France: Why the self-flagellation?

President Sarkozy wants France to become more like Germany. In a recent speech he made 15 positive references to the German economic model. Unlike France, he argued, Germany had reformed its economy and was reaping the rewards in terms of improved competitiveness and superior economic performance. He bemoaned the alleged decline in French industrial prowess and praised Germany’s success at defending its industrial base. Is Sarkozy right to be so critical of French performance? And would it make sense for France to emulate the German model?

Sarkozy is certainly right that Germany is a more industrial economy than France. The share of the French economy accounted for by industrial output is as low as in Britain (a country Sarkozy likes to deride as ‘having no industry’) and lower than the US. Germany’s share of world export markets has also held up remarkably well over the last ten years, whereas France’s has fallen steadily. However, the relative size of a country’s industrial sector has no bearing on its economic success. Just look at Italy, which has a comparably-sized industrial sector to Germany, but which is easily the worst performing large developed economy. Japan also has a very large industrial sector but has stagnated for much of the last 20 years.

France actually has a decent economic record relative to Germany’s. Between 1992 and 2001, France managed annual GDP growth of 2.1 per cent compared to Germany’s 1.6 per cent. Over the subsequent ten years – 2002 to 2011 – both countries grew by (an admittedly poor) 1.1 per cent per year. Although the German economy performed better in 2010 and 2011 than its French counterpart, the two countries’ growth prospects are very similar, at least according to the European Commission, the IMF and the OECD. All three forecast growth of around 0.5 per cent in 2013 and 1.5 per cent in 2013. Perhaps the best measure of economic performance is productivity. Productivity per French worker is somewhat higher than in Germany, while productivity growth averaged 0.7 per year in both countries between 2002 and 2011.

As recently as mid-2008, rates of joblessness were the same in the two countries. But Germany’s labour market performance has been superior to France’s over the last three years. By the end of 2011 the rate of unemployment had fallen below 6 per cent in Germany, whereas it has risen to almost 10 per cent in France. There is a demographic element to this – because of its very low birth-rate Germany has far fewer people entering the labour market than France. But there is clearly something else at play. The so-called Hartz reforms under the previous German government undercut the bargaining power of labour, and succeeded in pricing workers back into employment, albeit often on very low wages. Adjusted for inflation employee wages fell by 2 per cent in 2002-2011, compared with a rise of over 10 per cent in France. This, in turn, had an impact on private consumption. Over the same period, private consumption grew by just 4 per cent in Germany, against 17 per cent in France.

To the extent that Germany has become more ‘competitive’ this reflects wage restraint, not superior productivity growth. Wage restraint (and the resulting weakness of inflation) meant that Germany’s so-called real effective exchange rate within the eurozone fell by 17 per cent between the beginning of 1999 and the third quarter of 2011, making its exports much more price competitive. Over the same period, France’s real effective exchange rate rose by 4.4 per cent. Germany’s internal devaluation contributed to a big divergence in the two countries’ relative trade positions. Whereas ten years ago France and Germany both had small current account surpluses, France is now running a deficit of around 3 per cent of GDP, while Germany is running a surplus of 6 per cent. This is understandably causing anxiety in official circles in France.

France and Germany have similar levels of public debt, at just over 80 per cent of GDP. But France is running a bigger budget deficit. Whereas Germany’s fell to a little over 1 per cent of GDP in 2011 (compared with 4.3 per cent in 2010), France’s stood at 5.7 per cent (down from 7.1 per cent the previous year). There is no doubt that France needs to strengthen its public finances, but it is worth making a couple of points. First, the French government has been more concerned with maintaining growth in domestic demand than its German counterpart. Second, over a third of the difference in the size of the deficits in 2011 was accounted for by much higher levels of public investment in France – 3.2 per cent of GDP compared with 1.7 per cent in Germany (the second-lowest level in the EU).

The French president is right to be worried about France’s economic performance. In common with most of Europe, the country is in a rut. But it is important that the second biggest economy in Europe draws the right lessons from what has happened across the Rhine. France undoubtedly needs to reform its labour market. At present, so-called insiders – those with full-time jobs – enjoy comprehensive rights and generous entitlements. But this acts as a disincentive for firms to hire people on full-time contracts, condemning the young to a precarious existence on temporary contracts. However, Germany’s labour market reforms might not be the best blue-print for France. Germany has only been able to pursue such a strategy because others have not. If France really does attempt to emulate German wage restraint, it could prove a largely zero-sum game, depressing domestic demand in France (and hence across Europe), in the process worsening the eurozone crisis.

There are plenty of things that other EU countries, including France, can learn from Germany. But they need to be clear about what those things are. A large industrial sector and a big trade surplus are not necessarily signs of economic prowess. And for every country running a trade surplus, there has to be one running a deficit. France has its share of weaknesses. But in some important respects the French model – where the economy is largely propelled by domestic demand – holds out better prospects for a return to economic growth across the eurozone than does the German one.

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

Greece's real challenge

The German idea of sending Athens a ‘budget commissioner’ was daft. Berlin itself could not tolerate such interference in its fiscal sovereignty (the constitutional court would never allow it). But to restrict such budgetary oversight to Greece alone would be disdainful and a political non-starter. The idea predictably caused outrage in Greece. Chancellor Angela Merkel has quietly dropped the proposal but the underlying problem persists: Greece’s donors – not only Germany but also other EU governments and the IMF, no longer trust Greek politicians to turn their country around.

Greece desperately needs a deal on a new bail-out package before March 20th when €14.4 billion in debt repayments are due. The IMF and eurozone governments insist that new money will only be forthcoming if there is a realistic prospect of Greek debt becoming sustainable in the foreseeable future. The IMF says that ‘sustainable’ would mean a debt level of 120 per cent of GDP by 2020 – although most economists think that 60-80 per cent is the most that a weak economy like Greece could cope with.

Even to reduce the debt level to 120 per cent from the current 160 would require a deep cut in existing debt, more fiscal austerity, lots of further outside help and a return to economic growth. Media attention has focused on the debt restructuring talks between Athens and it private creditors. But for Greece’s future prospects, the question of whether bond holders get 3.8 per cent or 4 per cent interest on their restructured portfolios is insignificant compared with the much bigger question of whether and when Greece emerges from its devastating recession.

There is now broad agreement among eurozone donors and the IMF that Greece will not be able to squeeze more revenue out of an economy that is in its fourth year of recession. The IMF forecasts GDP to fall by a further 3 per cent this year but private sector forecasters, such as the Economist Intelligence Unit, think that the economy may contract at twice this rate. In 2010, Greece went through the most savage austerity programme ever implemented by an OECD country. Yet the budget deficit at the end of 2011 stood at around 10 per cent of GDP, so adding to the already unsustainable level of debt.

The emphasis of Greece’s negotiations with the troika (IMF, ECB and European Commission) has shifted to structural reforms designed to boost growth. The good news is that there is lots of room for improvement: by many measures, Greece is the EU’s least efficient economy. The National Bank of Greece has calculated that a comprehensive reform package could boost the annual growth rate by 1.5 per cent over the medium term, although the OCED thinks an additional 0.5 per cent is more realistic.

The previous government of George Papandreou started making headway in various areas, for example by removing some of the protection enjoyed by truckers, lawyers, pharmacists and 140 other ‘closed shop professions’, by simplifying licensing procedures, making life easier for small businesses or giving workers and their bosses more wiggle room to set pay and conditions in Greece’s over-regulated and union-dominated labour market. Papandreou’s technocrat successor, Lukas Papademos, has continued along those lines.

The bad news is that most of these reforms so far only exist on paper – and even here they are often timid and riddled with loopholes. In many cases, the biggest obstacle to real progress is Greece’s bloated and inefficient state administration. According to an OECD analysis published in December, the central government is simply not capable of designing and implementing the growth-boosting reforms that Greece so desperately needs.

The ILO counts 390,000 civil servants in Greece. But add the 660,000 working for public corporations and other semi-state entities and the number swells to over 1 million – more than one-fifth of the workforce. Even that number may be too low since there are all manner of quasi-civil servants on outsourced or temporary contracts who enjoy similar pay levels and perks as full civil servants.

For many years, public sector salaries had outstripped those in the private sector; before the crisis they were on average 60-70 per cent higher. Public sector workers also enjoyed plenty of extra benefits, in addition to job security. Since the onset of the crisis, labour costs in the public administration, defence and social security have fallen by about 6 per cent, according to Greece's National Institute of Labour. In some parts of the private economy, such as hotels and restaurants, labour costs have fallen by 30 per cent. And unemployment has predominantly hit the private sector, too. “The real conflict is not between Greece and its donors. It is between the public sector and the rest of the population”, says one Athens think-tanker.

The troika demanded early on that Greece shrink the public sector by only replacing one of five of those retiring. But between early 2010 and mid-2011, the government added 20,000 people to the public sector payroll (which still amounts to 13 per cent of GDP). Now the troika insists that the government get serious about cutting the headcount by up to 150,000 over the next three years.

The December OECD report found that the main problem with Greece's state administration was not its size but the fact that it adds too little value. There is little sensible policy-making because ministerial bureaucracies do not collect or use data on which to base their policy designs. Moreover, ministries communicate badly with each other, if at all. And even within ministries most departments work in “silos” – they produce rules and regulations without much of an idea how they fit into any broader policy plans. The average Greek ministry has 440 different departments or administrative units. One in five of these do not have any staff other than the head of department and only one in ten have 20 staff or more. The central government alone is spread over 1,500 different buildings.

The OECD also found that civil servants care little if new rules and policies are implemented, monitored and enforced. The result is a state administration that is top-heavy, inflexible, obsessed with process and is basically busy having “a conversation with itself”, as the OECD puts it. Having watched the government’s laboured efforts to improve matters, the OECD now thinks that only a “big bang” reform could give Greece a public administration capable of planning and implementing meaningful change.

Similarly, a white paper that came out of a brainstorming at London Business School last year suggests that in some government areas a completely new start is needed. The most urgent is probably the tax administration. The authors of the white paper (Michael Jacobides , Richard Portes and Dimitri Vayanos) are sceptical whether the cronyism and corruption that pervades local tax offices can ever be tackled. Although the government has told its tax collectors to get tough on evaders (some €60 billion in taxes are outstanding), many have simply failed to heed orders to, for example, conduct audits on big tax debtors. Even former finance ministry officials admit that Greece would probably be better off to abolish the 300 local tax offices because they cost more than they collect. Instead, Greece should set up an independent central tax and social security collection agency.

The white paper suggests similar independent bodies in other areas: buying medicines and equipment for the healthcare sector (here, Greece’s spending per head has been the highest in Europe for many years); public procurement more generally (public contracts amount to 11 per cent of GDP but it takes on average 230 days to award such a contract); a corruption watchdog (although graft appears to be declining, according to Transparency International, one in ten Greeks said they paid a bribe in 2010, with public hospitals and tax inspectors being the most greedy); and a central steering group to supervise structural reform – a proposal also dear to the OECD’s experts.

Such independent bodies could potentially be established quickly and make a noticeable difference. However, the few new bodies that the government has so far set up, such as the privatisation agency and the parliamentary budget office, have been woefully understaffed. And they have encountered much political resistance when trying to carry out their assigned tasks.

Greece’s donors know that there are no quick fixes for the country’s deep-seated malaise. But they no longer trust the political class to carry out a sustained reform programme. Both big parties, Papandreou’s social-democrats (Pasok) and the conservative New Democracy, draw much of their support from public sector workers and other molly-coddled groups that resist change.

The new ‘technocrat’ government will hardly make a difference: Papademos has been given only five months before the next election is due. And unlike Mario Monti in Italy, who was free to fill ministerial posts with experts and other non-political types, Papademos is lumbered with 45 cabinet ministers, most of whom are career politicians from Pasok and New Democracy.

EU politicians now insist that all party leaders must commit to the new troika reform programme beyond the April election. But both Pasok leader Papandreou and New Democracy’s Antonis Samaras are opposing chunks of the troika programme while suggesting that there is an easier way out of the crisis than radical reform.

The negotiations for the new support programme are a good opportunity for a new deal: the troika eases demands for rapid fiscal consolidation and finds additional money for growth-boosting investments, for example from Greece’s €15 billion unspent EU funds or the EIB; Greek political leaders, in turn, get serious about public sector reform and opening up the economy. Ultimately, only the Greek people – not any kind of outside watchdog – can hold the country’s often self-serving politicians to account. To help the Greek people, Greece’s donors must make a bigger effort to improve their image in Greece and explain to the Greeks what needs to be done to put the country on a sustainable growth path.

Katinka Barysch is deputy director of the Centre for European Reform.

Why France is leaving Afghanistan

The decision by President Nicolas Sarkozy to speed up the withdrawal of French troops from Afghanistan has re-awakened suspicions that Paris is not to be trusted as an ally. Sarkozy responded to the deaths on January 20th of four French soldiers by ordering the return of all France’s combat troops in 2013, a year before NATO plans to end major operations in Afghanistan. Defence officials in London and Washington have privately condemned the decision as poorly-timed or, worse, a cynical political ploy ahead of France’s presidential elections in April and May 2012. This belittles genuine concerns in France about the conduct of the war. A closer analysis shows that the French government is ahead of other allies in recognising that NATO's strategy has not worked.

French officials believe that the alliance is rewarding a profoundly corrupt government in Kabul that has shirked its commitment to reform. French thinking on Afghanistan is in line with that of David Galula, a French military strategist, who wrote what the US military itself regards as the definitive treatise on counterinsurgency. The lesson of the French war in Algeria in the 1950s and 60s, Galula wrote, is that military accomplishments are meaningless unless accompanied by a process to establish legitimate and broadly accepted political order. In Algeria, the French won the tactical battle against the insurgency but failed to offer a credible government to run the country – and in the end, the French public turned against what it saw as a hopeless problem requiring an expensive military commitment. In Afghanistan, the Americans are repeating France’s mistake from Algeria: they have put too much faith in a government that is so self-serving and corrupt that it stands no chance of increasing its credibility with the Afghan people. A recently leaked NATO report buttresses French views: it suggests that many Afghan officials have been actively working with the insurgency in order to distance themselves from the Karzai government.

The French have bitter first-hand experience with corruption and double-dealing on the part of Afghan officials. When Barack Obama launched an Afghan ‘surge’ in 2009, Sarkozy raised France’s contingent to just short of 4,000, and the French assumed a lead military role in Kabul and the neighbouring Kapisa province. Despite minimal consultations from Washington, Sarkozy decided to give Obama’s strategy the benefit of the doubt and refused to rule out additional troop increases in the future. But France quickly found that one of its most dangerous enemies in Kapisa was the provincial governor himself, who extorted the local populace and tipped off insurgents about the whereabouts and plans of French troops. Eventually, following considerable French and coalition pressure, President Hamid Karzai removed the governor in 2010. But French diplomats were appalled when the deputy attorney general, Fazel Ahmed Faqiryar, who was responsible for prosecuting the former governor, was in turn removed by Karzai. The president also vetoed a number of investigations of his senior government officials. Today Faqiryar, one of Afghanistan's chief fighters against corruption, lives under virtual house arrest in Kabul and is forbidden to receive visitors.

The Afghan security forces should be the French troops' closest ally. But in 2011 the International Crisis Group cited Kapisa as “one of the best examples of the nexus between the insurgency and corrupt Afghan security forces”, a statement privately endorsed rather than refuted by French military officers. France lays the blame on the Kabul government, which, Paris says, needs to reform and reconcile with its enemies if NATO intervention is to make any difference. And unlike Washington, Paris sees no point in sending a short-term ‘surge’ of troops to provinces where the Afghan government refused to curb the activities of predatory and corrupt officials.

Paris is having little success in getting Washington to listen; the US frequently ignores French concerns about corruption and incompetence in the Afghan government. Throughout 2010 and 2011, French diplomats in Afghanistan warned that the sharp increase in US aid under the Obama administration fuels corruption and indirectly funds insurgency (because many subcontractors pay 'protection' money to the Taliban). US officials recognised that their contracting and oversight procedures were flawed, but they chose to keep faith with Karzai’s vague promises to curb corruption, even though the Afghan government had deliberately obstructed several prior anti-corruption initiatives. Successive commitments to reform made at high-level conferences were ignored. Despite mounting evidence of misuse, US aid to Afghanistan almost trebled between 2008 and 2011.

Another clash between Paris and Washington occurred in 2010, when the International Monetary Fund (IMF) suspended the negotiation of financial aid to Afghanistan upon the refusal of the Karzai government to stop and investigate the theft of millions of dollars of aid money through Kabul Bank. France was particularly adamant that the international community should stand united in supporting the IMF and not allocate further large-scale funding to the Afghan government until it reformed the Kabul Bank and prosecuted those responsible for the scandal. But US military leaders complained that the Europeans were interfering with their timetable to build up the Afghan security forces and committed to fund the Afghan Ministries of Defence and Interior regardless of the IMF’s position.

Rather than addressing the shortcomings of NATO strategy, coalition headquarters in Kabul have a dangerous tendency to publicly present an exaggerated picture of success. For example, NATO officials cite polls claiming that the Afghan National Police (ANP), which assumed control of the Surobi district of Kabul from France in 2011, enjoyed 70 to 80 per cent approval ratings among the local populace. But French officers, who have seen first-hand the predatory behaviour of the ANP in Surobi, dismiss the figure as absurd, and point out that respondents are often afraid to voice their true opinions: many Afghan agencies that conduct such polls are not trusted and often travel with loathed private security companies. NATO needs the figures to look good because it has based its departure upon the capability of the Afghan government to deliver improved security and governance. France initially went along with this approach because it promised a quick exit but it has long doubted its credibility. The reality is that many provinces have become less stable since the US-led surge of 2009, yet NATO stubbornly claims that its strategy remains on course.

This is the context in which Paris made the decision to withdraw in 2013. France has had enough: its government has concluded that another year or so of a large-scale NATO military presence will not make a difference in the long-term as long as the Afghan government is obstructing rather than helping NATO to improve the governance of Afghanistan.

On balance, Sarkozy’s announcement is to be welcomed. After years of hand-wringing, misspent lives and money, a major member of NATO has finally sent a clear political signal to Kabul. In future France may become the first country to completely link its aid in Afghanistan to real progress in governance, as opposed to questionable opinion polls or recruitment numbers of new police officers. (There is no point in continuing to train security forces if their commanders are not interested in observing the law and intimidate anti-corruption agencies.) France should try to convince other countries and the EU to limit aid until the Kabul government seriously tackles corruption. The evidence is on the side of Paris: despite billions of dollars of aid and thousands of NATO casualties, Afghans trust the international community and their own government less and less.

US leaders such as former Defence Secretary Robert Gates failed the key rule of coalition fighting: the need to listen to, and act on, the views of other allies. They dismissed dissenting European voices on Afghanistan as a sign of weakness rather than foresight. Instead of giving allies more influence over the strategy, Washington repeatedly demanded more ‘boots on the ground’ and money. David Galula could have told them that this is never enough.

Edward Burke is a research fellow at the Centre for European Reform.

The Baltic states and Ireland are not a model for Italy and Spain

Eurozone policy-makers – from President Sarkozy and Wolfgang Schäuble to the former President of the ECB, Jean-Claude Trichet – advocate that Italy and Spain should emulate the Baltic states and Ireland. These four countries, they argue, demonstrate that fiscal austerity, structural reforms and wage cuts can restore economies to growth and debt sustainability. Latvia, Estonia, Lithuania and Ireland prove that so-called “expansionary fiscal consolidation” works and that economies can regain external trade competitiveness (and close their trade deficits) without the help of currency devaluation. Such claims are highly misleading. Were Italy and Spain to take their advice, the implications for the European economy and the future of the euro would be devastating.

What have the three Baltic economies and Ireland done to draw such acclaim? All four have experienced economic depressions. From peak to trough, the loss of output ranged from 13 per cent in Ireland to 20 per cent in Estonia, 24 per cent in Latvia and 17 per cent in Lithuania. Since the trough of the recession, the Estonian and Latvian economies have recovered about half of the lost output and the Lithuanian about one third. For its part, the Irish economy has barely recovered at all and now faces the prospect of renewed recession.

Domestic demand in each of these four economies has fallen even further than GDP. In 2011 domestic demand in Lithuania was 20 per cent lower than in 2007. In Estonia the shortfall was 23 per cent, and in Latvia a scarcely believable 28 per cent. Over the same period, Irish domestic demand slumped by a quarter (and is still falling). In each case, the decline in GDP has been much shallower than the fall in domestic demand because of large shift in the balance of trade. The improvement in external balances does not reflect export miracles, but a steep fall in imports in the face of the collapse in domestic demand.

Estonia had a current account deficit equivalent to 17 per cent of GDP in 2007, but by 2011 this has become an estimated surplus of 1 per cent of GDP. Latvia and Lithuania experienced shifts in their external balances of a similar magnitude. Ireland went from a deficit of 5.6 per cent of GDP in 2008 to a small surplus in 2011. There is little argument that all four countries needed to narrow their trade deficits. But countries that have experienced such enormous declines in domestic demand, and whose economic growth figures have been flattered by a collapse of imports (and hence improvement in trade balances) hardly provide a blueprint for others, let alone big countries.

Spain and Italy could bring about huge swings in their external balances by engineering economic slumps of the order experienced by the Baltic countries and Ireland. But a collapse in demand in the EU’s two big Southern European economies comparable to that experienced in the Baltic countries and Ireland would impose a huge demand shock on the European economy. Taken together, Italy and Spain account for around 30 per cent of the eurozone economy, so a 25 per cent fall in domestic demand in these two economies would translate into an 8 per cent fall in demand across the eurozone. The resulting slump across Europe would have a far-reaching impact on public finances, the region’s banking sector and hence on investor confidence in both government finances and the banks. The impact on sovereign solvency in Spain and Italy and on the two countries’ banking sectors would be devastating.

There are other factors that undermine the relevance of the Baltic and Irish experiences. In the face of mass unemployment, emigration, especially from Ireland and Lithuania, has ballooned. In the year to April 2011 alone, Irish emigration topped 76,000. The figures are similar for Lithuania, with 83,000 leaving in 2010. Comparable totals for Italy and Spain would be 1 million and 750,000 respectively. Moreover, the Irish have overwhelmingly moved to countries outside the eurozone (Australia, Canada, the UK and US). By contrast, a significant proportion of the very much larger number of Spanish and Italians would presumably be seeking work elsewhere in the currency union. The robust German labour market could absorb some migrants, but nothing like the numbers involved.

Despite massive movements in external balances that could not be repeated elsewhere and emigration that could not easily be emulated by others, Ireland, Latvia and Lithuania have experienced dramatic deteriorations in their public finances. Including the cost of bailing out Ireland’s banks, public debt has risen from just 25 per cent of GDP in 2007 to over 100 per cent in 2011. In Latvia the debt to GDP ratio increased from 9 per cent to 45 per cent over this period and in Lithuania from 16 per cent to 38 per cent. The exception is Estonia, which has managed to run largely balanced budgets over the last four years.

Italy and Spain have few lessons to learn from the experience of the Baltic countries or Ireland. Those advocating that Italians and Spanish emulate these economies should admit that they are arguing in favour of an unprecedented slump in domestic demand. They should then demonstrate how this would be consistent with the solvency of both governments and banks in Italy and Spain. Finally, they should explain how the European economy as a whole could cope with an economic shock of this order.

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

Is Austria the new Finland?

In August 2010, a newly elected Slovak government refused to contribute to the first Greek bail-out. A year later, the rising popularity of the anti-euro True Finns pushed the Finnish government to demand that Greece should put up collateral in return for new loans. Which eurozone country will be next in line to hold up a bail-out package or veto new rules? Austria could be a good candidate.

Each time a smallish EU country balks at euro rescue efforts, analysts and policy-makers scramble to figure out its political dynamics and wonder why they had missed the brewing storm. With populism on the rise in much of Europe, and big countries dominating eurozone decision-making, it is only a matter of time before the next member-state throws a spanner in the works.

The EU’s traditional mode of decision-making is too cumbersome to fight the euro crisis. Instead, Chancellor Angela Merkel and President Nicolas Sarkozy have regularly pre-cooked plans before euro summits. Small and discreet bodies such as the Frankfurt Group (Germany, France, the European Central Bank, two other EU representatives and the IMF) have taken centre stage. The EU’s Brussels-based institutions have often been sidelined. So have smaller EU countries. Resentment about not having a voice has helped to lift nationalist and anti-euro forces in such countries. Their interventions are making EU policy-making a lot less predictable.

Austria could be the next place where the rise of anti-euro populists turns into a problem for the EU as a whole. The anti-immigrant and anti-euro Freedom Party (FPÖ) is polling neck and neck with the established parties, the conservative People’s Party (ÖVP) and the Social Democrats (SPÖ), which currently govern the country in a grand coalition.

A national election is not due until 2013. But in Austria’s scandal-ridden politics, an early election cannot be ruled out altogether. Some say that the current impasse over a planned national debt brake and austerity measures could spell the end of the ÖVP-SPÖ coalition.

During the days of the late party leader Jörg Haider, the FPÖ joined a coalition government with the ÖVP, prompting the other EU countries to boycott the Austrian government. Wolfgang Schüssel, Austria’s wily chancellor (prime minister) at the time, managed to neutralise the FPÖ in government. The party duly split in 2005 and for a while fell back to single digit support levels. Now it could be heading back towards 30 per cent. It is too early to predict the next election outcome. But tired of their deadlocked, squabbling grand coalition, Austrians seem to dread the spectre of an even bigger coalition of ÖVP, SPÖ and Greens (to keep the FPÖ out of power) just as much as a renewed ÖVP-FPÖ tie-up.

Few Austrians think that the current ÖVP leader (and foreign minister), Michael Spindelegger, could control the FPÖ’s firebrand leader, Heinz-Christian Strache. Strache already boasts that he will be the next chancellor. Strache’s personal approval ratings are awful, he lacks a comprehensive programme, and his party is as prone to scandals as its peers. But Strache’s promises to stop sending Austrian money to Brussels, hold referendums on existing euro rescue packages and start a debate about Austria leaving the euro resonates with the many EU-sceptic Austrians.

The Austrians’ ambivalence towards the EU has long been a puzzle. As a small, open and centrally located country that lives on exports and tourism, Austria has benefited a lot from the EU single market and the euro. Yet Austria has punched below its weight in Europe, its EU policies have been rather parochial (with few initiatives beyond the Balkans) and it has not produced as many great European figures as, for example, Sweden or Finland.

In surveys the Austrians have consistently been among the most sceptical about the EU. In the latest Eurobarometer poll, published in December 2011, 42 per cent of Austrians said they had a bad image of the EU. In neighbouring Germany, France and Italy, those shares are much lower, at 20-25 per cent.

However, Austria’s euroscepticism looks shallow. When asked more specifically whether they trust EU institutions, and want the EU to get more involved in, say, protecting the environment or fighting terrorism, the Austrians show themselves as solid (though not enthusiastic) pro-Europeans. While the Austrians are much less keen on more EU co-operation to save the euro than the Dutch or Finns, over half of Austrians say they would welcome eurobonds.

If the public mood on Europe appears confused, the government’s EU policies are even more so. In a baffling U-turn on the big parties' traditional pro-EU stance, Faymann in 2008 promised to hold referendums on future EU treaty changes. But after agreeing to the new eurozone-plus treaty (‘fiscal pact’) in December, Faymann wiggled out of his referendum promise, causing glee in an FPÖ that has long demanded more direct democracy.

Having been as implacably opposed to eurobonds as Germany, the government changed its mind once Austria's own bond spreads started rising last autumn. Shortly afterwards, Faymann departed from Austria’s monetary orthodoxy when he suddenly called for the ECB to play the “leading role” in saving the euro by financing the EFSF and the ESM. Meanwhile, Spindelegger came out in support of a smaller European Commission – although Austria has always been a staunch defender of the principle that each country must have its ‘own’ commissioner in Brussels.

Asked to evaluate Austria’s EU policies in a recent interview, the Czech foreign minister, Karel Schwarzenberg, quipped that “I cannot comment on something that does not exist”. That verdict may be unkind. But the impression persists that the current muddle results from the coalition’s desperate attempt to catch the eurosceptic mood and thus stop the FPÖ’s rise.

In her euro policies, Merkel is trying to keep the ‘smalls’ on board. She makes a point of phoning leaders from smaller eurozone countries to discuss (some say inform them about) plans for the next summit. She met Faymann ahead of the December euro summit. She, and Sarkozy, need to do more to quell the impression that today’s EU is run by a directorate of big countries, or worse, by a Berlin dictate. But the smaller countries also need to take advantage of such opportunities by presenting constructive proposals. For some, it appears easier to moan about being steamrolled by the Franco-German juggernaut than to stand up for their own ideas and interests.

Austria – with its enviable growth and unemployment rates (roughly 3 per cent and 4 per cent, respectively, in 2011, on EU data) – would be well suited to act as a spokesman for eurozone’s smaller creditor countries. It could be pro-active in safeguarding the authority of the EU Commission, without which the EU cannot function well. It could use its close ties to neighbouring Germany to remind Berlin that growth-promoting strategies are needed to deal with the debt crisis.

Instead, the coalition government’s lack of an EU strategy is playing into the hands of the Freedom Party: at least Strache’s anti-euro message is loud and clear. Unless the two main parties come up with an attractive alternative, Austria could become the next euro country that feels compelled to veto a euro rescue plan to placate domestic voters.

Katinka Barysch is deputy director of the Centre for European Reform.

What Europe's new diplomatic service can do for Britain

As the influence of individual European countries vis-à-vis rising giants such as China declines, many look to the EU’s new diplomatic corps – the European External Action Service (EEAS) –– to augment their strength. But in 2011 Britain blocked the EEAS from articulating common EU positions at the UN, the Organisation for Security and Co-operation in Europe (OSCE), and in some foreign capitals, angering other member-states. However, a recent agreement among EU countries over representation at international organisations should allow Britain to adopt a constructive approach towards the EEAS. It may also help to add European weight to British foreign policy objectives.

Even prior to the 2009 adoption of the Lisbon Treaty, which created the EEAS, the EU had routinely spoken with one voice in multilateral forums. Therefore it came as a surprise to other EU member-states when Britain decided to renege upon established procedures. In May of last year, Foreign Secretary William Hague sent an urgent diplomatic cable to all British overseas missions, warning diplomats to look out for EEAS ‘competence creep’. Hague believed that the EEAS – without the consent of the member-states – was increasingly speaking for Europe on foreign policy issues, even where competence rested with national governments rather than the EU institutions. Shortly afterwards, British diplomats began to block EEAS officials from speaking at international organisations, saying that new arrangements were needed to clarify when the EEAS was speaking for the EU institutions, the member-states or both.

Germany, the Netherlands and other countries took a dim view of Britain’s concerns, seeing a eurosceptic, ‘spoiling’ agenda behind Britain’s actions. In particular, they resented William Hague’s opposition to a more forceful EU representation at the UN. Meanwhile, the European Commission threatened to take Britain to the European Court of Justice if the UK persisted in blocking the EU from speaking at multilateral organisations where it had at least partial competence.

On October 22nd 2011 EU foreign ministers agreed to new rules on diplomatic representation. In future, the EEAS and other EU representatives will have to identify when they are speaking on ‘behalf of the EU’ (implying that common institutions enjoy full competence over the matter), ‘on behalf of the EU and its member-states’ (in cases when common institutions share competence with national governments) or ‘on behalf of the member-states of the EU’ (when EU institutions have no competence and only act upon request of the member-states). Britain believes that these arrangements will prevent EEAS officials from making commitments without first consulting the member-states.

While the UK government feels vindicated by the October 22nd agreement, other capitals are grumbling about it. They argue that precedents have long existed for the EU to represent the member-states on issues of shared competence (as they have done for the past 20 years at the UN Food and Agriculture Organisation, for example). They are concerned that the UK will use the new rules to block a more proactive role for the EEAS in international organisations. Some also worry that the squabble over representation signals a deeper UK dislike for a collective EU foreign policy, and fear that the EU’s ability to reach out to the emerging powers, in particular, will suffer.

The UK government agrees that the EEAS should co-ordinate member-states’ policies towards countries such as Brazil, China or India, and try to bring European views closer together. But London opposes any suggestion that EEAS officials should craft foreign policy. As part of its wider vision of a more inter-governmental EU – as opposed to one with strong, centralised institutions – the UK wishes the EEAS to play a limited and strictly subservient role to its own diplomacy. In a speech at the Foreign Office in September 2010, Hague rejected any reduction in Britain’s own diplomatic outreach in favour of a new, European form of diplomacy: “We cannot outsource parts of our foreign policy to the European External Action Service as some have suggested. There is not and will never be any substitute for a strong British diplomatic service that advances the interests of the United Kingdom. We can never rely on anyone else to do that for us.” This view runs directly contrary to a desire of smaller member-states for the EEAS to speak on their behalf to the rising powers of Asia, Africa and Latin America.

Britain is not alone in refusing to substitute its bilateral relations with other countries for an approach led by the EEAS. Although the UK government is influenced by a long-standing ‘euro-scepticism’ within its ranks, the concerns of Germany, France and Italy derive from a more practical standpoint. These larger member-states are simply not yet convinced that the EEAS, despite the influx of seconded diplomats from EU countries, can match their own standards for political reporting and negotiation. They think that a collective European approach in foreign capitals is desirable but impractical under the current circumstances. So the EEAS is caught between misgivings over its right to speak on behalf of member-states and a lack of faith in its ability to do so. Consequently, the hopes of smaller member-states for an integrated European diplomacy in Beijing, Brasilia or New Delhi are likely to be disappointed.

It will take time to build a capable diplomatic service. The smaller member-states should therefore scale back their ambitions for the EEAS, and the EU as a whole needs to give its diplomatic service a more focused mission. The EU’s nascent diplomacy should mirror that of an emerging power, initially focusing on trade and consolidating its influence in the European neighbourhood. The EEAS should play a complementary role to the Commission’s trade duties by providing the political information that can make or break negotiations. While the Commission’s officials are good at technical dossiers they often lack an understanding of the internal political situation in the countries with which they are negotiating. For example, at a Doha round of WTO talks in 2008, EU officials underestimated the resistance of Brazil, India and others to a deal on reducing agricultural subsidies, leaving commissioners to appear surprised and defensive.

Similarly, in September 2010, the EU delegation failed to foresee that the European Union’s bid to gain speaking rights at the UN General Assembly would run into opposition from even traditional allies such as Australia, Canada and New Zealand. Neither was the EU aware until the last moment that the Caribbean Community, an important EU development and trade partner, would lead opposition to its proposals. This defeat exposed the lack of diplomatic capability within the EU, where an overwhelming focus on internal dialogue and co-ordination prevailed over outreach to external partners and political analysis. EEAS diplomats are well positioned to address this deficit, and the UK should push the EEAS and the Commission to work jointly to help the EU craft a better diplomatic strategy for future negotiations relating to trade and other areas.

Britain also has a strong motive to encourage the EEAS to become more active in the European neighbourhood, in particular in the Middle East and North Africa. Here, Britain lacks a comparative advantage over other member-states: Paris, Madrid and Rome have more influence in parts of the Arab world than London, and they have also taken the lead in shaping the EU’s policies towards the southern neighbourhood. The UK has previously opted for a secondary role, missing a valuable opportunity for added influence in a strategically important part of the world.

Britain has a security and trade interest in fostering stability in countries such as Egypt and Libya. And while it lacks the political and economic tools to do so alone, the EU is North Africa’s biggest market and investor. The European Commission now plans to spend €18 billion in development assistance from 2014 to 2020 in the neighbourhood countries, an increase of seven billion euros from the previous funding period. The EU has adopted a ‘more for more’ principle in the wake of the ‘Arab spring’, offering to negotiate enhanced access to EU markets in return for a strengthening of democratic institutions in neighbourhood countries. The UK should now press the EEAS to come up with clear criteria to measure progress towards political reform to ensure that ‘more for more’ becomes a consistent reality rather than mere rhetoric.

The UK relationship with the EEAS has got off to a difficult start. David Cameron’s decision in December 2011 to opt out of an agreement to create a fiscal union between most EU member-states further complicated Britain's relations with the rest of the EU. But foreign policy remains a prerogative of the full EU of 27 members, and Britain will have a strong say in it, even if it is not in the fiscal union. It is in the UK’s interest to work with other member-states to set coherent and achievable objectives for the EEAS. The agreement of October 22nd provides an opportunity for Britain to turn from defensive laggard on the EEAS to constructive pragmatist. The alternative is a constant, mutually destructive clash between competing bureaucracies. Britain is entitled to resist ‘competence creep’. The best remedy is for the UK to tell the EEAS what to do and where.

Edward Burke is a research fellow at the Centre for European Reform.

The Commission’s energy roadmap is a missed opportunity

by Stephen Tindale

The European Commission recently published its 'Energy Roadmap 2050'. The paper begins by repeating the EU's commitment to reduce greenhouse gas emissions by 80-95 per cent (against 1990 levels) by 2050, and highlights the 2020 greenhouse gas, renewable and energy efficiency targets. It then acknowledges that "there is inadequate direction as to what should follow the 2020 agenda. This creates uncertainty among investors, governments and citizens".

The Commission is right to accept the need to set policies beyond 2020, since energy investments are inherently expensive and long term. But the rest of the paper does not propose a clear direction. It simply outlines seven possible scenarios: a reference scenario; current policy initiatives; and five different scenarios involving decarbonisation. The roadmap ends by acknowledging that "the next step is to define the 2030 policy framework" and promising proposals next year on the internal market, renewable energy and nuclear safety.

This is a missed opportunity. The Commission's role is to make policy proposals and it should have spent 2011 preparing these. It should also have published a list of measures which it considers to be the key priorities for 2012.

The Commission's energy roadmap follows the low-carbon roadmap and a transport roadmap that it published last March. All these roadmaps are descriptions of various possible scenarios. Scenario planning and modeling are important, but it is not clear why the Commission thinks it should do these exercises itself; when it does so, it inevitably has to manage the different views of its own directorates-general, and the member-states, in drafting the text. The International Energy Agency publishes valuable and well-respected roadmaps. The European Climate Foundation has also published an excellent 2050 energy roadmap and 2030 electricity roadmap.

To be fair to the Commission, it did publish one significant energy policy proposal in June, the draft 'energy efficiency directive'. Adopting this should be the top EU energy priority for 2012. If Europe produced and used energy more efficiently, its economic recovery and the climate would benefit. But there is substantial member-state opposition to this Commission proposal – some on grounds of subsidiarity, and some on grounds of cost (though investment in energy efficiency will almost always be cheaper than investment in new energy supply). For example, many energy companies do not support the Commission plan to make combined heat and power mandatory on most new power stations – and energy companies have substantial influence over their host governments.

The second EU energy and climate policy priority for 2012 should be to rescue the Emissions Trading System (ETS). In 2007, so before the recession, allowances were trading at €25/tonne. They are now trading at less than €7, making the ETS irrelevant to investment decisions. All the roadmap's decarbonisation scenarios assume major increases in carbon prices. Many energy companies want the Commission to take steps to push up carbon prices. For example, the EU Corporate Leaders Group on Climate Change, whose members include Shell, Alstom, Philips and Dong Energy, has written to the Commission calling for "decisive action now".

The best way to ensure long-term ETS price stability would be to set a Europe-wide reserve auction price: governments could announce that no allowances would be sold for less than, say, €15/tonne. This could be achieved formally through an EU-wide agreement, or informally by member-states with sufficient numbers of allowances creating a 'coalition of the willing'. Such a coalition would need to include all the big economies which use large quantities of fossil fuels for electricity generation – which means all the large European economies except France.

There would be substantial opposition from Poland and Spain, because of the amount of coal these countries use for power generation, and support from the UK, where the government is already introducing a de facto carbon floor price. The view of the German government is harder to predict. Chancellor Merkel's retreat from nuclear power means that Germany will burn more fossil fuel. But Merkel's CDU is less close to the coal industry than the opposition SPD, and Merkel will be actively seeking green votes in the run up to Germany's 2013 elections.

The EU has already agreed arrangements for how the ETS will operate until 2020, and total numbers of carbon allowances for each year until then, so some policy-makers and businesses are arguing that it would be wrong to intervene in the market. But the number of allowances were set against a 'business as usual' scenario – and business is anything but usual at present. To rescue the ETS from irrelevance, intervention is essential.

The EU has agreed that the total number of allowances will reduce by 1.74 per cent each year. This annual reduction will continue after 2020. Apart from this, nothing has been agreed about how the ETS will operate after 2020.

Caps for the years 2021 to 2030 need to be set soon, and the annual rate of reduction increased above 1.74 per cent. But given the track record of ETS price fluctuations, even a greatly improved ETS is unlikely to provide an adequate post-2020 policy framework to give businesses and investors confidence.

So the third priority for EU climate and energy policy in 2012 should be to set out a strategy for 2020-30. At the press conference launching the Energy Roadmap 2015, energy commissioner Günther Oettinger called for an immediate discussion on targets for renewables by 2030, with a decision in two years' time. Targets are less important than policies, but can play a useful role. The roadmap states, correctly, that the 2020 renewables target has given investors greater confidence.

So the EU should give priority to three steps in 2012: adopting the energy efficiency directive, operating a reserve price for ETS auctions and setting a 2030 renewable energy target. Given the eurozone crisis, there is a danger that climate and energy issues will slip down the EU's agenda. But the Danish government, which holds the EU presidency in the first half of 2012, has made clear its intention to prevent this happening. It believes that strong climate and energy policies will boost 'green growth'.

The Danish climate and energy minister, Martin Lidegaard, has said that "every euro spent on energy efficiency will go to ensuring European jobs. Every euro spent on oil imports will go out of Europe". He has acknowledged that the current ETS price is "not sustainable" but not said what he will do about it.

Denmark has an excellent story to tell on climate and energy policy. Since the late 1970s, in response to the oil shocks of that decade, it has vigorously pursued energy efficiency and renewable energy. Denmark has the lowest energy intensity (energy used per unit of GDP) of any member-state. Over 20 per cent of its electricity comes from wind farms. There is a cross-party consensus on climate and energy issues.

Before she became commissioner for climate action, Connie Hedegaard was Danish minister for climate and energy. So despite the eurozone crisis, the treaty negotiations and the inevitable arguments over the multiannual financial framework, we can expect the Danish presidency to remind EU institutions not to neglect climate and energy policies.

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

The UK-EU split: The impact on Central Europe

By Tomas Valasek

The UK decision to boycott the new EU treaty removed an important liberal economic voice from the centre of European decision-making. This has left like-minded EU countries, including most of the Central European states, in a far weaker position to resist the etatist tendencies of France and (to a lesser extent) Germany - all the more so because Britain's actions have also shifted power in the EU from small to big states.

I spent the weekend at a Central European ‘strategy forum’ organised by the Slovak Atlantic Commission and attended by senior officials from the Czech Republic, Hungary and Slovakia. The economic crisis and last week's summit dominated the debates. The prevailing sentiment was one of disappointment that the new 'fiscal union' will operate on an intergovernmental basis: because the UK vetoed a new EU treaty the rest of the member-states will now set up a club outside existing EU rules. This weakens the role of common institutions such as the European Commission (in which each country has one member). The smaller countries prefer strong European institutions because they help balance the power of big member-states such as Germany and France. Germany wanted to work through the EU institutions too but France prefers a new club, seeing it as a way to undo the 2004 enlargement. The UK veto played into Nicolas Sarkozy’s hands, and cemented the dominant role of Germany and France in the new fiscal union, to the alarm of the Central Europeans. "We are being presented with decisions on which we have minimum influence", one official said at the event in Slovakia.

The new balance of power in Europe raises several worrying possibilities. The first is that the inner core will continue to shrink. This is because the perception of a Franco-German diktat is feeding a populist backlash in smaller countries. Voters in Central Europe but also in Finland or the Netherlands are alarmed by a lack of influence over their own affairs and turning to Eurosceptic parties. The Central Europeans worry that this might eventually cost them membership in the fiscal union: "The more excluded we are, the more difficult we find it to pursue sensible policies, and this in turn gives France more reasons to kick us out altogether", one participant observed.

The second key concern for the Central Europeans is that France and Germany may try to expand the remit of the core group beyond issues such as national budgets and deficits to include taxes or labour standards, as Nicolas Sarkozy's and Angela Merkel's joint letter from before the summit sets out. This presents a direct threat to the Central European economic model built on low taxes and investor-friendly laws. In particular, the French desire to harmonise some tax rates might remove one of the Central European economies' competitive advantages. I have heard a prime minister of one country in the region argue that "the freedom to set our own tax levels is an existential issue, for which we are willing to leave the core". If Paris and Berlin agree to unify tax rates, the EU's fiscal union could quickly lose more countries – as it is, the Czech and Hungarian governments asked for more time to assess whether they want to join in the first place.

In theory, the Central Europeans can veto any move to harmonise tax rates because it requires unanimity. In practice, smaller countries need the support of others to resist the pressure from the big countries. In the past, the UK could be counted on to fight alongside the Central Europeans to keep decisions on taxes and social issues in the hands of the capitals. But at the summit, London has managed to "drive itself towards the edges of European politics", one Central European ambassador said at the event in Slovakia. The remark was offered with regret, not glee. On social issues, taxation or the single market, the Visegrad countries are firmly in the UK, not Franco-German, camp. But they have little sympathy for David Cameron, who is seen as having brought the isolation on himself, and blamed for weakening common institutions and thus reducing the power of smaller states.

Another priority which the Central Europeans share with the UK is economic growth and a wish to rebalance Germany's one-sided insistence on fiscal austerity with measures to boost the European economies. At the Central European strategy forum, some think-tank participants argued that governments in the region should join forces with London to launch a drive to cut red tape and expand the EU's single market into new realms such as services and digital economy. The UK had proposed similar measures a few months ago, to little avail. A new joint initiative, in addition to boosting growth, would have the added benefit of underlining that decisions on issues such as single market, labour standards and tax rates are for the 27 to decide, not the core.

But the government officials present at the event showed little interest in the idea. Privately, they say that Britain has become toxic by association; that ideas which it sponsors will be resisted on principle, not on merit. And for governments that share London's liberal view on the economy, that is a depressing conclusion.

Britain on the edge of Europe

By Charles Grant

The outcome of the Brussels summit on December 8th and 9th is a disaster for the UK and also threatens the integrity of the single market. For more than 50 years, a fundamental principle of Britain’s foreign policy has been to be present when EU bodies take decisions, so that it can influence the outcome. David Cameron, the prime minister, has abandoned that policy. Britain will not take part in a new fiscal compact that most other EU countries will join.

France and Germany have persuaded the other eurozone countries that treaty changes are needed to enshrine stricter budget policies and closer economic policy co-ordination. The new procedures would apply only to countries in the euro. Most member-states wanted to enact those reforms through amending the existing EU treaties. That would ensure that countries in the euro, and those outside, would be subject to a single set of rules and institutions.

But Britain blocked that deal, pushing France, Germany and most other member-states to proceed with a new treaty, to sit alongside the EU treaties. The new treaty may face difficulties: the Irish may hold a referendum on it and could easily vote no. But Paris and Berlin are determined to press ahead with the fiscal compact and if the Irish vote against it they are likely to find themselves excluded.

Cameron blocked a treaty for all 27 because he could not obtain agreement on a protocol to protect the City of London. This protocol demanded a switch from majority voting to unanimous decision-making on a number of issues that matter for the City, including the extension of the powers of EU regulatory authorities, and rules that prevent national governments from imposing stricter requirements on bank capital.

Cameron was right to seek to protect the interests of Britain’s hugely important financial services industry. Most financial regulations are decided by qualified majority vote, and there is a risk that new EU rules could damage this vital national interest. However, Britain has never yet been outvoted on a significant piece of EU financial regulation. If Cameron had been prepared to compromise on his demands, he might have been able to secure a deal.

But France’s president, Nicolas Sarkozy, was annoyed by Britain’s demand for special treatment, and had no desire to do the City favours; indeed, after the summit he said that a lack of regulation of financial markets was responsible for many of the current problems. Other heads of government found Britain’s demands and the way it presented them unreasonable. They also complained about the lack of British diplomacy: the British Treasury took its time to draft the protocol and did not present it to the Council of Ministers legal service until the day before the summit. The British made no effort to sell the protocol to most of the member-states. In short, there was little goodwill towards Cameron.

As far as I can gather, the UK government’s position stiffened between the morning of December 7th and the evening of December 8th. At the start of that period, Cameron seemed to want a deal, as his article in The Times indicated. But then loud rumblings from Conservative eurosceptic backbenchers – and calls for a referendum from two cabinet ministers and London Mayor Boris Johnson – made the Conservative leadership reluctant to show flexibility. Some senior Conservatives worried that if the government accepted a new EU treaty it would struggle to push it through Parliament. Many Tories would have rebelled and it probably would have passed – if at all – only with Labour’s support, thereby humiliating Cameron. That is why some senior figures in the government did not want a deal in Brussels.

But Britain’s so-called veto – which has not stopped anything from happening – seems likely to damage its interests. For a start, the government failed to achieve any sort of protection for the City. The countries taking part in the new arrangements (between 23 and 26 member-states are likely to adopt them) will meet regularly and discuss economic policy. They are also bound to talk about single market issues such as financial regulation. In theory, single market matters will still be settled by all 27. In practice, the countries in the new club are likely to caucus and pre-determine the results of EU votes on single market rules – whether they concern the City or other matters.

In the new arrangements, the Commission and the European Court of Justice will almost certainly play a diminished role. That is because France and Germany, the dominant countries in the fiscal compact, are hostile to the Commission and favour a more ‘inter-governmental’ Europe. To the extent that these institutions are weaker, they will be less able to do their job of defending the single market and ensuring that all member-states are treated fairly.

Some British eurosceptics seem to imagine that the new club will not be allowed to use EU institutions without Britain’s permission. There are likely to be complicated law-suits, but if most member-states want the Commission and the Court to play a role in the fiscal compact, these institutions will play a role. The institutions will have to try and reconcile two sets of rules and procedures, which will make it harder for them to do their job of policing the market.

What if the eurozone countries want to harmonise banking regulations, which they may need to do in order to ensure the success of the euro? Britain would not support a centralised system of banking regulation, but could easily be outvoted. Rules on banking regulation, like other single market issues, will remain subject to qualified majority voting among the 27. But if Britain wants to win votes, it will need allies.

I can never recall Britain being so friendless in the EU. Countries that might be sympathetic to the UK, such as Denmark, the Netherlands, Poland and Sweden, have grown impatient with the Cameron government. They have always wanted Britain to be influential in Europe, to balance the power of France and Germany. They would have much preferred all 27 countries to stay together. Britain’s self-exclusion has left them disappointed. Many of the smaller member-states are unhappy: when EU institutions weaken, they are more likely to be pushed around by France and Germany.

Since it joined the EU in 1973, Britain’s impact on the EU has been positive in many ways. It has pushed for legislation to bring about the single market. Together with France, it invented EU defence policy and it has contributed a lot to EU external policies, in areas such as the Balkans, Iran and climate diplomacy. It has helped to maintain the EU’s Atlanticist orientation. It has encouraged the EU to look outwards and see globalisation more as an opportunity than as a threat. With Britain’s voice diminished, the EU is less likely to deepen the single market and more likely to be inward-looking.

It is conceivable that a different British government could seek to reverse this disastrous opt-out. More likely, Britain will continue on a path towards isolation, perhaps even leaving the EU itself.

EU summit: Enough to save the euro?

by Simon Tilford

The UK’s decision to marginalise itself by vetoing a new EU-27 treaty has dominated the post-summit media coverage. And for good reason – it could prove a big step towards UK withdrawal from the EU. However, the bigger question is whether the agreement reached at the summit will do anything to address the fundamentals of the euro crisis.

Unfortunately, the news on this point is just as bad. This summit will go down as yet another missed opportunity. Despite rhetoric to the contrary, the summit suggests that policy-makers have not yet taken on board the seriousness of the eurozone’s predicament. There was no agreement to close any of the institutional gaps in the eurozone, such as the lack of either a real fiscal union or a pan-eurozone backstop to the banking sector. There was no agreement to boost the firepower of the European Financial Stability Fund (EFSF), while the move to beef up the IMF’s finances fall far short of what is needed. As a result, there is little to prevent a further deepening of the crisis.

What has been agreed falls far short of a ‘fiscal union’. There will be no joint debt issuance, no shared budget, and no mechanism to transfer monies between the participating countries. Essentially, the agreement hard-wires pro-cyclical fiscal austerity into the institutional framework of the eurozone, with no quid quo pro in terms of a commitment to move gradually to debt mutualisation. It is little more than a revamped version of the EU’s existing Stability and Growth Pact. The market reaction has been less than euphoric – bond spreads have jumped sharply. Italian yields have risen back to close to 7 per cent.

This is unsurprising. Fiscal austerity alone will not solve the crisis. Indeed it has become part of the crisis. Such a strategy has already failed in Greece and Portugal and it threatens to make a bad situation in Spain and Italy even worse. What the eurozone needs is economic growth, and this agreement further worsens the outlook for that. The eurozone economy is facing a deep recession, and mounting signs of a credit crunch across much of its southern flank, as capital flight gains momentum. To adhere doggedly to a crisis strategy centred on the single pillar of fiscal austerity risks causing a further erosion of investor confidence.

But does the agreement at least give the Germans cover to back more substantive solutions to the crisis, such as debt mutualisation? So far, there is little indication of any thaw in the German opposition to debt mutualisation (‘eurobonds’), but a tough fiscal regime could potentially make it easier for the German government to accept, in principle, the case for eurobonds. The problem is that the longer the crisis goes on, the riskier eurobonds become for Germany economically and hence politically: the bigger the crisis, the larger the impact debt mutualisation would have on Germany’s own borrowing costs, and the larger the obstacles the government would face in trying to sell eurobonds to voters.

And does the agreement provide sufficient cover for the ECB to step up its buying of struggling eurozone countries’ government bonds?
The ECB has stepped up support for the eurozone’s battered banking sector. For example, the ECB has increased liquidity support for the banks: among other measures, banks will be able to borrow from the ECB on longer maturities. But there is no indication that the ECB will dramatically increase its bond buying or set targets for member-states’ borrowing costs. There was apparently strong opposition on the ECB’s governing council to the provision of additional support to the banking sector. For the time being it seems unlikely that the governing council will sanction the scale of bond-buying needed to dispel fears of default. The bank certainly could not intervene indefinitely, anyway. ECB action would need to be accompanied by institutional reforms, in particular a move to mutualise debt. In the absence of that, large-scale bond buying would quickly erode the ECB’s credibility.

The eurozone appears to be little nearer to striking the ‘grand bargain’ needed to secure the future of the single currency. Germany continues to believe that investor confidence can be won back through the imposition of legal regulations. But stability cannot be achieved through regulation. At a time when the European economy faces an acute risk of depression, the eurozone still has no economic growth strategy. Eurozone governments also failed to agree to set aside more money for the EFSF and all the indications are that the ECB will remain cautious.

So the summit has failed to bring any short-term reassurance to investors and done nothing to close any of the eurozone’s institutional gaps. It has set the scene for a new and even more dangerous phase of the crisis. Politics might still come to rescue of the single currency, but the omens are not good.