EUROPEAN UNION WORLD

ECB and the Eurosystem explained in 3 min.

COMMITTEE OF THE REGIONS

EUROPEAN OMBUDSMAN

EUROPEAN CENTRAL BANK

FOREIGN & SECURITY POLICY

EUROPEAN UNION LISBON TREATY

INSTITUTIONS

Committee of the Regions

The Committee of the Regions (COR) is one of the newer Community institutions, set up in the aftermath of Maastricht in order to facilitate the doctrine of subsidiarity; it met for the first time in March 1994. It was established as part of an attempt to bridge the gap between Brussels and citizens of the Union, although anti-federalists claimed that its creation was part of a Brussels plan to undermine the nation state.

The existence of the Committee reflects the growing importance of the regions in many member countries and, indeed, of the new relationships encouraged by cross-border regions such as the Rhine–Meuse (created from parts of Belgium, Germany and the Netherlands) and the Atlantic Islands Council (created by the UK, Republic of Ireland, Scottish Parliament, Welsh Assembly and the Isle of Man). The COR must be consulted during the legislative process on any matter which it is felt has regional implications, the key issues being identified as trans-European networks, health, education, culture and economic and social cohesion. There are those who would like to see the COR become a directly elected body and form a second chamber in an enlarged and strengthened European Parliament.

Like the ESC, the COR also has 344 members, provided by member states in exactly the same proportions and appointed for a four-year term. The criteria for appointment to the COR differ between member states, largely depending on their degree of decentralisation. As a federal state, Germany is represented by members of the Länder governments. Belgium is also virtually a federation of the Flemish and Walloon communities. Other countries such as Italy and Spain are highly regionalised into semi-autonomous regional administrations and these countries draw most of their COR members from the regional governments. More centralised states such as Britain have traditionally appointed COR members from the ranks of mayors of cities or chairmen of county councils. However, the devolved legislatures (the Scottish Parliament, and the Northern Irish and Welsh Assemblies) are also represented.

The COR meets in Brussels for five plenary sessions a year. Again, much of  its work is done through a structure of seven standing committees, covering areas such as:

• • Regional policy, structural funds, cross-border and inter-regional cooperation
• • Agriculture, rural development, fisheries
• • Urban issues, energy, environment.

As with the ESC, members are keen to belong to it, but often lament its lack of influence. Its internal divisions and the nature of its membership (deriving, as it does, from large, autonomous bodies but also smaller local councils) combine to mean that as yet it has not fulfilled all of the high hopes of those who devised it.

But it remains a useful channel of communication between the various units of government across the Union.

Ombudsman

The idea of appointing an ombudsman for the EU was first mooted at Maastricht but, because of ‘procedural delays’, no appointment was made until 1995. The ombudsman’s purpose is to reconcile the interests of EU citizens and EU institutions by providing for a thorough investigation of any accusation of maladministration on the part of any EU institution other than the Court of Justice. The appointee has wide-ranging powers of inquiry, the Community institutions being required to hand over all the documents and other evidence that he or she might demand of them. If maladministration is discovered the ombudsman:

• • Reports in full to the institution concerned and makes recommendations for correcting the fault
• • Can also refer the case to the European Parliament for further action.

In the first year of operation the ombudsman and his staff dealt with nearly 700 complaints, the largest number of which came from Britain. Most, however, were ruled to be inadmissible. The number of complaints received has increased steadily year by year since the office was established. In 2004, the total was 3,726, 195 of them from the United Kingdom. Spain has the highest proportion of complaints (482), although on a complaints to population basis Malta has the highest percentage, the UK the lowest.

European Central Bank

The European Central Bank (ECB) was instituted as of July 1998, at a meeting of the Ecofin council in Brussels. Prior to that date work on monetary union had been carried out by the European Monetary Institute (EMI) supported by the combined forces of the central banks of all Community members, the European System of Central Banks (ESCB).

Based in Frankfurt, the ECB is intended to serve as a normal central bank for those countries able and willing to participate in monetary union. As such the bank has three main areas of responsibility:

• • The printing, minting, issue and administration of the new euro notes and coins, together with the ultimate withdrawal of the old currencies after the transition to a single currency, which came about in July 2002
• • The determination of fiscal policy, including the setting of interest rates, for all countries in the ‘euro zone’
• • Maintaining a watching brief on the suitability for entry of countries currently outside EMU.

The ECB has an executive board and governing council that should be composed solely of representatives from those member states participating in stage three of EMU. But the European Council can give special associate membership to non-participating states, the UK being keen to maintain observer status. At the head of the ECB is a president who is appointed for eight years.

Foreign affairs, defence and internal security

The institutions described in this chapter have all been first and foremost institutions of the European Community, which is only one of the three pillars of the European Union, the other two pillars being a common foreign and security policy and a common policy relating to justice, home affairs and internal security. The only institution common to all pillars of the EU is the European Council. For the two created at Maastricht, the TEU had to create new institutions, or rather to rationalise existing ad hoc institutions within a framework of intergovernmental cooperation.

Institutions may seem dull and complex, but they are important to an understanding of the EU, providing the starting point for any understanding of how the Union operates, its policy processes and the direction in which it is moving. By achieving a clear idea of how they function and the way in which power is shared between them, we can better comprehend that the EU is an international body that is distinctive, still evolving and seeking to adjust to its enlarged membership.

Opinions vary as to where power lies within the Union. Supranationalists argue that the supranational institutions, the Commission, Parliament and Court of Justice, are a driving force behind the process of integration, for they are autonomous, being able to take decisions that are binding on member states. Intergovernmentalists stress the role of national governments (via the European Council and Council of Ministers) in making key decisions, leaving them in control of the direction of Union affairs.

Supranationalists can show that the introduction of QMV and co-decision, along with the growing importance of the European Parliament, all point to a loss in the influence of member states over decision-making. Intergovernmentalists can point to the ability of individual countries to opt out of policies they cannot accept as evidence that supranationalism is being held in check. Moreover, the ability of the European Council to shape the future direction of Europe reflects a broader trend in which the role of member states has been increasing in recent years, at the expense of the supranational Commission. The Council has played a leading role in the shaping of European integration and the resolution of contentious issues.

The way in which the Union moves forward is not on the basis of conflict between the various institutions, but via an attempt to achieve consensus which ensures that decisions are acceptable to as many countries as possible.

Glossary

Co-decision - A procedure introduced by the Maastricht Treaty that enhances the role of Parliament in the legislative process. Ultimately, parliament can in many areas veto a measure put forward by the Council of Ministers.

G8 – Group of Eight - An international forum for the governments of the original G7 advanced industrial countries (Canada, France, Germany, Italy, Japan, the United Kingdom and the United States), plus Russia, which achieved full status in 2002.

Together, the eight countries represent about 65 per cent of the world economy. The G7/8 Summit deals with macroeconomic management, international trade and relations with developing countries. The group’s activities include year-round conferences and policy research, culminating in the annual gathering attended by the heads of government of the member states.

EU (European Union) Economic Crisis 2013 - 2014 ; Jim Rickards

12. After the storm

SO WERE THE SCEPTICS RIGHT ALL ALONG? It is hard to avoid the conclusion that the single currency hás been a terrible folly. Its failings have brought misery to many parts of Europe and gravely damaged the post-war European project. At the height of the financial crisis, in early 2009, Jean-Claude Trichet, president of the ECB, could plausibly argue: “In stormy seas, it’s better to be on a large ship than in a small boat.” But the euro turned out to be no mighty ocean liner; it was just a pleasure boat, good for showing off in sheltered waters but dangerous on the open seas, lacking bulkheads, lifeboats or even a trained skipper and crew.

Being locked in a single currency made it too easy, almost inevitable, for deficit countries to build up large imbalances in good times (pumped by the savings of surplus countries) and agonisingly difficult for them to adjust in hard times. William Hague, the UK’s foreign secretary, was prescient when he predicted before the start of EMU (he was then the Conservative Party leader) that the currency zone would prove to be “a burning building with no exits”. Or as Silvio Berlusconi, then Italy’s prime minister, put it during the crisis, the euro is a “strange currency that does not convince anybody”.

With national currencies bond markets would have been more alert, demanding higher interest rates long before weaker countries could build up such large external deficits. And when the crisis came, devaluation might have allowed them to regain competitiveness more easily. But this judgment has to be tempered. First, any gains from devaluation might have been frittered away though inflation; and inflation would have pushed up borrowing costs. Second, it is likely that Europe’s currencies would have been linked in some way, and that the system would have been ripped apart when the financial storm blew in, with the Deutschmark appreciating sharply, the Italian lira devaluing and the French franc torn between the two. Third, currency chaos might easily have led to a protectionist freefor-all, undermining the single market.

In one form or another, major turmoil was probably unavoidable in Europe. What might once have been a currency crisis became, with the euro, a debt crisis. The euro allowed countries accustomed to high inflation to avoid reform in the good years as they benefited from low interest rates. Brutally, no doubt, the hardest-hit economies have been forced into overdue reforms, for instance in Ireland and Spain. Nowadays it is Italy and France, less traumatised but also less reformed than other countries, which present some of the biggest dangers to the future of the euro. They are too big to fail, too big to save and too big to bully from Brussels.

Europe’s real folly was not to look for the gains from a single currency in terms of trade, financial integration, exchange-rate stability and economic efficiency, even if they might have been overstated.

The madness was to believe that these benefits could be obtained on the cheap, without the political constraints, economic flexibility, financial transfers and risk-sharing mechanisms of genuine federations. What stands behind the euro? Germany? Up to a point. The ECB? Only sort of.

Almost everybody knew that the euro was incomplete when it was launched in 1999. Those who spoke up about the flaws were largely ignored. Those who kept quiet hoped that the problems would be repaired as and when they appeared. It was not an unreasonable assumption. The European Project has always advanced through half-steps, in the knowledge that inadequacies would eventually require further half-steps to be made good. As Jean Monnet, a founding father, once put it: “Europe will be built through crises.” The problem is that, when the euro crisis struck, it turned out to be far bigger than anyone had imagined. The debtors screamed for help, but the creditors feared being pulled under.

Yet the doomsayers were wrong in one crucial respect: they underestimated EU leaders’ commitment to the European project. The euro has somehow survived, and many a short-seller hás lost money betting on its demise. The euro’s failings have been compensated by sheer political will and the fear of what might happen if it broke apart. Angela Merkel, the German chancellor, has staked hundreds of billions of euros-worth of German taxpayers’ money to rescue other countries, while keeping her voters’ trust. She held back those who wanted to push out Greece. The Greeks underwent appalling hardships to stay in. Cyprus did not walk out even after its banks were crushed. The ECB stretched its mandate to make sure that the euro would not break apart. And countries are still lining up to join: Latvia has just done so, Lithuania may follow in 2015.

So in the end, it was those who subscribed to the “coronation” theory of the single currency who were closest to the correct answer: monetary union should have been the culmination of political union, not the means to achieve it. Does that mean it is time to break up the misbegotten euro, just as countries abandoned the gold standard in the 1930s?

Redenomination would be acutely painful. Changing currency is different from leaving a fixed peg. Whether done by returning to national money, or by creating a Germanic northern euro and a Latin southern one, redenomination would mean that currencies, assets and liabilities would all be repriced abruptly. Some companies, in both creditor and debtor countries, would go bust. Some countries that devalued would be crushed by their euro-denominated debt and default. And there could be bank runs as depositors in southern countries rushed to move their savings to northern ones. The dislocation would be most acute for the deficit countries. If the euro has to be split, it would probably be least disruptive if Germany were to leave, either alone or with a group of northern neighbours,allowing the rest to devalue. But Germany would not avoid economic pain, and a euro without the EU’s largest economy would make little sense.

It is also unlikely that the EU’s single market would survive the implosion, as it would probably be followed by capital controls, trade barriers and, possibly, a wave of migration. Without the euro or the single market, the EU would become irrelevant. And vulnerable democracies in eastern Europe, and even in the south, could lose their political anchors. The tow-line that is pulling the Balkan countries towards the EU could snap. In short, it must still be better to refit the euro than to scrap it; and better still to do it during the current lull rather than wait for the next storm.

The measure of failure

The euro zone has undergone extensive patching. It now has a permanent rescue fund; tougher rules to monitor budgets and economic imbalances, with the threat of semi-automatic sanctions; and national balanced-budget rules through the fiscal compact. In principle, all recognise the need for structural reform to regain competitiveness and enhance growth. In September 2013, Wolfgang Schäuble, the German finance minister, boasted that the slow return to growth in the euro zone, and the rebalancing of current accounts in deficit countries, was proof that the much-criticised medicine was working:1

Systems adapt, downturns bottom out, trends turn. In other words, what is broken can be repaired. Europe today is the proof.

Yet this is to miss the point. The euro’s is a story of survival, not of success. Although it is limping back to growth, its weaker members have sunk deeper into debt. Mass unemployment and debt deflation in Greece are hardly evidence of successful adjustment. The question is not whether economies eventually bottom out, but whether politicians limit or worsen the damage. One answer is to compare the euro zone’s performance with that of the United States. European leaders like to blame the United States for their crisis, and to boast that aggregate public debts and budget deficits are healthier than those of the United States. So why is the United States doing so much better than the euro zone? US output has surpassed its pre-crisis peak and is growing moderately; the euro zone has yet to make up the lost ground and growth is still fragile.

Unemployment was above 9% on both sides of the Atlantic in 2009, but it has since fallen close to 7% in the United States and risen above 12% in the euro zone. In the periphery the numbers are much worse. Europe as a whole has a less favourable demographic profile than the United States, so in terms of GDP per head the growth figures are a bit less dire. Nevertheless, the differences in performance are glaring.

A catalogue of errors

Europe’s response has been slow, partial and often baffling to outsiders. The adjustment has been needlessly painful for the debtors, and probably needlessly expensive for the creditors. Leaders of the euro zone are unlikely to acknowledge their errors, but their many changes of policy amount to na implicit admission of them.

Who is to blame for the fiasco? Those who created such a death trap of a currency union, to begin with, followed by the reckless borrowers and the irresponsible lenders of the first decade of EMU. The rulers of deficit countries foolishly thought they could live in a Germanic currency union, and enjoy low interest rates, without becoming more Germanic in their attitude to budgets and wages. Certainly, deficits in the periphery were mirrored by surpluses in core economies. But the truth is that running large external deficits is more dangerous than having surpluses when a crisis hits.

Once the crisis began, though, it is the creditor countries that must bear prime responsibility. They were best placed to limit the fallout, because everybody needed their money, but they made it worse.

Above all this means looking at the role played by Germany. It is wrong to accuse it of selfishness or, worse, of trying to dominate Europe. Germany has undoubtedly staked much of its treasure (as have other countries) on saving the euro zone. But it made serious errors. It treated the crisis for far too long as a question of fiscal profligacy, and of individual countries. Mario Monti would quip that for Germany “economics is a branch of moral philosophy”. Fiscal sinners had to atone, and the rightful had nothing to apologise for. Frequently in Germany economics was also a question of extreme legalism. Many of the most senior officials in the German finance ministry are lawyers, not economists, starting with Schäuble himself.

It was only in the summer of 2012 that Germany started to understand that the structure of the euro zone itself was unstable, and came around to accepting the need for a banking union. Even then it dragged its feet over anything that implied common liabilities, and insisted on a worryingly complex legal structure for the resolution mechanism.

The incoherence can be understood only in the light of Germany’s twin terrors: the fear of moral hazard and the fear of collapse. These are best encapsulated by two dictums: “chacun sa merde”, Nicolas Sarkozy’s summary of Merkel’s rejection of a joint bank rescue in 2008; and “ultima ratio”, Merkel’s justification for bailing out Greece in 2010. In other words, countries must deal with their problems on their own, and should be helped only as a last resort when the euro’s survival is at stake.

The constraints are meant to limit the liabilities of creditors and maintain pressure on debtors to reform. But they have raised the cost and length of the crisis, and allowed doubts about the euro’s future to fester, thereby hampering the recovery in the periphery and accelerating financial fragmentation.

On the face of it, the heroes of the crisis are the two presidents of the ECB, Trichet and especially Mario Draghi, whose interventions kept the system going when the politicians were at each others’ throats. The ECB gave timely warnings of the danger of imbalances, and responded decisively to the financial crisis. But once the trouble spread to sovereigns, it became much more cautious. It was willing to provide liquidity to banks, even those that were patently bust, but hesitated to do so overtly, even for solvent sovereigns. The Eurosystem of central banks cushioned the blow on deficit countries by accumulating large imbalances in the euro zone’s payment settlement system, known as “Target II”. At the height of the crisis in 2012, Germany’s Bundesbank had, controversially, accumulated claims worth more than €750 billion against the ECB. So over and above the visible taxpayer-funded bail-out by the German government, economists argued bitterly over whether there was also a large stealthy bail-out via the Bundesbank. The Target II imbalance is perhaps best seen as a reflection of capital flight from the troubled periphery, and raises the question of whether central banks in creditor countries would have to take large losses should the euro break up and the debtor countries refuse to settle their Target II liabilities. In the event, the imbalance declined steadily after Draghi’s “whatever it takes” speech in London in July 2012 restored confidence in the future of the euro zone.

That said, the ECB resisted for far too long the need to cut Greece’s debt, and refused to let Ireland impose losses on bondholders. It devised an effective means of halting contagion only in the summer of 2012, after two years of crisis and half-hearted interventions in bond markets. If governments responded too late, the ECB often responded even later. It feared that if it acted too soon, governments would be only too happy to leave it alone to deal with the crisis. In the darkest days of the crisis, frustrated officials would tell Trichet: “You may end up being a central bank without a currency.” To which he would reply: “And you may end up having a currency without a central bank.”

The ECB had its own twin fears, both of them German. They were called “Bundesbank” and “Karlsruhe”. The inflation-busting tradition of the Bundesbank meant that the ECB would rather flirt with deflation than let prices rise too high in Germany, or upset German savers by more aggressive lowering of interest rates. It never dared engage in the aggressive loosening of monetary policy, known as “quantitative easing” (involving the purchase of government bonds and other assets), long pursued by the US Federal Reserve and the Bank of England. Excessively low inflation, overly tight monetary policy and a high exchange rate made it even harder for the periphery to adjust relative to Germany. The Bundesbank openly opposed any resort to bond-buying to hold down borrowing costs.

And the ECB soon ran up against the even greater intransigence of the German constitutional court, which ruled that Draghi’s policy of outright monetary transactions (OMT), the one true firewall that had arrested the financial blaze, was illegal (though it offered a stay of execution by passing the case on to the European Court of Justice).

The fact that the crisis started in Greece, the clearest case of public spending gone wild and of a government unwilling or unable to enact reform, did much to reinforce the prejudices and fears of Germany and the ECB. It is plain to all in retrospect – and probably to those who knew the real numbers at the time – that the first Greek bail-out was ill-conceived. It treated Greece as a problem of liquidity rather than of solvency. The distinction is often hard to make, as it depends largely on a country’s prospects for future growth and the interest rate that investors demand to hold its bonds. But Greece was plainly bankrupt. Its debt should have been cut early and decisively rather than late and messily, thereby giving private creditors the chance to dump Greek bonds.

Greece was pushed into panicked and excessive austerity – partly because its debt was so high, and partly because of a lack of credible tools to stabilise the euro zone. And when the programme failed, through a combination of Greece’s shortcomings and those of its creditors, the threat of Grexit made everything much worse. The same was true, to a lesser extent, of other programme countries. The bailouts were all too optimistic in their assumptions about the recessionary impact of austerity, and put too much faith in the notion that hairshirt economics would restore market confidence. The economies of Greece, Ireland and Portugal all performed worse than forecast: recessions were deeper and unemployment was higher. Perhaps most striking is the sharp worsening of debt-to-GDP ratios. This is only partly because deficits were increasing the debt, or the numerator. A bigger factor was that recession was shrinking output, or the denominator. The numbers for Greece were especially dire – its debt ratio reached 176% of GDP and joblessness passed 27% in 2013 –even though the one thing Greece did achieve was a reduction in the deficit more or less according to plan.

Countries in bail-out programmes were at first made to pay punitive rates of interest. It was only comparatively late that the focus shifted from fiscal consolidation to structural reforms to make labour markets more flexible and enhance potential growth.

Of the members of the troika that negotiated the programmes, perhaps the biggest culprit is the European Commission. It had little experience of dealing with balance-of-payments crises and, under pressure from Germany, suffered from tunnel vision on fiscal rules.

Even so, the IMF cannot escape all blame. Its expertise was most needed at the start of the Greek programme, yet it had signed up to a deeply flawed programme. The IMF did, at least, try to redeem itself. Subsequent debt-sustainability assessments for Greece and Cyprus were more sober. It published a lessons-learnt report on Greece recognising that the country’s debt should have been cut earlier.2 IMF economists admitted that inappropriate fiscal multipliers had been used in forecasting the impact of austerity. And it has done much valuable future-oriented thinking, for instance on the design of a banking union and a putative future euro-zone budget. Such a spirit of self-examination and open inquiry has so far largely eluded the Commission.

Members of the European Parliament, who have started to inquire into the troika’s workings, dream that it will be replaced one day by a fully fledged European Monetary Fund (built around the rescue fund, the European Stability Mechanism) that dispenses with the IMF. But it will be some time before the treaties can be changed to create such a body, and even longer for it to build up the necessary credibility.

It is tempting to argue that the euro-zone crisis would have been handled better if left entirely in the hands of the IMF. But given the size and interconnectedness of the euro zone’s economies, and the slow pace of adjustment involved in “internal devaluation” with a fixed currency, the task was probably beyond the IMF’s resources. It would probably always require substantial euro-zone funds to run such bail-out programmes.

Awkward co-operation between the Europeans and the IMF may therefore be needed for years to come. But the presence of the ECB in the troika is an anomaly. The central bank’s mandate should not stretch to bargaining over budget cuts and reforms to labour markets, or threatening to cut off liquidity to banks if a country does not comply with its wishes. As the ECB becomes the euro zone’s main bank supervisor, the conflict of interest is glaring. It is time, surely, for it to depart. One advantage is that the IMF, unshackled from the ECB, might be in a better position to push the central bank to loosen monetary policy.

To enumerate the errors of the troika is not to absolve Greece, and its Byzantine polity. It hás proven obdurate when it comes to structural reforms. Nothing would have spared Greece the need for an agonising fiscal adjustment. But more coherence in the troika programme might have given Greece a greater chance of success, and avoided the death spiral that threatened to suck down the whole euro zone. Austerity was pursued too zealously, but given the levels of debt in the euro zone and the danger of losing access to markets in several countries, there was little space for anyone, apart from the likes of Germany, to engage in fiscal stimulus.

It is of course easier to be wise in retrospect. One explanation for the muddle was the real fear of financial instability. If Greece defaulted immediately, other countries might be pushed into bankruptcy too. Better to fudge the Greek numbers, buy time and wait for conditions to improve and growth to return. This argument would be stronger had the euro zone really used the time to redesign itself more profoundly. True, it cobbled together an inadequate bail-out fund. But it undid its own efforts with a ham-fisted bargain at Deauville and ignored the banking crisis for two years.

Perhaps the kindest thing that can be said is that the euro-zone’s policymakers, confronted with their first major crisis, had to learn by trial and error. To borrow Churchill’s apocryphal bon mot about Americans, the Germans can always be relied upon to do the right thing after they have exhausted all possible alternatives.

Hamilton and the F-word

The euro zone should look to the United States and ask itself: why does the prospect of default by one state not call into question the existence of the dollar? Why is the euro so flimsy that a default by an 3% of the euro zone’s GDP, should have been seen as an existential threat? The short answer is that the United States is a single federal country, while the euro zone is a much looser confederation of sovereign countries. It may use a single currency, but it has 18 national governments with 18 different economic policies.

The euro zone’s financial system was sufficiently integrated to spread contagion, but not

integrated enough to provide resilience. It has no central budget or other means of absorbing asymmetric shocks that hit one or two countries disproportionately. Until the ECB came up with the policy of OMT, it had no effective lender of last resort, so countries were in effect borrowing in a foreign currency. These faults meant that the no-bail-out rule, although enshrined in the Maastricht treaty, was not credible when the crisis hit. Yet the euro zone had no means of giving assistance to countries that got into trouble. By contrast, the US federal government has successfully resisted bailing out any of the states since the 1840s, leaving the markets to impose fiscal discipline.

Repeated bail-outs in the euro zone have, inevitably, led to more central controls on fiscal and economic policies. The “economic governance” created in recent years is a soup of incomprehensible jargon: six-pack, two-pack, fiscal compact, Euro Plus Pact, European semester, annual growth survey, excessive deficit procedure, macroeconomic imbalances procedure, “contractual arrangements” for reform, and much more. All this amounts to an unprecedented intrusion by an unaccountable EU bureaucracy that satisifes nobody: the Commission is accused by the debtors of doing the creditors’ bidding, and by the creditors of being too soft on the sinners. This system is ultimately untenable.

True, the IMF also imposes painful reforms when it is called in to help. But the IMF is a foreign doctor who eventually goes away. In the euro zone, the health inspectors move into the house forever. In its weird hybrid construct, part United Nations and part United States, the euro zone often suffers from the worst features of both. Elected governments are being hollowed out by a loss of power to Brussels; but citizens have no direct say on decisions taken in Brussels. At some point the euro zone will discover something of the truths set out more than two centuries ago by Alexander Hamilton, the first American treasury secretary, in the federalist papers that he co-authored: trying to coerce sovereign states to follow common rules eventually leads to conflict. A federal system must thus act directly on the citizen, not the component states. Having created what is essentially a federal currency for Europe, the countries of the euro zone have much to learn from studying Hamilton, particularly the way he got the American federal government to assume the war debts of the former colonies and issue new national bonds backed by direct taxes. His new financial system helped transform the young republic from a basket case into an economic powerhouse.3

Bring back no bail-out

So what is the way forward? In the longer term, the only workable answer is surely to restore the credibility of the no-bail-out rule and allow countries to go bust if and when they get into trouble. The question is, can it be done under the Maastricht model of autonomous national economies, now modified by a handful of stricter centralised rules and a safety net based on ultima ratio? Or does it require more US-style fiscal federalism, involving the sharing of liabilities through autonomous central bodies? Put another way, should “solidarity” in the euro zone happen only in extremis, after a country gets into trouble, in the form of “mutual assurance” by governments offering help in return for tough conditions?4 Or should it take place automatically, for instance raising European taxes to deal with banking risks or, say, unemployment insurance?

Expert opinion is divided. Ashoka Mody, a former senior IMF official, argues in a 2013 paper for Bruegel, a think-tank in Brussels, that European officials should recognise that the federalist impulse is at a standstill.5 Germany and other surplus countries will not accept any mutualisation of risk, be it in the form of joint debt or joint liability for the banks. Instead, the euro zone should concentrate on making it easier to restructure unpayable debt. Banks should issue contingent convertible bonds that can turn debt into equity when they get into trouble, so absorbing losses. And sovereign bonds should include provisions for maturities to be extended when debt exceeds a certain level. By contrast, the Glienicker group, a collection of 11 pro-European German economists, lawyers and political scientists, is pushing for a stronger dose of federalism.6 It calls for a “robust” banking union, a “controlled transfer mechanism” including common unemployment insurance and a common budget to promote public goods. Similar conclusions were reached by a French gathering calling itself the “Eiffel Group”.7 Economic logic points to greater federalism in fiscal and banking affairs. But political reality is that the wallet, and the power to tax, will remain national. The euro zone will therefore remain hybrid for the foreseeable future. Besides the risk of political backlash against economic governance, there are other reasons to worry that the current model is unstable. The ECB’s position as lender of last resort remains ambiguous. Mario Draghi’s great bluff, the OMT policy, may not hold forever. Moreover, the ECB’s one-size-fits-all interest rate is a one-size-fits-none arrangement that has a tendency to amplify economic divergence. It is now too low for Germany and too high for Mediterranean countries, whereas the situations were reversed when the euro began in 1999. Similar arguments apply to the common exchange rate, which has tended to favour high-end German exports over, for example, more price-sensitive Italian ones. Some worry that, as a result of the crisis money, production capacity and skilled workers are shifting permanently to core economies through the so-called “agglomeration effect”, with no transfers to soften the blow to the periphery.

Without a large American-style federal budget, countries of the euro zone need other means to adjust: more flexible markets for labour, products and services; greater mobility of workers; and more cross-border ownership of assets. But in all these respects, EU countries are a lot less integrated than the United States. The principal shock absorber is national borrowing. But in times of high debt, borrowing is a limited instrument, and may even be counterproductive if markets doubt a country’s solvency.

The IMF notes that federations such as the United States, Canada and Germany are able to absorb about 80% of economic shocks in their states or provinces,8 whereas the euro zone manages to smooth just 40% of asymmetric shocks. In other words, a 1% drop in GDP results in household consumption shrinking by 0.2% in federations and 0.6% in the euro zone. It is thus apparent that the euro zone should become, in some aspects, more federal if the euro is to function more effectively. As in the United States or Canada, the aim should be to create a European system that is resilient enough to allow each country to make its own choices, and bear the consequences when things go wrong.

Discipline is best exerted by markets, not Eurocrats. As the IMF paper notes, no-bail-out rules are more credible when there are risk-sharing mechanisms to contain the impact of default. Seen this way, more federalism in some domains is a means of restoring choice to governments, not of taking it away. It would relieve deficit countries of ever more intrusive central controls, and surplus countries of the duty to rescue others. Fiscal federalism does not imply that the EU (or euro zone) has to become the United States of Europe. Some powers could and should be repatriated as part of the bargain. Forget about a European army (it would never leave barracks) or a single EU seat at the UN. Europe does not need to speak with one voice. But it needs the euro zone to operate as one coherent financial system. Precisely how far integration must go remains something of a guessing game. But here are a few priorities.

Complete banking union

Begin with a real banking union. The euro zone’s trouble started as a banking crisis and, in contrast with the United States, it has yet to be resolved. The uncertainty over unseen losses in banks is hampering recovery. A new supervisor has been created and bail-in rules have been agreed. Germany has belatedly agreed to a complex bank-resolution mechanism and a pooled bank-resolution fund, paid for by banks, that will be created over several years. That is a precedent for mutualisation.

It is right that banks and their creditors bear the brunt of bank failures. But to become stable, banking union needs a taxpayer-funded backstop if a big crisis strikes. A common deposit-insurance system would help to provide greater stability. A half-baked banking union will not break the vicious circle between weak banks and weak sovereigns.

Cut unpayable debt

Sovereign debt is the other end of bank-sovereign loop. It has risen to its highest level since the second world war, and at the beginning of 2014 stood at 95% of GDP on average in the euro zone –Greece was at 176%, Italy at 133%. Private debt is also high in many countries.

One lesson of the crisis, especially in Greece, is the need for a clear-eyed distinction between problems of liquidity and problems of solvency. Fudging the assessment of a country’s debt and hoping for the best is a bad choice for debtor and creditor alike. In any future bail-out it is better to cut unpayable debt from the outset. The losses would thus fall on those that lent the money to uncreditworthy countries. Adjustment programmes need to have sufficient margins to deal with problems when forecasts inevitably go wrong. It is better for a country to exceed its targets than consistently undershoot them.

Having made the error, official creditors should lift the burden on Greece, as promised, now that it has reached a primary budget surplus (that is, before interest payments). A debt write-off would be better than an endless process of “extend and pretend” that leaves a perpetual cloud of uncertainty over Greece. The sooner and more explicitly it is done, the stronger the signal to markets that Greece is coming out of its misery.

Moreover, a similar principle could be extended to other rescued countries: the terms of their bailout loans should be softened once they have got into primary surplus. This is especially justified in the case of Ireland, which was prevented from wiping out senior bondholders of its bust banks, even though this has become an aim of banking union. Italy, Europe’s biggest debtor, needs to embark on sustained privatisation to pay off debt and encourage more competition. Other measures to make it easier to restructure debt, both private and public, would be sensible.

Bond together

In the longer term, the euro zone should move towards some form of mutualisation of debt. One reason is to limit excessive borrowing costs; another is to send a political signal of commitment to the common currency; a third is to create a safe asset for banks to hold, so helping to break the doom-loop with sovereigns.

There are now many proposals for Eurobonds. A 2010 paper by Jakob von Weizsäcker and Jacques Delpla for the Bruegel think-tank in Brussels proposes a hybrid “blue bond, red bond” system: countries would issue joint bonds, guaranteed jointly and severally by all euro-zone members (blue bonds), up to the “good” debt threshold of 60% of GDP; beyond that countries would issue riskier national bonds (red bonds). Another idea, proposed by the German government’s official council of economic advisers, was inspired by Alexander Hamilton: it would pool the “bad” debt above the Maastricht threshold in a temporary debt redemption fund that would be guaranteed by all, with a commitment by each member to pay off its share over 20 years.9 The latter is less complicated in legal terms and may be a good starting point. If such an assumption of debt could be achieved with another Hamiltonian touch, by simultaneously restructuring the debt to lighten the burden, it would be even better.

But such ideas for common bonds run into a huge objection: why should the thrifty guarantee debts accumulated by the profligate? Texas does not stand behind California’s debt. American treasuries are federal debt, paid for by federal taxes. Embryonic forms of European debt already exist, such as bonds issued by the rescue funds. But granting European institutions the authority to issue debt and raise taxes would be contentious. Euro-zone “treasuries” could start in a limited manner, for instance by issuing short-dated bills. Moral hazard is a real problem; after all, the euro zone’s imbalances built up at a time when markets behaved as if Eurobonds were already in existence. Clear qualification criteria could mitigate the risk and give countries good reasons to reform. Vulnerable countries need incentives as well as threats and rules to stick to the path of reform.

The need to balance

So far the burden of adjustment has been placed mainly on deficit countries, while Germany’s currentaccount surplus has continued to grow, to the point where the US Treasury complains that it is hampering recovery, both in the euro zone and globallyIn an open trading area the connection between Germany’s surplus and other countries’ deficits is complex. Boosting demand in Germany – say by increasing investment, allowing wages to rise or granting a tax cut – might suck imports from the United States, China or eastern Europe more than from the Mediterranean. Even so it would help, not least because it could help to weaken the euro’s exchange rate (though a better way of achieving this would be through looser monetary policy). In political terms, though, unless Germany is seen to do more to help the euro zone’s economic rebalancing, it will face stronger calls for some system of permanent fiscal transfers. It is striking that China has done more to reduce its surplus and rebalance the global economy, by raising its exchange rate and stimulating the economy, than Germany.

A stronger centre

Fully fledged federations have a central budget that provides public goods and redistributes income between rich and poor citizens (and states). The budget helps to absorb the shock when one or other region suffers a downturn. Even when local tax revenues drop, the federal government continues to spend on defence, capital projects, unemployment insurance and, often, health care. Federal budgets invariably act as the backstop for the banks. By contrast, the EU has a tiny budget, no power of taxation and no powers to borrow. And the euro zone has no budget at all.

Does the euro zone need a central pot of money? France wants common short-term unemployment benefits across the euro zone. Germany wants a more limited and conditional model: providing at most small transfers to countries as part of “contracts” for structural reforms. The IMF has suggested a modest “rainy-day” fund, a collective savings account that could make transfers when countries suffer a downturn.

But even a small fund runs into a big obstacle. Euro-zone countries already have large national budgets, consuming about 50% of GDP. Spending by federal and state governments in the United States amounts to just 38% of GDP, and 33% of GDP in Switzerland. The EU’s budget amounts to about 1% of GDP. Measured another way, federal spending accounts for 55% of total public spending in the United States and 43% in Switzerland. The 1977 MacDougall report suggested a central budget of 5–7% of GDP in the early stages of a European federation. Even Canada’s relatively small federal government accounts for 34% of total public spending. The equivalent figure for the EU is currently 2% of GDP. Any euro-zone fund would therefore require adding to an already heavy tax burden, or shifting spending from national to European level, or sharply cutting the rest of the EU budget. None of these would be easy.

The IMF thinks a euro-zone rainy-day fund, made up of annual contributions of between 1.5% and 2.5% of GDP (that is, about twice as large as the EU’s budget), would be enough to give the euro zone a similar level of shock-absorption as other federations and would roughly even out transfers over time. Had it been created in 1999, almost all countries (except tiny Luxembourg, which boasts the EU’s richest population) would have received roughly the same as they had put in. Germany would have benefited when it was regarded as the “sick man of Europe”. Such an automatic system would provide more timely help than a bail-out fund and avoid disputes over conditions imposed on recipients. If the European fund could also issue bonds, it could run a counter-cyclical European-level economic policy during a general recession, making it easier for countries to stick to balanced-budget rules.

The problem with a rainy-day fund is that it is hard to assess the economic cycle in real time, so deciding when to make payments, and how large they should be, could be tricky. The French idea of an unemployment-insurance system could act as a proxy. National governments would still pay for long-term joblessness, which reflects national labour-market rigidities, while a European fund could top up benefits for the first six months of unemployment that are more likely to reflect the short-term cycle. It is unlikely that Germany would ever agree to this without a high degree of harmonisation in labour-market practices. The Glienicker group would extend unemployment insurance only to “countries that organise their labour market in line with the needs of the monetary union”. Yet done properly and with clear limits and conditions, such a system could satisfy France’s desire for a “social” dimension to Europe and Germany’s insistence on labour-market reforms with the eurozone’s need for mobility of workers.

A more central bank

Visible progress towards integration would give the ECB greater confidence to intervene as a guardian of the euro while reforms are enacted. If a future euro-zone fund acted as a backstop for banks and issued European debt, the ECB could increasingly act as a lender of last resort to the European fund, rather than to national governments, thus freeing it from the uncomfortable business of setting conditions, directly or indirectly, in return for monetary action to help vulnerable countries.

As supervisor of euro-zone banks, the ECB should ensure that bond holdings are diversified and encourage cross-border bank mergers, to help break the doom-loop between banks and sovereigns.

And given that its supervisory role already raises questions about its political independence, not least because bank failures have an impact on national treasuries, the ECB should get out of the entanglement of the troika.

For now, the ECB must have the courage to loosen monetary policy more aggressively, despite German complaints that savings are being undermined, to avert the threat of deflation. A dose of American-style quantitative easing may be in order. Once again, though, it would be easier if the ECB had Eurobonds to buy instead of having to pick and choose which country’s debt to buy and which to exclude.

Narrow the democratic deficit

The integration of the euro zone, the intrusion of European bodies into national economic policy making and the growing popular disenchantment with the European project require the democratic deficit to be addressed more urgently than ever.

But for the foreseeable future – for as long as real power, budgetary authority and legitimacy lie with national governments – it is best to enhance the role of national parliaments and perhaps even downgrade that of the European Parliament. This can be done by giving national parliaments greater authority to scrutinise the decisions taken by national ministers, prime ministers and presidents in Brussels. National parliaments can also be given greater powers to veto or modify European legislation. Moreover, there could be scope for a joint body of national MPs to examine intergovernmental decisions, such as bail-out decisions by the troika and the Eurogroup.

Giving the system greater national democratic legitimacy would be a huge step in the right direction. But even this may not be enough to legitimise the full panoply of measures and procedures in the European semester and its associated pacts. If, as seems likely, national politics at some stage reasserts itself by reclaiming fiscal and economic autonomy from Brussels, it will be that much more important for parliaments to understand the European repercussions of national economic policies.

Germany realised this when it insisted that debt brakes be introduced in national legislation through the fiscal compact.

If the euro zone were ever to adopt truly federal elements, for instance if it were given a central budget or the power to raise taxes, these powers would certainly need to be held to account by the European Parliament. At that point there may even be scope for the direct election of some jobs in Brussels. For now, the indirect election of candidates for president of the European Commission, as envisaged by the European Parliament, is a travesty. Voters are not being offered a real chance to influence EU policies, but the experiment with Spitzenkandidaten (leading candidates) risks calling into question the impartiality of the Commission on a whole series of functions where it needs to act as a referee – not least in assessing the economic policies of individual countries.

A fitter Commission

The Commission remains the engine of the EU. But enlargement of the union has turned the cosy old college system into an unwieldy bureaucracy with 28 commissioners, each a little baron seeking to push pet projects, resulting in legislative overreach. Especially as the Commission gains powers to influence national economic policies, it should get out of the business of setting out the minutiae of regulation. The so-called REFIT initiative to cut red tape, such as a silly proposal to ban hairdressers from wearing high heels, is a good start. But much more can be done to make a reality of José Manuel Barroso’s dictum that “the EU needs to be big on big things, and smaller on smaller things”. That said, deepening the single market by necessity requires European-level regulation, if only to cut through the thickets of 28 different sets of national laws.

It is time to revive the notion of a more streamlined Commission, perhaps by having senior and junior commissioners, which might make it easier to slim down the volume of Commission activity – so long as it can free itself from the control of the European Parliament, which favours more legislation, not less. The Germans and the British have also suggested that all draft legislation, whether directives or regulations, should be dropped at the end of every term of a Commission, as happens in most national legislatures.10

If governments want a good Commission, a good place to start would be for them to appoint competent commissioners rather than use Brussels as a dumping ground for second-division political hacks.

Chart the course

Creating a more stable and integrated euro zone will require several big bargains – between creditors and debtors, between older and newer members, between euro ins and outs. There will need to be much more Europe in some areas in return for much less in others. And as the euro zone integrates, there should be more integration of the single market. To navigate through these treacherous waters, European countries need a clearer destination. The Monnet method of integration step-by-step, sector by-sector, with an ambiguous final objective, is reaching its limits. The euro now affects the core of national politics, so it cannot be delegated to technocrats indefinitely. The system will need more democracy and accountability, though how this is achieved may ultimately differ between the euro zone and the wider EU. Herman Van Rompuy, president of the European Council, was thinking along the right lines when he appointed himself to draw up his abortive road map for a “genuine economic and monetary union”.

Members of the euro zone do not yet trust each other enough to take on big liabilities in one leap. Reform will have to be done in stages to build confidence. To borrow Schäuble’s phrase about banking union, there could first be a “wooden” structure, followed by a steel one. But if debtors are to agree to more discipline, they need confidence that a system of greater solidarity will follow.

Germany has every reason to worry about moral hazard. Weak countries might fail to reform once market pressure is lifted. But moral hazard applies to the strong too: no sooner had fear of the euro’s break-up subsided than Germany started to water down banking union. A plan for greater sharing of liabilities matched by the restoration of a credible no-bail-out rule could prove an attractive bargain.

One problem is that many changes would require treaty change. Most leaders, like the institutions in Brussels, recoil at the idea of a big negotiation and multiple referendums at a time when voters are restive, populists are on the rise and incumbents in trouble almost everywhere. Germany, conscious of the strictures of its constitutional court, is more open to reform through a succession of small revisions under the “simplified procedure” that requires fewer referendums. But such piecemeal reforms may not provide scope for the necessary compromises. And there is always reluctance to give the UK the opportunity to complicate things with demands for repatriation of powers.

A full treaty negotiation may be inevitable, even desirable, in 2015 and 2016 to settle some fundamental questions and to explore whether the minimum that the UK can accept can be reconciled with the maximum that other EU countries are prepared to offer. But if the process gets bogged down, one way around these difficulties is to negotiate inter-governmental deals outside the EU’s treaties.

EU purists and the European Parliament intensely dislike inter-governmentalism. It detracts from the “community method”, it denies power to the Parliament and it creates more opportunity for big countries to bully smaller ones. But the accords establishing the European Stability Mechanism (ESM) in 2011 and the fiscal compact in 2012, both inter-governmental treaties, were negotiated easily and quickly. And they brought an important innovation, common in other international treaties (and indeed in the constitution of the United States), of coming into force once a threshold number of ratifications was reached, that is, without the requirement for unanimity. This reduces the scope for angry holdouts, be they referendum voters or obstreperous parliaments, to block everything. The ESM is already a common fund that can borrow on markets, so could easily be expanded to incorporate other functions.

Greater integration in the euro zone is bound to increase tensions between the 18 ins and the tem outs. But relations would be worse still if the euro zone failed to right itself. The task will be to bind the euro zone closer together within the wider EU. The trick is that integration of the euro zone should go hand-in-hand with deepening the single market. But beyond this, safeguards will be needed to ensure that the ins do not gang up on the outs, and that the euro zone’s policies are open to newcomers. It is hard to see the euro zone consistently voting as a block, but the habit of coordination, and the fact that most countries still want to join the euro, will worry the remaining outs.

The UK’s future status is an acute headache that could come to dominate much European business.

Unlike most outs, the UK is half out of the EU as a whole, and David Cameron is proposing a referendum on its EU membership in 2017. The UK has dithered over his demands in a renegotiation, partly because it does not know what might be on offer. But a more complete single market, ambitious trade deals, lighter EU regulation, curbing benefits for migrants and a smaller EU budget (say if farm spending were cut to make room for a euro-zone fund) might be achievable. The departure of the UK would be a grave loss, not just for the UK but also for the EU. Euro-zone countries need to liberalize markets, both to promote growth and to enhance their ability to adjust wages and prices. The UK’s liberalising zeal would be invaluable.

The twin dangers ahead

Which way is Europe heading? Its leaders have shown they will act to avoid imminent shipwreck. This means that a sudden, catastrophic default and currency redenomination is improbable. For the same reason, countries are unlikely to heed Trichet’s exhortations, at the start of the crisis, to “immediately jump into political union”. Even the more focused reforms proposed above are unlikely to happen spontaneously. Many will see the economic sense in such changes, but they come with a political cost to some or all governments. This means that leaders will act only when compelled to do so by events.

The most likely course is to drift, with periods of crisis and piecemeal reforms, followed by more drift. The next crisis – and there will surely be a next crisis – could come from any number of directions. It could be triggered, as at the outset, by a problem in the banks. The euro zone’s financial sector has had much capital injected into it but banks remain wobbly. A succession of discredited stress tests means that nobody quite knows how many more losses are lurking in bank balance sheets.

The ECB’s review of banks’ assets, due to be completed in 2014, might discover losses that sovereigns are unable to bear and the euro zone is unwilling to take on.

The forthcoming turmoil might be precipitated by doubts cast on the one policy that has most decisively halted any looming collapse: the ECB’s promise to intervene in bond markets if needed to stop the euro from breaking up. The policy of OMT could yet be undermined by the latest (or a future) adverse ruling in Germany’s constitutional court. Enacting OMT requires countries to seek, and receive, a rescue programme from the ESM, and often parliamentary votes. Would the Bundestag vote knowing it might unleash the ECB against the will of the Bundesbank and the Karlsruhe court? Would the Bundesbank comply with ECB demands to buy bonds? Conversely, will the ECB stand back if the euro is in danger and politicians fail to act? Nobody knows whether the ECB, in setting no limit for bond purchases, is genuinely ready to buy unlimited amounts of debt. In truth, the ECB’s policy of OMT is a bit like a nuclear weapon: a deterrent that may work best if it is never tested.

The two most obvious dangers to the euro zone are economic and political. The euro zone faces a long period of stagnation. Weak recovery means that countries will struggle to reduce mass joblessness in parts of southern Europe, and they could more easily be pushed into a triple-dip recession. If that happens, what chance is there that their people will put up with another round of austerity and Brussels-imposed “economic governance”? Japanese-style deflation was a growing worry in 2014. In short, the market’s optimism in early 2014 about the prospects for peripheral economies seemed overdone; bad news could bring a sudden reassessment, just as it did in 2010.

Even without such grim scenarios, slow growth and high unemployment are already radicalising politics and intensifying rejection of both national and European politicians. So the next crisis may well be political. Anti-EU, anti-immigrant and anti-establishment parties of all colours are on the rise.

The European elections – usually a sideshow – of May 2014 are an important moment. The rise of populist parties may point to a pressing need to reform the system; yet their strength might also make sensible changes hard or even impossible. Anti-EU parties are divided among themselves, and often more interested in megaphone (or YouTube) politics than in the detail of policy. Their direct impact on legislation in Brussels may therefore be limited, beyond making the European Parliament noisier.

But the populist parties could change national political dynamics in several countries, so affecting European policies more indirectly. Governments may feel under pressure to halt reforms, be they national or at the European level.

Thereafter, a national election in the south, say in Greece, could return a constellation of parties that refuses to comply with bailout conditions or decides that leaving the euro is the lesser evil. Or na exasperated creditor country in the north, say the Netherlands, might refuse to pay for the next bailout or just reject the debt restructuring that Greece needs. Or the trouble might come from a non-euro country, for instance if a British referendum were to come down in favour of leaving the EU, disrupting the whole system. Or important countries might just fail to muster the political support for long-delayed economic reforms. Italy is the perennial backmarker in economic growth. For many governments, Jean-Claude Juncker’s dictum about structural reforms still holds: “We all know what to do, we just don’t know-how to get re-elected after we’ve done it.” Even at the height of the crisis, and led by the reform-minded Mario Monti, the Italian government found it easier to raise taxes and cut spending than challenge vested interests by enacting structural reforms. In France, François Hollande has belatedly promised some still-vague supply-side reforms, but he may be too enfeebled to deliver.

With the far-right National Front gaining ground, France remains a cause of acute anxiety in bothGermany and Brussels.

All these risks offer good reasons for early action on the reforms set out here. A sense of direction towards integration, even if slow and conditional, would help stabilise the euro zone, restore confidence in markets that it is being repaired, provide incentives for reform and give citizens in the most stricken countries a sense of hope for a better future. It could help avoid the next crisis, or at least mitigate its impact. But Europe’s leaders have not proven to be endowed with long-term vision.

So the best that can probably be hoped for is that the euro zone lurches from one crisis-induced reform to another. This will be unnecessarily costly and painful, but might somehow lead to a more coherent and workable system. But there is another possibility: that the euro zone, and the EU with it, will stumble from one crisis to the next until, exhausted, one or all of its members lose the will to preserve the single currency, and perhaps the wider project.

Europeans like to point out that it took the United States more than two centuries, many crises and a civil war before it fully developed its model of federalism. To judge from the repeated flirtation with self-inflicted default, the US system could still be perfected. Europe can therefore be forgiven if it moves slowly and uncertainly. For all its flaws, the EU can claim to have helped support peasse among its members for more than six decades.

Europe’s model, if it survives, will be different from that of the United States. Europe is an older continent, with a more heterogeneous population and a deeper sense of distinct national histories. As well as the push for European integration, there is a counter-current of disaggregation. Well before the UK holds its referendum on EU membership, Scotland will hold a ballot in September 2014 on whether to remain within the UK. Catalonia is demanding a similar right to hold a referendum on whether to remain part of Spain.

So there will not be a United States of Europe, and nor need there be. That said, Europeans should not waste the opportunity to learn from others what works and what does not, particularly when it comes to currency unions.

A question of (German) history

Europe’s course will depend, in large part, on Germany – Europe’s most powerful economy and biggest creditor. In many ways, the question of the euro comes back to the old question of Germany, a country too strong to live with easily yet not strong enough to dominate permanently (or, indeed, to rescue everybody). The single currency, like the European Union, was meant to reconcile Germany with its old enemies and harness its strength for the benefit of the continent.

Germany needs a political strategy for Europe. It has been conditioned to avoid any notion of leadership. But lead it must. Failure to do so also has consequences. Angela Merkel has won a third term and the respect of many Europeans. She is a pragmatic politician, not a visionary one. Her favourite dictum is “step-by-step”. It is time for her to say where she wants to go. In 2014 the world looks back 100 years to commemorate the cataclysm of the first of two world wars, in which the heart of the matter was the power of Germany. Two works of history conclude by reflecting on the lessons for today’s leaders. In one, published in 2012, Christopher Clark notes:11

The actors in the euro-zone crisis, like those in 1914, were aware that there was a possible outcome that would be generally catastrophic (the failure of the euro). All the key protagonists hoped this would not happen, but in addition to this shared interest, they all had special – and conflicting – interests of their own.

In the second, published in 2013, Brendan Simms asks, more pointedly:12

Will Berlin come to accept that the alternative to a democratically controlled European currency is a German economic hegemony that will in the long run destroy the European Union?… If that happens, history will judge the European Union an expensive youthful prank which the continent played in its dotage.

The fathers of the European Union felt the weight of history. This was still true of the KohlMitterrand generation that created the euro. But today’s crop of leaders, for the most part, sees the problems, inconvenience, constraints and threat of Europe, rather than its promise. Perhaps they lack the memory of war, and have lost the fear of history’s judgment. Or perhaps now that war seems inconceivable an older history can reassert itself, one in which old nations do not easily abandon their powers, prerogatives and sense of identity. Or perhaps the European project has been so long in the making that it has lost its romance.

There is an asymmetry about Europe’s crisis. The euro has the potential to destroy the European project. Yet saving the single currency is a poor rallying-cry for European integration. So pressure from markets brings only short-term expedients, not a design for the future. Europe’s leaders fiar undoing European integration, but dare not promote it either.

Something of great value may thus be lost through carelessness or timidity. The best way to gauge the achievements of the European Union is to visit its eastern borderlands. The EU has helped to solidify post-communist democracies, many of which are among the fastest-growing economies in Europe. Here countries are still lining up to join the euro, flawed as it may be, because of the economic and political security it still offers in an uncertain region. Just beyond, countries are knocking at the door to be admitted to the EU. The countries of the western Balkans, many of them traumatised by the violent break-up of the former Yugoslavia, are still lured by the idea of belonging to Europe’s community of democracies. In Ukraine, protesters have for months held up the EU’s blue

flag as a symbol of freedom. Despite scores of people being shot dead in Kiev, they toppled a corrupt and inept government – and provoked a Russian military intervention whose outcome remains uncertain – in the attempt to draw their country closer to Europe.

Europe’s malaise is not one that time alone can heal. Delay is likely to make things worse, not better. Though the financial panic is in abeyance, the economic and political crises are far from over, and may well deepen. Right now the political momentum is towards fragmentation, not integration.

Unless the euro zone is redesigned with greater determination, in particular through greater risksharing, it is unlikely to recover economic vitality. And unless the euro can be shown to deliver prosperity and well-being, public support for the European Union will inexorably ebb away.

2014

END

Europe on the Brink -- A Wall Street Journal Documentary

11. Europe’s place in the world

THE EUROPEAN UNION’S HOPES that the Lisbon treaty would enable it to play a bigger global political role to match its economic weight were dealt a cruel blow by the onset of the euro crisis. That the Greek problem surfaced just as EU leaders were about to pick a new foreign-policy boss was especially galling. Over the past few years EU foreign policy has suffered not just because the euro crisis has been a distraction, but also because it has eaten away at the respect that the rest of the world previously had for a Europe that had long been considered an economic giant but a political pygmy.

The Maastricht treaty in 1992, building on arrangements previously known as European Political Co-operation, established a European Common Foreign and Security Policy (CFSP) as what was then called the EU’s “second pillar”, to be operated initially on an intergovernmental basis. Successive treaties expanded the scope and role of the CFSP, which was later brought under the normal community rules, though always subject to unanimous not majority voting. The 2009 Lisbon treaty then created the post of high representative for foreign and security policy, to be in charge of a new European External Action Service (EEAS). This formalised a job that was previously occupied by Spain’s Javier Solana, a former secretary-general of the North Atlantic Treaty Organisation (NATO).

Yet for all the aspirations of the treaties and despite the creation of new institutions, it has always been hard to secure the consent of member countries to a genuine common foreign policy. The main problem has been with the larger members, notably the UK and France, which continue to see themselves as having a global role of their own. Both are nuclear powers, as well as permanent members of the UN Security Council. The UK, in particular, has often frustrated hopes of the EU playing a bigger security or defence role, for instance blocking any suggestion of setting up an EU military headquarters. Although France under Sarkozy rejoined NATO’s military structure and hás embarked on direct military co-operation with the UK, it too has continued to aspire to a global role of its own, especially in Africa.

But it has often been almost as difficult to find unanimous agreement among other countries. Even as Maastricht was being negotiated and ratified, for example, the outbreak of war in the Balkans provided a first big test that Europe largely failed. It was the Germans who insisted in 1991 on the early recognition of Croatia, followed by other ex-Yugoslavian states; and it was Jacques Poos, the foreign minister of Luxembourg, who proclaimed this to be “the hour of Europe”.1 Yet subsequently the Europeans could not agree on whether or when to intervene in their own backyard, and it took the Americans to knock heads together and secure the Dayton agreement in 1995 that stopped most of the fighting in Bosnia.

Although in subsequent years there were more successful efforts to find consensus within the EU on smaller foreign-policy issues, it has often proved impossible on larger ones. There have been big differences among the larger EU countries on policy towards Russia, for instance, which the Russians under Vladimir Putin have gleefully exploited. And, as the Balkans showed, when it comes to war, the Europeans have more often been divided than united. Most obviously, the EU split over Iraq in 2003, with Germany and France joining Russia in opposing the war, while the UK, Italy, Spain and several countries from eastern Europe supported it (this was the time when the American defence secretary, Donald Rumsfeld, spoke of there being a new and an old Europe). A more recent example of division came over the 2011 war in Libya, which was prosecuted vigorously by the UK and France but opposed by Germany.

Foreign policy blues

The EU’s aspirations to build a stronger and more cohesive foreign policy to increase its influence in the world were never likely to be all that successful. But they have taken a further knock because of the euro crisis. By an unfortunate coincidence, the choice of the first new high representative came at the same time. The bargaining over names for jobs was, as usual, a shambles, with the UK’s prime minister, Gordon Brown, first trying to push David Miliband, the foreign secretary, into the job. In the end Miliband rejected it and the post went instead to the little-known Catherine Ashton, a former trade commissioner whose previous public-policy life was limited to running a health authority and serving in the UK’s House of Lords, and who had limited knowledge of or experience in foreign affairs. Predictably, the establishment of the new EEAS and the experiment with Ashton as a more powerful EU high representative have both been disappointing. Apart from her own limitations, the job has become almost too big for one person to do. As well as being high representative, she is a vice-president of the Commission, she chairs the Foreign Affairs Council and she is a guardian of

British interests in Brussels. She was not given any deputies, even though the exigencies of the Job often require her to be in two places at once. Everything has taken longer than expected and Ashton has continued to be overshadowed not just by national foreign ministers but also by José Manuel Barroso, president of the European Commission, and Herman Van Rompuy, the first permanent president of the European Council. The CFSP was supposed to sharpen the way the EU represented itself in the world, but the results have frequently seemed to do the opposite: both presidents as well as Ashton attend bilateral summits with the Americans, Russians and Chinese, for example. And the EU has continued to field too many assorted leaders at G8 and G20 summit meetings.

Even so, over the past year, Ashton has recorded some notable successes. These include a groundbreaking deal between Serbia and Kosovo that has enabled the first to open membership negotiations and the second to be given a membership perspective, ahead of Bosnia. Ashton has also been a key member of the team negotiating a tentative nuclear deal with Iran, which was in part her own personal achievement. She has become an indispensable partner of successive American secretaries of state, first Hillary Clinton and later John Kerry, with whom she has far more contact than most European foreign ministers ever do. She was the only diplomatic leader to meet the deposed Egyptian president, Muhammad Morsi, after his imprisonment. And she has played a leading role in negotiations to end the war in Syria. Yet despite all these achievements, the overall record of the EU in foreign policy has not been a strong one – and part of the reason for this has been the EU’s poor economic performance and the distraction of the euro crisis, which has reduced Europe’s overall influence.2

A further consequence of that crisis has been that defence budgets across Europe, already strained, have been further cut. In 2009 a European Council summit agreed to step up Europe’s military ambitions, with some talk of being able to deploy 60,000 troops within 60 days. But five years on little has come of this. The EU is meant to have two 1,500-strong battlegroups available at short notice, but none has ever been used. Overall, EU countries spend less than 1.5% of GDP on defence, far below both the agreed NATO target of 2% and the 4%-plus spent by the United States. Defence spending hás shrunk as a share of public spending. And the money is not spent as effectively as it could be were there to be more collaboration across borders.3 Successive American defence secretaries have continued to voice frustration as Europe has become in their eyes more of a consumer than a provider of security, a growing problem as the Americans pivot their attention towards Asia.

The experience with the onset of the Arab spring in January 2011, which coincided with one of the worst moments of the euro crisis, was illuminating. The Europeans, like the Americans, were taken by surprise by the sudden upsurge of people power, first in Tunisia and then in Egypt. The subsequent decision to intervene in Libya to stop a possible massacre in Benghazi by troops loyal to Muammar Qaddafi was taken by the British and French governments, with the Germans against (indeed, Germany chose to abstain in the vote in the UN Security Council, of which it was a temporary member). But after only a few days the two biggest European military powers were forced to call for more American help, including the provision of drones, air-to-air refuelling and stocks of smart bombs.4 Later, EU members were divided over whether and how to intervene in Syria, with the UK and France showing most interest in arming the rebels against the Assad regime, but Germany and others being broadly against (though the August 2013 vote of the UK House of Commons against intervention in Syria has curbed British enthusiasm for any military adventures).

In economic terms, the EU has also shown itself unable always to work out the most sensible response to the Arab spring. Grand talk by the Commission and the EEAS of the three Ms – money, markets and migration – has all too often run into the sand. Partly because of the euro crisis, there was never much on offer to support a policy that became known as “more for more”: the more Arab countries democratised, the more the EU would help them. Money was short. Fuller market access, particularly for agricultural products, has also been notable largely by its absence: three years after the Arab spring began, only Morocco has even begun negotiations on a deep free-trade deal with the EU. As for migration, hostility towards it has grown as the euro crisis has led to rising unemployment, especially in the southern Mediterranean countries. Far from providing more routes to legal migration, ever more resources have been poured into tightening controls on illegal immigration. Leaky boats carrying would-be immigrants continue to sink in the Mediterranean around the Italian island of Lampedusa, one of the nearest parts of the EU to north Africa. Over migration, indeed, the EU now stands towards north Africa rather as the United States stands towards Mexico – and a part of the reason for this is the dire economic consequences of the euro crisis in terms of jobs and growth at home.

Eastern questions

The EU’s relationship with countries to its east has also become more problematic in the past few  years. One reason for this is that the traditional policy of enlargement to admit new countries has run into trouble. Enlargement has often been described as the EU’s most successful foreign policy. In the 1980s, taking in countries like Greece, Spain and Portugal was hugely important in securing their transition from military dictatorship to democratic government. Even more spectacular was the process after the collapse of the Soviet Union of letting most of the central and eastern European countries that had ormerly been under its sway into the European club. The transition of these countries to free-market economies and liberal democracy would have been far messier and might not have happened in all cases had it not been for the powerful lure of eventual EU  membership. The contrast between Europe’s success with transforming its eastern neighbours and the United States’ failure with its southern neighbours is telling.

Since the admission of Bulgaria and Romania in 2007, however, the entire policy of enlargement has been under some threat. Part of the problem has been a growing disillusionment with past expansions of the EU. It is widely thought that Romania and Bulgaria were taken in as members before they were really ready; some of their present difficulties with a corrupt judiciary and political class could have been predicted in advance. Equally, Cyprus was allowed to join in 2004 even though the island’s division between a Greek-Cypriot south and a Turkish-Cypriot north remained unsolved.

Both the continuing Cyprus problem and Hungary’s precarious democracy have reminded the EU that the leverage it has over its members is far less potent than its leverage over applicants. And for much of public opinion in Europe, enlargement has become fatally linked to newly unpopular immigration, especially from Bulgaria and Romania following the lifting of remaining controls on free movement of labour on January 1st 2014.

Despite all this, the Commission argues forcefully that the enlargement process is continuing. Croatia was admitted as the EU’s 28th member in July 2013, and membership talks continue with Turkey and Montenegro (though talks with Iceland have been suspended). It is clear that the other western Balkan countries will eventually join the EU, if only because they have nowhere else to go. Indeed, it is only this prospect that has secured peace and stability in the region. Without the lure of EU membership, it would undoubtedly have been impossible to broker the 2013 deal between Serbia and its breakaway former province of Kosovo. Yet the reality is that the euro crisis, the broader malaise across the EU and increasing public hostility to unlimited immigration have combined to cast a pall over future enlargement.5

Who lost Turkey … and Ukraine?

This is seen most clearly in relation to the EU’s two biggest eastern neighbours, Turkey and Ukraine. After years of prevarication, including a negative Commission opinion on its membership application in 1987, it was seen as a triumph for both sides when at long last Turkey’s application was accepted in 2004 and membership negotiations were formally opened in October 2005. The Turkish government, led by Recep Tayyip Erdogan, was eagerly pushing through big economic, social and political reforms to prepare the country for EU membership. Although substantial opposition persisted, especially in France, Germany and Austria, and although a disunited Cyprus remained a large obstacle, there was a genuine optimism that, maybe after another decade or so, Turkey might actually join the European club. Yet eight years on few people even pretend that the talks with Turkey are going anywhere. Half of the 33 chapters of the negotiations remain frozen, either by Cyprus, or by France or by the EU as a whole, because Turkey has not implemented the Ankara protocol requiring it to open its ports and airports to Greek-Cypriot vessels. Only one chapter has been closed; and, in the past two years, only one has been opened. Several EU countries have made clear that, partly in response to their current economic difficulties, they are much less prepared to take the gamble of letting Turkey in. European leaders, distracted by the euro crisis, have barely engaged with the issue of their relations with Turkey, which have soured spectacularly. Understandably, many Turks seem to have lost interest in an EU that they believe has rejected them, perhaps out of anti-Muslim prejudice. And the EU has in turn lost much of the old leverage it had to encourage further reform in Turkey, which has drifted under Erdogan in an authoritarian direction, especially since the Gezi Park protests of June 2013 and the corruption scandal that broke in December 2013. Erdogan’s attempt to rekindle the membership talks by visiting Brussels and Berlin in early 2014 and helping to revive talks on a Cyprus settlement have not done enough to repair Turkey’s damaged image in Europe. Recent stories of corruption in the ruling party, and the country’s growing economic difficulties, are creating renewed worries about Turkey’s suitability as an EU aspirant.6

A similarly sad story can be told for the six countries of the EU’s eastern partnership: Armenia, Azerbaijan, Belarus, Georgia, Moldova and Ukraine. After the Rose and Orange revolutions in Georgia and Ukraine, followed by Russia’s war with Georgia in 2008, it looked as if, despite the Russian blockage on further expanding NATO, the Commission would at least be able to hold out a long-term prospect of EU membership to these countries. Yet once again European leaders took their eyes off the ball, partly because of the distraction of the euro crisis. At the Vilnius summit in November 2013, several countries, the biggest and most important of which was Ukraine, were meant to sign association agreements with the EU that could, eventually, have become a basis for possible membership. Instead, Russian pressure on Ukraine and some other countries to lean eastward paid off.

Only the relatively small Georgia and Moldova were persuaded to stick to their European ambitions. The sight of thousands of protesters on the streets and squares of a snowy Kiev, all waving EU flags to show their displeasure with the decision of their thuggish president, Viktor Yanukovych, to reject the EU association agreement in favour of closer links with Russia, was inspiring but also depressing. It was inspiring, because it showed how strong the appeal of ties with the EU still is to countries from the former Soviet block. But it was also depressing because, at least in part due to their own economic and political problems, EU leaders had paid too little attention to the admittedly dispiriting internal politics of Ukraine, allowing Russia quietly and insidiously to regain influence.

Russia’s president, Vladimir Putin, was able to derail Ukrainian plans to move towards Europe by the simple expedient of offering a no-strings-attached loan and a sharp cut in the gas price, which the EU simply could not match.7

That Ukraine subsequently grabbed the whole world’s attention, especially during the 2014 Sochi winter Olympics, was more to do with its own dysfunctional politics and the bravery of its protesters than with the EU. The Americans woke up to the situation, and especially to the interference of Putin, earlier than the Europeans; a truth that became starker when a leaked recording, presumably made by Russian security services, showed Victoria Nuland, the assistant secretary for Europe in the State Department, saying to her ambassador in Kiev: “Fuck the EU.” When a few days later Yanukovych’s goons began to kill people in Kiev and elsewhere, matters rapidly spun out of his control. Soon enough he had been chased out of the capital and a new government was installed that may yet turn back towards the EU. But determined not to lose Ukraine, Putin promptly launched an invasion of Crimea.

In mid-March 2014 Crimea, under the gaze of occupying Russian troops, declared its independence from Ukraine and asked to join the Russian Federation instead. The EU and the United States responded with a visa freeze and other sanctions on named individuals, as Russian forces gathered threateningly on the border with eastern Ukraine. The eventual outcome in Ukraine remains highly uncertain. But what seems clear is that the EU (and the West) drifted into its biggest confrontation with Russia since the cold war in part as an accidental by-product of its eastern neighbourhood policy, which distracted political leaders had left largely in the hands of Commission officials.

The EU’s hopes of playing a bigger role in the world and in its neighbourhood were always going to be hard to realise. A declining share of the world’s population and GDP, the rise of countries like Brazil, China and India and a diminishing appetite for military intervention have inevitably taken their toll. Yet the EU is still the world’s biggest economy and single trading block. Had the crisis not sapped its economic power and its political will, it surely would have been able to exert a bigger foreign-policy influence than it has managed over the past five years, especially in its own neighbourhood. In short, the baleful effects of the euro crisis have been seen not just at home, but also in the EU’s fading global clout.