Thursday, November 13, 2014

Iran nuclear talks: Patience is a virtue

When negotiators from Iran and the EU3+3 (France, UK, Germany plus the US, Russia and China) reached an interim agreement in November 2013 restricting Iran's nuclear programme, they set themselves a one-year deadline for sealing a comprehensive, long-term agreement. That deadline expires on November 24th. Now Western governments have to decide whether negotiators should stick with the deadline or extend the talks. They should choose the latter; the current geopolitical context does not favour the West and, in time, low oil prices could force Iran to compromise.

On the face of it, a deal should be within reach. The main point of disagreement is the number of centrifuges – tools for enriching uranium – Iran should be permitted to have. The more it has, the faster it can enrich enough uranium to build a nuclear weapon. US Secretary of State John Kerry has said he wants to ensure Tehran cannot build a bomb in less than one year. So far the Iranian government has built 19,000 centrifuges and says it intends to build at least twice as many. But the US and others want to reduce the number to the low thousands.

Under the November 2013 interim deal, Tehran agreed to suspend its uranium enrichment activities, dilute some of its higher enriched uranium stock and halt work at three nuclear sites. It also agreed to allow increased monitoring by the International Atomic Energy Agency (IAEA), the international nuclear watchdog. In return, the US and the EU, which had restricted Iran’s ability to sell oil and natural gas through a tough sanctions regime, released several billion dollars in Iranian oil proceeds and allowed access to specific goods, including medicine and aircraft spare parts.

The ‘prize’ of a successful negotiation is containing the spread of nuclear weapons in the Middle East. A comprehensive agreement would bring a dose of badly needed good news to the volatile region, and make a US or Israeli military strike unlikely. A deal would show that multilateral diplomacy involving the West and Russia can solve thorny international issues even when relations are tense because of the Ukraine crisis.

Even a comprehensive deal would not make Iran a friend of the West. But it would reduce the level of animosity and offer the prospect of a pragmatic détente. There are a number of regional issues which would benefit from greater co-operation, such as the conflict in Syria, Iraq and the threat from the terrorist group ISIL (the Islamic State in Iraq and the Levant), and the stability of Afghanistan. A deal would also help to revive Iran’s economy, for example by attracting investment into Iran’s energy sector.

Under a comprehensive deal the West may have to tacitly accept that Iran has the technical potential to develop a nuclear weapon. But Iran’s leaders would need to dismantle or roll back parts of the country’s nuclear programme, allow invasive inspections, make credible offers of transparency and accept that sanctions could be reinstated anytime. As economic and geopolitical realities influence the negotiations, Ayatollah Khamenei, Iran’s Supreme Leader – and his president, Hassan Rouhani – may not see the need to compromise enough to achieve a deal.

The US and Europe are using economic sanctions, particularly against Iran’s financial and energy sectors, to extract concessions at the negotiating table. Iran’s economy has suffered as a result: according to the US State Department, it is 25 per cent smaller than it would have been if it had continued to grow at its pre-sanctions rate. The economy has been in recession, Iran cannot market most of its vast energy resources and foreign reserves worth more than $100 billion (€80 billion) are out of Tehran’s reach, mostly locked in Asian banks.

However, Iran has had some success in circumventing the sanctions. According to the Central Bank of Iran, the first quarter’s growth rate was 4.6 per cent over the same quarter in 2013. Unemployment has dropped, and inflation has come down from 45 per cent to 27 per cent. The bank argues that the Iranian economy may recover, even under sanctions. If President Rouhani can deliver growth through negotiated sanctions relief and sanctions busting, he will have less interest in compromising during the nuclear talks.

In 2014, Iran’s national oil company exploited a loophole in the sanctions regime; exports of natural gas condensates – a very light oil – are only partially restricted. The interim agreement caps Iranian crude oil exports at 1 million barrels per day. But according to the International Energy Agency (IEA), in 2014 Iran exceeded the export cap by nearly 400,000 barrels per day ‒ mostly in the form of condensates ‒ adding $3.3 billion to the Iranian treasury.

Iran is also trying to attract the interest of foreign investors. In October, President Rouhani publicly endorsed a business roundtable in London that discussed post-sanctions economic opportunities. Tehran is luring international energy companies to return by offering them more profitable conditions, even though sanctions would only be lifted after a comprehensive deal was reached.

At the same time, cracks are appearing in Europe’s sanctions edifice. A ruling by the European Court of Justice (ECJ) on September 18th, citing procedural mistakes, annulled some of the EU’s restrictive measures against the Central Bank of Iran. On October 7th, another ECJ ruling in favour of Iran’s national tanker company allowed its assets to be unfrozen. While the EU responded by putting the company back on its sanctions list, these rulings suggest more of the sanctions package could be legally unpicked.

Iran may also be decreasingly willing to compromise for geopolitical reasons. US-led efforts to target ISIL are strengthening Iran’s regional influence. ISIL is an adversary of Iran’s allies in Damascus and Baghdad, and the group has targeted Shia communities and their holy sites in Iraq. In response, Iran’s Revolutionary Guard Corps helped prevent the fall of Irbil in August and is training Shia militias. Meanwhile Iran continues to prop up President Bashar al-Assad and offer him military backing through its Lebanese proxy group, Hizbollah.

A rapprochement between the US and Iran seemed possible in the run-up to US airstrikes on ISIL in late August. But Iranian officials have tied co-operation against ISIL to American leniency on Iranian centrifuges. The United States has made the opposite linkage: President Obama reportedly told Ayatollah Khamenei that co-operation against ISIL depended on Iranian nuclear concessions. But Iran has more influence on the ground in Iraq and Syria than the US does, and Obama is under domestic political pressure to deliver results against ISIL, strengthening Iran’s hand in the talks.

The Ukraine crisis could also help Iran’s negotiating position. Western negotiators say that Moscow is not letting the conflict in Ukraine contaminate the talks. But Russian attempts to frustrate Western diplomacy have emerged. In the energy domain, Iran and Russia are competitors. Yet Tehran is flirting with Moscow, hoping to agree on an oil-for-goods swap, which would see Russia importing 500,000 barrels per day from Iran and sending Russian manufacturing and drilling equipment in return. If relations between the West and Russia become more strained, this arrangement could go ahead, undermining the sanctions regime and Iran’s incentive to make a deal.

The oil price is another reason why Russia may not want a deal now and could be advising Iran to hold out. Any nuclear agreement will raise the prospect of more Iranian oil exports, putting downward pressure on the oil price. This would further harm a Russian economy dependent on oil exports and hit by Western sanctions over Ukraine. (The oil-for-goods swap would make sense to Moscow as the agreement would keep Iranian oil off the international market, while Russia would pay in kind, leaving spot oil prices undisturbed).

Although a compromise may be out of reach at present, neither the West nor Iran has an interest in talks breaking down. The Obama administration has invested significant political capital in a deal and sees it as a possible foreign policy legacy. For the majority-Republican US Congress, however, failed negotiations would confirm that the administration's diplomacy needs to be replaced by a more muscular policy of harsher sanctions. A reluctant Obama would face new pressure to put a military option back on the table.

Collapsed negotiations and a tougher US approach would cause splits in the EU3+3. Russia and China would consider bilateral trade and energy deals with Iran, and European companies would push their leaders to take a softer stance on sanctions. The sanctions regime could unravel.

America’s regional allies have been sceptical about the interim agreement from the start. If diplomacy failed and Iran resumed work on its nuclear programme, Israel and Saudi Arabia in particular would take counter-measures. These might range from lobbying Washington to take military action, to (in the case of Israel) launching unilateral military strikes or (in the case of Saudi Arabia) pursuing a nuclear option itself.

For Iran, the collapse of negotiations would put pressure on President Rouhani from hardliners to accelerate a weapons programme. On the economic front, the re-imposition of sanctions, or further measures, would be painful. Politically, Rouhani would have to gamble either that international solidarity would crumble, or that America’s next president would be as willing as Obama to try to do a deal, while facing opposition from Congress and US allies in the Middle East.

So if, as seems likely, the November 24th deadline cannot be met, the interim agreement and the talks should be extended. Initially, this is in the interest of all parties. The Iranians would get the continued benefit of some sanctions relief without having made major concessions, and need not fear a military threat. The Americans and the Europeans would steer away from yet another Middle Eastern conflict and a deal would still be within reach. And Russia could continue to build its commercial ties to Iran, without risking nuclear proliferation along its southern borders.

Looking ahead, an extension should favour the EU3+3. Due to the serendipitous ‘fracking’ revolution, America’s geopolitical clout is growing. US oil is flooding the market (and Saudi Arabia too is keeping the spigot open). In combination with slowing Chinese demand for energy, oil prices are now at their lowest point in four years. The IEA expects growth in oil demand to slow in 2015 and the International Monetary Fund (IMF) has adjusted its growth forecast for China downward. It suggests oil prices will remain down. The oil price at which Iran’s budget is balanced lies between $120 and $130, while the current market price is roughly $75-80. Iran’s economic recovery could be short-lived as low oil prices hurt its bottom line and offset likely gains from sanctions busting. Even a Russian-Iranian oil-for-goods deal would not be sufficient to keep its economy afloat. President Rouhani recently hinted at Iran’s vulnerability to the price slump. The longer it lasts, the more pain it will cause to Iran’s economy. An extension of six more months would allow the oil price to do its work on Iran’s willingness to compromise in the nuclear talks.

A sceptical US Congress could still try to derail an extension by imposing new sanctions on Iran. A two-thirds majority in both the Senate and the House is required to block a presidential veto. The House is strongly opposed to the talks, but Obama should be able to convince enough senators to back an extension.

By designating Catherine Ashton as the EU’s mediator on Iran, after her term as High Representative expired, the EU has signalled it could live with an extension. But the EU and its member-states should ensure that the loopholes in the sanctions regime – for instance on natural gas condensates – are closed, that EU lawyers successfully defend the sanctions regime at the ECJ, and that European companies that circumvent sanctions are fined – something which until now Europe has left to prosecutors in the US.

A deal might still be struck this month, but the odds are that it will not. In that case, Americans and Europeans should use their economic leverage to get a better agreement later.

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

Monday, November 10, 2014

Does a eurozone slump make Brexit more likely?

Two years ago the British economy was performing in line with the eurozone’s. Since then, it has grown rapidly and the country’s Office for National Statistics (ONS) has announced that the 2008-9 recession was shallower than previously thought (see chart 1). Over this period, the eurozone economy has stagnated, leading to a big gap in growth rates. Indeed, the UK has now performed better since the first quarter of 2008 than Germany, the eurozone’s supposed ‘star performer’, let alone the eurozone as a whole. Is this superior performance likely to continue? And what will it mean for the UK’s relations with the eurozone and its membership of the EU?

The UK suffered one of the biggest economic shocks of any member of the EU in 2008. The crisis led to a large contraction in financial and business services, a major industry in the UK: Britain faced one of the biggest banking sector crises of any EU country, with the government having to provide unprecedented support to crippled financial institutions. How has the UK done not only much better than comparably hard-hit eurozone economies, but also better than less hard-hit ones?

Chart 1: Economic growth

Source: Haver

The principal reason for the UK’s outperformance is macroeconomic policy. First, Britain has imposed less austerity than other hard-hit members of the euro. The UK’s coalition government has talked tough on the need for austerity but since 2012 has eased up considerably; in 2014 fiscal policy has boosted growth slightly. The UK’s structural deficit – the government’s deficit adjusted for the economic cycle – is on course to rise this year and is now the highest in the EU (see chart 2). Second, the Bank of England has pursued a much more expansionary monetary policy than the ECB. It cut interest rates faster and more aggressively than the eurozone’s central bank and has held them at record low levels first in the face of higher than target inflation and more recently against the backdrop of a recovering economy. The Bank of England also launched quantitative easing in 2009, which succeeded in stimulating the economy.

Chart 2: Structural budget deficits (per cent, GDP)

Source: Haver

A number of other factors have no doubt contributed to the UK’s stronger performance. Crucially, the British government moved quickly to clean up the country’s banks, taking stakes in the hardest-hit and winding up others. Partly as a result, credit growth has not been as weak as elsewhere. And timely action to recapitalise the banking system means that British banks are in a better place to respond to increased demand for credit than those in many eurozone economies.

The structure of the UK labour market has no doubt contributed to the relative resilience of private consumption. After the crisis, unemployment rose less than one might expect, given the steep drop in output. There appears to have been a number of reasons for this: firms were loath to let go hard to replace skilled workers, businesses slashed labour-replacing capital investment; and a large number of workers moved from full to part-time work. This helped prevent the huge increases in unemployment and hence collapse in consumer demand (and investment) seen in parts of the eurozone.

The surprisingly strong rebound in house prices does not seem to be having much of an impact on economic growth.  A strong housing market can boost consumption as home-owners borrow against the rising value of their homes or run down their savings (believing that the rising value of their homes cushions them from future risks to their income.) But there is little equity release taking place and house price inflation is heavily concentrated in London; prices across much of the country remain pretty depressed.

Finally, the weakening of sterling in the wake of the crisis has not enabled the UK to steal a march on the eurozone by virtue of having a cheap currency. Sterling fell from €1.50 in January 2007 to a low of €1.09 in January 2009, before recovering steadily to €1.27 in October 2014. At such, it is not undervalued relative to its long-term trend, trading at around the level it was at just prior to its ejection from the European Exchange Rate Mechanism (ERM) in 1992 (see chart 3). Secondly, Britain’s trade deficit with the eurozone has ballooned since the beginning of 2008 as growth in British domestic demand has outpaced that of the eurozone. The UK is certainly not guilty of ‘beggaring’ the eurozone: quite the reverse.

Chart 3: Pound-sterling’s real effective exchange rate

Source: World Bank

Can the UK’s outperformance be sustained?  Business investment is finally recovering, making the economy less dependent on consumption. Employment is rising quite strongly, and the number of full-time jobs is rising and the total of part-time ones shrinking. The fall in unemployment should eventually see real wage growth turn positive. Strikingly, the UK has experienced one of the largest falls in real wages of any EU state since 2008, which partly explains way immigration has become such a salient political issue.

Monetary policy will remain expansionary. The Bank of England is likely to delay raising rates until it is clear that recovery is firmly established and real wages have started to rise. That could be considerably longer than the markets currently assume. Although the UK economy is growing strongly, inflation pressures remain weak. Consumer price inflation stood at just 1.2 per cent in September (core inflation was 1.6 per cent). Given the high levels of corporate and household debt, any increases will be gradual. Once the general election to be held in May 2015 is out of the way, fiscal policy will be tightened somewhat irrespective of the outcome, holding back economic growth a bit.

The biggest cloud on the horizon is foreign trade. Exports to non-EU markets are up by around a third since 2008, whereas those to the eurozone are yet to return to 2008 levels. The UK’s sizeable current account deficit (of around 4 per cent of GDP) is entirely accounted for by trade with the eurozone. If, as appears all but certain, eurozone growth remains depressed for years, the UK’s deficit with it will continue to rise. And when the ECB finally launches QE, the euro is likely to weaken against sterling, exacerbating the trade imbalance. Despite the size of the UK’s external deficit, there is a risk of sterling strengthening too much, undermining the gradual recovery in investment in the tradable sector.

Chart 4: The UK’s current account balances

Source: Office for National Statistics

The UK’s economic prospects look reasonably good, but are flattered by the dire outlook for the eurozone. After expansion of a little over 3 per cent in 2014, most forecasters expect the British economy to grow by 2.5-3 per cent in 2015 and around 2.5 per cent the year after. Even the European Commission, which is notoriously bullish on the eurozone (resulting in it having to repeatedly revise down its numbers), expects the difference between eurozone and UK growth rates to be around 1 per cent in both 2015 and 2016. Most other forecasters expect a bigger gap.

What does this mean for relations between the UK and the eurozone? On the face of it, there is no reason why much stronger growth in the UK than in the currency union should harm relations. After all, Britain grew more rapidly than the eurozone in the decade running up to the crisis, and this coincided with a period of almost unprecedentedly good EU-UK relations. A Britain whose economy is expanding reasonably quickly could be more at ease with itself and with the rest of Europe. Concerns over immigration could dissipate, with attitudes returning to the grudging acceptance seen prior to the crisis. It could also become harder for the rest of the EU to ignore UK concerns about particular issues, helping to address the widely held perception in Britain that the country is unable to defend its interests.

However, there is a less optimistic scenario. Although real wages should start to edge up with the tightening of the labour market, it will take many years before they return to pre-crisis levels. As a result, popular resentment over immigration will remain a problem, especially as immigration from struggling eurozone countries set to remain high. At the same time, the UK’s net contribution to the EU budget will rise, reflecting its increased wealth relative to the EU average. This is likely to be happening at a time when Britain is becoming increasingly marginalised within the EU, partly because of its own lack of engagement but partly because it is not a member of the eurozone. Finally, the proportion of the UK’s trade conducted with the EU will fall steadily from the current 45 per cent. Although EU membership makes it much easier for UK exporters to access fast-growing emerging markets, eurosceptics will still cite the declining relative importance of EU trade as evidence of the diminishing benefits of being in the single market.

May’s general election will have a large bearing on which of these two scenarios is closest to reality. If the Labour Party wins or is able to form a coalition with the Liberal Democrats, there is a good chance it could be closer to the first. Relations with the EU would certainly be better than under the current government, although tensions over the EU budget, immigration and management of the eurozone would still be considerable. However, such a government will need a healthy majority if it is to resist pressure from eurosceptics within its own ranks to adopt a tougher line with the EU.

A Conservative administration, especially one with a small majority or even governing as a minority, will struggle to avoid the latter scenario. Much of the party is now eurosceptic and is bound to be even more so after the election. Egged on by the media, much of the party could agitate to leave the EU in 2017’s membership referendum. Antagonistic relations with the EU would isolate Britain, allowing eurosceptics to argue that it cannot defend its interests. With some justification, they would use rising budgetary contributions to argue that Britain is paying for the eurozone’s failure to get on top of its problems. And the fall in the proportion of UK trade done with the EU will be grist to the mill of those Conservatives who argue that the benefits of single market membership are exaggerated. In this case, economic outperformance could hasten Britain’s exit.

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

Friday, November 07, 2014

The European arrest warrant: A British affair

On Monday November 10th, the British Parliament will vote on Britain’s participation in the European arrest warrant (EAW) and other important European measures to fight trans-national crime. This vote will determine the future of Britain’s role in the area of EU policy known as Justice and Home Affairs (JHA).

Member-states used to agree JHA policies on an inter-governmental basis. The Treaty of Lisbon introduced a revolutionary change to the system, by placing JHA matters under the competence of the EU institutions and the supervision of the Court of Justice of the European Union (CJEU). Acts adopted before the entry into force of the treaty in December 2009, however, were not subject to CJEU authority during a transitional period of five years. This period ends on December 1st 2014.

Britain feared the increasing “Europeanisation” of JHA, and during the negotiations on the Lisbon Treaty it persuaded its partners to give it a block opt-out from measures adopted before the enactment of the treaty. For measures adopted after December 2009, the UK continues to enjoy its right to opt-in on a case by case basis; that is, only to measures it chooses to. The block opt-out from all pre-Lisbon measures was to be exercised before the end of the transitional period. In July 2013, the British government declared its intention of opting out of 130 JHA measures. Simultaneously, it announced that, for reasons of national security, it would opt back in to 35 of these measures, including Europol, Eurojust and the European arrest warrant. After some opposition (mostly from Spain) both the EU institutions and the member-states agreed that Britain could re-join the proposed 35 measures by the December 1st deadline.

The problem is that having convinced its partners that it should be allowed to opt back in, the British government may now fail to convince its own parliament. The timing of the vote could hardly be worse: with the rise of UKIP making many Conservative backbenchers nervous about retaining their seats in next year’s general election, the Conservative-led government is struggling to contain a parliamentary revolt by its own party.

Britain’s eurosceptics seem blind to the benefits of cross-border police co-operation. The 35 measures in question will help national police and intelligence forces to fight trans-national crime. Most of them do not imply any further transfer of competences to European institutions; instead, they are based on operational co-operation and mutual acceptance of member-states' judicial systems as equally valid. The majority of these measures, like Europol and Eurojust, have contributed greatly to Britain’s security.

Despite the long list of measures that the UK plans to opt into, criticism has centred on one particular instrument: the European arrest warrant. The EAW has, however, made extradition procedures smoother, faster, and cheaper.

Ironically, the EAW is based on a British initiative. In 1998, the then British home secretary, Jack Straw, suggested that the principle of ‘mutual recognition’ could be translated from the internal market to the criminal domain. In the single market, the principle of mutual recognition means that member-states recognise and accept each other’s lawfully marketed products. In the criminal domain, it implies that national authorities recognise and execute each other’s judicial decisions. The British proposal was based on the assumption that, by promoting mutual recognition of judicial decisions, further intervention from EU institutions in the area of criminal procedures could be avoided.

The events of September 11th, 2001 hastened the adoption of the EAW. The warrant was a necessary tool to fight terrorist networks which were spreading across borders. Member-states acknowledged the need to replace the 1957 European Convention on Extradition, which had become obsolete. The procedures of the non-EU Convention, to which all member-states were parties, were lengthy, expensive and allowed for a great level of political discretion, which complicated extradition procedures for offences such as terrorism.

The EAW was adopted in 2002 and came into force in 2004. Under the system, a warrant is issued by the judiciary of one member-state requesting that another surrenders someone. The warrant can be issued in order to carry out a criminal prosecution or enforce a custodial or detention order. The average time for surrendering individuals in contested cases is around 48 days, and in uncontested cases, a maximum of 15 days. This contrasts with the 18 months required on average to extradite a suspected criminal under the 1957 convention.

Warrants cannot be issued merely for investigative purposes. Member-states mostly apply the principle of double criminality, that is, a warrant can only be issued when the offence exists in both member-states. That means that, for example, a British national cannot be extradited to Greece for blasphemy if the action does not qualify as an offence under British law.

Under the EAW system, the principle of double criminality does not apply to 32 serious offences, such as terrorism or human trafficking. In such cases, if the law of the member-state applying for extradition provides for a sentence of more than three years for the alleged offense, a suspect can be extradited without verifying that their action would have been criminal in the member-state where they were detained. One of the objectives of establishing a list of serious offences subjected to expedited procedures is to avoid political interference in an otherwise purely judicial issue.

In 2013, EU member-states surrendered 127 suspects to the UK under the EAW regime, in contrast with the 19 surrendered in 2004 when the EAW came into effect. Likewise, the number of people handed over by the UK to other member-states increased from 24 in 2004 to 1,126 in 2013. The overwhelming majority – 96 per cent – of suspects extradited by the UK were not British nationals.

The EAW has contributed to the smooth handling of high-profile cases, such as that of Hussain Osman. Osman, a British national, was a suspect in the 2005 London bombings. He was swiftly extradited from Italy after the British authorities issued a European arrest warrant, and subsequently prosecuted in the UK. The EAW has also contributed to reducing the number of British fugitives absconding to Spain’s ‘Costa del Crime’.

Like any other ground-breaking legal instrument, the EAW has flaws which have become more evident with time. Some member-states issue too many warrants for minor offences. Poland is the main culprit: its prosecutors are required to issue warrants for all offences, regardless of their importance. Reform is underway to tackle the issue of proportionality in a way that still acknowledges Europe’s legal diversity. In 2014, the European Parliament proposed the introduction of a proportionality test to reduce the number of warrants. Poland and other countries are also introducing reforms to address the problem.

The EAW’s critics also argue that the current rules do not ensure that the basic rights of suspects facing extradition are equally respected in all member-states. This argument is often used to underline the risk that UK citizens suspected of crime may be prosecuted in countries which have fewer procedural rights than the UK.

This is a question of mutual trust. An efficient extradition system cannot work if member-states do not rely on each other’s legal order. But trust can be improved through knowledge. Further efforts should be made at the European level to increase the understanding of other national systems among national authorities. The EU should have more ‘exchanges programmes’ of legal practitioners, so that they can learn about each other’s systems, and it should strengthen existing forums of judicial co-operation such as Eurojust (the EU agency dealing with judicial co-operation in criminal matters) or the European Judicial Network (a network of European national authorities for the facilitation of co-operation in criminal matters).

Member-states would trust each other more if fewer extradited people faced unfair or lengthy pre-trial procedures. There are currently a number of European and national instruments that can be used to that effect. As the CER has previously argued, the European Supervisory Order (ESO) could be used more efficiently. Under the ESO, the authorities of a member-state can ‘outsource’ the supervision of a suspect to their home member-state until the trial is opened. This would allow, for example, British suspects sought by other member-states to remain under the supervision of British police while awaiting their trial. The ESO has not yet been transposed into UK law, since it is one of the 35 measures subject to the December vote. The British Parliament has, however, already agreed on an amendment to the Extradition Act with the aim of delaying the extradition of suspects until trials are ready to start.

Finally, the functioning of the EAW also depends on the member-states’ willingness to move forward with the Commission’s 2009 ‘roadmap on procedural rights’. The roadmap foresees a number of legislative measures aimed at granting equal and uniform protection to suspects and defendants across Europe. Some of the measures envisaged by the roadmap (such as the directive on interpretation and translation) have been already adopted. Others, like the directive on the presumption of innocence, are currently being discussed. The UK has been very keen on the adoption of these measures.

If the UK opts out of the EAW, it could revert to the inefficient 1957 Convention system. Alternatively, the British government could seek to conclude bilateral extradition agreements with each of the other 27 member-states. But this would be very complicated. Other member-states are increasingly fed up with the UK trying to pick and choose between measures it likes and dislikes; Spain tried to block the UK’s opt-in to the 35 JHA measures because it argued that some of those the UK wanted to opt into were intrinsically linked to others it wanted to stay out of. Some member-states would have to amend domestic legislation to enable continued cooperation with a UK which was no longer in the EAW system. This may make bilateral agreements very difficult to conclude.

Another option for the UK, if it opts out of the EAW, would be to negotiate an extradition agreement with the whole EU, mirroring the one concluded between the European Union on the one side and Norway and Iceland on the other. But there are, at the very least, two problems with this idea. First, it is not clear that the EU can conclude such an agreement with one of its own member-states (the EU treaties currently only allow for agreements with non-EU countries). Second, the agreement foresees a system almost identical to that of the EAW (same surrender procedures, same list of 32 offences, same deadlines and so on). Therefore, if such an agreement was to be concluded between Britain and the EU, many UK concerns about the operation of the system would remain.

Opting out of the European arrest warrant would also be expensive. With longer procedures, and large numbers of foreigners waiting in detention facilities to be extradited, the UK would have to spend more money on extradition cases.

Finally, opting out of the EAW may also have a negative impact on the relationship between the UK and some of its key partners, not least the Republic of Ireland: under the 1957 Convention, politicians had more power over extradition cases and it was often very hard, for example, for the UK to extradite suspected terrorists from Ireland. Terrorist cases were regularly contested between member-states, mainly for political reasons, hindering effective co-operation.

Staying in the European arrest warrant should not be turned into a political argument for more or less Europe. The EAW should be seen for what it is: an operational measure designed to support regional co-operation against cross-border crime, in an age when global criminal networks do not respect borders or national powers. Opting back into the European arrest warrant would ensure national security while promoting fair and speedy procedures for British nationals abroad. It would also ensure that the UK does not become a safe haven for criminals. MPs, however eurosceptic they may be, should listen to the law enforcement experts and vote to opt back in.

Camino Mortera-Martinez is a research fellow at the Centre for European Reform.

Wednesday, November 05, 2014

A Greek programme for Greece

Greece is currently negotiating its exit from the various programmes and ‘bailouts’ with its European and international creditors. Greece is still too weak to stand on its own, financially. But the problem is not the debt level alone, which is manageable over the short term because debt servicing costs are relatively low. The main issue is how to make Greece a prospering economy within the euro, after an epic economic depression and in the face of waning public support for further reforms. The country’s growth prospects will ultimately determine how much of Greece’s debt will get repaid. Of course, European policy-makers and the IMF could continue to muddle through, and Greece is unable to force them to change course. But with a crucial presidential election looming in early 2015 that could end the current government’s term and bring Syriza, the far-left party, to power, it is time to take stock. The Greek programmes had severe shortcomings that proved costly, both in terms of economic damage and in terms of popular legitimacy. What is needed is Greek ownership of further reforms, and a focus on long-term economic growth.

Taking stock

Over the last four years of crisis, Greece has never been the only – or even the main – problem in the eurozone. As a result, the eurozone’s Greek programmes have served other purposes: they have set a tough example for other countries, so they did not seek European money lightly; they have sought to prevent contagion to other countries and hence blocked a restructuring of Greek debt for a long time; by being tough, they have tried to preserve the political support in Europe’s northern core that might be needed if the crisis were to spread; and they have aimed to spare the fragile European banking system from ‘another Lehman’ because the Europeans failed to fully restructure and recapitalise their banks after 2008. At the same time, Greek society and its political leadership were ill-prepared for the crisis. They have struggled to collaborate with the IMF and the Europeans, neither of which knew the country well, in order to design an effective and inclusive reform programme.

The resulting programmes focused on cutting back spending and on sparing European and Greek private bondholders from losses. These wrenching fiscal cut-backs, together with the threat of a euro exit, predictably led to an economic depression: Greek GDP is currently 20 per cent below its 2009 level and hardly growing; unemployment stands at 26 per cent, three quarters of which is long-term unemployment. Greek public finances do show a primary surplus, that is, a surplus before the costs of servicing public debt have been subtracted. But with crumbling nominal GDP, Greek public debt has risen to 176 per cent of GDP – despite a massive haircut on private bondholders in 2012. Importantly, the depression has eroded the initial public support for an overhaul of the Greek economy and governance.

Structural reforms, meanwhile, focused on issues that were seen as crucial for Greece’s public finances: tax collection, cuts to public sector jobs, salaries and welfare, and privatisation. Some of these reforms were certainly needed, and Greece has been one of the OECD’s busiest reformers, according to the Paris organisation’s ‘reform responsiveness indicator’.

But they did little to raise Greece’s growth potential: public bureaucracy, regulation, the judicial system and land rights issues continue to weigh heavily on the Greek economy.

  • This recent EU Commission paper found that these constraints hold Greek exports back rather than uncompetitive prices or wages; 
  • Earlier this year, the OECD argued that Greek business could save €3.3 billion euro annually if the government removed unnecessary administrative burdens. 
  • The OECD also identified 555 regulations that severely hamper competition in the Greek economy.

Thus, the goal should be an overhaul of the way in which the political system and public bureaucracy works, which requires the support of the whole political spectrum, the public and the bureaucracy itself. It also requires action to reduce clientelism, which to a large extent is currently just on hold because there is very little public money to spend, or public jobs to fill. These crucial reforms could take a decade – some even a generation – rather than a couple of years to implement.

The current state of the programmes

Overall, therefore, the limited political capital in Greece was not spent on what was most critical for the long-term success of its economy, and hence, its public finances. As a consequence, Greece’s European creditors are less likely to be repaid, despite extending loan maturities and pretending that Greece could grow strongly and run politically unrealistic budget surpluses for years. The current round of negotiations between the Greek government and the ‘troika’ of the European Commission, the IMF and the ECB over the final review of the second adjustment programme could now be the breaking point.

The government cannot agree to the troika’s demands – a highly unpopular pension reform and making it easier to lay off workers collectively, among other things – in return for the final tranche of €7.2bn. In addition, the government would like to exit the programme entirely before the elections, foregoing further IMF funds pencilled in for 2015 and 2016, a plan that the troika rejects. Finally, it would like to reduce the amount of intrusive monitoring and outside interference, despite needing at least a precautionary credit line from either the Europeans or the IMF before it can safely return to markets – credit lines that usually come with significant outside monitoring.

The reason is clear: politically, the government has its back against the wall, ahead of the presidential election in February 2015. Under the Greek constitution, the president is elected by the parliament, and the winning candidate will need a three-fifths majority (180 votes). At present, the government only has 154. The remaining 26 votes need to come from either the former coalition partner DIMAR or independent MPs, both of which loath to help the government. If the parliament fails to elect a new president, there will be snap elections, one year ahead of time. The current government coalition is highly unlikely to win: the far-left Syriza is leading in the polls with roughly 33 per cent, compared to the main governing party, New Democracy, at just 26 per cent and PASOK, the junior coalition partner, down to 6 per cent.

If Greece elects Syriza, the eurozone would be back in unchartered territory. Syriza has vowed to reverse cuts to public spending, wages and pensions, and to cancel or at least substantially renegotiate the agreement with the troika. Given that Greece cannot stand on its own, financially, unless it defaults unilaterally on its debt, both sides would be on a collision course. Greece would be destabilised and less likely to repay its debt. It also might spook investors beyond Greece. Of course, the ECB has made it clear that it intends to prevent contagion from spreading across the eurozone. But the collision with Greece might come at a bad time. If eurozone growth continues to disappoint, the ECB has to use further unconventional measures (thereby enraging the German public), and Italy challenges the current policy course more openly, a collision with Greece might add fuel to the fire.

What Europe should do

The widely respected mayor of Thessaloniki, Yiannis Boutaris, has recently called for a national unity government of all the major parties. The EU should take the cue and try to find a long-term solution to Greece’s economic woes and its public debt that has broad support across the political spectrum; that ensures Greek ownership of further reforms; and that, based on local knowledge, removes the most binding constraints that currently hold Greek growth back.

One way would be to create a Greek reform council, consisting of Greek experts and representatives of Greek civil society, which would draft a long-term reform programme that the major parties in parliament – and the Greek public – can agree on. This programme should, at the same time, leave enough room for democratic decisions on policies. Europe and the IMF should continue to offer their technical help but mandate the Greek reform council with the monitoring of its new reform programme. In addition, a clear agreement should be made: that after a successful completion of the programme, Greek debt will be written down to a sustainable level. How much debt is sustainable is impossible to predict and depends on Greek growth, but it would be an effective incentive to make sure the reform council is a success. In the meantime, the European Stability Mechanism (ESM), Europe’s main bailout fund, should extend a precautionary credit line that the Greek government can draw on in case the markets are not willing to fund it at reasonable rates, conditional on the progress of the reforms.

Why would the current leader in the polls, Syriza, agree to such a Greek reform programme and reform council, just before the opportunity to come to power? Syriza’s problem is that it has to prove to the Greek public that it would not further destabilize the Greek economy. The threat of a euro exit scares the public. According to the latest Eurobarometer poll, 59 per cent of the Greek population still approve of the euro – which, strikingly, is above the eurozone average, and considerably above Italy’s 43 per cent. A genuinely Greek reform programme and a stable, long-term agreement with the rest of the eurozone and the IMF might give Syriza the credibility it needs. If early elections in the summer of 2015 were part of the agreement, Syriza’s chance of winning an outright majority might actually be higher than it is now.

What is more, Alexis Tsipras, Syriza’s leader, could use this Greek reform programme to discipline his party, which is a loose association of various socialist groups. At the same time, he would have enough leeway to push through some Syriza policies. Finally, Tsipras would preside over a light-touch monitoring of a genuinely Greek reform agenda, rather than having intrusive troika visits every couple of months; and he could avoid a stand-off with the EU that deep down he knows he cannot win without causing further short term damage to the Greek economy.

The eurozone would gain from a realistic long-term strategy for Greece that ensures a maximum amount of useful reform and economic growth. Such a long-term solution would also, despite writing down Greek debt, ensure that Greece’s official debt would get repaid as much as possible, and end the current charade of extend and pretend. If eurozone policy-makers continue to muddle through with Greece against a fading momentum for change, the Greek economy will remain half-reformed and continue to struggle inside the euro. Eventually, the political tension might spread beyond Greece.

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

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.