Friday, October 17, 2014

The eurozone’s German problem

There is a deal to be done to save the euro from deepening crisis. The outlines of it are generally accepted outside Germany: structural reforms in France and Italy and elsewhere combined with measures to strengthen their long-term fiscal positions; and in return, a large pan-eurozone fiscal stimulus and quantitative easing (QE) by the ECB. This offers the best way out of the current impasse in the eurozone, not just for the periphery but also for Germany. But it will take a political earthquake  for the Germans to back such a deal. Instead, the stability of the euro and the futures of the participating countries will continue to be vulnerable to the short-term exigencies of German domestic politics. This is a recipe for stagnation, deflation and political populism in France and Italy. It may culminate in a breakdown in relations between Germany and these countries and could even lead to eurozone break-up.

Why has Germany assumed such pre-eminence in the eurozone? How is it that German policy-makers from the finance minister, Wolfgang Schäuble, to the head of the Bundesbank, Jens Weidmann, can wag their fingers at everybody else for causing the eurozone crisis, while responding dismissively to any suggestion that Germany might be part of the problem? Germany’s initial pre-eminence following the crisis was understandable – it is a major creditor and in the early stages of any debt crisis, creditors tend to call the shots. However, as a debt crisis wears on, the creditors’ resolve typically weakens as the impoverishment of the debtors rebounds on the creditors politically and economically, and the debtors call the creditors’ bluff by threatening to renege on their debts.

This has not happened in the eurozone, with Germany (and other creditor states) able to subordinate the interests of the eurozone as a whole to their own perceived interests. The debtors have put Germany under little pressure to share the burden or to reform its own economy. There appear to be two principal reasons for this. One is that many members of the eurozone see Germany as a model to emulate rather than a significant part of the problem. The second reason is that even those who understand that the structure of the German economy is a threat to the stability of the euro have been circumspect about openly criticising Germany for fear of provoking a backlash against the euro in the country. This softly, softly approach has been bad for Germany itself as it has distracted attention from the country’s formidable structural problems, and encouraged a belief that the country does not need to compromise and can afford to say no to everything.

This deference to Germany is puzzling. While it is the largest economy in the eurozone, it is hardly dominant, accounting in 2013 for 29 per cent of eurozone GDP as opposed to France’s 21 per cent, Italy’s 16 per cent and Spain’s 11 per cent. Economic growth in Germany has certainly rebounded faster since the crisis than in other eurozone countries. But the German recovery now seems to have run its course, with exports to both European and non-European markets under pressure and domestic demand being held back by weak levels of public and private investment (see chart 1). Even the German government expects growth of just 1.3 per cent 2014 and 1.2 per cent in 2015.

Chart 1: Economic growth (Q1 2008 – present)

Source: Haver

Chart 2: Economic growth (1999 – present)

Source: Haver

There have been some tentative signs of rebalancing over the last 12 months – with growth in domestic demand outpacing overall economic growth. But Germany remains chronically export-dependent – its current account surplus is on course to exceed 7 per cent of GDP in 2014 for the second successive year. The country is certainly not the ‘locomotive’ of the eurozone economy, as some journalists like to call it, but a drag on it. Some German policy-makers argue that stronger domestic demand in Germany would have little impact on other eurozone economies, but they are being rather disingenuous. The government has attributed the economy’s loss of momentum over the course of 2014 to weak eurozone demand, so cannot simultaneously deny that what happens in Germany has no impact on other eurozone economies. With Germany accounting for almost 30 per cent of the eurozone economy, what happens to aggregate demand in Germany clearly has a major impact on the level of demand across the eurozone as a whole.

German policy-makers tend to bridle at any suggestion that they may be guilty of mercantilism and there is indeed little to suggest that they are consciously setting out to beggar their neighbours. But there is no denying that Germany remains dependent on foreign demand to bridge the very large gap between what it produces and what it consumes, and that this is not a replicable model. An economy as small and open as Ireland’s can rely on wage cuts and rising exports to underpin recovery. But big economies in which trade plays a lesser role cannot do this, at least not all at the same time. Eurozone member-states need to increase the size of the economic pie rather than fighting for bigger shares of a constant pie.

Chart 3: Current account balances (per cent, GDP)

Source: Haver

Indeed, Germany’s strong employment performance – unemployment stands at just 5 per cent and the employment rate at a record high – would look quite different were it not for that foreign demand. Employment has also risen by more that would be expected from weak economic growth, suggesting that German employers (like their UK counterparts) have been taking on more workers in preference to boosting capital expenditure (which is no higher than it was in the first quarter of 2008). Moreover, the tightness of the labour market has not yet fed through into a meaningful recovery in real wages after years of wage restraint. Real wages should rise by around 1 per cent in 2014 (after falling last year), but this partly reflects unexpectedly weak inflation. Indeed, far from experiencing a surge (as many in German commentators feared when the ECB held interest rates lower than they thought Germany needed), German inflation fell to just 0.8 per cent in September, compounding deflation pressures across the eurozone.

Germany’s public finances are in good shape, allowing it to portray itself as a saint among fiscal sinners (German policy-makers still stress above all else the role of fiscal ill-discipline in causing the crisis). The government will again run a small surplus this year (see chart 4) compared with substantial deficits elsewhere. With growth in the German economy faltering, this would be the ideal time for the government to boost its spending. And there is no shortage of things it could spend the money on. Levels of public investment are very low in Germany, even by Western European standards. Indeed, net public investment is negative (that is, Germany is not investing enough to replenish the country’s public capital stock), storing up problems for the future (see chart 5). Germany could also boost defence spending, which is languishing at just 1.3 per cent of GDP, and so help to improve its ability to play a useful role in providing for Europe’s security. Cuts in incomes taxes and/or value-added-taxes could also give impetus to the moderate upturn in private consumption that is underway, in the process helping the economy to shake off the impact of weaker exports.

Chart 4: Government deficits (per cent GDP)

Source: Haver

Chart 5: Net public investment (per cent, GDP)

Source: Haver

How is the German government likely to respond to the slowdown in Germany and the worsening crisis across the eurozone? It will probably continue to show some flexibility regarding the fiscal targets facing other members of the eurozone such as France and Italy, while sticking publicly to its hard line. There will no doubt be a bit of fiscal easing at home, but nothing dramatic, with the government citing the need to comply with a constitutionally-binding rule requiring the government to run a balanced budget, which comes into force in 2016. Taken together, these slight shifts in Germany’s position will do little to alleviate the pressures on the eurozone economy (a much bigger stimulus is required to ward off slump and deflation) or to rebalance the German economy. Meanwhile, Germany will remain the biggest obstacle to QE by the ECB, which would aim to boost inflation expectations and hence the readiness of firms and households to spend. Were Germany to support such action, other sceptical countries would no doubt fall in behind it.

If, as is increasingly likely, the ECB pushes ahead with QE despite German opposition, its effectiveness will probably be undermined by the lack of a major fiscal stimulus to the eurozone economy. The ECB may also struggle to bring about a substantial fall in the euro because of the size of the eurozone’s trade surplus, which boosts demand for euros. (The eurozone’s trade with the rest of the world would be broadly balanced were it not for Germany.) And if QE does succeed in weakening the euro without an accompanying programme of fiscal stimulus or aggressive steps to rebalance the German economy, it risks being seen by the eurozone’s trade partners as a mercantilist move in a global economy characterised by very weak demand. One consequence could be to further weaken the chance of brokering a meaningful Trans-Atlantic Trade and Investment Partnership (TTIP). It could also further unbalance the UK economy, strengthening Britain’s eurosceptics.

Germany’s current intransigence poses a far greater risk to its economic and political interests than the ‘grand bargain’ outlined at the beginning of the piece. Germany cannot afford the impoverishment of the eurozone. The rapid slowdown in world trade, in particular trade with China, has shown this. If the German economy is to grow sustainably, it will be as part of a healthy eurozone economy, in which Germany is deeply enmeshed through trade and investment. Nor does Germany’s current uncompromising stance limit the exposure of German taxpayers to bail-outs of other members. Aside from the impact that the ongoing slump across the eurozone will have on German growth (and hence public finances), debt burdens will reach unsustainable levels in more eurozone countries. The inevitable debt defaults in these countries will impose incalculable costs on the German taxpayer.

German politicians, like all politicians, are focused on getting re-elected, and they believe that their current approach to the eurozone is the best route to that. But long-term threats eventually become immediate threats. Germany needs a proper debate about the choices facing it, much as the German government has repeatedly demanded of the French, Italians and others. Unfortunately, there is little sign that this will happen without greater outside pressure. The French and Italians need to force this debate by making clear to Berlin that it cannot assume that the euro will endure in its current form without Germany making significant compromises. By ending their deference to the German government, they would hopefully expose the weakness of Germany’s bargaining position and prompt a more objective discussion within Germany of its own structural problems and how they play into the eurozone crisis. There is a risk that such a confrontation could play into the hands of the right-wing Alternative für Deutschland (AfD), which has already tapped into anti-euro sentiment. But Germany’s domestic politics should not be allowed to stand in the way of a solution to the crisis, any more than French or Italian politics should be allowed to do so. If Germany really is as pro-European as its politicians argue, its grand coalition should be able to convince enough Germans that a grand bargain is in the country’s own interests.

Simon Tilford is deputy director of Centre for European Reform.

Thursday, October 16, 2014

Would Britain’s trade be freer outside the EU?

In the ‘Brexit’ debate, there are two ideas that simply will not die, however much evidence is thrown at them.

The first is that Britain could leave the EU and then opt back in to those areas of the single market that it liked. The CER’s commission on the economic consequences of leaving the EU, which reported in the summer, explained why this would not happen. The remaining EU countries would not let Britain cherry-pick: the four freedoms of goods, services, capital and labour come as a package. And, in order to maintain undiminished access to EU markets – perhaps by joining the European Economic Area – Britain would have to sign up to all the EU’s rules and standards, but would have little influence over them. For a country so unhappy with ‘rule from Brussels’, it would be an odd choice to cede more power over the regulation of its economy.

The second idea, which is usually put forward after the first has been debunked, is that Britain outside the EU could compensate for any higher trade costs with Europe by signing free trade agreements (FTAs) with other countries. What follows is an attempt to test this proposition empirically.

Economists at the World Bank have put together a database that measures how costly trade in goods is between all the countries in the world. Trade costs can come in various forms. One cost is taxes on imports: tariffs. Another arises from non-tariff barriers, like quotas restricting imports, or national regulations that prevent imported goods, made to different standards, from being sold. Still another is distance. It costs money to transport goods from one country to another, so distant countries will tend to trade less than neighbouring ones. The World Bank’s researchers have quantified these costs. With their data, it is possible to compare the EU’s performance at cutting these costs for Britain – this, after all, is the point of the single market – compared to other countries.

Chart 1 shows the World Bank’s estimates of trade costs between Britain, the EU, the rest of the OECD and the eight emerging economies with which Britain conducts most trade: China, India, South Africa, Russia, Nigeria, Brazil, Malaysia and Indonesia (listed in order of how much they trade with Britain). Britain’s trade with non-European members of the OECD is more costly than it is with the EU: barriers to trade with these countries are equivalent to 98 per cent of the value of the goods traded, compared to the EU’s 85 per cent. In other words, these trade costs would add 98 pence to the price of a good produced in Britain for £1. The cost of trade with emerging economies is higher still. And costs have fallen less with Britain’s most important trade partners outside Europe – both developed and emerging – than with the EU since 1995, the first year for which there is data.

Chart 1. Trade costs between Britain and the EU, the rest of the OECD, and emerging economies.

Source: CER analysis of World Bank ESCAP database.

The cost of Britain’s trade with the EU, on the other hand, dropped by 15 percentage points between 1995 and 2010 – although the decline stopped after 2007. And since the EU is Britain’s largest trading partner, this fall is all the more valuable. Chart 2 shows by exactly how much. It weights trade costs between Britain and other countries by the amount of trade conducted with them. Since around a half of all Britain’s trade is with the EU, that fall has cut the total cost of Britain’s trade by 0.4 percentage points a year. The small declines in the cost of trade with the rest of the OECD, emerging economies and the rest of the world are less valuable, not only because they have been smaller, but also because Britain conducts less trade with those economies.

Chart 2. Countries' contribution to falling UK trade costs, annual average, 1996-2010.

Sources: CER analysis of World Bank ESCAP database and ONS UK trade data.

However, this is all about the past: one might argue that, after it left the EU, the UK could simply sign an FTA with the Union to secure the existing economic benefits of European integration. Although a Britain outside the EU might be able to negotiate such an agreement, British goods and services could only be sold in EU markets if they met European rules. If Britain’s antipathy to EU rules led over time to its adopting different rules for products sold on the domestic market, trade costs with the EU would increase.

Consider an optimistic scenario after a British exit. The EU does not impose the common external tariff on Britain’s goods, but trade costs do not fall as quickly with the EU as they had before, because Britain refuses to sign up to all future rules of the single market in order to secure access. And let us assume that the fall in trade costs forgone would only be worth 0.2 percentage points a year, since initiatives to deepen the single market have stalled since 2007. In ten years, this would amount to a missed opportunity in the form of a 2 percentage point reduction in the total cost of Britain’s trade.

Could Britain not easily sign FTAs elsewhere in the world to make up for these forgone gains? The answer has to be no.

While Britain’s trade with the rest of the world is growing faster than with the EU, Europe will continue to be its largest trade partner for decades to come. The rest of the world’s contribution to the total reduction of Britain’s trade costs was less than one-third that of the EU, between 1996 and 2010 (Chart 3). This means that any attempts to reduce the cost of trade through FTAs with non-EU countries would have to be very effective to make up for forgone trade with Europe.

Chart 3. Countries' total contribution to falling UK trade costs, 1996-2010.

Sources: CER analysis of World Bank ESCAP database and ONS UK trade data.

This would not be easy. Australia and Canada’s free trade agreements with the United States offer a rough guide to the size of the gains that the UK might make by signing a similar agreement with its second largest trade partner. Canada signed the North America Free Trade Agreement (NAFTA) with the US and Mexico in 1994. Australia’s FTA with the US came into force in 2005. Chart 4 shows the changes in Canada and Australia’s total costs of trade that can be accounted for by the US in the years after their agreements. The US accounts for 55 per cent of Canada’s trade, but the cost of trading with the US went up slightly between 1995 and 2008 – albeit from a very low base. Most of Canada’s trade gains from NAFTA arose from falling costs with Mexico. Australia’s trade costs with the US fell after its FTA came into force. But because Australia’s trade with the US only accounted for between 7 and 10 per cent of its total trade over the period, the US FTA did not bring down its total cost of trade very much – around 0.06 percentage points a year. The UK conducts a similar proportion of its trade with the US as does Australia – 8.5 per cent – so one could expect similar, small gains from any FTA signed with the US after Britain had left the EU.

At best, these gains would be far smaller than the opportunities forgone with the EU. At worst, they would make little difference, since tariffs between non-European OECD members are low, and it is very difficult to persuade countries as unwilling to share sovereignty as the US and China to agree to common standards and rules.

Chart 4. The US contribution to Australia and Canada’s total trade costs after FTAs were signed, annual average.

Sources: CER analysis of World Bank ESCAP database, Statistics Canada and Australia Foreign Affairs and Trade statistics.

Britain’s choice is this: it can choose to stay in the single market – a very deep FTA, agreed with its largest trade partners, and one with a proven track record in reducing the cost of trade. Or it can leave it, and try to sign dozens of free trade agreements with less certain benefits to make up for the opportunities forgone in Europe. The conclusion should be obvious: free traders should support Britain’s continued membership of the EU.

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

Thursday, October 02, 2014

Why devaluing the euro is not mercantilism

The value of the euro is a topic of constant debate in European policy circles. The debate follows a regular pattern: French or Italian policy-makers bemoan the strength of the euro because it hurts their exports; German policy-makers rebuff such claims; the European Central Bank (ECB) claims it is not aiming for a particular value of the euro as its mandate is focused on price stability only; and international commentators point out that the eurozone is simply too large to pursue a purely export-oriented strategy anyway. All sides have a point. But more expansionary monetary policy is necessary to kick-start a broader eurozone recovery, in part via a boost to exports from a lower exchange rate. This is not a mercantilist strategy as imports are likely to grow, too, when incomes recover. The recent fall from $1.37 in early July to $1.27 at the time of writing is a good start but the ECB needs to be innovative and drastic to lower it further and start a proper recovery.

A major benefit of having a national currency is that it devalues in times of economic weakness, thereby boosting exports. Such devaluations are usually not the main aim of monetary policy-makers but a side-effect of more accommodative monetary policy (or the expectation thereof): the central bank lowers interest rates, which leads investors to search for higher yielding assets abroad, and this weakens the currency. Besides its effect on exports, a weaker currency usually leads to higher inflation too, as imports – such as energy – become more expensive. The combination of stronger economic growth via exports and higher inflation via imports is what the central bank was after. The currency is thus one of many ways in which monetary policy actions affect the economy.

Currently, the euro is too strong for the eurozone. While there are various ways to estimate the ‘fair value’ of a currency, the easiest way is to look at current inflation rates and growth prospects. Both are, for various reasons, at exceptionally weak levels in the eurozone. Given that weakness, monetary policy is too tight, and the euro would be weaker with a more appropriately aggressive monetary stance. If the euro is too strong for the eurozone as a whole, it is certainly too strong for its weaker economies such as Italy. When France and Italy bemoan the strength of the euro, they are in effect calling for a more expansionary monetary policy. The currency is just a catchy way of phrasing that.

For Germany, the euro could in fact be higher than it is now; most estimates consider a value of around $1.40 as appropriate – despite disappointing German growth and inflation. The reason is that the demand for German goods from outside the eurozone, for which the exchange rate matters, is hardly to blame for low growth and inflation. The causes are rather the weakness of demand from within the eurozone, one of Germany’s main export markets, and of domestic German demand, which is growing on the back of moderate wage growth and record employment but not fast enough. A higher euro by itself would do little to weaken the German economy.

A stronger euro would give consumers a boost in real income, though. After all, a stronger euro buys more iPads and holiday trips than a weaker one. This is the first reason why Germany rebuffs demands to devalue. The second is that it involves further easing of monetary policy, which at this point, after interest rates are already at zero, means buying risky private assets and, more importantly, sovereign bonds – which Germany strongly resists. However, given that Germany would clearly benefit from a stronger eurozone economy, more monetary easing and a weaker euro is ultimately in Germany’s self-interest.

The ECB claims that it is not aiming for a particular value of the euro, and that its sole objective is to deliver an inflation rate of “below, but close to, two per cent”. While this is true, the euro’s value has an impact on the inflation rate and growth: if the currency’s value falls, it lowers the prices of export and raises those of imports. A rule of thumb is that a 10 per cent fall in the trade-weighted exchange rate of the euro leads to higher inflation of 1 percentage point. The ECB’s own estimates, for example, show that a euro value of $1.24 at the end of 2016 (down from the $1.34 at the time of this estimation, and corresponding to a 3.9 per cent decline in the trade-weighted exchange rate) increases inflation by 0.2-0.3 percentage points.

Since most other transmission channels of monetary easing do not seem to be working as expected or hoped, the currency remains an important way to stimulate the economy, and ECB president Mario Draghi has made similar points recently. But will it work to boost European exports, or even: should it? After all, the eurozone is a large part of the world economy, and an export-led growth strategy would have to be absorbed by the rest of the world via imports, which might be impossible or at least unsustainable.

It might seem counter-intuitive, but an export-led recovery, driven by a depreciation of the currency, does not necessarily lead to an increase in net exports (that is, exports minus imports). The reason is that more export revenues might be used to import goods from abroad. This is especially true in a depressed economy where imports have already massively contracted: incomes are low, and hence consumption, investment, and imports are depressed such that a gain in income boosts all three, leading to a virtuous circle of growing domestic incomes and more imports. The effect on the trade balance is ambiguous. The exchange rate depreciation can thus be a kick-starter for a broader monetary policy-led recovery, without driving the export surplus to unsustainable levels. In fact, it can reduce it.

Argentina and Japan are cases in point. In 2002, when Argentina devalued its currency, exports were a main driver of the recovery for the first six months, growing by an annualised rate of 6.7 per cent. Thereafter, however, imports grew by a whopping 50 per cent (annualised) during the two years between mid-2002 and mid-2004, making net exports a drag on growth and reducing the trade surplus considerably. Japan has recently embarked on a large devaluation experiment, as part of ‘Abenomics’. While the verdict is still out on whether it has been successful in boosting growth and inflation, it has certainly not, despite a massive devaluation of the yen, led to a surge in Japan’s trade balance (see chart one).

Chart one: Japan’s trade balance and exchange rate

Source: Haver

Of course, each case is special. The eurozone periphery has high levels of foreign debt and thus needs to pay down its debts (see chart two). This requires a positive trade balance for a while. Most eurozone countries are rapidly aging societies and therefore have fewer investment opportunities than the rest of the world. This means they should aim to invest abroad, again requiring a trade surplus. In addition, Germany’s current account surplus seems to be stuck at an extraordinarily high level, adding to the current account surplus of the eurozone which has now reached more than 2 per cent of GDP (up from roughly zero pre-crisis).

However, the current account surplus is unlikely to rise if and when more aggressive monetary stimulus depreciates the euro. As argued above, the depressed economies of southern Europe suggest that a boost to demand in the eurozone will reduce the trade surplus. The effect on the German current account surplus is ambiguous but a weaker euro might help to reduce it, too, if the boost to Germany’s exporters and the rest of the eurozone strengthens the German economy, leads to higher wages, and thus to higher incomes and more imports.

Chart two: Net foreign asset positions in million euros

Source: Haver

Overall, there is a strong case for more currency depreciation and hence, more aggressive monetary policy. Now that the euro has weakened, it seems that past ECB actions are finally working their magic via the currency channel. This downward trend is unlikely to continue for much longer, however. Currencies have a tendency to overshoot: investors first get out of low interest rate areas, causing the currency to fall, before it slowly appreciates. Japan has seen its currency constantly appreciate in the face of low growth, very low inflation and even lower interest rates.

The eurozone must avoid this Japanese trap. The ECB’s newest measures are unlikely to be enough to lower the euro further than the current $1.27, or to sufficiently stimulate the economy otherwise. First, its latest attempt to encourage banks to lend to firms (so-called TLTROs) has been underused by banks so far (the next round is in December), in part because demand for new lending from firms is low and the prospects of the eurozone economy do not suggest demand will increase by itself soon. Second, the ECB’s plan to buy private assets, while a good start, will not be effective if it remains a stand-alone measure, without the ECB pushing up inflation and income expectations of firms and households.

In order to provide the necessary stimulus to weaken the euro, the ECB needs to take two actions. First, it should make clear that it intends to make up for excessively low current inflation (just 0.3 per cent in September) with somewhat higher inflation in the future, such that two per cent inflation over the next five years is reached on average. This will increase future inflation, lower real interest rates and push down the euro. This approach is called price-level targeting. Second, in order to make its commitment to this price-level target credible, the ECB should announce unlimited purchases of assets of its own choosing – preferably domestic private and foreign public assets – until the target has been reached.  As the ECB has learnt when its famous OMT programme arrested panic in bond markets, threats of unlimited intervention by a central bank are much more effective than limited fiddling in financial markets. The Swiss were successful with a similar strategy of a credible promise and unlimited purchases in containing the appreciation of the franc.

With these two measures – the first innovative, the second drastic – the ECB will succeed in providing the monetary stimulus needed to put the eurozone on a path toward a proper recovery, including a weaker euro and potentially a lower trade surplus. Without more ECB action, however, the euro might well increase in value again, weakening exporters, lowering already too-low inflation and destabilising the eurozone economy further. The political backlash against the euro and the EU could become impossible to contain. It’s time for the ECB to really do whatever it takes, yet again.

Christian Odendahl is chief economist at the Centre for European Reform.

Tuesday, September 30, 2014

Ukraine, Russia and the EU

President Vladimir Putin is skilled at exploiting the weakness of his opponents. During the Ukraine crisis he has at times appeared to follow the principle that Russia should take as much as it can get away with. Therefore the fragility of the Ukrainian state is troubling. Its problems were evident during the Yalta European Strategy (YES) conference that I attended recently. This annual event, run by Viktor Pinchuk, a liberal oligarch, used to take place in Crimea but has had to move to Kyiv. 

Eight months after then-president Viktor Yanukovych fled Kyiv, the Ukrainian state remains corrupt and unreformed. The politicians are divided over how to handle the Russians. The economy is shrinking and risks running out of energy. Most Ukrainians hope for closer ties to the EU – but in order to placate the Russians, the implementation of the EU-Ukraine trade agreement has been partially postponed. Meanwhile Russian propaganda that the EU provoked the crisis in Ukraine continues to resonate in many European countries.

President Petro Poroshenko and Prime Minister Arseniy Yatsenyuk both impressed the international audience at YES with their eloquence and good English (still unusual for Ukrainian politicians). Poroshenko comes over as a bluff, reassuring figure who is trying to forge compromises, and Yatsenyuk as a bright technocrat with a hard edge. Poroshenko is the optimist among Kyiv’s politicians, believing that the truce which began on September 5th (and is just about holding) and his negotiations with Putin can lead to a peace deal. A key provision of any settlement would be far-reaching autonomy for parts of the Donbass, and the Rada (Ukrainian parliament) has passed a law to allow this. Poroshenko insists that he will not compromise on Ukraine’s territorial integrity, and that Kyiv will remain responsible for the foreign policy and security of the Donbass. But he emphasises that there is no military solution to the conflict. Many Ukrainians want peace at any price and back Poroshenko.

But Yatsenyuk and opposition figures like Yulia Tymoshenko are more pessimistic. They worry that the Donbass is becoming an enclave controlled, de facto, by Russia, just like Transnistria, a slither of Moldova. And they fear that Putin has designs on more of Ukraine. Some think he wants a ‘land bridge’ to connect the Donbass and Crimea; others that he wants to take the entire southern coast, all the way to Transnistria. Yatsenyuk and Tymoshenko do not overtly criticise Poroshenko’s attempts to deal with Putin, but doubt that any peace can hold for long. Yatsenyuk recently allied with militia leaders to form a party that is distinct from that of the president. Freed from prison in February, Tymoshenko is trying to revive her flagging career by adopting a hard line on Russia. A lot of Ukrainians share her concern that Poroshenko will give away too much and think the country needs to prepare for more war. If Poroshenko signed a deal that gave away Ukrainian territory, he would have to contend with a revolutionary Maidan.

The politicians are also divided over membership of NATO, which Poroshenko opposes. Any deal with Putin would presumably include Ukraine’s neutrality. Until recently most Ukrainians did not want to join the alliance. But the Russian invasion has shifted public opinion, which is now 50-70 per cent in favour of joining NATO. Yatsenyuk and Tymoshenko want to join, but most Western governments tell them to drop the idea, fearing that it will deter Moscow from seeking a settlement.

All the prominent politicians hope the West will supply lethal weapons and adopt stronger sanctions against Russia. But they are unlikely to get either unless Russia grabs more territory. One former intelligence chief, Ihor Smeshko, told the YES conference that Ukraine should build its own nuclear weapons – it would only take a year, he said, since the country had the necessary expertise. Though few Ukrainians echo his views on atomic bombs, many share his bitterness over the failure of the US and the UK to enforce the 1994 ‘Budapest memorandum’ (by which Ukraine transferred Soviet nuclear weapons to Russia in return for having its territory guaranteed).

In private, some Ukrainian politicians say they would happily give away the Donbass, so that the rest of the country could prosper as a more pro-EU and coherent entity. The rationale is that the people in Donetsk and Luhansk differ from other easterners, such as those in Kharkiv or Dnipropetrovsk, in not wanting to be in Ukraine. But such radical ideas shock other Ukrainians, who say that if you let Putin take one part of the country, he will then ask for another.

The state remains very weak. Entrepreneurs and NGOs are critical of Yatsenyuk’s government for having reformed so little. They believe that he is reluctant to upset oligarchs – some of whom back him – or the public with painful structural reforms. Ukraine’s governance problems remain: an inefficient state, widespread corruption, including in the judiciary, and politicians who are too close to oligarchs. The current Rada contains many former supporters of Yanukovych and cannot be relied on to back reforms – in September it refused to pass anti-corruption measures. A number of senior officials and ministers are widely regarded as incompetent. 

But Yatsenyuk claims that the current IMF programme, the EU’s Deep and Comprehensive Free Trade Agreement (DCFTA) and the government’s own ‘action plan’ are all driving reform. Poroshenko says that after parliamentary elections on October 26th, the priority will be reform of the courts and the security sector. But reform will be very hard to achieve so long as the country remains on a war footing.

Poroshenko’s strongest argument for trying to forge a deal with the Russians is that the economy needs peace. It may shrink by as much as 10 per cent this year. Inflation is close to 20 per cent and the budget deficit nearly 10 per cent. The current account deficit, having contracted after a summer devaluation, is not widening. Many of the exports that normally go to Russia, such as farm goods and steel, are blocked (Russia still takes armaments). The latest figures from the EU, however, suggest that Ukrainian exports to the EU in May-June 2014, after the EU removed barriers to them, rose by 25 per cent, or €587 million, over the same period in 2013. This almost balanced the effect of Russia’s embargo, which resulted in a fall in exports to Russia of €592 million in the same period.

One positive story is agriculture, which provides about a third of total exports; the country is the world’s second biggest exporter of grain. Nevertheless the existing promises of Western help – $17 billion from the IMF, $14 billion from the EU and less than $250 million from the US – are far from sufficient to meet future needs. 

Energy shortages are undermining the economy’s prospects. Russia normally supplies about half of Ukraine’s gas needs but cut off supplies in June. Ukraine produces nearly half of what it consumes but is now running down stocks of stored gas. It had started to import Russian gas indirectly, via Austria, Hungary, Poland and Slovakia, but Gazprom recently reduced deliveries to those countries, which have now ceased re-exports to Ukraine. Hungary stopped the reverse flow, after a meeting between Prime Minister Viktor Orbán and Gazprom CEO Alexey Miller. Many power stations rely on coal from the Donbass but the war has disrupted supplies. Energy subsidies cost the state 7 per cent of GDP, compared to defence spending of just 1.5 per cent. These subsidies explain why Ukraine is among the world’s most inefficient users of energy. The government has started to make modest cuts to energy subsidies, to comply with IMF prescriptions.

Not all the news is gloomy in Kyiv. Civil society is strong and vibrant. Many NGOs act as a check on the corrupt elite, monitoring what it does. The press is free and there is real political competition, even though the parties are built around personalities rather than policies. The Russian invasion has created a feeling of national unity across much of the country, including in many Russian-speaking areas.

The current crisis began last November when Yanukovych – under Russian pressure – abandoned the DCFTA and a related Association Agreement that his government had negotiated with the EU. Popular protests triggered the president’s flight. When Poroshenko was elected he revived these EU agreements. However, after recent talks between Brussels, Moscow and Kyiv, Ukraine announced that it would postpone the implementation of its side of the DCFTA for 15 months – meaning that it will maintain tariffs on imports from the EU. For more than a year Russia has been arguing that the agreement would unleash floods of imports from the EU, damage Ukrainian industry and lead to the dumping of Ukrainian products on Russia’s market. That is unlikely; Russia’s real concern is probably that it does not want its exports to face competition in Ukraine’s market. In any case, Putin has threatened “immediate retaliatory measures” if Ukraine implements any part of the agreement.

The EU has fulfilled its side of the DCFTA by scrapping tariffs on imports from Ukraine. At the YES conference, Yatsenyuk put a positive spin on the postponement, saying that Ukrainian industry needed time to prepare for the chill winds of EU competition, and that reform would not be delayed. Opposition politicians, however, were in despair at this caving in to Russian pressure. They fear that Russia will use meetings of the ‘association council’ that governs EU-Ukraine relations to engineer the amendment of the agreements’ implementing protocols in its favour. 

The EU is keen for Poroshenko to strike a deal with Putin. Therefore, despite having imposed several rounds of sanctions on Russia, it is holding out olive branches – and not only by agreeing to suspend parts of the DCFTA. Štefan Füle, the commissioner for the neighbourhood, told YES that the EU was willing to establish relations with the Russian-led Eurasian Economic Union and to contemplate a free trade agreement with it. The EU is also engaged in trilateral talks with Ukraine and Russia to solve the gas price dispute between Moscow and Kyiv. A deal on gas now seems within reach.

Ever since the crisis in Ukraine began, the Russians have held the EU culpable, claiming that it failed to consult them on the negotiation of the trade agreement with Ukraine. Not only have extremists like Nigel Farage and Marine Le Pen bought this story, but also a number of mainstream politicians and officials, including in Germany. An exchange at the YES conference shot down this canard once and for all. Commission President José Manuel Barroso recounted that for many years, at the six-monthly EU-Russia summits, he had put the DCFTA on the agenda. The Russians never showed any interest in discussing the matter until last year, he said. Then Igor Yurgens, formerly a close adviser of President Dmitry Medvedev, intervened: he said he had sat in on several EU-Russia summits, and confirmed that the EU had tried to raise the DCFTA but that the Russians had not wanted to discuss it. Barroso added that on several occasions Putin had told him he did not mind if Ukraine joined the EU.

Presumably Putin turned against the EU and its agreements with Ukraine when he decided to transform the Customs Union of Russia, Kazakhstan and Belarus into a more ambitious Eurasian Economic Union. Putin thought this project would count for little without Ukraine’s participation – and understood that it could not both adopt the DCFTA and join his Union (which has high external tariffs). 

The Western sanctions on Russia are making an impact, particularly on the ability of its firms to raise capital on international markets. The business climate in Russia is souring, investment by Russians and foreigners is tailing off and economic output is starting to drop. Though Russian leaders dismiss the sanctions as feeble, the prospect of stronger measures may be deterring Putin from further land-grabs in Ukraine. 

The other deterrent may be the prospect of dead Russians. The further that Russian troops move into Ukraine, the more of them will be killed. According to the Russian NGO ‘The Committee of Soldiers’ Mothers’, it is likely that several hundred Russian soldiers have already died, but the Russian media has more-or-less succeeded in hiding that fact from the public. More extensive casualties would be impossible to cover up.

The peace deal that Poroshenko hopes for would allow Ukraine’s economy to recover, give an opportunity for Kyiv’s politicians to modernise the state and enable the country to move closer to the EU. Such benign outcomes, however, may not suit Putin’s purposes, and he may try to prevent them.

The West therefore should do everything it can to strengthen Ukraine, including the provision of more generous financial assistance. NATO should train Ukraine’s armed forces and give them some of the weapons they need to defend their territory. The EU should maintain sanctions until Russia stops interfering in eastern Ukraine, while letting Moscow know that further encroachments will incur further measures. The EU should do more to strengthen Ukraine’s administration and judiciary, enhance energy links to European grids and dispense humanitarian aid where it is needed. And it should give Ukrainians a clear message of hope: the more they reform their country, the more closely it will become integrated with the EU. European governments must not close off the possibility that, in the very long run, Ukraine could become a member. 

Charles Grant is director of the Centre for European Reform.

Tuesday, September 23, 2014

How Brussels' medicine is killing the ‘French patient’

The French government’s announcement in early September that France would fail to bring its deficit below 3 per cent of GDP until 2017 was met with the usual mixture of frustration and resignation. Many eurozone policy-makers see France’s refusal to play by the fiscal rules and its inability to reform its economy as the biggest threat to the eurozone’s stability. The list of allegations is pretty comprehensive: a bloated state, a lack of competitiveness, intractable structural problems and a mulish refusal to reform or to acknowledge that globalisation has left France living on borrowed time.

Some of these criticisms have merit, but as a whole they form little more than a caricature. France has some supply-side problems: very high non-wage labour costs deter employment; and parts of the service sector urgently need an injection of competition. But these are secondary to those of its problems that stem from self-defeating austerity and chronically weak domestic demand elsewhere in the eurozone. Without change to the latter France could yet come to justify the ‘sick man of Europe’ tag so beloved of journalists.

How does the performance of the French economy stack up against its European contemporaries? France has certainly struggled since the financial crisis, along with the rest of the eurozone (with the partial exception of Germany). However, its growth performance has been nowhere near as bad as either Spain’s or Italy’s and, until recently, it has been better than the UK’s (see chart 1). And France’s record since 1999 has been rather good compared with many of its European peers. So much for past performance. Are critics of France (led by the European Commission and the German government) justified? Are they right to be so pessimistic about the country’s future and correct in the medicine they prescribe for it?

Chart 1: Economic growth (1999 – 2014)
Source: Haver

France certainly has a big state. Public spending stood at almost 57 per cent of GDP in 2012, higher even than in Sweden (see chart 2). There is little doubt that this is excessive, but France’s productivity levels (which are better than Germany’s and not far short of US levels) would not be so high if its large state sector was unproductive. Nor does the country’s big state appear to squeeze out private sector investment, which is about the same level as in Germany, Spain and Italy and much higher than in the UK (see chart 3). Moreover, putting together comparable data for the size of state sectors is far from straightforward. For example, spending by France’s state-owned rail operator (SNCF) counts as state spending, whereas spending by Britain’s (or Germany’s) nominally privatised railways does not. France could follow suit and sell off its railways, but it is far from clear that this would improve the quality of rail services or reduce the public’s liabilities.

Chart 2: General government spending, per cent GDP

Source: Haver 

Chart 3: Private sector investment

Source: Haver 

France’s general government budget deficit is sizeable (see chart 4), though much lower than Spain’s or the UK’s. Moreover, a sizeable chunk of the French deficit is down to much higher public investment than in the other big EU economies, and more generous childcare. For example, were French public investment as low as Germany’s, France would have no problem getting its fiscal deficit under 3 per cent of GDP. And generous childcare provision may help explain why France has the highest birth rate in the EU after Ireland. This could look like money well spent in a few years when populations start to age rapidly in many other EU countries, notably Germany and Italy.

Chart 4: Budget balances

Source: Haver

Is France really as uncompetitive as all that? The country’s share of world export markets has certainly fallen steadily over the last 15 years, but no faster than in other G7 economies, with the notable exception of Germany (see chart 5). France’s exports (like those of other G7 countries) have risen considerably but their share of the total has fallen as China and other big emerging economies have entered the global trading system. Germany has bucked this trend, but this is hardly a strategy all can emulate: if more countries become fully participating members of the trade system, Western countries’ overall share must inevitably fall.

Chart 5: Shares of global export markets

Source: OECD

France has run small current account deficits for much of the last decade (see chart 6). The principal reason is that domestic demand rose almost twice as fast in France in the 1999-2013 period as it did in the eurozone, with Germany accounting for much of the weakness of eurozone domestic demand. Persistent weakness in Germany – France’s biggest single export market – has been a continuing problem for French exporters. And while German domestic demand has strengthened gradually since 2010, this has been eclipsed by a much bigger combined fall in Italian and Spanish domestic demand, two of France’s other major export destinations.

Chart 6: Current account balances

Source: Haver

Which brings us onto the second reason for the deterioration in France’s trade performance: French exporters’ loss of competitiveness vis-à-vis their German counterparts. This has not come about because French costs have risen too rapidly (see chart 7), but as a result of prolonged wage restraint in Germany, where wages have lagged behind productivity growth. This was initially the product of a depressed German economy and then of structural changes in the German labour markets brought about by the so-called Hartz IV reforms introduced in January 2005.  German wage settlements have picked up a bit over the last year, but not by enough to make a dent in the gap that has opened up since the introduction of the euro.

Chart 7: ECB’s harmonised competitiveness indices (minus indicates increased competitiveness)

Source: ECB

Critics of France are on firmer ground when it comes to the supply-side of the French economy. Although France’s productivity levels are impressive, there are some significant structural problems. The first is that French unemployment is higher than it should be given the country’s growth performance and moderate wage growth (see chart 8). One reason is that the costs of financing social benefits are loaded too heavily onto employers, pushing up the cost of hiring people. Another is the inflexibility of labour contracts, which can deter employment. Successive French governments have introduced reforms to address these issues, such as reducing the cost of social insurance paid by employers, but more will need to be done, in particular to reduce the costs of employing low-skilled people.

Chart 8: Unemployment

Source: Haver

France also requires reform of various service industries. IMF data for total factor productivity – a measure of the efficiency of all inputs into the production process – suggest that the biggest problems lie in sectors such as accounting, legal services, insurance and logistics. The lack of competition and barriers to entry in these sectors mean that costs are higher than they should be, hitting overall business competitiveness.

To recap, the French economy is in trouble. It has barely grown for the last two years and unemployment is stuck at near record levels. But France has performed pretty well in a eurozone context. It stacks up favourably not only compared with the currency union’s periphery but also with the likes of the Netherlands and Finland. France’s supply-side problems are no doubt significant, but do not justify its status as some kind of hopeless case. They are certainly not as serious as those faced by Italy, and arguably no worse overall than those of Germany and the UK, although they are in different areas. Nor will France’s economic prospects be improved by adhering to the European Commission’s calls for austerity, wage restraint and labour market reforms which, if heeded, would exacerbate unemployment.

Since 2012 France has tightened fiscal policy considerably in a largely unsuccessful attempt to bring down its deficit. This failure was foreseen: the IMF has demonstrated that the so-called fiscal multipliers (the impact of changes in government spending on economic activity) are very large in today’s depressed European economic environment. Although spending has been cut, the resulting weakening of economic activity (and hence inflation) has meant that the deficit has fallen little. A long-term objective for the French government should be to reduce the ratio of government spending to GDP, but this can only happen once the economy is growing again. Further cuts to public spending now would further damage the economy by causing even competitive firms to go under and eroding physical and social infrastructure, for example by pushing more people into long-term unemployment.

Wage growth has fallen sharply in France as high unemployment has undercut private employees’ bargaining power and public sector wage freezes have come into force. However, such wage restraint has had little impact on the price competitiveness of French exports, because French wage restraint has been exceeded by the likes of Spain and Italy and matched by Germany. Even if France could depress wages relative to other eurozone economies, it would take a long time for that to bring about a big boost to France’s economy because exports account for less than 30 per cent of French GDP (as opposed to 40 per cent in Germany in the early 2000s, or over 100 per cent in Ireland today). In addition, further wage restraint would depress household consumption and prove a zero-sum game in terms of export competitiveness since Italy and Spain are attempting the same thing. It would also exacerbate deflationary pressures in the French economy and across the eurozone (see chart 9). Rather than cuts in its own wages, what France desperately needs is a sustained recovery in German wages (and with it, German domestic demand).

Chart 9: Core consumer price inflation

Source: ECB

The French government should certainly push ahead with structural reforms of its economy, but not necessarily those prescribed by the European Commission. When demand is very weak and firms do not need to hire workers, reducing social protection and wages increases unemployment rather than reducing it, and depresses consumption. However, France should reduce the burden of taxation from labour and transfer more of it to wealth, property and carbon consumption. And it should open up the country’s non-tradable services sector to greater competition. But even structural reforms of this kind will do little to increase economic growth without a change to fiscal policy, aggressive measures by the ECB to reflate the eurozone economy as a whole and concerted action by the German government to rebalance Germany’s economy.

France is not the ‘sick man of Europe’, but it is certainly ailing thanks to the medicine prescribed by Brussels and Berlin. The French government needs to step up its resistance. Indeed, perhaps the most serious charge that can be laid at France’s door is that it has meekly gone along with a eurozone policy doctrine that has done so much damage to the French economy rather than corralling opposition to it and forcing through a change in direction.

Simon Tilford is deputy director of the Centre for European Reform.

Friday, September 12, 2014

A UK without Scotland

If Scotland votes Yes…
At the time of writing it seems possible that the Scots will vote to leave the UK in the referendum on September 18th. The consequences of a Yes to independence are unfathomable but would stretch far beyond the British Isles. A Yes would not only shake up British politics but also increase the likelihood of Residual UK (RUK) leaving the EU, boost separatism elsewhere in Europe and diminish the global standing of what was left of Britain.

A Scottish exit would create problems for the Conservative Party. This would be the second time that it had been responsible for the departure of part of the British Isles from the United Kingdom. Ireland became independent in 1922, but it is often forgotten that when the Irish asked for Home Rule in the late 19th and early 20th centuries, most of them did not want independence. On several occasions Liberal governments tried to give Ireland Home Rule but were blocked by Conservatives in the House of Lords. This went on for decades, eventually driving the Irish (excepting the Protestants in Northern Ireland) to seek independence.

The Conservative prime minister, David Cameron, will take some of the blame if the Scots leave. He agreed to the timetable of Scotland’s first minister, Alex Salmond (a vote in 2014 rather than 2013 allowed the Scottish National Party more time to build support); to a ballot paper question which, though modified by the Electoral Commission, is favourable to the SNP (‘Should Scotland be an independent country’); and to the exclusion of further devolution as a third option on the ballot (which would have reduced the numbers voting Yes).

The austerity policies of the Cameron government must also bear some responsibility for the Conservatives’ appalling image in Scotland. One of the most potent arguments for independence is that Britain is an increasingly right-wing, Thatcherite and inegalitarian country. Much of that is hyperbole, but the nationalists have been able to argue that if Scotland wants to emulate modern, high-principled and social-democratic Nordic countries, it must break free of Tory Britain.

Cameron would come under pressure to resign, but he might limp on as a lame duck prime minister, even less capable of controlling his party’s powerful eurosceptic forces. If Cameron resigned his replacement would probably need to take a more anti-EU stance in order to be elected party leader. The party could move towards making radical demands for EU reform that other EU governments would not or could not grant; the upshot would be the Conservatives recommending a No in a referendum on maintaining EU membership.

Ed Miliband, the Labour leader, would also be damaged by a Yes. He is scarcely more popular in Scotland than Cameron. The recent surge in support for the Yes campaign has come mainly from Labour voters in working class areas. They do not regard the prospect of another Labour government at Westminster, with Miliband as prime minister, as exciting. The referendum is only happening because Labour – traditionally, the dominant force in Scotland – became so grey and uninspiring that the SNP was able to win office in 2007.

But whatever the failings of Cameron and Miliband, the Scottish campaign reflects larger, pan-European trends. In many parts of Europe, populism, much of it nationalist, is on the rise. In Britain, in the recent European elections, Nigel Farage’s UK Independence Party won more votes than the Conservative or Labour parties. Salmond’s SNP is different from UKIP in important ways: it lacks the latter’s hostility to the EU and immigration. But they both tap the same hostility to Westminster, elites and established political parties (Farage and Salmond have also both expressed qualified praise for Vladimir Putin). And though many of those working for a Yes are young and idealistic, in favour of a new sort of politics, their campaign, like UKIP, is gaining strong support from those who are less educated and fearful for their futures.

RUK would be more right-wing and eurosceptic than the full United Kingdom and thus more likely to leave the EU. The Conservative Party has long described itself as a unionist party but has only one Scottish MP, eight in Wales and does not contest elections in Northern Ireland. A party that was more centred on England, seeing UKIP as a key foe, would probably become more unashamedly for English nationalism.

Even if Ed Miliband won the general election in May 2015 his government would have little legitimacy, if his majority depended on Scottish MPs, as it almost certainly would. There would probably have to be another general election when Scotland left the UK, which SNP claims would happen in March 2016.  Labour would find it much harder to win a parliamentary majority without Scottish seats in Parliament. So a Scottish Yes would increase the chances of a Conservative government, and thus an EU referendum (Labour, like the Liberal Democrats, opposes a referendum unless more powers are transferred to the EU). And without five million relatively pro-European Scots, it would be harder for pro-EU voters in RUK to defeat the sceptics in a referendum.

British pro-Europeans who hope to win such a referendum will learn some lessons from the Scottish campaign. When middle-aged men in suits tell voters that departure will lead to less foreign direct investment and economic instability, many of them are unimpressed. Advice from the establishment can often seem patronising. The No campaign in Scotland has focused on economics and attempted to make people fear the unknown. Only belatedly has it tried to tell a positive story of how all parts of the union benefit from it.

The obvious lesson for an EU referendum is that pro-Europeans should not focus only on economics and negativity. However, it is much harder to create a positive narrative about the EU than about Great Britain. The English and Scots share a common history and have achieved a great deal together; they have not fought since the battle of Culloden in 1746. But it is only 70 years since Britain was fighting other Europeans, and the achievements of the EU – such as peace and prosperity – appear not to touch many British hearts.

A Scottish Yes would cause shockwaves elsewhere in the EU, particularly in countries with separatist movements. Catalan separatists already treat the Scottish referendum – whatever its result – as a victory, since Scotland is being allowed to vote. The Catalan government, led by Artur Mas and his moderate Convergencia i Unio party, wants a referendum in November 2014, but the Partido Popular government in Madrid has refused to allow it. This obstinacy is pushing more and more Catalans to favour independence.

If the Madrid government and the constitutional court continue to block the referendum, Mas may try to hold one anyway or simply call Catalan elections. Financial scandals have weakened Convergencia i Unio, so the more extreme Esquerra Republicana de Catalunya would stand a good chance of forming a government. This party has promised to declare independence if a referendum is not allowed. A Scottish Yes would surely embolden the Catalans, encourage more of them to insist on independence, and make Spain’s constitutional crisis more intractable. What happens in Scotland and Catalonia will make its mark on the Basque country, Flanders and other parts of the EU.

A Scotland that leaves the UK would have to apply for EU membership. The accession of an independent Scotland would be much more complicated, and take much longer, than the SNP imagines. As John Kerr has pointed out, Scotland could not accede until it had agreed terms with each of the 28 member-states, all of which would have to ratify the accession treaty. It would be technically very difficult, though hopefully not impossible, to ensure that Scottish citizens and companies did not lose the benefits of membership during the period between Scotland’s quitting the UK and joining the EU.

Many issues between the EU and Scotland could not be sorted out until RUK and Scotland had agreed the terms of their separation. The currency question would be a problem in both sets of negotiations. Scotland could not join the EU without committing to join the euro. But if it wished to regard that as a long-term goal and in the interim to have its own currency or use the pound, EU member-states might indulge it. London, however, would not agree to Scotland using the pound and having the Bank of England as its lender of last resort unless Edinburgh ceded substantial powers over economic policy.

Like any country applying to join the club, Scotland would find that it had to accept the terms imposed on it by the other member-states and EU institutions. For example, Scotland would not get a share of the UK’s rebate on its contribution to the EU budget. Spain would be one member in no hurry to allow Scotland to show that independence can be won easily and quickly (and it might extract a price in fishing rights).

At the same time as the difficult RUK-Scotland and EU-Scotland talks were under way, a Tory-led RUK could be trying to negotiate a new deal with the EU and, following a referendum in 2017, perhaps an exit. The EU could put the Scots on hold while it sorted out the (for most governments) much bigger problem of RUK’s departure.

Whether or not RUK stayed in the EU, a Scottish exit would diminish its international standing. In the past few years that standing has suffered.  The Conservative-led government has been less assertive in international affairs than its Labour predecessors, partly because public opinion has become sceptical of an activist foreign policy (after Tony Blair’s wars in Afghanistan and Iraq), and partly because of the Conservatives’ reluctance to pursue international goals through the EU. Britain has been relatively passive during the Ukraine/Russia crisis (at least its early phases) and the rise of Islamic State in the Middle East.

But the departure of the Scots would cause much greater damage. Other countries would react with a mixture of pity and derision.  RUK’s armed forces and diplomatic service – already under pressure from government budget cuts – would have to shrink further, hampering its ability to play a leading role in NATO and the EU. As the details of independence were negotiated – including the need to divide up all common assets – the RUK government could find it hard to focus on foreign policy crises at the same time.

The SNP is committed to getting rid of the Trident submarines that are based at Faslane on the Clyde. But the cost of constructing a new submarine base in England would be enormous – and perhaps tilt the argument in London, where the political class is increasingly divided on the wisdom of retaining a nuclear deterrent, towards scrapping it. Any decision to abandon or diminish the deterrent would lower the US’s estimation of RUK. All these shifts would make it harder for Britain to argue that it should maintain its place on the UN Security Council (though it cannot be forced to cede it). The UK’s permanent seat and veto already appear to be an anachronism, when the likes of India, Brazil, Germany and Japan have neither.

Even if – as the CER hopes – Scotland votes No, there will still be huge consequences. A No is unlikely to be the end of the matter, especially if the vote is close, as is likely. Although 60 per cent of the Québecois voted to stay in Canada in 1980, another referendum was held 15 years later, which the separatists lost by only a whisker.

The Conservative, Labour and Liberal Democrat parties have promised that a No vote will trigger the devolution of tax-raising and other powers to the Scottish Parliament. That, in turn, is likely to provoke rising resentment among the English. If the Scots get special deals, why should they not? Further devolution would increase the urgency of answering the ‘Lothian Question’: why should Scottish MPs at Westminster vote on subjects that are devolved to Edinburgh, when English MPs cannot vote on those issues in Scotland? Meanwhile the Welsh and perhaps some other regions would ask for more powers to be devolved. UKIP would do its best to profit from a sense of grievance among the English.

The rise of populism and nationalism will continue to destabilise Britain and the rest of Europe – unless traditional elites do a better job of solving economic problems and practising the kind of politics that inspires voters.

Charles Grant is director of the Centre for European Reform.

Wednesday, September 03, 2014

The challenge to the West: Restoring European deterrence

Mutually Assured Destruction, with its overtones of Dr Strangelove, was never a popular strategy in Western societies: the idea that NATO and the Warsaw Pact could wipe out human life many times over seemed immoral to many people. The acronym ‘MAD’ did not help. But MAD kept Europe peaceful, if nervous, through most of the Cold War.

The world of 2014 is very different from that of the 1950s, when John von Neumann, mathematician and game theorist, came up with the both concept and the term Mutually Assured Destruction. NATO leaders at their summit in Wales on September 4th and 5th, and EU foreign ministers when they meet on September 29th, need to think about an expanded concept of deterrence, covering military, economic and other measures, and how to use it to restore stability in Europe.

Deterrence depends on having both the capability and the will to inflict unacceptable damage on a potential enemy. The West certainly has the capability. In the military field, despite the huge increase in Russia’s defence budget under President Vladimir Putin (in real terms, it almost tripled from 2000 to 2012), the US and its NATO allies could defeat Russia in any conventional war. The US alone is numerically superior to Russia in every category of major weapons system except for main battle tanks, not to mention its technological dominance.  Russia could reduce the US to radioactive dust, as TV anchor Dmitri Kiselyov, later promoted to head the Russia Today state news agency, said in March 2014; but the US still has more than enough warheads to do the same to Russia.

Economically, the EU can inflict enormous damage on Russia. More than half of Russia’s state budget revenue derives from sales of oil and gas. EU countries buy 84 per cent of Russia’s oil exports and 76 per cent of its gas exports. Even small reductions in purchases would hit the Russian economy hard, and would make it more difficult for the Russian government to pay for increased defence and social spending.

The problem is that Western leaders have repeatedly shown since the beginning of the Ukraine crisis that they do not have the will to use the means available to stop gross violations of international law by Russia. Putin is exploiting the resulting security vacuum on NATO’s and the EU’s eastern border. And Western irresolution also risks encouraging other states to think that they can seize territory by force without any significant Western reaction – think of China in the South and East China Seas, where the credibility of US security guarantees is increasingly questioned, as Rem Korteweg wrote in a recent CER policy brief.

NATO’s deterrent posture worked during the Cold War because Soviet leaders really believed that successive US Presidents were prepared to launch massive nuclear strikes on the Soviet Union in response to Warsaw Pact attacks on NATO forces in Europe. Just in case there was any doubt, NATO exercised its procedures for using nuclear weapons regularly. Soviet leaders knew that, and the knowledge kept them honest: they wanted at all costs to avoid a European conflict that might escalate to a nuclear exchange. Western leaders had similar fears about the Warsaw Pact. Among the results of this shared fear were various hotlines and confidence-building agreements designed to ensure that the two sides never stumbled into war.

Once the Cold War was over, this sort of thinking seemed out of place: what Western leader would sit down with his Russian counterpart to discuss co-operation on Afghanistan, or investment in Russia’s oil and gas sector, while simultaneously threatening to obliterate Russia in the event of conflict? The result was that when Russia invaded Georgia in August 2008, three months after the Alliance had promised Tbilisi NATO membership (albeit at some unspecified future date), the Allies did nothing to help Georgia. Deterrence had broken down: and Putin no longer believed, or feared, that the West would impose an unacceptable cost for his adventurism.

The same pattern has been repeated in Ukraine. Western leaders have been too ready to say that there is no military solution to the conflict. There is – the Russian army is busy imposing it in Donetsk and Luhansk. The West has become the victim of unilateral deterrence on Putin’s terms: it has limited its action against Russia to measures that will not impose unacceptable costs and will not invite significant retaliation, and Putin has not been deterred at all by small, tit-for-tat steps. Estimates for how much Germany, Europe’s biggest exporter to Russia, may lose from the sanctions imposed so far range from 0.04 per cent of GDP to around 0.25 per cent (the latter figure coming from the business lobby with most at stake in Russia).

On one level this is understandable: European economies are fragile, so even small losses of business in Russia are unwelcome; and if Russia turned off the gas taps, a few Central European countries would freeze next winter. As for military deterrence, Russia is a nuclear power (and just in case anyone had forgotten that, Putin has warned in two recent statements that Russia is one of the most powerful nuclear nations and that it will surprise the West “with new developments in offensive nuclear weapons”); so why would anyone seek to change its behaviour by military means?

But the breakdown of deterrence is a serious threat to the European order which NATO has defended and the EU has helped to build and has benefited from. NATO and EU treaty obligations end at their eastern borders; their security interests in stable and prosperous neighbours do not. Though NATO talks of rapid reaction forces supported by pre-positioned equipment and supplies in Central Europe and the Baltic States, this is designed to protect existing allies, not countries like Ukraine and Georgia. Even in exposed countries like the Baltic States, there will be no permanently-stationed NATO forces. Germany and others worry that such forces would breach the NATO-Russia Founding Act of 1997. In this, NATO stated “that in the current and foreseeable security environment” it would carry out its missions without resorting to “additional permanent stationing of substantial combat forces”. Though the security environment has changed beyond recognition, the fear of provoking Russia has not.

The breakdown of deterrence has emboldened Putin to go ever further into Ukraine, while President Obama and others have been at pains to assure him that there is no risk that Russia will have to confront NATO forces there, or even Ukrainian forces with NATO armaments and equipment. An independent, democratic country that has had its problems but always had internal ethnic peace is gradually being dismantled by Russia. And the West, far from supporting Ukraine’s efforts to defend itself, is encouraging it to agree a ceasefire on the aggressor’s terms.

Restoring deterrence in Europe now will be much harder than maintaining it would have been even six months ago. But the longer Western leaders wait, the worse the consequences will be. Putin’s recent speeches, with their references to Russia’s obligation to defend not only Russian citizens abroad but ethnic Russians and “those who feel that they are part of the broad Russian world”, as he said to Russian Ambassadors on July 1st, point to the danger that he will interfere in other countries besides Ukraine. Why, after what has happened (or not happened) in Ukraine, should Putin believe that NATO countries will really deliver on their security guarantees to the Baltic States? Latvia and Estonia have substantial ethnic Russian minorities; no doubt Russian intelligence services could stir up enough of them to provide a pretext for some sort of peacekeeping intervention. Would there be unanimity in the North Atlantic Council for going to war to defend Riga or Tallinn?

The NATO Summit in Newport should borrow some fire from the Welsh dragon and come up with a package of military assistance for Ukraine to make Russia reconsider the costs and benefits of invading Ukraine. The Ukrainians need training, logistics, intelligence and equipment if they are to push Russian forces and their local proxies back. There are Central European allies who still have former Soviet equipment of a kind that Ukrainian troops will be familiar with; they should send it to Ukraine, perhaps as part of a lend-lease scheme. Germany has decided to send arms to the Kurds, to help them defeat the terrorists of the Islamic State; it should also arm the Ukrainians to help them withstand the Russian invasion, as should the UK. France should (belatedly) stop the delivery of its Mistral assault ships to Russia; it is unconscionable to arm the aggressor while refusing to help the victim.

At the same time, the EU should overcome its fear of short-term economic losses and Russian retaliation, and defend its long-term values and interests with sweeping and painful sanctions. Russia’s economy is in as bad a state as that of the eurozone and even less able to adapt to shocks. Even a modest reduction in Europe’s purchases of gas, oil and coal from Russia would have a major impact on Moscow’s finances.

The Union should follow through on the implicit threat in the conclusions of the European Council on August 30th to sanction “every person and institution dealing with the separatist groups in the Donbass”. EU legislation defines as terrorist offences “intentional acts… that may seriously damage a country or an international organisation where committed with the aim of… seriously destabilising or destroying the fundamental political, constitutional, economic or social structures of a country or an international organisation.” By that definition, the groups in the east are terrorists, and the EU should treat them and their backers as such. And it should exclude from European markets any company, Russian or foreign, which does business in Crimea without the permission of the Ukrainian government.

The EU should also take up British prime minister David Cameron’s reported proposal that Russian banks should be shut out of the SWIFT inter-bank payments system. This was one of the most effective sanctions applied to Iran to get it to suspend its nuclear weapons programme. Though Russian officials have talked about setting up a national system outside SWIFT, this would not be easy, and the short-term damage to Russia’s trade and corporate borrowing, as well as the disruption to the lives of high-net worth Russians with large overseas assets, would be severe.

Whatever steps the West takes, Russia will without doubt retaliate. But if the West does nothing, it cannot expect that Russia will allow Ukraine to go back to the status quo ante, or that Putin will be satisfied with annexing Crimea. EU economies will still suffer from the destabilisation of Ukraine, the disruption of trade with it and through it, and conceivably from large refugee flows if fighting continues (the UN High Commissioner on Refugees has reported that this year 20,000 Ukrainians have arrived in one (unnamed) Baltic state alone); and the West will be in an even weaker political position to face Putin’s next provocation.

Putin, as he has shown, is prepared to sacrifice a lot in order to dominate Ukraine, including an unknown number of Russian troops already killed in action. As he famously admitted in 2000, he received a negative character assessment in KGB training for his “lowered sense of danger”; but it is quite likely that at least some of his advisers have a better understanding of the damage Russia could suffer if the West ramps up the economic and military pressure. Germany’s intelligence chief reportedly told members of the Bundestag in July that splits were appearing among Putin’s backers, between oligarchs and security services.  Good. To widen those splits, the EU and NATO have to show that they are also prepared to make sacrifices for the sake of the European order. Deterrence can only be restored if the aggressor believes that the defender is ready to tolerate pain as well as inflicting it.

Ian Bond is director of foreign policy at the Centre for European Reform.

Thursday, August 21, 2014

Learning from Herman: A handbook for the European Council president

When member-states reconvene on August 30th in Brussels to decide on the remaining top EU posts, they should agree on candidates who not only have the right party affiliation, nationality or gender, but who can also respond to the EU’s mounting challenges. This applies to the President of the European Council, whose role is to forge a consensus among EU leaders — a difficult task these days. But the appointment of a successor to Herman Van Rompuy has so far been overshadowed by political squabbles around Federica Mogherini, the Italian foreign minister and candidate for the post of High Representative.

Many still believe that the job of the European Council president is nothing more than European ‘master of ceremonies’. This is wrong. The sovereign debt crisis elevated the European Council to the primary forum for EU discussions on economic governance. It also increased the importance of its permanent president. Van Rompuy has had his hands full ever since, trying to reconcile the divergent interests of debtor and creditor countries. The bar has been set high for Van Rompuy’s successor, who is expected to take over on December 1st. One of Van Rompuy’s last tasks will be to find a candidate able to get the European Council working as a team. Van Rompuy would do well to look in the mirror, draw up a list of his strengths and weaknesses, and seek a successor with some of his own best characteristics.

Efficient chairman. Despite a reputation for having the “charisma of a damp rag”, as Nigel Farage once put it, Van Rompuy made European Council meetings more efficient. He used concise conclusions to set out a strategic direction for the EU. The strategic agenda which EU leaders endorsed in June is a case in point. It identified priority areas which the EU should focus on in the course of the next five years. But the European Council has not always remained at the strategic level. It suggested deleting two articles from a draft regulation on the creation of unitary patent protection, despite in theory exercising no legislative powers. Not everyone liked Van Rompuy’s agenda management either. He pushed for the most sensitive and technical issues to be discussed over meals. This has been a headache for advisers, who had limited contact with their leaders at mealtimes. But trying to build consensus in the informal setting of a meal may have helped to overcome impasses, for example on the question of imposing a ‘haircut’ on holders of Greek bonds in order to reduce its debt. As there are still decisions to be made about euro governance and a settlement with the British to negotiate, a new president should keep Van Rompuy’s tactics up his or her sleeve.

Sensitive to concerns of euro ‘outs’ and ‘pre-ins’. Van Rompuy is an economist by profession, and this helped him to keep the European Council in the driving seat in discussions on the Economic and Monetary Union (EMU). Deliberations among all 28 EU leaders have limited any shift in the centre of gravity towards decision-making in the format of eurozone only. Van Rompuy, who initially gained a reputation for leaning too much towards Franco-German views, has developed a sensitivity towards the concerns of member-states that are not in the eurozone. In particular, the ‘pre-ins’ who are yet to adopt the common currency have a vital interest in long term arrangements in the eurozone. Member-states such as Poland therefore welcomed the decision to have the president of the European Council also chair euro summits as a small step towards greater transparency in the eurozone. But one might wonder if this arrangement can continue if Van Rompuy’s successor does not come from a euro ‘in’ country. It could well serve as an invitation to the French to renew their advocacy of the eurozone-only format.

Moderate on macroeconomics. The eurozone failed to register growth in the second quarter of the year and Italy slid back into recession. This will almost certainly bring the debate on ways to provide economic stimulus back to the EU leaders’ level. A new European Council president will find it very difficult to bridge divergent views on eurozone matters; anyone with strong views on either side of the stimulus debate will not get the job. The best that Van Rompuy can do is to focus on candidates who do not come from a major debtor or creditor country and are not closely associated with a particular view on macroeconomic policy.

Assertive towards the European Parliament. On paper, the European Council president should only report to the members of the European Parliament (MEPs) after EU leaders' meetings. But Van Rompuy understood the importance of nurturing relations with MEPs, who together with the EU Council exercise EU legislative powers. Yet he avoided setting any precedents which might give them even more power. He firmly resisted calls by the President of the European Parliament, Martin Schulz, for a seat at the European Council. Now that the European Council, by endorsing Jean-Claude Juncker as Commission president, has effectively accepted the Spitzenkandidaten process, the European Parliament is hungry for more influence. The European Council, and its deliberations on EU economic governance, is next on the menu. But the Parliament has its own legitimacy problem: fewer and fewer people vote, and support for Eurosceptic movements is on the rise. It is a bad time for the Parliament to demand more power. The next European Council president should, like Van Rompuy, keep the MEPs at arm’s length. Instead, he or she should champion a debate on how to plug national parliaments better into EU policy-making.

Good mediator with a small ego. Van Rompuy proved to be an efficient honest broker. In 2013 he managed to reconcile the interests of net contributors to and beneficiaries of the EU budget, and strike a fair deal on the long-term financing of the Union. But seeking consensus among EU leaders is a difficult balancing act, even for a president who is held in high regard and who has the ability to keep personal ambitions in check. The European Council in December 2011 illustrates it. Ultimately, Van Rompuy could not prevent David Cameron, the British prime minister, from vetoing a revision of the EU treaties to introduce stricter discipline on member-states’ budgets. Cameron arrived in Brussels with a wish list, on which he would not compromise. Van Rompuy's successor will have to deal with failures he cannot be blamed for and broker deals without claiming credit for them.

Critical but understanding of the British. If Van Rompuy were asked what made his job particularly challenging, he would probably point to the ‘British question’. In his Bloomberg speech in January 2013, David Cameron announced a radical redefinition of the UK’s relationship with the EU. Should the UK seek a renegotiation of its membership after the next general election, in May 2015, the European Council will be the primary forum for deciding whether to revise the EU treaties and consider Cameron’s wish list of reforms. The contenders for Van Rompuy’s job should have a good understanding of the dynamics of Britain’s engagement with Europe, and where to look for common ground with other member-states.

Finding a candidate that matches this profile will not be easy. It will be even harder because of competing demands for ‘balance’. The European Council will be expected to give one of the two top jobs to a representative of the Party of European Socialists (since Juncker is from the centre-right European People’s Party). The centrist Alliance of Liberals and Democrats for Europe, despite losses in the May elections, would like a reward for their pivotal role in the EU legislative process. There will be criticism if none of the top posts goes to a woman. And Van Rompuy will also have to deal with the insistence of the Central European countries that they are no longer junior partners and should hold one of the top posts. The EU, beset by crises, has no time to train a novice, so Van Rompuy’s successor should ideally be a current or former European Council member.

Names that would fit most of the criteria and are probably on Van Rompuy’s list already include Donald Tusk (Poland), Helle Thorning-Schmidt (Denmark), Valdis Dombrovskis (former Latvian prime minister) and Andrus Ansip (former Estonian prime minister). Dombrovskis and Ansip have now been nominated by their countries to be Commissioners. This does not rule out the possibility that one of them could emerge as a late compromise candidate, but it suggests that the Latvian and Estonian governments do not expect them to be chosen.

That would leave Tusk and Thorning-Schmidt. The fact that neither comes from a euro ‘in’ country counts against them. Some member-states may fear that it would be harder for them to insist on keeping the eurozone discussions at the level of the 28 rather than the 18. These concerns are not shared in London. And David Cameron feels that Thorning-Schmidt would be more responsive to British concerns than Tusk.

Tusk’s advantage is that Poland is committed to adopt the euro in the future, whereas Denmark has a permanent opt-out. His appointment would also recognise Poland’s rapid economic and political progress since joining the EU. Tusk enjoys friendly relations with Angela Merkel. On the other hand, the German chancellor values him as a reliable counterpart in neighbouring Poland, and as such she may prefer that Tusk stays at home for now. Merkel also wants to keep the UK in the EU. She will support a candidate who can best tick the ‘British question’ box. These two points tip the balance towards the Danish candidate.

If Denmark’s euro ‘out’ status makes Thorning-Schmidt unacceptable to some member-states, Van Rompuy should be ready to twist some more arms, like that of Enda Kenny, the Irish taoiseach. He comes from a euro ‘in’ country, and enjoys good relations with the British. Ireland has completed the financial assistance programme and has a liberal economic outlook, but needs policies that will boost growth. This may make Kenny acceptable to both the southern and northern blocs.

One final complication for Van Rompuy: he will have to secure unanimous support for his successor. The EU treaties allow a vote on the European Council president, but leaders will probably resist this way of breaking the impasse. A lack of unity would damage contenders’ credibility at home and in Brussels, a risk that active politicians are unwilling to take. So brokering a consensus among the 28 over his successor is likely to be the final and biggest test for Van Rompuy’s conciliation skills.

Agata Gostyńska is a research fellow at the Centre for European Reform.