Europe places too much faith in supply-side policies

Supply-side thinking now dominates European economic policy. Most governments, and the European Commission, argue that attempts to boost demand would be counterproductive, achieving little but a delay to the necessary consolidation of public finances. With close to unanimity, they believe that structural reforms offer the only hope for depressed European economies: these reforms will improve competitiveness and confidence, leading to stronger growth, a rebalancing of trade between European countries and sustainable public finances. But are policy-makers and the Commission putting excessive faith in the power of structural reforms? Is there a risk that a strategy weighted so heavily towards supply-side measures could actually end up further eroding Europe’s growth potential? And is it right to argue that structural reforms will help bring about sustainable rebalancing?

Few doubt the need for structural reforms in Europe. The region needs faster productivity growth and this requires, among other things, more flexible and competitive markets: labour and capital must be freer to move from slow growing sectors to faster-growing ones. But structural reforms alone will not achieve this. Indeed, in the short to medium term such reforms will further depress demand. Only in the long-term could they have the desired effect and only then if businesses invest in new organisational structures and new products, and if workers (especially young ones) have the right skills and experience. But business investment is at historic lows in Europe as firms worry about the lack of demand.

 

And unemployment is back to levels last seen in the early eighties and set to remain chronically high for years. In short, the damage done to Europe’s supply-side by very low investment and mass unemployment is likely to offset the potential benefits of the reforms. For example, all the academic evidence shows that persistently high unemployment does lasting damage to economies’ human capital and hence growth potential.

A further problem is the nature of the structural reforms underway in Europe. Supply-side reforms in the context of the eurozone largely mean labour market reforms, or more particularly, labour market reforms that erode the bargaining power of labour. By contrast, there is much less emphasis on opening up markets for goods and services to greater competition, which is arguably more important from the perspective of economic growth. This is perhaps unsurprising. Germany’s Hartz IV reforms, which are the inspiration for much of what the eurozone is doing, led to a weakening of workers’ bargaining power, but did little to promote reform of Germany’s domestic economy. Indeed, according to the OECD, Spain’s product markets are considerably more competitive than Germany’s. This helps explain the persistent weakness of German domestic demand: it fell in 2012, with all of the economy’s 0.9 per cent growth down to net exports.

The European Commission argues that the structural reforms underway in the peripheral eurozone economies are boosting their trade competitiveness, and points to the narrowing of their current account deficits in 2012 as evidence of this. But this improvement is mainly the result of unprecedentedly weak domestic demand (and hence declining imports) in these economies, rather than rising exports. Faced with stagnation at home, some firms have successfully scrambled to boost exports. However, a sustained rise in exports requires investment in new capacity and products and stronger export demand. Neither is happening: investment in manufacturing is at all-time lows across Europe, but it is especially weak in the periphery. Demand across the European economy, meanwhile, is chronically weak.

Three years ago, the Commission argued that rebalancing within the eurozone needed to be symmetric if it was to be consistent with economic growth. It followed that the onus needed to be on the economies with big trade surpluses to rebalance their trade as much as the deficit ones. In reality, very little emphasis has been placed on rebalancing the surplus economies. And in a report published in December 2012, the Commission downplayed the role that stronger demand in the region’s surplus economies would have on the exports of countries such as Spain, Greece and Portugal. The Commission illustrated this by showing the limited impact a 1 per cent increase in German domestic demand would have on the exports of the country’s eurozone trade partners: the peripheral ones do less trade with Germany than the country’s immediate neighbours, and would hence benefit less from stronger German demand for imports. The Commission acknowledges that there would be second and third round effects – for example, stronger demand in Germany would boost the French economy, which in turn would boost the Spainish one – but almost certainly underestimates the significance of these.

However, the bigger problems with the Commission’s analysis are the narrowness of its focus and its use of such a modest increase in German domestic demand to illustrate its point. There is no doubt that a 1 per cent increase would have only limited impact on peripheral countries’ exports. But if domestic demand in Germany (and in other surplus economies such as the Netherlands and Austria) expanded by 4 per cent per year over a five year period, the impact on their trade partners would be significant, even on the assumptions employed by the Commission. Moreover, if their demand were to increase by this amount, the surplus economies’ ‘marginal propensity to import’ (that is, the proportion of any increase in demand spent on imports) would rise: their domestic industries would lack the domestic capacity to service the increased demand and a rising share of it would be met by imports. Firms would be likely to step-up investment in the domestically orientated-sectors of these economies, reducing their trade surpluses, and with it the drag they impose on the rest of the eurozone economy. The flip-side would be stronger investment in the export-orientated sectors of the peripheral countries.

On their own, the structural reforms underway across Europe will bring neither economic recovery nor rebalancing. The current reforms focus strongly on labour markets, and risk leading to similar results across Europe to those seen in Germany: very weak consumption and investment. Europe needs to do much more to strengthen demand, which requires symmetric structural reforms and stimulus. While there is no doubt that Spain needs to reform its labour market, Germany would also benefit from reforms of its product markets. Those governments that have the scope to provide stimulus need to do so: Germany actually posted a budget surplus in 2012. Stronger demand in the countries running trade surpluses will not suffice to rebalance the eurozone economy and return it to growth, but it is an indispensable element of what is needed. The European Central Bank, meanwhile, could redouble its efforts to boost credit growth. As it stands, demand is likely to remain very weak across Europe for a prolonged period of time, further eroding growth potential and the sustainability of public finances.  

The Commission’s readiness to place so much faith in structural reforms as a solution to Europe’s economic ills is a product of the region’s political realities. The surplus countries have successfully resisted pressure to take steps to rebalance their economies and there is little appetite among eurozone governments for simultaneous reflation involving fiscal stimulus and quantitative easing by the ECB. The current strategy is not without political risk: the more European policy-makers talk about growth, the less growth there is. Whereas unpopular national governments can be voted out and replaced with ones that do not shoulder responsibility for unsuccessful policies, this is not the case with the Commission, whose standing could suffer long-lasting damage.

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

How can the EU influence China?

For the EU, China matters more than any other emerging power. Two-way trade in goods between them amounted to €429 billion in 2011. Diplomatically, the Europeans and the Chinese meet in scores of summits, dialogues and working groups. Yet the EU and its member-states have a poor record of getting China to do what they want.

Most notably, China has resisted European pressure to open its markets. Chinese protectionism is one factor behind both the EU's €156 billion trade deficit in goods in 2011, and the meagre level of trade in services (€43 billion) – a European strength – in the same year. China has done much less than the Europeans would have hoped to enforce intellectual property rights: 73 per cent of all fake goods seized at EU borders in 2011 were from China. And when it comes to traditional diplomacy, whether the EU asks the Chinese to act on a human rights case or to recalibrate their policy on Syria, they often stonewall.

Why does the world's biggest economic bloc have such little sway in China? The problem is not so much that EU governments are disunited over China policy, though sometimes they are. It is rather that they fail to understand that pooling their efforts through the EU would give them more clout. Furthermore, the EU fails to take a 'strategic' approach to China, in the sense of focusing on a small number of key objectives.

The Chinese are skilled at using their commercial leverage to dissuade particular member-states from criticising them or welcoming the Dalai Lama. But while Chinese diplomacy sometimes divides the Europeans, they also do a good job of dividing themselves. The southern Europeans are the most reluctant to make human rights an important part of the EU-China relationship. And the northerners are the most unwilling to support protectionism against Chinese imports. The 'big three' – Britain, France and Germany – dominate EU foreign policy, but are inclined to do their own thing on China. They share the same goals, such as supporting liberal economic and political reform in the country. But viewing each other – some of the time – as competitors for the best contracts and contacts in Beijing, they prioritise bilateral ties.

The Germans tend to focus on their commercial relationship with China. They would like the EU to lever open Chinese markets. But some Germans are sceptical that the EU can do that effectively, given that few of its member-states have much manufacturing industry. German officials point out that 47 per cent of EU merchandise exports to China are German.

Yet surprisingly, when the European Council discusses China, Chancellor Angela Merkel does not attempt to lead EU policy and often says very little. She did not do much for European solidarity when in Beijing last August on a trade mission: perhaps hoping for commercial gain, she urged the European Commission not to start an anti-dumping action against Chinese solar-panel manufacturers for allegedly unfair pricing (ironically, the Commission had taken up the matter in response to complaints by German firms, and it opened a case against China in September).

The French, too, tend to be commercially focused and, like the Germans, reluctant to work through the European External Action Service (EEAS). They have urged the EU to apply 'reciprocity' to the Chinese, meaning that it should close some of its markets until the Chinese open more of theirs. The British are quite 'European' on China. They see the value of the member-states concerting their efforts and working with the EEAS. But some EU governments think the British are too willing to follow an American agenda in East Asia.

A new division may be emerging, between the Central Europeans and the rest of the EU. Last April, Donald Tusk, the Polish prime minister, hosted a summit of ten leaders from Central European member-states, six from the Balkans and Wen Jiabao, the Chinese prime minister. Wen met all the leaders bilaterally and offered €10 billion of cheap credits for infrastructure projects. Everyone at the summit pledged to keep their markets open. This 16+1 summit is likely to become an annual event, and there are parallel meetings at official level. The Chinese foreign ministry has established a secretariat to co-ordinate this group, under Vice Foreign Minister Song Tao.

That Poland, an increasingly influential EU country, should wish to take the lead on an important area of foreign policy – in response to a Chinese initiative – is neither alarming nor surprising. Having faced criticism for focusing too intensively on its own region, Poland wants to show that the big three are not the only member-states capable of thinking globally. Nevertheless, some EU officials worry about the consequences of the 16+1 process. What if Beijing’s price for investing in infrastructure is that the host government promise to thwart European criticism of its human rights record, or push for scrapping the EU’s arms embargo on China?

It is too soon to judge whether China may gain such benefits. The Poles have an honourable tradition of standing up for liberty in communist-run countries and would probably not kowtow to Beijing on human rights issues. But the Chinese could win some new friends through the 16+1 meetings. They already have several in Europe: Hungary, having benefited hugely from Chinese investment in its chemicals industry, and Greece, which has welcomed Chinese investment in ports and shipping, are inclined to speak softly about China. Cyprus has never been known to criticise China on anything.

Though Poland has helped to create one sub-group of member-states, it has been excluded from another. The US has convened informal meetings of senior officials from the US, Britain, France, Germany and Italy to discuss East Asian security. It hopes to influence EU policy on Asia through this ‘Quint’. US officials sometimes criticise the EEAS – which is not invited to the Quint – for lacking expertise on the region and they urge the EU to think about security issues as well as commerce.

Despite all the sub-groups and divisions, the 27 member-states often agree on China policy. They maintain the arms embargo and refuse to give China 'market economy status'. They delegate EEAS officials to speak to the Chinese about human rights (Britain and Germany are among the member-states that also have their own human rights dialogues with China, though France does not). They all want the Chinese to remove restrictions on foreign investment, better respect intellectual property and give foreign firms 'equal treatment'. The EU representation in Beijing is co-ordinating the embassies of the 27, for example when they collectively draft reports for the EEAS on events in China.

The current atmosphere in EU-China relations is quite positive. The Chinese are glad that the EU has backed down over its efforts to force Chinese airlines into its carbon emissions trading scheme. And EU officials are grateful for China’s help on the euro. They say it has bought "significant" amounts of sovereign bonds issued by southern eurozone states. There are reports that China has purchased about 30 per cent of the bonds issued by the European Financial Stability Facility, the EU’s bail-out fund, and that a quarter of its $3.3 trillion foreign currency reserves are in euros. China has contributed $43 billion to a new IMF facility that could be used to help distressed eurozone countries, which the US has shunned.

The long-running talks between Beijing and Brussels over a new partnership and co-operation agreement have stalled, partly because of China's reluctance to open its markets. As an alternative, the EU and China now hope to negotiate a more modest investment agreement. This would protect the rapidly growing Chinese investments in Europe, while the Europeans would gain better market access, including to public procurement, and equal treatment for their firms in China. Negotiations could start in the spring, after the formation of a new Chinese government.

The Europeans sometimes work with the Americans on economic issues. They made joint representations to the Chinese government on its 'indigenous innovation' law that could have forced foreign firms to hand over intellectual property – and achieved some results. They have also made several joint complaints to the World Trade Organisation, including one over China's ban on rare earth exports.

The US would also like to work with the Europeans on broader issues of Asian security. It points out that although the EU and its member-states provide more development aid to Asia than either the US or China, they have gained very little diplomatic leverage in return. For example, the annual East Asia Summit will not allow in the EU.

The Americans are glad that Catherine Ashton, the EU's High Representative, has taken part in an annual 'strategic dialogue' with State Councillor Dai Bingguo, the senior Chinese official for foreign policy, even if its substance has been limited; and also that she meets the Chinese defence minister regularly. They encouraged Ashton to sign an EU-US statement on the Asia-Pacific region when she met Hillary Clinton in Phnom Penh in July. This referred to their common commitment to promote democracy and human rights in the region. In the South China Sea they urged ASEAN and China "to advance a Code of Conduct and to resolve territorial and maritime disputes through peaceful, diplomatic and co-operative solutions." Those anodyne words were enough to upset some South East Asian governments, which grumbled about the EU sticking its nose into their affairs.

Some European diplomats do not want transatlantic collaboration to become too concrete: if the EU is perceived as being in the Americans' camp in their great game against the Chinese, its own brand and credibility may suffer – particularly in the many Asian countries that want to avoid taking sides.

The US does not expect Europeans to play a military role in the region, but hopes they will deploy their soft power. For example, the EU could use its expertise on regional governance to help East Asians build their own regional bodies; it could offer its good offices for resolving territorial disputes and promoting freedom of navigation; it could prepare economic aid for North Korea if that country embraced reform; and it could explain the benefits of stronger global governance in areas such as weapons proliferation.

The Americans are right that the EU could and should take a more strategic approach to the region as a whole and to China in particular. With China it should focus on a small number of key objectives. One should be securing better market access – including in services – and protection of intellectual property. A second should be urging the Chinese to strive harder to counter the diffusion of dangerous weapons, and in particular to persuade Iran to curb its nuclear ambitions. A third should be encouraging the transfer of the energy-efficiency technologies that the carbon-belching Chinese economy sorely needs. The big three and the EEAS should seek to line up all 27 governments behind these priorities. A united and focused EU would be more influential in China and more respected by other powers in the region.

Charles Grant is director of the Centre for European Reform.

Sound public finances require more than low budget deficits

The European Commission and the European Central Bank like to compare the eurozone's budget deficit and overall level of public indebtedness favourably with the US and the UK. Senior policy-makers from both institutions cite the allegedly superior fiscal performance of the eurozone to justify their outspoken support for austerity. They claim that the eurozone has acted more decisively to put its public finances on a sustainable footing and will reap a growth dividend for this, as confidence returns more quickly to the eurozone than to the US or UK. Is the Commission’s confidence justified? Or is it guilty of using data selectively to justify policies that are not working?

The eurozone as a whole has certainly run smaller budget deficits than the US or the UK over the last five years. Whereas the eurozone deficit averaged 4.4 per cent of GDP per year in 2008-12, the UK's was 8.4 per cent and that of the US almost 10 per cent. However, an economy’s budget deficit only says so much about its debt dynamics. The sustainability of a country's fiscal position is less about the size of its budget deficit at a particular point in the economic cycle, and much more about the size of its debt stock, the cost of borrowing and the trend in nominal GDP (that is, economic growth plus inflation). And here the picture becomes less clear.

The eurozone budget deficit may have averaged less than half the US's over the last five years, but the eurozone’s ratio of public debt to GDP has grown only slightly less rapidly than the US's. The eurozone's debt stock has increased from 70 per cent of GDP in 2008 to an estimated 94 per cent in 2012. Over the same period, the comparable US ratio rose from 76 per cent to 107 per cent, and that of the UK from 52 per cent to 89 per cent.

Moreover, around five percentage points of the rise in the US debt stock reflects the cost of recapitalising the country’s banks (the comparable figure for the UK is around 8 per cent of GDP). It is hard to put a figure on the cost to the tax-payer (so far) of bank recapitalisations in the eurozone, but it is certainly less than 2 per cent of GDP. It is legitimate to include the costs of bank recapitalisation in the three economies' debt stocks: eurozone governments (individually or collectively) will eventually have to pump large amounts of public money into their banks, pushing up the level of public debt across the currency union. 

If the cost of bank recapitalisation is excluded, public indebtedness has only risen slightly more quickly in the US than in the eurozone. The UK's debt ratio has increased significantly faster than the eurozone, even after taking into account the expense of recapitalising banks. However, the rise in the UK's debt stock has outpaced that of the eurozone's by less than suggested by the UK's much bigger budget deficit.

Why has the ratio of eurozone debt to GDP risen almost as much as in the US, despite the US running a budget deficit of twice the size of the eurozone over this period? One factor is nominal GDP or the 'denominator', which has grown more quickly in the US than in the eurozone, reflecting a much stronger economic recovery. This has contained the expansion of debt to GDP in the US relative to the eurozone, where the expansion of nominal GDP has been much weaker. Nominal GDP in the UK has also risen more rapidly than in the eurozone, although this reflects higher inflation rather than a superior growth performance. Inflation is no panacea, of course. Eventually investors will demand a higher premium to compensate for it. But they are only likely to do so once economic recovery is underway (and other assets become more attractive than government bonds). At that point fiscal deficits should fall rapidly in any case, as tax revenues rise and social transfers fall.

 

The crucial importance of nominal GDP to a country’s debt dynamics is illustrated by Italy. Despite managing to run a small deficit, Italy has experienced a very large rise in the ratio of debt to GDP over the last five years. One reason is that Italian nominal GDP actually fell slightly between 2008 and 2012. Greece, Ireland and Portugal, together with Spain, have all run much larger deficits than Italy, though only in the case of Ireland has the deficit been significantly bigger than in the US (reflecting the scale of Ireland’s bank recapitalisation programme). But Greece and Ireland have experienced huge falls in nominal GDP (14 per cent in both cases), whereas Spain and Portugal have posted declines of around 3 per cent. Falling nominal GDP is a major reason why they have all experienced dramatic increases in their debt ratios, far in excess of the US or the UK.

Another factor explaining why the eurozone's debt stock has risen so quickly despite a relatively small deficit is higher real borrowing costs. Quantitative easing by the US Federal Reserve and the Bank of England, combined with concerns over weak economic prospects (which undermines the attractiveness of other assets), have pushed down government borrowing costs. Both the US and UK have been able to borrow (and refinance debt) very cheaply. Crucially, borrowing costs have been below the rate of inflation in both countries, which slows the accumulation of debt relative to GDP.

By contrast, average borrowing costs across the eurozone have been considerably higher. While Germany, the Netherlands, Finland and Austria have been able to borrow as cheaply as the US, and France has only had to pay a bit more, struggling eurozone economies such as Italy and Spain and, of course, the three small peripheral economies, have had to pay far more to borrow funds. Investors have questioned whether their membership of the currency union is sustainable and have demanded a premium to offset the convertibility risk. Since the ECB indicated in mid-2012 a readiness to purchase potentially unlimited quantities of struggling eurozone countries’ debt, borrowing costs have fallen. However, they still remain well above the rate of inflation.

A combination of stagnant or declining nominal GDP and borrowing costs in excess of inflation is poisonous for many eurozone countries' debt dynamics. It is all but impossible to prevent a rapid accumulation of debt to GDP when the nominal GDP is not growing, irrespective of how much fiscal virtue a country demonstrates. Indeed, from the perspective of debt dynamics, fiscal austerity can be counterproductive. As Italy demonstrates, running a primary budget surplus (the budget balance before the payment of interest) is no guarantee of fiscal sustainability if interest rates are high and nominal GDP stagnant or falling.

What about the future? The European Commission forecasts that eurozone public debt will barely rise as a proportion of GDP in 2013 and actually start falling in 2014. Economic forecasting is necessarily imprecise, but the Commission’s strain credibility. Every six months it has to revise down its growth forecasts and revise up its forecasts for debt. The coming year’s revisions look set to be even bigger than those we have seen over the last few years.

Even assuming the ECB continues to hold down borrowing costs, there is little indication that they will be below the rate of inflation in the struggling eurozone countries. And the outlook for economic growth is extremely poor. Assuming that austerity in the current economic climate is as bad for growth as the Commission and the IMF now acknowledge (but do not incorporate into their forecasts), real GDP will fall steeply in 2013 across much of the eurozone, pushing down inflation with it. Nominal GDP will do little more than stagnate (falling steeply in the south, stagnating in France and the Netherlands and rising somewhat in Germany). Assuming further austerity (on top of that already announced) is avoided, the eurozone could eke out a bit of nominal GDP growth in 2014. The risk, however, is that the deepening of the slump brought on by austerity will weaken public finances further and be used to justify more austerity. This, in turn, would weaken nominal GDP further.

There may be a miracle, but in all likelihood the eurozone is going to combine the worst of both worlds: stagnant or falling GDP and rapidly rising debt. The prolonged slump threatens to further weaken the eurozone's banks, increasing the amount of money that eurozone governments will eventually have to borrow in order to recapitalise them. It is impossible to say whether by 2017 (ten years after the start of the crisis) the eurozone or the US will have experienced the bigger build-up of debt relative to GDP. However, what can be said with a high degree of certainty is that the US economy will be substantially larger in 2017 than it was in 2007.

Not only is the eurozone likely to experience a lost decade, but the growth potential of its economy will almost certainly have eroded further as mass unemployment and weak business investment damages the supply side. The UK’s experience is likely to be much closer to the eurozone's than the US's. Notwithstanding its euroscepticism, the strategy of the British government has more in common with the rest of Europe than it does with the US. It is stepping up the pace of fiscal austerity in the face of extremely weak consumption and business investment and a worsening outlook for exports.

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

Time to stop the EIB’s carbon subsidies

The European Investment Bank (EIB) is greener than it used to be – it now lends half its annual energy pot to energy efficiency and renewables. But it is still lending to coal projects. This is inconsistent with EU climate policies, and must stop now.

Some leading politicians, such as UK Chancellor of the Exchequer George Osborne, are arguing that, given the continuing economic crisis, we cannot afford to ‘go green’ at the moment. This is a serious mistake.  Climate change is not only an environmental problem; it is already causing death and want. A recent report on vulnerability to the effects of climate change (http://daraint.org/climate-vulnerability-monitor/climate-vulnerability-monitor-2012/) found that climate change is already killing nearly 400,000 people annually world-wide each year. And it is already costing the global economy €930 billion each year.

The EU’s 2011 Energy Roadmap, a document laying out the Union’s aspirations that was backed by all member-states bar Poland, proposes the need for an 80 per cent reduction in carbon emissions by 2050. New coal-fired power stations would make it impossible to meet this target, since they emit high levels of carbon dioxide, the main greenhouse gas. Taking account of the full life-cycle (including construction and decommissioning), coal plants emit around twice the amount of carbon dioxide per unit of electricity generated as gas plants do, eight times as much as nuclear plants and 32 times as much as wind farms.

Since 2007, the EIB has lent a total of €1.88 billion to three coal projects in Slovenia, three in Poland, two in Germany and one each in Romania, Italy and Greece. It is true that the EIB does take climate change into account when making investment decisions, to some extent. Its rule is that the new plant has to replace an existing coal or lignite plant and lead to a decrease of at least 20 per cent in emissions, compared to the old plant. It also has to be ‘carbon capture ready’, so that if carbon capture and storage (CCS) proves to be effective at scale and affordable, it can be retrofitted to the plant. But that remains a very big ‘if’, and the EU’s failure so far to award any money to a CCS demonstration does not bode well for rapid progress. In practice, the requirement that a plant be carbon capture ready means little more than ensuring that a patch of land suitable for a CCS plant is left free near the new power station.

Carbon emissions, like all form of pollution, have externalities. The EU has a scheme to force the producers of the pollution to pay – the Emissions Trading System. But the price under this system is languishing below €8/tonne. This is far too low to have any impact on investment decisions. To its credit, the EIB uses instead what it calls an ‘economic price of carbon’. This is a calculation of the full costs to society of dealing with each tonne of carbon emitted, and is currently set at €30/tonne. This will increase €1 every year from now on.

However, this does not prevent the EIB from lending to coal projects without CCS. So the economic price sounds a good policy instrument, but does not actually stop the EIB from lending to projects that they think will be financially profitable. This lending amounts to a massive subsidy to coal, which undermines the renewables target.

The EIB currently takes decisions on energy projects based on the guidelines in its 2006 energy policy document. But it is consulting on a new approach, which it aims to adopt next year. The science and understanding of climate change have moved on considerably since 2006, and the situation is much more urgent. A minimum of 2 degrees of warming now looks all but inevitable – driven largely by the burning of coal. The top priority for the EIB’s new policy must be to stop lending to all coal and lignite plants unless they have CCS. Without this change, the EIB will continue to undermine the EU’s climate policies.

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

Europe’s youth job crisis

Youth unemployment rates in some EU countries are scandalously high. Many EU countries are hoping to copy the success of the German apprenticeship system. Although countries should be encouraged to learn from each other, there is no one-size-fits-all solution to the job crisis. And many measures will not bite until growth returns.

Unemployment among young people has always been higher than general joblessness but the economic crisis has widened the gap further. According to Eurostat, 22 per cent of 15-24 year-olds in the EU are unemployed. In those countries hardest hit by the crisis, such as Greece and Spain, the rate is 50 per cent.

Such figures are shocking but also somewhat misleading. Just like general unemployment statistics, youth unemployment is measured as the share of job-seeking youngsters in all youngsters who are either working or looking for work. But many young people do neither. Millions are in education. Many have simply given up looking for a job. These groups are not captured in youth unemployment statistics, which pushes up the youth unemployment rate.

A more accurate indicator of the youth employment crisis is the NEET concept: the total of young people not in employment, education or training. Last year, Europe had 7.5 million NEETs aged 15 to 24. Extend the age bracket to 29 and the number swells to 14 million – the equivalent of 15 per cent of all young people in the EU.

NEET rates are highest among the South and East European EU countries and lowest in the Nordics, Germany and the Netherlands. In Greece and Bulgaria, almost a quarter of all under 30s are NEET, in Austria and the Netherlands it is only 5-8 per cent. The UK – unusually for a country with a flexible labour market and decent education – has one million NEETs, roughly the same as Italy and Spain (because of its bigger, younger population, the British NEET rate, at around 16 per cent, is still below those of Italy and Spain, at just over 20 per cent).

NEETs are a big burden for European countries. According to Eurofound (an EU research agency that looks at work and welfare), they cost the EU countries €153 billion in social benefits and lost output in 2011. That is more than the entire EU budget. More importantly, a prolonged inactive period can scar youngsters for life: many a NEET’s earnings will never catch up with their peers; many face long-term unemployment and social problems. Some economists already talk of a “lost generation”.

What should, what can, European countries do to help their young people find work?

Growth is obviously important: those countries that have suffered the sharpest downturns in the crisis  – Greece, Ireland, Portugal and Spain – have also seen the most pronounced rise in youth unemployment rates.  Germany, Austria and the Netherlands have been doing better economically and have also so far escaped the youth job crisis. Demographics also matter: because of persistently low birth rates, fewer young Germans are entering the labour market. France and the UK, with better demographics, have more young people to look after.

However, the persistence of youth unemployment in many EU countries implies that growth alone will not fix the problem. And a country such as Italy has a shrinking population and yet young people cannot find jobs. Deeper reforms are needed.

A good education is in many cases the best unemployment insurance. In France, for example, over 80 per cent of those with a university degree have a job but only 55 per cent of those with basic education do. A university degree is not a job guarantee: in Spain, the share of those getting a degree is roughly the same as in in the Netherlands. Yet Spanish students struggle much harder to find a job (and did so even before the current crisis) than Dutch ones. Governments must ensure that universities teach the kind of skills that employers are looking for.

Often employers prefer a well-trained apprentice to a graduate with an unsuitable degree. Countries with well-functioning dual education systems – that combine on-the-job training with schooling – tend to have lower NEET rates. Germany, Austria and the Netherlands are good examples.

These dual systems make it easier for youngsters to move from education into the world of work, reducing drop-out rates. They are also a good feedback mechanism to show school leavers what companies need and want.

The UK is only one of several EU countries that have been trying to emulate the benefits of the German apprenticeship system. Success has been mixed. Only about 8 per cent of British companies train apprentices, compared with over 30 per cent in Germany.

As Hilary Steedman from the London School of Economics points out, Britain tends to play politics with its apprenticeship system. Labour sought to get youngsters off the street so it focused on training that is short and easy. The average duration of a British apprenticeship is only one year (three in Germany), theoretical training can be as little as one hour a week (at least one day a week in Germany) and the proliferation of vocational qualifications leaves potential employers confused and unenthusiastic. The Conservative party is focused more on higher skill levels and so prefers training that is longer and more sophisticated. The current coalition government has promised to help pay for an extra 250,000 apprenticeships. The result is a huge increase of older apprentices as cash-strapped companies re-classify their retraining schemes as ‘apprenticeships’ in order to qualify for government support.

Although the UK and other countries are right to study the German success, there are many features that are not easily replicated and others that are not worth copying. For example, while the British labour market is rather flexible, in Germany over 300 professions are accessible only for people with formal qualifications. In other words: no apprenticeship, no job. Such entry regulations have some benefits as they push up general skill levels, which in turn makes it easier for young workers to switch jobs later. But they also make labour markets more rigid and prevent innovation. 

Improving education and building functioning dual education systems will at least take a long time. In the meantime, EU countries might use so-called active labour market policies (ALMPs) to get people working again. Currently, less than a fifth of those taking part in such retraining and make-work programmes in the euro countries are under 25. But many EU countries are now designing ALMPs specifically for young people.

Sweden, Finland and Norway pioneered the idea of ‘youth guarantees’ in the 1980s and 1990s. The employment services there work out a personalised plan for every youngster who is at a loose end and then quickly pack him or her off into either education, work experience or a job. Low NEET rates in all Nordic countries suggest that these programmes are working. However, despite low unemployment rates, the Nordics spend lots of money on such schemes (1-2 per cent of their GDP for all ALMPs). And even their efficient employment services were overwhelmed when youth unemployment rose as a result of the crisis. South European countries with millions of unemployed youngsters would struggle to replicate the Nordic youth guarantees, especially at a time when they are forced to cut budgets and sack civil servants.  The EU has made some money available to help EU countries set up ALMPs for youngsters, encourage them to start businesses and to improve apprenticeship systems. But the sums (€8.3 million for 27 countries in 2012-13) are tiny compared with the scale of the challenge.

Another – potentially cheaper – way of helping young people to find jobs is to make labour markets more flexible. Eurofound presents evidence that strict regulations, such as job protection laws, hurt young job-seekers disproportionately. A company will not hire young inexperienced workers if it cannot get rid of them in case they turn out to be useless or the business outlook deteriorates. Measures that are on the surface designed to benefit young workers – such as stronger rights for temporary and part-time workers or minimum wages – can push up NEET rates. However, although politicians regularly deplore Europe’s high youth unemployment rates, the steps to improve the situation are often timid.

Employment specialists at a recent World Economic Forum workshop in Rome agreed that successful labour market reforms are not usually imposed by governments. They are haggled out between trade unions and employers. However, Europe’s trade unions tend to represent older workers with full-time, permanent positions. They fight less fiercely for the interest of young workers, those in part-time or temp jobs or those looking for work. Only 10 per cent of young workers are members of trade unions in the UK. In the Netherlands, roughly two-thirds of trade union members are over 45. The average age of officials in Germany’s powerful engineering union is almost 50.

The result is that the needs of young people are not properly represented in debates about how to change labour markets. Hence another – perhaps somewhat surprising – solution to the youth unemployment problem is for more young men and women to join trade unions and make their voices heard.

Europe’s young people are suffering disproportionately in the current crisis. European countries, and the EU, must do more to prevent them becoming a lost generation. Although many structural reforms will only really yield results when economic growth returns, the time to put them in place is now.

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

How to confront the carbon crunch

Emissions of damaging carbon dioxide within the EU have fallen over the last two decades, but not primarily due to climate action policies. The de-industrialisation of much of the continent and increase in goods imported from countries such as China has been a much greater driver of the reduction. Worldwide, carbon emissions continue to increase.  The 1997 Kyoto Protocol has made little impact, partly because – despite being legally-binding – it is not really enforceable, and partly because it seeks to address carbon emissions arising from production. It should instead address emissions arising from consumption.

At a recent CER meeting, Dieter Helm, a professor of energy policy at Oxford University and a leading voice in European energy policy, outlined a possible new approach to EU climate action. (These were based on his new book, ‘The carbon crunch: how we’re getting climate change wrong – and how to fix it’.) Helm favours market mechanisms, such as price signals, over direct state intervention, such as governments deciding whether we should use gas or offshore wind power to heat our houses. The EU has established a market-based mechanism to reduce carbon emissions, the Emissions Trading System (ETS), but it does not work.

The ETS has not lead to a significant reduction in emissions, nor to much investment in low-carbon energy technologies. The main reason is that the EU has handed out too many permits to pollute to EU-based companies. As a result, the carbon price has been too low to encourage companies to become greener.

In 2008, the European Commission implemented a number of useful steps to fix the system: it started auctioning permits rather than handing them out for free and it set a Europe-wide cap for overall emissions, rather than leaving each EU country to set its own. But then the EU economy plunged into recession, economic output fell and the number of permits once again was much higher than needed.  The carbon price has fallen to around €8 per tonne of carbon dioxide, far below the €30 that experts say is needed to have an impact. The Commission has rightly proposed that permits now need to be withdrawn from the market. But EU member-states are reluctant to put pressure on their companies in the middle of the downturn.

Helm argues that instead of trying to fix the system, the EU should opt for a carbon tax. A carbon tax , levied on each source of carbon pollution or on retailers of, for example, transport fuel, would introduce much greater certainty and predictability than the ETS has done. The EU could introduce the tax at a low level but with a pre-announced escalation.

However, faced with a higher carbon price, many European companies would relocate yet more of their production to countries that do not impose a price on pollution. Climate experts refer to this process as carbon leakage. Europe would consume the same amount of goods. But these goods would be produced in countries that are less energy-efficient and often use more of the most polluting fuel, coal. Add the carbon emitted through transporting these goods back to Europe and it becomes clear that carbon leakage increases global emissions. For the world’s climate it does not matter where emissions occur.

Helm therefore argues that the 1997 Kyoto Protocol has a central flaw: it seeks to reduce greenhouse gas production in signatory countries. It should instead address greenhouse gas emissions resulting from consumption. If goods are manufactured in, say, China but then imported into, say, Europe, the emissions caused by the goods’ manufacture and transport should be attributed to Europe, not China.

Helm would address this problem through imposing a tariff on goods that incorporate a high carbon content, a so-called border tax adjustment. To avoid falling foul of World Trade Organisation rules, any country that imposes a carbon price would be exempt from these border taxes. Countries around the world would then have a strong incentive to establish a carbon price, to gain free access to the world’s single biggest internal market.  As Helm points out, governments will prefer to collect revenue from carbon taxes or a version of an ETS rather than seeing the EU collect the revenue through border taxes. So this approach could help to spread carbon pricing.

Helm’s solutions are well-thought out and intellectually coherent. He is right to argue that a bottom-up approach based on carbon pricing and carbon consumption would achieve more than the defunct ETS and the top-down carbon production targets of the Kyoto Protocol. But he fails to take into account sufficiently the political context in which such solutions would have to be implemented.

Helm is not alone in advocating carbon taxes. Many economists do so. Indeed, Jacques Delors, perhaps the most persuasive president the European Commission has ever had, argued strongly for a carbon and energy tax during his tenure from 1985-1994. Then, as now, the governments of the member-states insist that tax is a matter of national sovereignty and each country has a veto over EU proposals. The UK in particular is categorically opposed to the EU getting involved in tax policy, even if its purpose is to help the climate. This is why the EU then opted for the ETS – which as a trading system could be established by qualified majority voting.

A more promising route would therefore be to add a carbon floor price to the ETS to push carbon prices up and imbue them with the stability needed to trigger investment in new technology. The floor price would be a ‘safety net’ rather than a tax so it would not require unanimity.

An effective ETS would still need to address the issue of carbon leakage. The Commission explored the idea of border tax adjustments in 2008, when it last amended the ‘emissions trading directive’. Nicolas Sarkozy, then French president, was a strong supporter. But Germany and other exporting nations feared reprisals from international trading partners and a generally negative impact on global trade. The Commission shelved the idea.

The current Commissioner for Climate Action, Connie Hedegaard, says that border tax adjustments should not be ruled out, but she has little support in the rest of the Commission. There is, however, an example of EU proposed action on border taxation. The EU has recently included emissions from airplanes in the ETS. All airlines will be required to buy permits for emissions generated by flights to and from Europe. Since this increases the price of flying from say, Dallas to Paris or from London to Shanghai, it is a de facto border tax adjustment. Chinese and Indian airlines in particular have threatened reprisals. The Commission has agreed to postpone the operation of the new system until the autumn of 2013 to see if international agreement on a carbon price for aviation can be reached. But Hedegaard made clear that if no agreement is reached, the EU will proceed with the inclusion of aviation in the ETS.

What are the chances of EU governments agreeing an ETS floor price and border tax adjustments? Countries such as Poland, which burns a lot of coal, would oppose a floor price but the threat of being outvoted would make them more likely to compromise. The French government would support this approach, given France’s reliance on low-carbon nuclear energy and its predilection for industrial policy and managing trade flows. The UK government has introduced its own ETS price floor, but it is increasingly hostile to anything proposed by ‘Europe’.

Germany’s position will be key. The country’s decision to phase out nuclear power will inevitably increase its greenhouse gas emissions, at least in the short to medium term where it will rely more on coal. So it might be cautious about imposing a higher price on carbon. Berlin also remains hostile to any interference in international trade.

The Germans could, however, be brought round if the economic arguments stacked up in favour. Michael Grubb of Climate Strategies calculates that if an ETS price floor of €15 per tonne was introduced in 2015 and raised €1 each year, the cumulative revenue by 2020 would be €150-190 billion, depending on how many permits were given out for free. Around a third of this revenue would go to the German government. Germany could do with this extra money to finance its so-called Energiewende – the very costly transition from nuclear, coal and gas to renewables. Other countries, such as the UK, would also use the extra revenue to keep energy bills down despite the mounting costs of renewables.

A Berlin-Paris-London coalition in support of a stronger ETS and border tax adjustments is unlikely in the near future but not inconceivable. All those concerned about the global climate – and about European economies – should support Helm’s proposed path the tackling the carbon crunch.

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

Much ado about little: Britain and the EU budget

As almost all European governments are cutting spending, it is hardly a surprise that the EU’s budget is under fire. The European Commission has rather optimistically proposed a real terms increase of five per cent in total spending over the next budget period, which runs from 2014 to 2020. This amounts to 1.05 per cent of projected EU GDP over that period. Most of the countries that pay more into the budget than they get back reject this proposal. Germany and Ireland want the budget limited to one per cent of EU GDP (which means that as Europe’s economies grow, the budget can grow too, but at a slower rate than the Commission wants). However, British Prime Minister David Cameron wants to go further: he has promised to veto anything but a freeze in real terms. It may be difficult to back down from this position in budget negotiations: the opposition Labour party combined with backbench Conservative rebels to win a parliamentary vote last week that called for a cut to the budget, defeating the government. Cameron would be unlikely to get a larger EU budget through the UK’s parliament if he compromises at the summit, on November 22nd.

Britain is not the only budget hawk: Sweden and the Netherlands have also demanded big cuts to the Commission’s proposal. But neither has demanded a freeze. The UK is likely to be further isolated in Europe, after its veto of the fiscal compact in December last year, if Cameron refuses to compromise. Amid the politicking over the size of the total budget, Westminster has paid little attention to the potential costs to the Exchequer of the proposals on the negotiating table, and how much extra the UK could pay. This note offers some answers, and in doing so allows us to judge whether UK obduracy is likely to achieve very much.

How much does the UK currently pay, and how much does it receive?
As a comparatively rich country with a small agricultural sector, the UK has in recent years been a net contributor to the EU budget. The UK passes tax revenue to Brussels, and receives less expenditure in the form of Common Agricultural Policy (CAP) payments, regional development funds, and other transfers in return. But it has a rebate from Brussels – a reduction in its contributions negotiated by Margaret Thatcher in 1984, which many other EU countries consider to be unfair now that Britain is one of the richer members of the club.

Britain’s net contribution is how much it pays in, less how much it receives back, in EU spending and the rebate. In most budget negotiations, British governments try to reduce wasteful and iniquitous farm spending and the size of the budget, and protect the rebate. Tony Blair’s 2005 agreement to cut the rebate to help pay for the costs of EU enlargement is the exception that proves the rule: even Blair, a pro-European prime minister at the height of his power, did so reluctantly, and fought hard for CAP reform.

Given that any country can veto the EU budget, member-states must build alliances to succeed. The UK is isolated after its veto of the fiscal treaty, and so would do well to be cautious if it wants to reduce spending. Britain wants the budget frozen at its 2011 level. But if the talks collapse, which is a distinct possibility, the 2013 budget will simply be rolled over to 2014, but with inflation added. The budget would end up far larger than 2011.

If the UK really wanted to cut wasteful spending and promote growth, it could accept the German proposal for a budget capped at one per cent of EU GDP, in exchange for cuts to the CAP and a transfer of that money into infrastructure and regional development spending. France has threatened to veto any budget that does so, but they could be isolated if Britain were prepared to make concessions, which President Hollande may wish to avoid, given the difficult negotiations over the euro.

But such a deal may be difficult for Cameron, who has chosen to make budget cuts his priority. The UK’s net contribution grew by three-quarters between 2006 and 2012, from £3.9 billion to £7.4 billion (€4.8 to €9.2 billion). The UK’s transfers to Brussels were low in 2008 and 2009 because it suffered a larger recession than other member-states, and in 2010 and 2011 payments were larger because its economy made a (small) recovery. On the expenditure side of the ledger, European Social Fund and Regional Development Fund spending in the UK is falling over time. These funds provide support for struggling regions with an income less than three-quarters of the EU average. Over the course of the last budget, Brussels has phased in the poorer newer members in Central and Eastern Europe, so that a greater proportion of structural funds go to these countries. These two factors explain most of the rise in the UK’s net contribution.

As regional funding has declined, agricultural payments have become the large majority of EU spending in Britain. This change in the composition of spending explains why Cameron is in a difficult negotiating position. Switching money from the CAP to regional spending would mean that the UK’s net contribution would rise, as fewer regional funds are disbursed in Britain, thanks to enlargement. If Cameron were to try to offer up more of the rebate to convince France to reform the CAP, the UK’s net contribution would rise even further. Thus, Cameron can either try to limit the UK’s contribution to the EU or try to improve what it is spent on. The best policy would be the latter, but the best politics – at least in domestic terms – is the former.

How much could the UK contribute to the next budget?
Britain’s net contribution to the next budget will not be decided before the negotiations at the summit in late November – and quite possibly not even then. But we can make some assumptions about how much more the British taxpayer might end up paying. The UK’s fiscal watchdog, the Office of Budget Responsibility, assumes that the UK net contribution is going to stay at around the 2012 level as a percentage of the total EU budget – five per cent. This seems right, for the following reasons. The UK is unlikely to give up or reduce its rebate. British economic growth is projected to be around the EU average: if it grew faster than other countries, the budget arithmetic would mean it would become a bigger net contributor. Finally, regional development funding is not coming back to the UK: Central and Eastern Europe will remain poorer than Western Europe between now and 2020. Given that the UK contribution should stay at around the same level, as a proportion of the total budget, we can then project forward how much it is likely to contribute, given the three main proposals on the table.

* A budget freeze (UK proposal: the British Parliament’s vote for a cut is only advisory, and this remains the UK government’s position)
* A budget capped at one per cent of EU GDP (the German position)
* A five per cent increase in the budget, as a proportion of EU GDP, to 1.05 per cent (the Commission proposal)

The UK government’s position implies a continued UK net contribution of around £7.4 billion (€9.2 billion). The German government’s proposal would mean the UK paying slightly more – an average of £400 million (€499 million) a year over the budget period. The Commission’s proposal would see the UK contribution grow, in tandem with Europe’s economic growth. So, under the Commission’s proposal, the UK’s net contribution would grow from £7.4 to £8.2 billion (€9.1 to €10.2 billion), an average of £550 million per year (€690 million) higher than under the UK proposal. This would mean a total increase, above the UK’s proposal, of £3.9 billion (€4.8 billion) over the seven years. (See chart).

 

 

Source: author’s calculations, based upon the GDP and budget projections in European Commission, ‘Proposal for a Council regulation laying down the multiannual financial framework for the years 2014-2020’, (2011) p. 20.

These numbers are difficult to appraise without context. Under either Germany’s proposal, or the Commission’s, the UK could end up paying around £400 and £550 million per year more, at most. This is around 0.03 per cent of GDP. It is the same amount that England and Wales spend each year on flood and coastal defences, or the same size as Oxfordshire County Council’s budget.

Furthermore, Britain’s hand is weakened, because of the rebate. It is difficult for Cameron to build consensus for either an overall freeze to the budget, or a cut to the CAP, because of it. Britain's net contribution is smaller than other big EU countries. Germany is the largest net contributor, followed by France and then Italy. The UK is the fourth largest, despite being both richer and larger than Italy. If Cameron brought down the negotiations over such a small sum, the UK would find itself pressed further into the margins of Europe. It would do better to compromise on the overall size of the budget, and negotiate for it to be spent more wisely.

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

Russia needs a plan for modernising its economy

Russia’s economy is not performing badly. Thanks to the high oil price, economic growth is likely to stay at 4 per cent or a little less for the next few years – respectable by West European standards. The problem is that Russia’s rulers do not appear to have a plan for modernising the economy, which is alarmingly unbalanced. Oil and gas provide half the government’s revenue and almost 70 per cent of export earnings. Output of oil and gas is flat and few new fields are coming on stream. Even if the oil price stays high, Russia is heading for current account and budget deficits in the years ahead.

But Vladimir Putin, now in his third term as president, seems unconcerned. I recently attended the Valdai Club, a group of Russian and foreign think-tankers, academics and journalists that meets Putin and other Russian leaders once a year. Compared with six or seven years ago, when I first attended these meetings, Putin’s attitude has evolved. He has become increasingly relaxed, to the point of complacency. He displays little sense of urgency about tackling the challenges facing Russia.

One participant, former German defence minister Volker Rühe, asked Putin an easy question: “Historians will say that in your first two terms as president, you brought stability to Russia. What would you like them to say about your third term?” Putin answered that he did not care what historians said, and that he was a pragmatist. He was happy that personal incomes had doubled during his time in charge, that Russia had $500 billion of foreign currency reserves and that the demographic decline had been arrested. He had nothing to say about his vision for Russia’s future or his own role in shaping it.

Asked whether it was important for Russia to reform its institutions, Putin merely talked about some legal reforms that were underway, adding that the central bank was an efficient body and that the tax administration had improved. Probed on the brain drain from Russia, he was insouciant: he said it was normal for people with skills to move from one country to another, in the way that many Britons went to the US. He told us that Russia was enticing lots of foreign academics to spend periods at its universities by offering them scholarships.

Putin was particularly upbeat about economic co-operation with China. It is now Russia’s biggest trading partner, with $83.5 billion of trade a year, compared with Germany at $70 billion, according to Putin. He said that both sides wanted trade to reach $100 billion a year. “This will happen as we are happy to buy more Chinese goods and they will buy more oil – and in the future, gas.” That last point is debatable: the Chinese seem unwilling to pay the price for gas that Russia is demanding. Putin added that there would be more co-operation on nuclear power – the first plant built by Russia in China was running and there would be more to come – as well as aviation and space technology. Other Russian leaders told us that growing economic ties to China – plus co-operation over Syria at the United Nations – would not extend to security (in Beijing there are reports that Russia proposed closer military relations earlier in the year, but had been rebuffed by Chinese leaders).

“We don’t need to go east or west, we are in a good place in the centre of Eurasia,” asserted a senior parliamentarian. Russian leaders are proud of the initial success of the Customs Union with Belarus and Kazakhstan, which has boosted trade (by 40 per cent, according to the parliamentarian). Russian economists say the Customs Union has led to regulatory competition between Russia and Kazakhstan, as they seek to attract investment. This competition may have helped them move a little way up the World Bank’s ease of doing business index – Kazakhstan has climbed to 47th place, and Russia to 120th.

The Russian economy can certainly benefit from more trade within the Customs Union and with China. But neither will bring about the structural changes that it needs. Russia’s liberals are in a gloomy state. On my previous visit to Moscow, last March, some of them – both within the government and outside it – were optimistic about the prospects of change. Following the winter demonstrations, Putin seemed to have understood that Russia needed political reform. He had announced that regional governors would be elected and that it would be easier to register political parties. But now the state is clamping down on opposition leaders. While the Valdai Club met, Leonid Razvozzhayev, a leftist opposition politician, was kidnapped in Kiev, taken back to Moscow and charged with various crimes.

There are still plenty of economic liberals in positions of power, either as ministers or advisers inside the government, or think-tankers on the outside who provide reports for ministers. But they see that Putin is leaning in an authoritarian, statist direction and that improving the rule of law is not his priority. They know that so long as the judiciary remains subject to pressure from the state or special interests, foreigners will think twice before investing in sectors other than oil and gas.

One senior figure in the Russian system summed up the liberals’ despair: "Russia needs a new model of economic growth, and a new system of governance – the current one is not suited to meet new challenges. Putin has been an outstanding leader. But the destiny of Russia depends on the mind of a single person and his ability to change the paradigm of how he sees things."

The ‘tandem’ system of government – when Prime Minister Putin shared power with President Dmitri Medvedev – has been replaced by what the Russians call an extreme vertikal of power. Although the presidential elections were not conducted fairly, Putin’s victory reflected the popular will and has enhanced his legitimacy. This has facilitated the concentration of power in one person’s hands to a greater degree than ever happened in the Soviet system, post-Stalin. President Putin alone decides foreign policy. On economic policy, according to some observers, Medvedev, now prime minister, still has a little influence.

Everyone in government pays lip service to the idea that the economy should rebalance, so that manufacturing and services play a greater role. But nobody seems to have a convincing plan for achieving that objective. One minister admitted: “We don’t understand how to break the dependency on oil and gas, since different players have different interests.” In fact, the hard-liners in the security establishment and some of the clans around Putin probably do not want rebalancing: it would curb the rent they extract from the natural resource industries and would have to be accompanied by a strengthening of the rule of law, which would constrain their freedom of action.

The Valdai Club heard two views on how the economy could rebalance: top down and bottom up. Some senior figures said simply that the state needed to invest more in high-tech industries like space-science, biometrics, pharmaceuticals, nano-technology and nuclear energy. Putin said the government had found an extra $60 billion for a special fund that would invest in hi-tech industries.

The bottom-up view, which is much more plausible, was well expressed by one of Putin’s advisers: "The only way to rebalance the economy is to improve the investment climate, so that we get more foreign investment into non-oil and gas sectors. That means tackling corruption." 

One leading banker was extremely critical of the government: "Russia is a big exporter of oil and gas, entrepreneurial talent and capital." He described the customs administration as "totally corrupt". He complained bitterly about Putin’s election promises to raise the salaries of public sector workers, which had led to knock-on wage inflation throughout the economy. Several ministers expressed worries about the economy’s declining competitiveness – one of them reporting that Russian wages were now 2.5 times comparable ones in Ukraine.

Another senior banker said the government did not have a mechanism for implementing decisions except by shouting at people. Since German Gref had departed as economy minister in 2007, he said, the government had had no comprehensive vision; now each ministry did its own thing.

A year ago Alexei Kudrin, an economic liberal, resigned as finance minister, partly because he disliked plans for a massive boost in defence spending. Many Russian economists agree with Kudrin that the boost will harm the economy. In the ten years to 2020 the defence budget is due to grow by 23 trillion roubles (more than $700 billion) – at the cost of spending on infrastructure, health, education and R&D. The share of government spending taken up by the defence, interior and emergency ministries is due to stay in the range of 18-20 per cent from 2011 to 2015. But the proportion spent on education, science, healthcare, justice and culture is due to fall from 8.3 per cent to 5.8 per cent. 

Putin, predictably, defended the military build-up. “We see the growing application of force in the international arena, and this is revitalising international relations, so we are strengthening our defence and military capabilities.” Also, he pointed out, a lot of Russia’s defence systems were old and needed replacing.
 
Amidst all the gloom over the Russian economy, some of the more liberal ministers took a brighter view. They talked of the seven-year plan for selling off stakes in state companies that would run to 2019. Its purpose, they said, was not only to make companies more competitive but also to raise money for the budget.

These liberals also pointed to the benefits of membership of the World Trade Organisation (WTO), which would subject Russian industries to increased competition – though more from China than from the West. The WTO will force Russia to lower its average tariffs from 9.5 per cent to 6 per cent by 2015. WTO membership will also make the government curb subsidies to some industries and to farming. “We will have to learn how to apply government support in ways that don’t break the rules,” said one senior minister, who predicted disputes over cars and agriculture.

But the liberal ministers know that Russia cannot properly modernise its economy without progress on the rule of law and democratisation. "We have a working judicial system and democratic rules, though they’re not ideal," said one. “Many people are unhappy about that, but the majority don’t care – they are focused on their wages, children and housing, rather than the political system. That is an argument for more democracy.” He is almost certainly right that less than half the population cares about political freedom. This is the root of Putin’s power and bodes ill for the economy.

Charles Grant is director of the Centre for European Reform

Will the euro crisis lead to the break-up of EU member-states?

Last month over a million Catalonians marched for independence in Barcelona. Opinion polls say that support in the province for separation from Spain has doubled since the economic crisis started – and some polls put it at over 50 per cent. The Economist sees a clear link with the economic crisis, noting recently: "Whereas one-third of Catalans are convinced separatists, many others are simply enraged by their tax money propping up poorer regions." Meanwhile in Belgium, Bart de Wever's nationalist New Flemish Alliance did well in Flanders' local elections, and de Wever has become mayor of Antwerp. Like Catalan separatists, the Flemish dislike subsidising their poorer neighbours in Wallonia.  The two events seem to suggest a trend. But while bailouts and the austerity that stems from the euro crisis are making central governments unpopular throughout Europe, Spain's and Belgium's woes may be a poor predictor of developments elsewhere.

The growing support for independence in Catalonia is only partly driven by the crisis. Jordi Vaquer of the Barcelona Centre for International Affairs notes that the Partido Popular's (PP) return to power in Madrid in 2012 bears some responsibility for the surge of pro-independence sentiment in Catalonia. The conservative PP blames Spain's budgetary woes on the provinces' profligacy (they represent 40 per cent of total public spending in Spain). The Madrid government has set out to tighten control over the regions' finances. Many in Catalonia think the PP is using the crisis as an excuse to pursue their longstanding agenda of curbing regional autonomy. They note that Spain's economic woes are mainly the result of excessive private sector borrowing, over which the provinces have had no control.

Pro-independence sentiment in Spain and other parts of Europe has also grown stronger because some separatist parties have grown more adept at selling their message. The New Flemish Alliance (NVA) is a much smoother party than the hard-right Flemish Interest, who NVA replaced as the standard-bearer for independence. In Edinburgh, Alex Salmond of the Scottish National Party (SNP) has proven to be a capable leader, who has governed competently during his five-and-a-half years in power (Scotland has enjoyed considerable autonomy since the 1998 devolution of some powers from London to Edinburgh). In an effort to showcase his party's new moderation, he recently persuaded it to ditch its longstanding policy of withdrawal from NATO. Both de Wever and Salmond say they would keep a common army with their southern neighbours. The success of these moderate, articulate nationalists in some parts of Europe has boosted the appeal of pro-independence movements elsewhere. "Previously, voters in Catalonia saw separatism as something that dictators in the former Soviet Union and Yugoslavia did. Now it has become difficult to brush aside nationalists as crazies," Vaquer observes. 

But while the Flemish and Scottish pro-independence parties have learned not to scare voters, the appeal of nationalism in other parts of the EU has waned. The Slovaks elected a parliament in 2012 that for the first time in the country's 20-year history does not include the Hungary-bashing Slovak National Party (voters have grown wary of infighting in its top ranks, and of its leader's penchant for yachts and jets). A mildly-separatist party of ethnic Hungarians in Slovakia has also lost its place in the parliament in the same election; another mostly Hungarian party that openly favours good relations with the central government in Bratislava has taken its place. Politics in Europe remains deeply local – and while nationalist leaders in Spain or Flanders have being doing well, others have fallen victim to their own hubris or incompetence.

In 2014 the Scots may dampen separatist spirits in Europe. Earlier this month, the SNP agreed with the London government to hold a referendum on Scottish independence in the autumn of that year. However, a recent Ipsos MORI poll shows that only 35 per cent of those who plan to vote will opt for separation from Britain. If the Scottish referendum on independence fails, nationalist movements like those in Catalonia or the Basque country may find their case weakened (though the Scottish nationalists may make progress with their demands for greater autonomy from the central government).

In Scotland, ironically, the euro crisis has proved very damaging to the cause of independence. In the past the SNP said that an independent Scotland would join the euro. In current circumstances that policy would not be a vote winner. So the SNP’s new line is to favour independence but keep the pound. But if there is one thing that the euro crisis has taught people, it is that currency unions do not work without some sort of fiscal union. A separate Scotland that used the pound would have to accept the constraints of a 'fiscal compact' with the remainder of the United Kingdom. So it would not be as free from London’s dictat as many Scots would wish.

There is little doubt that austerity measures have generated anger against political classes everywhere in Europe. In Spain, this protest takes the form of demonstrations against the 'Madrid elites', from which pro-independence movements benefit. In the future, similar conditions may exist in other parts of Europe, such as Italy or France, so events in Catalonia or Flanders bear watching. But it would be too simple to extrapolate from them that other countries will go the way of Spain or Belgium. The grievances that drive pro-independence movements differ from country to country. And so does the quality of local political elites, both on the pro-independence side and among the central governments, which have the job of addressing the grievances that fuel separatism.

Tomas Valasek is former director of foreign policy and defence at the CER.

Alice in euroland: What political union for the single currency?

"When I use a word," Humpty Dumpty said, "it means just what I choose it to mean – neither more nor less." 
"The question is," said Alice, "whether you can make words mean so many different things." 
"The question is," said Humpty Dumpty, "which is to be master – that’s all." 
(Lewis Carroll, Through the Looking Glass, Chapter 6)

The underlying purpose of the ‘European project’ has always been clearer than its ultimate destination. Its purpose – to escape a traumatic past disfigured by dictatorship and war – has never been particularly contentious (what sane European would want a return to that?). But the same cannot be said of the EU’s final destination. For much of its history, the EU has hidden behind the foggy ambiguity of its aspiration to build an “ever closer union among the peoples of Europe”. The trouble is that this worthy aspiration has always meant very different things to different people. Those of a minimalist disposition, often to be found among the British, have usually understood it to mean little more than the removal of cross-border barriers to the free movement of goods, services, capital and people. Those of a more ambitious bent, more often to be found in continental Europe, have seen the ultimate goal of the project to be some sort of ‘political union’ (however understood).

The eurozone crisis has once again exposed the gulf between British and continental visions of the EU. But it has done a lot more. It has also forced European leaders to speak a little less airily about ‘political union’ than they have become accustomed to in the past. All agree that the single currency must be embedded in a real ‘political union’ if it is to survive. But they are being forced to define their terms. Roughly speaking, two schools of thought have emerged. One (mostly northern European) school thinks that the crisis resulted from errant behaviour. For it, political union means tighter rules, more strictly enforced. The second school believes that the architecture of the eurozone is flawed. For it, political union means transferring a number of critical responsibilities from national to European level. If the first school frets about moral hazard, the second worries about a dearth of solidarity. The first school emphasises collective discipline, the second mutual burden-sharing.

Which of the two schools has the better story to tell? Although Greece is a convincing poster child for the first school, the balance of evidence weighs heavily in favour of the second. To start with, compliance with rules before 2008 turned out to be a poor predictor of countries’ subsequent plight. Like Mark Twain’s stories, the eurozone had its good little boys to whom bad things happened and its naughty boys who prospered. (Ireland never broke the fiscal rules before 2008 but is now in a slump, while Germany did and is not.) Second, despite having lower levels of debt in aggregate, it is the eurozone, not the US, which has been in the eye of the storm – strong evidence that it is the eurozone’s architecture, rather than the behaviour of its constituents, which is to blame. Third, the more the principle of collective responsibility has been asserted, the worse the eurozone’s plight has become: efforts to instill discipline have signally failed to restore confidence in the eurozone.

The symptoms of this failure are numerous. Financial markets within the union have fragmented as private-sector capital has drained out of countries in the ‘periphery’. Long-term borrowing costs inside the union have become unsustainably polarised, pushing systemically important countries such as Spain and Italy perilously close to insolvency. Target 2 balances within the European System of Central Banks have ballooned as public-sector capital flows have replaced private ones. Countries experiencing private-sector capital flight have been forced to pursue self-defeating policies of fiscal austerity. Sound banks domiciled in countries with stressed sovereigns have become vulnerable to depositor flight. And so on. The countries under strain partly have themselves to blame. But they are also victims of the eurozone’s structure: Spain’s borrowing costs are vastly higher than those of euro ‘outs’ such as the UK, even though Spain’s public finances are in no worse shape.

European policy-makers have been slow to accept that the eurozone’s institutional configuration makes it structurally unstable. But in June 2012, the so-called ‘Gang of Four’ – a group consisting of the presidents of the European Council (Herman Van Rompuy), the European Commission (Jose-Manuel Barroso), the European Central Bank (Mario Draghi) and the Eurogroup (Jean-Claude Juncker) – submitted an important plan to set the eurozone on a more stable long-term footing. It marked an important departure, because its focus shifted to correcting the eurozone’s architectural flaws rather than the behaviour of its members. The policy areas covered – banking supervision, resolution regimes, deposit protection – may have been dry and technical. But the plan was deeply political. It proposed that the stabilisation of the eurozone required key functions to be moved from national level to European level. It was, in other words, a plan to federalise the eurozone.

Why is the federalisation of certain functions necessary to restore confidence in the eurozone? The answer is not that the tasks concerned will necessarily be carried out more competently at European level (the reverse may even be the case). It is that the existence of federal powers and instruments is both a symbol and a guarantee of member-states’ commitment to the union. The reason the eurozone faces an existential crisis while the US does not is not the result of a financial market conspiracy orchestrated by Anglo-Saxons (as some Europeans darkly claim). It is that the eurozone’s decentralised configuration raises doubts about individual states’ commitment to the union. Unlike in the eurozone, bank failures in the US did not push any of the constituent states (such as Delaware) into insolvency, because the associated costs were mutualised. No one thinks that the parlous state of California’s public finances will result in its exit from the US (unlike, say, Greece from the eurozone).
  
A currency union embedded in a fiscally decentralised confederation, it turns out, has been a highly unstable arrangement (particularly in the aftermath of a financial crisis). The adoption of new rules that constrain national sovereignty have not really helped to restore confidence or stability. Indeed, as new rules have proliferated, the eurozone has come to look less like a single currency and more like a rigid fixed exchange rate system on life support. For much of the past two years, redenomination risk has stalked the eurozone. So the Gang of Four is right. The eurozone needs a degree of federalisation to persuade investors and depositors that its members are committed to the currency union’s integrity and survival. Far from being some obscure technocratic fix, a banking union is better understood as an essential pillar of the sort of political union that the eurozone needs if it is to endure and prosper. The question, then, is whether the member-states now accept this.

The answer is that they are still split. The recent report by EU foreign ministers on the future of Europe (the ‘Westerwelle report’) hinted at a number of unresolved arguments between confederal and federal visions of Europe. A striking feature of the report was the number of reservations placed by certain member-states on the proposals of the Gang of Four. On the subject of a banking union, for example, the report said that “some members of the group underlined the importance of a common deposit protection scheme and of a restructuring and resolution scheme”. By implication, other member-states still think that such steps are unnecessary. Indeed, the impression created by the Westerwelle report is that there is more agreement among member-states about the need to develop the foreign policy than the economic dimension of political union. If this is what EU leaders end up doing, they risk creating a Potemkin village rather than a political union that stabilises the eurozone.

Alice’s question to Humpty Dumpty was spot on. Words can be made to mean very different things. Since the onset of the eurozone crisis, two meanings of political union have done battle. The first has emphasised collective discipline, or the need for rules that bind member-states. This is the language of confederalism. The other has emphasised mutualisation, or the need for solidarity and common institutions. This is the language of federalism. For much of the past two years, the language of confederalism has dominated: reforms have focused on improving behaviour rather than on fixing the eurozone’s flawed structure. But a more federal language is starting to emerge. There is more acceptance now than there was two years ago that rules may be necessary to curb moral hazard, but that they are insufficient to eliminate redenomination risk (and so restore confidence in the eurozone’s stability). This view, however, is still far from being universally shared by the member-states

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