German inflation backlash alert (it took about 12 hours)

Well, it didn't take long. You may have thought that yesterday's comments from people allegedly close to Bundesbank President Jens Weidmann to the effect that Germany could live with the shocking inflation rate of 2-3% were in any way a sign that Germany was about to cave in on its resistance to anything that resembles high inflation. Well the front page of Bild Zeitung - the gold standard of European tabloids (pun intended) - says it all:

The “Bundesbank is going soft on the euro”, adding that:

“Over the next few years prices in Germany will rise much faster than before. Our venerable Bundesbank, the sacred guardian of price stability, will do nothing about this since it considers it to be ‘manageable’”.

And in case the 13 million or so Bild readers didn't get the message, page 2 features a giant picture of a one trillion DM banknote from the Weimar era:

An op-ed by the paper's chief editor Nikolas Blome argues that:

“[inflation] will above all hit workers, employees and pensioners. Precisely those who kept a cool head and ploughed on through the crisis. This is unfair. It gnaws at our trust in money and our major institutions, in politics and central banks… since Germans have bitterly experienced it themselves they know that high inflation ultimately breaks down every society”. 

It wasn't only Bild though. The man himself, Weidmann, moved swiftly to deny the reports, claiming in an interview with Süddeutsche that this was an “absurd discussion”. He clarified that keeping inflation below 2% in the eurozone as a whole meant that “in some cases” German inflation would be higher, but that “we will ensure [in the ECB’s governing council] that inflation in Germany will not run out of control. Citizens can rely on the vigilance of the Bundesbank”.

This is one national core belief you don't mess with.

EU Referenda games: staying in, leaving or renegotiation - it's all complicated

With Europe as fluid as ever, talk of some sort of EU referendum is heating up in the UK (well at least in the Westminster bubble).

The always excellent James Forsyth of the Spectator argued in the magazine yesterday that London Mayor Boris Johnson’s support for a referendum and UKIP’s rise taken together “make it highly likely that Britain will have its first vote on Europe since 1975 within the next five years."

He also notes that,

"The popularity of Cameron’s EU veto made his circle realise how much of a political asset Euroscepticism could be, if used in the right way. There is also concern in No. 10 that if the Tories don’t offer the public a vote, Labour will."

He goes on to say that,

"One source intimately involved in Tory electoral strategy told me recently that a referendum in the next manifesto was ‘basically a certainty’...My understanding is that, at the moment, the favoured option is to propose renegotiation, followed by a referendum on the new arrangements within 18 months. During the campaign, the Tories would argue for staying in if new terms could be agreed but leaving if the rest of Europe refused to play ball." 

The equally excellent Paul Goodman over on Conservative Home today echoes Forsyth, listing a range of reasons why a referendum draws nearer.

And Forsyth's colleague Alex Massie also picks up on this on the Speccie's Coffee House blog, looking at all the complications involved in trying to square an EU renegotiation with a referendum (the "on what?" question always looms large). We've looked at the various options for a referendum in detail before, so this is all familiar (if you're interested in the different options, we strongly recommend reading this piece).  Massie makes a good point though. An EU referendum is too often seen in Tory leadership ranks as being about "a matter of party morale, discipline and tactical positioning", not getting something that actually works for the UK.

We agree. The thing is, this is far too complicated an issue to make a matter of mere party management. It will be part of the equation, of course, but making it subject to pure party politics will reduce the discussion to the usual Westminster back-and-forth on vague concepts such as "influence", "isolation" or "sovereignty" - it will be Mandelson land.

But where Massie - and a whole range of other commentators and politicians - get it wrong is when they say that in contrast to the renegotiation option, "an in/out plebiscite at least offers a choice between easily-grasped options."

No it doesn't. Staying in raises a whole range of complicated questions - what does the UK do if the eurozone takes that quantum leap towards further integration? What happens if the EU merely becomes a political extension of the eurozone (which Britain can't join)? In other words, if we want things to stay as they are, things will have to change.

And the "out" option? It sounds easy at a superficial glance, but in a serious discussion, it would raise far more questions than answers. In fact, there's virtually no "out" option (save perhaps one) - all options to withdraw from the EU treaties (which is what 'out' must mean, though it is rarely defined), involves joining something else. Doing a "Norway" would be suicide for UK, i.e. accepting 2/3 of EU laws but with no say over them; a Switzerland would be slightly better but still immensely complicated. A different type of Free Trade Agreement altogether involving business paying hefty fees or facing new admin burdens on exports to the EU, which contain some imported components? A customs union a la Turkey meaning being stuffed on market access on services? Simply falling back on the WTO's Most Favoured Nation (MFN) rules, with a range of costly barriers to trade and movement?

Answers anyone? The truth is that most of the complications that apply to renegotiation, also apply to the "out" option, including the need for some sort of "approval" from other countries for whatever alternative arrangement the UK enters into (apart from the WTO option) possibly. The truth is that all three options: staying in on current terms, renegotiation or withdrawal from the EU treaties are massively complicated. To whet your appetite, we're about to publish a comprehensive report looking at the different options for the UK was it to vote to decide to leave. And trust us, it's complicated.

What we do know is that both Britain and the eurozone will simply have to move. It's therefore right that No 10 is now considering different options.

But again, it should be for the right reasons.

Is the Bundesbank going soft?

Shock horror. According to Reuters Deutschland, an unnamed central banker close to Bundesbank President Jens Weidmann today said the following, in response to the wide rumours that the Bundesbank may be willing to accept higher inflation to help solve the eurozone crisis:

“By this it is meant [that with] a rate of inflation that is moderately above the target of the ECB which is just under 2 per cent...No one need be afraid of massive currency devaluation”. 

 Apparently, the belief is that the Bundesbank 'can live with' 2.5% or 2.6% inflation.  

This follows an interview with German Finance Minister Wolfgang Schäuble,  published by Focus over the weekend, in which he said thus:

“It is fine if German wages are currently increasing more sharply than in all other EU countries”. 

After many years of reforms, he said, Germany has done its homework and can afford higher collective wage settlements than other countries.

So is this a sign that Germany is starting to follow the advice of a whole host of Anglo-Saxon commentators who see higher inflation in Germany as vital if the euro is to survive? 

We wouldn't bet on it. When commentators talk about higher inflation, they have something much higher than 2.5% in mind (though some commentators may not realise that themselves) - this certainly doesn't seem high enough to encourage the re-balancing and evening-out of competitiveness which many believe the eurozone needs to survive in the long term. The media may be getting ahead of itself on this one.

The buck passing continues in Greece

The political situation in Greece following Sunday's elections is getting even messier. Following the failure of conservative New Democracy to even begin a serious discussion about forming a government (negotiations lasted all of six hours), the Radical Left (SYRIZA) yesterday also threw in the towel. The "dream" of a leftist Coalition government had failed, said SYRIZA's leader Alexis Tsipras, but added that his party had nonetheless forced Europe to reconsider the Greek bailout package (perhaps a bit premature). 

The buck has now been passed to socialist PASOK, the former governing party which slumped to third in the elections. PASOK leader Evangelos Venizelos said yesterday that he will ask Greek President Karolos Papoulias - who by now must be a seriously nervous man - to give him the go-ahead to start discussions with other parties in a last-ditch effort to try to form a government. If that fails, we're definitely looking at fresh elections, probably in June. The prospects for PASOK succeeding are slim - to say the least.

So what's going to happen? Frankly, heaven knows. As we have noted before, even fresh elections may not generate a stable government, though there's a chance that those people who voted on smaller parties that didn't get over the 3% threshold to enter the Greek parliament, may shift their votes to bigger parties. SYRIZA clearly remains the X-factor, and could potentially pick up more votes. The party has outlined a five point plan - including completely ripping up the bailout agreement - that is simply fundamentally incompatible with the position of the Germans and the IMF. The politics are immensely complicated, but if SYRIZA's support is required for forming a government, then we're basically looking at three potential outcomes:

1) SYRIZA and Germany/IMF stick to their guns, the bailout cash is frozen, Greece defaults and almost certainly leaves the euro
2) SYRIZA caves and Greece is given the next tranche of bailout cash and the charade continues for a bit longer
3) Germany/IMF cave, the bailout terms are revised and Greece is given the cash

Perhaps a path between the second and third options would be possible too - and given the stakes, not unlikely. In any case, it ain't lookin' good.

A bit of European political dynamite in the Queen's Speech

The Queen delivered her "Queen's Speech" earlier today - which, for non-UK readers, isn't her speech at all but rather the government's, setting out its agenda for the forthcoming year (a rather odd ceremony but good opportunity to see Ken Clarke in a wig if nothing else).

For those interested in the ever-so-opaque EU dimension, the Queen said in passing:

"My Government will seek the approval of Parliament relating to the agreed financial stability mechanism within the euro area."

And

 "My Government will seek the approval of Parliament on the anticipated accession of Croatia to the European Union."

The latter won't be much of an issue - most MPs will play along as further enlargement rightly enjoys buy-in across the political spectrum.

The former is a different story. This relates to the EU treaty change dating back to December 2010, when the Germans managed to get agreement for tweaking the Lisbon's Treaty Article 136 to allow the eurozone's permanent bailout fund, the ESM, to be put on a more legally sound footing (at least that's how Berlin sees it). This treaty change has now finally come up for UK ratification in Parliament. Before carrying on, just to clarify, this is not the EU treaty change that Cameron vetoed in December 2011, and which gave rise to the separate Fiscal Treaty.

The December 2010 agreement didn't cause a whole lot of fuss at the time, and MPs gave their preliminary approval. Back then, Cameron had far greater control over both events and his own backbenchers. And the UK media was still waking up to the massive - and ongoing - continental political shift unleashed by the euro crisis.

2012 is a different matter altogether.

The ESM won't actually impact on the UK itself, so the 'referendum lock' wouldn't kick in. However, the treaty change that Cameron vetoed back in December wouldn't actually have had a direct impact on the UK either - that veto was about getting guarantees that UK interests were protected as the eurozone integrates further, and the rules of the game are effectively changed.

Exactly the same logic could apply to the Treaty change to put the ESM on legal footing. Like the Fiscal Treaty, the ESM will lead to greater integration in the eurozone (indeed, the two go together - see here), so Tory MPs could use the same line of reasoning they did leading up to the December summit in calling for the UK to block the measure, in return for EU concessions. Remember, an EU treaty change is not a change at all until it has been ratified by all member states.

Will they? So far, there are no signs that this issue is fully on MPs' radar and the UK government prays it will stay that way. But a lot of things to look out for:

• The UK government is likely to sell the measure as a guarantee that it will never again be forced to indirectly contribute to eurozone bailout funds - a few papers have already run with that story. At the same December summit, Britain won a political declaration and an EU decision that the article that forced it to contribute to the EU-wide bailout funds, the EFSM, won't be used again (Article 122 - for background, see here and here). However, the legal status of this guarantee is uncertain. It is not part of the treaty change itself, and MPs may argue that a guarantee that isn't anchored in the Treaties could well prove ineffective. After all, the UK has received guarantees before which proved to be pretty worthless (clue: Charter of Fundamental Rights, Working Time Directive). If MPs wake up to the legal ambiguity underpinning the 'guarantee' they may ask for something firmer in return for ratifying the treaty change.

• The timing of the ratification will be crucial, i.e. if it coincides with some cataclysmic event or political row in Europe (there will be a few to choose from), it would make life potentially much more difficult for the UK government. The ratification certainly won't happen before the summer' that's for sure. 

• Under the current agreement between eurozone leaders, the ESM is supposed to be up and running by 1 July (in parallel with the temporary bailout fund, the EFSF). This is important, because without the ESM in force, the lending capacity of the euro bailout funds will be a lot lower than markets are expecting, meaning more market nervousness, in particular as Spain is struggling.  

• To make matters even more complicated, the treaty change itself isn't actually what's needed to approve the ESM in eurozone countries - for that, eurozone leaders have agreed a separate 'ESM treaty' which is now going through national parliaments in the eurozone. As you'd expect, this is by no means plain sailing as the treaty - for obvious reasons related to taxpayers' cash - is subject to controversy in Germany and the Netherlands, which are still to ratify it. Before the ESM treaty can become operational and lend money to countries and banks, it needs to be approved by eurozone countries accounting for at least 90% of the contributions to the fund (meaning that Germany, France, Italy and Spain have an effective veto).

• And this is where things get rather bizarre.  Even if all euro countries manage to ratify the ESM treaty, the Germans originally said that they absolutely need the separate EU Treaty change for the ESM to be fully legal. However, since the UK won't have ratified the EU treaty changes by 1 July, the ESM will be up and running before the 'vital' Treaty change designed to make the whole construction legal is actually ratified in national parliaments. In other words, expect another batch of court cases to soon land in the in-tray of the German Constitutional Court in Karlsruhe.

Pretty messy - but then again, we're talking eurozone politics and EU 'law'. That one short line in the Queen's Speech hides so many complications...

The Bankia bail-out is only the tip of the iceberg in Spain

Over on City AM Forum we have an article looking at the implications of the Spanish government's decision to bail-out Bankia both for Spain and the eurozone. As we noted in our recent Spanish briefing the problems in the Spanish banking sector run deep and Bankia is therefore clearly only the start.

See below for the full piece:

Another day, another U-turn in the eurozone – although this time it may mark the Spanish government’s acceptance of the huge problems in the country’s banking system.

The Spanish government announced on Monday that it will be injecting Bankia, the country’s third largest bank, with up to €10bn in capital, using the state-backed FROB bank restructuring fund, despite previously dismissing the possibility of doing so. Given the timing of the announcement – on the same day that Greece went through political upheaval – one can’t help but think that the Spanish government harboured some hope that the declaration might fly under the radar.

Given the size of Bankia and the implications of the bail-out such hopes were deeply misplaced. Bankia has one of the largest exposures to the country’s bust real estate and construction sector at €38bn, of which €18bn is considered problematic. It was also the poster child for what now looks to be the laudable but ultimately doomed structural reform of Spanish banks which took place last year. It is the largest of the consolidated ‘cajas’ (Spanish regional banks) and the problems on its balance sheet highlight how little the banking consolidation solved.

Taxpayer-backed bank bailouts are never ideal but if Spain chooses to go down this road, getting the correct mix of support and strong conditions is vital.

The most likely form of any future intervention is the widely mooted ‘bad bank’ plan. A plan to remove the huge amount of risky assets lurking on bank balance sheets sounds great in theory but it is never that simple.

The first question, as always, is where will the money come from? Currently Spanish banks have €54bn in provisions against €136bn in doubtful loans. The latter number looks set to increase as conditions worsen, particularly with much larger falls in real estate prices expected – we predict that provisions will need to be at least doubled, while the corresponding capital need to underpin a ‘bad bank’ would be large. Bankia is likely to be only the tip of the iceberg both in terms of problems in Spanish banks and the use of public funds.

Securing private funding will be near impossible, leaving two sources of public funds: the Spanish FROB bank restructuring fund and the EFSF/ESM eurozone bailout funds. The FROB in theory has a lending capacity of €99bn, but most of the cash must be raised by issuing debt, with only €18bn directly guaranteed by the state. There are rightly questions over whether the fund could borrow cheaply if it backed a bad bank, potentially leaving the majority of the gap to be filled by eurozone bailout funds.

Given the growing political opposition to both the bailouts themselves and the austerity conditions which they come with, such a large transfer of European funds could be political dynamite in Europe.

The main concern is the huge moral hazard associated with bailing out banks – this was a trend which many in Europe hoped had been bucked, opening it up again would do significant damage to credibility in the eurozone. The aim is ultimately to encourage banks to start lending and aiding economic growth again but this is notoriously difficult – who’s to say they won’t continue hoarding funds over wider fears of a eurozone break-up. The most important part of the process will be an honest external valuation of these doubtful loans, something which Spain and the eurozone have shied away from before.

Any funds must therefore come with clear conditions. The key element to enforcing these will be allowing some banks to fail or be wound down, if too large a percentage of their assets need to be shifted to the bad bank. In the end, many of these banks have unworkable balance sheets in the aftermath of the housing bust. This will be the clearest signal to show that public funds are not being used to solely prop up banks, that only viable businesses will survive and that the Spanish government is committed to reform.

In many ways the use of public funds to help Bankia could be a turning point for the crisis in Spain. The good news is that the Spanish government finally accepts the need to tackle the wider problems with its banks, presenting an opportunity to flush out the sector once and for all. On the other hand, it significantly increases the likelihood of taxpayer-backed Spanish and eurozone funds being used to bail out banks once again. What’s clear is that, until the problems are fully addressed, the Spanish banking sector malaise will still threaten to engulf the whole economy and potentially drive the country into a full bail-out programme.

Meanwhile, in Italy...

Italian daily La Repubblica had an interesting story over the weekend. Apparently, Italian Prime Minister Mario Monti and his team are trying to win support for watering down the EU's deficit and debt rules.

Italy is suggesting that 'virtuous investments' (i.e. public spending aimed at boosting 'growth') should not be counted when calculating a country's deficit and debt under the EU's budget rules (3% deficit, 60% debt-to-GDP ratio). The same exception should be applied to the re-payment of money currently owed by the various public administrations to private firms - some €70 billion in Italy's case.

The always well-informed Marco Zatterin - Brussels correspondent for La Stampa - writes on his blog that Italian Europe Minister Enzo Moavero Milanesi has already been talking to EU Commissioners for Internal Market (Michel Barnier), the Budget (Janusz Lewandowski), and Industry (Antonio Tajani, Italy's man in the Commission) over the past few days. EU Economics and Monetary Affairs Commissioner Olli Rehn is reportedly willing to consider the proposal. The Monti government hopes that EU leaders will discuss the proposal at the European Council at the end of June.

These exceptions, Italy's reasoning goes, would make the fiscal treaty "more sustainable" once it comes into effect. But is this really a good idea? As we pointed out before (see here and here), the fiscal treaty already has some serious credibility issues and has already been watered down.

Allowing for some debt to be swept under the carpet doesn't exactly inspire confidence. Do people remember how we got here in the first place?

Meanwhile, mayoral elections took place in Italy over the weekend (we understand if you didn't notice given everything else that was going on during the eurozone's 'Super Sunday'). Still, a couple of interesting facts are worth flagging up:

• Candidates from Silvio Berlusconi's People of Freedom party did not make it to the second round in any of the bigger cities where elections took place (Genoa, Palermo, Parma and others). Following the results, the party's Secretary General, Angelino Alfano, said that backing for Monti's government continues, but no more 'mini-summits' with the centre and centre-left leaders supporting Italy's technocratic cabinet in parliament will be held from now on. This could have an impact on Monti's ability to push through his reform agenda, especially since he has no electoral mandate to fall back on when things get tough;
 

• Lega Nord, Berlusconi's former ally, also did quite badly in the wake of the scandals that forced its leader Umberto Bossi to step down last month. Lega Nord managed to keep Verona, but lost several towns traditionally considered strongholds in the Lombardy region;
 

• Turnout was about 67% - almost 7% lower than in the previous local elections;

• The Movimento Cinque Stelle (Five Star Movement), led by Italian stand-up comedian Beppe Grillo (in the picture) came out as the real winner. Its candidates achieved double-digit percentages in a couple of important cities (including Genoa, Beppe Grillo's home town, and Parma, where the Five Star Movement's candidate Federico Pizzarotti made it to the final run-off, with 19.5% of votes). A political maverick, Grillo has been campaigning for the need to clean up Italian politics, for instance by barring convicted people from running for the Italian parliament. Most interestingly, he has recently been claiming that Italy should drop the euro (but remain in the EU) and refuse to pay back at least part of its public debt. 

The general elections will be a different ballgame altogether, but it's interesting how the Italians, too, are now looking for something different.

German media responds to ‘Super Sunday’

Following Sunday's elections in which French and Greek voters were able to have their say on their governments’ handling of the eurozone crisis, which as we’ve covered in our daily press summary, was unequivocally negative. Given the position that Germany will adopt will be the single most important factor in determining the future of the eurozone, we thought it would be worth taking a closer look at the reaction in the German press to the weekend’s results.

Starting off with Bild, Germany (and Europe’s most widely-read paper), the paper’s Greece correspondent Paul Ronzheimer argues that:

 “In a democracy, each voter has the right to decide freely. And no one wants to deny the Greeks this right. But a free choice can have consequences… About two-thirds of Greeks want to stay in the eurozone. But at the same time, they chose to vote for radical parties that reject all that is required for this membership: savings and reforms. Germany and the EU desperately need a Plan B: How can the eurozone best continue on without Greece?”

Moving onto FAZ, we have economics editor Holger Steltzner, a well established austerity hawk arguing in a piece entitled “Merkel fights alone” that:

“How do you deal with a country that firstly swindled access to the euro, then plunged the EU into an existential crisis, and then cast two-thirds of votes for radical parties that deny austerity?” 

 On Hollande, Steltzner is slightly more restrained, if still pessimistic:

“Merkel takes the debt brake seriously, Hollande does not want to submit to any rule to curb the deficit. When Merkel speaks of growth, she means structural reforms to loosen restraints on the labour or manufacturing markets. About the beneficial effects of competition (the fruits of which the German economy is currently reaping) Hollande speaks barely a word.” 

This gloomy take is also shared by the Die Welt’s foreign affairs editor Clemens Wergin who argues the election results are triumph of denial over reality, and the embodiment of “old Europe”:

“Greek and French voters have rebelled against what they perceive as German savings and reform diktats. This is however unfair when measured against the significant risks and liabilities which Germany has taken on in order to save the EU’s problem countries from bankruptcy. Likewise Germany’s fiscal capacity is significantly overestimated by those who think that Berlin should commit even more money towards Europe-wide stimulus programmes.”

Wergin continues by saying:

“While Italian PM Mario Monti is trying to implement real reforms and in the longer term adopt German-style austerity politics, it seems Hollande does not realise the enormous need for reforms that the eurozone’s problem countries are procrastinating over… Europe could cope with an irresponsible Greece committing suicide in the eurozone. Some would even welcome it. However a France that loses the confidence of financial markets would be the worst case scenario for the euro - and for Europe.”

However others strike a slightly more optimistic tone, with Die Zeit’s Gerd Appenzeller arguing that:

“In Greece, as in France, the desire is now for more growth in lieu of cuts, regardless of where the credit comes from… Francois Hollande will, nevertheless, be committed to European integration and Franco-German strength, like all other French presidents before him. In spite of this, he is not likely to make concessions with the fiscal compact and austerity plans. Indeed, Greece poses even more of a problem with its intentions to discontinue further cuts which would mean that it could be imminently bankrupt. This would ultimately endanger Greece more than the rest of Europe.” 

 Meanwhile, Handelsbaltt’s EU correspondent Ruth Berschens argues that:

“If the second largest EU state were to veer from the path of savings and reform, then the monetary union would come into its heaviest existential crisis yet. However, it does not appear that Hollande would so lightly put the euro, the most important legacy of his political mentor François Mitterrand, at risk.”

All in all then the Germans are not hitting the panic button just yet, although arguably many are clearly worried that Merkel risks becoming politically "isolated", a concept we think is far too simplistic in the context of European politics (see here and here for examples). However, it is certain that following the French and Greek results, the road ahead for the eurozone rescue is looking more bumpy than only a few days ago.

Cable gets it 100% right on EU regulation (almost)

Vince Cable: Unimpressed by the Working Time Directive

In a nice contrast to the doom, gloom and cynicism which all too often characterise the European debate, here's some much needed can-do spirit from UK Business Secretary Vince Cable. The topic - how to cut down on EU regulation - is a favourite of ours (sad, we know). In a piece for the Telegraph, Vince described a recent meeting in Vilnius, where, apparently, 15 member states, going under the catchy name of the "Like Minded Group", agreed to work towards less cumbersome and more business friendly EU regulation.

Cable attacks the "dreadful economics" and "illiberal" nature of the Working Time Directive in particular and EU social and employment laws in general (at least by implication). But he concludes "the tide is turning":

"Beyond the Like Minded Group, Spain and Italy want the EU to focus more single-mindedly on a growth agenda, including deregulation. Last November the European Commission agreed to attack the regulatory burden with exemptions for micro businesses. And earlier this year, following sustained UK lobbying, we achieved agreement in Brussels to exempt around 1.4 million UK small businesses from burdensome EU accounting rules...I discovered in Vilnius that we are not on our own. We are part of a new progressive European majority replacing the dinosaurs of the past."

This is good stuff, and as we have argued repeatedly, exactly the type of measures that the UK Government should push for (nicely tying in with our piece, also in today's Telegraph, on how the UK should be actively courting Germany in a bid to put free trade at the heart of what the EU does).

However, Cable also rules out a scenario is which the UK "could carve out a comprehensive opt-out of all EU employment legislation", saying that "in practice it is difficult to see how Britain could on the one hand continue to enjoy the benefits of the Single Market, worth £3,500 a year per UK household, while on the other refusing to engage on difficult issues."

It's of course true that it would be politically very difficult to get a carve-out from EU employment law. It's also true that EU employment law acts as a 'subscription fee' for the UK's participation in the single market. But as we set out in our recent paper on EU employment law, where does that argument take you? Should the UK then accept other sub-optimal policies such as the CAP and CFP as that, after all, is part of the 'package deal'.

This position also assumes that EU membership for the UK (and other member states) is "Pareto optimal" i.e. there's no other possible outcome of European cooperation that makes every member state at least as well off and at least one member states strictly better off. Looking at how well Europe is working at the moment (ehum), that is clearly not the case. It's therefore right for the UK to consider the division of labour between member states and the EU in employment law - and other policy areas as well.

But in any case, it's a positive that Cable and the UK government are active in this area. Lets hope they keep up the good work...

Hollande's victory is an opportunity for David Cameron to strengthen his position with German Chancellor Angela Merkel

In an op-ed for today's Telegraph, we argue:

"Viewed from London, the most interesting effect of François Hollande’s victory in Sunday’s French presidential elections may not be how it changes the UK’s relationship with France, or even how it could create tensions in the Franco-German axis. Rather, it is how it has the potential to strengthen ties between Berlin and London."

We note,  

"While the bickering between London and Paris will continue, 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. Remember, this is a vision that has been presented as “non-negotiable” to the German electorate and which still draws support from a clear majority of voters there (only about one third of voters would prefer economic stimulus over austerity, even at home). Unsurprisingly, Hollande’s threat to veto the EU fiscal treaty – Merkel’s political cover for putting up German taxpayers’ cash – has caused dismay in Berlin and Frankfurt. As the German newspaper Die Welt put it: 'The fiscal pact is the best thing Europe has. Now it has come to an end even before its introduction. If it continues like this, that’s the end of the eurozone.'"

There may be plenty of empty election rhetoric in Hollande’s promises to take on Germany, and the most likely outcome is that Merkel and Hollande reach a deal on the fiscal treaty that does not involve outright renegotiation but that allows him to save face, perhaps by adding a fiscal stimulus clause, loosely attached to the treaty. The two have too much to lose from an almighty row. [But] at the same time, though, the Germans know that politics in the EU balances on a knife edge."

We go on to argue that,

"taken together, election results in 2012-13 could massively increase perceptions in Germany that either it is prepared – in the words of the German tabloid Bild – 'to stand alone' or accept being slowly but inexorably pushed into the arms of the spending- and inflation-prone Mediterranean bloc. Clearly, Germany wants neither. To escape this binary choice, it will need allies. And this is where Sunday’s election results really become interesting for Britain. With Berlin growing anxious, this is the perfect chance for No 10 to begin a concerted effort to lure Berlin in the direction of a more liberal, outward-looking Europe. Cameron won’t break the Franco-German axis – nor should he try to. But he could now create a lot of goodwill in Berlin by throwing his weight behind a Europe based on sound money and that lives within its means. As Merkel’s charm offensive following Cameron’s EU veto back in December illustrates, Berlin knows that it pushes Britain away at its own peril. Not only does it need the UK inside the EU tent to balance the less-disciplined southern bloc, London’s support will also be vital in upholding a rules-based system where goods and services can be traded across borders, as Europe goes through a highly unpredictable – and defensive – phase. A southern bloc led by Hollande may challenge austerity, but a northern bloc, containing the UK (if it can get its economy in order), the Scandinavians, and some of the new member states, would possess Europe’s economic fire power – and its Triple A ratings. 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.

So how should the UK respond? First, of course, get a working relationship going with Hollande – France remains a key partner and neither Britain nor Europe would be the same without it. Second, don’t give up on Spain and Italy – both governments contain plenty of good people who understand the need for structural reform. But in parallel, British EU diplomacy ought to be reoriented far more towards Berlin. Despite its importance, the UK far too often talks about the past or misunderstands Germany, as was made painfully obvious when Cameron thought he had Merkel’s support ahead of December’s EU council – a misunderstanding that triggered his veto.

A good place to start for the UK government would be to stop lecturing the Germans on the need for turning the eurozone into a debt union. Such lectures annoy Berlin in return for no apparent diplomatic benefit. What Britain can do, however, is set a good example by getting its own economy in order, while continuing to push for pro-growth and structural reforms at the EU level when this is within the UK’s mandate. And as Europe searches for cause and meaning, Britain can also set out an alternative vision for its place in the EU. While stressing the benefits of cross-border trade, such a vision should be based on the realisation that Britain cannot join the euro, and will therefore need a different – and looser – arrangement under EU law than euro members. This would provide a focal point for diplomatic relations with Germany in particular, but also other key allies that too often are left perplexed as to what Britain actually wants in Europe."

 We conclude - in a nod to those commentators who claim that Hollande's victory 'isolated' Cameron (whatever the event in Europe, the outcome is always that Cameron is isolated, have you noticed?):

"If Cameron can pull that off and cultivate relations with Berlin, Hollande’s victory – far from isolating the Prime Minister – may just have strengthened his hand."

The beginning of the end game in Greece?

At some point you have to wonder if Greece just enjoys the limelight…

This weekend’s election was expected to be relatively predictable with the largest parties forming a coalition and eventually adhering to the latest EU/IMF bailout package. Most eyes were on the French Presidential election and its impact on the Franco-German axis. Unfortunately, as we predicted, there were still a few surprises in store in Greece. Here’s the (almost) final result:

New Democracy – (18.86%) 108 seats

SYRIZA – (16.77%) 52 seats

Pasok – (13.18%) 41 seats

Independent Greeks – (10.6%) 33 seats

KKE (Communist party) – (8.48%) 26 seats

Golden Dawn (far-right) – (6.97%) 21 seats

Democratic Left – (6.1%) 19 seats

The biggest surprise is clearly the huge rise in SYRIZA’s share of the vote and the drastic fall in Pasok’s share.

In our post in the run up to the elections we laid out three scenarios: a stable ND-Pasok coalition, an unstable coalition leading to new elections where ND win a majority and an unstable coalition which falls leading to a cycle of elections where no-one can win a clear mandate. Those three scenarios clearly still hold, but the probabilities have definitely changed. Previously, the likelihood ran in order, however, now the second and third scenarios are looking increasingly probable.

ND and Pasok only hold 149 seats, short of the 151 majority they need. The Democratic Left has ruled out joining a three-way coalition. This makes new elections (probably in June) essentially inevitable as there is no stable coalition to be formed.

However, given the showing in the elections it is hard to imagine ND, or any party, gaining a clear majority. Given the strength of the anti-austerity feeling in Greece it is unlikely that these results would be a one-off. The anti-austerity parties only look likely to gain ground in subsequent elections, making a stable coalition less likely. This analysis suggests that a cycle of elections looks increasingly probable in Greece.

What does all this mean for the eurozone?

More uncertainty, that’s for sure. Germany and the EU have already both come out to reiterate the need for Greece to maintain its commitment to the latest bailout packages, stress that keeping Greece in the euro requires strong participation from both sides (rather ominous if you ask us).

Unfortunately, this looks unlikely, even if by some miracle ND and Pasok manage to form a workable coalition at some point. ND leader Antonis Samaras has already come out saying that he will “modify the memorandum [of understanding]” with Greece’s creditors to focus on growth. This can probably be seen as the start of his next election campaign but will still send shivers down the spines of German politicians.

A renegotiation of some form looks on the cards and will not be well received. Samaras would still be the EU’s preference given his history of strong rhetoric but then still signing up to the bailout programme. The alternatives are not appealing from eurozone leaders’ perspective: either there is a cycle of elections leaving no government in place to implement the reforms or the anti-austerity feeling grows so strong that a SYRIZA led government of some form comes to power, signalling the end of the bailout programme for good.

There is a confluence of factors here which increases the prospect of a Greek exit from the eurozone. The broader feeling in Greece although still in favour of the euro is shifting strongly against austerity – how this tension will play out is unclear but the usual fall-back of broad public support for the eurozone looks shakier than it has ever been.

Since the last round of poisonous bailout negotiations the eurozone and financial markets have been preparing for a Greek exit, if not publicly than definitely behind the scenes. The stance against any renegotiation and flexibility on reforms has hardened from eurozone leaders. Furthermore, Greece is approaching a primary surplus, the point where an exit and a full default look slightly more attractive as the country could (at least in theory) survive without access to financial markets or direct support.

Greece’s future will not be decided in the next few days but the coming weeks and months could well settle its place in the eurozone once and for all. This election may not provide many answers, as we expected, but it could mark the beginning of the end game in Greece.

If the Conservatives’ UKIP problem looks bad now, wait until 2014

Open Europe's Christopher Howarth has the following article published on Conservativehome:

UKIP have done well in the local elections, securing almost 13% of the vote, in the places where they stood, and caused real problems for the Conservative Party. It might be tempting for the Conservative leadership to retreat into Downing Street, curl up in their well-beingness zone and ignore this local squall, or still worse, insult those former Conservatives who decided to vote UKIP. This would be a serious mistake as events are conspiring to create a perfect UKIP storm going into the 2014 Euro elections just before the (now fixed) 2015 general election.

Firstly, before I explain further, I do not believe that the Coalition’s actions on Europe are the whole, or even a major explanation of UKIP’s good showing. Not all UKIP voters are former Conservatives and even if they were, not all would return – when is a protest no longer a protest? Europe is not the only issue that motivates people to vote UKIP. Perceptions that the Conservative Party does not share voter’s concerns on immigration, law and order, has a Maoist fascination for unwanted and damaging constitutional change (such as House of Lords reform), as well as an air (hopefully temporary) of incompetence all play their part. However Europe remains an issue and cannot be ignored. This is why:

There will be a European election in 2014. Last time (in 2009) UKIP came second with 16.5% of the vote, in 2014 they could do a lot better providing momentum going into the general election. In 2009 the Conservatives had a coherent European narrative (based on a Lisbon referendum) and although they chose to focus on domestic issues it was in line with majoritarian British thinking. In 2014 the Conservatives are unlikely to have a clear narrative.

In 2014 we will still be seeing the after effects of the euro-crisis (or worse) which may be perceived to have caused further direct costs to the UK taxpayer in the form of further IMF contributions.

In 2014 the UK will have to decide whether to opt in to EU jurisdiction over 130 EU police and Justice measures, including the EU arrest warrant, or leave them completely with the Liberal Democrats potentially fighting hard to stay in.

In 2014 we will see a major House of Commons Parliamentary vote on ratifying the EU’s seven year budgetary framework, which on past performance could see a rise or a freeze but not a cut. Voting it through would be unpopular when the UK is facing tax hikes as well as some cuts.

In 2014 the EU will implement a provision of the Lisbon Treaty changing the EU’s voting system meaning the UK could be out voted by the Eurozone acting as a caucus, with severe implications for the UK’s financial and social regulation. All manner of unpopular measures could appear in the meantime.

And all this with a General Election set in stone for 2015

So what can be done by the Conservatives to retake the initiative?

This is obviously difficult in a Coalition context but there are things that can be done. The Conservatives could set out distinctive policies, based around getting powers back from the EU that would in due course go into their manifesto. The Conservatives could set out a vision for the UK in a flexible Europe, post the eurozone crisis, based on the UK remaining outside the euro - President Klaus of the Czech Republic has recently set out something similar. The UK should say now that they will exercise their block opt-out over EU police and justice matters so it is not left hanging or reduced by 2014. The UK should also set out innovative ideas to shrink and radically reform the EU budget (Open Europe has suggested this on agricultural spending and this on EU structural funds). The UK could also consider unilaterally adopting a minimalist approach when implementing some of the worst aspects of EU regulation obviously aimed at Britain, such as the Agency Workers Directive and aspects of financial regulation.

Finally the Conservatives and the UK should show they understand the modern world by renewing its focus on economic liberalisation, securing the benefits of the single market while seeking out opportunities in high growth emerging markets – the two are not mutually exclusive. With these measures, the Conservatives could set out a narrative that would not please all, but would be in line with public opinion.

 

Greek elections unlikely to yield any answers

The Greek elections are almost upon us. Much of the attention (including ours) has been focused on the French election, possibly rightly given the potential impact on the Franco-German axis and the austerity approach to the eurozone crisis. The lack of attention may be down to Greece-fatigue following the intense start to the year with the Greek restructuring, or the fact that with a bailout and strict programme in place the room for flexibility with the new government is severely limited. That said, the Greek elections have the potential to be almost as important.

Despite the well documented rise of fringe parties and the strong talk from New Democracy (ND), a coalition between Pasok and ND looks to be the most likely outcome. Combined the parties may gain around 35% - 40% of the vote. The largest party (likely to be ND) gets an extra 50 seats under Greek electoral rules, meaning that the coalition would be the largest combined group in the Parliament and may just scrape a majority. This position will be aided by the fact that all the other parties are fairly disparate and unlikely to form any cohesive opposition.

However, even if this coalition is formed there numerous ways in which it could play out:

1)      Stable coalition – ND and Pasok manage to gain and hold a majority in the Parliament. They set about attempting to implement the EU/IMF bailout package. May be some talk of renegotiating elements of the package, particularly to boost growth. If anyone is to have success on this front it would be this coalition as it has at least some experience and knowledge of negotiating with EU/IMF.

Impact on the eurozone: This added stability would likely be positive for markets and the eurozone in the short term. Ultimately, it will not make much difference since Greek debt still looks unsustainable and implementing the necessary reforms will be a massive challenge on the ground even if they are pushed through parliament. There is less chance of external financing being cut off anytime soon, since the government will at least try to adhere to the programme.

2)      Coalition breaks up, new elections where ND wins a majority – The coalition fails to gain a full majority in Parliament (possibly due to Pasok defections after the deal is struck) or fails after a very short time due to lack of cohesion between parties (especially if ND leader Antonis Samaras feels he could gain a full majority in new elections). Elections delay implementation of EU/IMF package but once ND government comes into power the implementation continues, although calls for growth policies will grow louder.

Impact on the eurozone: Ultimately, depends on how long the coalition lasts and the policies which ND uses in the new election to gain a majority (potentially shift further right if there is growing disillusionment with the EU/IMF austerity).  ND unlikely to push for euro exit or full renegotiation of EU/IMF package so that adds certainty, but the inherent problems with the package (mentioned above and covered in detail here) still hold true. The turnover between elections could be important. Any delay in implementing the package will not go down well with the EU or IMF and could reduce its effectiveness even further.

3)      Coalition breaks up, new elections fail to deliver suitable replacement leading to an election cycle – Coalition breaks down as mentioned above, but this time the new elections fail to deliver a clear winner, possibly with an even greater move towards the far left and far right parties. This would likely trigger a series of unstable coalitions and probably more elections. Once this cycle has begun it will be hard to break, particularly with Greece’s economic situation seemingly only getting worse.  

Impact on the eurozone: This would be the worst of all outcomes. The EU/IMF package would fall by the wayside due to lack of willingness or a government to implement it. If a cycle of elections does take hold it could feed anti-euro sentiment, although anger has, for now, been largely directed at the austerity bailout rather than euro membership more generally. This would eventually result in funding being cut off and Greece probably having to exit the eurozone. This is unless such a threat galvanises the population to vote a single party supporting the euro into power.

Overall, a ND-Pasok coalition looks likely but it will probably be far from stable. It is definitely hard to see it serving a full term. The most likely outcomes (1 and 2 above) may deliver some short term certainty but problems loom large for Greece over the medium to long term. The EU/IMF package still looks unachievable for Greece and will not solve its debt sustainability problems, while there is surely a tipping point where the Greek population withdraws its support for the euro more. At the moment this is still some way off. These elections will certainly not deliver a definitive answer to long term issues in Greece and there is still a chance that an uncertain outcome could worsen Greece’s situation.