Thursday, November 27, 2014

What should an energy union cover?

The events of the last year, and in particular the risk that the fighting in Ukraine could jeopardise Russian energy supplies to Europe, have highlighted the absence of a co-ordinated European energy policy. Donald Tusk, the incoming president of the European Council, has talked of the need for an ‘energy union’. What kind of policy co-ordination should European leaders undertake?

The basic facts are clear. The European Union is importing an increasing proportion of its energy, as output from mature oil and gas fields in the North Sea declines. Oil can be bought on the international market, but the EU has become dependent on imports of Russian gas, which now meet a quarter of our daily consumption. The gas reaches Europe through a series of pipelines, two of which run through Ukraine.

Securing gas supplies is not, of course, the only issue at stake in the European energy market. There are Europe-wide targets to reduce emissions, improve efficiency and increase the share of renewables, which were recently extended to 2030. The European Union also aims to keep energy affordable. However, European competence in the area of energy is limited. There is no common energy policy and the pattern of supply and demand is the product of 28 distinct national policies. So what might an energy union mean and how might it advance the three goals of security, cost competitiveness and environmental protection?

It is important to start with a dose of realism. Countries’ choices about energy supply often transcend rational economic calculations. Attitudes to one form of supply or another can owe more to emotion and history than to economics. No European directive is going to make Germany reverse its decision to close its nuclear power stations by 2022, or remove the overwhelming opposition to the technology of ‘fracking’, which can produce oil and gas from shale rocks, in France and Bulgaria. Nor are we likely to see common European energy prices, not least because energy taxation is such an important source of national government revenue. In the UK 80 per cent of the price of every litre of petrol goes to the government in taxes.

In addition, different countries hold different natural resources, and widely varying requirements for imports. The United Kingdom is still a significant producer of oil and gas, even if the volumes have fallen. Poland is still a major coal producer. Many of the other countries in Central and Eastern Europe have limited local energy supplies and rely on imports, often imports of gas and electricity from Russia. Donald Tusk, when Polish prime minister, argued that Europe should create a single buyer to match the market power of Russian exporters. But the pattern of trade across Europe is too complex for that. If the European Union created another centralised structure, it would not change that reality.

An energy union will therefore have limitations but could still be valuable. In at least three ways, a rational co-ordination of policy could give us all a more secure, cleaner and lower-cost energy supply system.

The first role is to link what we have already. Most of the energy systems across Europe, along with patterns of ownership and regulation, remain strictly national in scope. The most recent European Council set an objective that, by 2030, 15 per cent of the installed electricity production should be linked across borders. The scale of the aspiration seems limited compared to the potential. Last May the European Commission published a long list of potential projects that could usefully develop cross-border links. These included physical projects such as linking the southern Italian grid to the north of the country and onward, or a link over the Pyrenees between Spain and France. Under a working energy union, such links should be the norm rather than the exception.

An integrated distribution network, combined with a diversity of sources of supply, is clearly the most effective means of achieving energy security. If we had that, European countries could continue to trade with Russia – if it made economic and political sense – but would know that, if things did go wrong, alternative sources of gas and alternative pipeline networks were always available.

The second role is to establish a new pan-European grid with the capacity to transmit power across the continent from multiple sources. A so-called ‘super grid’ would enhance security but also enable us to better use power from areas in surplus. It cannot be efficient or cost effective for every one of the 28 member-states to maintain their capacity at the level necessary to meet peak demand. A super grid, which has in the past been backed by the German government, could be built step by step, starting with the plans for a new grid around the North Sea. A super grid would help to open markets to competition and to keep prices down. If European leaders are really serious about the notion of using infrastructure investment to drive economic recovery, a modernised grid would be a good place to start.

The third role for an energy union is to invest in the research necessary to transform the system as a whole. The EU’s plans for reducing emissions by means of carbon pricing and emissions trading, conceived six years ago, have not succeeded. The carbon price (the cost of having the right to emit one tonne of carbon dioxide) is proving insufficient to prevent a resurgence of  low cost, but high carbon  coal use. Renewables may be growing in scale – at a high cost – but their benefit in terms of reducing emissions is being offset by increasing use of coal.

An energy union could be a very useful way of focusing collective funds on the important research objective of finding a source of power which is both low cost and low carbon. One option, on which some initial work is being done in the United States, is to find a way of storing electricity efficiently. If successful, that would transform the economics of renewables – allowing much more power generated from the sun and the winds to be captured and used. Effective storage would also remove the problem of intermittency, which at the moment means that expensive back-up systems have to be in place to provide cover when wind and solar are unavailable. Why should Europe, with its extensive scientific base, wait for the US to find the answer?

An energy union should not mean centralisation and uniformity. Different countries will continue to pursue various policies. Such diversity is a good thing, not a problem. The EU’s role should be to enhance security, cost competitiveness and emissions reductions in ways which individual countries cannot achieve on their own.

Nick Butler
Visiting professor and chair, King's Policy Institute, King's College London

Ukraine after the elections: Democracy and the barrel of a gun

Ukraine has lost control of parts of its industrial heartland, as well as Crimea. The question is whether there will now be a government in Kyiv that can make a success of the rest of the country. There are reasons for concern.

The good news is that most of Ukraine voted for a new parliament on October 26th. Pro-European parties backing President Petro Poroshenko and Prime Minister Arseniy Yatsenyuk won a majority of the 423 seats contested (which excluded occupied areas). More than 900 international observers monitored voting; they described it as "an amply contested election that offered voters real choice". The Russian Foreign Minister, Sergey Lavrov, said grudgingly that the elections seemed to be valid, though not in every part of Ukraine.

The first piece of bad news is that Russian forces and their local proxies did not give Ukrainians in the occupied parts of Donetsk and Luhansk regions the chance to cast a ballot. Instead, on November 2nd the separatists organised sham elections in the self-proclaimed statelets. These polls were criticised by the EU, the US and the Organisation for Security and Co-operation in Europe. The Russian foreign ministry, however, said that Russia respected "the declaration of the will of people in south-eastern Ukraine".

About 15 per cent of the Ukrainian population lives in the areas Russia controls (or used to live there – the UN estimates that the conflict has created over 900,000 refugees or internally-displaced persons). Ukraine, while asserting its territorial integrity de jure, is effectively challenging Russia to take responsibility for these areas: on November 15th, Poroshenko ordered state institutions in the occupied territories, including schools and hospitals, to close, and banks to cease operations. Poroshenko's action is understandable: he could not control what was happening in the area. But he risks consolidating the division between the self-proclaimed Donetsk and Luhansk 'People's Republics' and the rest of Ukraine.

The second piece of bad news is that the potential coalition partners are wrangling over the composition of the government, including which party should fill the important posts of interior minister and finance minister. The president’s 'Petro Poroshenko Bloc' has the most MPs, with the prime minister's 'People's Front' as runner up. Between them they have 214 seats, a narrow parliamentary majority. Important reforms such as devolving powers to the regions will require constitutional changes, for which 300 votes are needed. So coalition talks include three smaller parties (including the far-right 'Radical Party', which argues for Ukraine to have nuclear weapons).

What Ukraine needs, immediately, is a competent government with honest ministers, rather than one designed to divide the spoils among its constituent parties. The coalition parties should sink their differences and install a government based on ability and integrity rather than party affiliation. For most of the last two decades Ukraine was a case study in post-Soviet poor governance. The new government must do better. Fighting the corruption for which Ukraine has been famous will demand both government transparency and effective law enforcement. An EU mission will start work on December 1st on police and judicial reform; the EU should also attach advisers to ministries and agencies to help them combat corruption.

The third problem is a collapsing economy. The European Bank for Reconstruction and Development forecast in September that Ukrainian GDP would fall by 9 per cent this year and a further 3 per cent in 2015; meanwhile inflation will rise from minus 0.3 per cent in 2013 to 11.8 per cent this year. The current account deficit is undergoing a forced correction, from 9.2 per cent of GDP last year to 2.5 per cent in 2014, through a painful contraction in imports. The value of the hryvnia has fallen by almost 50 per cent this year, making imports impossibly expensive.

In theory, the devaluation of the currency should help Ukrainian exporters. Unfortunately, the Russian market, which absorbed around a quarter of Ukraine's exports in 2013, is now effectively closed; and as long as much of Ukraine's heavy industry in the east cannot operate, Ukraine's export potential will be limited.

The Ukrainian government cannot cope without international help. The $17 billion (€14 billion) IMF package and the €11 billion mixture of EU grants and loans agreed earlier in the year are insufficient. Yields on Ukrainian government bonds are over 18 per cent, with investors assuming a high probability of default. A senior American official suggested recently that Ukraine would need an extra $10-15 billion in 2015 alone. The US itself has been niggardly, giving around $1.3 billion in loan guarantees and grants; both Washington and its international partners need to do more for Ukraine to have a chance of succeeding. The EU should not have delayed implementation of its association agreement with Ukraine under Russian pressure. It should now do everything possible to accelerate Ukraine's convergence with EU standards and regulations. Then Ukraine can re-orient its economic ties westwards (as Georgia did, successfully, after its war with Russia in 2008).

Finally, the ceasefire agreed in September has broken down. According to NATO, Russian forces and equipment are again crossing Ukraine's border. The Russians' aim may only be to consolidate their hold, and perhaps straighten out some 'kinks' in the front line (for example by taking the town of Shchastya, home to a power plant supplying almost all the Luhansk region's electricity, or they may intend something more ambitious, such as capturing the port city of Mariupol and the rest of the coastline between there and Crimea (which is proving hard to supply by ship from Russia). Poroshenko has said that Ukraine is prepared for a "scenario of total war" with Russia; but in reality, while Ukrainian forces could certainly inflict large-scale casualties on attacking forces, they could not resist an all-out invasion from better equipped and more numerous Russian forces.

So far, Western leaders have refused to do much to increase Ukraine's military capability, hiding behind the mantra that "there is no military solution" to the conflict, and suggesting that arms supplies might encourage Kyiv to think that there is. But as long as Ukrainian forces are so much weaker than Russian forces, there is indeed a military solution: outright Russian victory. The best way to deter further Russian advances is to help Ukraine with equipment, training and intelligence, so that the domestic political cost of victory for Russia, in casualties incurred, becomes prohibitively high.

'Realist' commentators like Henry Kissinger often assert that Ukraine matters more to Russia than to Europe or the United States. A strong case could be made, however, that the success of Ukraine matters more to the West than it does to Russia. The EU and NATO would be better off with a prosperous, stable nation of 45 million people next door, rather than a corrupt, unstable economic basket-case. The West should be prepared to invest in achieving the right outcomes by both strengthening the government-controlled parts of Ukraine and preventing Russia from further demolishing the country.

Ian Bond
Director of foreign policy, Centre for European Reform

Free movement: Why Britain does not need to change the rules

Now that the European Commission, Germany and other member-states have made clear that they will not accept quotas or ‘emergency brakes’ on EU migrants, British Conservatives are looking again at limiting their access to benefits. As this bulletin went to press, David Cameron was preparing a major speech on the issue. But he will find it very hard to achieve significant changes to the rules on benefits.

A recent ruling of the European Court of Justice (ECJ) in the Dano case seemed to offer encouragement to Britain. The ECJ confirmed the right of the German authorities to refuse unemployment benefits to a Romanian citizen who had no history of work in either country. Many Conservatives hope this means that the EU institutions will not block reforms to reduce EU migrants’ access to welfare. They are probably wrong: the court merely upheld a 2004 directive (the ‘citizens directive’) that already limited migrants’ access to benefits.

Free movement has never been an unconditional right. EU law offers a number of tools to control intra-EU migration and prevent abuse of welfare systems. In the past, the ECJ has tended to expand the scope of free movement rights, particularly for non-active migrants. The Dano ruling may be a sign that the Court is reacting to growing national concerns over free movement and national welfare systems.

The ‘citizens directive’ gives EU citizens the right to live in another member-state for more than three months, but only if they are employed, studying or economically self-sufficient. In the latter two cases, they must have health insurance. Once these conditions are met, EU citizens have the same rights as nationals of the host country. In turn, those migrants who become an “unreasonable  burden” (a term undefined in the directive) on the welfare system of the host country can be denied benefits. Member-states are allowed to expel those EU citizens who do not fulfil the conditions for legal residence.

EU law prohibits flagrant abuses of social security systems. These abuses are, in any case, vanishingly small in number. Neither the CER nor the European Commission can find much evidence of ‘benefit tourism’ in the UK – the idea that migrants head for the UK because of its welfare system. And a new study from University College London has found that immigrants from the EU – including from Central and Eastern Europe – were net contributors to the public purse, a finding that has been replicated in other member-states.

Various Conservative MPs and think-tanks have suggested that benefits should not be granted to EU migrants for a period of two to three years, either by amending existing EU laws or by proposing new ones. But the chances of other member-states and the EU institutions agreeing to such a reform are very low. It might require treaty change, if the denial of in-work benefits were to amount to discrimination between workers from different member-states, which is prohibited by the treaties. If that were the case, such a change would require the unanimous agreement of all 28 member-states.

Even if the UK could find reforms that would not require treaty change, the reform would still need to go through the EU’s legislative procedure.The new or amended legislation would need to be proposed by the Commission and approved by a qualified majority in the Council (at least 15 member-states representing 65 per cent of the European population) and by the European Parliament. In the unlikely event that the UK convinced 14 other member-states to support reform, it would still need to persuade both the European Commission and the Parliament that such a change was needed. Given the lack of evidence supporting the claim that EU migrants are bad for the UK’s economy, and the strong stance taken by the EU institutions in defence of free movement, this would be difficult. Existing EU legal safeguards against the abuse of welfare systems would also weaken the case for reform.

Further limitations to the rights of EU migrants are unnecessary and may well be politically unfeasible at the European level, however popular they would be with some Britons. They are also not in Britain’s interest. There are many retired British citizens living in Spain or France who enjoy free access to healthcare, paid for by their host member-state. If Britain were to push for measures to delay or limit benefits to EU migrants, the UK taxpayer would probably end up bearing the cost of healthcare for British pensioners abroad.

The UK should learn the right lesson from the Dano ruling, and stop blaming Brussels for problems which can and should be solved at the national level. EU laws, which the UK agreed to adopt, allow member-states to prevent abuse of the benefits system. Britain could exercise closer oversight of EU migrants by, for example, establishing a compulsory register for EU citizens. The majority of member-states use such registers to check that EU migrants fulfil the necessary conditions and that they are not a burden on the welfare state. Those not meeting the requirements could be expelled.

Free movement is a cornerstone of the internal market, which the UK has traditionally championed. Hostility to EU migration has become the most salient issue in British politics, despite evidence of its positive economic impact. But ultimately, Britain has to face up to reality: the only way to stop EU migrants entering the country is to leave the EU, with all the economic and geopolitical damage that entails.

Camino Mortera-Martinez
Research fellow, Centre for European Reform

Wednesday, November 26, 2014

Hungary and the West: We need to talk about Viktor

Prime Minister Viktor Orban still dominates Hungary’s political scene, in spite of recent large demonstrations in Budapest. But his political reforms and economic and foreign policies are raising more and more questions abroad as well as at home. If Orban thinks he can ignore such criticism, he is wrong: Hungary's economic development depends on its Western partners.

Worries about Orban’s intentions started soon after his election in 2010, when he quickly consolidated his Fidesz party’s grip on power, and purged political opponents from positions of influence. In 2011, German Chancellor Angela Merkel (among others) criticised measures to control the media; in 2012 the European Commission started infringement proceedings against Hungary for limiting the independence of the Central Bank and the data protection authority, and for compulsorily retiring 274 judges (who were replaced by more Fidesz-friendly figures).

But concerns about Orban have heightened recently as a result of two speeches. His inaugural speech to parliament in May, after his re-election, called for autonomy and 'communal rights' for ethnic Hungarians in neighbouring states, including Ukraine. It upset neighbours like Poland, where Prime Minister Donald Tusk suggested that it sounded too similar to Putin's line on ethnic Russians abroad. Orban’s speech to a gathering of Hungarian students in Romania in July 2014 caused even more trouble. In it, he proclaimed a shift from liberal democracy towards the construction of an “illiberal state" and cited Singapore, China, India, Russia and Turkey as models.

Does the reality of Orban’s policies live up to the rhetoric? Hungarians close to the ruling party argue that the rest of the West listens too much to Orban’s leftist political opponents. They claim that Hungary has been a reliable EU partner, whatever critics say. They point to Hungary’s successful presidency in 2011: it secured Croatian accession to the EU, and laid the foundations for the European Parliament’s involvement in the negotiations on the EU’s long-term budget.

Some foreign experts on Hungary suggest that however alarming the ‘illiberal’ label sounds, what Orban means is merely that the EU’s current approach to tackling the economic crisis is not working; and that the liberal model, which privileges the rights of the individual over the interests of the community, is one of the reasons for its failure. Orban, according to this interpretation, wants to build closer links with economically successful, albeit authoritarian states.

Even Hungarians who do not support Fidesz accept that some of the steps taken reflect a necessary if belated attempt to purge ex-Communists from positions of influence, where they could obstruct change and perpetuate the power of the Cold War-era nomenklatura.

Whether or not Orban’s motives were pure, the effect of his reforms has been to create strongly pro-Fidesz state structures, rather than a politically neutral administration. Murky links between business and politics have developed: in October the US government imposed visa bans on a number of officials, after repeated attempts to get the Hungarian authorities to tackle corrupt practices which favoured Fidesz-linked firms. And Orban has intensified pressure on civil society: in September police raided the Budapest offices of an NGO funded by Norwegian government grants, following Hungarian government allegations that it was funding Fidesz’ political opponents.

Economically, Orban has pursued populist policies, such as trying to reduce the role of foreign investors in key sectors. In September 2014 Deputy Prime Minister Zsolt Semjen said that nationalising the energy sector was the only way to guarantee security of supply for Hungarians, despite ample evidence that liberalising markets would work better. The government has also forced banks to take large losses in order to protect Hungarian borrowers against exchange rate fluctuations, and seems poised to buy up the assets of any banks that leave the Hungarian market as a result. In response, the Commission has expressed concern about Hungary's compliance with rules on state aid.

Orban might be able to thumb his nose at the Commission if his economic policies were a success. But from 2008-2013, Hungary’s GDP grew at the slowest rate in the Visegrad Group (which comprises Hungary, Poland, Slovakia and the Czech Republic and is often referred to as the V4).

The main victims of Orban’s domestic policies may be his own citizens, but his foreign and security policy could damage wider European interests. His statements often hint at a wish to revise Hungary’s borders, established after the First World War, which left Hungarian minorities spread across several neighbouring countries. His implicit encouragement of irredentism worries other countries, particularly Slovakia and Romania which have significant ethnic Hungarian populations. It also complicates co-operation within the V4.

As neighbours of Ukraine, the V4 should have been central to formulating the EU's response to Russia's annexation of Crimea and continued interference in the Donbass. The V4's experience of economic and political transition and of European integration should make them natural mentors for the new authorities in Kyiv. Instead, Orban has contributed to V4 disunity and questioned EU efforts to put pressure on Russia.

One European politician who has known Orban for many years suggests that his cultivation of Putin comes from a mixture of anger at the way other EU leaders treat Hungary and pure opportunism. Whatever the cause, Orban has tied his country closely to Russia, especially in the energy sector. In January 2014 he signed an agreement with Putin on expanding Hungary's Paks nuclear power station; 80 per cent of the project will be financed by a Russian state loan. In July, he restated his support for the South Stream gas pipeline from Russia to Europe (which would bypass Ukraine) – a project which the Commission has said is illegal in its current form.
And in September, after a meeting with Gazprom CEO Aleksei Miller, he halted the re-export to Ukraine of gas bought by Hungary; by doing so, he made Russia's cut of gas supplies to Ukraine more effective.

Though the US has loudly criticised Orban's democratic back-sliding and closeness to Russia, Brussels has more leverage with Hungary than Washington. What can the EU do with this awkward but democratically-elected man? So far, the member-states and the Commission have only grumbled, to little avail. As an organisation often criticised for its own lack of democratic legitimacy, the EU has hesitated to challenge someone who has a large majority in his national parliament.

If the political will to act exists, the EU has two types of tools it can use. First, the Commission can take action against a government which breaks European law and in the process goes against EU values. It allows the Commission to launch infringement proceedings. But such proceedings cannot address cases where a government acts contrary to the EU's values but does not break any specific EU law. In the case of the compulsory retirement of judges, the Commission based its legal action on EU rules against age discrimination in employment; but it had no standing to tackle more fundamental questions of the rule of law and independence of the judiciary. Hungary settled the case by compensating the judges but not reinstating them.

Second, the EU can address democratic shortcomings in a member-state through Article 7 of the Treaty on European Union, which enables the European Council to determine “the existence of a serious and persistent breach of EU values” in a member-state; and to suspend some of its membership rights, including voting rights. The European Council must decide unanimously (minus the country concerned) that a breach has taken place. Other countries would probably want to see evidence of much more serious misbehaviour than anything Orban has yet done before resorting to such a nuclear option.

Article 7 also has a ‘warning mechanism’: four-fifths of the member-states may determine that there is a clear risk of a serious breach of EU values in another member-state. This ‘yellow card’ permits a dialogue with the member-state in question before more radical steps are taken. But member-states are even afraid of using this mechanism. It would fuel debate about whether the EU should be able to interfere in the affairs of a member-state. It could also lead to an East/West split in the Council, if the Central Europeans believed that ‘old’ member-states were using Article 7 against them while overlooking failings in one of their own number. It is worth noting that in 2000, when Austria’s coalition government included the far-right Freedom Party, other member-states introduced political sanctions without using Article 7 that had been introduced by Amsterdam treaty and entered into force in 1999.

Doing nothing about Orban’s policies is not acceptable. He has challenged the EU’s role as the champion of democratic values, which was the basis of past enlargements and is the reason the EU has remained so attractive to countries like Ukraine. Inaction would weaken the EU’s power of example.

Some governments would like a proper debate about Hungary’s behaviour. In 2013 the German, Dutch, Danish and Finnish foreign ministers wrote to the Commission urging it to do more to promote respect for the rule of law in the EU. They proposed various measures to respond to breaches of EU principles that could be deployed before escalating to the use of Article 7. These ranged from political dialogue with the Commission about issues of concern to the suspension of structural funds (currently only possible if a country breaks the EU’s macroeconomic rules).

A majority of member-states have so far blocked proposals to enhance the EU’s role in policing the rule of law. Some, like the UK, fear that strengthening the Commission’s power would play into hands of eurosceptics; others, including in the Baltic States, worry that the EU would interfere with their policies towards national minorities. The General Affairs Council will revert to the issue of the rule of law in December, but there is no guarantee of progress. For the moment, therefore, more informal ways of handling Orban must be found.

The other members of the V4 have an important role to play. Some of them share Orban’s misgivings about sanctions against Russia; but they have developed a ‘brand identity’ as modern, successful European societies, and Orban’s populist nationalism threatens this reputation. They should work behind the scenes to shift Orban back into the liberal, market-oriented European mainstream.

British Prime Minister David Cameron should also speak up. Orban joined Cameron in his unsuccessful efforts to oppose the nomination of Jean-Claude Juncker as Commission President. Cameron’s views on the EU are sometimes compared with those of Orban. But unlike Orban, Cameron has been outspoken about the threat Putin's policies pose to Europe. Nobody has accused Cameron of trying to monopolise state institutions for the Conservative Party. Cameron could suggest that Orban join the UK in trying to reform and strengthen the EU, internally and externally, rather than chasing after illiberal democracies that have their own economic and political problems.

Perhaps the best hope is that other centre-right politicians in Europe can talk Orban round. He has benefited from the support of the European People’s Party (EPP), which unites most of the centre-right parties in the EU, including Fidesz. It is time for leaders like Angela Merkel of Germany or the new Polish Prime Minister, Ewa Kopacz, to remind Orban that almost 80 per cent of Hungary's trade is with other EU member-states, and that his main economic and political partners are still in the West, not in Moscow.

Agata Gostyńska is a research fellow and Ian Bond is director of foreign policy at the Centre for European Reform.

Thursday, November 13, 2014

Iran nuclear talks: Patience is a virtue

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Monday, November 10, 2014

Does a eurozone slump make Brexit more likely?

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

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

Chart 1: Economic growth


Source: Haver

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

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


Source: Haver

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

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

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

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

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


Source: World Bank

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

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

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

Chart 4: The UK’s current account balances


Source: Office for National Statistics

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

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

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

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

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

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

Friday, November 07, 2014

The European arrest warrant: A British affair

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Wednesday, November 05, 2014

A Greek programme for Greece

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

Taking stock

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

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

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

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

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

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

The current state of the programmes

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

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

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

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

What Europe should do

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

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

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

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

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

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

Friday, October 17, 2014

The eurozone’s German problem

There is a deal to be done to save the euro from deepening crisis. The outlines of it are generally accepted outside Germany: structural reforms in France and Italy and elsewhere combined with measures to strengthen their long-term fiscal positions; and in return, a large pan-eurozone fiscal stimulus and quantitative easing (QE) by the ECB. This offers the best way out of the current impasse in the eurozone, not just for the periphery but also for Germany. But it will take a political earthquake  for the Germans to back such a deal. Instead, the stability of the euro and the futures of the participating countries will continue to be vulnerable to the short-term exigencies of German domestic politics. This is a recipe for stagnation, deflation and political populism in France and Italy. It may culminate in a breakdown in relations between Germany and these countries and could even lead to eurozone break-up.

Why has Germany assumed such pre-eminence in the eurozone? How is it that German policy-makers from the finance minister, Wolfgang Schäuble, to the head of the Bundesbank, Jens Weidmann, can wag their fingers at everybody else for causing the eurozone crisis, while responding dismissively to any suggestion that Germany might be part of the problem? Germany’s initial pre-eminence following the crisis was understandable – it is a major creditor and in the early stages of any debt crisis, creditors tend to call the shots. However, as a debt crisis wears on, the creditors’ resolve typically weakens as the impoverishment of the debtors rebounds on the creditors politically and economically, and the debtors call the creditors’ bluff by threatening to renege on their debts.

This has not happened in the eurozone, with Germany (and other creditor states) able to subordinate the interests of the eurozone as a whole to their own perceived interests. The debtors have put Germany under little pressure to share the burden or to reform its own economy. There appear to be two principal reasons for this. One is that many members of the eurozone see Germany as a model to emulate rather than a significant part of the problem. The second reason is that even those who understand that the structure of the German economy is a threat to the stability of the euro have been circumspect about openly criticising Germany for fear of provoking a backlash against the euro in the country. This softly, softly approach has been bad for Germany itself as it has distracted attention from the country’s formidable structural problems, and encouraged a belief that the country does not need to compromise and can afford to say no to everything.

This deference to Germany is puzzling. While it is the largest economy in the eurozone, it is hardly dominant, accounting in 2013 for 29 per cent of eurozone GDP as opposed to France’s 21 per cent, Italy’s 16 per cent and Spain’s 11 per cent. Economic growth in Germany has certainly rebounded faster since the crisis than in other eurozone countries. But the German recovery now seems to have run its course, with exports to both European and non-European markets under pressure and domestic demand being held back by weak levels of public and private investment (see chart 1). Even the German government expects growth of just 1.3 per cent 2014 and 1.2 per cent in 2015.

Chart 1: Economic growth (Q1 2008 – present)

Source: Haver

Chart 2: Economic growth (1999 – present)

Source: Haver

There have been some tentative signs of rebalancing over the last 12 months – with growth in domestic demand outpacing overall economic growth. But Germany remains chronically export-dependent – its current account surplus is on course to exceed 7 per cent of GDP in 2014 for the second successive year. The country is certainly not the ‘locomotive’ of the eurozone economy, as some journalists like to call it, but a drag on it. Some German policy-makers argue that stronger domestic demand in Germany would have little impact on other eurozone economies, but they are being rather disingenuous. The government has attributed the economy’s loss of momentum over the course of 2014 to weak eurozone demand, so cannot simultaneously deny that what happens in Germany has no impact on other eurozone economies. With Germany accounting for almost 30 per cent of the eurozone economy, what happens to aggregate demand in Germany clearly has a major impact on the level of demand across the eurozone as a whole.

German policy-makers tend to bridle at any suggestion that they may be guilty of mercantilism and there is indeed little to suggest that they are consciously setting out to beggar their neighbours. But there is no denying that Germany remains dependent on foreign demand to bridge the very large gap between what it produces and what it consumes, and that this is not a replicable model. An economy as small and open as Ireland’s can rely on wage cuts and rising exports to underpin recovery. But big economies in which trade plays a lesser role cannot do this, at least not all at the same time. Eurozone member-states need to increase the size of the economic pie rather than fighting for bigger shares of a constant pie.

Chart 3: Current account balances (per cent, GDP)

Source: Haver

Indeed, Germany’s strong employment performance – unemployment stands at just 5 per cent and the employment rate at a record high – would look quite different were it not for that foreign demand. Employment has also risen by more that would be expected from weak economic growth, suggesting that German employers (like their UK counterparts) have been taking on more workers in preference to boosting capital expenditure (which is no higher than it was in the first quarter of 2008). Moreover, the tightness of the labour market has not yet fed through into a meaningful recovery in real wages after years of wage restraint. Real wages should rise by around 1 per cent in 2014 (after falling last year), but this partly reflects unexpectedly weak inflation. Indeed, far from experiencing a surge (as many in German commentators feared when the ECB held interest rates lower than they thought Germany needed), German inflation fell to just 0.8 per cent in September, compounding deflation pressures across the eurozone.

Germany’s public finances are in good shape, allowing it to portray itself as a saint among fiscal sinners (German policy-makers still stress above all else the role of fiscal ill-discipline in causing the crisis). The government will again run a small surplus this year (see chart 4) compared with substantial deficits elsewhere. With growth in the German economy faltering, this would be the ideal time for the government to boost its spending. And there is no shortage of things it could spend the money on. Levels of public investment are very low in Germany, even by Western European standards. Indeed, net public investment is negative (that is, Germany is not investing enough to replenish the country’s public capital stock), storing up problems for the future (see chart 5). Germany could also boost defence spending, which is languishing at just 1.3 per cent of GDP, and so help to improve its ability to play a useful role in providing for Europe’s security. Cuts in incomes taxes and/or value-added-taxes could also give impetus to the moderate upturn in private consumption that is underway, in the process helping the economy to shake off the impact of weaker exports.

Chart 4: Government deficits (per cent GDP)

Source: Haver

Chart 5: Net public investment (per cent, GDP)

Source: Haver

How is the German government likely to respond to the slowdown in Germany and the worsening crisis across the eurozone? It will probably continue to show some flexibility regarding the fiscal targets facing other members of the eurozone such as France and Italy, while sticking publicly to its hard line. There will no doubt be a bit of fiscal easing at home, but nothing dramatic, with the government citing the need to comply with a constitutionally-binding rule requiring the government to run a balanced budget, which comes into force in 2016. Taken together, these slight shifts in Germany’s position will do little to alleviate the pressures on the eurozone economy (a much bigger stimulus is required to ward off slump and deflation) or to rebalance the German economy. Meanwhile, Germany will remain the biggest obstacle to QE by the ECB, which would aim to boost inflation expectations and hence the readiness of firms and households to spend. Were Germany to support such action, other sceptical countries would no doubt fall in behind it.

If, as is increasingly likely, the ECB pushes ahead with QE despite German opposition, its effectiveness will probably be undermined by the lack of a major fiscal stimulus to the eurozone economy. The ECB may also struggle to bring about a substantial fall in the euro because of the size of the eurozone’s trade surplus, which boosts demand for euros. (The eurozone’s trade with the rest of the world would be broadly balanced were it not for Germany.) And if QE does succeed in weakening the euro without an accompanying programme of fiscal stimulus or aggressive steps to rebalance the German economy, it risks being seen by the eurozone’s trade partners as a mercantilist move in a global economy characterised by very weak demand. One consequence could be to further weaken the chance of brokering a meaningful Trans-Atlantic Trade and Investment Partnership (TTIP). It could also further unbalance the UK economy, strengthening Britain’s eurosceptics.

Germany’s current intransigence poses a far greater risk to its economic and political interests than the ‘grand bargain’ outlined at the beginning of the piece. Germany cannot afford the impoverishment of the eurozone. The rapid slowdown in world trade, in particular trade with China, has shown this. If the German economy is to grow sustainably, it will be as part of a healthy eurozone economy, in which Germany is deeply enmeshed through trade and investment. Nor does Germany’s current uncompromising stance limit the exposure of German taxpayers to bail-outs of other members. Aside from the impact that the ongoing slump across the eurozone will have on German growth (and hence public finances), debt burdens will reach unsustainable levels in more eurozone countries. The inevitable debt defaults in these countries will impose incalculable costs on the German taxpayer.

German politicians, like all politicians, are focused on getting re-elected, and they believe that their current approach to the eurozone is the best route to that. But long-term threats eventually become immediate threats. Germany needs a proper debate about the choices facing it, much as the German government has repeatedly demanded of the French, Italians and others. Unfortunately, there is little sign that this will happen without greater outside pressure. The French and Italians need to force this debate by making clear to Berlin that it cannot assume that the euro will endure in its current form without Germany making significant compromises. By ending their deference to the German government, they would hopefully expose the weakness of Germany’s bargaining position and prompt a more objective discussion within Germany of its own structural problems and how they play into the eurozone crisis. There is a risk that such a confrontation could play into the hands of the right-wing Alternative für Deutschland (AfD), which has already tapped into anti-euro sentiment. But Germany’s domestic politics should not be allowed to stand in the way of a solution to the crisis, any more than French or Italian politics should be allowed to do so. If Germany really is as pro-European as its politicians argue, its grand coalition should be able to convince enough Germans that a grand bargain is in the country’s own interests.

Simon Tilford is deputy director of Centre for European Reform.