Eurozone slump derails Britain's economic strategy

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

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

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

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

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

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

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

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

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

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

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

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

Has the ECB done enough to save the euro?

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

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

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

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

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

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

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

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

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

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

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

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

Cameron’s optimistic, risky and ambiguous strategy

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Charles Grant is director of the CER.

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.