Wednesday, March 26, 2014

Why Cameron's timing on EU reform is off

British prime minister David Cameron is in a tight spot on EU reform. He must balance calls by eurosceptics in his Conservative Party to repatriate powers from Brussels, and the political reality in Europe that favours less far-reaching change. Cameron hopes to start renegotiating the terms of British EU membership after the 2015 election and believes Germany and the Netherlands will support him in this endeavour. But their plans and timetables do not match his.

Across the Union the debate about reform is gathering momentum. It has reached EU foreign ministers at General Affairs Council meetings in November 2013 and March of this year. Cameron has said that he wants to reform the EU, and renegotiate the UK’s relationship with it, before an in/out referendum in 2017. But instead of leading the debate, Cameron has been holding his cards close to his chest. It is an unwise strategy that threatens to leave him empty-handed.

His wish list for reform is unclear and Europe’s leaders are left to guess which changes Cameron wants. In an op-ed published in The Telegraph on March 15th 2014, Cameron said he does not want to “lay all Britain’s cards on the table”. This reflects the difficult position he is in. No proposal for EU reform acceptable to his European colleagues will be enough to appease the eurosceptics in his own party. Besides, his government cannot reach a common position because his coalition partners, the Liberal Democrats, disagree strongly with his ‘renegotiation and referendum’ strategy. Instead, he wants to wait until after the 2015 general election before discussing reform in earnest. But his caution is making potential European allies impatient.

Cameron has mentioned few practical steps to improve the Union; in general he thinks powers should flow back and forth between the national and European levels and he wants to remove the words “ever-closer union” from the EU treaties. But beyond this, there have mostly been vague promises of repatriation and reforms (for instance, about restricting benefits to migrants and cutting red tape) in the event of treaty change. The latter is particularly problematic for other member-states. Some European governments, like the Netherlands or France, may favour changes to the EU treaties in theory, but they dread the mechanics it involves; a potentially long-winded intergovernmental conference which would require referendums that increasingly eurosceptic populations might not support. Or, like Germany, they see treaty change as a long-term endeavour, not a short-term issue.

Cameron however, needs allies if he hopes to get the change in Brussels he wants. In his op-ed, Cameron pointed to the leaders of the Netherlands and Germany as his fellow travellers for EU reform. Downing Street has been flirting with The Hague and Berlin for some time. In February, Cameron rolled out the ‘reddest of red carpets’ for German Chancellor Angela Merkel, inviting her to address the Houses of Parliament. That same month, Dutch prime minister Mark Rutte sat down for an ‘informal dinner’ at Chequers to talk about EU reform.

But instead of opening up the treaties and repatriating powers, The Hague and Berlin are thinking differently. Their focus has shifted to reform initiatives that do not require cumbersome treaty change. And their views are gaining traction across Europe.

Central to their thinking is strengthening subsidiarity. This concept – enshrined in the Treaty on European Union – holds that the Union should act only when doing so achieves better outcomes than member-states acting separately at the national level. Subsidiarity is not an instrument for repatriation, since it accepts the division of competences, but where the treaties are ambiguous it does allow greater flexibility in deciding where powers lie, and it is a check on an overly ambitious Commission.

Subsidiarity will not be a panacea for the Union’s problems, but lifting the concept out of its technical and legalistic environment, and onto the highest political platform, would be helpful. For too long subsidiarity – an important but ill-defined concept – has been allowed to shelter in the dark recesses of the EU treaties. Putting subsidiarity into practice means paying more political attention to it.

In an op-ed in Handelsblatt on March 18th 2014, Germany’s foreign minister Frank-Walter Steinmeier and Dutch foreign minister Frans Timmermans called for an EU that is more selective in the issues it tackles, saying it “should be big on big issues and small on small issues.” Stronger enforcement of subsidiarity, they say, would cull unnecessary initiatives from the Commission and reduce the EU’s democratic deficit since national parliaments would become more involved: better use of ‘yellow card’ procedures would allow European parliaments to co-operate and block Commission initiatives they deem unnecessary or inappropriate. The two ministers continue that if Commissioners were to work in clusters, rather than pursuing 28 separate dossiers, the EU would be more focused and effective, and increase its legitimacy with the European public. (The CER made similar suggestions in ‘How to build a modern European Union’, October 2013.)

Among the few things Cameron has spelt out that he wants are a stronger role for national parliaments and better enforcement of subsidiarity. So he is giving intellectual support to the Dutch-German idea. It also resonates with Finland, Sweden and France. (Some of these countries, like France, may prefer treaty change in the long run – for instance to strengthen eurozone governance – but realise this is currently not politically feasible.) An added benefit of the Dutch-German plan is that it can be done within the existing treaties; it would require a political deal.

In her speech at Westminster, Angela Merkel referred to such a deal when she said “more attention needs to be paid to the subsidiarity principle in Europe. [European governments] should set priorities for the future Commission’s work.” Indeed, a political agreement between the European governments, the European Parliament and the Commission could set the agenda for a more focused Commission – outlining the areas where the Commission would, and would not legislate – underline the centrality of subsidiarity and support stronger involvement of national parliaments.

When could such a deal be reached, since the European Council, the European Parliament and the Commission must all be involved? Germany and the Netherlands foresee a window of opportunity between the election of the new European Parliament on May 22nd, and when the new Commission takes office in the second half of 2014. Only then, they believe, will the new European institutions be receptive to a political ‘gentlemen’s agreement’. There is no point in making a deal with the current lame-duck Commission or the outgoing Parliament, and it makes little sense to strike a deal after the next Commission has already started proposing EU policies.

This suggested timing will cause problems for Cameron, who hopes to keep his powder dry until after the UK general election in May 2015. He would have to support a political agreement that reined in the Commission and strengthened subsidiarity – because he agrees with the need to do both – particularly if the initiative came from his allies in Berlin and The Hague. But if a deal is done in late 2014, and then in May 2015 Cameron wins a majority without the Liberal Democrats and embarks on his renegotiation strategy, momentum for reform among his European colleagues will have dissipated. This would cause a major headache for Cameron who has been betting that he does not have to seriously discuss renegotiation or reform until next year.

Instead, Cameron should make his objectives on EU reform clear; embrace the prospect of reform by political agreement – rather than treaty change; and start contributing to the European debate with a British subsidiarity agenda, for which the government’s balance of competences review could provide the basis. If the moment passes him by, other prospects for reform may become increasingly unlikely.

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


Monday, March 10, 2014

The eurozone’s ruinous embrace of ‘competitive devaluation'

The euro was supposed to put an end to competitive currency devaluations, and with it ‘unfair competition’. But this has not been the case. Germany was often portrayed (wrongly) as the victim of other countries’ competitive devaluations before the introduction of the euro. But contrary to received wisdom, Germany’s real exchange rate – which takes into account differing inflation trends in Germany and its trading partners – did not rise in the run-up to the introduction of the single currency. And it has fallen steeply during the 15 years of the euro’s existence. This has handed German firms a competitive advantage of the kind the euro was supposed to eradicate. What is more, Germany is not under pressure to do anything about it. In fact, other eurozone countries are being encouraged to follow suit.

The European Commission compiles so-called ‘harmonised competitiveness indices’ for eurozone economies (see chart one). These are the member-states’ real exchange rates in anything but name. They show that Germany’s fell by almost 20 per cent between the beginning of 1999 and the end of 2011, before edging up a bit in 2012-13. The main reason for the decline in the country’s real exchange rate was very low wage increases and hence weak inflation. Spain’s (and to a lesser extent) Italy’s real exchange rates rose rapidly over the early part of the 2000s but have fallen sharply since 2008: Italy’s is now barely higher than in 1999, whereas Spain’s is up around 9 per cent. France’s real exchange rate is actually lower now than in 1999 (or in terms of the Commission’s analysis), its ‘competitiveness’ has improved. In short, the eurozone’s imbalances have less to do with its Latin members allowing costs to get out of hand than they do with Germany engineering a beggar-thy-neighbour cut in costs.

Chart one: Harmonised ‘competitiveness’ indices
(real exchange rates, quarter 1 1999 = 100)

Source: European Central Bank

To the extent that the steep fall in Germany’s real exchange rate within the eurozone is acknowledged in Brussels and Berlin, it is typically attributed to the need to reverse the rise in the country’s real exchange rate in the run-up to the introduction of the euro. German firms, so the argument goes, needed to rebuild their competitiveness after the shock of reunification, so set about reducing costs, which led to a fall in the real exchange rate. The problem with this analysis is that it is not corroborated by the data. Chart two below shows the real exchange rates of Germany, France, Spain and Italy between 1980 and 1998. Germany’s was actually lower in 1998 than it had been in 1980. There were devaluations in France in 1983-84, and in Italy and Spain following their ejections from the Exchange Rate Mechanism (ERM) in 1992, but in each case these devaluations were largely corrective (in response to bouts of currency overvaluation) and by 1998 their real exchange rates were back to where they were in 1980. Over the period as a whole, it was Germany that had the more ‘competitively valued’ real exchange rates.

Chart two: Real effective exchange rates
(quarter 1 1980 = 100)

Source: UNCTAD, Global Development Indicators

The result is that Germany now has a hugely undervalued real exchange rate (something that neither Italy nor Spain managed before the introduction of the single currency). Why is Germany not accused of engaging in a competitive devaluation, when Spain and Italy were? After all, Germany’s real exchange has fallen sharply relative to its long-term trend, whereas the 1990s devaluations just took the lira and peseta back down to their long-term trends.

One reason is the widespread belief that eurozone countries do not have real exchange rates because they all share the euro. By virtue of sharing the euro, devaluations are seen as impossible. A devaluation is only considered a devaluation if it involves a movement in a country’s nominal exchange rates, such as when the lira and the peseta were ejected from the ERM. But when devaluation comes about as a result of low inflation (which in turn is usually the product of weak domestic demand), it is seen as a ‘competitiveness’ gain. However, the impact on other countries is the same: they face a loss of price competitiveness relative to firms based in the devaluing country and sell less to it.

Far from being considered a problem and condemned as a ‘beggar-thy-neighbour’ strategy (as was the case with Italy and Spain), Germany is lauded for its success in reducing its real exchange rate, and other countries are called upon to emulate it in order to improve their ‘competitiveness’. So, in a curious reversal the country that underwent a large competitive devaluation is not only under little pressure to reverse it but is widely regarded as a benchmark for others.

This conflation of real exchange rates with competitiveness has been damaging. A real or ‘internal devaluation’ of the kind engineered by Germany in the eurozone has harmful macroeconomic effects because it involves suppressing domestic demand and with it inflation over a long period of time. By contrast, Spain and Italy quickly returned to growth in the 1990s following their devaluations, with the result that German exports to these countries did not suffer. If Italy and Spain persevere with attempts to devalue their real exchange rates rather than Germany revaluing its real exchange rate, the result will be persistently weak demand across the eurozone, a worsening of the currency union’s already broad-based deflationary pressures and further increases in debt ratios.

While the Commission has criticised Germany’s excessive and persistent current account surplus, it has been at pains to stress that it would make no sense for the Germans to cede ‘competitiveness’. Yet it is impossible for all members of the eurozone to enjoy the unfair advantage of an undervalued exchange rate. The Commission’s implicit assumption seems to be that all eurozone economies can engineer real (or internal) devaluations, boosting their exports to non-eurozone markets and driving an economic recovery across the eurozone. But there has already been a big swing in the eurozone’s current account position, from a deficit of around €85 billion (1 per cent) in 2008 to a surplus of almost 2.5 per cent in 2013, as Germany’s surplus remained very large while the deficits of the southern members-states narrowed. It is a moot point whether the eurozone's external surplus can continue rising: it already comprises a big drag on a fragile global economy, which the eurozone in turn is increasingly dependent on. Moreover, an economy with a big trade surplus tends to experience currency appreciation because demand for its currency outstrips the supply of it, something which is now happening to the euro. A strong euro will hit demand for eurozone exports, especially the more price sensitive ones of the currency union’s southern economies.

The eurozone needs Germany’s real exchange rate to rise (that is, for the unfair advantage that Germany has carved out within the eurozone to reverse), but this will not be easy. Germany’s export-led economy – underpinned by its social partners’ ability to deliver wage restraint – combined with rapid population ageing mean that it will generate little inflation. The German economy is growing more quickly than the eurozone as a whole, but Germany’s rate of inflation is barely above the eurozone average, not least because real wages fell in 2013. More expansionary macroeconomic policies could help. First, a combination of income tax cuts and increased public investment would boost domestic demand (and hence inflation) without posing a threat to fiscal stability: the country ran a budget surplus in 2013, with the result that its debt ratio fell. Second, Germany could withdraw its opposition to the ECB embarking on aggressive monetary stimulus, which would in turn boost economic activity (and inflation) in Germany. The problem is that a fiscal stimulus of this kind would contravene Germany's constitutional requirement to balance the budget. And there is little sign that Germany will accept aggressive moves by the ECB to reflate the eurozone economy.

For its part, the Commission needs to stop defining competitiveness in terms of the real exchange rate. Competitiveness defined in this way is a zero-sum game: one country’s ‘gain’ is another’s loss. If competitiveness means anything useful it is labour productivity or total factor productivity, not the real exchange rate which can fall simply because of wage restraint depressing demand and leading to deflationary pressures. European member-states cannot rely on the ECB coming to the rescue and countering the deflationary impact of the current race for competitiveness. They should demand that Germany do the unthinkable: lose competitiveness!

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

Monday, March 03, 2014

French federalists propose a Euro Community

A dozen French EU experts have written a manifesto proposing the creation of a new ‘Community’ for the eurozone. The self-styled ‘Eiffel group’ makes an intelligent case for a federal, political union that would exist alongside the existing European Union. The chances of such a Community emerging are, in my view, rather small. But the manifesto deserves to be read, because the authors are serious people with first-hand knowledge of how the EU works. They include Yves Bertoncini, director of the Notre Europe - Jacques Delors Institute; Laurence Boone, an economist at Bank of America Merrill Lynch; Sylvie Goulard, a liberal MEP; Denis Simonneau, a member of the board of GDF Suez; and Shahin VallĂ©e, economic adviser to President Herman Van Rompuy. If they get their way, the EU itself would become a second-class club with little appeal to members such as Denmark, Sweden or the UK.

The Eiffel group’s analysis of the euro crisis is similar to that of the Centre for European Reform. The authors argue, for instance, that fiscal policy has been too restrictive. And they are unhappy with the way Germany exerts leadership in the eurozone. “The current situation, where German federal bodies (Bundestag or the Karlsruhe court) hold the fate of the euro in their hands is not good for Germany, placed in a position of hegemony, nor for Germany’s partners, reduced to complying.”

But the institutional thinking of the Eiffel group makes the CER uncomfortable. Its chief proposal is for the euro countries and others committed to a “common destiny” to negotiate a treaty for a Euro Community. This Community would be about much more than the euro, covering education, training and innovation. It would invest in digital, transport and energy networks, as well as research. The group proposes new instruments to absorb economic shocks and support the most vulnerable people. It wants EU-level unemployment benefits and “partial harmonisation” of labour markets. 

The authors call for “putting an end to the ill-defined concept of subsidiarity [the idea that decision-making should rest at the lowest practicable level], a pretext for the renationalisation of policies”. And they would aim for a common external representation (though the authors say very little about what kind of foreign policy the Community should have).

A eurozone parliament would elect an executive to run the Community. That parliament’s members would double-up as MEPs. A levy on companies or a carbon tax would pay for the Community’s budget. It would borrow collectively to finance future projects, though not to cover past debts.

The Eiffel group is hostile to a greater role for national parliaments in the EU or the new Community. Nor does it want joint meetings of national parliamentarians and MEPs, as envisaged in the 2012 ‘fiscal compact’ treaty.  “The principle must be imposed that a European decision requires European control, and a national decision national control.”

The existing European Court of Justice would police the Community’s rules and enforce sanctions on those who breach them. However, nothing is said about how the European Commission – or, indeed, the entire EU – would relate to the new Community. The authors appear to think that the relationship between the euro-ins and -outs is not a problem, because they expect most of the member-states outside the euro to join it within a few years.

The manifesto’s discussion of the single market is cursory. It suggests that the single market take in countries that cannot easily join the EU, such as Albania, Moldova, Turkey and Ukraine. It assumes that Britain would be much happier if left in an outer tier consisting of not much more than the market, alongside such countries. Though they never state it openly, the authors imply that a big advantage of the new Community would be to ensure that the British cannot block further European integration.

This French manifesto was inspired by a similar German enterprise: last year the ‘Glienicker group’ of German experts drew up its own federal manifesto. The Eiffel group believes that France and Germany together have a special responsibility to manage European integration (Italy, Spain and Poland are scarcely mentioned in the French manifesto). Nevertheless many Germans will have problems with the Eiffel proposals.

Germans tend to like subsidiarity, and may baulk at the Eiffel group’s derogatory language on this principle. Similarly, they are big fans of the single market (even if they are reluctant to extend it further into services), so may wonder why these French authors seem so uninterested in it. The suggestion that the poorer Balkan countries, Turkey and Ukraine should join the single market implies that it is a slap-dash creation, rather than a construction that needs to be policed vigorously with strong rules and institutions.

The Eiffel group calls for the Community to build energy, transport and digital networks, but surely many of the most important infrastructure projects would achieve more if extended across the entire EU rather than merely the eurozone? For example, carbon capture and storage cannot take off seriously in the EU without a pan-European network of pipes to take CO2 from the places it is emitted to suitable underground burial sites (such as those which lie under the North Sea).

Some Germans will agree with the Eiffel Group that the eurozone needs to develop into a strong Community, but they will be concerned that the authors more-or-less ignore the relationship between the 28 and the 18. How could one ensure a smooth fit between the EU and the Community? What happens to the Commission? And what if the Community executive takes actions that harm the single market?

The manifesto implies that such difficulties will be resolved by nearly all the EU countries joining the euro. But that may be wishful thinking. Lithuania apart, none of the euro-outs has taken even the first steps towards joining the euro, such as entering the Exchange Rate Mechanism. In Poland both the constitution and public opinion seem likely to prevent the adoption of the euro until well into the next decade. Some non-euro countries – unlike the UK – may be willing to accept the disciplines of the euro, because they plan to join in the long run. But they will still want to ensure that the single market remains intact and that economically illiberal forces in the eurozone do not smother it.

French authors have a particular credibility problem in proposing the kinds of idea contained in this manifesto. This is because a number of senior people in France – though not the manifesto’s authors – lament the enlargement of the EU into Central and Eastern Europe, regret the waning of French influence in the wider EU, and hope to build a new, smaller club around the euro, in which France can exert significant influence. Not long ago, I heard a senior French official say that the EU was no longer useful for France, because there were too many Central Europeans in it, and because the French could no longer steer the Union.

Those outside France may imagine, however unfairly, that the Eiffel group is serving a protectionist agenda: they know that economic liberalism is, in relative terms, weaker in the eurozone than the wider EU (where the presence of Denmark, Poland, Sweden and the UK, among others, reinforces market economics). The manifesto’s reference to harmonising labour market rules and unemployment benefits in the eurozone will reinforce such fears.

As for questions of democracy and accountability, it is not only the British who argue that the European Parliament has a legitimacy problem and that national parliaments should play a bigger role in the EU. Since the CER published proposals in favour of enhancing the role of national parliaments, last October, we have had more-or-less sympathetic reactions from several governments, including Denmark, Germany, the Netherlands, Poland and Spain.

The Eiffel group has come up with an interesting and thoughtful contribution to the debate on Europe’s future. On paper, many of the authors’ ideas for a more federal eurozone make sense. They seem to imagine that the UK and others outside the euro will try to block the integration that the authors regard as necessary. But the real obstacle to these proposals lies not in London but elsewhere. The euro countries cannot hand over powers to a new Community unless their leaders can convince electorates – during election or referendum campaigns – that a federal government is desirable. So far, there is no sign that leaders in France or elsewhere are capable of that task.

In private, one of the authors has explained to me that the manifesto’s key point is that the current set-up does not work and is economically and politically unsustainable; he believes that both elites and citizens can be convinced of that point, and that they will therefore see the need for a tighter euro union. He may be right that the eurozone cannot flourish without significant reform. But politicians will find it very hard to persuade voters that a lot of powers now held by member-states should be transferred to new or existing Brussels institutions.

Charles Grant is director of the Centre for European Reform.