Friday, January 30, 2015

Genetically modified crops: Time to move on from theological dispute

One month after taking office, the Juncker Commission reached an agreement with the European Council and the European Parliament on an issue which had complicated life for both Barroso Commissions: genetically modified (GM) crops. Under this agreement, the Commission will continue to have the regulatory role of deciding, on scientific advice, whether a GM crop is safe to be grown anywhere in the EU. National governments will then be allowed to choose, on non-scientific grounds, whether to allow that crop in their country. This is a scientifically sound and politically pragmatic agreement, which should now be implemented without further argument.  

MEPs voted overwhelmingly to accept this agreement on January 12th. Donald Tusk, the president of the European Council, had opposed GM crops when Polish prime minister, but must now cast his own views aside and encourage the Council of Ministers to respect the agreement. It should not waste more time on a theological dispute about genetic modification: arguments about GM crops have been clogging up European institutions for the last 15 years.

GM technology should not be supported or opposed per se. There are good GM crops and bad GM crops, just as there are good chemicals and bad chemicals. New agricultural technology is necessary. As the world’s climate warms, there will be changes in rainfall patterns and more droughts. With the global population expected increase to over 10 billion by 2100, more food will be needed. Genetic modification can make crops more drought-resistant. It can also make crops pest-resistant. So the technology can reduce the need for pesticides, protects wildlife and reduces the contribution of agriculture to greenhouse gas emissions by cutting the use of chemicals. GM can also increase crop yield per hectare, making it easier to feed a growing population without cutting down the remaining forests. And GM can be used to breed plants which are more nutritious, thus reducing disease.

On the downside, GM can also produce crops which are able to grow with more pesticide being sprayed on them without being damaged. This trait is less desirable than pest resistance because it might lead to greater use of pesticide: farmers would not need to worry about the chemicals damaging the crops. Increased pesticide use is of benefit to the agrochemical industry but not necessarily to wider society, and certainly not to wildlife. GM crops should be treated as a series of proposed technological changes, to be assessed and regulated on a case-by-case basis. 

An example of a bad GM technology was the 1990s development by Monsanto, and other companies including AstraZeneca and Novartis, of seeds with ‘terminator technology’ inserted into their genes. Instead of producing new seeds each year, the crops were sterile, so that farmers would have to buy new seed. This would have damaged farmers in developing countries, and outweighed the benefits of higher yields. And a lack of genuine competition in the seed market could have meant that non-sterile seeds were not available to some farmers. Following extensive campaigning by green groups in the US and Europe, Monsanto announced in 1999 that it would not commercialise any crop with terminator technology. 

An example of a good GM technology is ‘Golden Rice’ – rice which provides those who eat it with additional vitamin A. Vitamin A deficiency increases the risk of disease, resulting in up to 2 million deaths a year. It also damages eyesight, causing half a million children a year to go blind every year. The development of Golden Rice has been funded by the Rockefeller Foundation for the last two decades. 

A number of patented technologies have been used in developing Golden Rice, but the lead company Syngenta negotiated with other involved firms (including Bayer, Monsanto and Zeneca Mogen), to allow plant breeding institutions in developing countries to use Golden Rice free of charge.

GM crops have been widely grown in many countries around the world for years, but in Europe only five member-states have any commercial GM agriculture. Spain has the most: about a fifth of its maize is GM. GM crops are also grown in the Czech Republic, Slovakia, Portugal and Romania. Nine countries – Austria, Bulgaria, France, Greece, Germany, Hungary, Italy, Luxembourg and Poland – ban GM crops. The other member-states do not have national policies preventing GM agriculture, but there are no GM crops grown, mainly because of public opposition. The British government would like to have GM crops grown commercially in the UK, but public opinion has so far won the argument against them.

National bans are illegal under European law. At the height of the GM controversy, when public opposition to the technology made the planting of any GM crops in Europe seem unlikely, member-states agreed to a directive on the release of GM material into the environment (in 2001) and a regulation on GM food (in 2003). These give regulatory control over GM crops to the Commission, which must base its decisions on the scientific advice of a separate, non-political agency, the European Food Safety Authority (EFSA). A national government is allowed to operate a temporary moratorium if it believes that the EFSA has overlooked some relevant scientific information. This government must then submit its evidence to the EFSA. Several governments have done this, but each time the EFSA has rejected the appeal. The member-state is then supposed to lift the moratorium. None has done so. The Commission has tried to put pressure on national governments – notably France, Germany and Poland – to permit planting, but without much success. In November 2012, after the Polish senate had lifted a ban on GM cultivation (at the behest of the Commission), Prime Minister Tusk said that he would reverse this decision

In 2010 the Commission proposed a sensible compromise: it would remain responsible for deciding whether particular GM crops were safe, based on scientific advice. But member-states would then be allowed to operate national bans on non-scientific, political or ethical grounds. The Council did not agree to this: a majority of governments supported the proposal but a minority of anti-GM countries blocked it, even though it would have made their bans legal, because they wanted to achieve a Europe-wide end to all GM planting. In his statement to MEPs at his confirmation hearing in July 2014, Jean-Claude Juncker said that the political views of elected governments on GM should have the same weight as scientific advice in regulatory decision-making. Then on December 3rd, the Commission reached agreement with the Parliament and the Council to follow the approach which the Commission had proposed in 2010. This will lead to some countries, such as the UK, planting GM crops commercially for the first time, while Germany, France, Poland and other anti-GM countries will be allowed to retain their bans.

Have GMOs been proven to be safe? No. That is not how science works; nothing is ever definitively settled and more discoveries are always possible. Is there enough evidence that GMOs are safe to permit their release into the environment? Yes – if the benefits of the crops are sufficient to justify the inevitable risk that accompanies the release of new organisms into the environment. 

The European Academies Science Advisory Council (EASAC) published a wide-ranging assessment of genetic modification in 2013. This states that: “There is no validated evidence that GM crops have greater adverse impact on health and the environment than any other technology used in plant breeding.” GM opponents argue that the risk of releasing new forms of life is so great that it should always be avoided, and often invoke “the precautionary principle”. However, the EU’s definition of this states that scientific evaluations of proposed new technologies should include both “a risk evaluation and an evaluation of the potential consequences of inaction”. The EASAC report says that: “There is compelling evidence that GM crops can contribute to sustainable development goals with benefits to farmers, consumers, the environment and the economy.” So the risk of action is small; the risk of inaction is large.

December’s agreement gives the EU a sensible case-by-case approach to GM regulation. This balances science and politics, as well as the single market and concerns over national sovereignty. A single market in agricultural goods requires that one member-state does not exclude produce from another country because it contains GM. Member-states have harmonised standards for GM produce since 2003. So Germany or France cannot ban maize from Spain because it is GM. They can now choose not to allow GM crops to be grown on their territory, and do not need scientific justification for this ban. As the Commission’s former chief scientific adviser, Professor Anne Glover, said at a CER event in July 2014, there may be economic or social reasons why a government chooses to ban GM crops. The fact that science says a crop is safe does not mean that countries should be forced to grow it. 

Now it is up to national governments to agree to disagree on GM crops. The British, Czech, Spanish and Portuguese governments should stop pressing for more countries to allow GM cultivation, and the Austrian, French and German governments should stop trying to prevent any cultivation anywhere in Europe. 

For its part, the EU needs to move on from a narrow focus on GM crops, and address wider issues of how to make agriculture more efficient and sustainable, as well as better able to withstand climate change and feed a growing global population.

Stephen Tindale is a research fellow at the Centre for European Reform. He spent six years as executive director of Greenpeace UK, which opposes GM crops. However, he has always thought that GM technology should be assessed case-by-case. He minimised campaigning on GM – never authorising direct actions against GM during his time in charge – and told Greenpeace’s campaigners to focus instead on how to make agriculture less environmentally-damaging.

Tuesday, January 27, 2015

After Paris: What’s next for the EU’s counter-terrorism policy?

In the aftermath of the Charlie Hebdo shootings, both national governments and the European Union have announced that they will adopt new laws to combat terrorism. On January 29-30th the justice and interior ministers of the 28 member-states will hold an informal meeting in Riga to discuss what measures the EU should take. Rather than focusing on radical initiatives like the establishment of a European CIA, or the re-imposition of border controls, they should take some modest but important steps. In particular, they should overcome their differences on several key pieces of legislation which have been under discussion for some time and agree to use some powerful instruments that are already at their disposal.

Anti-terror legislation in the EU has traditionally evolved in response to events: urgent measures, like the European Arrest Warrant and the setting up of Eurojust (the Union’s agency for judicial co-operation) were taken after the 9/11 attacks. Then in the wake of the Madrid and London bombings, in 2005, the EU adopted its first-ever counter-terrorism strategy. That was followed in 2006 by the so-called data retention directive, which required communication providers to store data about their customers for up to two years. However the European Court of Justice (ECJ) recently declared this directive void, stating that its provisions violated EU rights of privacy and data protection.

In recent years, faced with the alarming phenomenon of returning jihadists, the Commission has tried to put in place a battery of measures which either the European Parliament or influential governments in the Council have opposed. These measures include sharing passenger data and a more effective use of the Schengen countries' internal database. The Paris events will undoubtedly help to unblock some of these measures. But what should be the EU’s priorities for a coherent and effective set of counter-terrorism policies?

High on the Council’s wish list is the controversial directive that seeks to establish an EU system for exchanging information about airline passengers departing for or arriving from third countries, known as Passenger Name Records (EU PNR). PNR data includes, inter alia, the name and address of the passenger, banking data, itinerary and emergency contact details. There is currently no obligation for airlines to transmit PNR data to member-states, although international agreements with the US and Canada oblige air carriers to share data on European passengers travelling to those countries with the authorities at the destination. The PNR directive, tabled by the Commission in 2011, introduces a requirement for air carriers to transfer PNR data to the member-state of arrival or destination. The civil liberties (LIBE) committee of the European Parliament has so far blocked the directive, on the grounds that it does not offer sufficient safeguards against violations of fundamental rights to privacy and data protection.

This argument is similar to the controversy in 2010 over the EU-US agreement on the Terrorist Finance Tracking Programme (TFTP), which ended with the Parliament blocking, for the first time in its history, an international agreement between the EU and a third country. The TFTP agreement was eventually adopted, once clauses safeguarding privacy – requested by the Parliament – had been introduced.

Both the Council and the Parliament should learn from the mistakes they made then, if they want to find a solution on PNR. The Council should make sure that national intelligence services brief security-vetted MEPs on the reasons why an EU PNR system is needed. This briefing procedure, which was made available to allow the Parliament to take informed decisions on security-related issues, has not yet been applied in relation to PNR.

The Treaty of Lisbon conferred full legislative powers on the Parliament in the field of Justice and Home Affairs, including counter-terrorism. The Council should now treat the assembly as an equal partner and involve it fully in the decision-making process. This could be done by explaining the value of the system to MEPs and trying to accommodate their demands to the greatest possible extent. Likewise, the Parliament should outgrow its sometimes naïve approach to security matters (as in the row over TFPT), and take a more responsible stance. It should avoid using security measures as a weapon in a test of strength with the Council and focus on the practical consequences of its vote. The Commission should act as an honest broker between the two institutions, ensuring that member-states do not use the Paris shootings to dismiss legitimate concerns about privacy and civil liberties.

One of the main demands of the European Parliament is that the PNR directive should not be adopted before the EU has completed the reform of its data protection rules. The reform includes the introduction of a specific directive covering the rules for the exchange of data between police and judicial authorities. The revised data protection rules would provide the general legal basis for all the privacy safeguards that MEPs would like to introduce into the PNR directive. The EU is set to complete this revision in the course of the next months. Early agreement on data protection reform will help institutions to find consensus on the PNR directive.

The EU is responsible for harmonising counter-terrorism measures in national criminal systems. The framework decision on combatting terrorism, adopted in 2002, requires member-states to introduce in their criminal codes provisions penalising terrorism and harmonising punishments for terrorist offences. It was amended in 2008 in order to criminalise offences related to provocation, recruitment and training for terrorist purposes. The decision now needs a comprehensive revision, among other things, to align its provisions with a United Nations Security Council resolution – UNSCR 2178 (2014) – on foreign fighters. The resolution requires countries to penalise travelling, or planning to travel, to foreign countries with the intention of preparing, or training for, a terrorist attack. It also criminalises financing and facilitating such activities. Harmonising legislation across the EU in order to tackle the problem of returning jihadists is crucial for the work of security forces and prosecutors. Some member-states, which take the threat from foreign fighters particularly seriously (such as France, Germany or the UK) have already adopted, or are in the process of preparing, relevant legislation; several other member-states, however, such as Hungary or Romania, do not share the same sense of urgency and lack proper legislation. This could lead to the creation of ‘safe havens’ where returning jihadists could find sanctuaries inside the EU.

In order to restrict the freedom of movement of potential terrorists, some member-states are pushing for systematic passport checks to be reintroduced on borders within the Schengen area, and for more stringent controls on Schengen’s external borders. The European Commission, however, opposes systematic checks and argues that member-states should instead make more use of the tools already at hand, like Schengen’s database, the Schengen Information System (SIS II). Member-states can input ‘alerts’ into SIS II to signal, for example, that a person is wanted for a criminal offence or that a firearm or identity document has been stolen. Such ‘alerts’ then pop up whenever the border authorities of a member-state perform a check on a person attempting to enter their country.

The Schengen Borders Code requires systematic checks at the external border while allowing for non-systematic checks within the Schengen area. Inside Schengen, border authorities can perform thorough controls (involving checking SIS II and other databases) on random samples of passengers, or on passengers identified as a ‘threat’.

The Commission has said that not all member-states are consistently performing such checks and that SIS II is being underused. SIS II is one the most powerful tools in the fight against terrorism, but member-states do not always enter the required data on suspected terrorists. This hampers the effectiveness of the system. The sub-optimal use of the SIS II database is closely linked to the reticence of national authorities to share intelligence information. Intelligence services are inherently reluctant to share information, but they may be missing the potential benefits of a more co-operative approach – for instance in the case of returning jihadists. The Commission and the Council can encourage such co-operation, by showing member-states the effect of entering more intelligence-based ‘alerts’ into SIS II. They can also make use of formal structures like Europol and the EU Intelligence Analysis Centre (EU INTCEN, part of the European External Action Service), and other initiatives. Federica Mogherini (the EU High Representative for Foreign Affairs and Security Policy) has a plan to appoint security attachés in EU delegations in relevant countries. While the idea of a European CIA remains, for the time being, a fantasy, EU institutions have an important role in co-ordinating the input of national intelligence agencies in the fight against terrorism.

A vital factor in the success of the Charlie Hebdo killings was the terrorists’ access to weapons. The Kouachi brothers and their fellow terrorist Amedy Coulibaly reportedly acquired their arsenal near Brussels’ main train station and then brought the weapons into France. The EU regulates the free movement of weapons used for legitimate purposes and has also taken steps to prevent cross-border smuggling of firearms. The EU has imposed very strict standards for the import, export and transfer of firearms and their replicas and adopted very clear rules on the deactivation of weapons. Despite these efforts, relatively accessible black markets for firearms still exist across Europe, enabling terrorists to purchase weapons and move them across borders. The European Commission hopes to introduce stricter controls at the EU level and has called for a better exchange of information on the manufacture and trafficking of firearms. The EU should continue its efforts to strengthen oversight of the firearms trade in Europe and use the opportunity to urge member-states to share information on arms smuggling, not least through inputting alerts into SIS II.

The incidents in Paris and the subsequent counter-terrorism raids and arrests across Europe are a reminder of the need for a concerted European response to terrorism. The EU does not want to start a futile "War on Terror", as President George W Bush did in 2001. The events in Paris should not prompt governments and Commissioners to ignore legitimate concerns over the impact of security on civil liberties. But member-states and EU institutions can do more to ensure that they use the tools they have effectively and update criminal laws where necessary. That way, they can fight radical Islamism while still protecting fundamental European rights and values.

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

Monday, January 26, 2015

The implications of Syriza’s victory

Syriza’s victory creates much uncertainty for the eurozone. Given the party’s outspoken criticism of Greek economic and social policies over the last four years, and its sometimes confrontational statements vis-à-vis the eurozone, there are understandable fears that the election could presage a Greek exit from the single currency. This prompts several questions: is it in Greece’s interest to leave? What would be the consequences for the Greek economy and that of the eurozone? And is the rest of the eurozone willing to let Greece go? What follows is an attempt to answer these questions, and to predict what will happen, given what we currently know about the economics and politics of Greece and the eurozone.

Are there any benefits of Grexit for Greece?
Greece would regain autonomy over its monetary policy – the most effective tool for maintaining demand in an economy. Central banks influence the expectations of consumers and investors. Currently, firms in Greece expect low demand and deflation, and consumers low income growth. An independent Greek central bank, if it were able to control inflation, could raise those expectations, leading consumers and investors to spend and invest. The Bank of Greece would also be in a position to ensure that real interest rates (that is, interest rates after accounting for inflation) were low enough to stimulate investment and consumption.

What is more, the likely sharp fall in the value of the drachma against the euro would reverse the loss of trade competitiveness suffered by Greece since it adopted the single currency. Exports would no doubt be slow to recover given the collapse in investment in the country’s tradable sector in recent years. And many structural problems that hold investment back are yet to be tackled. But exports would eventually rise as investment recovered. One sector that would be sure to benefit would be the tourism industry.

After the inevitable default on its euro-denominated debt, the country’s debt burden would be much reduced, allowing the country to run a more expansionary fiscal policy. The Greek government would be able to borrow in its own currency as opposed to the euro, which would enable the Bank of Greece to act as a true lender of last resort to the government. This in turn would allow the government to stand behind the country’s banks. Finally, Greece would in all likelihood end up under an IMF programme, which would require the Greek authorities to persist with much-needed structural reforms in return for financial support.

The short-term would no doubt be chaotic and living standards would inevitably fall further as the price of imported goods rose. However, if the exit was well-managed, the economy could then recover relatively rapidly until the country is running at full potential (it is currently around 15 per cent of GDP below potential). Beyond that, the rate of growth would depend on the success of the Greek authorities in reducing structural impediments to growth. Finally, the threat to democratic stability and the legitimacy of national democratic institutions would recede, and with it the threat of political populism.

What would be the costs of Grexit for Greece?
A Greek exit from the eurozone would be a step into the economic and political unknown. An unmanaged exit would cause far-reaching financial and economic disruption. Huge capital flight from Greece would prompt runs on the country’s banks. This would force the newly independent Greek central bank to print large amounts of money to recapitalise the Greek banking sector, which might cause the drachma to collapse in value and lead to very high inflation. To prevent the gains from devaluation being whittled away by higher inflation, the Greek authorities would have to maintain the political momentum for structural reforms. Many Greek businesses with large foreign currency debts would either be forced into bankruptcy or need to be rescued by the Greek authorities. There would also be pressure from within the eurozone to expel Greece from the EU (legally, a country quitting the currency union must also forfeit EU membership), which would be highly destabilising for a fragile democracy such as Greece.

However, there is a decent chance that Grexit would be a more managed affair involving the pre-emptive imposition of capital controls; the provision of interim ECB support for the Greek banking sector; and the rapid redenomination of contracts – at least those written under Greek law – from euro into drachma. And although some might be tempted to make an example of Greece, the EU is likely to balk at pushing Greece out of the Union since this could involve Greece defaulting on nearly all of the debt it owed eurozone governments and institutions as well as damaging the credibility of the EU. However, even under this scenario, the newly-introduced drachma would weaken very significantly. The Greek authorities would have to work hard to establish institutional credibility and hence economic stability, and Greece’s relations with other eurozone governments would be seriously damaged. The short run downsides for Greece could therefore outweigh the potential (but uncertain) future upside.

What about contagion to the rest of the eurozone?
The short-term financial contagion following Grexit would be less acute than it would have been last time it seemed likely, in early 2012. The ECB is now committed to acting as lender of last resort to eurozone governments, eurozone banks are in better shape and there is a rescue fund (however unsatisfactory) in place. In the case of a Greek exit, investors may well test the ECB’s promise to act as lender of last resort, but it should have little problem responding in the required manner.

However, the longer-term risk of contagion could still be serious. A Greek exit from the euro would demonstrate that membership of the single currency is not necessarily forever. This could prompt an increase in borrowing costs for those countries considered at risk of exit, such as Italy. It has been hard for the ECB to start quantitative easing in the face of opposition from a group of members led by Germany, so it is far from certain that the central bank will be able to fulfil its promise to buy the bonds of struggling member-states under its Outright Monetary Transactions (OMT) programme. Moreover, the eurozone has failed to establish proper federal risk-sharing institutions or to write down debt to sustainable levels. In the absence of fiscal federalism, and with intra-eurozone adjustment in relative prices being thwarted by very low inflation in Germany, there are legitimate doubts over the ability of a number of eurozone countries to sustain membership.

Finally, the Greek economy might, after a shaky few months, recover relatively quickly following an exit from the eurozone, as both monetary and fiscal policy boosted demand. Such an economic surge would embolden political forces in other member-states like Italy who favour exit from the currency union. In order to stop this political contagion, the eurozone would have either to make a leap of integration, or throw most fiscal restraints over board and engage in aggressive monetary policy to engineer a proper recovery. Not only are both options hard to conceive in the current political climate. It is also unclear whether that would be enough to keep the eurozone together. The potential risks of Grexit are therefore large for the eurozone.

Does Germany really believe that Grexit would be manageable?
Despite these potentially large risks, both German Chancellor Angela Merkel and Finance Minister Wolfgang Schäuble reportedly believe that the eurozone is strong enough to cope with a Greek exit, as do a host of senior German MPs. But German politicians have the German voter foremost in mind when making public statements. Taking a hardline with Greece plays well. However, a very careful politician (and gifted tactician) like Merkel is highly unlikely to run the sizeable risk of contagion – especially since there are other ways to put pressure on a new Greek government.

Do Greeks want to leave the euro?
Greek popular support for the country’s euro membership remains strong. Despite an economic depression that is to a large extent a result of being part of the eurozone and the failure of the troika’s assistance programmes, three-quarters of Greeks say that Greece should stay inside the euro “at all costs”, according to a recent Greek poll. The reason is that there is little trust in domestic political institutions to manage an exit, and a return to a Greek currency, as well as the fear that exiting the euro might mean leaving the EU altogether. No government in Greece will have a mandate to take the country out of the euro. The threat to leave is therefore not a particularly credible one, despite some representatives of Syriza having toyed with the idea in the past.

Three key areas of negotiation
Neither Greece nor the rest of the eurozone has an interest in a Greek exit. As a result, negotiations between Greece and the rest of the eurozone will focus on addressing the following issues:

1. Debt relief

Syriza hopes to call a debt conference similar to the one held in London in 1953, in which Germany’s debts were cut in half. Syriza has made debt relief a priority, despite it no longer being the main obstacle to economic recovery in Greece: although the ratio of public debt to GDP stands at a very high 175 per cent of GDP, debt servicing costs are moderate because the interest rates on official loans from the EU are low. The EU and Germany are – for a combination of political and legal reasons – unwilling to grant a formal debt restructuring. But the middle ground of some further reductions in interest rates, and further maturity extensions could be the route to compromise.

 2. Austerity

Greece’s economic depression has in large part resulted from unprecedented fiscal retrenchment. Syriza has pledged to roll back some of those spending cuts; it wants to run a balanced budget rather than aim for the surpluses demanded by the troika; and it wants to spend €2 billion immediately to alleviate hardship among the poorest. But even these demands seem acceptable: current plans by the troika already entail a slight easing of fiscal policy and a €2 billion programme is modest in size (roughly 1 per cent of Greece’s GDP). The most controversial issue will be the pension system. Greece has already made significant cuts to pension entitlements, but further adjustments will be required because of the depth of the economic crisis.

 3. Structural reforms

Some of the troika’s demands, like simpler collective dismissal regulation, could be dropped without harmful effects on the Greek economy. Similarly, judicial reform, the continued overhaul of public administration and tax collection as well as land rights issues could be agreed upon, as Syriza has fewer constituencies affected by those reforms than the current government parties. The overhaul of the public sector would be much more problematic, as Syriza’s supporters are in part disgruntled public employees. The effect of raising the minimum wage, as Syriza plans, is controversial. But given the track record of past governments on structural reforms, even here a compromise with the troika is not out of sight.

The likely outcome
The political game between the troika and a Syriza government will be complex, and periods of brinkmanship are probable. There are some nuclear options for both sides: the withdrawal of liquidity for Greek banks, which the ECB has said it is considering; and the unilateral default on official loans by Greece. However, both sides have an interest in avoiding the nuclear scenario. The rest of the eurozone will have to appear tough in order not to set a precedent for populist parties elsewhere, but it has little interest in precipitating a collapse of Greece’s banking sector. For its part, Syriza would have little choice but to try a find agreement with the troika. It will face a €6-12 billion funding gap in 2015. Even funding for the first quarter of the year is uncertain without official funds, which are on hold until the troika’s final programme review of the second assistance programme is concluded.

The Syriza victory is unlikely to lead to a Greek exit from the euro, at least for the time being. European policy-makers and Greeks alike might regret Greece’s entry into the common currency in 2001. But divorce would be costly for both sides, and eurozone policy-makers now have too much experience to allow it to happen by mistake. However, this does not mean that the current situation is without risk. The middle ground between the Greek and eurozone positions is small and there is a possibility that the eurozone will not offer enough to satisfy Syriza. This would open the way for political instability in Greece, the outcome of which is hard to predict. Even if the two sides can reach agreement, they could find themselves back at the negotiating table in the near future if the economic and social situation in Greece does not improve.

Christian Odendahl is chief economist and Simon Tilford is deputy director at the Centre for European Reform.

This insight is based on a previous article by Christian Odendahl and Simon Tilford titled: ‘Greece will remain in the euro for now’. Read it here.

Wednesday, January 21, 2015

Quantitative easing alone will not ward off deflation

The ECB will embark on a programme of quantitative easing (QE) tomorrow, as very low inflation poses a mounting threat to the economic stability of the eurozone. The rate of consumer price inflation has dropped below zero, and hence far below the European Central Bank’s (ECB) target of just below 2 per cent. This highlights the degree of weakness in the eurozone economy and further increases doubts over debt sustainability across the currency union: without a healthy dose of inflation, it is much harder for households, firms and governments to reduce their debt burdens.  The problem is that QE alone is unlikely to be effective without a significant change in the ECB’s approach to monetary policy. The ECB needs to manage people’s expectations about the future path of demand, income and inflation more forcefully if it is to generate a proper economic recovery across the eurozone.

According to one view of monetary policy, central banks set short-term interest rates to keep the economy close to full employment and inflation at the target level. In exceptional cases, this interest rate can fall to zero, but not below. In such circumstances, the central bank has to find other ways to stimulate the economy. One approach is QE: buying long-term assets like government bonds in order to drive up their price and bring down their ‘yield’, or interest rate (the price and yield of a bond are inversely related). The hope is that buying these bonds will drive up the prices of other long-term assets like corporate bonds, equities and even property. QE would thus lower long-term interest rates, increase the value of firms and real estate, and drive up the wealth of households. Ideally, this induces firms and households to invest and consume more, and help the central bank reach its target on inflation.

A different view of monetary policy claims that interest rate setting or bond buying are just tools to keep firms’ and households’ expectations about the future path of income, demand and inflation on a reasonably stable and appropriately optimistic path. Such stable and optimistic expectations are a precondition for the investment and consumption decisions that keep an economy close to full employment, and inflation close to target. Of course, effective tools are necessary so that people believe that the central bank can steer the economy and, hence, so that the central bank can influence people’s expectations. But without properly managing economic expectations, the tools alone will be ineffective, according to this second view. Tools and expectations are thus complementary. With these two approaches in mind, the ‘tools view’ and the ‘expectations view’, it is worth assessing the potential for QE to revive the eurozone economy, and hence, inflation. Starting with the tools view, there are several channels of transmission of QE.

* Lower long-term market interest rates could boost (larger) firms’ investment. But European firms raise finance predominantly from banks, not capital markets where the impact of QE would be directly felt. The impact of QE on firms’ investment decisions is therefore likely to be low.

* For households and investors, lower interest rates would make buying property more attractive. A rise in property prices usually stimulates the economy via construction and real estate services. QE could boost property prices in eurozone members-states such as France, Spain and Italy, where levels of house ownership are very high, but will have less of an impact in Germany, where the level of home ownership is low.

* Property and other assets are also part of households’ wealth: QE would push up the prices of such assets, and households could thus consume more and save less (the so-called 'wealth effect'). However, the evidence on the size of this effect is mixed. According to an ECB paper, housing wealth does not seem to have much of an impact on consumption in the eurozone at all; financial wealth has a larger impact but it is still lower than in the US where households often own stocks and property for their pensions. Banks, as large owners of assets, are likely to benefit from QE which could induce them to increase lending.  However, banks’ lack of capital is only one of several reasons that prevent them from increasing lending to firms and households.

* Households are also directly affected by interest rates, as savers and debtors. Debtors will benefit from lower interest rates, and could in turn increase their consumption. However, savers could increase savings in response to lower interest rates if they are saving for retirement. This is particularly true if savers – instead of buying financial assets which would benefit from QE – put their money into simple savings accounts. German savers, for example, hold around €2 trillion in such accounts, roughly 40 per cent of their financial wealth.

* By reducing long-term interest rates, QE would make the euro less attractive to investors, lowering its value, all else being equal. The recent fall of the euro is in part the result of markets expecting the ECB to embark on unconventional measures such as QE. A lower euro should boost demand for European exports, especially those from southern Europe, demand for which is more sensitive to price changes. Herein lies possibly the strongest channel through which QE can boost the eurozone economy directly.

* Finally, QE would help the treasuries of troubled countries such as Italy or Spain. By lowering the yield on their sovereign bonds, QE would lower the cost of government borrowing. This lowers the pressure on governments to implement (mostly self-defeating) budget cuts in times of recession or weak growth, which would help the economy. It takes time for this effect to play out, however, as the costs of servicing existing debt are unaffected.

Overall, these direct channels are weaker in the eurozone than they are in the US or the UK. This is one reason to be sceptical about the likely impact of QE on the eurozone economy.

The second approach to thinking about monetary policy, the expectations view, induces further pessimism: firms' and households' expectations would be unlikely to change much for the better if the ECB simply implemented QE. And without such a change in expectations, the direct channels discussed above would do little to change firms' and households' behaviour.

The reason is that the ECB has failed to convince households and firms that it is doing all it can to lift the economy out of recession. It raised rates in mid-2011 at the height of the eurozone crisis when more stimulus would have been warranted and the bout of inflation was clearly temporary. Then it was slow to cut rates, even though the underlying price dynamic signalled clearly the future low inflation. And the ECB has been reluctant to use unconventional tools at a time when high unemployment and a weak economy would have called for more aggressive measures than incremental cuts in interest rates – not least because inflationary dangers were non-existent. Starting QE now, after inflation has undershot the ECB's own forecasts repeatedly – essentially being dragged to the QE altar – is unlikely to convince anyone, especially if QE were watered down by making it smaller, or indicating that it would a temporary measure. The conservative approach of the ECB towards the economy and inflation, its hawkishness, is now firmly entrenched.

To make QE a success, the ECB needs to accompany it with the sort of strong commitments the Bank of Japan (BoJ) or the Federal Reserve Bank (Fed) have made: the BoJ said that it intends to continue a policy of QE and low rates until it has reached the new inflation target of 2 per cent (up from a de facto target of zero); the Fed has tied the duration of its unlimited QE programme to reaching certain targets on economic activity and unemployment. Both approaches led firms and households to change their expectations about the economy – about demand for their products or their income and future inflation – which in turn shaped their consumption and investment decisions.

A higher inflation target is, of course, out of the question for the ECB. With a mandate that is strictly focused on price stability and not much else (contrary to that of the Fed), it is also difficult for the ECB to tie QE to unemployment or economic growth – though reasonable people disagree on this.

However, the ECB does have the power to make a commitment that is purely focused on inflation (and hence firmly in line with its mandate). The ECB should announce that it aims to reach 2 per cent inflation on average over the next five years (an approach called ‘price-level targeting’). It might sound innocuous, but the word 'average' makes all the difference: since inflation is currently low and likely to remain low for a while, the ECB would commit to overshooting on inflation in the future. In other words, such a target would require the ECB to tolerate a mild boom in the eurozone to get the 3 per cent inflation necessary to reach a 2 per cent average over five years. Anticipating this, firms and consumers, financial markets and banks would increase consumption and investment.

If the ECB were to combine unlimited QE with a temporary price-level target – 2 per cent on average for five years – it could stimulate the economy and inflation, while remaining true to its mandate of price stability close to 2 per cent. Such a temporary price-level target would be new territory for the ECB, as would QE. But after years of misjudging the state of the economy and inflation, it is time for the ECB to be bold and innovative – and not to wait for Germany to come on board.

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

This insight is based on a previous article by Christian Odendahl titled: 'Quantitative easing alone will not do the trick'. Read it here.

Monday, January 19, 2015

Mogherini's mission: Four steps to make EU foreign policy more strategic

At her confirmation hearing, Federica Mogherini, the EU’s new high representative for foreign affairs and security policy, said that she wants to make EU foreign policy more ‘strategic’. She called for a ‘strategic rethink’ and asked for 100 days to review the External Action Service (EEAS), the EU’s diplomatic arm that she now leads. What steps should she take?

Mogherini heads a service that struggles to live up to expectations.  Four years after the creation of the EEAS, European foreign policy remains disjointed, overly technocratic and too slow in response to political crises. There have been a few successes, including the negotiations between Serbia and Kosovo, the diplomatic détente with Iran and political reform in Myanmar. But too often, member-states pursue narrow national agendas while EU institutions lack the political clout to push for a common European agenda. The result has been a European foreign policy that punches below its weight.

A stronger, more robust European foreign policy is needed. Europe’s security environment is more volatile and unpredictable than at any time since the end of the Cold War. From North Africa to Eastern Europe, business-as-usual no longer suffices to promote a stable and prosperous neighbourhood.

On this, many agree. But Europe’s default mode has been to favour the status quo. In European capitals there is a sense that there is little to gain and much to lose in the current international environment. At the turn of the century, Europe was affluent, dynamic and an aspirational global power. But those certainties have faded after years of financial crisis, the sobering experience of conflicts in Iraq and Afghanistan, rising euroscepticism and a range of security crises on Europe’s doorstep. European publics have become inward-looking, sceptical of military force and suspicious of European projects. This creates a tendency to respond to events, rather than to shape them. But the EU cannot sit back and wait. To misquote the old nobleman in Lampedusa’s The Leopard, if the EU wants everything to stay the same, everything must change.

The EEAS, of course, is not solely responsible for Europe’s foreign policy ailments. After all, it depends on the political consensus of the 28 member-states before it can act. But the EEAS, with its staff of 3,600 personnel, was created to develop and co-ordinate common foreign policy positions, and it must be an essential component of any stronger European voice in foreign affairs.

If only it could act strategically. That term has come to mean many things. Here, ‘strategic’ means the concerted use of all the means at the disposal of the EU and its member-states ‒ including trade, development, diplomatic and military tools ‒ in pursuit of strengthening Europe’s geopolitical position and protecting its interests. To increase the EU’s ability to act strategically, Mogherini should take the following four steps.

Firstly, to act strategically, the EU needs a strategy. The existing European Security Strategy, a document approved in 2003, is out-dated. It takes no account of the deteriorating security in Europe’s immediate neighbourhood, the effects of the financial crisis or the structural changes in global geopolitics as a result of the rise of China. Without a coherent and updated overarching framework, European foreign policy action is bound to be fragmented and driven by ad-hoc responses to events. On October 6th, Mogherini suggested that she wanted to midwife such a new document, and this week the process starts.

To ensure that EU external action has a firm strategic footing Mogherini should appoint a Chief Strategy Officer (CSO). He or she should have two roles: lead the drafting of a security strategy; and assisting the High Representative with putting the strategy into practice. The EEAS leadership will need to respond to unexpected and diverse security crises; within this, the CSO should guard the overall strategic direction of EU foreign policy. The EEAS already has a ‘strategic planning division’ but it lacks influence at the highest level of policy-making. The current division is headed by a mid-career diplomat, yet the CSO should be a senior official with the political and bureaucratic gravitas to push for strategic initiatives, selected and mandated to challenge traditional thinking inside the EEAS. The ‘strategy czar’ should work closely with the High Representative, provide senior EEAS leadership with strategic analysis and inject strategic input into the policy-making process. Crucially he or she should be a member of the EEAS corporate board. Instead of being distracted by the day-to-day humdrum of EU diplomacy, this officer’s team – drawn from the current strategic planning division – should monitor long term security trends and assess how they impact the Union. The division should draw on the traditional diplomatic reporting from EU delegations and the policy planning documents of EU member-states, and leverage ties with counterparts within the member-states, the EU’s ‘strategic partners’ and the intelligence, research and think-tank communities. Thus, the CSO would help Mogherini offer a common picture of longer-term trends in the security environment, and develop policy responses.

Secondly, with a new security strategy and a CSO, Mogherini should push for greater European unity of effort. The decision to move her office to the Commission building should increase the coherence of European external action and increase geopolitical awareness of those directorates-general of the Commission working on development aid, energy and trade. But she must do more and attempt to manage the foreign policy cleavages that run through the EU. A well-known schism lies between Europe’s south and east. Proximity to a threat shapes policy priorities. So Italy is more worried about immigration flows across the Mediterranean, and Poland about a resurgent Russia. But neither Warsaw nor Rome can deal with these issues alone. Mogherini will not be able to overcome strong national reflexes in foreign policy but, more than her predecessor, she should be visible in European capitals making the case for European strategic solidarity.

Moreover, she must address security free-riding within the Union. Some states take the deterioration in Europe’s security environment more seriously than others, and are willing to commit the necessary resources and political attention. The effectiveness of European foreign policy ultimately depends on the resources and capabilities that back it. Mogherini must argue for a European military ambition commensurate to the EU’s economic weight. She should promote defence co-operation (together with her colleagues at NATO) and push for tangible results on defence spending when European foreign ministers solemnly declare that “geopolitics is back”. But military capabilities have declined since the financial crisis, or even earlier. Fewer resources equate to lower expectations: in the late 1990s the EU discussed creating a 60,000-strong ‘Helsinki headline force’, in the early 2000s the new focus became 1,600-strong Battle Groups. Today, the 300-strong training mission in Mali is considered a large EU mission. European defence ministers applaud marginal progress in defence co-operation, when far-reaching initiatives are called for. Mogherini should initiate a debate about the role of hard power in EU foreign policy.

Thirdly, she should make EU foreign policy more (geo)political. The EU prefers to project externally what brought it peace and stability internally. This means that EU external action often takes on legalistic, not political, overtones. Diplomatic successes are considered those legal agreements that are signed when technocratic checklists are complete. It is a reflection of the EU's origins when the power of trade and institution-building trumped power politics in Western Europe. This system was exported effectively when the EU waved the carrot of membership at its neighbours, making the acquis communautaire one of the most effective European foreign policy instruments over the years. Enlargement, however, appears to have run its course for now. Instead, foreign policy focuses on those states with little chance of joining the EU, but whose political and economic stability is essential to European security. Here, the appeal of the EU’s single market is important but not sufficient to sway key decisions in Europe’s favour. The EU must build its influence through a mix of financial aid, trade incentives, security assistance and diplomacy, based on strong personal relationships with the region’s leaders. The best mix will depend on the country. For instance, Egypt’s autocratic turn has estranged it from the EU, yet it remains a country of strategic importance. Mogherini should pursue a dialogue with Cairo based on security co-operation, which is a shared interest, instead of cutting ties or attempting to curry favours through a trade deal or financial assistance.

EU officials often use the mantra that “the EU does not do geopolitics”. But in the Ukraine crisis, EU sanctions rather than NATO’s military toolkit have squeezed Moscow. This makes the EU – and the EEAS – a geopolitical actor, and to Russian eyes, a geopolitical competitor. Mogherini should push her staff to develop policies that reflect this geopolitical competition. This has consequences for her personnel. As she considers a reshuffle of the EEAS senior management – a new Secretary-General will take office in April, and the post of Chief Operating Officer might disappear – she should scrutinise broader EEAS human resource policies. Not every EU diplomat is, or should be, a good strategist. Career paths at the EEAS should, however, create a space for developing strategists, not only excellent diplomats that can execute policy. In particular she should review the system of EU special representatives: senior diplomats that act as Mogherini’s substitutes on specific regions, but whose effectiveness is harmed by their turf wars, open-ended mandates and unclear ties to the EEAS bureaucracy.

Fourthly, inside the EU, Mogherini should attempt to build a special relationship with the EU’s most important country, Germany. In the Ukraine crisis, German chancellor Angela Merkel has shown herself a leader, rallying other EU capitals in support of sanctions. But it remains to be seen whether this more robust stance will translate into other areas of its foreign policy. For instance, Berlin’s relations with China continue to be trade-focused, and avoid thorny security issues. Even worse – as Hans Kundnani of the European Council on Foreign Relations pointed out in a recent article – Germany’s foreign policy interests may not necessarily align with the rest of Europe’s. More than any other large member-state, Germany is uneasy about the utility of force in its international relations; even the recent decision to provide 100 trainers for the Kurdish Peshmerga was politically controversial and Berlin is not involved in the air campaign against the Islamic State terror group. As its political and economic clout in Europe grows, other member-states – particularly its neighbours – increasingly look to Berlin for foreign and security policy guidance. Mogherini was wise to visit Germany in her second week in the job, but she must make it a priority to cajole Germany to commit to an ambitious European foreign policy, even if she faces strong headwinds doing so. As long as Germany under-invests in the tools of foreign policy, Berlin will weaken the EU and provide a convenient excuse for the inaction of others.

These four steps would help Mogherini strengthen Europe’s voice in foreign affairs, even though progress may only be incremental; member-states remain reluctant to give too much influence to someone in Brussels. But given the overwhelming need for a common and credible response to Europe’s increasingly dangerous neighbourhood, she should make it her mission to search for strategic convergence among the 28 sovereign states. Her most strategic work might, after all, not be to find diplomatic consensus with governments outside the Union, but with those within.

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

Friday, January 16, 2015

Greece will remain in the euro for now

Greece will hold a snap election on January 25th, after the country’s parliament failed to elect a new president with the necessary majority. Syriza, a left-wing party (or rather a coalition of parties) led by Alexis Tsipras, currently leads the polls. Given Syriza’s outspoken criticism of Greek economic and social policies over the last four years, and its sometimes confrontational statements vis-à-vis the eurozone, some fear that Greece might quit the single currency. This prompts several questions: is it in Greece’s interest to leave? What would be the consequences for the Greek economy and that of the eurozone? And is the rest of the eurozone willing to let Greece go? What follows is an attempt to answer these questions, and to predict what will happen, given what we currently know about the economics and politics of Greece and the eurozone.

Are there any benefits of Grexit for Greece?
Greece would regain autonomy over its monetary policy – the most effective tool for maintaining demand in an economy. Central banks influence the expectations of consumers and investors. Currently, firms in Greece expect low demand and deflation, and consumers low income growth. An independent Greek central bank, if it were able to control inflation, could raise those expectations, leading consumers and investors to spend and invest. The Bank of Greece would also be in a position to ensure that real interest rates (that is, interest rates after accounting for inflation) were low enough to stimulate investment and consumption.

What is more, the likely sharp fall in the value of the drachma against the euro would reverse the loss of trade competitiveness suffered by Greece since it adopted the single currency. Exports would no doubt be slow to recover given the collapse in investment in the country’s tradable sector in recent years. And many structural problems that hold investment back are yet to be tackled. But exports would eventually rise as investment recovered. One sector that would be sure to benefit would be the tourism industry.

After the inevitable default on its euro-denominated debt, the country’s debt burden would be much reduced, allowing the country to run a more expansionary fiscal policy. The Greek government would be able to borrow in its own currency as opposed to the euro, which would enable the Bank of Greece to act as a true lender of last resort to the government. This in turn would allow the government to stand behind the country’s banks. Finally, Greece would in all likelihood end up under an IMF programme, which would require the Greek authorities to persist with much-needed structural reforms in return for financial support.

The short-term would no doubt be chaotic and living standards would inevitably fall further as the price of imported goods rose. However, if the exit was well-managed, the economy could then recover relatively rapidly until the country is running at full potential (it is currently around 15 per cent of GDP below potential). Beyond that, the rate of growth would depend on the success of the Greek authorities in reducing structural impediments to growth. Finally, the threat to democratic stability and the legitimacy of national democratic institutions would recede, and with it the threat of political populism.

What would be the costs of Grexit for Greece?
A Greek exit from the eurozone would be a step into the economic and political unknown.  An unmanaged exit would cause far-reaching financial and economic disruption. Huge capital flight from Greece would prompt runs on the country’s banks. This would force the newly independent Greek central bank to print large amounts of money to recapitalise the Greek banking sector, which might cause the drachma to collapse in value and lead to very high inflation.  To prevent the gains from devaluation being whittled away by higher inflation, the Greek authorities would have to maintain the political momentum for structural reforms. Many Greek businesses with large foreign currency debts would either be forced into bankruptcy or need to be rescued by the Greek authorities. There would also be pressure from within the eurozone to expel Greece from the EU (legally, a country quitting the currency union must also forfeit EU membership), which would be highly destabilising for a fragile democracy such as Greece.

However, there is a decent chance that Grexit would be a more managed affair involving the pre-emptive imposition of capital controls; the provision of interim ECB support for the Greek banking sector; and the rapid redenomination of contracts – at least those written under Greek law – from euro into drachma.  And although some might be tempted to make an example of Greece, the EU is likely to balk at pushing Greece out of the Union since this could involve Greece defaulting on nearly all of the debt it owed eurozone governments and institutions as well as damaging the credibility of the EU.  However, even under this scenario, the newly-introduced drachma would weaken very significantly. The Greek authorities would have to work hard to establish institutional credibility and hence economic stability, and Greece’s relations with other eurozone governments would be seriously damaged. The short run downsides for Greece could therefore outweigh the potential (but uncertain) future upside.

What about contagion to the rest of the eurozone?
The short-term financial contagion following Grexit would be less acute than it would have been last time it seemed likely, in early 2012. The ECB is now committed to acting as lender of last resort to eurozone governments, eurozone banks are in better shape and there is a rescue fund (however unsatisfactory) in place. In the case of a Greek exit, investors may well test the ECB’s promise to act as lender of last resort, but it should have little problem responding in the required manner.

However, the longer-term risk of contagion could still be serious. A Greek exit from the euro would demonstrate that membership of the single currency is not necessarily forever. This could prompt an increase in borrowing costs for those countries considered at risk of exit, such as Italy. It has been hard for the ECB to start quantitative easing in the face of opposition from a group of members led by Germany, so it is far from certain that the central bank will be able to fulfil its promise to buy the bonds of struggling member-states under its Outright Monetary Transactions (OMT) programme. Moreover, the eurozone has failed to establish proper federal risk-sharing institutions or to write down debt to sustainable levels. In the absence of fiscal federalism, and with intra-eurozone adjustment in relative prices being thwarted by very low inflation in Germany, there are legitimate doubts over the ability of a number of eurozone countries to sustain membership.

Finally, the Greek economy might, after a shaky few months, recover relatively quickly following an exit from the eurozone, as both monetary and fiscal policy boosted demand. Such an economic surge would embolden political forces in other member-states like Italy who favour exit from the currency union. In order to stop this political contagion, the eurozone would have either to make a leap of integration, or throw most fiscal restraints over board and engage in aggressive monetary policy to engineer a proper recovery. Not only are both options hard to conceive in the current political climate. It is also unclear whether that would be enough to keep the eurozone together. The potential risks of Grexit are therefore large for the eurozone.

Does Germany really believe that Grexit would be manageable?
Despite these potentially large risks, both German Chancellor Angela Merkel and Finance Minister Wolfgang Schäuble reportedly believe that the eurozone is strong enough to cope with a Greek exit, as do a host of senior German MPs. But German politicians have the German voter foremost in mind when making public statements. Taking a hardline with Greece plays well, and prevents a further increase in support for the populist Alternative für Deutschland (AfD). In addition, the German government would like the current Greek government to prevail at the general election, and thereby avoid any destabilising confrontation between the eurozone and Syriza. The message that the eurozone can do without Greece is also meant to scare Greek voters into eschewing a vote for Syriza. A very careful politician (and gifted tactician) like Merkel is highly unlikely to run the sizeable risk of contagion – especially since there are other ways to put pressure on a new Greek government.

Do Greeks want to leave the euro?
Greek popular support for the country’s euro membership remains strong. Despite an economic depression that is to a large extent a result of being part of the eurozone and the failure of the troika’s assistance programmes, three-quarters of Greeks say that Greece should stay inside the euro “at all costs”, according to a recent Greek poll. The reason is that there is little trust in domestic political institutions to manage an exit, and a return to a Greek currency, as well as the fear that exiting the euro might mean leaving the EU altogether. No government in Greece will have a mandate to take the country out of the euro. The threat to leave is therefore not a particularly credible one, despite some representatives of Syriza having toyed with the idea in the past.

Three key areas of negotiation
Neither Greece nor the rest of the eurozone has an interest in a Greek exit. As a result, negotiations between Greece and the rest of the eurozone will focus on addressing the following issues:

1. Debt relief

If it wins the election, Syriza hopes to call a debt conference similar to the one held in London in 1953, in which Germany’s debts were cut in half. Syriza has made debt relief a priority, despite it no longer being the main obstacle to economic recovery in Greece: although the ratio of public debt to GDP stands at a very high 175 per cent of GDP, debt servicing costs are moderate because the interest rates on official loans from the EU are low. The EU and Germany are – for a combination of political and legal reasons – unwilling to grant a formal debt restructuring. But the middle ground of some further reductions in interest rates, and further maturity extensions could be the route to compromise.

2. Austerity

Greece’s economic depression has in large part resulted from unprecedented fiscal retrenchment. Syriza has pledged to roll back some of those spending cuts; it wants to run a balanced budget rather than aim for the surpluses demanded by the troika; and it wants to spend €2 billion immediately to alleviate hardship among the poorest. But even these demands seem acceptable: current plans by the troika already entail a slight easing of fiscal policy and a €2 billion programme is modest in size (roughly 1 per cent of Greece’s GDP). The most controversial issue will be the pension system. Greece has already made significant cuts to pension entitlements, but further adjustments will be required because of the depth of the economic crisis.

3. Structural reforms

Some of the troika’s demands, like simpler collective dismissal regulation, could be dropped without harmful effects on the Greek economy. Similarly, judicial reform, the continued overhaul of tax collection (after some progress has been made), and land rights issues could be agreed upon, as Syriza has fewer constituencies affected by those reforms than the current government parties. The overhaul of the public sector would be much more problematic, as Syriza’s supporters are in part disgruntled public employees. The effect of raising the minimum wage, as Syriza plans, is controversial. But given the track record of past governments on structural reforms, even here a compromise with the troika is not out of sight.

The likely outcome
The political game between the troika and a Syriza government will be complex, and periods of brinkmanship are probable. There are some nuclear options for both sides: the withdrawal of liquidity for Greek banks, which the ECB has said it is considering; and the unilateral default on official loans by Greece. However, both sides have an interest in avoiding the nuclear scenario. The rest of the eurozone will have to appear tough in order not to set a precedent for populist parties elsewhere, but it has little interest in precipitating a collapse of Greece’s banking sector. For its part, Syriza would have little choice but to try a find agreement with the troika. It will face a €6-12 billion funding gap in 2015. Even funding for the first quarter of the year is uncertain without official funds, which are  on hold until the troika’s final programme review of the second assistance programme is concluded.

A Syriza victory is unlikely to lead to a Greek exit from the euro, at least for the time being. European policy-makers and Greeks alike might regret Greece’s entry into the common currency in 2001. But divorce would be costly for both sides, and eurozone policy-makers now have too much experience to allow it to happen by mistake. However, this does not mean that the current situation is without risk. The middle ground between the Greek and eurozone positions is small and there is a possibility that the eurozone will not offer enough to satisfy Syriza. This would open the way for political instability in Greece, the outcome of which is hard to predict. Moreover, even if the two sides can reach agreement, they could easily find themselves back at the negotiating table in the near future if the economic and social situation in Greece does not improve.

Christian Odendahl is chief economist and Simon Tilford is deputy director at the Centre for European Reform.

Thursday, December 18, 2014

EU-Israel relations: Confrontation or co-operation?

For the last decade, relations between the EU and Israel have been strained by tension over the Middle East peace process, but strengthened by intensive scientific and economic co-operation. So far, confrontation has not crowded out collaboration, but with the EU’s decision to get tougher on Israel’s settlements policy, this may change. Both Israel and the EU will need to find a balance between their disagreements over the settlements and the beneficial economic and scientific co-operation. They can take a number of steps in order to achieve this.

The positive aspect of the relationship is not often recognised. Economic and research links between the EU and Israel are strong. In 2013, the value of EU-Israel trade was €29.5 billion (equal to 13.7 per cent of Israel’s GDP), with €12.5 billion imports to the EU and €17 billion exports to Israel. The EU is Israel’s main trading partner, accounting for one-third of its total trade. Large Israeli corporations have sizeable investments in Europe and employ many Europeans, while Israel, despite its small size, is one of Europe’s most important trading partners in the Middle East. It supplies Europe with high-tech products, including software and apps used in most PCs and smartphones, medical devices, chemicals and pharmaceuticals (Israel’s TEVA is one of the most important sources of generic medicines for Europe).

Beyond trade, Israel and the EU have been collaborating in fields such as agriculture, aviation, science and in a wide variety of R&D fields (including nanotechnology, health, environment and communications). Israel participated in the latest EU R&D Framework Programme (FP7) and in June 2014 it joined the EU’s research and innovation programme, Horizon 2020, and will contribute to its budget. Hundreds of leading Israeli institutions have received EU funding for innovative research, in many cases sharing their expertise and knowledge with their European counterparts.

There are also defence ties: Israel conducts joint military exercises with Bulgaria, Greece and Italy, while some EU member states, including Germany, the UK and Italy trade defence goods and services with Israel. In addition, Israel’s intelligence agencies and their European counterparts (among them agencies in the UK and Germany) collaborate closely.

But alongside that co-operation, political tension, rooted in the Israeli-Palestinian conflict, is increasing. Issues such as the political status of Jerusalem, human rights, the humanitarian situation in Gaza and EU funding for left-wing NGOs in Israel have been troublesome.

The EU and Israel also disagree on the timetable for peace. While many European leaders believe that now is the moment to push for an agreement, Israeli politicians often stress the current instability in the Middle East. Moreover, Israelis remember the 2005 withdrawal from Gaza and fear that leaving the West Bank will only lead to a ‘second Gaza’ under Hamas rule or turn it into fertile ground for jihadist movements.

The issue of Israeli settlements in the West Bank undoubtedly casts the longest shadow. European leaders criticise new houses and neighbourhoods built beyond the 1967 borders. They fear that Israel’s actions undermine the territorial integrity of a future Palestinian state, thus making it harder to achieve a two-state solution. Many Israeli politicians, on the other hand, argue that the real obstacle for peace is not the settlements policy but rather the absence of a credible Palestinian partner who is willing to compromise.

Since 2012, the EU’s attitude towards Israeli settlements in the West Bank has become more assertive. This is reflected both in rhetoric and policy. For example, recent statements issued by the European External Action Service (EEAS), say that the settlements “constitute an obstacle to peace” and “question Israel’s commitment to a peaceful negotiated settlement”.

In practical terms, the EU has published strict new guidelines for EU grants, preventing Israeli entities located in the West Bank from receiving EU funding. Additionally, the EU no longer recognises Israeli veterinary services in the West Bank, which in practice prevents the export of dairy and poultry products from settlements to Europe. According to media reports, EU officials are considering applying additional ‘sticks’ in the future if construction continues, among them labelling Israeli products produced in the West Bank and requiring visas from Israeli settlers.

While these European policies are limited in scope, they damage the dialogue between Israel and the EU, especially with a right-wing Israeli government. They may also discourage bilateral co-operation in other areas. Last year’s negotiations on Israel’s participation in the Horizon 2020 programme shows how things can snowball.

During the negotiations, the EU wanted to ensure that European funds would not reach Israeli institutions located in the West Bank, East Jerusalem or the Golan Heights. The Israeli newspaper Haaretz reported that tough meetings took place within the Israeli government; some ministers supported signing the agreement, among them Finance Minister Yair Lapid, while Foreign Minister Avigdor Lieberman and his deputy Ze’ev Elkin argued that Israel should not participate in the programme. They felt that by signing, Israel would de facto acknowledge that the settlements were illegal. For his part, Prime Minister Benjamin Netanyahu raised the possibility of attracting alternative funds from Asia and North America in order to compensate Israeli research institutions.

What started as a discussion about access to Horizon 2020 funds soon became a political argument, creating tensions that had the potential to damage fruitful scientific collaboration. Israel’s academic and research institutions could have lost millions of euros in research grants, as well as access to European knowledge and markets. The EU would have lost one of its most innovative and successful scientific partners.

The Israeli media give more coverage to such disagreements than to co-operation with Europe. Israeli politicians, academics and diplomats have accused the EU of dealing with Israel unfairly, by only pressuring Israel for concessions, and of not understanding the mentality of the Middle East. Furthermore, the increasing number of anti-Semitic incidents across Europe and boycott campaigns in European universities and companies receive significant media attention in Israel. Although these incidents are often condemned by European leaders, they reinforce Israeli mistrust.

The case of Horizon 2020 however, also shows how tensions can be managed. Amid the crisis, prominent Israeli academics, including heads of Israeli universities, members of the Israeli Academy of Sciences and representatives from the Committee of the Council for Higher Education (the state body responsible for distributing higher education funding) repeatedly urged the government to sign the agreement; they were worried about the implications for Israeli research. This pressure eventually paid off. The Israeli government showed some flexibility and a diplomatic agreement was reached: EU regulations will be respected and funding will not flow to settlements, but Israel added an annexe to the agreement stating that it disagrees with the EU’s legal position concerning the settlements.

Other parties can also play a role in calming tensions and preventing future rows about EU policy towards Israeli settlements from damaging collaboration. First, high-tech and medical businesses in Europe and Israel should speak up in times of political friction about the direct benefits they get from a good relationship.

Second, the EU’s representatives have to voice more clearly what they are trying to do. The EU’s guidelines and demands concerning Horizon 2020 were portrayed by some Israeli commentators as part of a ‘European boycott’; but in fact the EU made a legitimate decision not to fund organisations in Israeli settlements in the West Bank, which violate international law. The EU should make clear that, in areas of productive co-operation where there are not the same legal issues, it will do its best to maintain the relationship. It should emphasise the positive contribution that the EU brings to the daily lives of Israelis. For instance, the EU-Israel ‘open sky pact’ reduces the prices of airline tickets for Israelis; its funding for institutions based within the 1967 borders boosts Israeli research and jobs; and the EU-Israel free trade agreement has a positive effect on Israel’s market.

Third, Israeli and European politicians should focus on quieter, pragmatic dialogue, rather than play to the crowd. Member-states, the Commission and the EEAS all have a role to play in managing the relationship and talking frankly about disagreements. Federica Mogherini’s first visit outside Europe as High Representative for Foreign Policy was to Israel and the Palestinian territories. She stated that she intended “to use the Union’s political potential in this region”, which suggests that she plans to continue (or even deepen) the dialogue and the EU’s involvement. Israeli senior politicians should commit to doing the same.

These tools should allow both parties to manage some of the tensions and hostility that have emerged in Israel as a result of the EU’s stance on the settlements. In the long run, however, without meaningful progress in the Middle East peace process, and with more settlements under construction, the EU may be tempted to be tougher. This could translate into more restrictions on Israeli entities located outside the 1967 borders. The longer the status quo remains, the greater the chances of such EU actions. This should be cause for alarm, particularly in Israel. Although the benefits of the relationship are mutual, they are not symmetric; Israel is much more reliant on Europe than vice versa. Turning a deaf ear to Europe’s complaints could be a costly mistake for Israel’s leaders.

Yehuda Ben-Hur Levy is a Clara Marina O'Donnell fellow at the Centre for European Reform.

Tuesday, December 16, 2014

Germany and the eurozone: The view from Paris

On recent visits to Berlin, I have been surprised at how negative people are about France. Key officials regard the country as incapable of controlling spending or enacting serious structural reform. They do not show much understanding of the political constraints that limit President François Hollande’s freedom of action. The officials add that, so long as the mistrust between Berlin and Paris persists, they cannot strike a bargain to strengthen eurozone governance. In any case, they say, there is no urgent need to do so, because – in their view – the eurozone as a whole is not in crisis. There are just specific problems in a few countries like France and Italy, caused by politicians lacking the courage to do what is necessary.

So I went to Paris to discover what the government thinks about Germany and the future of the euro. In Paris there is a sense of urgency about the stagnation of the eurozone (which is likely to grow at less than 1 per cent this year and to do not much better next year), the deflation afflicting parts of it (prices are falling in France) and the negative impact that these problems will have on French growth, job-creation and debt sustainability. Even French officials who are life-long believers in Franco-German amitié admit that the relationship is now ragged and horribly unbalanced: on the big questions, Germany sets the agenda for the eurozone.

Among the questions being considered by the French government are: what is the best way of influencing the Germans; whether the economic thinking in Berlin and Frankfurt may evolve to become less anti-Keynesian; whether the presence of the SPD in the German government could prove helpful; and how eurozone governance should be improved.

There are divisions on how to deal with the Germans. The predominant view is that France has a credibility problem with Berlin. Therefore it should show some results on implementing reforms and controlling spending, before taking on Berlin on eurozone governance. The other view is that the economic situation in France and in the eurozone is so dire that the Germans need to be confronted right away.

Everyone in the government is upset that Commissioner Günter Oettinger in the Financial Times and Chancellor Angela Merkel in the Welt am Sonntag criticised France for neither reforming nor complying with EU budget rules. This finger-wagging reinforces the narrative in France that Hollande and Prime Minister Manuel Valls have to reform to keep Berlin happy – whereas their line is that reform is good for France. Some of those close to Hollande think the criticism unfair, given that, as they see it, France is doing a lot to reform: the Loi Macron promises to deregulate professions, shopping hours and coach services, while the social partners are due to hammer out new labour market rules in January. But others point out that many Socialist deputies – and even some ministers – oppose these reforms for being too libérales and may well succeed in watering them down.

French officials worry about the intellectual gulf that separates the thinking of Germany’s financial and political elite – which emphasises the supply side to the exclusion of demand, and rules rather than macro-economics – from most of the rest of the world. In particular, they worry about the Germans’ reluctance to analyse the eurozone economy as a whole, rather than as a series of national economies; about their indifference to deflation; and about their rejection of the principle that an economy can suffer from a lack of demand that requires a macro-economic stimulus. They lament that so many key officials in the Chancellery and Ministry of Finance are lawyers rather than economists.

The French find the Germans more uncompromising on their economic philosophy than they were a few years ago, and less prepared to accept that they might be wrong (the recent downturn in the German economy has not been harsh enough to prompt many Germans to reconsider their views). Therefore when Germany has to compromise in the EU, for example on budget deficits, it does it out of political necessity, not because it admits to any chinks in its argument. As one official puts it, “the Germans don’t think economically, but judicially and in terms of rules and the rapport de forces”.

This intellectual divergence makes it hard for Berlin and Paris to agree on the next steps for the euro. At a time of supreme German self-confidence, the French are particularly unwilling to contemplate a new treaty or revision of the eurozone rules – because they think the Germans would write them.

Economy Minister Sigmar Gabriel, the SPD leader, has disappointed Paris. Intellectually, he doesn’t follow the hard line of Finance Minister Wolfgang Schäuble on the need for austerity in the eurozone. But he is not prepared to argue for a softer line in public, lest the SPD alienate German voters.

Some French officials credit Gabriel with helping to persuade Schäuble to make a small shift by accepting the case for more investment in Germany. Other officials think they have succeeded in changing the thinking of their opposite numbers in Berlin on the need for more investment at eurozone level. But they recognise that this supposed intellectual shift has not yet led to significant new policies for the eurozone or Germany. The Germans still think structural reform is the only really effective way to revive growth. And they have ensured that Commission President Jean-Claude Juncker’s €315 billion plan to boost investment contains little new money (the idea is to lever €21 billion from the EU budget and the European Investment Bank).

As always, there are frequent gatherings of French and German ministers and officials, but these are not bringing about a meeting of minds. Recently, the four ministers of economy and finance produced a joint paper on the need for more investment in the EU, France and Germany, but it said little that was new. Gabriel and Macron also commissioned Henrik Enderlein and Jean Pisani-Ferry, two eminent economists, to write a report on ‘Reforms, investment and growth: An agenda for France, Germany and Europe’. This called on each country to take a series of steps, for example for the Germans to boost public investment and the French to introduce more flexible labour markets. But the ministers have only weakly endorsed the report, given that its recommendations are controversial, and for now it is not being translated into political action.

October’s European Council asked the ‘three presidents’ (of the Commission, European Council and European Central Bank) to prepare a report on the future of the monetary union. This will put eurozone governance on the agenda in 2015. Given the strained state of the Franco-German relationship, however, there is not much optimism in Paris about what this exercise may achieve. In any case, the French do not currently have a set position on eurozone governance. Nevertheless they are mulling over a number of ideas. These include:

  • Inserting more economic analysis into the EU’s process of vetting national budgets. Officials are vexed that when the Commission recently looked at the French budget, it carried out no analysis on the economic impact of different possible budgets. The decision-making is purely rule-based and political. The French think that the appointment of a high-profile chief economist would help to correct this deficiency in the Commission. Some officials think that the French committee which examines the national budget – looking, for example, at the credibility of forecasts and figures – could serve as an example for a similar committee at EU level. Such a committee could also cover structural reform. The French also want the EU’s budgetary process to take into account the eurozone’s aggregate fiscal stance.
  • Reviving old ideas such as establishing a full-time Eurogroup president and giving the EU a role in national unemployment schemes. As one official put it, “the emphasis should be on carrots, not sticks – so no to Merkel’s reform contracts”. For the past few years the chancellor has been pushing the idea that the Commission should negotiate binding accords with each eurozone member, committing them to structural reform. But the official thought that a similar idea could work if given a positive spin: “Germany won’t agree to counter-cyclical policies at EU level, but why not incentivise structural reform in say Spain with a eurozone contribution to its unemployment benefits?”
  • Producing a ten-year plan for converging the eurozone economies. Like the Maastricht treaty scheme for the euro, this could have three phases, which would help to mobilise support. Politically, this would be an easier sell than Merkel’s contracts. To keep Germany happy, the plan could cover labour markets and the single market in goods and services; to keep France happy, it could cover tax (harmonising corporate tax bases) and social issues (how minimum wages are calculated). The plan could also deal with other prerequisites of growth, such as co-operation on industrial policy, digital markets, energy and R&D. Apparently the Commission is not enthusiastic about this convergence plan, though President Donald Tusk and the ECB are supportive. Some French officials are hopeful that the Germans – aware of the long-term challenges to their own growth model of high exports and low investment and consumption – could back such ideas. 
French officials say it is not clear whether any of this may in the long run need treaty change, though they are adamant that for the time being they will resist attempts to revise the treaties.

The French do not expect the new Commission to be particularly helpful vis-à-vis the Germans. Many of them have a positive view of Jean-Claude Juncker, seeing him as more understanding of their problems than his predecessor, José Manuel Barroso. But they worry that so many of the Commission president’s chief advisers and senior colleagues (such as Valdis Dombrovskis and Jyrki Katainen) are ‘German’ in their thinking. Nobody is yet sure whether Pierre Moscovici, the French Commissioner for Economic and Financial Affairs, will prove influential. French officials are not particularly worried by the prospect of EU fines for their budget deficit; they assume they can go on negotiating with the Commission, making little adjustments to stave off punishment.

There is a lot of unhappiness in Paris about the ECB’s deference to Germany. Officials are frustrated with its inconsistency: it criticises in public the governments which borrow too much, yet although President Mario Draghi believes that Germany should adopt an expansionary fiscal policy, he will not say this unambiguously in public.

Amidst all this gloom, what strategy should the French pursue? They would certainly gain credibility in Berlin if they could show that they were controlling spending and implementing structural reform. But they believe they are caught in a vicious circle: Germany’s austerian policies – for both the EU and Germany – make it harder for France to grow, which worsens the fiscal position and makes painful reform politically more difficult.

The eurozone probably has to face a much deeper crisis before anything gets better. The Germans still believe that either fiscal or monetary easing would remove the pressure on countries like France to reform. But there may come a point when even the fiscal hawks of the German finance ministry have to acknowledge that the eurozone faces systemic difficulties (and not just policy errors in a few member-states). Negative growth and high unemployment, perhaps prompting social unrest, may impact on German thinking. If the current governments in Greece, Spain or Italy – all of which have more or less tolerated Germanic economics – were to collapse, bringing to power politicians opposed to the euro or to the German view of it, Berlin would have to compromise.

Charles Grant is director of the Centre for European Reform.