Wednesday, May 27, 2015

How will the eurozone cope with the next downturn?

Spring brought a burst of sunshine over the eurozone economy. The French economy expanded rapidly in the first quarter of 2015 and even the Italian one managed respectable growth. Fiscal policy is no longer contractionary across the eurozone as a whole. Cheaper oil is boosting consumption. A weaker euro is boosting exports. And the ECB's quantitative easing appears to be working: money supply growth is picking up, suggesting deflationary pressures are easing.

But it would be risky for eurozone policy-makers to mistake a modest cyclical upturn after years of stagnation for something more than that. First, business cycles are getting shorter and downturns deeper. The reasons for this are complicated but globalisation and increasingly complex financial linkages between countries appear to be playing a part. Nobody knows how long this eurozone cycle will last but it is probably fair to assume that we are already some way into it.

Second, when the next downturn comes, the eurozone is going to be poorly placed to handle it. There is little to suggest that the current upturn will be strong enough to undo the damage caused by the crisis. Eurozone growth is unlikely to exceed 2 per cent even at the peak of the cycle, with growth in the weaker economies much lower. This will not be enough to render debt sustainable (whether public or private). Given the amount of slack in the eurozone economy, unemployment will remain high and inflation pressures weak. Against this backdrop the ECB is unlikely to raise interest rates, meaning that it will have no room to cut them in an effort to counter the next downturn.

Furthermore, the eurozone has largely failed to address the underlying institutional weaknesses of the currency union. The reforms that have been made basically comprise crisis management tools and rules, whereas the crisis has demonstrated that monetary union without fiscal and financial integration is unstable. Unfortunately, there is little appetite for this integration, especially now that the eurozone is growing. Meanwhile debt burdens continue to grow in the weaker economies and the eurozone governments refuse to acknowledge the need for debt write-downs.

The eurozone needs further fiscal and financial integration to prevent its members from having to pursue precisely the opposite macroeconomic policies to the ones they need. Eurozone countries have given up the safety valve of an independent currency and monetary policy, hence need an even larger shock absorber in the form of fiscal policy.
Not only does the eurozone lack any fiscal transfer mechanism, but the rules of the fiscal compact tightly circumscribe the ability of member-states to impart counter-cylical fiscal stimulus.
As it stands, the eurozone is a mechanism for divergence among its members, not convergence: real interest rates are highest in the weakest countries, lowest in the strongest. This almost guarantees divergence as capital and the more productive labour become concentrated in the core. This state of affairs persists in currency unions such as the US, the UK or Germany, but the negative effects of it are offset by fiscal transfers between the participating regions or states. The banking union is work in progress: regulation has been federalised but risk not mutualised; banks are still largely back-stopped at national rather than federal level.

What happens regarding Greece will have a bearing on how the eurozone copes with the next downturn. If Greece leaves the eurozone, the ECB might well be able to contain the immediate financial fall-out. But a Greek exit will end the irreversibility of membership. Unless it acts as a catalyst for closer integration, the risk is that the eurozone will come to look like an exchange rate mechanism rather than a currency union. This will increase the likelihood of speculative attacks on the weaker members come the next recession.

The eurozone is all but certain to go into the next downturn with interest rates close to, or at, zero, high levels of public and private sector indebtedness and unemployment still well above pre-crisis levels. The ECB will be able to employ quantitative easing, but its effects will probably be exhausted by then. Critically, there will be little scope for fiscal policy to counter the weakness of private sector demand, especially in the countries most in need of it. And weak banks in struggling countries will essentially still be back-stopped by fiscally constrained governments.

In short, many eurozone governments could face the prospect of further deep recessions despite having barely recovered pre-crisis levels of activity, amid persistently strong support for populist parties. The politics of this is likely to be combustible. At this point it could be make-or-break regarding the bigger institutional questions hanging over the eurozone. It is possible eurozone governments will bite the bullet and agree a fiscal union including a degree of risk mutualisation and transfers between participating economies. But this could prove politically impossible.

The euro is not out of the woods. Eurozone reforms have not abolished the business cycle and the need for counter-cyclical fiscal policy. There is little to suggest that the current upturn will be strong enough to bring down debt levels or enable the ECB to raise interest rates in any meaningful way. But there is much to suggest that the upturn will be used as a justification for further delaying the adoption of the federal structures needed to make the euro a success.

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

Don't mention Beijing: The EU and Asia's maritime security

The security challenges facing EU member-states and south-east Asian countries are strikingly similar. Both regions have difficulties with their neighbours: assertive Chinese claims in the South China Sea are a less dramatic version of Russia's annexation of Crimea; refugees in boats and illegal migration are creating humanitarian and security challenges, and piracy threatens sea-borne commerce. More co-operation between the EU and ASEAN (the Association of South East Asian Nations) on maritime security could help both of them, but it could especially contribute to south-east Asian security.   

Mention maritime security at an ASEAN meeting and the conversation quickly turns to China and the South China Sea. Five of its six littoral states are members of ASEAN. But China claims 80 per cent of the South China Sea, including its islands, rocks and reefs and the natural resources it contains. That does not go down well in the region. The most recent spat arose when satellite photos showed China reclaiming land, erecting infrastructure and even building a runway on Mischief Reef and Fiery Cross Reef. These semi-submerged reefs are part of the Spratly island group, some or all of which is claimed by Vietnam, the Philippines, Taiwan, Malaysia, Brunei and China. In this tangled mess of maritime disputes, China’s construction work creates new brick-and-mortar facts and further weakens prospects for international dispute settlement. On April 28th, increasingly alarmed by Chinese moves, ASEAN's ten member-states adopted an uncharacteristically unified position, saying that the land reclamations "eroded trust and confidence and may undermine peace, security and stability in the South China Sea." South-east Asian officials next expect China to declare an air-defence zone over a major part of the South China Sea, in a further step to bring the sea under de facto Chinese control. Not surprisingly, all littoral states have been investing in submarines, ships or other capabilities as part of a naval arms race.

For Europe the main concern is that trade disruptions resulting from tensions in the South China Sea affect European companies and consumers. The EU is ASEAN's second largest trading partner; the largest source of foreign direct investment, and main development aid donor. The EU has concluded, or is negotiating, free-trade agreements with nearly all ASEAN members. Thus, Europe shares south-east Asia's interest in maritime security.

That security is not only jeopardised by Chinese assertiveness; boatloads of migrants from Bangladesh and refugees from Myanmar pose a challenge to the Thai, Malaysian and Indonesian authorities. European states are also grappling with the migration issue. In April, the European Council held an emergency meeting after more than 800 migrants died when their boat capsized in the Mediterranean. The European Commission now wants to disrupt the smuggling networks. Some ASEAN governments, controversially, opt to turn the boats around, leaving the refugees to face uncertainty and peril. The symmetry of the threat posed by illegal migration, and the diversity of their responses, should convince the EU and ASEAN at least to share their experiences of approaches that work.

Piracy is another area where the two regions share interests. Since 2008 European navies have co-ordinated a multinational anti-piracy mission off the Horn of Africa, to which some Asian navies have contributed, including those of Singapore and Malaysia. In the Straits of Malacca, since 2004, four littoral states have organised a patrol with aircraft and naval vessels to increase security in the strategic waterway. Both operations have had success, as piracy rates have dropped, although the threat remains and the two organisations should share lessons learnt.

ASEAN's main geopolitical challenge, however, is the rise of China. The organisation is too divided and weak to balance China's growing influence. Individual states, such as Thailand, the Philippines and increasingly Vietnam, look to Washington for help. Simultaneously, these and other governments express concern at being caught in the middle of a Sino-American 'great power' clash. Stronger relations with the EU could offer a way for south-east Asian states to hedge; to avoid being overly dependent on either Washington or Beijing. In a region of intense geopolitical competition, the EU is welcomed as a non-threatening party that promotes multilateral, not zero-sum, solutions.  Meanwhile Europe, reluctant to play the part of America’s junior partner but increasingly aware of its economic and security interests in Asia, is slowly finding its voice.

In 2013, the EU and ASEAN set up a high-level dialogue focused on maritime security. This dialogue could eventually contribute to resolving South China Sea disputes by encouraging ASEAN to act coherently on maritime issues, although this is not its official objective. For now, the question of how to handle China is too controversial for ASEAN. And so, the EU and ASEAN talk about a response to China's actions, without actually mentioning the big neighbour: after all, many of the things ASEAN could do to counter piracy, illegal migration or smuggling would also improve the region's ability to monitor, respond to and possibly discourage Chinese moves in disputed areas of the South China Sea.

The EU should offer its support and expertise on maritime security – drawing on its own experiences. By focusing on issues like people smuggling or piracy, Europe's involvement in south-east Asian security affairs will increase; it will build trust between the two organisations, and, by making maritime security about more than just China, it will invite the involvement of all members of ASEAN, not just those who have problems with Beijing.

As part of its dialogue with ASEAN, the EU should launch practical and political initiatives. On the practical side, resolving technical issues related to data sharing and analysis between coast guards and other regional agencies would improve maritime awareness. The EU could also help ASEAN member-states identify shortfalls in their maritime assets and develop ways to resolve them. On the operational side, the EU and ASEAN should organise joint exercises and training, for instance in the field of search and rescue operations. European navies, coast guards and Frontex – the EU’s border agency – should share experiences (whether positive or negative) from Operation Triton, the EU’s border security mission in the Mediterranean. The EU could give advice on how to organise civil-military missions with a group of 28 diverse member-states. At the political level, the EU should help ASEAN develop common norms for policing its maritime zone. This could result in a code of conduct that respects international maritime law and the freedom of navigation. This would help countries in the region to defuse tensions and avoid misunderstandings.

These measures will not easily change the security dynamic in the region, but they would better equip south-east Asian nations to respond to maritime challenges. They may be designed to address non-traditional security issues like piracy or illegal migration, but a more coherent and capable ASEAN would also offer the best chance of deterring risky Chinese manoeuvres. Sometimes it is best to pretend that the elephant is not in the room.

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

Five ways to win a referendum, and five potential pitfalls

David Cameron's new Conservative government is committed to a referendum on EU membership in 2016 or 2017. Many commentators assume that he will negotiate a package of EU reforms, cajole much of his party to back the result, and then cruise to victory in the referendum. And so he might. But there’s many a slip twixt cup and lip. How can Cameron maximise his chances of winning? And what are the chief obstacles that lie in his path?

Here are five pieces of advice for Cameron. First, he should not over-bid. Many Conservatives will urge him to ask for the moon. But if he tries to make fundamental changes to the EU, he will fail. Britain’s partners have no appetite for a new treaty, which would need ratification in 28 member-states, in some of them by referendum. Most capitals, including Berlin, fear that the lengthy process of changing the treaties would be like opening Pandora's box. There is no chance of a new treaty being ratified before the end of 2017. The best that Cameron can hope for is an agreement on minor treaty changes, to be ratified at some point in the future.

Second, Cameron must start making the case for EU membership. He did so with his Bloomberg speech of January 2013 – but never followed up, for fear of annoying Conservative eurosceptics and potential UKIP voters. Britain's partners will not take Cameron seriously until he is willing to explain to the British the benefits of EU membership – and thus to make enemies in his own party. Cameron must grasp the nettle that at some point in the campaign his party will split into two hostile camps, perhaps undermining its long-term cohesion.

Third, Cameron should take initiatives in the EU and seek to lead in areas where Britain has expertise. One reason why Britain's influence has waned in recent years is that it has often sat on the sidelines and appeared happy for others to lead. Britain's EU partners would listen to it with more respect if it made concrete proposals in areas such as foreign and defence policy, climate and energy, trade and the single market or co-operation on policing and counter-terrorism. They would welcome a more pro-active Britain.

Fourth, he must work hard at building alliances in the EU, where he has few good friends. When the European Council chose the new Commission president last June, only Hungary's Viktor Orban joined Cameron in voting against Jean-Claude Juncker. Angela Merkel is a friend on a good day, but she and Cameron are prone to misunderstand each other (as they did over Juncker's appointment). Other leaders sometimes complain that Cameron is a very transactional politician who does not invest sufficient time in building relationships. Britain's ties to the Central Europeans have frayed in recent years, partly because of the Conservatives' anti-immigration rhetoric. But the problem is not just the Conservatives. Under the last Labour government, too, many of the EU’s smaller members complained that British ministers and officials seldom took them seriously, for example by making the effort to visit them to discuss areas where they could work together.

Fifth and finally, clubs have not only rules but also mores. British politicians tend to forget that their rambunctious style of domestic politics – involving confrontation, bluntness and a win-or-lose psychology – goes down badly in Brussels. The EU works through long negotiations and compromises that end in everyone feeling that they have got something. Sometimes Cameron gets this: two years ago he worked patiently with Germany and other partners to forge a deal that shrank the EU budget. Sometimes he does not: during talks over the Commission presidency, Cameron told one leader that Juncker's appointment could prompt him to campaign to take Britain out of the EU. Such threats alienate potential allies.

Cameron is an intelligent, successful and – so far – lucky politician, who will probably get some of these things right. But as the last few decades of European history show, governments often lose control during referendum campaigns on EU issues. Here are five things that could go wrong.

First, Britain’s highly-charged debate on Europe may not only spur Conservative eurosceptics to demand reforms that are unattainable, but also damage the already tarnished British brand, and so make it harder for Cameron to clinch a good deal with his partners. In recent years, for example, sometimes hysterical press reports on EU immigrants have led many people on the continent to view Britain as a nasty country. The government's current refusal to take any North African boat people, and the prospect of Britain quitting the European Convention on Human Rights (so that it would join Belarus as the only European non-signatory) do nothing to help. The worse Britain’s reputation, the less likely are other governments – who all have their own domestic politics to worry about – to give Cameron what he wants.

The second reason to worry is that other EU leaders may not make significant efforts to help Cameron. True, they hope Britain stays in the EU. But Cameron has nothing to offer them in exchange for their concessions. Several governments have indicated that they will not agree to his probable demands and that if the British choose to leave, that is their problem. Madrid, Paris and Vienna are three capitals where there is not much sign of a willingness to accommodate British desires.

The third worry is that a flaming row over migration during the renegotiation may energise the get-out campaign. For Cameron, and many Britons, the priority will be to restrict EU immigrants' access to in-work and out-of-work benefits. Some of Cameron's demands challenge the fundamental EU principle of non-discrimination and thus require treaty change. But as my colleagues Camino Mortera and John Springford have written, Britain's partners are in no mood to indulge Britain on this. The danger is that Cameron raises the expectations of the British people on what can be achieved and then disappoints them.

A fourth risk is that the euro crisis turns nasty. Despite the eurozone economy's modest improvement this year, Greece's place in the currency union remains precarious. A Grexit could trigger panic in the financial markets and thus the need for emergency summits and improvised institutional repairs. If eurozone leaders – who are the same as EU leaders – are once again seen as economically incompetent, the EU's image in Britain will suffer. A new eurozone crisis would also divert leaders' time and energy from addressing British concerns.

A final concern is whether Britain's pro-Europeans can run an effective keep-Britain-in campaign. As in the EU referendum of 1975, much of the establishment is likely to support staying in. But the country has become less deferential since then. In Britain, as in much of Europe, the EU is disliked because it is seen as a project of the rich, successful, cosmopolitan and well-travelled elite. Pro-EU forces must marshal arguments that appeal to people who never went to university. A top-down, 'we know what is good for you' campaign could easily fail. But if Cameron keeps his demands modest, works on his relationships with other leaders and uses his fine skills as a salesman to make the case for the EU, the referendum is winnable.

Charles Grant is director of the Centre for European Reform.

Friday, May 22, 2015

After a deal: How to keep Iran honest?

A nuclear deal with Iran may be concluded before the deadline of June 30th. But the deal could undermine stability in the region, not promote it, unless the US and Europe are willing to contain Iran and reassure its neighbours.

Western and Iranian negotiators say an agreement on Iran’s nuclear programme is within reach. A deal that puts a brake on Iran’s nuclear programme would be a momentous achievement, but only if it can be verified and enforced.  It may not be. The prospect that an agreement could bring Iran in from the cold – after lifting international sanctions and restoring trade and diplomatic relations –   yet still leave room for it to cheat, is making Tehran’s neighbours nervous. Without Western willingness to contain Iranian influence, a deal will make the region more volatile.

There are two reasons why a comprehensive deal might fall short. The negotiators on both sides still have hard work to do. On April 2nd, the United States, France, the UK, Germany, China and Russia (otherwise known as the EU3+3), and Iran announced that an accord had been reached on the political contours of a final, comprehensive deal. This political framework, however, has many loose ends. Iran says an agreement will expire after 10 years, but the US says some restrictions on its nuclear programme should apply for up to 25 years. Iran says research and development on advanced uranium centrifuges can continue under a deal. The US disagrees. Iran does not want to give inspectors access to military sites. The US, and the International Atomic Energy Agency (IAEA), the UN’s nuclear watchdog, insist it should. They also say that Tehran must be more transparent about the possible military dimensions of its nuclear programme. If these issues are not resolved, a deal would either have little value or collapse.

Another reason for pessimism is that the deal may be skewed in Iran’s favour. The political framework agreed on April 2nd says Iran will freeze – not dismantle – its enrichment capability and reduce – not remove – its uranium stockpile. In return the UN, US and Europe will cancel most sanctions (except some proliferation-related sanctions and those linked to its missile programme and sponsorship of terrorism).

The problem is that those sanctions worked; they brought Iran to the negotiating table. But once sanctions are lifted US and European leverage will vanish. Any Iranian violation of the agreement will be difficult to detect, and even more difficult to respond to through a concerted international effort. US officials are overconfident when they suggest that it will be possible to create a reliable system to ensure that sanctions could reactivate, or ‘snap back’, automatically. The negotiators will have trouble devising a procedure that is immune to a Chinese or Russian veto in the United Nations Security Council – a necessary condition to put the sanctions back in place. The Security Council is more divided than five years ago as relations between Russia and the West have soured. The Russian ambassador to the UN, Vitaly Churkin, said on May 13th that there could be "no automaticity, none whatsoever" about re-imposing sanctions. In short, the West will have to compromise at the UN to get a deal.

The West could still re-impose its own sanctions, but once a nuclear deal has been reached, it may also be difficult to maintain transatlantic unity. Iran has the fourth-largest oil reserves and the second-largest reserves of natural gas in the world. It is actively promoting a bright economic future – fuelled by its ample hydrocarbon reserves – that European firms can be a part of. And a future pipeline connecting Iran’s gas fields to Turkey’s trans-Anatolian pipeline would contribute to the EU’s energy security. As more European firms enter the Iranian market, and in the absence of blatant Iranian violations of the nuclear agreement, European governments might favour protecting their commercial and energy interests over a unified transatlantic response to an ambiguous violation of the deal.

Ultimately, however, the US and Europe hope that their concessions during the negotiations will encourage Tehran to help stabilise the Middle East. The EU’s foreign policy chief, Federica Mogherini, said on April 28th that she was convinced a deal could “open the way to a different role of Iran in the region”. The West hopes a nuclear deal turns Iran into a helpful partner – but hope is not a strategy.

The US and Europe are right that Iran is needed to fight the Islamic State terror group, reach a solution in Yemen, and bring Syria’s civil war to an end. But it is risky to assume that Iran will suddenly change its colours after a nuclear agreement and become more helpful on all regional security issues. Why would it? Despite years of tough sanctions and economic stagnation, Iran is now a rising power in the Middle East. Its population is young, well-educated and large; second only to Egypt in the region. It has a strong sense of national identity and culture; huge hydrocarbon reserves, and a regional network of allies and militant groups, such as Hezbollah. Iran’s influence in the region has increased since the fall of Saddam Hussein. With a hand in Lebanon, Syria, Iraq, and Yemen, its reach stretches from the Eastern Mediterranean to the southern entrance of the Red Sea and the Straits of Hormuz. Riyadh, highly insecure and deeply suspicious of Iranian intent, feels encircled. Even in the Persian Gulf, a vital international waterway, Iran is flexing its muscles: on April 28th the Iranian navy forced a Danish container ship to divert its course and two weeks later it fired warning shots at a Singaporean cargo ship. The Sunni Arab world and Israel are rightly concerned about Iran unshackled from its sanctions; it will make Iranian assertiveness in the region more likely.

Viewed from the region, the nuclear deal is another sign of US withdrawal from the Middle East. Just as in Syria, where the West pushed to rid Syria of chemical weapons but did little to end the civil war, Sunni Arab states – including Saudi Arabia, the UAE and Kuwait – think that the West is negotiating with Iran about weapons, while doing little to challenge Tehran’s ambitions. Over the past two years, countries around the world have sought assurances from Washington. In areas of intensive geopolitical competition from East Asia to Eastern Europe, countries like Japan and Poland have asked questions about US commitment to their security, and received some reassuring answers from the US. Now it should be the turn of America's allies in the Middle East. At a Camp David summit on May 14th, President Obama made his case for an Iran nuclear deal to several Gulf leaders. The success of his efforts remains uncertain.

Paradoxically, an agreement that was meant to avoid another war in the Middle East may add to the region’s turbulence, unless a balance of power can be maintained. The Gulf countries and Israel primarily look to the United States to deter Iran. Washington will most likely give them some security assurances and sell them more sophisticated military equipment. But Europe has a role to play too.

European countries should help make sure Iran keeps its end of a nuclear deal by taking a tough line on sanctions; providing enough resources to spy on Iranian nuclear facilities, and improving the ability of Gulf countries to stand up to Iran. The EU should insist on gradually phasing out the sanctions, not removing them instantaneously. Measures such as those that blocked Iranian shipping companies from accessing the European reinsurance market and underwriters have been central to the sanctions’ overall success. The EU should only remove these measures if Iran meets clear commitments; for instance on reducing its uranium stockpile or disabling its enrichment cycle. Importantly, if needed, the EU should be willing to reactivate the sanctions unilaterally (or with the US), even without a UN resolution.

Paris, London and Berlin will actively promote their defence exports, seeking to persuade countries in the Middle East that stronger forces are necessary to keep Iran at bay. In May, France announced the sale of fighter jets to Qatar, and negotiations on a similar military package continue with the UAE. Germany has sold four advanced submarines to Israel. Saudi Arabia is the UK’s largest defence technology export market. But alongside selling more kit, Europe should help improve the ability of Arab militaries to counter threats from Iran by improving their professionalism and skills.

The UK, in co-operation with allies, should continue to use its intelligence capacities to monitor Iran’s nuclear supply chain. This would help to verify Iranian nuclear commitments. If the West is to keep Iran honest, Tehran has to know that its activities will be very closely scrutinised. The UK and other European governments should also direct more intelligence resources to disrupt Hezbollah’s military wing; that organisation has been on the EU’s list of terrorist organisations since 2013.

France, more than any other European country, has stood up for Arab interests during the Iran talks. It has also gained Arab credit for showing its resolve against Islamist terrorists in places like the Sahel. On May 5th, President Francois Hollande became the first foreign head of state to attend the summit of the Gulf Co-operation Council (GCC), a political and economic forum for Arab Gulf countries. Paris should use that diplomatic credit to persuade Arab Gulf countries not to over-react to a nuclear deal, and to make clear that they should end support for Sunni militant and terrorist groups: the prospects for stability in the Middle East will not be helped by continuing sectarian violence.

The EU’s high representative, Federica Mogherini, has an important role to play too. She chaired the nuclear talks and her shuttle diplomacy was essential to agreeing the political framework in April. But her triumph will only last as long as an agreement holds. Her diplomatic access with the Iranians should allow her to push Tehran to stick to a deal. But perhaps her biggest challenge is that she should convince Iran to play a constructive role in places like Syria, Iraq and Yemen.

An ugly consequence of a nuclear deal is that it may encourage Arab countries to seek the same nuclear technology that Iran has. A nuclear agreement will most probably legitimise Tehran’s right to uranium enrichment, so Saudi Arabia has said it wants a nuclear fuel cycle too. This poses a serious problem to the West: an agreement meant to avoid the spread of nuclear technologies, may do just that. Riyadh could get the technology from Pakistan, which is widely believed to have developed nuclear weapons with Saudi financial assistance, and has a poor record on nuclear non-proliferation. But Laurent Fabius, the French foreign minister, also discussed nuclear power projects when he visited Riyadh in April. So the West faces a choice: it could decline Saudi requests and push Riyadh towards Islamabad, or it could help Saudi Arabia develop civilian nuclear technology and keep an eye on its nuclear programme. The latter option is preferable.

A nuclear deal may still collapse. But if a deal is reached, Europe should engage with Iran, but be willing to contain it too.

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

Monday, May 18, 2015

The Riga Summit: Enter, pursued by a bear

The Eastern Partnership summit in Riga on May 21st-22nd will be a gloomy affair. Russia’s aggressive behaviour has put EU member-states on the defensive. Enthusiasm for further integration between the EU and its Eastern neighbours is on the wane. But Europe should be bolder: a grey zone to its east is not in the EU's interests.

The Latvian Foreign Minister, Edgars Rinkēvičs, said in February that the EU’s meeting with its eastern partners would be a “survival summit”. The run-up to the meeting suggests that the Eastern Partnership will still be in a critical condition after Riga. The six partners (Armenia, Azerbaijan, Belarus, Georgia, Moldova and Ukraine) are a disparate group, and EU member-states are divided in their views of the partnership’s future. Here are five steps to save the Eastern Partnership.

First, decide what the goal of the partnership is. The EU has never seemed sure. Within the EU, some countries, primarily in Central Europe, have wanted to give the Eastern partners a perspective of eventual EU membership; others have not. Partners are equally divided: Georgia, Moldova and Ukraine have been more or less enthusiastically pro-EU; Ukrainian presidents (even Viktor Yanukovych) have been talking publicly about Ukraine’s long-term intention to join the EU since at least 1996.

President Aleksandr Lukashenko of Belarus, on the other hand, has been under some form of EU sanctions since 1997. Azerbaijan, with its large hydrocarbon reserves, has little interest in the trade privileges offered by the Eastern Partnership and still less in good governance, human rights and democracy. Armenia is balanced uncomfortably: too dependent on Russia for defence against Azerbaijan to sign an association agreement against Moscow’s will, but keen to benefit from any EU assistance available.

There has been protracted wrangling ahead of Riga over how to refer (or to avoid referring) to the possibility of enlargement. At the last summit, in Vilnius in 2013, the EU and its partners acknowledged “the European choice of some partners” and said that the partnership had a particular role in supporting “those who seek an ever closer relationship with the EU”. At the time of writing, even this vague wording seems to be in question.

The Treaty on European Union says clearly that any European state which respects EU values “and is committed to promoting them may apply to become a member of the Union”. By refusing to refer to this language, even indirectly, the EU reinforces two Russian arguments: that the EU does not want the Eastern Europeans as members under any circumstances; and that Eastern Europe is a region of “privileged interests” for Russia, in the phrase used by then-President Dmitri Medvedev in 2008. The EU should come off the fence, and say that it will keep the door to membership open, however long it takes partners to get through it; and that Russia has no right to close it.

Second, differentiate clearly between the partners. The pre-summit press release talks confusingly of the EU’s “determination to pursue closer, differentiated relations”. But there is no point in wasting limited EU resources on countries which are not committed to the partnership’s principles of democracy, the rule of law and good governance. Georgia, Moldova and Ukraine are at least making efforts to improve. Georgia and Ukraine will be disappointed that one of the most attractive elements of the partnership, visa-free access to the Schengen area, is still out of reach, for technical reasons. The principle of ‘more for more’ should be more than a slogan: EU programmes and funding should flow to the countries that have made the most progress.

There are good reasons for the EU to want a strong relationship with a major energy producer like Azerbaijan, but the Union should not behave as though Azerbaijan is gradually converging with European norms and values. The 2014-2015 progress report on Azerbaijan presented by the European Commission and the European External Action Service is stark. It talks of deteriorating conditions for civil society, the detention of human rights defenders and restrictions on freedom of expression and association. Notwithstanding the EU sanctions against it, Belarus is in fact a better performer on human rights than Azerbaijan, and should get a little more love from Brussels.

Where a government is a difficult or uncooperative interlocutor, the EU should focus more attention on civil society organisations – including through increasing the resources available to the European Endowment for Democracy. Support for civil society does not have to mean support for the political opposition or confrontation with the existing regime: it can cover help and advice for environmental groups or groups working to protect the rights of vulnerable minorities; all help to increase the resilience of society, and to prepare for the possibility of political evolution.

Third, communicate better. The then-foreign minister of Sweden Carl Bildt said in Vilnius in 2013 “Putin makes you an offer you can’t refuse; the EU makes you an offer you can’t understand”. The EU’s public diplomacy effort in Eastern Partnership countries needs to be turbo-charged. The Union has to do a much better job of countering ignorance, misunderstanding and misinformation and telling the positive story of the benefits co-operation with the EU will bring. Eighteen months after the first Maidan demonstrations, the EU delegation in Kyiv still has a website with information in English and Ukrainian only. It was left to the British Embassy in Kyiv to produce a Russian-language pamphlet setting out the advantages to Ukraine of its association agreement with the EU. The Ukrainian President’s website is in Ukrainian and Russian; if Petro Poroshenko thinks it is politically acceptable to speak to Russian-speaking Ukrainians in their native language, why does the EU not do the same?

Russian anti-EU propaganda has had the field almost to itself throughout the Eastern Partnership region, and it shows in the opinion polls. In Moldova, a poll in April showed 58 per cent in favour of joining the Russian-led Eurasian Economic Union (with 26 per cent against) and only 40 per cent in favour of joining the EU, with 42 per cent against. That is a remarkable statistic, considering that Russia has blocked Moldovan agricultural exports since July 2014, while the EU has increased Moldova’s access to European markets and given Moldovans visa-free access to the Schengen area.

Fourth, stop thinking that the Eastern Partnership is a purely technical exercise. For the countries that have signed association agreements, the process of harmonising local laws and regulations with European law is indeed a complex, tedious, legalistic marathon; and only a handful of people will ever read the whole text of the agreements, or need to. But Putin is right to think that if the EU’s partners implement the new laws and regulations and live up to their commitments under the agreements something dramatic will change in Europe.

The Eastern Partnership was never intended as a geopolitical project, but if it results in some of its members adopting the vast majority of the EU acquis communautaire, it will produce a decisive break between them and their Soviet past. The EU needs to understand that Putin sees the adoption by Russia’s neighbours of EU standards, open markets and above all the rule of law as inherently threatening to his interests.

Fifth, ensure that Ukraine succeeds. Ukraine's population is around 50 per cent greater than the other five partners combined; its GDP is almost equal to that of the other five. While it would certainly not be good if reforms stalled in Georgia or Moldova, failure in Ukraine would be fatal to the Eastern Partnership and deeply damaging to the EU itself.

The EU's interests lie in having neighbours that share its values and its ways of doing business. It needs to be ready to react to Russian moves to destabilise the countries of the region with much more speed and determination than it showed in Ukraine in 2014.Then, its sanctions were initially too weak to make Russia rethink its aggression, and its support for Ukraine too modest to match the scale of the economic, political and military challenges Kyiv faced.

Though in 2004 Putin said that Russia would welcome Ukrainian membership of the EU, since 2013 he has exerted enormous, destabilising efforts to ensure that Ukraine cannot benefit from its association agreement with the Union, let alone make progress towards membership.

German chancellor Angela Merkel and French president François Hollande made a serious error in Minsk: they supported the idea of talks between the EU, Russia and Ukraine “to find practical solutions to the concerns raised by Russia about the implementation” of the EU-Ukraine Deep and Comprehensive Free Trade Agreement (DCFTA). The DCFTA will force Ukraine to make painful reforms; but it also offers a long-term route to a better-managed, open and ultimately more successful economy.

Russian intentions towards the DCFTA are neither reasonable nor honourable. If Russia wants to ensure that its goods remain competitive on the Ukrainian market, it should negotiate its own free trade agreement with Kyiv; it has no more right to seek amendments to the DCFTA than the EU has to demand changes to the arrangements for the Eurasian Economic Union. But the proposed amendments put forward by Russia go further. They are clearly intended to wreck the DCFTA and to ensure that Ukraine cannot profit from it; they would damage both EU exporters and Ukrainian consumers. The EU should make clear that it will not postpone the implementation of the DCFTA any further: it will start on December 31st 2015. And the EU and its partners should be prepared to stand up to any Russian retaliation. As wildlife experts advise, “if a bear approaches or charges you, do not run”.

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

Thursday, May 14, 2015

Cameron’s EU reforms: You can’t always get what you want

David Cameron has outlined six areas for EU reform. In five, compromise is possible. But restricting in-work benefits for new EU migrants requires treaty change, which is not on offer. Thus he faces confrontation with the anti-migration wing of his party or with the EU – and he should choose to face down the former.

David Cameron has made treaty change the totemic issue in his quest to renegotiate the UK’s relationship with the European Union: he believes that he must have it to convince his party that the EU has been reformed. But he is engaged in two negotiations – one with his own party and eurosceptic press, and the other with the rest of the EU.

Cameron’s problem is that Britain cannot get the treaties changed before the referendum, since other member-states do not want to re-open them, especially if Britain might leave anyway. Germany’s finance minister, Wolfgang Schäuble, said on May 12th that treaty change would not be possible by the end of 2017, Cameron’s deadline. Many governments would need to hold referendums on an amended treaty, and do not think they could win them. And Britain does not seem to realise that other governments face political constraints too: a treaty tailored specifically to Britain’s interests would be an impossible sell to their voters.

Charles Grant has already set out a five-point plan for winning a referendum. This insight looks in more detail at the six areas of reform that Cameron has outlined in articles and speeches. In five of them there is some possibility of compromise if Cameron backs down on treaty change (which will be tricky enough, because he has made it so totemic). But on the sixth – stopping EU migrants from claiming benefits for the first four years of residence – compromise between the EU and Britain looks very difficult. This is the area where British public opinion is most hostile to EU rules, where Cameron has been most specific in his demands, and where treaty change is most needed to secure them.

Cameron’s first demand is a safeguard for the single market to prevent the eurozone from caucusing, and potentially damaging the interests of the euro ‘outs’. Ultimately, this issue is something of a red herring, since the eurozone is – on average – more economically liberal than it used to be. But there is a case to be made that financial rules made in the eurozone’s interest could damage the City of London: the European Central Bank’s attempt to repatriate euro-denominated clearing and settlement is one example. Britain and other outs could be given observer status in the Eurogroup to act as advocates for the single market in eurozone meetings. The Fresh Start group of Conservative MPs has proposed that Britain should be able to refer new financial rules it disliked to the Council where unanimity would apply, handing the UK an effective veto. But any new legal safeguard of that sort would require treaty change, and would receive little support in the rest of Europe.

Second, Cameron has said he wants a stronger role for national parliaments. One idea, floated by Britain’s Europe minister, David Lidington, is for national parliaments to be able to club together to give Commission proposals a ‘red card’. Currently, they may give proposals a yellow card, which forces the Commission to reconsider, but a red card would make it drop a proposal. While a ‘legal’ red card would require treaty change, the Commission could promise to treat all new yellow cards as red ones. This would not require treaty change, and the other member-states could agree to write this into the next treaty. Meanwhile the UK could use the current yellow card system more effectively if it improved its own parliamentary scrutiny procedures.

The third demand is that powers should flow back to the member-states. This is already possible under the Lisbon treaty, if member-states agree to do so. But which powers? The British government’s own balance of competences review did not find any that should be returned to Westminster, so it will be difficult for Cameron to convince the others that it is necessary.

The fourth demand – removing the ‘ever closer union’ text from the treaty – is symbolically important to British eurosceptics, for whom the phrase threatens inexorable progress towards a European super-state. Dropping it entirely would obviously require treaty change, and other member-states would oppose this. But Britain might be able to secure an opt-out, with a so-called ‘interpretative protocol’ to make clear that it did not apply in Britain’s case.

Fifth, on promoting free trade and extending the single market, there are several policy changes that are already underway. Cameron wants TTIP and other free trade agreements to be ‘turbo charged’, but that is up to the European Commission and the countries they are negotiating with, not the UK, since external trade is an EU competence. On trade within the EU, there are already plans to open capital and digital markets, so it would be difficult for Cameron to claim that this was the result of his negotiation. And the same is true of better regulation, although Frans Timmermans, the commissioner in charge, should take up some of the proposals of Cameron’s business task force and give Britain credit for the reforms.

The electoral threat of UKIP – and defections to the party from his own MPs – forced Cameron to be specific about EU migrants’ access to benefits in a speech in November 2014, and it is in this sixth area that trouble awaits.

In that speech, Cameron demanded that EU migrants should not have access to either unemployment or in-work benefits for four years. The former will be easier than the latter to renegotiate, but still extremely difficult. The right of unemployed people to move to another country and claim unemployment benefits, though not unlimited, has been endorsed by the European Court of Justice in case law. To deny workless EU migrants unemployment benefits, a new directive would have to be passed through the EU’s ordinary legislative procedure, which could take years. And this would require the Council and Parliament to agree, and the latter has been very hostile to the idea.

Changes to in-work benefits would require treaty change, since they would in effect skew labour markets in favour of domestic workers. As CER’s Camino Mortera-Martinez pointed out, article 45 of the Treaty on the Functioning of the European Union says that there will be no discrimination between EU workers “as regards employment, remuneration and other conditions of employment”. Should in-work benefits be considered as such? There are very good reasons to think that they should.

Consider the average Central and East European migrant working in the UK (all data are from Britain’s quarterly Labour Force Survey). He is male, aged 32, has one child, and is either married or cohabiting. He works full-time, and his household’s earnings are 60 per cent of the British median. He lives in low-cost private housing in the south east of England. Overall, his weekly earnings after tax are £265 per week. This would be barely enough to cover his rent, bills and council tax. Under the new universal credit, that income would be topped up by £305 per week, to allow him to cover his other costs.

Many in Britain might consider withdrawing benefits a fair outcome, believing that if a migrant cannot support himself then he should return to his home country. But the legal test is whether this constitutes discrimination under the treaties. It must, since the equivalent British worker – or EU migrant who has been in Britain for more than four years – would receive more than twice as much income, and would be much more willing to do the job. Newcomers, especially those with children, would be discriminated against in the bottom end of the labour market.

The Financial Times and others have argued that it is not against the EU’s fundamental principles to restrict benefit access. This is, at a stretch, true of unemployment benefits, because European judges have been responsible for extending rights, not the member-states, and the treaties give rights to workers, not the unemployed. But restrictions on access to in-work benefits will discriminate against immigrant workers, which free movement rules are supposed to prevent. Thus this reform would require treaty change. Treaty change requires unanimity. And it is difficult to see Central and East European governments agreeing to it.

Free movement is the least popular part of EU membership among Britons (at least, in relation to other EU citizens coming to the UK – around 2 million British citizens live in other EU countries), but Cameron should seek to divert attention from the issue rather than pander to these views. Optimists point to the opinion poll lead for staying in the EU, and to Cameron’s strengthened authority in his own party after his shock election victory. But a drawn-out wrangle on migrants’ benefits could see the polls swing back in favour of Out. Cameron’s best hope is to ally himself with the pro-business wing of the party, which is more in favour of open labour markets, focus his reform proposals on steps to promote jobs and growth in the EU, and face down the Conservatives’ anti-migration wing. That way, he might just get what he needs.

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

Friday, May 08, 2015

A five-point plan for Cameron to win an EU referendum

The politicians hardly mentioned Europe during the campaign, yet the most important consequence of Britain’s general election will be a referendum on EU membership. Prime Minister David Cameron plans to negotiate reforms to the EU and then hold an in-or-out referendum before the end of 2017. What does he have to do in order to win a referendum on keeping Britain in the club? What is he likely to ask for, in terms of reform? And what would be the impact of ‘Brexit’ on the rest of the EU?

The voters defied opinion polls and delivered a shocking result: the centre-right Conservatives performed much more strongly than expected in England, the centrist and pro-EU Liberal Democrats lost most of their seats, and the Scottish National Party (SNP) won almost every seat north of the border. The anti-EU United Kingdom Independence Party (UKIP) won 13 per cent of the votes but only one seat. The centre-left Labour Party – which according to the final opinion polls had a good chance of forming a government – finished almost a hundred seats behind the Conservatives.

At least three factors explain the Conservatives’ triumph: Cameron was a more convincing leader than Labour’s Ed Miliband; the economy’s recent strong performance strengthened the Tory reputation for economic competence; and in the closing stages of the campaign, the Conservatives played on fears that a Labour government propped up by the SNP would be bad for the English.

But although Cameron is the clear winner, he may face some of the problems faced by John Major after he – also in defiance of opinion polls that proved wildly wrong – won the 1992 general election. Major had a majority of 20, soon eroded by by-elections and deaths, which enabled his party’s eurosceptic right-wing to make his life a misery. Cameron’s majority is 12. For the past five years his Lib Dem coalition partners have given him a clear parliamentary majority, and thus some protection from Tory eurosceptics. But now they will be urging Cameron to make maximalist demands of his European partners; they will shed few tears if such demands cannot be met, since that would only reinforce their point that Britain should leave the EU.

Cameron will have to fend off the Conservative hard-liners if he wishes to keep Britain in the EU. He can face them down if he wants to: his surprise victory has given him considerable political capital. He does not need to consult backbenchers on the finer points of his negotiating strategy. If Cameron wants to, he can negotiate some modest improvements in the way the EU works. But he will need to be diplomatic and constructive. The British brand in the EU is much more toxic than many people in the UK appreciate. Here are five pieces of advice for Cameron.

First, do not over-bid. If Cameron tries to make fundamental changes to the way the EU works, he will fail. Britain’s partners have no appetite for treaty change: a new treaty would need to be ratified in all 28 member-states, some of which would have to hold referendums. The process of changing the treaties would take many years, and most governments – including Germany, which leads the EU – fear that reopening the treaties would be like opening Pandora’s Box. There is no chance of a new treaty being ratified by 28 countries before the end of 2017. The best that Cameron could obtain would be a promise of very minor treaty changes, to be ratified at some point in the future.

Second, make the case for EU membership. Cameron did so with his Bloomberg speech of January 2013 – but never followed up, because he did not want to annoy his party’s eurosceptics or potential UKIP voters. Britain’s partners will not take Cameron seriously until they see that he is prepared to explain to the British the benefits of EU membership – and thus be ready to make enemies in his own party. Cameron surely understands that during the referendum campaign the Conservative Party will inevitably split into two hostile camps – and that that may in the long term damage its unity (just like Labour’s EU referendum in 1975 presaged the split of 1981, when a group of pro-Europeans set up the separate Social Democratic Party).

Third, take initiatives in the EU and seek to lead in areas where Britain has expertise. One reason why British influence has dwindled in recent years is that it has often sat on the sidelines and appeared happy for others to lead. Britain’s EU partners would listen to it with more respect if it made concrete proposals in areas such as foreign and defence policy, co-operation on policing and counter-terrorism, climate and energy, or trade and the single market. Many other member-states would welcome a more pro-active Britain.

Fourth, work hard at building alliances and making friends. Cameron has very few close friends in the EU. When the European Council voted on Jean-Claude Juncker’s appointment as Commission president last June, only Hungary’s Viktor Orban joined Cameron in opposition. Angela Merkel is something of a friend, on a good day, but she and Cameron are prone to misunderstand each other (as in December 2011, when he wrongly thought that if he signed the ‘fiscal compact’ she would give him a protocol protecting the City of London). Other leaders tend to complain that Cameron is a very transactional politician who does not invest sufficient time in building relationships with them. Britain’s relations with several Central European countries have frayed in recent years, largely because of the Conservatives’ anti-immigration rhetoric. Of course, the problem is not just Cameron. Under the last Labour government, too, many of the EU’s smaller members complained that British ministers and officials seldom took them seriously, for example by making the effort to travel to discuss areas where they could work together.

Fifth and finally, a point that my late colleague Philip Whyte often made is that clubs have not only rules but also mores. British politicians tend to forget that their rambunctious style of domestic politics – involving confrontation, rudeness and a win-or-lose psychology – goes down badly in the EU. The EU works through long negotiations and compromises that end in everyone feeling that they have got something. Sometimes Cameron gets this: two years ago he worked patiently with Germany and other partners to get a good deal on the EU budget, shrinking its size. Sometimes he does not: prior to the appointment of Juncker, other leaders reported that Cameron had threatened to campaign to take Britain out of the EU if the Luxembourger was appointed. Such threats alienate potential allies.

Cameron has to take two decisions very quickly: when should he hold the referendum, and what should he ask for, in terms of EU reform?

On the first point, there is a strong case for bringing the referendum forward to the second half of 2016. The longer it is delayed, the more the climate of uncertainty will afflict the British economy and potentially deter foreign investment. Furthermore, newly-elected governments usually have more credibility and popularity than tired governments in mid-term. If the referendum happened at the end of 2017, some voters might vote against the EU only because they were fed up with Cameron. Then there is the electoral cycle of other key countries to consider: both Merkel and France’s President François Hollande face elections in 2017 and will be unwilling to make big concessions to the UK in the period leading up to them.

On the second point, Cameron’s EU partners will, of course, urge him not to ask for too much. Many in his own party – and the UK’s eurosceptic media – will tug him in the other direction, arguing that unless he extracts major concessions from other member-states, the British people will never agree to stay in the club. Cameron and his officials have given several hints of what Britain’s priorities would be in a negotiation with EU leaders:

* He will ask for limits on the in-work and out-of-work benefits available to migrants from EU countries. As my colleague Camino Mortera-Martinez has written, several of his demands would be difficult to achieve and require treaty change. See Cameron's migration speech and EU law: Can he change the status quo?

* He will try to shift the institutional balance in the EU, so that the Commission becomes less dependent on the European Parliament than it has been in recent years, and closer to the Council of Ministers. Part of this rebalancing would involve giving national parliaments a bigger role in scrutinising subsidiarity and proportionality in EU rule-making. See Not in front of the MPs: Why can't parliament have a frank discussion about the EU? by Agata Gostyńska.

* He will try to introduce safeguards for the single market. There is a potential risk that the 19 countries in the euro will club together, caucus and seek to impose their views on the broader 28-country single market. In fact such caucusing has not yet happened, but Cameron will ask for new mechanisms to ensure that it cannot.

* He will urge the EU to pursue British priorities on economic policy-making, such as negotiating more trade agreements, extending the single market into services and the digital economy, and improving the quality while minimising the quantity of regulation. In fact the Juncker Commission is doing most of these things already, but Cameron will need to dress this up as a triumph for his agenda.

* He also is keen to get some sort of opt-out from treaty language on ‘ever-closer union’. And he may seek radical changes to Britain’s relationship with the European Convention on Human Rights (though this is separate from the EU).

None of this would be easy to negotiate, but on most of these dossiers Cameron will find allies as well as opponents. So far, Britain’s partners have not taken the question of Brexit very seriously. They have been pre-occupied with the problems of Russia and Greece. Many EU leaders were praying for a Labour victory. They have not given much thought to the areas in which they could help Cameron to achieve some of what he wants. A successful British renegotiation will require moderation and constructive diplomacy on their part as well as that of Cameron.

Other leaders will now have to consider the impact of a British departure on the EU. Economically, the EU would lose its biggest champion of free trade and the single market (which is why some protectionists would welcome a Brexit). In terms of foreign and defence policy, the British – despite recent defence cuts, and their reluctance to become involved in the diplomacy over Ukraine – have serious capabilities; without the UK, the EU would find it harder to become any kind of power. If the EU lost one of its two countries with seats on the UN Security Council, other powers would take it less seriously.

And then there is the transatlantic relationship: though UK-US ties are weaker than they were, the British have so many economic and cultural links to the Americans that they can often explain the EU to them; and they can help continental Europeans to understand the US. For example, the UK has played a key role in forging transatlantic agreements on counter-terrorism. Finally, there is the German question. Germany’s weight in the EU often dominates economic decision-making, and is increasingly important on foreign policy, too. A Brexit would leave Germany even more preponderant, which would concern a lot of other countries – as well as a number of Germans.

Brexit is far from inevitable. Recent opinion polls in Britain suggest that more voters wish to stay in the EU than leave. But for a referendum to be won, Cameron needs to become more strategic and less tactical. And Britain’s EU partners need to help him to frame a deal that he can sell to the British people.

Charles Grant is director of the Centre for European Reform

Wednesday, May 06, 2015

The evil of two lessers

Britain faces some major challenges. The recovery is unbalanced, and productivity growth has been weak. Poor infrastructure, patchy skills and constrained housing supply are holding back the economy. The Union itself is in danger, with the rise of the Scottish National Party. And relations with the EU and the US are at a low point. Yet neither the Conservative party nor Labour has a compelling strategy for tackling Britain’s problems.

There are only two possible governments after Britain’s general election on Thursday: a minority government led by the Conservatives or one led by Labour. Neither main party will command a majority at Westminster, even in coalition with the Liberal Democrats. Both have ruled out going into coalition with the Scottish National Party (SNP), which will be the third largest parliamentary force following the election.

The UK faces major challenges. While its economy has grown swiftly since 2012, so has its current account deficit. Productivity growth has been weak, and there are serious supply-side problems, especially in infrastructure and housing. Britain’s influence with both the EU and the US has diminished as the country has withdrawn to the margins, and the future of the UK itself is in danger. Which of the two possible governments is more likely to tackle the political and economic uncertainties facing the country?

Assuming (as the polls suggest) that the Conservatives emerge as the largest party, they will have first crack at forming a coalition. One involving the Conservatives, the Liberal Democrats and Northern Ireland’s Democratic Unionists might get close to the 323 seats needed. But although the Liberal Democrat leader, Nick Clegg, has indicated that he would back another coalition with the Conservatives, he could struggle to bring his party with him, opening the way for a Labour-led coalition.

A coalition between Labour and the Liberal Democrats is unlikely to command much more than 300 seats, and so would fall even further short of a majority. However, the SNP is likely to secure nearly 50 seats. Ed Miliband has ruled out a formal coalition with the SNP, but one can imagine an informal arrangement, whereby a Labour-Liberal Democrat coalition governs with the tacit support of the SNP.

The UK’s economic performance compares well with the eurozone since the trough of the downturn. However, this partly reflects the fact that the British government has (sensibly) eschewed the draconian fiscal austerity seen across much of the eurozone. As a result, the UK’s fiscal deficit in 2014 was the second-highest in the EU after Spain. Furthermore, Britain’s current account deficit has widened sharply, to 5 per cent of GDP in 2014, in the process ending the coalition’s hopes of rebalancing the economy away from consumption in favour of investment and exports (see Chart 1).

Chart 1. Government, current account and private sector balances
Source: Office of National Statistics, Haver Analytics. Private sector and government are calculated as four-quarter rolling averages.

To a significant extent, the British government is powerless to do anything about the external imbalance. The UK’s exports to non-EU markets have grown strongly in recent years, but exports to the EU have fallen, since demand in the eurozone has been weak (see Chart 2). Indeed, the UK’s trade with non-EU markets is broadly in balance, with the deficit mainly accounted for by the EU, suggesting that the origins of the deficit lie as much in weak demand in export markets as supply-side constraints at home. Stronger eurozone growth should start to rebalance trade with the EU, although the current strength of sterling against the euro suggests that progress will be slow.

Chart 2. UK exports to the EU and the rest of the world
Source: UK trade info

However, policy differences between the Conservatives and the Labour Party could influence the outlook for the UK economy. While the UK faces several more years of fiscal consolidation regardless of the outcome of the election, the Conservatives are also likely to cut spending on education and infrastructure – two of the UK’s key weaknesses – by more than the Labour party. While Labour has announced that it will balance the current budget (that is, the budget excluding investment spending) by 2020, the Conservatives are committed to balancing the overall budget (including investment spending) by then, implying much tighter policy than under Labour.

The Conservatives’ ‘reform and referendum’ EU strategy is economically risky. It proposes minor changes – some of which might help the economy (such as deepening the single market, and striking more trade agreements with non-European countries) and some of which might not (making it easier for national parliaments to block legislation to deepen the single market). But the loss of foreign direct investment deterred by a referendum campaign would far outweigh any benefits from such tinkering. And if ‘Brexit’ does happen, it could result in considerable damage to Britain’s manufacturing base, and to the City of London, since it would raise barriers to competition between firms in Britain and the rest of Europe, rather than reducing them. It would also hit the poorest regions of the UK hardest.

Britain has a productivity problem. Output per hour remains lower than it was in 2007. The pick-up in economic growth since 2012 has been founded on a growing labour force rather than productivity growth. Neither of Britain’s biggest parties has a coherent set of policies for dealing with the supply-side problems responsible for this trend, and some of their proposals might worsen it.

Both Labour and the Conservatives promise to intervene in prices – for domestic energy, rail travel and housing – in a clumsy attempt to tackle the ‘cost of living crisis’ brought on, in part, by a failure to address the underlying supply-side constraints. Labour has proposed a price freeze on household energy prices and controls on rents. The Conservatives have promised to cap rail fares and provide subsidised finance for homebuyers. These policies would discourage investment in energy and rail capacity, reduce the number of homes to rent, and inflate house prices.

Despite Conservative claims that Ed Miliband is suspicious of markets, it is Labour that promises more forceful attempts to promote competition. It wants to compel the big six energy companies to build a Chinese wall between their generation and supply businesses, and to make companies buy and sell energy on exchanges. It promises two new challenger banks ‘on the high street’ (although it has not specified how it will create them) and is more likely to take concrete steps to alleviate the UK’s chronic housing crisis.

The Conservatives will do very little to address Britain’s biggest supply-side problem – the constrained supply of housing. The party plans 200,000 new ‘starter homes’ for young people over the next parliament, although its dire performance in this regard since 2010 strongly suggest this target will not be met (see Chart 3). But it will ensure ‘local people have more control over planning’ and promises to protect the green belt (the areas of largely agricultural land that surround Britain’s largest cities and which may not be built upon). It will pump up house prices by extending the ‘help to buy’ scheme, which offers subsidised finance for first time buyers. And it will reduce the availability of affordable rental housing by forcing housing associations (private charities that provide Britain’s cheaper rented accommodation) to sell to tenants, with the government subsidising their purchases. This set of policies would make the situation worse, not better.

By contrast, Labour promises 200,000 new homes a year. Although it is short on the specific policies to deliver them, its track record on housing is far stronger than the Conservatives: two-thirds as many houses were built in 2014 as in 2007. However, Labour has not said how it would tackle the issue of excessive business rents, which are as important a supply constraint as private housing. And while it promises a so-called ‘mansions tax’, which will hit the owners of expensive homes, Labour has no plans to reform Britain’s low and regressive property tax rates.

Chart 3. Housebuilding
Source: Department of Communities and Local Government

What impact will the election result have on the outlook for constitutional reform? The rise of the SNP in Scotland after the country voted to stay in the UK at last September’s referendum is, at first sight, perplexing. But the Scots were promised more devolution in the referendum campaign, only for David Cameron to announce the morning after the vote that more devolution would only happen if Scottish MPs were stopped from voting on English matters in Westminster. Since then, the Conservatives have portrayed any Labour government reliant on SNP support as a betrayal of the English, and Ed Miliband has felt compelled to say that Labour will not deal with the SNP if Labour forms a government. If the Scots return 45 to 50 SNP MPs to Westminster, and both major British parties shun them in an attempt to court English votes, Scottish voters will be disenfranchised and the Union will be further weakened.

There is one way out of this: reforming the voting system to make it more proportional, and devolving more powers to Scotland, Wales, Northern Ireland – and to the English regions. Proportional representation (PR) would ensure that parliamentary representation was more closely aligned with voter preferences, and would mean that more voters’ views were represented in parliament and government, since coalitions would be more likely. And crucially, it would prevent Scotland from becoming a permanent SNP fiefdom. The SNP has taken over from Labour as the beneficiary of first-past-the-post in Scotland. With PR, there would be far more Labour, Liberal Democrat, Green and Conservative MPs in Scotland, slowing or stopping the drift towards independence.

In many ways, Conservatives’ attitudes towards the EU are the mirror of Scottish Nationalists’ attitudes towards the UK. Both want sovereignty returned to ancient parliaments, and both consider themselves to have bad deals in their respective unions. Labour is the best hope for constitutional change. Having lost most of the Scottish MPs, it will no longer be a beneficiary of the current first-past-the-post voting system, and could hope to be the dominant political force in most the UK’s devolved regions.

Finally, could the election reverse Britain’s increasing international marginalisation? The current coalition has presided over a dramatic worsening of Britain’s relations with the EU. This has partly been the result of David Cameron’s decision to concede a referendum on membership of a ‘reformed’ EU. As there is no appetite on the part of the rest of the EU for a treaty change to accommodate major concessions to the UK, the relatively minor reforms Cameron is likely to achieve will not be enough to assuage the eurosceptics in his party. Even if Britain votes to stay in the EU, a referendum campaign will ensure that British politics is inward looking until the vote is held, further weakening Britain’s already diminished status in the Union.

A Labour-led government would be better placed to improve relations with the EU. Crucially, it is highly unlikely there would be a referendum. Nor would Labour seek to renegotiate the terms of the UK’s EU membership. Britain’s relations with a number of EU governments could improve significantly: the Conservative-led coalition has focused on relations with Germany almost to the exclusion of relations with other countries because it believes that Germany is key to a successful attempt to renegotiate membership. A Labour-led government is also more likely to reboot Franco-British military co-ordination, which has been badly neglected by the current government since François Hollande became the French president. However, even under Labour, it is far from clear that Britain would revert to a more assertive role in the EU, given the need to manage what promises to be a tricky domestic situation.

Not only has the current British government damaged relations with the EU, but it has undermined relations with the US. The UK’s waning influence in the EU combined with big cuts in defence spending, and a growing reluctance to participate in international military operations, has made the UK a less important partner for the US. However, this is unlikely to change much regardless of the outcome of the election. A Labour-led government would at least remove the spectre of a referendum and with it the biggest threat to British influence in the EU. But neither party is likely to try to meet the NATO target of spending 2 per cent of GDP on defence, although both would renew the Trident nuclear deterrent. Similarly, as minority governments, neither would risk participating in international military action in the face of strong domestic opposition.

The general election campaign has shown some of the uglier features of British politics. It has been marked by short-termism: the Conservatives have been willing to risk both Britain’s membership of the EU and the UK itself in order to court English votes. For its part, Labour has focused on populist responses to the UK’s poorly performing markets (such as price and rent controls) as much as on policies to make those markets work better. The campaign has focussed on side issues: how each party plans to cut the budget deficit has featured far more prominently than what they will do about weak productivity growth, or how to make Britain’s government more legitimate in the eyes of its people. And British politics is becoming insular: while the Middle East and Eastern Europe are torn by conflicts and a rising China squares up to the US, the next parliament will ignore those challenges in favour of arguments over ‘Scoxit’ and ‘Brexit’.

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