful of Britain's growing estrangement from the EU – there was no sense of 'good riddance' or gloating. But Britain’s likely demands for opt-outs from EU policies will have very little support from them (with the possible exception of the Czech Republic). A dangerous situation has emerged. Even though the government in London seems likely to attempt to unpick some of its ties, rather than sever them all, it risks rejection. And would a bruised UK want to remain in the EU? The Central Europeans fear that Britain may drop out in anger, in effect leaving the EU by accident rather than by design. But, as one Polish official acknowledged "as long as the eurozone is a mess, Britain will not want to be shackled to a sinking ship. We need to sort out our banks and economies first, thus giving London the reason to stay".

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

Has the eurozone reached the limits of the politically possible?

June's EU summit was the first to agree measures that address the core of the crisis: inflated government borrowing costs that weaken public finances and ultimately make sovereign insolvency self-fulfilling; and a vicious cycle in which worries about bank and sovereign solvency feed on and amplify each other. Unfortunately, the agreed measures were modest and have already prompted a backlash in various countries, not least in Germany and the Netherlands. Indeed, much of what was agreed at the summit is unlikely to come into effect. All this suggests that the limits of the politically possible may already have been reached.

Many commentators have raised the possibility of a grand bargain under which the Germans sign up to debt mutualisation and the French agree to cede sovereignty over budgetary policy. Germany has not ruled out debt mutualisation and a banking union, but argues that there must be a political union first. The problem with Germany's position is that the French have never ruled-out a loss of budgetary sovereignty in return for a proper fiscal union. Nor have the Spanish or the Italians. They are not opposed to political union, but argue that there must be crisis management first. 

This French-Italian-Spanish argument makes sense; there is not time to create a political union before acting. Also, countries cannot cede sovereignty without getting something immediate in return. For example, if Mario Monti signed up to whatever the Germans mean by political union without extracting a concrete commitment to mutualise debt, he would be out of power very quickly. If the Germans offered some form of risk mutualisation in return for much closer political integration, the French, Italians and Spanish would no doubt readily sign up. The Germans know that. The problem is not how to strike a grand bargain; the question is whether the Germans want it or are able to deliver on their part of it.

The necessary institutional reform can hardly be pushed through under the radar, but must win democratic approval. This will clearly not be easy to secure. Of course, while Germany is running a big trade surplus with the rest of the eurozone which Germany's private sector is no longer willing to finance, transfers of one sort or another are inevitable. But no-one should be under any illusions about how difficult this is for politicians to explain to their electorates, even if they understand themselves. In the public's eyes and in the minds of many politicians, a trade surplus just shows that their country is more competitive. What could be wrong with that?

And the Germans and others do have legitimate concerns about the sustainability of a fiscal union. It will require a high degree of solidarity between its component parts. We see that solidarity within Germany, or in the UK or US, but it is less clear that it exists in the eurozone. Even if they could win democratic approval for such measures, German politicians understandably fear that a fiscal union would be difficult to sustain politically. This would especially be the case if the performance of eurozone's southern members failed to improve, creating a kind of giant Mezzogiorno. German politicians fear that this could give rise to populism and anti-EU feeling. There are similar concerns in the Netherlands and elsewhere.

In short, there is a far from negligible risk that the Germans and their allies are not going to move far enough to save the euro, or that they fail to get the necessary political buy-in for whatever they do agree to. Under such a scenario the euro really could unravel. If – and it is hard to see how they can avoid it under the current policies – Spain and Italy get caught in a vicious cycle of slump and rising debt, Spanish and Italian borrowing costs will continue to rise, shutting them out of the market. The ESM is too small to bail-out them out, and there is no chance of it being granted a bank license so as to borrow unlimited sums from the ECB. The ECB itself could enter the market itself and buy large volumes of Spanish and Italian debt, but the central bank may not be able to do this in the face of staunch opposition from Germany and a number of others. Could Germany and its allies be outvoted on the ECB? This is possible. But if they were, this would put paid to the possibility of the Germans, Dutch and other sceptical countries making concessions on the institutional questions, so it could prove a pyrrhic victory.

At this point the politics would start to look decidedly dicey in the struggling economies, and between them and the core of the eurozone. Politicians may start to feel trapped. Italy could prove pivotal. With Monti gone and replaced by a more populist leader, at the head of a coalition including the new anti-euro movement led by Beppe Grillo, the Italians could threaten to quit the euro unless the costs of sharing the currency are pooled. This would be a credible threat. Italy has a primary budget surplus (that is, a surplus before the payment of interest). The Italians would be loath to play such a card, but Italy could come to perceive departure as the lesser of two evils. If Italy withdrew, so would Spain. France would then come under massive pressure. The Germans would probably offer France a debt union, but would the latter go for it? They would have a hugely overvalued currency and would be a very junior partner.

To many this scenario will sound far-fetched – how could something that will have such far-reaching implications for the European economy, the region's political stability and its security, be allowed to happen? Because the solution to the crisis requires governments to do things for which they have no mandate. And the longer the crisis festers, the more difficult it will be to win such a mandate. This is the tragedy of the eurozone's handling of the crisis. Had the ECB been allowed to intervene in the markets and dispel fears for the solvency of the Spain and Italy, and had the region's creditor countries refrained from imposing self-defeating fiscal austerity on the struggling economies, the eurozone would have had much more time to prepare the ground for the necessary institutional reforms, which could have been implemented incrementally. But the crisis has now deepened to such a point that only big institutional steps will restore the credibility of the eurozone. This puts politicians in the eurozone's creditor countries in an invidious position: save the euro and be voted out of office, or open the way for an unravelling of the single currency with all the resulting economic and political fall-out. 

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

Britain should not go Swiss

British eurosceptics want to renegotiate the UK’s relationship with the EU. They divide into two camps. There are those who want Britain to stay in the EU, but win opt-outs from social and employment legislation and from justice and home affairs policy. This includes most Conservative government ministers. A second group, which includes many Conservative backbenchers, wants a looser relationship still. This camp seeks a British withdrawal from the EU.

The second group is vaguer about the terms on which the UK would carry on its trade with continental Europe after withdrawal. Some speak of a Norwegian arrangement, which would involve the UK joining the European Economic Area (EEA). Alternatively, the UK could sign a bilateral free trade agreement, under which Britain would be free to regulate its own markets as it sees fit. For most people in this camp, EU membership burdens the UK with too many regulations. If the UK left the EU, British products would still be in high demand, and the UK could carry on trading, but free of the EU’s supposedly constraining rules. And without those rules, the UK could concentrate on chasing growing demand in Brazil, China and the rest. The UK could become Norway or Switzerland – that is, in Europe but not in the EU, and freer and more prosperous as a result.

There are three flaws in this analysis, which arise from confusion about the nature of the single market, a failure to be hard-headed about its costs and benefits, and a lazy assumption that the UK can become Norway or Switzerland.

To take the last point first: Norway and Switzerland have a semi-detached relationship with the EU. But they are more attached than some eurosceptics imagine. As a member of the European Economic Area, Norway (along with Iceland and Liechtenstein) has access to the EU’s single market, and Norwegian citizens have the right to travel and work in the EU. Norway, moreover, has opt-outs from EU policies it does not like – like the EU’s common fisheries policy. But Norway’s special arrangements come at a price: the country must implement the EU’s single market legislation – including the social policies so disliked in Britain – but is excluded from decision-making on the rules. Norway must also contribute to the EU budget for structural funds and regional development.

If Britain withdrew from the EU and joined the EEA, it would be able to opt out of the common agricultural and fisheries policies. This would save a modest amount (around £1.1 billion a year, or 0.07 per cent of GDP) because Britain pays more into these programmes than it gets out. But Westminster would still have to sign all single market legislation into law, including social and employment policies.

What about Switzerland’s arrangements with the EU? Switzerland is not in the EEA, but has negotiated a series of bilateral agreements to get access to some areas of the single market. Switzerland must largely accept EU legislation pertaining to the markets it wants access to.

But is this not precisely the relationship the eurosceptics want? Could the UK, like Switzerland, have its fondue (the ability to sell to the rest of Europe) and eat it (avoiding those Brussels directives it dislikes)? Unfortunately, the answer is no. Switzerland signed up to the EU’s customs union in 1972, which abolished subsidy and tariff barriers. Since then, it has also decided to sign up to the majority of the single market: it is a full member of the single market for goods, a signatory to the Schengen agreement, and it has signed up to most of the single market for capital. In many areas, therefore, Switzerland is effectively a member of the single market. But like Norway, it does not have the ability to affect the rules that govern it.

Swiss firms are asking for further integration, too. Switzerland decided not to sign up to a range of financial services legislation in the 2000s, and was frozen out of some EU markets as a result. Swiss fund managers were prevented from offering asset management across the EU. Swiss banks are now starting to put pressure on the government to sign up to the EU’s post-crash financial rules.

All of which brings us to what the single market is, and why the UK needs it. Among developed countries, the biggest remaining obstacles to trade are non-tariff barriers like different national regulatory regimes. Eliminating tariffs and subsidies will only get you so far: if drugs have not been licensed for sale in another country, they cannot be exported. The single market aims to eliminate non-tariff barriers to trade by establishing common minimum standards, then forcing member-states to open their markets to foreign firms.
Yes, the EU’s approach to this has created some economic costs in the form of regulation (partly to soothe workers’ fears of competition run amok). But it is hard to argue that they are particularly large: under the working time directive, people have the right not to work more than 48 hours, and if they want to work more they are allowed to do so. Meanwhile, the benefits of single market membership are enormous. In principle, British firms have access to a huge market for their products, without 27 different sets of national barriers getting in the way. And foreign firms can enter our markets, forcing domestic companies to improve their performance.

It is difficult to imagine that the rest of the EU would cheerily say goodbye to Britain, but then let it have access to the single market without keeping the rules it has already signed up to, and agreeing to sign future rules into national law. And unlike Norway, the UK is a big and diverse trader. It does not specialise in oil: the UK is a big trader in many services, including telecoms, business consultancy, software and computing, law, financial services, publishing, design and much else. It also exports many high-technology goods, especially pharmaceuticals, chemicals and photographic equipment. Common regulations in each of these sectors allow UK firms to export without adapting their products and services to meet the rules of every country. This is not to suggest that foreign imports are not also good for the UK economy. British firms that cater for domestic markets are challenged by other European firms, forcing them to be more productive and innovative. Therefore, if it left the EU, it would still be in the UK’s interest to sign up to many of the EU’s rules.

In any event, it is almost certain that Britain’s eurosceptics will not get what they want: access to the single market without having to respect the common rules that make it work, or the policing of those rules by the Commission and the Court of Justice. Britain’s partners do accept its opting out of the single currency and some justice and home affairs policy. But they will not let Britain have something for nothing.

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

Are Europeans a better transatlantic security partner than meets the eye?

The latest wave of European military spending cuts is swelling the ranks of Americans who believe that Europeans are not contributing enough to global security. But this assessment is too harsh. It is true that Europeans spend less on defence than their American counterparts. They have also been less willing to use force in recent years. But the US itself is reassessing the merit of its military interventions over the last decade. And when one takes into account policies that are not strictly military, such as aid, sanctions and homeland security, Europeans are making some significant contributions to international stability.

A number of European countries are undoubtedly falling short of their NATO and EU promises to develop a global military reach. Many governments have been slow to transform their militaries from immobile forces designed to counter a Soviet invasion into rapidly deployable combat troops. Even prior to the economic crisis, most European NATO allies had stopped spending the alliance's agreed benchmark of 2 per cent of GDP on defence. And Nicolas Gros-Verheyde, the influential French blogger, estimates that the economic downturn will lead to a 30 per cent drop in total military spending by EU member-states between 2006 and 2014. As a result, even if America cuts its own defence budget by $1 trillion over the next decade – as Congress is currently considering – the US military will still receive more than twice as much as the armed forces of all EU countries combined. 

Since the end of the Cold War, a number of European countries have also been reluctant to deploy troops, particularly for heavy combat operations. Many governments have refused to send their soldiers to the most dangerous parts of Afghanistan. More than half of the European countries in NATO did not participate in the deployment to Libya. And many EU military and civilian missions have been too small to make a significant impact. Washington critics are particularly dismissive of the 60 EU officials advising Iraqis on how to improve their criminal justice system and the approximately 500 EU police trainers in Afghanistan.

Europe's recent military track record derives from the fact that most Europeans have not felt threatened. Many also do not believe that war should be used to obtain 'justice'. In a recent GMF survey of the US and 12 EU countries, only 33 per cent of Europeans believed that war is sometimes necessary to obtain justice – in contrast to 75 per cent of Americans. In addition, Europeans have been particularly doubtful of the merit of Washington's use of force over the past decade, be it Afghanistan or Iraq.

In light of this mindset, Europeans have actually been quite active on the military front. According to the Stockholm International Peace Research Institute, in 2011, Britain, France and Germany were still amongst the ten largest military spenders in the world (ranking third, fourth and eighth). The combined defence expenditure of European NATO members is still more than twice what China spends – even though Europeans do not reap the full benefits of it because they duplicate many of their military efforts. 

For several years, European troops made up more than half of NATO's mission in Afghanistan. And on a per capita basis, Denmark and Estonia have suffered more casualties there than the US. Europeans undertook 90 per cent of the strike missions in Libya. In addition, many of the EU's missions, even if modest, are still helping to stabilise countries across the world. In the Gulf of Aden, an EU naval force protects vulnerable boats from pirates, including the World Food Programme vessels which deliver food to Somali people. In the months to come, the EU will deploy civilians to help the government in Niger reform its security sector (a country where, according to European governments, Islamist militants threaten international security). EU experts will also soon help improve the security at the international airport in Juba, the capital of newly independent South Sudan.

In any case, American policy-makers are themselves reconsidering the merits of how the US has used force over the last decade. The Obama administration has been extricating US armed forces from Iraq and Afghanistan – even though in both countries, the US has not achieved the level of stability which it had initially aspired to. The government's new defence guidance stresses that the US does not intend to deploy similar missions in future. It also argues that America cannot meet its security challenges through military force alone and that it must strengthen all the 'tools' of American power, including diplomacy, development, intelligence and homeland security. 

These are areas in which Europeans are significant players. Combined, the EU institutions and member-states are the largest aid donor in the world. According to the OECD, they spent €69 billion in 2011 – notwithstanding the fact that some European countries reduced their budgets because of the economic crisis. This is more than twice the amount the US gave. Between 2002 and 2013, the EU institutions and member-states will notably have provided €11 billion in aid to Afghanistan. And in response to the Arab Spring, the EU institutions alone have offered nearly €7 billion over three years. 

Europeans also invest significant resources in homeland security, even if budgets risk declining somewhat over the next few years because of the economic turmoil. Based on the latest OECD figures, the 21 EU member-states which belong to the organisation spent nearly €240 billion on 'public order and safety' in 2010 – nearly 90 per cent of what the US spent. This covers police forces, intelligence services, the judiciary and ministries of internal affairs. The US is a beneficiary of this spending too – in addition to supporting Europe's internal stability, these bodies tackle the international terrorism and organised crime that afflict Europeans and their allies alike. 

European countries are also increasing the EU's involvement in security matters – including through the EU's bilateral ties with third countries. One EU agency, Frontex, monitors the Union's southern and eastern border, while another, Europol, tackles organised crime. EU funds for homeland security, although still modest, are increasing despite the economic crisis. From 2014 to 2020, the EU is expected to spend nearly €10 billion in this field. The money will notably fund research into intelligent maritime surveillance systems and help partner countries across the world fight criminal networks and monitor their borders more effectively.

European governments also leverage the EU's large common market to pursue their foreign policy objectives. They offer preferential trade ties to support the economic development of numerous fragile countries across the world, and to encourage them to improve their governance. Pakistan is one of the states which qualify for some of the EU's most generous trade concessions. EU countries also impose heavy sanctions on countries which they believe are undermining international security. Among other things, the EU recently introduced an oil embargo against Iran – even though the measure is inflicting significant economic hardship on Greece and other EU states which were already struggling with the financial crisis. And through the offer of EU and NATO membership, Europeans (and the US) have managed to spread stability across the European continent.

The fact that Europeans wield such extensive foreign policy 'tools' does not mean they always use them wisely. Nor should it allow Europeans to neglect their armed forces. Governments must ensure that their peacekeeping efforts are not hampered by inadequate military equipment, and that they retain the capacity to respond to a serious military threat if one were to emerge. But America is less alone in upholding global security than some in Washington would suggest.

Patryk Pawlak is a research fellow at the EU Institute for Security Studies and Clara Marina O'Donnell is a research fellow at the Centre for European Reform and a non-resident fellow at The Brookings Institution.

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.