Germany’s plans for treaty change – and what they mean for Britain

Last year, German leaders talked of the need to strengthen the eurozone through changing the EU’s treaties. One person who listened carefully was David Cameron. The British prime minister may have assumed that what Germany wants in the EU these days, it gets. When he made a big speech on Europe in January, Cameron predicted that the EU would need a new treaty in the next few years. He implied that Britain would be able to extract concessions from its partners, in return for signing the treaty – all in time for the referendum on UK membership that he promised in 2017.

But Cameron’s strategy is based on a false premise. The mood has changed in Berlin. Recent meetings there with government officials and politicians have convinced me that Germany will not push for the kind of treaty that Cameron wants, at least not in time for his 2017 deadline.

The Germans, it is true, are keener on treaty change than most of their European partners. When they encounter a problem, they look to contracts, laws and treaties, rather than to political fixes. And they may have a preference for treaty change rather than mere legislation, since politicians can easily change the latter. German officials also worry about the constitutional court in Karlsruhe, which has expressed concern about some steps taken by the EU to manage the eurozone crisis. The court could block further moves unless they are backed by new treaty articles.

In Berlin people talk about two sorts of treaty change – big and little. Proponents of a big new treaty want it to establish a ‘political union’. The first step would be a ‘convention on the future of Europe’, including MEPs and national parliamentarians, of the sort that met in 2001-03, before the drafting of the constitutional treaty. The second step would be an inter-governmental conference to draw up a treaty introducing changes like more power for the European Parliament, direct elections for the Commission president and tighter co-ordination of economic policy. Guido Westerwelle, the foreign minister, and Wolfgang Schäuble, the finance minister, have at various times supported big treaty change. Some Bundestag members and Foreign Ministry officials share their federalist sentiments.

But Chancellor Angela Merkel is in overall charge of EU policy. And she told a conference of the Trilateral Commission in Berlin on March 15th that Europe does not need a major new treaty in order to become competitive. She and much of her government have cooled on the idea of big treaty change for four reasons.

First, the government thinks – notwithstanding the imbroglio in Cyprus – that the eurozone crisis is more or less under control. The risk of the currency union breaking up has receded, and with it the need for dramatic moves towards greater integration. Second, the Germans understand Cameron’s tactic of using treaty change as a tool for extracting concessions from Britain’s partners, and they have no desire to give him that leverage.

Third, France and most other member-states do not want a big new treaty. They worry about the difficulties of ratification: some, such as Ireland and perhaps France, would have to hold referendums. The Germans have listened. As one German official commented: “If we embark on another major EU treaty, it could take us about ten years to get the whole thing negotiated and ratified, just like it did with the Lisbon treaty.”

Fourth, the more that some Germans have thought about political union, the more wary they have become. French officials often make the point that the Germans can easily enthuse about political union because they have never had to define precisely what it means. But if EU leaders sat down to draft a text for political union, the Germans would have to acknowledge that greater economic and political integration would cost them money, whether through a eurozone budget, eurobonds or some other mechanism for helping poorer countries.

Even if Germany’s general election in September produces a new coalition, there is little chance that any German government will pursue big treaty change in the foreseeable future. However, many German officials want minor amendments.

In the Chancellery they are keen on changing one or two articles that would allow stronger co-ordination of economic policies. They want to give the old ‘Lisbon agenda’ of economic reform – which ran from 2000 to 2010, with only limited success – some teeth. Their proposed mechanism is a system of economic contracts between particular member-states and the EU. After a dialogue between the government and parliament of the country concerned, and the Commission, the member-state would commit to certain reforms – for example of labour markets or pension systems – in a contract. Discipline would come through penalties for non-compliance, or rewards for good performance, perhaps via a eurozone budget. German officials acknowledge that such economic contracts could be drawn up under the existing treaties, but reckon that either penalties or a eurozone budget would require them to be amended.

In the German Finance Ministry, officials are unenthusiastic about the contracts, but supportive of a different treaty change. They worry that the board of the European Central Bank will be responsible for both monetary policy and banking supervision, and could therefore face a conflict of interest. So they want a new article to entrench the independence of the supervisory system (most other member-states think that legislation can ensure the necessary independence).

Until recently, German officials wanted a minor treaty change to strengthen fiscal discipline. They liked the Dutch idea for a ‘super-commissioner’ with the power to tell national governments to amend budgets. But German officials now realise that tighter budgetary rules than those already set out in the fiscal compact treaty and in recent EU legislation would be unacceptable to many member-states. Furthermore, German attitudes are shifting slightly: though most officials still support strict budgetary targets, they now place a greater emphasis on structural reform as the best way to put the eurozone on a sustainable footing. So they have dropped the idea of a treaty change to enforce greater fiscal discipline.

Some Berlin officials think that a small treaty change to cover economic contracts could be pushed through quickly, without a cumbersome convention, but others disagree. The current treaties allow amendments to be made without a convention in two ways. First, through the ‘simplified procedure’, which cannot be used for changes that increase the EU’s competences. A new article on economic contracts might increase those competences. Second, through the ‘ordinary procedure’. This normally involves calling a convention, but need not if the European Parliament deems it unnecessary. Two recent changes to the EU treaties – to enable the creation of the European Stability Mechanism (the bail-out fund), and to alter the number of MEPs – used the ordinary procedure without a convention. However, the Parliament would probably be unwilling to waive through economic contracts without a convention, given its current support for big treaty change.

Some German officials are quite relaxed about the prospect of a convention. They believe that the European Council would give the convention a specific and limited mandate, to discourage it from attempting to rewrite all the existing treaties. And even if the convention exceeded its mandate, they say, the governments could ignore any unpalatable proposals when, after the convention, they meet in an inter-governmental conference.

Though some German officials are eager for the EU to amend the treaties to underpin economic contracts, they are pessimistic about their ability to persuade the French to agree. The French say that they would not accept the contracts – which they consider unnecessary – without other amendments, for example to allow the mutualisation of sovereign debt, which Germany would balk at. The context for this bargaining is that, as one German official put it, “in more than 20 years of working on Franco-German relations, I have never seen them in such a bad state”. Other countries, too, could seek to balance German demands by asking for new articles that could trouble Germany. So German officials are resigned to the eurozone muddling along without treaty changes for the next few years.

It is possible that at some point France and the other member-states will give the German government the small treaty change it desires. But that would still not solve Cameron’s problem. If the British government wished to, it could probably block a major revision of the EU treaties; the others would find it very hard to bypass a British veto. But if Britain’s partners wanted to change just one or two articles affecting eurozone governance, they could probably get round a British veto as they did in December 2011, when 25 member-states committed to the fiscal compact that was technically not an EU treaty.

If a future Conservative government wanted to renegotiate the treaties, and the other member-states did not, it could not force them to open an inter-governmental conference. The calling of such a conference requires a simple majority – and any ensuing treaty changes would have to be ratified by every member-state. In practice the only option available to Britain would be to activate the Lisbon treaty article that allows a country to quit the EU. That would lead to a negotiation that could, conceivably, conclude with the UK and its partners agreeing on changes that would leave the British inside the EU.

Evidently, moods can change quickly in the EU. A profound crisis in the eurozone could revive talk of a quantum leap towards political union. A new German government could push more forcefully for treaty change than the current one. If France fell into severe difficulties it could become less resistant to German pressure for treaty amendments. And the European Parliament to be elected in May 2014 will certainly – alongside the Commission – press for a federal future. But on current trends, David Cameron will be denied the major treaty change that he seems to be counting on.

Charles Grant is director of the Centre for European Reform

Could Cyprus reignite the eurozone crisis?

Each of the crisis-hit eurozone countries shares some responsibility for its predicament. Italy used membership of the single currency as an excuse to go slow on pushing through much-needed structural reforms of its economy. The Irish and Spanish were excessively relaxed about their booming housing markets. Greece and Portugal were simply not sufficiently converged with the rest of the eurozone to be able to flourish within it; they should not have applied to join or been allowed in. At the same time, all were to a greater or lesser extent victims of the structure of the currency union and the tardy response of its member-states.

But Cyprus is different. The country really is the architect of its own misfortune. This makes finding a workable solution to the crisis even more difficult, and explains why a country with a population of around 1 million could pose a systemic threat to a currency union of 400 million.

How did Cyprus get into this mess in the first place? The answer is that it managed to combine all the excesses of every other European country. Cyprus was Spain, Ireland, Iceland, and Greece rolled into one – but with a Russian twist. Like Spain, it ran large current-account deficits. Like Spain and Ireland, it experienced a real estate bubble. Like Ireland and Iceland, it developed a runaway banking system (with assets reaching 800 per cent of GDP). As in Greece, the public finances were mismanaged. And as in Iceland, the sovereign could not afford to rescue insolvent banks. The twist is that Cyprus achieved all of this while offering high interest bank accounts to non-resident ‘residents’ – mostly wealthy Russians. So Cypriot bank liabilities consisted primarily of deposits, rather than bonded debt.

Ever since the eurozone crisis flared up in late 2009, the politics of crisis management have been marked by the conflicting perspectives of creditor and debtor countries. The same has been true of the Cyprus crisis. Given the sheer accumulation of Cypriot sins, the desire of creditor countries to draw a line in the sand over moral hazard is understandable, not least because of domestic political constraints: it would be impossible for political leaders in other eurozone countries to explain to taxpayers at home why they should have to honour commitments made by Cypriot banks to wealthy Russians. Even so, the terms of the proposed bail out of Cyprus were badly designed. In effect, policy-makers brandished threats that undermined much of what they have spent the past year trying to achieve.

Broadly-speaking, the deal agreed on March 15th looked like this. The Cypriot sovereign would be bailed out by the eurozone, provided it agreed to ‘bail in’ the creditors of its banks. Since Cypriot banks mostly funded themselves from deposits rather than by issuing debt, this meant that depositors in Cypriot banks would have to take a haircut. The precise form of that haircut would be for the Cypriots to decide. But if they refused to play ball, no bail out would be forthcoming – and Cypriot banks would not qualify for ECB funding under its Emergency Liquidity Assistance (ELA) programme. The result: Cyprus would default and its banking system would collapse. Faced with this choice, Cyprus agreed to ‘bail in’ bank depositors. It announced a 9.9 per cent tax on deposits over €100,000 and a 6.75 per cent tax on deposits under €100,000.

By March 18th, however, the deal was already beginning to unravel under the weight of its contradictions. Several problems had become apparent. First, the Cypriot tax cast doubt over commitments under EU law to guarantee deposits up to €100,000. Second, the Cypriot tax seemed to subordinate the interests of ordinary depositors to those of bondholders. Third, the deal seemed to be at odds with broader attempts to build a banking system in which investors, rather than taxpayers, pay for banks’ mistakes. Fourth, the deal did not ‘bail in’ creditors of the banks in the framework of an orderly bank resolution procedure. Fifth, the ECB’s threats to cut off emergency funding to Cypriot banks cast doubt upon its willingness to do “all that it takes” to save the euro (or to keep a country in it). Finally, the bail-out highlighted some of the design flaws of the currency union that have still not been resolved.

Where does this leave Cyprus? The Cypriot authorities appear to believe that it is still possible for Cyprus to remain in the eurozone while retaining the country’s offshore banking model. It is not. The only hope the Cypriots have of staying in the currency union is to impose much larger losses on their foreign depositors. These creditors knew what they were doing when they deposited money with Cypriot banks, and the investment has proven highly profitable for them. Only by forcing much larger losses onto foreign creditors can the Cypriots have any hope of raising their share of the costs of the bail-out, and of defusing the understandable anger felt elsewhere in the eurozone at the prospect of tax-payers’ money being used to bail-out Russian oligarchs.

In exchange for forcing the Russians and other foreign creditors to finance more of the cost of the clean-up, it is possible (though far from a foregone conclusion) that the rest of the eurozone could increase the amount of money it is prepared to contribute to the bail-out. Any attempt by Cyprus to raise the necessary funds by imposing haircuts on domestic bank deposits or attempting to borrow the needed funds against future revenue streams from offshore gas or privatisations will end in failure. First, the needed sums of money are simply too big in the context of an economy as small as the Cypriot one. Second, the Russians need to be seen to be taking a big hit if other eurozone countries are to be able to persuade their reluctant electorates to come up with more money for Cyprus.

Where does this leave the rest of the eurozone? If the Cypriots fail to impose the lion’s share of the costs onto foreign creditors, some eurozone governments (not least the German one) could face insurmountable political obstacles to a bail-out of the country.  However, if Cyprus imposes a big haircut on large (mostly foreign) creditors, the rest of the eurozone would have more political wiggle room, possibly opening the way for a workable deal. If not, the outcome will be an uncontrolled default. Cyprus would not necessarily have to leave the currency union, but in reality would probably have little choice because the Cypriot central bank would need to print money in order to keep the country’s banking sector afloat.

So far, financial markets have taken the latest crisis in their stride, suggesting that they do indeed see Cyprus as a special case. But the ramifications of an uncontrolled default and/or exit from the currency union could still be far-reaching. In such an event, investors could conclude that the membership of other indebted member-states cannot be taken for granted, igniting a fresh wave of capital flight from the periphery which may be difficult to control.


Simon Tilford is chief economist and Philip Whyte is senior research fellow at the Centre for European Reform

Two cheers for Beppe Grillo

The Achilles heel of the euro has always been democracy. Although the euro is unlikely to break up, that risk cannot be entirely excluded: one day, voters may choose a government committed to policies that are incompatible with the conditions set by Europe’s leaders for membership of the single currency.

Democracy in the eurozone suffers from a structural problem and a policy problem. The structural problem is that the new rules agreed since the euro crisis began – including the ‘six pack’, the ‘two pack’ and the fiscal compact – have deprived national parliaments of the freedom to set the budgets which they believe are best for their country. The European Commission and other eurozone governments can now order a national government to revise its budget.

The policy problem is that the particular prescriptions pushed by eurozone governments, the Commission and the European Central Bank (ECB) – all dominated by German thinking – have exacerbated the debt problems of southern Europe, including in Italy. So long as the southern European economies shrink or fail to grow, subjecting many people to considerable pain, the EU and its leaders are going to be unpopular in those countries.

There is no silver bullet that can instantly revive growth in the eurozone’s periphery, but the EU’s current emphasis on austerity is condemning these countries to further stagnation. And so long as that endures, the risk of populist revolts against EU-driven policies will be permanent.

The strong showing for Beppe Grillo’s Five Star Movement in the Italian election shows that voters wanted to kick Italy’s corrupt and incompetent political class. But the fact that Grillo and Silvio Berlusconi between them won 56 per cent of the votes also signals a rejection of the austerity policies that Prime Minister Mario Monti and eurozone leaders prescribed for Italy. Both Grillo and Berlusconi made a point of criticising excessive austerity during the campaign.

Monti, who restored some sobriety to the governance of Italy and pushed through long-needed reforms, such as those to labour markets, is an admirable figure. Neither the ethically-challenged Berlusconi nor the flippant Grillo are inspiring leaders. Peer Steinbrück, the German Social Democrats’ chancellor candidate, may have been offensive when he said that the Italians had voted for two clowns, but he was not inaccurate. Nevertheless, Grillo, Berlusconi and those who voted for them had a point.

Italian borrowing costs came down following Monti’s election, as investors hoped that this would open the way for concessions from the German government. However, once it became clear that it would not, and that austerity was pushing the Italian economy deeper into slump, borrowing costs rose back to record (or very close to) record levels.

Of course, Italy’s problem of low growth preceded the formation of the Monti government: it has grown more slowly than all the other members of the euro since 1999. But fiscal austerity, which increased when Monti came into office, proved self-defeating. The economy shrunk by 0.8 per cent in the final three months of 2012, the sixth consecutive quarterly decline. It slumped by 2.2 per cent in 2012 as a whole and is now around 8 per cent smaller than it was prior to the onset of the financial crisis.  Despite running only modest deficits, Italy’s debt burden has been rising: the ratio of public debt to GDP moved from 103 per cent in 2007 to an estimated 128 per cent at the end of 2012.

Sadly, voters now associate structural reforms with slump, rising unemployment and social stress. The Berlin-Brussels-Frankfurt consensus on austerity implemented by the Monti government – and to some degree, the preceding Berlusconi government –  has discredited the very reforms that are needed to boost the performance of the Italian economy.

Of course, austerity alone is not responsible for the weakness of Italy’s economy; the lack of structural reform since the start of the euro in 1999 has contributed to a very weak record on productivity and thus growth. But as the IMF observed last November, the tightening of fiscal policy by eurozone governments (including Italy’s) has been excessive given the weakness of private sector demand. The tightening depressed an already fragile Italian economy and made it harder to consolidate the public finances. This is what Keynes meant by the paradox of thrift: if everyone spends less and saves more, everyone will become poorer (across much of Europe, citizens and especially companies are taking demand out of the economy by sitting on cash rather than spending it).

The implications of Italy’s elections for the eurozone will depend to a large extent on how the Commission, the ECB and the German government respond. They could react by acknowledging that their strategy for combating the eurozone crisis needs recalibrating. They could agree that the pace of fiscal consolidation in the eurozone periphery and France should be slowed, that Germany should embark on a fiscal stimulus and that the way should be opened for the ECB to cut interest rates and launch quantitative easing. Such shifts could help to prevent the further radicalisation of Italian politics and enable an Italian government – perhaps following another election – to sell structural reforms to the Italian electorate. 

However, if the Commission, the ECB and the German government respond to the election by saying, to quote Margaret Thatcher, “there is no alternative”, they will be laying the foundations for future and increasingly serious crises. Such an inflexible response would almost certainly undermine Italy’s already weakened mainstream and pro-EU political forces. And that, in turn, would almost certainly preclude the construction of an Italian government that was willing and able to push through structural reforms and fiscal consolidation. Politicians and voters in other southern European countries would take note.

Eurozone policy-makers had become strikingly complacent about the eurozone in recent months, with some going so far as to claim that the crisis was over. Although the spread between southern European government bonds and German bunds had fallen, helping to create an atmosphere of confidence, that did not reflect a revival of the problematic countries’ economies or the readiness of governments to address the eurozone’s weaknesses. Indeed, the economic situation in the peripheral economies has worsened rapidly since last summer, as have their debt burdens. Eurozone governments have agreed to place responsibility for supervising the region’s biggest banks in the hands of the ECB, but they are no closer to agreeing to mutualise risk by establishing a joint eurozone back-stop for their banks or by launching eurobonds.  

Borrowing costs fell steeply in the autumn of 2012 after the ECB announced it was ready to buy potentially unlimited amounts of peripheral country government debt (through ‘Outright Monetary Transactions’, or OMTs). This went a long way to dispelling the break-up risk that had caused borrowing costs across the periphery to balloon. But the OMTs always involved an element of bluff: for the ECB to commence bond-buying, the country in question would have to request a rescue from the European Stability Mechanism (ESM), the eurozone’s bail-out fund. That would involve the supplicant signing up to a programme of fiscal austerity and structural reform, which would have to be approved by all 17 eurozone governments, and in Germany’s case, its Parliament.

So the OMTs cannot work for a country whose government rejects austerity and supply-side reform. Grillo would probably oppose ESM conditionality, but is unlikely to form a government. Whatever Italian government does emerge, it is likely to be moderate, weak and incapable of delivering much in the way of spending cuts or reforms that tackle vested interests. Investors could start to doubt the credibility of the pledge by ECB president Mario Draghi to “do whatever it takes to save the euro”. Italy’s borrowing costs would soar as investors started to factor in the risk of the country leaving the euro.

The politics of the eurozone crisis are now formidably difficult, not least because the stand-off between Italy and the eurozone will be played out against the backdrop of Germany’s general election campaign. This will make it very hard for the Germans to alter their stance. Merkel has a huge interest in maintaining the pretence that the current strategy is working. And in Germany, the Italian result is seen more as evidence that Italians are unwilling to face up to their problems than as an understandable reaction to an intellectually bankrupt strategy.  The fact that the beneficiaries of the anti-austerity vote in Italy are unappealing populists such as Berlusconi and Grillo has reinforced the Germans’ view.

If Italy can find a serious government to negotiate with its eurozone partners, it does have cards to play. It is in a stronger position than the other peripheral eurozone economies. First, the Italian government runs a primary budget surplus (that is, a surplus before the payment of interest on outstanding debt). This makes it much less dependent than the others on support from the rest of the eurozone: if Italy were to default, the Italian government could still pay its bills. Second, Italy’s banking sector is essentially sound; the country does not face the need to raise large sums of money to recapitalise its banks. Third, despite having such a high level of public sector debt, Italy’s overall debt burden (that is, its stock of both public and private debt) is not only lower than the other peripheral economies, but also below that of France and the Netherlands. Fourth, Italy’s external asset position (Italians’ foreign assets minus foreigners’ investments in Italy) is broadly balanced; by contrast, Spain, Portugal and Greece owe large amounts of money to the rest of the world.

In summary, Italy is not quite the basket-case it is often portrayed as abroad. It cannot be so easily bullied as the other peripheral countries. Leaving the eurozone would pose fewer risks to Italy than to the others. This puts the Italian government in a stronger position to play hard-ball in negotiating its fiscal policy. 

In the short term, Italy’s voters have made it harder for Europe’s leaders to manage the euro crisis. But the Italians may have done Europe a service by shaking those leaders out of their complacency. Since François Hollande became France’s president, he has sought to soften the eurozone’s emphasis on austerity. His officials hope that, after the German elections in September, a coalition government including Social Democrats may be more willing to shift Germany’s stance. It is true that the Social Democrats are a little less austerity-focused than Merkel. French officials believe that countries with big current account surpluses such as Germany can and should do more to stimulate demand in the eurozone. But France needs to improve its own economic performance before it can gain much leverage over German policy. And if Italy, too, can somehow conjure up a stable and respected government – one that is serious about reform, but softer on austerity – it might help persuade Germany to rethink its policies.

Charles Grant is director and Simon Tilford is chief economist of the Centre for European Reform.

In Mali, now comes the hard part

Last month, French military forces freed the main population centres in northern Mali from jihadist control. Progress on the military front has created new political momentum as Malians plan to go to the ballot box this summer, ending 15 months of interim rule. But as the European Union deploys a training mission to build the Malian armed forces, the hardest work still lies ahead. A fragile transition phase approaches as the French get ready to hand over responsibilities to AFISMA, the African-led mission. Recent clashes in Gao and a car bomb in Kidal show that the peace has not yet been won. Political reconciliation is a long way away, regional spillover of the conflict is increasing and a jihadist threat remains. Superficial comparisons with the EU’s effort in Somalia are misleading; European member-states will need to play a more central role and commit for the long term to increase the prospects for stability in the Western Sahel. Four challenges in particular stand out.

The first is to continue to pursue the jihadists. This requires sustained counter-terrorist operations and considerable human and signals intelligence efforts. The military phase has now concentrated on the inhospitable Adrar des Ifoghas mountain range on the Mali-Algerian border. Chadian forces, US and British surveillance assets and US, British and Italian refuelling aircraft are supporting the French. The threat of ambushes, improvised explosives and shoulder-fired missiles, coupled with the unknown terrain, means that the operation may last several weeks or months. Concern for several European hostages - thought to be held captive in the Ifoghas – also commands caution.

The counter-terrorist operations impact the region at large. Close co-operation with Algerian security forces is necessary, to avoid their side of the mountains becoming a place of refuge. Jihadists have made their way to Algeria, Mauritania, Niger and perhaps further afield. Mauritania recently arrested nine people suspected of links to the jihadists. Spill-over to Algeria or Niger could jeopardise key mining areas. In response, the United States and France have strengthened their military presence in uranium-rich Niger. As the AFISMA mission continues to deploy, it is drawing in states from the region, placing their soldiers in harm’s way. An offshoot of the Nigerian Boko Haram terror group attacked Nigerian soldiers en route to Bamako, killing two. Kidnappings in Nigeria and Cameroon show that instability may spread at the expense of Western interests. A bomb-scare on February 4th at the airport of Ouagadougou in the Central African Republic involving a Malian Tuareg has put other states on edge as well. Further out, Al Qaeda’s Yemen-based sister organisation has similarly called for a jihad in the Sahel. Although regional security services are on high alert, they are also at risk of becoming overstretched. It is necessary to co-ordinate security efforts and share intelligence. European intelligence services, in particular in the UK, should assist in this process. On the military front, European states should sustain their commitment to the French operation with logistics and surveillance support.

The second challenge is to consolidate the gains made thus far. Mali is vast and in many places the government has a limited presence. The French operation focused on the main urban centres, and has left smaller villages and rural areas untouched. This creates the risk of a power vacuum that local militias or remaining jihadists can exploit. The African-led stabilisation mission is meant to fill the void, yet it is suffering from corruption, insufficient capabilities and lack of local knowledge.  There are plenty of practical concerns. For instance, while Malians and many AFISMA troops are French-speaking, the operation’s Nigerian commander is not. The mission could turn out to be a case of the deaf helping the blind. Due to these and other concerns, the United Nations is gearing up to take command of the mission. This may also enable non-ECOWAS states, such as Algeria and Chad or EU countries, to join the operation under a single command. It would however slow the deployment for several weeks, leaving parts of Mali vulnerable. This means that Paris's March deadline to withdraw its forces may not be realistic, requiring France to stay longer.

Although the EU Training Mission starts soon, its mission is focused on rebuilding the Malian armed forces so that they can re-establish control over the country. Brussels is taking its cues from its experience in Somalia, where some 120 EU trainers have helped reform Somalia’s military. Confidently, the EU has called that training mission a ‘European success story’. The parallels with the plan for Mali are striking. As in Somalia, the objective is to support the ailing government by training its armed forces to restore territorial integrity and rout jihadist rebels. As in Somalia, the EU operates alongside a UN-mandated stabilisation operation composed of African forces. As in Somalia, the training mission is part of a regional comprehensive approach, consisting of a patchwork of several EU missions. In the Horn, a small-scale EU civilian mission is helping develop a coastal police force while European navies are fighting pirates in the Gulf of Aden. In the Sahel, the EUCAP-SAHEL civilian mission is focused on strengthening the rule of law and the justice system. It is now only active in Niger, but will expand to Mauritania as well. An EU mission to help secure Libya’s borders is also likely.

Yet this is where the parallels stop. In Somalia, the training takes place in neutral Uganda. In Mali, the training centre is just north of the capital Bamako. In Somalia, a previously non-existent state is slowly expanding its influence over the south of the country with the help of the African Union. In Mali, an embattled and corrupt state is struggling for survival. Two decades of civil war, years of political negotiations, external military intervention and a wholesale collapse of the state have created war fatigue in Somalia. While this means progress in Somalia will be slow and uncertain there are grounds for optimism. Mali’s lethal cocktail of emerging tribal tensions, a power vacuum, jihadist presence, a deteriorating food crisis, foreign intervention and supplies of small arms is much more recent. In Somalia the Transitional Federal Government has international legitimacy, while in Mali civil-military relations are a mess. The interim government is the product of a coup d’état, while in-fighting among different factions of the Malian armed forces raise doubts over who the EU will be training. In an environment where Somalia looks good in comparison, the job surely is difficult.

The EU’s objective is to train the military so it can maintain and enforce territorial integrity. It will rearm Malian forces and prepare them for offensive operations. This puts pressure on the traditional image of Europe as a ‘civilian’ power. On paper, the EU trainers are excluded from combat, but they could be drawn in to give practical training and advice should an insurgency pick up steam. It may create fissures within Europe. The French have already criticised Germany for not responding more quickly with military support when the intervention started. Now Berlin’s ‘culture of military restraint’ must digest a combat training mission.

Since 2010 the EU has trained 3,000 Somali forces. Although the EU is sending twice as many trainers to Mali as to Somalia, some 240 in total, the fifteen month timeline for the operation is wholly inadequate. The EU should ensure that the Malian army is of good quality. Previously the United States attempted to build a Malian military capable of dealing with the insurgent threat. As became painfully clear, it did not pay enough attention to human rights and civil-military relations. While some US-trained forces played a leading role in the Tuareg insurgency, others starred in the coup d’état meant to counter it. The EU should conclude that investing in quality is the only option. This calls for a long-term effort. Crucially, given the mounting ethnic tensions, the trained Malian forces must reflect the tribal composition of the country and respect human rights.

This leads to the third challenge. Political reconciliation that addresses mounting ethnic and tribal tensions in Mali is essential. If unsuccessful, this can destabilise the western Sahel. Looting and reprisal killings are pitting tribal communities against each other. Lighter-skinned Malians – whether Arabs or Tuaregs – are no longer safe in southern Mali. Kill-lists are circulating and vigilantism is on the rise.

In the north, a worrying development is that the Tuareg Mouvement National pour la Liberation de l’Azawad (MNLA) and the Islamic Movement of Azawad (MIA) ‘liberated’ Kidal, the regional Tuareg capital. They have made clear that no Malian or West African forces are allowed to enter the city, creating a de facto division in the country. The French do not want to be seen as occupiers but AFISMA is not welcome either. Several Tuareg groups aspire to a significant degree of regional autonomy. Although the EU is committed to maintaining the territorial integrity of Mali, it has not excluded a possible measure of Tuareg self-rule.

While giving the Tuaregs special status in the Malian state might clear a path for political reconciliation, this may be unpalatable to the government in Bamako. It would also make Mali’s neighbours nervous. The Azawad, the term for the Tuareg homeland, stretches well beyond Mali’s borders into Algeria, Libya and Niger. In Mali, while Kidal is the main Tuareg capital, Timbuktu and Gao have mixed tribal populations. These cities could become flash points in the absence of political reconciliation. The Tuaregs themselves are also divided, with some backing Bamako and others vying for independence. Other tribes have so far kept relatively quiet, but if Tuareg demands are met at their expense, this may well change. The immediate priority for the soon to be appointed EU Special Representative for Mali is to cajole the different factions to the negotiating table.

Finally, the fourth challenge is to remain vigilant for terrorism against European interests. As the recent kidnappings make clear, European nationals in the region can increasingly become a target. The EU military presence is also a factor in the conflict dynamic. The longer that French and European forces stay in Mali, the greater the danger that Mali and its environs will become a magnet for foreign jihadists. A longer presence might also fuel local xenophobic and ‘anti-colonial’ sentiments. Unfortunately, a longer presence is precisely what the EU should prepare for. The French and other European member-states may have to outstay their welcome to stop the crisis in the Sahel from deteriorating.

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

Freeing the transatlantic economy – prospects, benefits and pitfalls

In mid-February, the EU and the US agreed to launch negotiations aimed at sealing a Transatlantic Trade and Investment Partnership (TTIP). Like Yogi Berra, cynics might be tempted to dismiss the project as déjà-vu all over again. After all, this is hardly the first such initiative the two sides have launched. In 1990, they signed a Transatlantic Declaration; in 1995, a New Transatlantic Agenda; in 1998, a Transatlantic Economic Partnership; and in 2007, they established a Transatlantic Economic Council (TEC), a body that was supposed to give political impetus to freeing up commercial relations across the Atlantic. Past attempts to lower the barriers that impede trade and investment across the Atlantic are a story of rising ambition, but frustratingly elusive results. So why bother?

Part of the answer is that the scale of the transatlantic economy makes the effort seem worthwhile. Despite the rise of China and other emerging economies, the transatlantic axis remains the largest bilateral commercial relationship in the world. Although the data indicates that the EU and the US now trade more goods with Asia than they do with each other, such figures are misleading. One reason is that they are distorted by the increasingly global nature of supply chains (so that finished goods like iPhones show up as Chinese exports, even though the value added to an iPhone in China is tiny). Another reason is that they ignore trade in services and foreign direct investment (FDI). Yet FDI has been growing faster than trade in goods for years; sales generated by foreign outlets outstrip those derived from cross-border trade; and services account for a rising share of transatlantic commerce.

The transatlantic economy, then, is larger than a casual look at the data for ‘visible trade’ might suggest. Despite the rise of Asia, moreover, the axis has tightened, not loosened, in recent years. Trading across borders is important, but it is a less intimate relationship than establishing a physical presence to produce and sell goods and services in another country. And it is the second mode which dominates the transatlantic economy. US firms are the largest foreign investors in the EU, and vice versa. Taken together, the investment of American firms in the EU and of European firms in the US approaches $3 trillion. Despite the economic difficulties they have experienced since 2008, the EU and the US still meet most of the leading criteria that influence where businesses want to invest: they offer wealthy consumers, skilled workers, political stability and predictable business environments.

Yet for all its value, the transatlantic economy is still riddled with barriers to trade and investment. Tariffs, though low on average (at 4 per cent), have not been eliminated, and remain astronomical for certain goods – notably in the agricultural sector. Eliminating tariffs, however, would still not free up the transatlantic economy, because the principal barriers to trade and investment now lurk ‘behind the border’. Examples of non-tariff barriers that clog up transatlantic commerce include: regulations (such as the EU’s ban on imports of genetically-modified foods); burdensome customs procedures (particularly in the US since 9/11); different product standards; curbs on foreign ownership of companies (in, for example, the US maritime freight sector); subsidies (notably to aircraft manufacturers); public procurement markets that are still closed; and so on.

The size of the transatlantic economy means that even a partial reduction of some of these barriers could yield non-trivial economic gains, mainly through the ‘dynamic effects’ of increased competition on productivity. A recent study by the European Centre for International Political Economy (ECIPE) estimates that eliminating tariffs alone would yield GDP gains of 0.5 per cent for the EU and 1 per cent for the US. Such gains are not to be sniffed at. It is misleading, however, to think of the TTIP as providing a boost to growth and jobs at a time when economic activity (particularly in Europe) is so weak. Set aside the time-lag that will elapse before a deal – if one is reached – enters into force. Even if such a lag did not exist, trade deals are long-term, supply-side measures: they are not a solution to the short-term, demand-side weakness that afflicts much of Europe.

So what are the prospects for an agreement to lower trade and investment barriers? Seasoned observers caution that such barriers are notoriously difficult to get rid of. In many policy areas, trade-impeding barriers reflect conflicting regulatory approaches – for example, the EU’s ‘precautionary principle’ versus the US’s reliance on risk-based scientific evidence – that remain deep-seated. If such barriers had been easy to dismantle, they would have been a long time ago. The TTIP may therefore struggle to avoid the fate of previous such initiatives, which have tended to get bogged down in technical detail, resulting in a loss of political interest at the top; have become hostage to trivial-sounding but often rancorous disputes that cannot be resolved, like trade in chlorine-rinsed chicken; and have consequently delivered far less market opening than originally hoped for.

Set against this, optimists counter that the political stars appear to be better aligned than for a long time. The intellectual case for lowering barriers to transatlantic trade and investment is arguably more widely accepted than it has ever been by politicians and businesses on both sides of the pond. Cheerleaders are more numerous, refuseniks more muted. President Obama, who took little interest in transatlantic trade during his first term of office, mentioned it in his State of the Union address on February 12th. The rise of China has provided further impetus. The US and the EU recognise that there is more to the TTIP than just transatlantic relations. In addition to promoting a trade liberalisation agenda at a time when the Doha Round is moribund, a successful TTIP would influence behaviour, regulations and technical standards in third countries such as China.

How should the success of the TTIP be measured? The TTIP should not be judged relative to an idealised but unrealistic outcome. It is wholly unrealistic to expect the result to be a transatlantic free trade area (which would imply the complete elimination of tariffs), let alone an enlarged version of the EU’s single market (which would imply full freedom of movement for people, goods, services and capital across the Atlantic). A successful TTIP would make steps towards a free trade area (by reducing, but not eliminating, tariffs), and modest ones towards a single market (perhaps by delivering some mutual recognition of regulations, reaching some agreements on common technical standards, and by improving market access in services). But it would fall short of both. The test of the TTIP is not whether it eliminates all barriers, but whether it lowers some of them.

The prospects for a successful outcome would be greatly improved if the two sides could agree on some rules of engagement. First, they should not allow the best to be the enemy of the good: better to focus on credible objectives and deliver than to be unrealistically ambitious and fail to do so. Second, to provide a sense of purpose and momentum, the two sides should commit to early tariff cuts, before proceeding to the more difficult barriers ‘behind the border’. Third, they should identify the regulatory and other issues on which progress is least likely and agree to set them aside for the time being. Fourth, they should refrain from linking unrelated issues by making progress on one conditional on the other. If the EU and the US fail to observe such rules of engagement, the TTIP is more likely to produce finger pointing and recrimination than any substantive market opening.

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

Why British prosperity is hobbled by a rigged land market

The British have the least living space per head, the most expensive office rents and the most congested infrastructure of any EU-15 country. Thanks to a rapidly growing population –  the result of a healthy birth-rate and immigration – these trends are worsening steadily. At the same time, the British economy is languishing in a prolonged slump brought on by a collapse of demand. The answer is obvious: Britain needs to build more. Unfortunately, the obstacles to development are formidable. Britain’s supply-side problems are of a different character to those holding back other struggling European economies, but arguably no less serious.

Britain is generally considered a flexible, economically liberal economy, in which insiders have few opportunities to rig the system for their own benefit. To the extent that supply-side problems are considered a significant obstacle to economic growth, attention generally centres on the country’s patchy skills base. A high drop-out rate from secondary school and weak vocational training are no doubt real constraints on the UK economy, but there is an equally, if not more, serious one. Housing, commercial property and infrastructure are central to a country’s economic and social well-being. The UK’s essentially rigged market for land and its restrictive planning system are as big an obstacle to economic growth as restrictive labour markets and protected professions are in Southern Europe.

The number of new homes built each year in Britain has lagged far behind demand from a growing population for 30 years. Despite faster population growth, house construction is currently running at half the level of the 1960s. At the same time the average size of homes built in Britain is now the smallest in the EU. The result of these two trends has been a steady fall in the amount of living space per head. Property prices relative to average household incomes have come down a bit since 2007, but remain very high. Moreover, the problem is not just restricted to the residential sector: Britain has the highest office rents in the EU. Firms in cities such as Manchester pay more than in Frankfurt or Milan. And transport infrastructure is very expensive to build in Britain, which is one reason why there is too little of it.

Britain is small and densely-populated, but does not suffer from particularly acute land scarcity. Around 13 per cent of the UK is built on, a lower proportion than in countries with a similar population density such as Germany, Belgium or the Netherlands. Britain’s problem is that the supply of new housing and commercial space is uniquely unresponsive to increases in property prices. Alone among the countries that experienced a house price boom in the run up to the financial crisis, Britain had no construction boom. The number of houses being built picked up only slightly, despite UK house prices rising by more than in any other developed countries except Ireland.

This situation has far-reaching economic and social consequences for the UK. Massive house price inflation has aggravated the UK’s already high levels of inequality by shifting wealth from the young (and property-less) to the old (and propertied). The poor availability of affordable housing undermines labour mobility – people are unable to move to where jobs are available because they cannot afford accommodation. Those on welfare are discouraged from working (as they then lose access to subsidised housing).  Congested, expensive infrastructure combined with pricey commercial property pushes up the cost of business, depresses investment and holds back economic growth.

The two reasons for Britain’s land-use woes – a complex planning system and insufficient land for development – are inter-related. A major constraint on the supply of land is the existence of a protected ‘greenbelt’: land around cities on which development is very tightly controlled. There are also strict controls over building on other so-called green-field sites. The market for land is essentially rigged in favour of landowners, who pay no tax on their land holdings and hence pay no penalty for sitting on it, waiting for the artificially-created scarcity to push prices up further. With no revenue from land taxes, local authorities are unable to capture any increase in the value of land that takes place when planning permission is granted. As a result, they have little incentive to open up land for development. 

The UK should, of course, redevelop so-called ‘brownfield’ sites – vacant or derelict buildings and land. But this will only ever comprise part of the solution to its land use crisis. By its very nature, brownfield land is concentrated in parts of the country where people do not want to live. And it is often very expensive to redevelop, not least because the government has stipulated that 60 per cent of new homes must be built on brownfield sites. There is no alternative to building on the green-belt, much of which is neither beautiful nor green. The greenbelt was originally established to combat urban sprawl, but is now an obstacle to sensible development. For example, allowing London to expand by between two and three miles in each direction would easily solve the city’s land-use problems. Increasing that proportion of the UK’s surface area under development by between 1 and 2 percentage points would address the country’s  land constraints  and would not involve concreting over England’s ‘green and pleasant land’. Urban sprawl could easily be prevented by good quality town planning.

The sanctity of the greenbelt, and green-field land more generally, has much to do with vested interests perpetuating a system which rewards speculation. Many Britons have profited from land scarcity (and the tax-free property price gains it has led to), and are determined to defend those gains. They may complain about their children being unable to buy a house, but at the same time will staunchly oppose new development. For their part, landowners are a powerful and politically well-connected lobby; many of the biggest sit in the House of Lords (the country’s upper house). They have a big stake in inflated land prices and are well-placed to resist the taxation of land.

A land tax would involve property owners paying a percentage of the value of their land in tax each year. If the value of their property rose, so would the amount of tax paid on it. This would achieve a number of things. First, local authorities would have a financial incentive to change land from agricultural to residential (and commercial) use as they would profit from the increased value of the land this would cause. Second, it would make it more expensive to speculate on future rises in land values, and some of those gains would be captured by the government. Third, construction companies would not be able to sit on large amounts of land (so-called land banks), and drip feed the market, maintaining prices at artificially high levels. Instead, land would have to be developed or sold, which together with the increased availability resulting from the freeing up of greenbelt land, would bring down the price of developing land and with it the cost of housing, commercial property and infrastructure. Lower land costs would also increase competition by reducing barriers to entry to the construction sector: for example, at present housing building is dominated by a small number of big players.

Supply-side measures are rarely a quick solution to a demand-side crisis. That is certainly the challenge facing other struggling European economies. Spain and France suffer from inflexible labour markets, Germany from over-regulated product and services markets, Italy from both. Academic research shows that addressing such problems improves economic performance in the longer term, but it provides no immediate boost to demand. However, the UK is almost certainly an exception. Addressing Britain’s biggest supply-side problem (its rigged market for land) could provide a more immediate economic stimulus by releasing massive pent-up demand, as well as lift growth potential.

Britain should turn its weaknesses into strengths. Other struggling European countries have a surfeit of housing and infrastructure and poor demographics. For example, boosting construction in Spain would do no good – Spain has far too many unsold houses and it is now suffering from net emigration (more people are leaving the country than arriving). In Italy and Germany, populations are stagnant, although there is more scope to boost spending on infrastructure than in Spain. France’s population is growing, but as a result of persistently strong public investment, it already has very good physical infrastructure. And thanks to a rational planning system and plenty of land, it does not suffer from a housing shortage. Unlike Britain, these countries have few low-hanging fruit.

Far-reaching reform of the greenbelt and the introduction of land taxes could open the way for a boom in housing and commercial development. Local authorities and the national government could agree to set aside a proportion of the funds raised through land taxes to fund investment in infrastructure. Moreover, land taxes would make the tax system fairer by taxing unearned income. And by redistributing money from the wealthy (who save a high proportion of their income) to construction sector workers (who save little of it), it would provide a further boost to economic activity. The current Conservative-Liberal government has pushed through modest reforms of the planning system, but has shied away from opening up the greenbelt and has no intention of introducing a land tax. 

An economy in which speculation is rewarded and wealth is increasingly concentrated in the hands of those with property risks stagnation. It faces an uphill battle to hold on to its young or attract skilled immigrants. Britain needs to strike a better balance between the interests of existing property-owners and the rest of the country. This includes acknowledging that the value of land is determined by the activities of society as a whole and not the landowner, and hence needs to be taxed accordingly.

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

Time to bite the bullet on European defence

Europe’s military spending is in free fall. As highlighted during a seminar organised by the CER in December as part of the FR-UK Defence Forum, the EU countries combined have reduced defence spending from €200 to €170 billion since the start of the economic crisis in 2008. In response, governments have signed up to a variety of new bilateral and multilateral initiatives. These are designed to limit the impact of budget cuts on their armed forces. But so far, the savings incurred pale in comparison. At the December discussions, participants estimated them at €200 to €300 million. Many sensitivities relating to national security make it hard for governments to implement collaborative defence efforts. But at a time when Europe’s neighbourhood is replete with instability and the United States is scaling back its own armed forces, Europeans need to do more to stem the damage to their militaries.

Notwithstanding their budget cuts, taken together EU states are still the second largest defence spenders in the world. And not all European countries are reducing the level of funding to their armed forces. According to a 2011 study for the European Parliament, Finland and Denmark have maintained military spending steady in recent years. Poland and Sweden have increased it.

But even prior to the economic crisis, most European countries spent less than 2 per cent of their GDP on defence – even though NATO members are in theory committed to devote at least that much to their militaries. And, according to the European Parliament study, most middle-sized European countries have cut their defence spending by 10 to 15 per cent since 2009. Some of the smaller EU states, including Latvia and Lithuania, have cut by more than 20 per cent. Britain is reducing its military budget by 7.5 per cent over four years. And according to Andrew Dorman from Chatham House, the actual reduction is nearly 25 per cent because the ministry of defence has many unfunded liabilities and has to unexpectedly pay for the replacement of the UK’s nuclear deterrent. France is expected to scale back its military once it announces its new defence priorities this year. As a result, US officials warn that Europeans will soon be incapable of deploying a mission like the one they sent to Libya in 2011.

European governments have acknowledged that closer co-operation between their armed forces could offset – at least partly – the impact of such large spending cuts. They have introduced some welcome measures. For example, last year, 14 countries agreed to buy surveillance drones for a joint NATO-run squadron. Eighteen states now take part in an EU network to facilitate maritime surveillance through information exchanges. Last April, Belgium and the Netherlands decided to co-operate in helicopter maintenance. In September, Bulgaria and Romania agreed terms to make it easier to police each other’s airspace. Britain and France are training together to develop a new joint expeditionary force. And the UK and other Europeans are providing logistical support to France’s deployment in Mali.

But governments remain wary of pooling military capabilities. They still fear that their partners may block their access to shared equipment if they disapprove of a particular operation. States also disagree on the best way to develop new military technologies. For example, the UK wants to acquire defence equipment with France bilaterally. But since President François Hollande has been in office, France has become increasingly keen to allow other European countries to take part in Franco-British procurement projects. Many countries are averse to committing to ambitious initiatives because they know that these can be costly in the short term – last year Britain notably abandoned its plans to adapt its aircraft carrier so that French planes could land on it, after realising how expensive the adjustments would be. Several EU states are loath to integrate their defence companies with those of other countries, as Germany illustrated when it refused to support the merger between BAE and EADS. Finally, governments do not want their defence firms to lose out on contracts. Many in France worry that several of the cost-saving projects proposed by NATO, including missile defence and the joint purchases of surveillance drones, favour US defence companies.

Europeans need to overcome some of these continued aversions to co-operation. Even though governments would prefer to avoid using military force, they might not have a choice. Several conflicts risk undermining stability in Europe’s southern periphery over the next few years – not least the partial take-over of Mali by Islamist militants, where French forces have already felt compelled to intervene, the civil war in Syria and a possible standoff with Iran. And Washington, struggling with its own budgetary constraints, wants its allies across the world to take more responsibility for their regional security.

President Hollande’s government can allay some of the French concerns about the lack of European industrial participation within NATO cost-saving initiatives. To do so, Paris could suggest projects to the alliance which involve equipment made in Europe. As a participant from the CER seminar has proposed, Berlin, London, Paris or Rome could sell some of their old fighter jets to countries in Central Europe which want to strengthen their arsenals cheaply.

As suggested by another participant at the December discussions, Europeans should buy cutting edge military capabilities only when it is necessary. Over the last few decades, the cost of defence equipment has grown exponentially. Even when their economies are stronger, European governments will increasingly struggle to arm their militaries. In some cases, national security will require governments to continue acquiring the most technologically sophisticated capabilities. But for less sensitive tasks, governments should explore cheaper equipment options and a greater use of civilian suppliers, for example in communications.

Finally, European governments must ensure that they do not duplicate their efforts to build the next generation of drones. European governments have long argued that it has been very inefficient for Europe to have three manned fighter jets programmes (Rafale, Eurofighter and Gripen). The duplication has prevented the various programs from benefiting from economies of scale, it has curtailed interoperability amongst European armed forces, and it has led Europeans to compete against each other in export markets.

Over the next few years, Europeans will decide how to develop unmanned combat aircraft and other sophisticated drones. It is still unclear how governments will proceed. France and Britain have announced plans to develop next generation drones bilaterally. EADS and Finmeccanica, Italy’s largest defence company, have floated intentions to do the same. And France has agreed to work on unmanned aircraft with Germany, too.

Under current spending trends, there is insufficient demand in Europe to support several competitive next generation large unmanned aircraft programmes. So Europeans must avoid several unco-ordinated efforts taking place simultaneously. EU countries could barely afford duplicating expensive aerospace programmes prior to the economic crisis. They definitely cannot afford it now.

Clara Marina O’Donnell is a senior research fellow at the Centre for European Reform and a nonresident fellow at the Brookings Institution.

The FR-UK Defence Forum is an initiative between Chatham House, CER, FRS, IFRI and RUSI. It explores the opportunities and challenges for Franco-British defence co-operation.

Eurozone slump derails Britain's economic strategy

The British government's attempt to rebalance the UK economy has failed. In 2012, the deficit on the country's current account (the broadest measure of foreign trade) was larger than in any year since 1990. Britain's problem is not its trade performance with non-European markets: exports to these are rising strongly and the country runs a small surplus with them. The UK's problem is the weakness of its exports to the EU, and the huge trade deficit it runs with its EU partners. As the eurozone’s biggest trade partner, the UK is bearing the brunt of the eurozone’s neglect of domestic demand.

The UK's current account deficit narrowed from 2.3 per cent of GDP in 2007 to 1.3 per cent in 2011, before jumping to an estimated 3.5 per cent of GDP in 2012. There is no doubting the scale of the challenge posed by this deterioration. After all, a key element of the government’s growth strategy is to rebalance the economy away from an excessive dependence on private and public consumption in favour of business investment and exports. It was relying on a positive contribution to economic growth from net trade (exports minus imports) to help offset the impact of fiscal austerity, and to narrow the country’s external deficit. 

The UK's persistently weak trade position is often attributed to British firms' failure to tap fast growing markets outside Europe. This narrative does not bear scrutiny. The truth is that British exports, and with it chances of rebalancing the economy, are being held back by the country's trade with the rest of Europe rather than with the supposedly hyper-competitive economies in Asia or the Americas. The value of exports to non-EU markets is growing quickly: between 2006 and 2012 they increased by half (a 65 per cent rise in goods exports and a 35 per cent rise in exports of services). The value of exports to the EU, meanwhile, rose by just 5 per cent over this period (a 5 per cent fall in goods exports and a 23 per cent rise in services). As a result of these trends, the UK earned almost 60 per cent of its foreign currency earnings from non-EU markets in 2012, up from under a half in 2006.

With imports from the EU easily outpacing exports, the trade position with the EU has deteriorated steadily. Despite exports to the EU accounting for little over 14 per cent of GDP in 2012, the UK is estimated to have run a current account deficit with its EU partners equivalent to 4.5 per cent of GDP, double the deficit of five years ago. The value of goods exports to the EU are estimated to have fallen by 5 per cent in 2012, led by declines of 18 per cent to Italy and 12 per cent to Spain.  Exports of services to EU markets also fell, as did the returns on British investments in the eurozone, pushing the balance of income with the EU deeper into deficit. By contrast, exports of goods and services to the rest of world rose 5 per cent in 2012, and trade with these markets remained in surplus. 

The UK runs a surplus with the non-European world, which accounts for almost three-fifths of its foreign current earnings, but is massively in deficit with the EU, which accounts for just over two-fifths. This is not because the UK is 'competitive' with the rest of the world and uncompetitive in Europe, but because of the collapse in demand across the EU. UK exports are rising to the rest of the world because demand is rising in the rest of the world, and are falling to EU markets because demand for imports is falling across the eurozone. The reason why the UK's current account deficit rose sharply in 2012 and those of Italy and Spain fell is not because the latter have improved their 'competitiveness' more than the UK. Spain's and Italy's current account deficits have shrunk because demand in their economies has declined dramatically, leading to a steep fall in imports.

The eurozone’s decision to eschew symmetric adjustment of trade imbalances within the currency union in favour of asymmetric rebalancing (where domestic demand contracts in the deficit countries but there is no offsetting rise in demand in the surplus countries) has serious implications for the UK. Britain was criticised for allowing its currency to fall in value following the onset of the financial crisis in 2007, on the grounds that it constituted a competitive devaluation. But it is the eurozone, not the UK, which is pursuing a mercantilist strategy. 

What can the UK do about its increasingly unbalanced trade with the EU? It would make no sense for the UK to leave the EU. As the data show, membership of the EU has not undermined Britain’s exports to non-European markets. And leaving the union would have little impact on the trade imbalance with European economies; the UK outside the EU would not be able to erect significant trade barriers against imports from EU countries. Not only is EU membership no obstacle to increased trade with the rest of the world, it is probably facilitating such growth: with the growth of bilateral trade deals in place of multilateral ones, it pays to be part of a heavy-weight negotiating bloc.

The British government could emulate the Italians and the Spanish and tighten fiscal policy by so much that import demand implodes. This would lead to a sharp narrowing of the UK's trade deficit with the EU and a rising trade surplus with the rest of the world (as the British imported less from non-EU markets). Such a strategy would be politically impossible in the UK. The coalition government would suffer a huge defeat at the next general election and for good reason: this approach would depress investment and push up unemployment, eroding the country's growth potential.

David Cameron and George Osborne could mount a campaign for more expansionary economic policies across the eurozone. However, even if the British government were not increasingly isolated and resented within the EU, such pleas would fall on deaf ears: the rest of the eurozone could also justifiably argue that they are only doing what the British government has routinely argued that every country must do: cut public spending and 'live within its means'.

The British government should give up on any hope that stronger EU demand for British exports will help rebalance the UK economy. In all likelihood, demand across the eurozone will remain chronically weak for a very long time. Instead, Cameron and Osborne should concentrate all their efforts on boosting domestic economic activity. They should slow the pace of austerity and kick-start a large-scale housing and infrastructure programme. Combined with aggressively expansionary monetary policy – the incoming governor of the Bank of England, Mark Carney, has indicated that monetary policy is set to remain very loose – this should be enough to drive an economic recovery.

If the UK government were to opt for this approach, the British economy would no doubt suck in imports from the rest of the EU, leading to a further widening of the bilateral trade deficit. However, the worsening of the country's trade position, together with the Bank of England's more inflationary strategy than the ECB, would almost certainly prompt a fall in the value of sterling. A significant devaluation would probably suffice to halt the rise in Britain's deficit with the rest of the EU, although the shortfall is unlikely to narrow much while demand remains so weak across the eurozone. Eurozone governments would no doubt accuse the UK of engaging in a competitive devaluation. Given the recent trend in the EU-UK trade balance, such accusations would ring hollow. 

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

Has the ECB done enough to save the euro?

On July 26th 2012, European Central Bank President Mario Draghi told a London conference of bankers: “the ECB is ready to do whatever it takes to save the euro”. He paused, somewhat theatrically. “And believe me, it will be enough.” His comments were an exercise in expectations management. The ECB was trying to convince financial markets that betting on the euro’s downfall would be a fool’s errand.

To all appearances, the plan seems to have worked. In the first half of 2012, investors had been withdrawing capital at an accelerating pace from Spain and Italy. Banks had been finding it increasingly difficult to get funding. Borrowing costs for the Spanish and Italian governments had risen to unsustainable levels. After Draghi’s comments in July, the ECB announced it would buy government bonds in Spain and Italy in unlimited quantities, if necessary (a plan it dubbed Outright Monetary Transactions, or OMT). This plan has not yet been activated, but Spanish and Italian borrowing costs have fallen by a fifth. This has led some to claim that the worst of the euro crisis is behind us. José Manuel Barroso, the European Commission’s president, said that “the existential threat to the euro has essentially been overcome”. The Italian prime minister, Mario Monti, said the crisis is “almost over”. Is this so?

Before the ECB announced its plan, markets had been pushing for it to act more like the US Federal Reserve or the Bank of England. Countries whose central banks had bought government bonds in exchange for newly created money – quantitative easing (QE) – have not suffered from capital flight, unlike the euro’s periphery. In 2009, the British government faced a banking bust and public sector deficit of a similar scale to those of Spain, Portugal and Ireland, but has since avoided their financial woes.

QE provided monetary stimulus, even as central bank interest rates could not go any lower. Moreover, it served to put a ceiling on government borrowing costs. This helped governments to fund their deficits in the short term. It also helped domestic banks get cheaper funding: they use government bonds as collateral and as safe assets that they can easily sell in exchange for money or more risky assets. When government borrowing costs rise, government bonds fall in value. This covers the balance sheets of the banks that hold them in red ink. QE also changed expectations: investors knew that if they dumped American or British government bonds, the Fed or the Bank of England would simply buy them up, swapping them for new money. So there was little point in trying it.

Thus, the Federal Reserve and the Bank of England defined investors’ expectations, and made government borrowing safe and financial markets stable. The ECB’s interventions so far have been less far-reaching. It has lent money to banks at very low interest rates, and it has continued to accept the periphery’s government bonds as collateral. It has bought some government bonds – but exchanged them for money already in the system, so that there was no further monetary stimulus. But it has not done as much as its counterparts to make government debt safe.

The ECB’s OMT plan amounts to a promise to do QE, in a limited way, at some point in the future. The central bank said it would buy up the bonds of troubled governments if the integrity of the euro were threatened. The quid pro quo: governments must sign up to budget management by the Commission, the International Monetary Fund and the ECB. Spain and Italy have so far been reluctant to do so: borrowing costs came down after Draghi’s announcement, and governments have preferred to wait and see.

Will the current rally continue without the plan being activated? It seems unlikely. The eurozone as a whole is in recession. Spain and Italy’s economies are likely to shrink for most of next year: the European Commission projects GDP to fall by 1.4 per cent and 0.5 per cent respectively. The Commission has consistently underestimated the impact of austerity on growth, and so these figures may turn out to be quite a lot worse, further undermining government finances. Little progress has been made on banking union, which would help to shore up banks’ and governments’ books. Given these conditions, markets are likely to test the ECB’s commitment to hold the currency together.
If Spain and Italy’s borrowing costs spike again, they will quickly sign up to budgetary oversight and the ECB will start buying bonds. If the ECB buys enough, it should secure the currency from immediate break-up. But there would still be grinding economic stagnation, years of high unemployment, and a fraught federalising process to create a currency union that works. A party committed to withdrawal from the single currency could win power and fulfil its mandate, pulling the eurozone apart. And this possibility, even if it failed to materialise, would hold back economic growth, because private investors would be deterred. The peripheral countries, which desperately need investment if they are to grow, would still be forced to pay premiums by financial markets to cover the risk of exit, even if those premiums were smaller than they are now. The eurozone would still be caught in a trap.

Is there anything the ECB could do in such a situation? Not by a narrow interpretation of its mandate. The ECB’s role, as currently constituted, is to keep inflation low and stable. All other objectives – unemployment, economic growth, financial stability, and so on – are subordinate.  Draghi has interpreted the mandate flexibly, to mean that prices will not be stable if the single currency breaks up or if financial markets are not working. This makes the OMT plan legal. But the OMT is primarily a plan to keep the single currency together, rather than to promote growth.

However, other central banks have made growth the priority. The Federal Reserve, the Bank of England and the Bank of Japan have indicated that loose monetary policy will continue, irrespective of (moderately) higher inflation. The Federal Reserve is committed to monetary stimulus until unemployment falls to 6.5 per cent of the workforce, which it expects to happen in 2015. This shifts its priority from inflation to unemployment, although it has a mandate to tackle both. The Bank of England has been silent on what it will do in the future, other than its commitment to set policy to meet its 2 per cent inflation target. But it has consistently allowed inflation higher than this – it has averaged 3.5 per cent over the last five years – without tightening. The Bank of Japan has raised its inflation target, and is considering more QE. A consensus is forming: central bankers should favour employment over inflation, at least for now.

The ECB is the odd man out, because it was constructed in the Bundesbank’s image. Germany, given its corporatist wage-setting process and high savings rates, is allergic to price rises. Unions and businesses have agreed to keep wage growth low to maximise employment – and higher inflation would reduce living standards. German employees and businesses have very high savings rates, and savings are eroded away by price rises. But the eurozone faces years of low growth, not high inflation. Inflation in the eurozone is just above the 2 per cent target, but it has been pushed up by high energy prices and governments raising value-added tax rates, not higher wage demands by workers. The gap between the current rate of growth and its potential rate is large. There are 26 million people unemployed in the eurozone, which should hold wages and prices down. All of these reasons suggest that if the ECB eases monetary policy further it will not push inflation to unsustainable levels. By starting a QE programme – buying up all government bonds in proportion to their economies’ contribution to eurozone GDP – it would raise the bloc’s growth rate. And it would make clear to investors that the ECB will keep monetary policy loose until growth is restored, which would allay fears of break-up.

Political opposition from the Bundesbank and the German public would have to be overcome. A legal fix would have to be worked out to get over the prohibition on the ECB financing member-states. But the alternatives are far worse. Looser monetary policy through QE, with an explicit focus on growth, must be an important part of any plan to make the eurozone escape the trap of constant speculation about its future.

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

Cameron’s optimistic, risky and ambiguous strategy

David Cameron has promised that if the Conservatives win the next election, they will renegotiate the terms of Britain’s EU membership and then hold an in-out referendum before the end of 2017. In his long-delayed speech on Britain and the EU, he pledged to campaign for a Yes vote "with all my heart and soul". The speech contained much that is sensible. But its implicit message to Britain’s partners was: "Give us what we want, by the deadline that we specify, or we may well leave the EU." Many other Europeans consider that not far short of blackmail. Given that Cameron cannot get what he wants without the co-operation of the other member-states, the strategy he has adopted is risky. The speech made many optimistic assumptions and was riddled with ambiguities.

Cameron had to promise a referendum in order to maintain control of his own party. Had he failed to do so, the Conservatives' most eurosceptic backbenchers – who want a referendum to propel Britain out of the EU – would have become even more truculent and rebellious than they are already. And some Conservatives who want to stay in the EU believe that only a referendum pledge can undermine the surge of support for the United Kingdom Independence Party, which threatens to deprive the Tories of many seats at the next general election.

But although the necessities of party management underlay what Cameron said, the speech was much more thoughtful than many pro-Europeans expected. Cameron was right to say that much in the EU needs to change; that the Union should accept the principle that powers can flow not only from member-states to institutions but also the other way, too; and that national parliaments should become more closely involved in EU decision-making. Cameron stated very clearly the economic and strategic benefits of EU membership for the UK. And he hit on the head the silly argument made by some eurosceptics that the Norwegian and Swiss models of association – whereby they have access to parts of the single market, without being able to vote on its rules – could be suitable for Britain.

Cameron did not, at least overtly, ask for UK ‘opt outs’ from specific areas of EU policy-making; many of his party's eurosceptics argue that such opt outs should be the price of Britain staying in the EU. The thrust of the speech was to ask for reforms that benefited all member-states, rather than only the British. This was a wise approach, since Britain would be unlikely to find many allies if it demanded changes merely for itself.

Cameron said very little about what his demands would be. One understands why: he did not want to annoy either Conservative europhobes, who want him to seek the 'repatriation' of EU powers, or the other member-states, which do not want to let Britain cherry-pick the policy areas it takes part in. The government’s review of EU competences, due for completion in autumn 2014, will analyse the beneficial and harmful effects of EU laws and actions on the UK. This review will feed into the specific demands that the Conservatives eventually make.

At some point Cameron will have to resolve the ambiguity over whether he merely wants to reform the EU, or engineer a significant repatriation of powers from it. If his ambitions are modest and he goes for the first option, he might succeed in obtaining a 'new deal for Britain'. With some deft British diplomacy, for example, the other governments could conceivably agree to reform the working time directive (singled out for criticism in the speech), deepen the single market in areas like services and the digital economy, give some protection to the special status of the City of London, enhance the role of national parliaments and put into the treaties a new procedure for allowing powers to return to member-states.

Such a modest settlement would not satisfy hard-line Conservative eurosceptics, many of whom would split their party by campaigning for withdrawal in the referendum campaign. But with luck, a Conservative-led government – backed by Labour and the Liberal Democrats – could persuade the British people to vote to stay in the EU. (In the past six months, most opinion polls have shown a majority of voters wanting to leave the EU, though some very recent polls suggest growing support for staying in.)

But Cameron may well – as many Conservatives assume – attempt a more ambitious renegotiation, in order to feed his back-benchers the 'red meat' they crave. He could, for example, ask for Britain to be exempted from EU labour market law; from rules on the free movement of labour; from the Common Fisheries Policy; and from all police and judicial co-operation (some of which Britain already has the right to opt out of). Leading Conservatives have already called for these and other opt outs. Boris Johnson, the mayor of London and a popular figure in the party, has said that Britain should stay in not much more than the single market.

However, any treaty change requires unanimity and Britain's partners have no intention of granting Britain-specific opt outs. They fear that Cameron would be opening Pandora's box: if Britain could spurn the bits of the EU that it disliked, others would demand the same privilege. The French hate EU rules that limit how much they can subsidise their car industry, while the Poles, with their coal-centred economy, find EU rules on carbon emissions irksome, and so on. Once you allow countries to treat the EU as an à la carte menu, the single market starts to unravel.

But might Britain's partners make an exception for labour market rules? After all, the then prime minister, John Major, managed to opt out of the Maastricht treaty's 'social chapter' in 1991 – which Tony Blair later opted back into. And some Central Europeans share the Conservatives' disdain for EU involvement in social policy. But the French and several other governments would never agree to reviving that British opt out: they regard labour market rules as intrinsic to the single market and think that allowing Britain an exemption would give it an unfair advantage in seeking to attract foreign investment. They want more social Europe, not less.

In his speech, Cameron said it was likely that eurozone governments would want a major new treaty – for the purposes of strengthening the euro – in the next few years. He argued that this would give the UK leverage: if the other member-states needed a signature on the treaty from Britain, it could demand concessions in return. Cameron is right that if a large treaty was on the agenda, covering many things that the Union does, the others could not easily sidestep a British veto by drafting a new treaty outside the framework of the EU.

A few months ago, Cameron's assumption seemed plausible. The Germans, alongside the European Commission and the European Parliament, were calling for negotiations on a 'political union' to start soon after the 2014 European elections. Most EU governments did not want a significant new treaty, partly for fear of the difficulties of ratification. But many assumed that what the Germans want, they get.

The mood has changed in recent months, notably in Berlin. Perhaps the Germans have listened to their partners’ opposition to the idea of a major treaty change – and especially to that of the French, who worry about having to ratify a new treaty by a referendum. Perhaps the Germans are recoiling from the prospect of having to commit to a 'political union' that could entail financial transfers to poorer members of the eurozone and the loss of sovereignty. And perhaps they are reluctant to give the British the possibility of blackmailing the rest of the EU into making concessions. Furthermore, in Berlin and in other eurozone capitals, governments now believe that the euro crisis has been at least partially sorted out. They therefore see little urgency in pursing the radical solutions that were on the agenda only a few months ago.

Whatever the reasons, most EU governments now see no need for a big treaty revision, of the sort that would entail a Convention on the Future of Europe and a grand inter-governmental conference, for many years to come. And if the health of the euro required an institutional fix – such as the establishment of an EU-wide deposit insurance scheme – they think a small and speedy treaty change, like those which set up the European Stability Mechanism and the fiscal compact, would suffice. Britain lacks the power to stop that sort of treaty: when Cameron tried to veto the fiscal compact in December 2011, 25 governments went ahead with a non-EU treaty to establish new rules on national budgets.

Cameron quoted the Commission president, José Manuel Barroso, to justify his assertion that a major new treaty was likely. But Barroso – though a believer in a more federal future – does not set the EU’s agenda. Evidently, moods can shift, and a major new crisis in the eurozone could revive talk of a new treaty. But in such circumstances the most likely response would be a mini-treaty that can be ratified quickly.

Cameron recognised the possibility that Britain's partners might not negotiate a new treaty in a timetable that suited Britain. In that case, he said, a Conservative government would seek a unilateral renegotiation of the EU treaties. But that would be difficult since its leverage would be limited and treaty change requires unanimity.

Many Conservatives make another assumption that may turn out to be false. They believe that the Germans do not want to be left 'alone' with the statist, protectionist French, that they want the British to be on the inside fighting for economically liberal policies – and that they will therefore do whatever it takes to keep the UK in the EU, including by offering exemptions from EU policies. The first two parts of the previous sentence may be true, but not the conclusion. Notwithstanding Angela Merkel's polite response to the speech, the officials around her – like most senior German politicians – say that although they hope the British will remain in the EU, they are not prepared to pay the price of opt outs. The Conservatives have form when it comes to misreading German intentions: in December 2011, at the summit which gave birth to the fiscal compact, Cameron wrongly thought that Merkel would support his demands for treaty changes to protect the City.

If Cameron did ask for opt outs, as many in his party hope, but failed to secure them, how would he handle a referendum? It is hard to imagine him campaigning for a No, given what he has just said about the virtues of EU membership. But he might also find it hard to campaign for a Yes, if he had failed to change fundamentally the terms of Britain’s membership.

All of the above assumes that Cameron will lead a Conservative government in the next Parliament. But recent opinion polls suggest that, although the next general election is still more than two years away, a Labour government is more likely. Labour leaders remain reluctant to promise a referendum. Like the Liberal Democrats – who in the past have supported an in-out referendum – Labour believes that with the EU in flux, this is not the right time to talk about referendums, and that to do so creates uncertainty and could deter foreign direct investment.

Labour may also worry about its ability to win a referendum on staying in the EU. Unlike the Conservative Party, Labour does not want to renegotiate the terms of Britain’s membership. So although a Labour government would seek to reform the EU, it could not claim during a referendum campaign that it had transformed Britain's relationship with Brussels. Moreover, the Conservatives in opposition would be likely to install a more eurosceptic leader and campaign for a No vote. Yet despite Labour's current opposition to an EU referendum, party leaders have not ruled one out. If the Conservatives appear to profit from their referendum promise, Labour may have to offer a similar pledge.

Even if Labour wins the next election and continues to oppose a referendum on EU membership, at some point in the future there will be another Tory government. That government would almost certainly hold an EU referendum. Therefore those who value Britain's membership should treat the Cameron speech as a wake-up call to come up with a convincing agenda for reforming the EU and explain to the British people why they are better off in.

Charles Grant is director of the CER.