Tackling the slow, painful decline: A bad day of economic data for the eurozone

Some have said the worst of the eurozone crisis is over – this morning’s economic data did not provide much support to their argument.

 

Top of the list are the growth figures for the eurozone in Q4 2012 – as a whole the bloc contracted by a massive 0.6%. Maybe not a huge surprise but still worse than most expected. Furthermore, there were few glimmers of hope. 

As the graph above shows, Germany posted a contraction of 0.6%, Italy 0.9% and Portugal a massive 1.8% (more on this in a minute). France’s 0.3% contraction looked relatively mild, although it confirmed that the French economy saw zero growth in 2012 – it also put pay to any hopes of the French government achieving its growth projections for 2013 or its deficit target (see here for more on this). For all of these countries, this was the worst quarterly growth performance in almost four years (2009Q1).

The Italian statistics agency confirmed that growth for 2012 was -2.2%, a timely reminder of Italy’s real problem – an endemic and chronic lack of economic growth. The absence of any credible policy for correcting this in the current electoral campaign should be of grave concern to all of Europe.

Portugal was undoubtedly the stand out performer, but not in a good way. The 1.8% contraction in the final quarter brought the annual real terms contraction in 2012 to 3.2%. This result, along with the German contraction (which was put down to a collapse in European demand for German exports), highlights the substantial risk of expecting export lead recoveries to materialise when the entire eurozone is in a recession. The stumbling growth in the US and China at the end of 2012 likely created a further drag.

In fact, the only countries to provide any strongly positive data were the smaller central and eastern European economies – particularly Estonia, Latvia and Lithuania. Some would highlight that these are the countries that have already completed a significant round of structural reforms and internal devaluation. In any case, they are far from large enough to help pull the rest of the eurozone out of its current slump.

Meanwhile, the Greek statistics agency Elstat also released its figures for Greek unemployment in November 2012. Overall unemployment reached 27%. As we have noted many times before, this far outstrips the EU/IMF/ECB troika estimate for the end of 2012 which was 24.4% (this is even after it was revised upwards significantly in the IMF’s January report on Greece).

More worryingly though, youth unemployment has reached a whopping 61.7%. Think about that figure - it's absolutely extraordinary, especially when compared to the fact that it was only 28% three years ago. We can’t help but wonder how long such high levels of unemployment can be sustained before the political and economic impact becomes too heavy for the state to carry alone (i.e. before Greece demands further eurozone funding and concessions on its reform programme). Again, the risk is that the very fabric of Greek society could start disintegrating under such sustained pressure.

There has been plenty of optimism around the eurozone recently, some of it warranted and we should relish this. But this data should be a timely reminder of, arguably, the biggest challenge of them all for the eurozone: how to reverse the trend of slow, grinding decline.

If EU leaders thought for one minute that there were room for complacency, they can think again.

A new angle to UK-EU trade?

The WTO and the OECD yesterday announced the release of a new set of trade data. This data tries to pin down the “value added” from trade rather than just the gross figures. Essentially, this means the data tries to track where the final demand for an exported product/service comes from, thereby netting out trade which simply contributes to the production line of the finished good/service.

The data provides an interesting new contribution to the UK-EU debate on trade. Notably the figures highlight that, under the value added approach, US trade looks more important to the UK than European countries. The Guardian questions whether this could aid the calls for the UK to exit the EU.

Superficially it may, but looking at the data more deeply, we think not. As the WTO/OECD note:

“This suggests that UK exports to other EU countries are at least partly intermediate services and inputs that are then further processed and shipped to other countries (in particular to the US).”

So, although the US is the source for the ‘final demand’ we still have to export our products or services to other countries in the EU for them to take advantage of this demand. Being a member of the EU and the single market plays a big role in allowing us to do this. The real question is, would the UK still be able to access this final demand from the US if it left the EU?

Well, it’s almost impossible to say. One thing that seems certain though, is that, since many of these exports are intermediate ones, there is no guarantee that we would still be able to export them outside the EU even if the final demand remains from the US (this point is hinted at by Ian King in the Times).

A final interesting point is that the increase in value added exports to the US seems to occur for most large EU countries. Why this is, is not entirely clear. To us, it seems that it could be motivated by specialisation within the EU, with EU members producing various component goods and services which are then combined into final exports to the US. If this is the case then this seems a positive result to us, as it surely increases the cost competitiveness of exports from the EU (including the UK).

From the perspective of the UK/EU debate this 'value added' data is another interest metric to add, although at the moment it offers little more conclusive evidence than what we currently have. The bigger benefit comes in broader terms, as the FT notes, providing further support for free trade. With protectionist forces flaring up during the eurozone crisis, countries would do well to keep that in mind as well.

The draft euro fiscal pact: not great news for the eurozone either...

We’ve already reviewed what the latest draft version of the fiscal compact means for the UK (not much good) being the first in the UK to publish the draft of the compact (beating the Telegraph by a hair). But let’s not forget what the treaty is supposed to be about – saving the eurozone. There are still those out there, not least the ECB and the IMF, who believe that this treaty can form an integral part of the solution to the eurozone crisis (along with an increased firewall and structural reforms).

Looking at the latest version of the treaty it seems that not much has changed in the fiscal rules department. As always the 60% debt limit and 3% deficit limit provide the framework, while the 0.5% limit on ‘structural deficit’ is included as with the previous draft. There is no further detail provided on what exactly the ‘structural deficit’ is envisaged to be, although there are some qualifying statements which suggest such stringent rules could be waived in the case of “exceptional economic circumstances”. Still very vague with some key ideas not clearly defined. This doesn’t fill us with confidence. Remember this compact is meant to provide the original stability & growth pact with some teeth, by actually establishing some tools to enforce the fiscal rules.

Article 5 of the new draft suggests that the budgets of countries under excessive deficit procedure will be submitted to the European Commission and Council for “endorsement”. This isn’t much, if at all, different to the new six pack rules, while it again remains unclear what they mean by “endorsement” – will the Commission and/or Council retain a binding vote on national budget plans?

In terms of the overall debt level, the commitment for countries which exceed the 60% debt to GDP ratio to reduce their debt by one twentieth every year remains. However, this still raises lots of questions over implementation. Will this rule apply as soon as the treaty comes into force? Take Italy for example: if it was applied from this year, the government would have to potentially find a €108bn in savings or a 7% of GDP swing in the budget, in order to cut the debt by the required amount. This is more illustrative than anything, but the key point is the tension it represents. Realistically the rules cannot be enforced next year or possibly even the year after, otherwise too many countries would be sanctioned and be forced into ever greater austerity. However, to convince markets, there needs to be a clear plan for implementation and some signs that the immediate problems will be tackled. This latest version of the draft simply does not tackle these issues, nor do any of the wider discussions relating to the fiscal compact.

As we pointed out with our post on the draft’s impact on the UK, there is a widely increased role for the EU institutions. In particular, countries which are seen to have broken the fiscal rules can be taken to the ECJ by other members or the Commission. This gives the proposals significantly more teeth, but given the UK’s position it is far from a foregone conclusion that EU institutions will be able to play this role under the finalised new treaty. It also seems that much of the stuff in the compact can be done within the existing treaties anyway, begging the question why this, new over-lapping deal is necessary in the first place (and yes, we do appreciate German domestic concern).

Until the significant amount of uncertainty is removed from the fiscal compact – in terms of implementation, use of institutions, timeline, severity of sanctions and exceptions it is likely that markets will continue to be underwhelmed by it. Unfortunately, while these short comings persist eurozone leaders continue to meet and talk up their negotiations, which only seems to add to the eventual let-down.

And they're off! What will the Spanish elections mean for the eurozone and the UK?

News in earlier today, Spanish Prime Minister José Luis Rodríguez Zapatero has finally set a date for national elections - 20 November. Parliament will be dissolved on 26 September. As expected, Zapatero will step down and make way for a new socialist party leader, Alfredo Perez Rubalcaba (pictured on the right), who was selected by his party earlier this year.

Elections were originally planned for early 2012, with an ultimate deadline of March 2012, but in view of the economic crisis and increasing pressure from the public, the press, the opposition, and some members of his own party, Zapatero finally caved in today. Spain’s main opposition party, the Partido Popular (PP) are now tipped for a big win, according to opinion polls and the PP’s recent successes in regional elections. However, Spain’s economic problems indicate that stormy times are ahead.

“I have chosen the date to project economic and political certainty”, Zapatero said. Conveniently for Zapatero, October’s budget will now be delayed until next year, after the elections. The election campaign will now certainly be dominated by the impending budget, and the need for deeper austerity cuts. This debate could be tricky for the PP, who will have to strike a balance in the election campaign between identifying in detail the cuts it envisions, and not scaring the electorates back into the arms of the Socialists. And with an eye on the Conservatives' record in last year's election campaign in the UK, the PP will want to avoid leaving any sort of impression that it's flip-flopping over cuts. What's clear is that whichever party ends up at the helm will have to make tough decisions to navigate Spain through the eurozone crisis’ Bermuda triangle.

El Pais also notes cynically that the date of the election happens to fall on the anniversary of the death of Spain’s notorious right-wing dictator Franco. The left-wing government was quick to dismiss the ‘coincidence’ saying it’s a date “like any other”.

A few questions:

What will this mean for the eurozone crisis? Well, the timing of the elections may not buy Spain any favours with financial markets. The uncertainty that comes with any election is far from ideal given the already rising borrowing costs. In addition, the election will put a complete pause on the economic reform and austerity programmes. It's also unclear whether the expanded EFSF will get ratified by the Spanish Parliament before the election - something which the French and German governments, not to mention investors, are keen to see done asap. If Spain misses any important targets over the next few months due to the elections, be sure that the markets will push borrowing costs even higher.

How will a PP-led government differ from a Socialist one? At a recent event of ours, the PP's Secretary of Economy and Employment Álvaro Nadal set out his priorities for the coming years noting that the PP will go much further on labour market reforms than its predecessor, particularly with changes to the collective bargaining system, in addition to more privatisations and stricter budget conditions for regions. In terms of restructuring the Cajas (the regional saving banks), it looks as if PP will continue where Zapatero left off, since the reforms were very much based on a cross-party deal in the first place. Nadal suggested that the mandate given to the PP in the recent regional elections and polls shows that the people are ready and willing to accept these reforms. Once past the uncertainty of the elections, a Spanish reform-minded government, with a strong mandate from the electorate, can only be good news for the eurozone.

Interestingly, Nadal said that a PP run government would probably not support Eurobonds - which is becoming increasingly fashionable as a "solution" to the eurozone crisis. Nadal said,"For [Spain] it would be suicidal. The current eurobonds are very ill-designed. We need a method to encourage fiscal discipline but they are not it". Nadal concluded by reiterating a stance taken by Mervyn King, Governor of the Bank of England, saying, “We have been treating this as a liquidity problem when actually it is a solvency one”.

How will social discontent in Spain impact on the elections? Intertwined with its economic problems, Spain is also suffering from serious social discontent at the moment. The so-called ‘indignados’ (indignant protesters) will pose a serious challenge to both parties during the election campaign, but probably hurt the incumbent government the most. Support for the indignados is high and growing, not really a surprise in a country with unemployment rates of 21% (climbing to 45% youth unemployment). Last weekend saw crowds of 35,000 march through Madrid, more are on the way.

What will this mean for the UK? In fact, a PP victory is Spain could provide the Coalition with a potential centre-right ally in Europe at a time when both Germany and France could see centre-left governments take over within the next two years. And there's scope for deals to be struck between the Coalition and a PP-led Spanish government, including on some crucial economic issues such as services liberalisation, the EU better regulation agenda, bank recapitalisation, and potentially also on external trade. (However, other areas will be trickier, including the EU budget where any Spanish government and any UK government are poles apart).

What's clear is that a successful Spanish economy is absolutely vital for the health of the eurzone and the European economy. A vibrant Spain would do a lot to get the eurozone back on track.

Downing Street goes for much needed shock therapy

With the eurozone destined for years of navel-gazing, as it struggles through the current sovereign debt and banking crisis, the UK is actually very well placed to push for EU reform. Its own economic challenges aside, Britain now has a chance to use the debt and competitiveness predicament facing several European countries and the EU as a whole as a springboard to get Europe back on the road to growth.

In other words, this could be turned into a benign crisis for those of us who are in favour of a growing and competitive Europe (it's hard to argue that Europe doesn't need reform when several countries are on the verge of bankruptcy).

Encouragingly, Downing Street has moved today to try and push this agenda, with a new initiative entitled "Let's choose growth" - and there's lots of good stuff in there (and the format is refreshingly innovative and easy to grasp, including this You Tube clip). Besides the proposals to liberalise the single market further, by creating a common market for digital and service industries and calling for deregulation, there also seems to be an emphasis on 'shock therapy'. Cameron and Co have made it plain to EU leaders that standing still is not an option as the rest of the world moves on.


This chart should be all the motivation Europe needs. As you can see, by 2050, only Germany and the UK are predicted to remain among the world's economic elite, and they will only be hanging on to the bottom two rungs of the ladder.

The rise of the likes of China, India and Brazil is inevitable but this is no excuse for Europe to give up. The big question however is whether the UK and other like-minded governments, such as the Scandinavians, the Dutch and the Czechs, will be able to keep the eurozone's attention long enough to make the point.

For this to happen, the British government needs to roll up its sleeves and get down to business: form alliances (cultivate, cultivate, cultivate the Scandies, new members - and the biggest prize of them all - Germany), horse-trade, manage the European Parliament, convince through pursuing best practice at home (such as the 'Better Regulation agenda', and a strong, healthy economy), on EU proposals get in early and get in low - but be tougher and shrewder when negotiations get rowdy.

Downing Street should be given credit for raising its game on EU reform. But now it must show it can turn a catchy pamphlet into concrete action.

Hungary declares "economic freedom fight" with EU and IMF

The new Hungarian government, and its Prime Minister Viktor Orbán, has decided it's had enough of being dictated to by the EU and the IMF, which both recently halted bailout-loan talks, saying Hungary wasn't doing enough to make durable cuts in state spending.

Orbán's government has said it will adhere to the 2010 budget-deficit target - 3.8% of GDP - set under the terms of its current loan agreement with the IMF and EU. But it insists how it goes about it shouldn't be the IMF or the EU's concern.

"It's an economic freedom fight," said a senior official in Mr. Orbán's administration. "We are getting back the financial independence of the country."

This will certainly prove to be an interesting backdrop to the ongoing EU discussions regarding 'economic government'.

What made Europe great?

We take a look at this question over at EUobserver.

The eurozone's next problem?

If all the recent events weren't enough, a story in today's Guardian poses another question mark against the long-term economic prospects of the eurozone. Germany, the EU's economic powerhouse and 'paymaster of the eurozone', is shrinking and faster than people thought before:

Last year 651,000 babies were born in Germany, 30,000 less than the previous year. With only 8.2 children being born for every 1,000 citizens (compared with 9.3 in 2000), and with 10 in 1,000 citizens dying every year, Germany is nowhere near approaching a replacement rate that would keep the population table.

Eurostat's current population projections already see Germany falling from 82m to 76m by 2045. The UK and France are set to grow from 62m and 63m to 73m and 71m respectively.

But looking at the 'dependency ratio' (projected number of persons aged 65 and over expressed as a percentage of the projected number of persons aged between 15 and 64) is even more worrying. We accept it is worrying for the EU as a whole, particularly Eastern Europe.

However, Germany's ratio will increase from 31% today to 55% in 2045, France from 26% to 44%, Italy from 31% to 58%, Spain from 24% to 54%, Portugal from 27% to 50%, Greece from 28% to 53%, Netherlands from 23% to 46%.

No wonder then that Germany is so desperate for the eurozone members to get their budgets in order - there is a huge social security bill heading their way and far less people to pay for it.

And, for those who still harbour a desire for the UK to one day join the eurozone or suggest that the UK risks being marginalised in Europe, compare the stats for the UK: the ratio will rise from 25% now to 37% in 2045. Not great, but far better than elsewhere.

While the UK still faces major challenges, such as paying for its bloated public sector pensions and reducing the alarming deficit, in 2045, the UK should be where the economic action is. This will be hard for others to ignore and should spur the UK to be more confident about setting out an alternative vision for the EU.

Germany's worst nightmare?

The Commission has today presented plans to tighten up budgetary supervision and oversight in an attempt to avoid a repeat of the current eurozone crisis in the future (i.e. making up for the obvious and fundamental flaw of the eurozone, which is that monetary union cannot exist without economic and political union). “We want governments to send their budget outlines to Brussels for review before they are approved by their national parliaments," EU Economic and Monetary Affairs Commissioner Olli Rehn said today. "We can then see early whether a country is adhering to the Stability and Growth Pact. If not, we would intervene."

However, the Commission has also said that it wants to "expand economic surveillance beyond the budgetary dimension to address other macroeconomic imbalances, including competitiveness developments and underlying structural challenges." This jargon-laden sentence represents a victory for the belief, long-held by the French in particular, that the eurozone should coordinate not just monetary and fiscal policy but also create a genuine economic union/government. The Commission says:

Looking at the euro area as a whole and on a country-by-country basis, the Commission would assess the risk of all possible forms of macroeconomic imbalances that jeopardise the proper functioning of the euro area...The Council, with only euro-area Members voting, would invite the Member State(s) concerned to take the necessary action to remedy the situation. Should the Member State(s), within a stipulated time frame fail to take the appropriate measures to correct the excessive imbalance, the Council, with a view to ensure the proper functioning of EMU, could step up the surveillance for the Member State concerned and decide, on a proposal by the Commission, to issue precise economic policy recommendations. Where necessary, the Commission would use its possibility to issue early warnings directly to a euro-area Member State.

This, in effect, means using the EU's institutions to encourage/force eurozone states to adopt economic policies that fit not just economic but also political aims - an anathema to the doctrine of low inflation, price stability and frugality engrained in the German public's psyche.

As many people have pointed out, improving competitiveness and employment in the periphery eurozone states such as Greece, Portugal and Spain is not just a one-way street of lowering wages in these countries but also increasing domestic demand in Germany for these countries' goods and services. French Finance Minister Christine Lagarde infuriated Chancellor Merkel earlier this year when she said,

"Clearly Germany has done an awfully good job in the last 10 years or so improving competitiveness. When you look at unit labour costs, they have done a tremendous job in that respect. I’m not sure it is a sustainable model for the long term and for the whole of the group. Clearly we need better convergence. While we need to make an effort, it takes two to tango."

Merkel's response was to immediately rebuff any idea that Germany should do more to boost domestic demand:

"The problem has to be solved from the Greek side, and everything has to be oriented in that direction rather than thinking of hasty help that does not achieve anything in the long run and merely weakens the euro even more."

However, IMF chief Dominique Strauss-Kahn has been stirring German sensitivities again today by suggesting that the eurozone introduce short-term fiscal transfers between member states.

To add insult to injury, the proposals tabled by the Commission will be decided by majority voting, meaning that Germany could be outvoted and be asked to revise its budget. We can't see that there's anyway Germany will accept this. The German public has already been asked to stump up a €123bn bailout package and swallow a growing politicisation of the European Central Bank, with its decision to start buying government bonds. But it seems the Commission, backed by the French political elite, has kept pushing.

There surely comes a point when Germany has to push back.

Kick-start

Open Europe has a short article in this month's edition of Parliament Magazine, detailing how the Spanish EU Presidency could contribute to getting Europe's economy back on track. We argue:

Instead of trying to make economic underperformance illegal and centralise more powers in Brussels, the Spanish Presidency should kick-start the new Lisbon agenda by empowering Europe’s businesses to create real jobs and growth....The threat to Europe’s overall competiveness arises not from a lack of binding targets or Commission powers, but from over-intervention and rules that de-incentivise growth, innovation and job-creation. Growth cannot be legislated – it receives its thrust from individuals, businesses and communities. Designing the right environment for these actors is therefore absolutely vital to unleash Europe’s potential and talent. And here the Spanish Presidency can help by resisting the temptation to pursue activist and mis-targeted regulatory policies.

When a real crisis hits...

People who thought that the EU went through a crisis this summer when the Irish rejected the Lisbon Treaty must have experienced some serious reality checks lately. Or at least recieved a lesson in semantics.

At yesterday's EU 'emergency' summit tensions were running high, and the use of the word "crisis" actually seemed justified for a change.

EU leaders seemed unusually desperate to put on a show of unity. Czech Prime Minister Mirek Topolanek said, "In the media it looked as if we had very different views, but in the discussions we very much agreed." (while adding: "This is the greatest crisis in the history of European integration.")

However, few doubt that the financial crisis-turned-recession is rapidly turning into a full-blown policy crisis, with some serious cracks emerging within the EU.

Mark Mardell notes on his blog. "Make no mistake, the world's economic crisis is putting this unique institution, the European Union, under very serious strain. The jeopardy is financial, political and philosophical."

It appears that competing interests, fuelled by the recession, have created - or perhaps re-created or reinforced - at least three default lines within Europe:

East vs. west: At the summit, EU leaders rejected the idea, put forth by Hungary, for a regional aid package of up to €190 bn to help underwrite the bad loans currently plaguing many of the eastern and central European economies. Instead, they agreed that aid should in principle be extended to the new member states on a case-by-case basis.

Some of the newer member states fear that they will be left hanging, lacking the ability of the bigger economies to inject cash into the their ailing economies and insure the toxic loans they're stuck with. As Poland's Europe minister Mikolaj Dowgielewicz put it, "We fear there will be two plans to save the European economy, one for the west and the eurozone and another for the rest. That's an idea that would be very dangerous for the EU." Hungary's PM Prime Minister Ferenc Gyurcsany went a step further warning that "We should not allow a new iron curtain to set up and divide Europe into two parts."

Protectionists vs. free-traders: And speaking of east-west divides, Nicolas Sarkozy appear to have taken a step back from his plans to condition state aid to the French auto sector on all parts of being "made in France". In early February, Sarkozy infuriated the Czechs by making specific reference to a Peugeot-Citroen plant in the Czech Republic as an example of where such provisions should apply.

According to a statement from the Commission, Sarkozy agreed over the weekend that any aid to carmakers will come without the "requirement to prioritise France-based suppliers"- although the details are still unclear.

However, the old free trade-protectionism default lines remain - with perceptions of what "protectionism" actually means diverging sharply. All over Europe, policy-makers are faced with the dilemma of how to formulate pragmatic policies that will satisfy voters at home, while avoiding sinking deeper into protectionism.

In this scenario, it is perhaps unsurprising that the line between protectionism and pragmatism is becoming increasigly blurred. But some seem less keen than others to keep the distinction. On Thursday the French Industry Minister, Luc Chatel, said of his government's aid package to French car plants,

"There is nothing protectionist about this plan. It is aimed at companies which
make cars on French territory, whatever their nationality. It comes with
conditions which have always existed at the heart of the European Union."

And following the summit yesterday, a far from repentant Sarkozy said,

"Take my friend Gordon Brown - and you know how much I trust him - who owns
70% of a bank. Seventy per cent! It's nationalisation. So explain where is
the logic in saying there's no problem when a state takes 70% of a bank but
helping manufacturers to get credit, that is a problem. Who says
Gordon Brown is a protectionist ? Who would say such nonsense? Nobody
is a protectionist in Europe, nobody!"

Eurozone vs. the rest: As the crisis puts serious strains on the eurozone, even German leaders - traditionally opposed to grand rescue schemes - have signalled that they're willing to bail out fellow eurozone members if one of them (such as Ireland) were faced with bankruptcy. The Merkel/Steinbrueck U-turn has been subject to some serious criticism from ECB heavyweights (highlighting the "moral jeopardy" involved and the "no bail out" clause in the Maastricht Treaty) while sparking fears in the eastern and central parts that future aid from Europe's bigs will be skewed towards eurozone members.

The stakes are certainly high: the east-west divide - percieved or real - could land a blow to the post-communist European integration of recent decades, while protectionist measures could seriously undermine the Single Market, effectively hampering a European economic come-back. And in the background is the looming threat of a cracking eurozone.

Amid these tensions, EU politics is clouded in unusual uncertainty. On his blog, Bruno Waterfield asks the critical questions:

If Hungary or other countries cannot raise cash to buy debt, what does the EU
do?

If a government, either in the Union or the euro, defaults on debts
what happens?

If the EU lets one of its own go to the wall what is its political
future?

Sensibly, the European leaders yesterday committed themselves to “getting the real economy back on track by making the maximum possible use of the single market, which is the engine for recovery.”

But can they deliver? As unemployment reaches record levels, credits are downgraded, more industries shut down and voters grow impatient (think Lincolnshire), will Europe's leaders be able to 'sell' the idea of free trade as the path to recovery? The answer is probably that they will have to - but it will be a tough sell indeed. In times of recession, 'open borders' is not the most popular policy in town.

And do EU leaders have a mandate from their citizens to engage in large cross-border rescue operations, involving taxpayers' money?

Alas, the EU has spent much of its political capital in recent years on institutional navel gazing, vain projects, and attempts to push through a treaty that would have done nothing to help Europe through the recession - ignoring three referenda results in the process. Now, when faced with a real crisis, that capital would've come in handy.

Not all Germans desire a Union of Debt

German Finance Minister Peer Steinbrueck has indicated that Germany is prepared to bail out suffering eurozone countries. This appears to signal a shift in German thinking - the prevalent view in the past was always that that struggling countries would have to find a solution themselves, like it or not.

The reason behind Steinbrueck's U-turn is not all that clear - at least partially it could well come down to the overexposure of Austrian banks to the economic woes of Central- and Eastern Europe. The WSJ reports that Eastern European borrowers need to repay about $400 billion in debt owed to Western banks this year. According to a report by Swiss bank UBS, much of that amount is denominated in foreign currencies, making the situation worse as Eastern European currencies have lost value. In other words: Europe could soon be faced with a subrpime crisis of its own, this time coming from the East. Also Swedish, Greek, Italian, and Belgian banks are heavily exposed. So Steinbruck wants to help.

However, not everyone in Germany agrees with the Finance Minister - to say the least. Heavyweights such as the former Chief Economist at the ECB, Otmar Issing, for instance. Issing recently told the Frankfurter Allgemeine Zeitung that it would be a catastrophe to water down the “no bailout” clause in the EU treaties, arguing that it would spell an end to "the political stability of the monetary union”. Article 103 of the EU Treaty, for those of you not familar with this particular section of EU law, states that neither the European Central Bank, the EU, nor national governments shall be liable for or assume the commitments for other national governments.

Issing thinks that in order for financial discipline to prevail every member state must be responsible for its own debt and deficits: “without this there would be no end”, he says.

In an article in Der Spiegel, the current ECB Chief Economist Jürgen Stark concurs, saying: "the ban preventing the EU and its member states from taking responsibility for the debts of partner countries is an important foundation needed for the currency union to function."

Meanwhile, the Financial Times Deutschland quotes "an expert" saying that a German bailout operation of other eurozone countries “could cost the taxpayer about 1.5 billion euro per year” (Simon Tilford of the CER calls such concerns "parochial"). According to the article, the such bailout could take the form of:

• Direct aid,
• The creation of a large fund through the European Investment Bank, which would buy up the bonds from countries in difficulties, or
• The common issuance by members states of bonds.
  

Interestingly, Standard & Poor’s says in the FTD article that an "EU bond" would only receive an “A” rating, due to Greece’s low creditworthiness.

In any case, there is a "no bailout" clause in the EU Treaty, so the discussion should really be academic at this point. Because we all know how good the EU is at sticking to the letter of the law when things get a bit hot...

Are bond traders pricing in an EMU break-up?

Tony Barber on the FT's Brussels blog urges readers to "watch the yield spread" when it comes to the debt of eurozone governments.

This is an issue Ambrose Evans-Pritchard at the Telegraph has been writing about for a while, and is certainly an interesting proxy for the market's faith in European monetary union. Barber singles out the spread between German and Italian 10-year government bonds: 25.8 basis points one year ago, 69.6 one month ago, 72.3 one week ago and 95.6 today. He summarises the relevance of the issue for EMU:

"[widening bond yield spreads] hint at a degree of uncertainty among investors about the cohesion of the 15-nation eurozone itself - namely, whether Greece and Italy are economically strong and fiscally disciplined enough to share the same currency with Germany over the long term.

This would not be an issue, of course, if the eurozone were like the US and had a central fiscal authority to transfer revenues between flourishing states and states suffering an economic shock. But you cannot have a central fiscal authority without a much greater shift in the direction of European political union than most politicians, taxpayers and voters appear ready to contemplate."

One comment on Barber's blog complains that his argument is focussing too closely on a recent timeframe, citing an enornous yield spread in the mid-90s. But although the yield spread between Italy and Germany by today's standards may have been extremely big at that time, it is also hugely significant what happened to spreads after the launch of the euro.

We had a look back over the data, and as the graph below shows (referring to the differential between the average of non-German eurozone members' bond yields and German bunds), the spread did narrow after the launch of the euro in 1999 (ie. it comes closer to zero, the German baseline), but around midway through last year this trend was sharply reversed, reflected in the upward slope away from zero:




The above graph is a simplification, and will be slightly skewed as a result of the effect of Greece - a relatively small economy with a very high yield on its debt - on the average. But even when we look in detail at the individual national spreads relative to German bunds, this trend is corroborated (apologies for the haziness of our graph - click on it to view in detail):

SOURCE: Eurostat

EU integration under the stress test

The FT's Brussels blog notes that officials in Brussels are resorting to the predictable thinking that the events of the past week can be used to catalyse a fresh integrationist dynamic in Europe:

the 1992 crisis in the European exchange mechanism appeared to deal a serious blow to the goal of creating a single European currency. But the reaction was spirited. Only seven years later, the euro was up and running.

Similarly, it took the 9/11 terrorist attacks on New York and Washington in September 2001 to prompt EU leaders into agreeing, at a summit just three months later, on the principle of a European arrest warrant. This allows the swift transfer of criminal suspects for trial and detention from one EU member-state to another...

On the face of things, the financial crisis offers a perfect opportunity to push forward closer European integration.

This could be right, or could be wrong. There is a clear narrative developing that Europe faces a very stark choice between closer integration or a reversal of the current contradictory model of full monetary union and only partial political union. There are three key faultlines that have profound implications for the EU as we know it: 1) EU competition policy, and the tensions raised by unilateral declarations of deposit guarantee with state aid rules/ bank nationalisations; 2) The Stability Pact, and the implications for budget deficits of dealing with the crisis; 3) the longer term debate over a single monetary policy, and the lack of institutional capacity of the ECB or central institutions in dealing with a true banking emergency.

Larry Elliot notes succinctly:

In the long term, monetary unions do not survive without political union, and so the…conclusion is that there are pressures both for closer integration and for disintegration. The crisis could strengthen those who argue that the halfway house is inherently unstable and will remain so until there is fiscal as well as monetary union. On the other hand, the growing threat of recession may make some countries question the value of remaining in a monetary union.

It is important to note that this year has seen the process of EU integration questioned not only in terms of its economic legitimacy, but also in terms of its democratic legitimacy - through the Irish No vote, following on the heels of the rejection of the EU Constitution by voters in France and Holland.

Two of the key pillars underpinning consent for the EU as a process of irreversible centralisation are now facing a severe stress test.

tax cooperation

There are a bunch of interesting things in the Treasury's review of the internal market (which comes ahead of the Commission's own review in March).

What exactly is this passage on tax "cooperation" about?

Looking ahead, in an increasingly global economy, no country will be able to set its tax policy in isolation from other countries and so cooperation between countries in the EU and elsewhere will important in ensuring that national tax systems can coexist effectively. This will involve continuously working together to drive down costs to business, improve transparency, exchange information and tackle fraud. The key is to preserve national flexibility, while strengthening the effective cooperation between Member States, rather than creating rigid structures incapable of adapting to the evolving demands of globalisation.

It's certainly a change from Gordon Brown's previous attitude to tax coordination (i.e. "no, no, no"). Presumably they are trying to play nice because they need the Commission's permission to take action on VAT carousel fraud.