Anglo-German partnership on EU reform could prove crucial at the negotiating table

Die Welt's Economic Editor Tobias Kaiser has an opinion piece in today's paper entitled entitled “Stay with us, Brits”, in which he argues that:

“Berlin needs London as a partner in the fight for fiscal reason [in the EU].” 

Kaiser highlights that:

“Berlin and London have to put their ideas of Europe against the French coined version of European etatism... The openness of the European economy has to be guaranteed and the protectionist regulations and national rules – which still prevent the development of a genuinely free exchange of goods, people, and ideas within Europe – have to be dismantled.”

This is an argument we have been making for a while. In 2012, following the election of Francois Hollande as French President, Open Europe Director Mats Persson argued that:

"Hollande simply rubs the Germans up the wrong way. His spending rhetoric is an outright challenge to German Chancellor Angela Merkel’s vision of a euro firmly grounded in Prussian budget discipline."

"Therefore, though it won’t be easy, the scope for a new bargain between London and Berlin – based on Britain needing new terms of EU engagement if it is to remain inside, and Germany needing the UK’s quiet support for a more economically sustainable euro – is possibly greater than ever."

While Hollande's push against austerity has waned, the process of Anglo-German cooperation has gained pace - exemplified by the recent joint op-ed in the FT where George Osborne and Wolfgang Schäuble agreed on the need for safeguards for the single market in the face of tighter political and economic integration in the eurozone.

Kaiser's call for greater economic openness within the EU also echoes the argument in favour of greater services liberalisation by Die Zeit's London correspondent John F. Jungclausen, who cited Open Europe's report which found that removing barriers to cross-border services trade could alone produce a permanent increase to EU-wide GDP of up to 2.3% or €294bn.

It's good to see the process beginning to bear fruit and gain wider traction in the German media, particularly on the specific areas where reform is necessary. As we pointed out ahead of Chancellor Merkel's recent visit to the UK, there is scope for a wide ranging 'Anglo-German bargain' in areas such as EU migrants' access to benefits, greater powers for national parliaments, and the devolution of some EU back to the national or local level. According to a recent Open Europe/YouGov poll, an EU reform agenda built on these pillars would enjoy significant public support in both countries.

With all this in mind, now would seem the perfect time for the UK government to begin road-testing specific reforms in Germany and other countries. 

Italian PM launches opening salvo against austerity - but where will the cash come from?

The new Italian Prime Minister Enrico Letta announced his first raft of policies in his first speech to the Italian parliament yesterday. The speech was strong on anti-austerity rhetoric but short on details of how his new approach would be funded - illustrating that ever-so-relevant dilemma in the eurozone (and elsewhere): it's easy to criticise austerity, much harder come up with alternatives. Here are the key points:

·    The government will scrap up to €6bn worth of tax rises, although Letta provided no detail about how this funding gap would be filled. Much of this move was motivated by Silvio Berlusconi’s insistence on scrapping a new housing tax which was laid out as a precondition for the formation of the grand coalition

·    Some phrases which will make German Chancellor Angela Merkel wince, such as: “We will die of fiscal rigour alone. Growth policies cannot wait any longer”, “[Europe faces] a crisis of legitimacy” and there is a need for a “United States of Europe”.

·    Letta believes Italy’s welfare system is inadequate and will look to broaden it to provide further help to women, young people and temporary workers.

·    Businesses will also receive tax incentives to hire young workers.

·    Again no details on how such policies will be funded. La Stampa reports that all in, the “Letta Agenda” could cost €20bn. He made no mention of privatisations or the sorely needed reforms to the labour and product markets to make Italy more competitive.

·    Letta did stress that Italy will meet all of its EU commitments and targets.

·    He set himself and the new government an 18 month window in which to achieve the some success in turning around the economy or “face the consequences”.

·    Promised to reform the electoral law and cut MP’s pay.

A very interesting opening salvo from Letta. In fact, not too dissimilar to French President Francois Hollande’s early comments regarding austerity – we can’t help but wonder if his enthusiasm and/or success will wane in a similar way.

One thing that is clear from the speech is the continuing power of Silvio Berlusconi (as we previously noted). La Stampa suggest up to €12bn of the cost of the ‘Letta Agenda’ actually comes from Berlusconi’s demands, while following the speech Angelino Alfano, the new Deputy PM and key Berlusconi ally, said, “I share the words of Enrico Letta’s speech from the first to the last. It is music to our ears.” Meanwhile, Berlusconi also took the opportunity to this morning ramp up his own rhetoric against austerity, calling for the new Italian government to “renegotiate its deficit commitments” with the EU.

All of this sets an interesting tone and background for Letta’s first meeting with Merkel which takes place this afternoon. As we have noted previously and at length, the key question surrounding this whole austerity debate remains, if not through cuts, then who will pay for the party? Germany and the ECB certainly aren't ready to foot the bill indefinitely and while market sentiment is positive now, it likely could not withstand a new spending spree in a country with a debt-to-GDP of 120% already. We suspect Merkel may make just that very point...

Is the IMF turning bearish on Spain?

It’s been a busy week for the IMF, releasing their latest iterations of the World Economic Outlook, Global Financial Stability Report and the Fiscal Monitor. We’ve been poring over the reports and will continue to do so (see here for some initial thoughts on the WEO). One forecast in particular caught our eye – Spain's.

The IMF seems to have turned significantly more pessimistic on the prospect of a Spanish recovery. The charts below provide a comparison with the previous WEO forecasts (highlighting how these forecasts tend to be overly optimistic) - which very much confirms what we have noted before about the real risks in Spain.

The latest projections for the Spanish deficit (the dark blue line in the above chart) definitely represent a break from previous forecasts. In particular, the forecast for 2014 is 2.3% of GDP higher than in October. The IMF says this is:

“Reflecting the worse unemployment outlook and the lack of specified medium-term measures.”

Translation: the government does not have the necessary budget cuts and reforms in place to meet its desired deficit path – step it up Rajoy.

Such an increase manifests itself in the debt level projections as well. Worryingly, these no longer peak in 2015/16 and level off thereafter. Instead, Spanish debt to GDP is forecast to reach 111% in 2018 and looks set to keep growing rather than peaking and levelling off.

Effectively, this graph also highlights how the forecasts have progressed as the crisis in Spain has evolved from from financial, to a sovereign liquidity crisis and now into a sovereign solvency one. As the IMF notes, sustaining this will be tough:

“[Countries such as Spain] would need to maintain large primary surpluses over the medium term. In the absence of entitlement reforms, projected increases in age-related spending mean that additional measures will still be needed over time, however, to keep the primary surplus constant.”

Translation: Spain needs to run large primary surpluses for a long time, but in the face of increasing welfare and pension spending, this will need to come from a series of additional and painful cuts.

So the IMF does not paint a pretty picture for Spain. Longer and deeper recession, larger deficits at a time when it needs to be moving to surplus and increasing debt, in turn raising questions about the country's solvency. Let’s not forget, that’s before bringing the bust banking sector into the discussion. Plenty for Rajoy to get on with then…

Update 16:20 18/04/13:
Christine Lagarde has reportedly suggested that Spain should be allowed to ease its austerity programme. Lagarde argues that, although Spain needs fiscal consolidation, it does not need to be front loaded. Such an argument is not going to sit well with the eurozone and will increase the tensions within the Troika (some of which were outlined in this FT article earlier today). As the graph below shows such an approach may not fit well with the IMF own growth forecasts. Even with a 7% deficit, growth next year in Spain will be 0.7% according to the IMF. How much more would need to be spent to get to a respectable 1.5% GDP growth? Double the deficit?

Maybe not something this extreme but with debt already heading towards an unsustainble path it's not clear that there is much scope for further spending, while markets may put pressure back onto Spain once again. This raises the prospect of a further bailout or transfers from other eurozone states, but as we pointed out at length yesterday, Lagarde is talking about something very different than removing austerity in that case.

Details of Cypriot bailout agreement filtering through

The package is coming together. The IMF has officially announced that it will take part in the Cypriot bailout, providing €1bn of the total €10bn in loans - that gives a UK share of around €50m (see our thoughts here on UK IMF shares). That leaves €9bn to be provided by the eurozone, likely through the ESM. Below we breakdown the country shares (click to enlarge):

Other details of the Memorandum of Understanding (MoU) filtering through include:

• 2.5% interest rate on the loan, with a 10 year grace period on repayments, it will then be repayable over a 12 year period (repayments start in 2023 and finish in 2035).
• 4.5% in cuts/savings to be found before 2018 (on top of the 7% already scheduled by 2015) to drive Cyprus from a 2.4% primary deficit now to a 4% primary surplus in 2018 (two years later than previously envisaged).
• The figures given in the MoU leaked yesterday (which reports suggest are the same in the final agreement) imply an 8% contraction in GDP this year and 3% next year. This seems optimistic and could be closer to 10% and 5% respectively, if not worse, but ultimately depends on how long the capital controls are in place for.
• Eurozone officials will review the agreement tomorrow, with a final proposal to be presented on 9 April, which eurozone finance ministers are expected to approve at an informal Eurogroup meeting in Dublin on the 12 April.
• The Bundestag could vote on the deal around the 15 April. IMF board expected to approve the deal in early May.
• First tranche of bailout funds expected in early May, ahead of debt maturing at the start of June which Cyprus needs to pay off.

A few hurdles left to jump then in terms of approval from national parliaments – which is no mean feat given that the figures underpinning the bailout are likely to come under some well-deserved scrutiny.

Europe’s Fiscal cliff? Hardly.

MEPs - or at least some of them - aren't exactly doing themselves any favours at the moment.

European Parliament President Martin Schulz has been waxing lyrical about how devastating a cut in the EU budget would be.

"We want a modern EU budget…As far as we can tell, however, the proposal on the table today would be something very different, namely the most backward-looking financial framework in the history of the EU."

“I won’t sign a deficit budget…Europe, like the U.S. a few weeks ago, is heading for a fiscal cliff.”

Wait. What? Did he just compare a real terms cut in the EU budget to the US Fiscal cliff?

Frankly, this a ridiculous comparison. As Schulz-types themselves are keen to point out, the EU budget amounts to around 1% of EU GNI while the US Federal Budget amounts to around 15% - 20% of US GDP (and has historically been even higher than that).

The fiscal cliff would have amounted to tax rises and spending cuts worth almost $600bn. The current proposal sees EU budget commitments falling by €34bn in real terms (increasing in nominal terms). This is 0.3% of EU 2011 GNI. The US fiscal cliff could potentially have caused US GDP to fall by 4% - 5% in a short space of time; the cut in the EU budget will barely register, especially in comparison to the other problems in the European economy.

The EU budget has important implications for the politics of the EU and can provide some useful funding in certain areas (which it often fails to do by spending so much on the CAP) but will this type of stuff make taxpayers around Europe take Schulz more seriously?

The key to understanding the eurozone crisis: sequencing

An EU leader saying that he or she is in favour of “more Europe” in response to the Eurozone crisis means absolutely nothing. Ask Germans whether they’re in favour of more Europe, meaning codification of Bundesbank-style fiscal discipline at the EU level, using the EU institutions to enforce it, and naturally they will nod approvingly. Ask them if they want joint EU borrowing or backstops for banks, and support for “more Europe” evaporates. Shock horror, in countries more prone to tax and spend – and here we include France – the trend is pretty much reversed.

The key to understanding the next step in the Eurozone crisis therefore comes down to one thing: sequencing. The Germans want surveillance before solidarity (code word for more cash on the table). The French the opposite. Which is why it’s not surprising that Angela Merkel and Hollande are clashing over the former’s idea to stick an EU veto on national budgets (her finance minister has proposed a fiscal tsar, sitting in the EU commission, to do the job).  Merkel says she wants “genuine powers to clamp down on national budgets…that we stick up for this won’t change”. Translation: if you want our credit rating, you need to accept our Ordnungspolitik. For his part, Hollande stresses intégration solidaire - ‘integration with solidarity’. Translation: cash first, budget vetoes later (sort of).

We’ve made this point several times before, but it keeps on reasserting itself. The see-you-in-court fiscal controls that the Germans need as political cover (and as a safeguard against moral hazard) to press ahead with transfers are incredibly difficult to achieve politically, as they effectively mean redefining national democracy in debtor states (key decisions on spending and taxation would no longer ultimately be subject to decisions in national parliaments).

The question is what the absolute minimum level of fiscal control the Germans can accept to press ahead with the next step. This is why Herman Van Rompuy's proposal for a contract-style agreement between an individual country and an EU institution, resting on a paid-in insurance scheme (of sorts), could be an interesting to watch. If sold as "temporary" (which of course it may not be at all) and linked to reforms, that might be easier for Germany to swallow.

But at the moment, we suspect Angela Merkel herself doesn’t know the answer to that question…