Wednesday, July 23, 2014

The EU and an independent Scotland

Scots living in Scotland vote on September 18th on whether to end their 300-year union with England. If they win, the nationalists aim for actual independence, and full EU membership, in March 2016. Opinion polls currently show a lead for the pro-Union side, but 15 or 20 per cent remain undecided. The debate is becoming heated, with arguments concentrating on the economic risks and opportunities of independence. The EU dimension has attracted less attention, with each side brusquely dismissing the other's assertions. Most Scots want to stay in the EU: the nationalists assert that this would be quick and easy; their opponents predict problems; impartial voices go largely unheard. Here are eight points which Scots might like to consider.

1. Beware those who say all is clear

 … it isn't. Anyone who says that it's certain the Scots could, or could not, have their own seat at the Council table from 2016 is driven more by advocacy than analysis. The fact is that the EU would be in uncharted waters. There is neither precedent nor treaty provision for a member-state splitting, with both parts wishing to stay in. Greenland chose to leave in 1985, with metropolitan Denmark negotiating its exit. The Czechs and Slovaks had split long before they joined in 2004. The EU is treaty-based: only independent states can negotiate and sign treaties. There would be concern in Brussels not to deprive EU citizens of EU rights because they live in Scotland; but the treaties are clear that EU citizenship is the corollary of citizenship of a member-state. And Scotland could not become a member-state until the relevant new treaty provisions came into force. Whether this circle can be squared is as yet uncertain. Don't believe anyone who says it definitely can or can't be.

2. Remember it isn't just up to the Scots

… or London, or even Brussels. All existing member-states would have to agree that Scotland could join, with their governments agreeing the terms, and their parliaments (or referendums) ratifying their decision. National governments have a natural aversion to secession: several EU countries that were ready to fight to stop Serbian ethnic cleansing in Kosovo can't yet bring themselves to recognise the fact of Kosovar independence from Belgrade. The oft-drawn parallel between Scottish and Catalan separatism is not exact: the Scots and English have always had different legal systems, and Scottish nationalists want to keep the Crown. Of course, the arguments for respecting the democratic will of the Scots would be strong; but so, in some EU capitals, might be the desire to demonstrate to domestic secessionists that the road to independent EU membership could be long and winding. Other countries could have other preoccupations; and nothing happens unless everyone signs up to everything.

3. Aim to settle the divorce terms first

… because the EU will adamantly refuse to mediate between London and Edinburgh. Getting involved in a domestic dispute between constituent parts of a member-state is off-limits for the Brussels institutions and would be anathema to other member-states. So full prior London/Edinburgh agreement on, for example, the division of UK assets and liabilities, and future currency and regulatory arrangements, would be a certain Brussels pre-condition for membership. Continuing disputes over an issue unrelated to EU membership could also cause knock-on delays if it meant that full UK government co-operation in Brussels was for a time withheld: the Trident nuclear submarines might be one such issue (the nationalists say they would insist on the Royal Navy vacating the Scottish bases that are essential for its strategic nuclear force). Unravelling the skein of the union would in any case take time, even with goodwill on both sides.

4. Negotiations should be easier

… with the EU than with London, provided Scottish negotiating aims are realistic. The Scots already respect all current EU laws, though discrimination against their English, Welsh and Northern Irish neighbours, for example on student fees, would become a breach of EU law when the two countries became separate member-states, and would have to cease. Those who argue that the Scots would be required to adopt the euro haven't noticed that Scotland would fail all the economic tests for candidates for eurozone membership: a declaration of intent to join at an appropriate unspecified future date would probably suffice. Equally implausible is the suggestion that the Scots would be obliged to join the Schengen area of passport-free travel, leaving the current UK/Ireland common travel area. Common sense would prevail, making it probably enough for Edinburgh to express a willingness to join Schengen whenever Dublin and London do. Voting weight in the Council is now determined automatically, by reference to population, and Scotland could expect to keep its six seats in the European Parliament (and might indeed be able to mount a case for an extra three, on grounds of parity with Denmark, whose population is also 5 million.) But on the price of membership, Scotland's net contribution to the EU budget, the nationalists would need to drop their current breezy claim that they would be due a rebate similar to that secured for the UK by Margaret Thatcher in 1984. Existing member-states, many much poorer in per capita terms than Scotland, would not agree to pay more to let the Scots pay less. Mrs Thatcher's success was the product of a long campaign, fought from inside: the chutzpah of simultaneously seeking to join the club and pay a reduced subscription would be an obvious deal-breaker. And, in EU legal terms, Scotland would be outside, knocking at the accession door, because Brussels is clear that…

5. Leaving the UK would mean leaving the EU

... in strict constitutional terms. This legal view has been spelt out by the president of the European Council and successive Commission presidents, now including president-designate Jean-Claude Juncker. The residual UK, minus Scotland, would be the ‘continuator’ state, and remain at the EU table. Scotland, as a new state, would need to ask, from outside, for a new seat: the relevant accession procedures are laid down in Article 49 of the Treaty on European Union. Nationalists in Scotland disagree, and claim that separate membership could be achieved seamlessly from within, using Article 48, which sets out how existing member-states can seek to change the treaties. It is not clear, however, how they envisage overturning established Brussels doctrine, and there are strong legal arguments against using a general article (48) for an issue (admitting a new member) that is covered by specific provisions (Article 49). The key point is that the Scots cannot make up the rules. They may claim that the referee is wrong, but it is he who runs the game. It follows that ...

6. Minimising disruption matters most

A more constructive aim for Edinburgh would be to focus on seeking transitional arrangements to maintain the EU status of Scottish citizens during the hiatus between secession from the UK and full membership of the EU. Even in the highly unlikely event that the Scots managed to persuade the referee to reverse his ruling, and turn to Article 48, facilitating pre-independence negotiations, such a gap looks unavoidable, for two reasons.
(i) Recognition. Only sovereign states can sign treaties. Scotland would not be sovereign until independent. And before the Scots could sign an EU accession treaty, all existing EU member-states would have to recognise that independence.
(ii) Ratification. EU treaties do not enter into force until ratified by all signatory states. This takes time: in Belgium, for example, seven separate legislatures have to approve. And the EU is a convoy, moving at the speed of the slowest ship.
Countries whose accession treaties have been agreed but not yet universally ratified are usually allowed an observer's seat in Council of Ministers, though the right to vote and to nominate a commissioner has to await full membership. What would be novel (though not necessarily unachievable, given that the situation itself is unprecedented) would be an agreement that, de facto while not yet de jure, Scottish enterprises, farmers, fishermen, workers and students should retain their EU rights. This is what matters most, because ...

7. It would all take longer than you think

Settling the intra-UK divorce terms, a pre-condition for any EU negotiation, won't be easy. Even when campaign tempers cool, actual secession by 2016 looks unrealistic. The 2015 UK election will supervene, and may be followed by the distraction of a UK EU renegotiation and 2017 referendum, occupying Brussels' attention, and perhaps tempting other member-states to adopt a policy of wait and see. Scotland's position in the EU would clearly be very different if the residual UK were to leave. Negotiation (or informal pre-negotiation) before independence could be obstructed by other member-states (point 2 above); or held up by intransigence in London or Edinburgh (point 3): by over-bidding by Edinburgh (point 4); or by constitutional quarrels over the rules (point 5). And even if substantive terms, and sensible transitional arrangements, had been informally agreed before Scottish secession, the twin hurdles of recognition and ratification (point 6) would still lie ahead. So don't hold your breath.

8. Anglo-Scottish teamwork would be critical

To maximise the chances of escaping from the constitutional catch-22 that Brussels institutions may negotiate only with states, pre-independence discussions with Brussels would have to be led, at least notionally, by the London government. Nationalists in Edinburgh now recoil at the idea; and so might bad losers in London if the nationalists win on September 18th. Yet co-operation would be essential to success in Brussels, and UK embassies across the EU would need to work to an agreed UK/Scottish brief. And, apart from considerations of duty and equity, it would be in London's self-interest to help the Scots: if no transitional arrangements for Scotland were in place when the UK broke up, the task of manning the EU customs union's new frontier on the England/Scotland Border would fall to those south of Hadrian's Wall.

9. Remember point 1: No-one really knows

… for sure what a Yes on 18th September would mean for Scotland and the EU. I certainly don't, though I know the EU quite well. Sir David Edward, a Scotsman who served with distinction as a judge in the European Court of Justice, is right to ask Scots to question – in an article earlier this month – the purpose of "launching ourselves on this sea of uncertainty."

Full disclosure. I admit that, as a diaspora Scot disenfranchised by David Cameron's casual concessions to Alex Salmond, I hate the idea of my countrymen being obliged to choose between being Scottish and being British. I think the dichotomy as false as that between being British and European. Wider horizons create greater opportunities; and just as EU membership has greatly benefitted the British, so the 1707 Union has hugely benefitted the Scots. Long may both last.

Lord Kerr of Kinlochard is a former permanent under-secretary in the Foreign and Commonwealth Office and is chairman of the Centre for European Reform.

Wednesday, July 09, 2014

Will the eurozone gang up on Britain?

Both British eurosceptics and Britain’s continental critics believe some or all of the following: that the eurozone will have to integrate further; that the priorities of the eurozone will predominate over those of the euro ‘outs’; and that David Cameron will win nothing but minor reforms in any negotation.

In this view, the “remorseless logic” of eurozone integration will marginalise Britain to such an extent that it will be forced to leave the EU, since it will not join the euro. This argument has some merits – there is little reason to believe that the British have enough political capital to lead a push for major EU reform, for example. But the economic interests of the ‘ins’ and ‘outs’ are aligned to a greater degree than they are opposed. If these interests are managed with care, there is no reason why Britain should leave the EU.

The eurozone needs to integrate in two ways to become more stable. It needs a more integrated market for capital and labour, so that workers and capital can move easily to the places where they can be most productively employed. This would help it to respond to shocks more rapidly, and requires a deeper single market – one of Britain’s reform priorities. The eurozone also needs a way to share risk – a common budget, a common backstop for the banking sector, and further debt mutualisation – to help stabilise demand in countries in recession. There is little appetite in the eurozone for such a system at present, but the next downturn may force it to reconsider. Greater integration would make its economy less fragile – and would in turn help Britain. The eurozone is Britain’s largest trading partner, and its crisis has badly hit British exports, putting paid to hopes of an export-led recovery.

British fears that a eurozone ‘caucus’ will materialise, particularly on single market regulation, are overblown. The Germans, Finnish and Dutch have little interest in, say, extending ‘social Europe’ – and align themselves more with the British on social and employment rules. Western Europeans in general are as concerned about immigration from Central and Eastern Europe as the British, even if the tone of their newspapers and mainstream politicians is less hostile. Italian prime minister Matteo Renzi has made a deeper single market for services one of his priorities.

On extending the single market and free trade agreements, it is an exaggeration to say that eurozone member-states constitute a protectionist bloc, and are opposed to market liberalisation. To understand why, consider the Organisation for Economic Co-operation and Development’s (OECD) product market regulation indicators, which show how keen different EU member-states are to regulate their economies. Between 1998 and 2013, the eurozone and other EU member-states converged on the UK, as their levels of product market regulation were reduced more quickly than Britain’s (see Chart 1). Their overall level of product market regulation is now only marginally above that of the UK (the index ranks countries’ level of regulation between 0 and 6).

Chart 1. OECD index of product market regulation

Chart 2 shows the OECD’s measure of the willingness of countries to open their markets to foreign competition. It shows the same pattern of convergence as the overall index, and offers little evidence that the eurozone will club together to block free trade deals or the European Commission’s initiatives to extend the single market.

Chart 2. OECD barriers to trade and investment index

If the eurozone ‘caucus’ is going to be a problem, it will be in decisions on financial regulation. The City of London’s position as the EU’s dominant wholesale financial centre – and one that is outside the eurozone – would seem to suggest a major clash of interests. Many Britons fear that the the rest of the eurozone will gang up on the City in an attempt to shift activity to Frankfurt and Paris. However, the situation is more complex than City of London banks, the British media and eurosceptic think tanks suggest.

The UK has already won a double majority voting system on the European Banking Authority – the agency that writes EU ‘prudential’ financial rules, which seek to prevent the financial system from blowing up. Under the system, both eurozone and non-eurozone members must find a majority in favour of a financial rule. Eventually, if other member-states join the single currency, this system will have to be revisited, as it would end up giving Britain disproportionate power over regulation. But this is likely to be a long time coming: Poland, the Czech Republic, Sweden, Hungary, Croatia, Romania and Bulgaria do not look likely to join the single currency any time soon. Denmark has a opt-out from the euro, like the UK.

Moreover, British and eurozone member-states do not have serious differences over prudential regulation. The UK has gone further than most other EU member-states to force their banks to raise capital and liquidity, to reduce leverage, and to try to ringfence retail and investment banking. Before the crisis, the UK was rightly accused of running a light-touch regime. This charge no longer holds: now the problem lies in the difficulty of creating a eurozone banking union that is capable of preventing banking crises and limiting their effects when they do occur.

There are areas where the UK is losing its battles, but it is far from clear that a eurozone ‘caucus’ is to blame. The financial transactions tax is likely to be a lower tax on a smaller number of financial instruments than the original proposal, because the member-states that have signed up to it – several eurozone members have not – cannot agree on how much activity it should catch in its net. It may end up covering only shares and some derivatives. If so, the financial transactions tax would be similar to the UK’s stamp duty on shares, which also has extraterritorial reach: an investor from another EU member-state that sells a share in a British company must pay UK stamp duty. And the European Court of Justice has yet to rule on the final proposal. It may find that the extraterritorial scope of the tax means that it is illegal under the EU treaties (as the European Council's legal service has found).

But is not the European Central Bank’s (ECB) ‘location policy’ a sign of increasing regulatory protectionism on the part of the eurozone? Last week, the European Court of Justice started hearing evidence on the British government’s case against the policy, and if it rules in favour of the ECJ, City clearing houses specialising in euro-denominated trading will relocate across the Channel. The British media has turned the case into a test of the EU institutions’ willingness to balance British interests against those of the eurozone. The ECB’s rationale for the policy is not without justification: it argues that it should supervise clearing houses, since they will need emergency central bank lending in euros – ‘liquidity’ – if they get into trouble. Clearing houses are increasingly important bearers of risk, because complex derivatives – financial contracts that were at the centre of the 2008 crash – are being standardised and investors forced to trade them on exchanges. Regulators hope that this will make the risks in the financial system more transparent. If a clearing house gets into trouble, derivatives markets will freeze, unless the central bank keeps it going with liquidity. And in trades denominated in euros, most participants are large eurozone-based banks: the ECB has a legitimate interest in the supervision of this activity. The British should not blame eurozone protectionism for the ECJ’s ruling, if it concurs with the ECB.

There are a few other areas where it is possible to envisage conflict in coming years. The resolution of a eurozone headquartered bank with large operations in the City of London is one. The eurozone and the UK government may have opposing interests when it comes to resolution: eurozone authorities will seek control of the bank’s assets, even if a part of its balance sheet is under the Bank of England’s jurisdiction. There are unresolved questions about how banks that get into trouble in London will access ECB liquidity.

But the City of London’s position as the EU’s largest wholesale centre does not appear to be severely imperilled by the eurozone. And even where conflicts do arise, as a member of the EU, it can form alliances with other member-states to make changes to proposals and defend its single market rights at the ECJ. Rather, the potential for serious conflict lies more in the EU’s institutions and priorities than its rules. The solution lies in diplomacy.

The British government will have to get used to the fact that the top jobs in the next European Commission will mostly go to eurozone member-states, as the UK is the only rich and large EU country that is not in the euro. There is some sympathy in Northern Europe for the UK’s position. But the British are squandering this sympathy, by pursuing a strategy of threats, vetoes, and red lines. The source of the trouble is the Conservative demand for a renegotiated settlement as the price of the UK’s continued membership of the EU. This strategy was intended to appease English euroscepticism while securing policy changes at the EU level, but it has stoked anti-British sentiment to the degree that other member-states fear making common cause with the UK. And the strategy makes it harder to create the conditions for compromise between the interests of the eurozone, the UK government and the City of London that is needed to make Britain’s position – in the EU, but not in the eurozone – legitimate on both sides of the Channel.

The route to a new EU settlement will be slow and tortuous. The eurozone will probably have to integrate further to flourish, and, over time, some member-states who have committed to joining will do so. But there are few reasons why a political settlement between members of the single market and of the eurozone cannot be reached, if politicians will only try.

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

Tuesday, July 08, 2014

The eurozone’s real interest rate problem

When the UK was considering euro membership, former chancellor Gordon Brown suggested five criteria that needed to be met. The first, and arguably most important, concerned interest rates. Specifically, he said economies of the eurozone needed to be sufficiently compatible to live with common eurozone interest rates on a permanent basis. The recent crisis suggests they were not. The main underlying reason is that real interest rates, that is, the interest rates after adjusting for inflation, can diverge quite drastically in a monetary union – and unfortunately in the wrong direction, thereby amplifying boom and bust cycles. This is especially true in a diverse and decentralised monetary union like the eurozone. Fiscal and regulatory policies need to work aggressively against this phenomenon, to ensure countries grow steadily without protracted booms or slumps. Before the crisis, the eurozone clearly failed on this account. Today it continues to do too little to avoid such harmful divergence, which points to a period of low and uneven growth in the eurozone.

In the eurozone, market forces and the benchmark rates set by the European Central Bank (ECB) collaborate to make nominal interest rates converge in normal times. If there were differences, markets would make use of it and ‘arbitrage’ the difference away. As a result, nominal interest rates for government bonds or corporate loans across the eurozone are usually similar. However, it is real interest rates which ultimately matter for investment and consumption decisions because they represent the real cost of borrowing. If nominal interest rates are 2 per cent but inflation is also 2 per cent, the cost of borrowing is zero because everything will have become more expensive over the year. Since inflation rates differ across countries that are at different points of the business cycle, real interest rates can and usually are very different across countries in a monetary union.

Unfortunately, this divergence tends to amplify the cycle. When an economy is booming, inflation is usually high; whereas when an economy is stagnating or in recession, inflation tends to be low. Real interest rates will thus be low in booming countries with high inflation. This gives the boom a further push, as lower real interest rates encourage consumption and investment. In stagnating economies, where inflation is low, real interest rates will be high, further weakening the recovery.

Chart one: The difference between real interest rates for German and Spanish governments

Source: Haver Analytics, CER calculation; the calculation is simplified: 10 year government bonds minus current CPI (instead of inflation expectations).

Spain in the early 2000s is a case in point: the more the economy boomed and the more inflation rose, the lower real interest rates became (see charts). This stimulated the economy further, as low interest rates made investment (for instance in real estate) more worthwhile. Since there was no national Spanish interest rate but a eurozone one, such self-reinforcing dynamics played out almost uncontested – until the crash. In Germany, with low inflation and growth in the first half of the 2000s, the opposite was the case: low inflation led to high real interest rates. Thus, the economy was further weakened at a time when it needed stimulus, prolonging the period of subpar growth. Now the pattern is reversed, Spain has experienced a depression and struggles to recover while Germany is growing. Real interest rates show the same upside-down pattern: Spain’s real interest rates are significantly above Germany’s, crippling a recovery in Spain while low real rates in Germany potentially stimulate its already robust economy further.

Chart two: Real interest rates for firms in Europe

Source: Haver Analytics, CER calculation; the calculation is simplified: 1-5 year interest rates on firm loans minus current CPI (instead of inflation expectations) for the past, and IMF inflation expectations for 2014-2019.

Divergent real interest rates are a natural phenomenon in a monetary union. The policy response to them is not: fiscal and regulatory policies need to be used aggressively in order to counteract the negative effects of this upside-down divergence – especially in a decentralised monetary union like the eurozone where there are no automated fiscal transfers. In a boom, fiscal policy needs to be very restrictive – Spain’s surpluses before the crisis were not large enough. Financial regulation should make lending more expensive in booming countries, thus effectively increasing interest rates for businesses and consumers there. At the same time, eurozone member-states that are in recession or only growing slowly need to be able to use fiscal stimulus to counteract the negative effects of higher real interest rates. Financial regulation should facilitate lending in these countries.

Unfortunately, the eurozone is not drawing the right conclusions. Most countries are consolidating their budgets during a period of low growth and inflation, instead of counteracting the drag from high real interest rates. For the future of eurozone growth, that means too high real interest rates will continue to weigh on countries like Spain, Italy and even France. The verdict on German fiscal policy is still out, given that Germany has yet to boom.

Likewise, regulatory policies are not being used to lower interest rates in countries in recession or stagnation, and to tighten standards in the booming parts. The reason is not a policy failure by regulators – they stand ready to counteract booms, certainly more so than in the past. The failure lies with the ECB and the overall fiscal policy in the eurozone. Both have prevented the eurozone from growing at a sufficient level by being too cautious (ECB) or outright restrictive (fiscal policy). Ideally, the overall fiscal and monetary policy stance should raise average growth and inflation to an appropriate level. Regulatory policies could then curtail a lending spree in the booming parts that enjoy too low real interest rates while facilitating lower real interest rates in sluggish economies.

Finally, the financial sector is adding to the divergence in real interest rates: banks and, more importantly, firms have to pay a premium on borrowed money for the simple fact of being in, say, Italy. This is because financial risk after the crisis is still attached to the government of the state where the bank or firm is located. The European banking union was supposed to bring an end to this ‘country risk’ but it has so far only partially succeeded: in the event of a major crisis, German banks will still be perceived as safer, reducing their borrowing costs now, and vice versa for Italian or Spanish banks. Thus, some country risk will remain for the coming years. As the cruel logic of a crisis mandates, this country risk adds to the real interest rates in the worst-affected countries, worsening the macroeconomic dynamic outlined above.

For the growth prospects of the eurozone, in particular those countries currently growing slowly, this has important implications. While diverging real interest rates are a common feature of a decentralised monetary union, fiscal, regulatory and monetary policy play an important part in counteracting their upside-down dynamic. But as long as eurozone fiscal and monetary policy does not change to support growth, and inflation remains very low as a result, real interest rates in the South will remain high – too high for a meaningful recovery. The recent news on a stalling recovery should come as no surprise.

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

Friday, June 27, 2014

The eurozone is no place for poor countries

The economic rationale for poorer countries joining the eurozone was that it would hasten economic convergence between themselves and the richer members of the currency union. They would benefit from a stable macroeconomic environment and more trade and inward investment. And Portugal aside, there was some convergence in the early years of the single currency. But this went into reverse in 2008 and by 2013 the poorer members of the currency union were no better off relative to the EU-15 average than they had been in 1999. Worse still, they have been overtaken by a number of the 2004’s EU intake, who in 1999 had been much poorer. Has the euro become a mechanism for divergence? If so, what are the implications for growth across the eurozone as a whole and for the case for joining?

In 1999, Greek and Portuguese per capita GDP were around 70 per cent of the EU-15 average, and Spanish a little over 80 per cent. By 2013, Greek and Portuguese GDP was under 70 per cent of the average. Spain has not done quite as badly, but has been diverging since 2008 (see chart 1). Indeed, far from converging with the richer members of the EU, they have converged with the Central and Eastern European countries which joined the EU in 2004. In 1999, the GDP levels in Poland and Slovakia (a euro member since 2009) were 42 per cent and 43 per cent of the EU-15 average respectively. The Czech Republic’s was just over 60 per cent of the average. By 2013, these figures were 65 per cent, 72 per cent and 75 per cent.

Chart 1: GDP per capita


Source: European Commission

For crude supply-siders, the lack of convergence between members of the eurozone reflects the failure of the poorer member-states to push through reforms of their economies rather than anything to do with the structure of the currency union. This has cost them competitiveness, leading to economic stagnation.

Others maintain that divergence since 2008 is cyclical and will be quickly reversed. According to this view, the South is simply going through what Germany went through in the early 2000s. Interest rates are too high for the periphery in much the same way as they were for Germany between 1999 and 2006; conversely, they are now too low for Germany. Germany will grow more rapidly than the south for the next few years, but that will then reverse as Germany loses competitiveness and finds itself in similar position to that of the periphery now – with an overvalued real exchange rate and excessively tight monetary policy. At that point there will be renewed convergence between rich and poor. The worst that can be said is that the eurozone has amplified business cycles, but not that it has become an obstacle to convergence between rich and poor.

There are problems with both these arguments. First, it is hard to ascertain a correlation between the kinds of structural reforms the Commission is demanding of the South (principally labour market deregulation) and economic growth. Some of the best performing European economies over the last 20 years – notably Sweden and Austria – have relatively highly regulated labour markets. Germany – the benchmark for much of the Commission’s thinking – also has a tightly regulated labour market (notwithstanding 2004’s Hartz IV reforms), at least in regards to permanent workers (see chart 2). There is certainly a case for labour market reforms to address insider/outsider problems and to help young people and those with poor skills into work. But it is important not to exaggerate the economic effects of such reforms.

Chart 2: OECD indicators of employment protection legislation, 2013
(0 = least restrictions, 6 = most restrictions)

Source: OCED

Nor can differences in product market regulation explain the lack of convergence in living standards within the eurozone. First, according to the Organisation for Economic Co-operation and Development (OECD), there has been steady convergence of such regulation among EU member-states. Second, there is no discernible correlation between levels of product market liberalisation and economic growth. For example, Sweden has among the more tightly regulated product markets in the EU, while Germany and Italy score about the same as each other. Greece does rank badly, but only as badly as Sweden did five year earlier (see chart 3).

Chart 3: OECD indicators of product market regulation
(0 = least restrictions, 6 = most restrictions)

Source: OECD

This is not to say that – all other things being equal – competitive product markets will not boost economic performance, only that they can be more than offset by other things such as the wrong macroeconomic policies or misalignments of real exchange rates. The latter can have a big impact on levels of capital stock per employee and labour skills, which are more important in determining economic performance than levels of labour and product regulation. Cuts in education spending, large-scale emigration of young skilled workers and huge falls in business investment have damaged the productive capacity of the eurozone’s poorer economies.

The cyclical argument for the lack of convergence is also weak. There are several differences between Germany’s position in the early years of the euro and the south now. Germany’s period of retrenchment within the euro was essentially over by 2006. Germany’s real effective exchange rate was not seriously overvalued to start with. Germany was aided in its drive to reduce its real exchange rate by inflation being relatively high elsewhere in the eurozone. And, finally, the country was not highly indebted.

By contrast, the retrenchment in the poorer members of the eurozone has already lasted longer than in Germany in the early 2000s, and there is no end in sight for a number of reasons. First, their loss of trade competitiveness relative to the core is far bigger. Second, they are trying to regain competitiveness by holding inflation rates below the eurozone average at a time when inflation is chronically low elsewhere in the eurozone (German inflation is around 1 per cent and forecast to remain low). And third, they have very high levels of debt. Their drive to improve competitiveness is pushing them into deflation, increasing the real value of their debts and making it harder to deleverage.

As a result, overall levels of indebtedness in Greece, Portugal and Spain are still close to their all-time highs. Their levels of private sector debt have fallen, but there has been an offsetting increase in public debt. According to Standard and Poor’s, the so-called leverage ratio (public and private debt as a share of GDP) in Greece, Spain, and Portugal is currently around twice what it was at the beginning of 1999; Italy’s is 35 per cent higher.

Reducing these leverage ratios will be hard. Firms and households will continue to pay down debt for a long time to come, depressing consumption and investment. For their part, poorer eurozone governments risk contributing to the weakness of demand by continuing their drive to consolidate public finances. The result threatens to be weak economic growth and inflation and hence slow deleveraging. This is less a cyclical issue than a semi-permanent state of affairs. Growth in the poorer states will at some point in the future exceed that of the wealthier North, but any convergence is likely to be slow because of the permanent damage done to their growth potential.

A combination of debt write-offs, co-ordinated eurozone fiscal stimulus and a concerted drive by the European Central Bank (ECB) to drive up eurozone inflation could head off this unfavourable outcome. Anything is possible, of course, but all of these things look unlikely. Low borrowing costs have reduced pressure for institutional reforms of the eurozone, even if low bond yields should be ringing alarm bells (reflecting as they do mounting deflationary pressures). The eurozone might agree an investment programme, but a big fiscal stimulus is impossible without rewriting the rules. And there is little chance the ECB is going to morph into a European version of the US Federal Reserve and launch a full-blooded battle against deflation.

The fate of poorer EU-15 members of the eurozone should give prospective eastern and south-eastern EU member-states pause for thought before joining. They should also closely monitor the experience of Slovenia and Slovakia, which joined the single currency in 2007 and 2009 respectively. Slovenia is considerably poorer relative to the EU-15 average than when it joined. Slovakia has performed respectably within the single currency, but its real effective exchange rate has risen steeply relative to its peers (Czech Republic and Poland) and it has slipped into deflation.

For some – Lithuania, for example – joining the euro is about guarding its independence against a revanchist Russia. But the others face a trade-off: join the euro and get a seat at the top table (more and more of the real decisions on economic issues are taken by eurozone countries rather than the EU) in return for a loss of policy autonomy and much increased economic risk. Or reiterate their commitment to join but postpone doing so in the hope that the eurozone is reformed in such a way that it becomes a mechanism for convergence rather than divergence. This is the strategy being successfully pursued by Poland and the Czech Republic. Others would be wise to follow suit.

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

Wednesday, June 25, 2014

Russia’s gas deal with China: Business is business

Does Russia’s agreement to sell China gas worth $400 billion (€294 billion) over the next 30 years foreshadow a Sino-Russian special relationship, and a geopolitical earthquake that could threaten European gas imports from Russia? Or has Russian president Vladimir Putin mortgaged Russia’s future to China’s goodwill? Gazprom CEO Aleksei Miller called it an “epoch-making event”, but former Russian deputy minister of energy Vladimir Milov said the terms of the deal are “an insulting lesson for Putin”. Two things seem certain: the China deal will give renewed impetus to EU efforts to reduce gas dependency on Russia; and the biggest winners from the contracts signed during Putin’s visit to China on May 20th-21st will be his friends in the energy and construction sectors.

For China, the deal brings mostly advantages. To help tackle its huge pollution problem, China wants to burn more gas and less coal. It also needs to meet growing energy demand. China’s current gas consumption is forecast to more than double by 2020; from 170 billion cubic meters (bcm) to more than 400 bcm. Beijing is developing significant domestic shale gas reserves (BP expects these to supply 22 per cent of total Chinese demand by 2030), but this will not be enough. So China must rely more on imports. It is investing in liquefied natural gas (LNG) terminals (nine are under construction or have been approved), building new pipelines across Central Asia and eyeing offshore fields in contested areas of the South and East China Seas. If international sanctions on Iran are lifted, China will also be first in line to sign gas contracts with Tehran (Iran has the second largest natural gas reserves in the world – after Russia). Russia has now agreed to supply almost 10 per cent of Chinese demand from 2018, and could increase this later to around 15 per cent.

China has driven a hard bargain. It negotiated with Russia for more than ten years before getting the deal it wanted. The exact price remains a commercial secret, but Russian energy minister Aleksandr Novak said that $350 per thousand cubic metres was “close to” the figure. This is below the European average ($380) and well below the average price in East Asia: Japan currently pays $538 for its LNG. The price is above the $280 per thousand cubic metres which China pays for Turkmen gas. But given the pipelines and other infrastructure that still need to be built, and in comparison with Japan’s soaring gas bills, China has negotiated a hefty discount.

On the negative side for China, gas will not flow for at least four years. Meanwhile, China has agreed to pre-pay $25 billion to help fund construction of the pipeline in Russia. Beijing has also accepted a gas price linked to the oil price. This link is being broken elsewhere by downward pressure on global gas prices as a result of increased LNG availability (due to the US shale gas revolution and new production in East Africa, Indonesia and Australia). So Beijing could possibly have held out for an even better deal.

For the Russian government, the pluses and minuses are more finely balanced. On the one hand, Gazprom diversifies its clients: currently 76 per cent of its gas is sold to EU member-states, many of whose economies are still smaller than before the financial crisis. Since the contract with China involves exploiting relatively undeveloped fields, the state-owned company will increase its total production and revenue. It will now have a long-term contract with a rapidly growing economy; and the pipeline will give it scope to export to other parts of East Asia over time. It is a “take or pay” contract (of the kind which the EU is trying to outlaw) so Russia would not lose revenue even in the unlikely event that Beijing no longer wanted or needed to take the contracted amount of Russian gas.

The up-front payment from China will partially offset the costs to Russia of new infrastructure required for the deal. Moscow may also feel that having China as a customer gives Russia more leverage vis-à-vis European customers because of the additional revenue, although Europe will remain by far the biggest importer of Russian gas for the foreseeable future.

On the other hand, the deal is expensive for Moscow. It involves developing two new fields, Chayanda and Kovykta, and building a 4,000 km pipeline through difficult, seismically active terrain to China, at a total cost of $55 billion. By contrast, the costs of field development and existing pipelines to Europe were written off long ago. At a conference on energy strategy on June 4th, Putin said that the state might recapitalise Gazprom to cover its investment in the China deal, using Russia’s gold or foreign exchange reserves, or its wealth fund. This fund is supposedly intended to fill shortfalls in the national pension fund, which is already in deficit. Using the wealth fund to help Gazprom would significantly worsen Russia’s problem of unfunded pension liabilities. To compound this, the Russian finance minister, Anton Siluanov, said that Russia might consider exempting gas for China from the mineral extraction tax, which would cost the Russian treasury around $450 million a year.

Overall, Gazprom may not be able to make a profit from the deal; particularly if increasing availability of alternative gas supplies forces it to lower its prices at some stage (as it has had to do with some of its European contracts). Russia has always had the upper hand in its dealings with European countries, because the pre-existing pipeline system and lack of investment in bringing gas from elsewhere to European markets left Russia as a de facto monopoly supplier to some eastern European countries. But this is now changing: a number of EU member-states have been able to negotiate price reductions from Gazprom by investing in alternatives. Lithuania, for instance, negotiated a 20 per cent reduction in May 2014 following its decision to build an LNG terminal on the Baltic coast. With China, Russia could face a monopsony: in the short term, China is likely to be the sole purchaser for gas from Kovykta and Chayanda, but will have a range of other suppliers, from Turkmenistan to Australia, as well as growing domestic gas production – useful levers if world gas prices fall and Beijing wants to get a better price from Russia. China will be a tougher customer to bargain with than many EU member-states.

For the EU, this deal – coming on the heels of Russia’s Crimea annexation and European sanctions – has reinforced the fear that Russia may ‘turn off the taps’ and divert gas to China to punish Europe. This seems unlikely, given Russia’s financial needs and its interest in maintaining the trust of international capital markets. A politically-motivated cut in gas supplies to Europe (as opposed to Ukraine) would tarnish Russia’s image as a reliable partner. Still, European consumers may be the victims of the escalating gas dispute between Russia and Ukraine; one-third of European gas imports transit Ukraine.

The EU should therefore treat both the Ukraine crisis and the China deal as opportunities to stimulate debate on Europe’s energy security and take steps to wean itself off over-reliance on Russia. At present, six EU countries rely completely on Russia for their gas imports. The EU should act vigorously to shield these member-states from the effects of possible Russian supply cuts, by making it easier to move gas around Europe through bi-directional interconnector pipelines, developing more LNG terminals and importing more gas from non-Russian sources. The Commission has already identified projects to fund in pursuit of these objectives. The EU should further liberalise the European gas market through effective enforcement by the Commission of existing rules on unbundling ownership of production, transmission and retail energy operations; and it should encourage energy efficiency and the development of new energy sources.

One question under consideration is whether the EU should take up Polish Prime Minister Donald Tusk’s suggestion that the EU set up an “Energy Union”, including by creating a single purchaser of gas. Although in theory this would increase Europe’s bargaining power, the Polish proposal is unlikely to be accepted in full: the EU would struggle to predict accurately the energy needs of 28 states for years to come; and many states would be wary of giving the Commission the power to negotiate gas contracts on their behalf. But some elements of the Tusk proposal make a lot of sense: if there was full transparency about the deals European companies make with Gazprom, there would be more opportunity for the Commission to act against market-distorting behaviour, and less chance for Russia to divide and rule in the EU. The Commission has also said that it will consider permitting voluntary collective negotiation of gas contracts by interested countries, which would strengthen the purchasing leverage of those currently most vulnerable to pressure from Gazprom.

For one European country, perhaps, the Russia-China gas deal may be worrying. Russian supplies to China will be nearly equivalent to the amount of gas it sells to Ukraine; 38 bcm and 30 bcm per year respectively. Gazprom cut gas exports to Ukraine on June 16th in a dispute over payment arrears, in parallel with Russia’s efforts to destabilise the country. Together with the South Stream pipeline, which would bring Russian gas to Europe without transiting Ukraine, the deal with China would ultimately allow Moscow to leave Ukraine in the cold without greatly affecting Gazprom’s revenue. But this assumes that by 2018 relations with Ukraine are still as bad as today; and that South Stream gets a green light from the Commission, which is currently uncertain. Under pressure from the Commission, Bulgaria has suspended work on its section of South Stream, but during Putin’s visit to Vienna on June 23rd Austria rejected EU criticism and signed a contract with Russia for construction of the Austrian section of the pipeline.

So what is the geostrategic significance of the deal with China? A Russian-Chinese naval exercise took place during Putin’s visit, suggesting the possibility of closer security ties between Moscow and Beijing. But neither military co-operation nor gas supplies will be enough automatically to create a Sino-Russian ‘special relationship’. While the two countries work together in the UN and relations are generally cordial, there are too many divergent interests for them to become brothers-in-arms. Bilaterally, there is still mistrust in Moscow about China’s influence and long-term goals in the Russian Far East. Russia is also concerned about China’s forays into Central Asia, which Moscow still considers as part of its traditional backyard; the Russian-led Eurasian Economic Union could hinder China’s trade with the region. In China’s backyard, on the other hand, Russia is building closer ties with Vietnam to gain access to the naval port in Cam Ranh Bay at a time when Chinese-Vietnamese tensions are increasing over energy resources in waters claimed by both sides.

Another sign that the deal is less than a geopolitical game-changer is the currency in which the deal will be settled. Fearing further Western sanctions, Russian firms want to move to renminbi-based contracts; instead, at least initially, the gas deal will operate in US dollars and thus not threaten the global position of the greenback (though it is unclear whether the contract allows for a switch of currency in the future).

Finally, one group of people who are likely to benefit, not only from the Gazprom contract with China, but from the many other deals signed during Putin’s visit, are his friends. Someone has to build a 4,000 kilometre pipeline in Russia, and two of the main options are Stroygazmontazh, described by Russian media as Gazprom’s largest contractor and owned by Arkady and Boris Rotenberg, who are both subject to US sanctions; and Stroytransgaz, controlled by Gennadiy Timchenko (also subject to US sanctions). Timchenko is also a major shareholder in several more companies which signed lucrative contracts with China during Putin’s visit.

For China the gas contract looks like a business deal, pure and simple. For the oligarchs involved, it does too. Not for the first time, those close to Putin are likely to do well by doing good for the Motherland.

Ian Bond is director of foreign policy and Rem Korteweg is senior research fellow at the Centre for European Reform.

Monday, June 23, 2014

Why the push to install Juncker is so damaging

If Jean-Claude Juncker is crowned president of the European Commission, it will be a major blow to David Cameron. Britain’s prime minister made a mistake in drawing a red line over the appointment of a federalist politician from a tiny country, who shows little understanding of the crisis of legitimacy facing the EU. But the German (and to a lesser extent) French newspapers have been full of anti-Cameron rhetoric, arguing that this is the latest in a series of British attempts to stymie EU integration; Cameron is beholden to eurosceptics on his right, who cannot be allowed to control the pace of that integration. This is wrongheaded and hypocritical. The battle for Juncker is not a principled fight in defence of democratic accountability, but a combination of power grab by the European Parliament and power-broking by national governments.

Britain is not the one spoiling the federalist party. Cameron and his finance minister, George Osborne, have repeatedly said that the eurozone needs to become more of a federation. They have not tried to stop the eurozone from mutualising more debt or creating a system of transfers between its member-states – both of which would make the currency union more stable. The eurozone member-states themselves decided to carry on with a fiscally decentralised currency union and technocratic central governance without real democratic legitimacy. This is because creditor countries refused to provide the credit needed to make such a system work, and neither they nor debtor countries were willing to accede to the political union that would be needed to run it.

Cameron’s strategic error was more modest: he and his advisors imagined that the process of eurozone integration would be faster than has proved to be the case, and they hoped that, along the way, they could negotiate some reforms of the EU that would make the EU more palatable to British voters. In recent months, they have lowered their ambitions from a broad renegotiation of Britain’s membership to more modest reforms. In his March 16th article in the Sunday Telegraph, Cameron listed his reforms: less red tape; more free trade deals; a longer period before migrants could claim benefits; the removal of “ever closer union” from the EU treaties; and more powers for national parliaments to block EU rules. This is hardly Europe à la carte, or the fundamental transformation of the EU that Cameron and his spokespeople argue it is. This is precisely because they realise that Britain is marginalised, and in no position to dictate terms.

Cameron’s proposed reforms are not in any way inimical to the interests of the eurozone: they are minor tweaks that would allow him to say that he has made the EU more open and liberal. They would have negligible effects on European economic growth – unlike a better system of eurozone governance, which Britain is no obstacle to. Britain shares next to no blame for the economic and political crisis in the EU; responsibility for this lies in the eurozone. Indeed, Britain is one of the innocent bystanders – chronically weak demand in its biggest export market is a major problem for the UK economy. The mishandling of the eurozone crisis has also made it much harder for the British government to counter eurosceptic arguments. And now Britain is unable to influence decisions that have profound implications for the country because those decisions are now the product of trade-offs within the currency union.

Britain’s European strategy is not uniquely driven by its domestic political constraints. Similar calculations are made in all member-states. If German Chancellor, Angela Merkel, does indeed back Juncker it will not be because she considers him the best man for the job, or because she believes that it is the democratic thing to do. It will be because it will create fissures in her grand coalition and draw criticism from the country’s media if she does not. Her coalition partner, the centre-left SPD, meanwhile, is angling for a senior appointment for their European leader, Martin Schulz, in return for backing Juncker. The Socialists in the European Parliament are backing Juncker in an effort to expand the powers of the Parliament. If they were properly accountable they would be concentrating their efforts on fighting for policies their voters favour. Such motivations notwithstanding, the majority of German media and punditry has portrayed the issue as a battle for European integration and democracy against British nationalism, which is absurd.

Merkel’s vacillation over the issue – initially signalling understanding for Cameron’s position and then coming down strongly behind Juncker – may be a sound tactical move in terms of Germany’s domestic politics, but it is bad European politics. Matteo Renzi, the Italian prime minister, is considering signing up to Juncker’s candidacy in the hope that Italy will be allowed to relax austerity. And Juncker is very popular among the smaller countries in the EU because he has been an outspoken advocate of their rights. Some of the small member-states that act as tax havens are keen on him because his home country Luxembourg is a tax haven and Juncker’s federalism does not stretch to clamping down on tax avoidance. None of them are driven by purer, more European motives than the British. Neither is the British public uniquely eurosceptic. Euroscepticism is rising across the EU, especially in France, the Netherlands and among the Nordic countries. For example, confidence in the European Parliament in many member-states is no higher than in the UK. And if the appointment of Juncker had the same toxic connotations in any of these countries as it does in Britain, they would have worked equally hard to thwart his appointment.

The key point about this affair is not whether Cameron’s strategy has been a good one (it has not). The most important aspect is that it has given a brutal demonstration of where power lies in Europe. The message to British politicians is that EU member-states – even those fellow reformers such as the Netherlands and Sweden – would rather risk pushing Britain out of the EU than cause some temporary problems for Merkel. Merkel, in turn, would rather risk making Cameron’s position untenable than temporarily upset her coalition partner or the German media. The UK is not alone in its self-interest, but simply much less adept at cloaking it in pro-European language. If it does end up leaving the EU, the blame will not be Britain’s alone.

The appointment of Juncker would be the wrong way for the EU to respond to the strong showing of eurosceptics and populists at last May’s European Parliament election. It suggests that governments are not listening to their electorates’ concerns, and risks further undermining already very low popular confidence in the Parliament (turnout at the recent election was up just 0.1 per cent on the all-time low of four years ago). If Europe is to address these concerns, governments will have to accept that the current state of affairs is unsustainable. An opportunistic power grab by the Parliament followed by opaque bargaining between governments resulting in the appointment of a Brussels fixer will erode the legitimacy of the EU, not bolster it. Finally, the prospect of exorcising the UK from the EU may feel good to some governments and commentators, but it won’t make it any easier to address Europe’s problems.

Simon Tilford is deputy director and John Springford is senior research fellow at the Centre for European Reform.

Friday, June 13, 2014

More investment, for Germany’s sake

Germany, the biggest economy in Europe and, more importantly, in the eurozone, is being urged to invest more at home. Those that support greater investment argue that it would help to spur a faster recovery in the eurozone and reduce the German current account surplus – lines of argument  that meet resistance from the German public and the country’s policy circles. After all, many Germans feel (rightly or wrongly) that they have done enough for Europe. Luckily, the case for German investment can be based entirely on narrow self-interest: for the sake of its future prosperity, Germany needs to invest more, regardless of whether that helps the rest of the eurozone. Why is Germany not investing more, then? The answer is, as so often, political. But there could be a way to convince the German government to do what is best for Germany – and ultimately for Europe, too.
German investment has been falling steadily over the past two decades, from around 21 per cent of its GDP in the late 1990s to just above 17 per cent now (see chart one). The biggest drop came after 2000, when the German economy slid into a period of low growth and high public deficits. This led both private and public investment to fall: private investment for lack of profitable opportunities, and public investment because of eurozone budgetary constraints.

Chart one: Gross investment as a share of GDP
Source: European Commission / Haver Analytics

By international comparison, this is a low number: The EU15 (roughly the eurozone plus the UK) invested around 20 per cent of GDP in the run-up to crisis. Because of the severe recession in many EU15 countries, this has recently fallen to German levels (but notably not below). Investment in the US and Switzerland has been even higher. But such overall investment figures can only provide a rough guide: they contain construction and equipment, both private and public, each of which needs to be analysed. In addition, intangible investment such as software, R&D and organisational know-how is not included.

Breaking German investment down into its constituent parts reveals that the fall in construction is mostly responsible for the decline in aggregate investment; investment in machinery and equipment has only decreased slightly (see chart two). So does that suggest that German investment is fine? After all, construction investment has not been the wisest use of savings in countries like Spain or Ireland – where much of the money invested was in fact German.

Chart two: German gross investment by type as a share of GDP

Source: European Commission / Haver Analytics

However, by international standards, investment in equipment is also low. While Germany compares well to the US or the EU15 average (see chart three), its real peer group – countries with similarly large manufacturing sectors – invest considerably more: Germany’s manufacturing value added accounts for 22 per cent of GDP, compared to just 10 per cent in France or the UK, and 13 per cent in the US. The relevant comparison group – Japan, Switzerland and Austria with manufacturing sectors contributing similarly to GDP – invest between 1.5 and 4 percentage points of GDP more than Germany in equipment.

Chart three: Gross investment in equipment as a share of GDP

Source: European Commission / Haver Analytics

This investment gap is not compensated for by intangible investment either. On the contrary, such investment in software, R&D and organisational know-how is low compared to countries like the US that have similar levels of investment in equipment. Germany invests more than 5 percentage points of GDP less than the US, and 2.5 percentage points less than the UK or Sweden. Considering both equipment and intangible investment combined, Germany clearly invests too little.

Chart four: Intangible investment as a share of GDP

Source: Carol Corrado, Jonathan Haskel, Cecilia Jona-Lasinio and Massimiliano Iommi (2012) "Intangible Capital and Growth in Advanced Economies: Measurement Methods and Comparative Results" and the associated database; European Commission / Haver Analytics
Public spending on education is not usually considered to be investment. And yet it is clear that, from an economic point of view, education spending is mostly investment in human capital and should be included in investment totals. By international comparison, German public investment in education is very low as a share of GDP. And while the greater number of young people in France, the UK and Sweden explains part of the difference, the difference with Switzerland cannot be explained by demographics; the difference between Germany and Sweden is simply too large to be fully explained by demographic differences, and has been for long.

Chart five: General government expenditure on education as a share of GDP

Source: European Commission / Haver Analytics

Finally, public investment in construction and equipment is also very low – it is actually negative once depreciation is factored in. After all, public capital deteriorates just like private capital: roads get potholes and school equipment breaks. After deducting depreciation of the existing capital, Germany has been investing less than zero in its public infrastructure and equipment for a decade. In essence, Germany has been running down its public capital stock.

Chart six: Net public investment as a share of GDP

Source: European Commission / Haver Analytics

All this leads to the conclusion that Germany has not been investing enough: not in equipment, given its large manufacturing sector, not in R&D and other intangible assets to grow new sectors, not in education or in public infrastructure. This is particularly worrying as the German population is aging quickly, with the median age already close to 47 (up from 40 in 1999) – a high number if compared to Sweden (41.2), the UK (40.4) or the US (37.6). An ageing society needs to invest domestically to make its workers more productive, because these workers will need to support pensioners in the future. Productivity growth is especially important in Germany because its pension system is largely ‘pay-as-you-go’: the young pay for the old. If people had private pensions, in which they built up pension pots for their own use, these could be invested abroad, which would make domestic productivity less of an issue.

What is more, Germany is saving much more than it invests, the result of which is a massive current account surplus of 7 per cent of GDP. Whatever Germany saves beyond what it invests domestically will be invested abroad. But the German banking system, through which most of these savings are intermediated, has not been able to invest this surplus productively. In fact, Germany has lost around €400 billion on its investment abroad since 1999, according to calculations by the German Institute for Economic Research (DIW). In Germany, their research shows, the return on investment – measured by the economic growth per unit of investment – was among the highest in the world over that period of time.

There are essentially two ways for policy-makers in Germany to increase investment. One is to encourage private investment through policies such as predictable energy policies or further liberalisation of services markets, both of which would help. But the biggest impact the government could make is to increase public investment, for a very simple reason: Germany can currently borrow money essentially for free. Interest rates on 10 year government bonds are around 1.4 per cent, which is likely to be below the average inflation rate over the next ten years. This implies that the German government is paid (in real terms) to borrow: the real interest rate is negative. Bonds that mature in 30 years yield 2.3 per cent and hence barely more than the probable inflation over that period of time.

Given that the case for more public investment in Germany is so strong, why is the German government not investing more? There are three reasons. First, the German economy is growing relatively rapidly; the Bundesbank recently upgraded the outlook for 2014 and 2015 to 1.9 and 2 per cent respectively. Germany has little, if any, underutilised capacity and such growth figures are a good deal above Germany’s potential growth, that is, the underlying growth rate around which economies fluctuate. This means that there is currently little need for public investment to stimulate the economy further, from a business cycle perspective. In fact, given that the European Central Bank (ECB) needs to keep rates low to help the rest of the eurozone, there is a danger the German economy might overheat. However, German inflation (a key indicator for a boom) is not projected to rise beyond 2 per cent until 2016, according to Bundesbank estimates. What is more, the risks for the eurozone economy are “to the downside”, as Mario Draghi likes to point out, such that additional public investment would serve as an insurance against a renewed eurozone downturn.

Second, the German constitution contains a fiscal rule known as the ‘debt brake’ that, after a transition period, comes into full effect in 2016. It mandates that the structural balance – the budget balance after the effects of the business cycle have been taken into account – does not exceed 0.35 per cent of GDP. This in effect excludes debt-financed public investment in Germany in the future – a questionable rule to begin with, given the arguments above. However, until 2016 at least, the government has room to go beyond the 0.35 per cent limit and should use this fiscal space. According to KfW, a German state-owned bank, the German government could invest €100 billion more over the next five years (which equals roughly 3.5 per cent of current GDP) without violating the transitional rules of the ‘debt brake’.

Finally, the most important reason why public investment is low is that fiscal consolidation is politically more appealing in Germany than investment: after decades of belt-tightening and fears of ever increasing public debt, a balanced budget is seen as a big accomplishment. This is why the coalition agreement between the two governing parties contains a balanced budget pledge that goes beyond the constitutional debt brake and aims for a faster fiscal consolidation. Unravelling this pledge now, the argument goes, would open a Pandora’s box of government consumption demands and hence not increase investment. Therefore, it is best to keep the lid on it, despite the beneficial effects of more public investment.

The only way to convince the German government to invest more is to emphasize Germany’s gains from such investment rather than Europe’s; to make sure it is politically more profitable than fiscal consolidation; and to ensure that the added fiscal spending really does go into investment rather than public consumption, and preferably sooner rather than later.

One proposal that fulfils all three criteria could lie with German municipalities. First, they are responsible for roughly two thirds of German public investment. Second, they are heavily indebted, some are essentially insolvent, and need help. And third, they are the main stumbling block for dismantling Germany’s local business tax (Gewerbesteuer) – a tax that generates volatile revenues for municipalities; that is uneven both between municipalities and between firms of different types and sizes; and that complicates the German corporate tax system unduly. Wolfgang Schäuble, the German finance minister, has in the past attempted (but failed) to reform municipal finances and to dismantle the Gewerbesteuer. He could offer the municipalities a grand bargain: €133 billion – the total debt of German local governments – in debt relief and investment funding for municipalities in return for a comprehensive reform of municipal finances.

The political benefits of such a deal would be significant and arguably higher than those of fiscal consolidation: removing the municipal business tax is the holy grail of German tax reformers, and municipal spending is an important issue for the public; additional funds would be spend on investment rather than consumption; and the benefits of such investment would accrue visibly to the German public rather than to other European countries. But whatever the details of a deal, convincing the German government to invest more will not be easy.

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

Tuesday, June 03, 2014

Presidential candidates, European federalism and Charles Grant

In a recent CER insight Charles Grant offers a number of criticisms of themes in my book, ‘Turbulent and Mighty Continent: What Future for Europe?’ My basic thesis in the part of the work he criticises is simple. The coming of the euro has created de facto economic federalism at the core of the EU. The eurozone countries have become irrevocably interdependent. New forms of collective economic management simply have to be set up to manage that interdependence – and to cope with the strains and conflicts it has produced. The Union is so far only in the early stages of that process, which will have to involve fiscal mechanisms, and not only a banking union.

Economic federalism, I go on to argue, is not possible in the longer term without political federalism – in some form or other – because otherwise it has no effective legitimacy. The euro may have been set up in the usual EU fashion, as a back-stage deal between a few major states, but the consequence has been to undermine that very way of doing things. The traditional problems of the EU – lack of democratic involvement of the citizenry, and the absence of legitimate political leadership – can no longer be simply swept aside or disregarded. The surge of support for populist parties has its origin in this new situation.

Grant has several objections to this analysis. He doesn’t like talk of federalism, because it means ‘more Europe’. This isn’t something he wants, nor is it supported by the bulk of the electorate. He is not a fan of the European Parliament and he thinks the involvement of that body in the choice of a new president of the Commission is a mistake (he has made this point in a recent CER insight). Grant wishes to stick with the existing inter-governmental system, in which as he puts it, ‘the member-states (who in practice tend to be led by the big ones) should set the agenda and take key decisions.’

‘Politics in Europe’, he says, ‘remains largely national’. ‘Variable geometry’ (the principle that groups of member-states can integrate in particular policy areas, without the involvement of all 28) is the order of the day. Reform should be confined to such strategies as the greater involvement of national parliaments in decisions of European consequence. The euro, he continues, can survive and even prosper with the limited policies that have already been put in place. The antagonisms between North and South can be dealt with by relaxing austerity, encouraging economic reform and the writing off of a certain amount of debt. What Grant offers is more or less a business-as-usual scenario, give or take a bit of tweaking.

I find this analysis deeply unconvincing. The combination and the financial crisis and the travails of the euro have already transformed the political situation in Europe. Tinkering with the status quo is not going to resolve the issues that have to be faced up to. Such an approach recognises neither the scale of the problems to be resolved, nor the emerging forces that have irretrievably altered the political landscape. Largely because of the depth of its difficulties, the EU has become what I call in my book a community of fate. This is signaled by the fact that the EU is in the news almost every day in a way it never was previously – even in that most un-European of European countries, the UK. The challenge for pro-Europeans is to change that negatively charged consciousness into a positive one.

The recent European elections are the first to have been fought in some substantial part on European rather than strictly national issues. The populist parties that have arisen are mostly hostile to the EU and some want to see the end of it altogether. Some have noxious or wholly impractical ideas, or a mixture of the two. In an odd way, however, these parties are doing pro-Europeans a favour – at least if we respond in the right ways. They are helping to create a pan-European political space. Moreover, at least some of the basic issues the populists have forced onto the agenda are all too real. The system Grant seems to approve of – decisions taken by a few large states behind closed doors – is in fact a core part of the EU’s lack of accountability.

The leading candidate from the European Parliament to be the next head of the Commission, Jean-Claude Juncker, has been widely derided as colourless and a member of the establishment. Yet his name is in the frame as a result of a democratic process. If he is rejected as a result of horse-trading behind closed doors, the EU will be reverting to some of its worst traits.

Whatever happens, the involvement of the Parliament in such decisions is clearly no more than a beginning. If the EU is to achieve renewed stability, pro-Europeans simply must think more radically, just as the populists do. I want to see a lot of reform, even if it will take an extended period of time and, yes, ultimately treaty change, to achieve. I want an EU that is more open, democratic and flexible, as well as quick-acting in responding to a world of massive change. Federalism to me is more or less the opposite of what Grant takes it to mean. It is not about the centralisation of power but about finding a balance between effective leadership and democratic accountability. A new system of governance could and should be far more streamlined than the cumbersome and arcane set of practices that exist at the moment.

The eurozone countries should act as an avant-garde, since they can make significant innovations without treaty change. The work of stabilizing the eurozone is far from done – the euro remains vulnerable. For that reason, unlike Grant, I am sympathetic to the programme of far-reaching further reform set out by the Glienicker Group in Germany. As the Group observes, “Europe has structural problems that require structural solutions”. Contrary to what Grant says, there won’t be a great deal of scope for variable geometry, at least in sheer economic terms. I do not in fact argue, as he claims, “that most of the ten EU countries not in the euro will join it soon”. However, the majority of them are in line to sign up at some point and this expectation will inevitably shape their economic policy in a convergent direction.

A battle for the future of Europe will be fought over the next few years. To me the new narrative for the EU among pro-Europeans should be about maximising the benefits of intensifying global interdependence – which, short of catastrophe, is unstoppable – while muting its risks and dangers. I don’t accept that creating a more democratic, cohesive and effective Union means further sacrifices of national sovereignty. The picture is much more complex than this. One cannot give up something that has already been largely lost. Even when acting alone, member-states gain more sovereignty – real power to shape the world – by being part of the EU than they could ever hope to achieve as a disorganised gaggle of separate countries. To be effective in everyday politics, of course, these lofty thoughts must be brought down to earth and integrated with citizens’ concerns, hopes and fears. As the battle to reshape the Union unfolds, let’s take on the arguments of the populists in a direct way. Let’s do so by means of reason and the judicious marshalling of evidence; but let’s throw in a dose of passion too.

Anthony Giddens is a former director of the London School of Economics, a Labour peer and the author of ‘Turbulent and Mighty Continent: What Future for Europe?’.

Friday, May 30, 2014

The new European Commission: which president, and what priorities?

The EU has probably never faced greater challenges. Chronically slow economic growth, and a euro crisis that is dormant but far from resolved, have undermined support for the EU – helping anti-establishment parties to win 20 per cent of the seats in the European elections. A wave of europhobic sentiment may carry Britain out of the EU, while Russia is becoming a more menacing neighbour.

The EU cannot tackle such problems without a strong European Commission – the body that defines the common interest, helps to forge common policies and polices the rules. Yet many intelligent and serious pro-Europeans want the Commission’s next president to be chosen by a method that is bound to weaken it.

This is the system of Spitzenkandidaten, or designated candidates, promoted by the European Parliament and the main pan-European political parties. They argue that the recent elections gave voters a real choice – between Jean-Claude Juncker, the candidate of the centre-right European Peoples’ Party (EPP), Martin Schulz, the candidate of the Party of European Socialists, and those representing smaller groups. Advocates of this system also claim that it enables people to see a link between the way they vote and the faces running the EU. And because the EPP won the most MEPs (though many fewer than five years ago), they argue, the European Council should bow to the ‘popular will’ and anoint Juncker. However, these arguments suffer from serious flaws.

First, the two leading candidates did not offer voters a real choice. Juncker and Schulz hold similar views, supporting more powers for the EU without wanting to change much in the way that it works. In any case, electors cannot realistically choose between candidates without knowing who they are. Most of those who voted have never heard of Schulz or Juncker, which is not surprising, since they are obscure politicians to most people living outside Brussels.

Second, the idea of Spitzenkandidaten is based on the assumption that if people vote for one face rather than another, policy will shift. But in reality the appointment of Juncker rather than Schulz would make little difference to what the Commission does, even if they held significantly different views: either would be constrained by having to work with a broad coalition of 27 commissioners, from various parties, appointed by national governments. Only the most dynamic of Commission presidents, such as Jacques Delors, have been able to make much difference.

Furthermore, the Commission has little executive power, except in a few areas like competition policy. Most key decisions in the EU are taken by the Council of Ministers. And although the Commission initiates legislation, the Council and the Parliament revise and then have to pass each law. So if advocates of Spitzenkandidaten lead electors to believe that their votes will change EU policy, through determining the Commission president, the result may soon be disillusionment.

A third problem with Spitzenkandidaten is that this idea would make the Commission more party-political, at least in terms of perceptions. A President Juncker would be seen as accountable to the EPP group in the Parliament. That would have serious implications for the Commission’s credibility and legitimacy as a regulator and enforcer of rules. Suppose that the centre-right Spanish government broke eurozone budget rules, and that the Commission treated it softly; the institution would be accused of political bias. Many of the Commission’s tasks require to it remain above party politics.

The fourth and most important reason for the European Council to reject Spitzenkandidaten is that the quality of those running the EU is hugely important. Schulz’s executive experience is limited to being mayor of a small German town. Juncker has considerable political experience, having been prime minister of Luxembourg from 1995 to 2013, but he left office under a minor cloud, having mismanaged a spy scandal. As chairman of the Eurogroup, from 2008 to 2013, he can hardly be blamed for the eurozone crisis. Nevertheless he lacked the clout to stand up to the big member-states, when the eurozone made mistakes, and was out of the loop at many key moments. Jean Pisani-Ferry’s excellent new book, ‘The euro crisis and its aftermath’, reveals that from January 2010 to June 2012, US Treasury Secretary Tim Geithner called the ECB president (whether Jean-Claude Trichet or Mario Draghi) 58 times, Wolfgang Schäuble (Germany’s finance minister) 36 times, Olli Rehn (the EU economics commissioner) 11 times and Juncker just twice.

The televised debates among the presidential candidates generated little interest in most member-states, perhaps because they were between largely unknown and uninspiring figures – the exception being Alexis Tsipras, the far left’s designated candidate, who has some charisma. If the debates had featured not only Tsipras but also, say, Angela Merkel, Silvio Berlusconi, Nicolas Sarkozy and Marine Le Pen – politicians who have made an impact outside their homelands – many millions might have watched.

But the system of Spitzenkandidaten discouraged heavyweight leaders from putting their names forward. Those in office would have had to resign without any certainty of gaining the nomination or winning the presidency. Several plausible candidates for the presidency – some with fresher faces than the designated candidates – held back from seeking nomination. These include Dalia Grybauskaite, Enda Kenny, Christine Lagarde, Fredrik Reinfeldt, Helle Thorning-Schmidt and Donald Tusk, respectively the leaders of Lithuania, Ireland, the IMF, Sweden, Denmark and Poland (other serious contenders, currently out of office, include Finland’s Jyrki Katainen, France’s Pascal Lamy and Italy’s Enrico Letta).

Rather than humouring the Parliament by appointing a designated candidate, the European Council should appoint a strong president. That would strengthen the Commission as a whole. Indeed, that institution’s weakness is one cause of the EU’s travails, and thus, indirectly, of the rise of euroscepticism. The Commission has been poorly led, lacked focus and proposed too many regulations that are badly drafted. It has become too willing to pursue the Parliament’s agenda, thereby damaging its credibility in national capitals.

A strong Commission requires a dynamic and effective president – one who can shake up the institution while retaining the confidence of both the Parliament and the member-states. The Commission’s priorities should include:

* Boosting economic growth. The Commission should propose to extend the single market (especially in services and the digital economy), negotiate more trade deals with other parts of the world, support the best research in the EU and invest in crucial infrastructure like energy transmission. Some of these measures would be unpopular. The president must therefore be astute at building coalitions for change, explaining the benefits and ensuring help for those who may be disadvantaged. The Commission should be more careful not to create impediments to growth: it should improve the impact assessments that it carries out on draft laws, and resist the Parliament when it demands regulations that are unnecessary. In the long run, faster growth would undermine support for populists.

* Restoring the eurozone to health. The euro's difficulties have done much to damage the EU’s overall economic performance. Though the euro crisis has slipped out of the headlines, major problems remain: an ill-conceived focus on austerity that smothers demand; deflationary pressures in Southern Europe that the European Central Bank (ECB) has failed to tackle; barely sustainable levels of public debt in much of Southern Europe; the reluctance of some governments to commit to painful structural economic reforms; and Germany’s unwillingness to generate the domestic demand that would stimulate activity elsewhere in the eurozone. Particularly in the early years of the crisis, the Commission lacked the backbone to stand up to the ECB, Germany and other governments when they pursued harmful policies.

* Encouraging the 28 to forge a common response to a more assertive Russia. The member-states have not reacted in the same way to Russia’s meddling in Ukraine: some worry about their military security, others fear for their energy supplies; some want the EU to prioritise human rights, others believe that engagement assists moderate voices within the Russian system. Despite these disagreements, even the modest EU sanctions adopted so far have hurt market confidence in Russia. In order to maximise Europe’s leverage vis-à-vis Russia, the Commission should work with the European External Action Service and the key member-states to herd the 28 towards a coherent approach. The Commission is developing sensible ideas for improving the EU’s energy security – including boosting energy efficiency, accessing alternative energy sources, building gas and electricity connections between member-states and co-ordinating the member-states’ negotiation of gas contracts with third parties – but will need drive and determination to persuade national governments to adopt them.

* Coping with the British problem. Whichever party wins the next British election, the UK is likely to demand major reforms to the way the EU works. Some member-states will support its efforts. Others will be less enthusiastic, but after the European elections, fewer governments will be willing to say that ‘business as usual’ is acceptable. The Commission president will face a Herculean task: constructing an agenda for reform that helps to keep the UK in the EU, but at the same time is acceptable to 27 other governments. And because there is unlikely to be a new EU treaty in the next few years, EU leaders will find it hard to craft reforms within the existing treaties that look substantive. The appointment of Juncker as Commission president would decrease the chances of keeping the British in the EU, since he (like Schulz) has an antagonistic relationship with them.

The EU treaties are clear: when the European Council chooses the Commission president, it should take into account the European elections; MEPs then have to approve that choice. This means that the president probably has to come from the party – or group of parties – that can muster the largest number of MEPs. The treaties, however, say nothing about Spitzenkandidaten. European leaders should not indulge the Parliament by tolerating its attempted power-grab. The challenges facing Europe are far too serious for its leaders to risk the choice of a weak Commission president. Of the potential candidates from the centre-right, Christine Lagarde is among the strongest (though apparently François Hollande would rather not have her as president). She would bring her experience as a minister and at the IMF, her communications skills and her economic expertise to the job.

Charles Grant is director of the Centre for European Reform.

Friday, May 23, 2014

Devolution in Ukraine: Panacea or Pandora’s Box?

Russia and the West do not agree on much about Ukraine, but both say that state power there has been too centralised. They are right that people in Ukraine’s regions do not feel that the authorities speak for them; but the real cause is ineffective and corrupt government at all levels, not an over-mighty central government. Both Russian and Western prescriptions for redistributing powers could make things worse if the underlying issues are not addressed first.

For Russia, the buzzword is ‘federalisation’ – a radical reallocation of powers so that the oblasts (regions) in southern and eastern Ukraine could have their own foreign and trade policies. According to Sergei Glazyev, Russian president Vladimir Putin’s adviser on Eurasian integration, this could include the right to join the Russian-led Eurasian Customs Union. Ukraine’s interim prime minister, Arseniy Yatsenyuk, has called this “feudalisation”, designed to make Ukraine subordinate to Russia. It would certainly be impossible for Ukraine to implement a free trade agreement with the EU if part of the country was in a customs union with Russia.

On the other side, the EU supports ‘decentralisation’, a vague term which could include giving some budgetary and other powers to local authorities below the oblast level. One of the principal proponents of decentralisation, Anatoliy Tkachuk of the Civil Society Institute in Kyiv, said recently that the focus should be on “consolidating and strengthening municipalities and districts” (smaller units than oblasts). Tkachuk argued that giving more power to the oblasts would “create a layer of oligarchic activity that would continue business as usual”.

Ukraine’s immediate focus is on the presidential election, the first round of which will be held on May 25th. After that, attention will switch from who runs the country to how it is run. Decentralisation features in the ‘roadmap’ for Ukraine put forward by the Swiss Chairman-in-Office of the Organisation for Security and Co-operation in Europe (OSCE), Didier Burkhalter. At the Foreign Affairs Council (FAC) on May 12th, EU foreign ministers welcomed Ukraine’s steps to implement this. Decentralisation is likely to be a key agenda item in the series of public roundtable meetings, held under OSCE auspices, which started in Kyiv on May 14th. The roundtable is co-moderated by the former German diplomat, Wolfgang Ischinger (full disclosure: he serves on the CER’s advisory board).

The key question is whether over-centralisation of power really has been nefarious, and therefore whether either version of devolution is the right answer. While on paper Ukraine’s constitution may suggest that power is too concentrated in the hands of its central government, the events of the last six months have shown that the reality is quite different. The weakness of Ukraine’s central institutions, the influence of wealthy regional power-brokers and the interference of Russia create a risk that Ukraine may fragment. In a country as large and diverse as Ukraine, ensuring that people throughout the country have a voice at the centre is vital. But in focusing on decentralisation without strengthening national-level institutions, the OSCE and the interim government could inadvertently increase the risk of break-up.

Ukraine has amended its constitution repeatedly since gaining independence in 1991, shifting the balance of power back and forth between president and parliament at least three times. The version of the constitution currently in force is as amended in 2004, following the cancellation of amendments strengthening presidential powers that were adopted in 2010 under Yanukovych. It remains a very flawed document. Meanwhile, Ukraine has failed to build strong institutions, particularly courts and law enforcement agencies. In 2007 the Council of Europe warned of a tendency towards “legal nihilism” in Ukraine; things only got worse under Yanukovych, who appointed one of his cronies as chair of the constitutional court. The police are often corrupt and (as recent events in the east of Ukraine have shown) either incompetent or disloyal.

Since central organs of power are so impotent, oligarchs with regional power bases have been able to capture effective control of their areas, particularly in the industrial east, and to manipulate the state to their own advantage. All Ukrainian presidents have relied on these power brokers to a greater or lesser extent. The current interim government in Kyiv has had to accept that real power in the east lies with the oligarchs, appointing Ihor Kolomoyskiy, multibillionaire owner of PrivatBank, as governor of Dnipropetrovsk oblast and Serhiy Taruta, billionaire founder of the Industrial Union of Donbass, as the governor of Donetsk oblast. Ukraine’s richest oligarch and Donbass ‘boss’, Rinat Akhmetov, who seemed for some weeks to be taking a neutral position on the demands of pro-Russian protesters, has now thrown his weight behind the cause of Ukrainian unity. Steelworkers from one of Akhmetov’s plants cleared pro-Russian separatists from the south-eastern city of Mariupol after Ukrainian forces had failed to do so. This may be a good thing in the short-term, but it sends a worrying signal of private power and state feebleness.

Ukraine could probably have muddled on with weak central government and strong regional oligarchs, were it not for Russia’s intervention. The annexation of Crimea, though clearly a grave breach of international law and Russia’s commitments, was relatively unimportant in terms of the future of Ukraine as a state: Crimea was already an autonomous region; it is the only part of Ukraine where ethnic Russians are in a majority; and it contributes less than 3 per cent of Ukrainian GDP. What is happening in the south and east, however, is an existential threat: the majority in these areas, whatever language they speak, identify themselves as Ukrainians; and these regions are Ukraine’s industrial heartland, with GDP per capita above the national average.

Russia’s longer-term aims in these areas are unclear; they may extend as far as annexation on the Crimean model, or the creation of an ‘independent’ state in what Putin has called (using a Tsarist era term for the area) “Novorossiya” (New Russia); or they may be limited to ensuring, by whatever method works, that Ukraine cannot integrate with the EU or NATO. But Moscow’s short term actions seem designed to make the Donetsk and Luhansk oblasts, which contain about 15 per cent of Ukraine’s population, at least partially ungovernable. The central government and the security forces have so far failed to find an effective way to respond.

In these circumstances, any move to devolve power before the centre can re-assert itself is likely to reinforce fissiparous tendencies in Ukraine. The assorted Russian agents, irregular Russian Cossack groups and armed local malcontents running parts of the east are highly unlikely to produce the good governance, economic reform and respect for human rights that Ukraine needs. As they have shown already, they are more likely to foment chaos and violence, with or without the Ukrainian security forces to fight. On the other hand, if the centre gives in to the temptation to hand control of eastern oblasts to the traditional regional bosses, the oligarchs are likely to go back to the corrupt and predatory behaviour which has left Ukraine as such a shocking contrast with its neighbour Poland (see Simon Tilford’s CER bulletin article ‘Poland and Ukraine: A tale of two economies’).

What Ukraine needs in order to progress, and what the EU, US and international organisations should help it to build, are effective institutions at all levels. Once a president has been elected and a government is in office, Ukraine’s first priority should be to start drafting a constitution which delineates clearly what powers belong where, so that citizens know who is accountable for what. The Council of Europe’s Venice Commission on Democracy through Law has been involved in advising Ukrainian governments on the constitution in the past, but the new government should accept its advice more wholeheartedly – including on the need for an inclusive and comprehensive drafting process. It is up to the Ukrainians themselves to discover what system will command the greatest support, but experience in post-communist countries suggests that parliamentary systems consolidate democracy and promote economic reform more effectively than presidential systems: parliaments provide a forum for compromise and coalition-building, while powerful presidencies facilitate state capture by well-connected elites.

Second, Ukraine needs a court system able to make judgements based on the constitution and the law, rather than on threats and bribes. At the FAC on May 12th, ministers tasked the European External Action Service to come up with the concept for an EU rule of law mission. The next FAC should move quickly to agree on recruitment and deployment. In 2004 to 2005, the EU mounted a successful rule of law mission, EUJUST THEMIS, to help Georgia reform its criminal justice system, including fighting corruption in it; Ukraine needs something similar but more wide-ranging, covering civil as well as criminal justice.

Third, Ukraine needs a well-trained and motivated police service which upholds the law and defends the rights of citizens. The police are often the first point of contact between the citizen and the authorities; if the interaction is positive, people are more likely to feel that the government is ‘on their side’. The UN’s ‘Brahimi Report’ of 2000 on peace operations underlined this: “The fairness and impartiality of the local police force … is crucial to maintaining a safe and secure environment, and its effectiveness is vital where intimidation and criminal networks continue to obstruct progress on the political and economic fronts” – a pretty good description of present-day eastern Ukraine. Both the EU and the OSCE have experience of training and mentoring police, particularly in the Balkans; they should agree on a sensible division of labour to tackle the enormous challenge of Ukraine.

Finally, to show the Ukrainian people that the new authorities are serious about fighting corruption, Ukraine needs more open government. Procurement needs to be transparent, so that the flow of money from the state to its suppliers can be audited by citizens. The gas transit business needs to be transparent, so that people can see how much is imported, how much is sold at what price and where the revenues go. At present only Russia knows exactly how much gas enters Ukraine; and the involvement of intermediary companies and the manipulation of prices for different classes of consumers make it hard to work out what happens to the gas inside the country. And the wealth of public officials needs to be transparent, to make it harder for the corrupt to hide illegitimate income. The interim government started well, by appointing the investigative journalist Tetyana Chornovol as its anti-corruption chief, but her efforts to establish a new system for fighting corruption seem to be stalling amid disagreements on the accountability of the planned anti-corruption service. The UK’s Department for International Development and non-governmental organisations like Transparency International could offer their expertise to help Ukraine ensure that public money is not diverted to private pockets. Ukraine is already a member of the Open Government Partnership, a group of 64 countries where government and civil society have agreed to improve government openness and accountability; it should start implementing the steps it has committed itself to.

None of these changes will be easy to implement; and Ukraine will also need economic and other forms of assistance if it is to develop. But if these reforms encourage Ukrainians, wherever they live and whatever language they speak, to feel connected to and protected by the state, they will help to underpin its foundations. Without reform, any edifice of devolved powers may prove fatally unstable.

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