Pieces in the puzzle

Just as the fall of the Berlin Wall in 1989 kick started the wave of globalisation, so the Russian invasion of Ukraine threatens to throw the process into reverse. Whereas its rise was initially a slow process which only seeped into the wider consciousness around the turn of the century, the reversal of globalisation is likely to take the form of a screeching U-turn as the west reassesses its security and economic needs. Whether or not the fighting in Ukraine quickly comes to an end, it is clear that Russia under its current government will remain an untrustworthy geopolitical partner which will require governments to reassess their political alliances. This in turn will have consequences for the shape of the global economy.

Assessing China’s position

The role of China will be particularly fascinating. Prior to 2008 it was hoped that China would align more closely with the west as rising prosperity convinced the government that opening up the economy would be in its best interests. That has proved a forlorn hope. An ever stronger China has continued to plough its own political and economic furrow with ambitions of usurping the US to become the dominant Asian power. It is ultimately likely to achieve that goal one way or another. At issue is the timing and the extent to which this transition occurs peacefully or otherwise.

It was therefore particularly interesting to hear suggestions that Russia has asked China for financial and logistical support for its invasion of Ukraine which further complicate the geopolitical mix. Whether China will agree to do this remains unclear. Last month, Russia and China extended the 2001 Sino-Russian Treaty of Friendship for another five years which commits China to support Russia “in its policies on the issue of defending the national unity and territorial integrity of the Russian Federation.” It also states that “when a situation arises in which one of the contracting parties deems that peace is being threatened and undermined or its security interests are involved or when it is confronted with the threat of aggression, the contracting parties shall immediately hold contacts and consultations in order to eliminate such threats.” Clearly, the ties between the two are very strong although it is questionable whether China expected Russia to launch its invasion which runs counter to its interests.

A particularly interesting article by Hu Wei, vice-chairman of the Public Policy Research Centre of the Counsellor’s Office of the State Council, suggests that China’s alignment with Russia could cause more problems than it solves. The thrust of the text is that if the conflict were to spiral, with NATO becoming involved, Russia cannot win by military means which would raise US influence on the global stage and leave China more isolated. He suggests that “China cannot be tied to Putin and needs to be cut off as soon as possible … Being in the same boat with Putin will impact China should he lose power. Unless Putin can secure victory with China’s backing, a prospect which looks bleak at the moment, China does not have the clout to back Russia.” It is important to stress that this does not reflect government policy and the fact that it was submitted to the Chinese-language edition of the US-China Perception Monitor and translated into English suggests it was designed for a western audience.

The official Chinese position views the world in zero-sum terms: What is good for the US must be bad for China (although the Trump administration was guilty of the same mindset). It does not have to be this way and rather than issuing threats about how the US would react – wielding the big stick would likely prove counterproductive, especially since China is aware of the consequences – a better approach may be to highlight the benefits of the cooperation which China claims to value. Whilst we should not expect China to publicly oppose Russia’s actions, at the UN or elsewhere, it has more potential than any other external force to act as a restraining influence.  

China is also aware that it runs significant reputational risk if it aligns itself with Russia and has more to lose than to gain if the west does decide to loosen economic ties. Moreover, Russia’s actions will cause problems for one of China’s signature economic policies – the Belt and Road Initiative. The BRI is designed to create a land route across central Asia, linking China to consumer markets in western Europe and raw material producers across Europe and Asia. War in eastern Europe will disrupt the supply of commodities to China and elsewhere, particularly in the event of a protracted conflict. It is thus in China’s economic interests that the war in Ukraine is swiftly resolved.

Big questions for Europe

From a European perspective, the western alliance has come together far more quickly and in a more unified fashion than we have seen for many years. The EU’s actions are a reminder that it has its roots in a project designed to ensure that the continent would not revisit the ravages of the first half of the twentieth century – a point that was lost on large parts of the UK electorate during the Brexit referendum. With the spectre of conflict once again at the EU’s border, the nature of the union is likely to change. The commitment to raising defence spending will mean more expansionary fiscal policies across Europe. During the Cold War, European economies routinely spent around 3% of GDP on defence. Recent figures suggest that this has slipped to around 1.5%. In order to boost outlays will mean either higher taxes or an increase in debt issuance (and this is before we discuss the costs of dealing with the refugee crisis).

In addition the rush to diversify away from Russian energy sources will impact on living standards for many years to come as the relative cost of energy remains elevated. This may also have implications for the EU’s green agenda. Whilst there are increased incentives to diversify away from hydrocarbon fuels, it will be difficult to make the sudden switch to renewables. Consequently, many EU countries may be forced to extend the lifetime of coal-fired power stations, rather than using gas as a transition fuel until such times as renewable sources come online.

Across the continent, governments are likely to be far more engaged in economic management than has been the case for many years, which they will justify on national security grounds. As this post from the Breugel think tank pointed out, the private sector may have responsibility for the generation and distribution of energy but has no responsibility for ensuring security of supply nor for ensuring that consumers have access to energy. The private sector may also be unwilling to carry the costs of replenishing supplies at current prices, for fear of huge losses in the event that oil and gas prices fall. All of this suggests that significant fiscal intervention may be required to guarantee energy supply.

Europe has perhaps been too complacent about the risks emerging from the geopolitical sphere in recent years, partly because it has had to cope with the aftershocks of the Greek debt crisis and Brexit. However, it has acted remarkably swiftly in the last three weeks as latest events highlight that the time for complacency is over. In the wake of the 2008 crash, hopes were expressed that we could return to the old world order. The pandemic and the war in Ukraine suggest that we are likely to return to a geopolitical order more reminiscent of 1985 than 2005.

The price of war

As the war in Ukraine unfolds and the harrowing scenes of death and displacement fill our TV screens on a daily basis, questions are increasingly being raised as to what is the end-game. Far from this being a Russian invasion with a swift conclusion, it could turn out to be a protracted conflict as Russia becomes bogged down in Ukraine. Without claiming to be an expert on Russian policy, there is plenty of good material out there which allows us to draw some conclusions as to how proceedings might unfold. One thing is evident: A range of different outcomes are possible and it is unwise to identify a single outcome at this stage of the proceedings.

Major military operations often take considerable time to conclude – for example, it took US forces one month to take Baghdad after launching its Iraq invasion in 2003. However, the Iraq invasion was planned as a slow and methodical affair: The Russian invasion of Ukraine appears from the outside to have miscalculated the strength of opposition. This runs the risk that ever more desperate measures will be taken to hasten the conclusion and increases the longer-term risks, both for Russia and the west.

How much pressure does Putin face at home?

Looking at the issue from Putin’s perspective, it is now an established fact that he sees Ukraine as part of a “greater Russia.” Having committed substantial resources and having put his domestic reputation on the line in order to take the country by force, the likelihood of him backing down before completing his objective is lower than a further escalation of Russia’s military effort. There have been suggestions that the sanctions against Russia will help to undermine Putin’s position as the oligarchy rises up against him. But a Twitter thread by Professor Olga Chyzh suggests this may be a naïve hope. Chyzh points out that they owe their wealth and position to Putin and if he goes, they do too. In her view, “the oligarchs are simply managers delegated with over-seeing day-to-day activities … Putin’s oligarchs have no political power whatsoever. Their domain is strictly economic.” She further notes that whilst the oligarchs may wield the economic power, it is the siloviki (strongmen) who wield the muscle capable of overthrowing Putin but since their interests are aligned with his, they have no incentive to bring him down.

However, Putin is not invulnerable. As a very informative article in Foreign Affairs, published last year, noted: “because of the compromises he has had to make to consolidate his personal control over the state, Putin’s tools for balancing the competing goals of rewarding elites who might otherwise conspire against him and appeasing the public are becoming less and less effective.” This suggests that sanctions may be effective. However, they will take a very long time to achieve their objective and are likely to do so only by making life for ordinary citizens intolerably hard.

The manpower cost of Ukrainian expansion

In the meantime, in the absence of a ceasefire – which currently looks unlikely – the war in Ukraine is set to continue. It is possible that Ukraine may be able to hold out long enough for Russia to opt for a face-saving exit strategy. That does not look to be on the cards at present, although we should never say never. Russia might instead decide to cut its losses and conquer only the territory to the east of the Dnieper River, claiming this was the goal all along. Alternatively it may double down its efforts and push through to the western border which will prove to be a long haul. Either way, having taken the territory it will prove economically and militarily ruinous to hold it.

In looking at the economics of occupation I am indebted to work by the economist John Llewellyn, conducted when he was working at Lehman’s in 2004 (available here). A study of the numerical requirements for a successful occupying force concluded that “no post-WWII occupation of a country has been successful at a force ratio of less than 20 troops per thousand head of population. And indeed some occupations … failed notwithstanding a force ratio of nearly 40.” This implies at the very least Russia would have to commit almost 900,000 personnel in order to have a chance of successfully occupying the whole of Ukraine. With an army comprised of one million active personnel and two million in reserve, this would require committing almost one-third of the available numbers to the task. Even if it were to occupy only the eastern half, Russia would still have to commit around 400,000 personnel which would be a considerable drain on resources.

Assessing the financial costs

Then there is the financial cost. The US is estimated to have spent $8 trillion in its 20-year “war on terror”, including its invasions and occupations of Afghanistan and Iraq. Even if Russia were to spend 5% of this amount, it would still require outlays of $400 billion – roughly seven years of Russian military spending – and this at a time when the economy will be under severe pressure as a result of global sanctions. Prior to the war, Russia could tap into $630bn of foreign exchange reserves. That amount has been roughly halved after western nations announced sanctions preventing access to any reserves held on their territory. Consequently reserves now amount to around 10 months of import coverage.

Despite the imposition of sanctions, however, oil and gas are exempt and European countries continue to buy Russian energy. German Chancellor Scholz stated yesterday that: “Supplying Europe with energy for heat generation, mobility, electricity supply and industry cannot be secured in any other way at the moment. It is therefore of essential importance for the provision of public services and the daily lives of our citizens.” Even though Urals crude is trading at a $25 discount to Brent, it is still around $100/bbl. On the basis that Russia exports around 4.5 million barrels per day to Europe, that amounts to $13.5bn per month in oil revenues alone. Similarly, Europe currently imports 32% of its gas from Russia (Russia met 40% of consumption needs in 2021). Last week, the think tank Bruegel calculated that at then-current market prices, the daily value of gas imports was around $755 million, or almost $22bn per month. If the world is serious about imposing sanctions, a reduction in hydrocarbon imports from Russia is essential otherwise the revenues will be used to further conduct the war.

The EU is working on a plan to cut Russian gas imports by two-thirds over the next twelve months, which is double the amount proposed by the IEA’s 10-point plan announced last week. Frans Timmermans, who leads the European Commission’s work on the European Green Deal, reckons that near-term savings could be made by cutting energy use, filling up gas storage in 2022 and finding new sources of supply, with the EU already in discussions with the likes of Egypt, Qatar, Australia and the US. If this can be realised, the flow of funds into Russia will dry up very quickly and reduce Putin’s capacity to pursue his war.

Weaning the EU off Russian energy imports will come at a significant economic cost. A paper published yesterday[1] attempted to measure the costs to Germany of ceasing to import energy from Russia. The authors conclude that “the effects are likely to be substantial but manageable. In the short run, a stop of Russian energy imports would lead to a GDP decline in a range between 0.5% and 3% (cf. the GDP decline in 2020 during the pandemic was 4.5%).” This is a big economic price to pay. But the moral price of continuing to fund Putin’s activities may be even higher.

Last word

Aside from the grief and heartache it causes, war is also an expensive economic enterprise. Even if Putin achieves his objective of conquering Ukraine, Russia will struggle to hold onto the territory unless it significantly raises its military commitment. But as the west cuts ties with Russia, leaving it increasingly economically isolated, Putin may not have to the resources to achieve this. Quite how a cornered Putin then reacts depends on whether the west allows him a face-saving way out and how his people react. It is not going to be pretty.

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[1] Bachmann, R., D. Baqaee, C. Bayer, M. Kuhn, A. Löschel, B. Moll, A. Peichl, K. Pittel and M. Schularick (2022) ‘What if? The economic effects for Germany of a stop of energy imports from Russia’, ECONtribute Policy Brief No. 028

A border skirmish

I have spent the last five years hammering the British government for its failings in dealing with the EU so it is only fair to apply the same criteria to the EU when it gets it wrong. Both sides of the Brexit divide in Britain were critical of the European Commission’s (EC) decision to impose a border in Ireland for the purposes of halting the export of Covid vaccine. This follows AstraZeneca’s (AZ) announcement that it would only be able to deliver 25% of the planned 100 million doses of the vaccine to EU members by March. The fact that the Commission subsequently backtracked suggests it realises it made a mistake. Although no physical harm was done, it shows the extent to which relations between both sides remain tense and calls into question a number of aspects of Covid management on both sides of the Channel. 

How did it come to this? 

There has been growing discord across continental Europe about the slow pace of vaccine rollout which lags well behind the UK (chart above). For the British government, which this week came under renewed pressure as the UK death toll topped 100,000, it is important that the vaccination rollout is a success after the failings in many other parts of the Covid response programme. Indeed, despite the apparent success (so far) of the UK vaccination rollout, it cannot detract from the fact that the UK has one of the highest per capita mortality rates in the world. But this is about more than just the UK.

In June 2020 the EC set up a scheme whereby vaccine purchases are negotiated centrally on behalf of all member states. This was not a compulsory scheme but all members signed up to it on the basis that the enhanced buying power of the EC would reduce costs and ensure that all would be treated equally. Under the terms of the agreement, no member can negotiate with a supplier who is already in discussions with the EC. However, the German government did a side deal with Pfizer in September, with whom the EC was already in negotiations, by signing up for an additional 30 million doses.

The German action was in part motivated by the EC’s slow progress towards signing contracts with vaccine producers. One reason for this was that the EU insisted that the drug companies assume liability for any side effects resulting from the use of the vaccine, which slowed down the negotiation process. Accordingly, the EU signed its first contract with AZ only in August, three months later than the UK. Similarly, the EU only signed a contract with Pfizer in November whereas the UK signed up with them in July. The EU was also a bit slower to approve the first coronavirus vaccines than the UK and US. The UK approved the Pfizer vaccine on 2 December, just over a week earlier than the US, whereas the European Medicines Agency did not grant approval until 21 December. This is not necessarily a criticism of the EU approach. Its cautious approach to the science was justifiable and it was buying in much larger quantities than the UK. 

The Commission’s real problem is with AstraZeneca 

But where the EC can be criticised is that although it signed contracts with AZ much later than the UK, it still expected deliveries to be made at the same time – a point made by the company’s CEO Pascal Soriot, who is ironically a French national. At this point, the legal implications of the case start to get murky. The EU believes it has the right to insist that AZ delivers on its contractual obligations and was so convinced of the rectitude of its position that it released online a redacted version of the purchase agreement (here). The first thing that jumped out at me was the sentence “AstraZeneca shall use its Best Reasonable Efforts to manufacture the Initial Europe Doses within the EU for distribution.” This is a standard legal phrase which basically means that AZ will do the best it can to deliver but it does not specify that it must do so at any cost.

The EU’s objection is that if it can be shown that AZ is producing in the EU to satisfy orders outside the region, this constitutes a breach of contract. There is no clear cut answer to this. If there were, neither side would be engaged in dispute in the first place. But the Commission believed that a breach of contract had occurred and in retaliation invoked Article 16 of the Northern Ireland protocol which allows the EU or UK to unilaterally suspend cross border trade if either side considers that trade actions lead to “economic, societal or environmental difficulties.”

It is important to understand the implications in this case. The EC initiated trade sanctions against a third party despite no evidence that the UK government did anything wrong. AZ is responsible for the production and delivery of the vaccine and any action that the Commission wanted to impose should have been directed at the company. I am obviously not an expert on contract law but surely the EC should have taken its dispute against AZ to a court of law, arguing for non-fulfilment of contract, rather than impose border controls without having the courtesy to inform the Irish government first. After all the talk from the EU during the Brexit negotiations about protecting the open border in Ireland, as enshrined in the Good Friday Agreement, this kneejerk reaction from the EC seems rather ill-advised. The fact that the Commission quickly backed down after discussions between Brussels, Dublin and London suggests it realised it had acted too hastily. 

Two unfortunate consequences: (i) Shaky UK-EU trade foundations 

There are two obvious consequences which flow from this unfortunate spat. In the first instance it acts as a reminder that the post-Brexit trade deal is built on shaky foundations. Just 29 days after the trade agreement came into force, with the ink barely dry and exporters on both sides of the Channel struggling to come to terms with the new arrangements, we have a demonstration of the weakness of the UK’s position. Such capricious behaviour does nothing to bolster confidence that there will not be similar tit-for-tat actions which will disrupt trade flows in future. Obviously the EU has no need to take account of British public opinion when taking action but the events of recent days act as a propaganda gift to Brexit supporters who have railed against the EU’s overbearing attitude and will lead to calls to revisit the treatment of Northern Ireland in the trade agreement. Admittedly the British government has form when it comes to dealings in international law, but as the old saying goes “two wrongs don’t make a right.” 

(ii) The ugly spectre of vaccine nationalism 

A second, and perhaps more worrying, aspect is that this is a demonstration of vaccine nationalism that the WHO long ago warned about. In response to concerns that AZ is prioritising deliveries to the UK at the expense of EU countries, the EC imposed controls on vaccine exports to keep track of how many doses were leaving the EU and where they were going. Although EC Vice-President Valdis Dombrovskis told the press that “The measure is not targeting any specific country," the list of countries exempt from the controls unsurprisingly excluded the UK. The EU may call this a transparency measure but in reality it looks like a targeted export ban.

Poorer countries are vulnerable to the actions of the industrialised nations. The UK and Canada have options to purchase enough vaccine to immunise their population four times over whilst the much larger EU has purchased 1.6 billion doses – more than three times the population. This has given rise to accusations of hoarding and the concerns raised by international bodies such as the WHO appear to be falling in deaf ears. Although the COVAX programme is designed to ensure access to Covid-19 vaccines for all countries, many people in world’s poorer nations will not be immunised in the course of this year. Unequal distribution of the vaccine will impose economic costs, with the Rand Corporation  suggesting it could knock $1.2 trillion off world GDP.

Whilst vaccine nationalism is understandable as governments seek to protect their populations, it is not a zero-sum game. From an economic perspective, there are spillover effects from ensuring that poorer countries also gain access to the vaccine (e.g. there will be less disruption to global supply chains from which industrialised nations benefit). From a health perspective, it helps to ensure faster global herd immunity. As the head of the WHO said last September, the vaccine should initially reach "some people in all countries, rather than all people in some countries." Viewed in that light, the actions of the EC do not look good.

EU expansion

After appearing to drag its feet on the issuance of joint bonds, the German government last week endorsed a French proposal to set up a fund capable of delivering €500bn of grants to EU member states suffering from the economic impact of Covid-19. This week the European Commission went further by setting out a plan to borrow €750bn by directly issuing bonds and distributing the proceeds to member states. After a decade of wrangling, this is a very important step and is vital if the EU is to hold together as a cohesive body. At last, the Commission has decided to lend its weight to a plan to issue pan-European fiscal instruments and will thus back up the ECB which has done all the heavy lifting on policy up to now. There are many who see this as a game changing event. And if implemented, it will be. But there are a number of hurdles to be crossed before the plan can be realised.

What does the plan entail?

Ursula von der Leyen, the Commission President, outlined a programme dubbed Next Generation EU. This is very apt because if it can be made to stick the EU could be about to take the first steps on the way to a fiscal union. Who knows, but this plan may be to the formation of a common fiscal policy what the snake in the tunnel was to the single currency. If nothing else it would break the taboo on fiscal cooperation which has long been one of the structural issues which has prevented the euro zone/EU from becoming the economic entity that the 1990s generation of leaders envisaged. That said, this measure is viewed as a one-off plan, nor will the Commission take any responsibility for debt already incurred by member states.

The idea is that the Commission will use its strong credit rating to borrow €750bn on international capital markets and recoup the funds though future EU budgets “not before 2028 and not after 2058”(i.e. not within the current budgetary period). Of this total, €500bn will be distributed in the form of grants whilst the remainder will take the form of loans. But the Commission is not simply proposing to write blank cheques: The funds will be distributed via EU programmes designed to achieve specific goals such as boosting competitiveness, supporting a broader green agenda and building the digital economy.

In order to facilitate repayment, the Commission suggested that a number of additional revenue raising items could be agreed at the pan-European level with each country paying the revenues from these streams into a centralised budget. “These could include a new own resource based on the Emissions Trading Scheme, a Carbon Border Adjustment Mechanism and an own resource based on the operation of large companies. It could also include a new digital tax … These will be in addition to the Commission’s proposals for own resources based on a simplified Value Added Tax and non-recycled plastics.”

In terms of the entitlement of individual states, the Commission has set out a formula based on three main economic factors: (i) population; (ii) the inverse of GDP per capita and (iii) the average unemployment rate over the past 5 years compared to the EU average. Based on this formula, Italy would be entitled to the largest share of the grants (20.5%) followed by Spain (19.9%), whereas France would only be able to secure a maximum of 10% and Germany 7% (chart).

What are the obstacles?

The first obstacle, and the most difficult, will be to convince the ‘frugal four’ (Austria, Denmark, Netherlands and Sweden) to sign up. The plan requires unanimous approval from governments, primarily because it entails structural changes in the EU budget that demand ratification by national parliaments. The frugal four have consistently opposed the creation of a debt union and have led the opposition which the German government is not willing to explicitly lead but which its electorate supports. But although Germany may have come somewhat reluctantly to the table, the government realises that failure to take action will ultimately weaken the ties that bind the union. After all, rising euroscepticism in Italy risks taking the EU in a direction it would rather not go and Germany certainly does not want to be the trigger for a breakup of the union. Arguably, however, the frugal four have less to lose and since they do not have the clout to bring down the union on their own, they act as a useful sounding board for the fears of all the northern countries.

A second concern is whether the establishment of an EU-wide fund will prompt individual governments to reduce their own efforts to put in place measures to combat the economic crisis. There has long been a concern amongst northern European members that an EU-wide safety net would result in moral hazard issues.

There are also some concerns with regard to fiscal legitimacy. One of the biggest problems is that only national governments have the power to levy taxes on their citizens since the government derives its tax-raising power from its electorate. Although there is a European Parliament which derives its legitimacy from citizens of the EU, it looks after pan-EU interests rather than the local interests which are generally more important to electorates. The levying of specific taxes for pan-European purposes might thus be seen as problematic.

But a brave attempt for all that

A decade ago it was clear that the euro zone is not a proper economic union – it was effectively a fixed exchange rate system in which debtor nations had to bear the brunt of the necessary economic adjustment. Greece and Ireland learned this lesson in a very painful way as the global debt crisis unfolded. It was also equally clear that some form of fiscal transfer mechanism would be necessary if the euro zone were to survive in the longer term, but efforts by Emmanuel Macron to make headway over the last three years largely fell on deaf ears. Now the tide has turned. That said, the Commission’s proposals are unlikely to be accepted in their current form and a compromise will emerge instead. Nor do the proposals outlined this week constitute a fiscal union. But they do mean that some form of countercyclical transfer mechanism could be in place sooner rather than later. In my view it is a very heartening move – at least from an economic standpoint although we can argue about the politics. The only disappointment is that it took so long to get here.

Macronomics

In a recent fascinating interview with The Economist, French President Emmanuel Macron reiterated his long-held view that the EU has to adapt if it is to survive in a much-changed world. As Macron noted, things that were unthinkable five years ago are now the norm and that “if we don’t wake up … there’s a considerable risk that … we will no longer be in control of our destiny.” It is hard to disagree with this: The historically strong relationship between the US and Europe has become less anchored in recent years, initially as a result of Barack Obama’s pivot towards Asia and more lately thanks to Donald Trump’s retreat from rational policymaking. Since the EU is unable to rely on the US to help deal with the rise of China as a world power, whose interests do not chime with those of the EU, Macron believes that European nations have to act proactively in their own interests.

Whilst most European leaders would profoundly disagree with Macron’s assertion that NATO is “brain dead”, at the very least it should act as a rallying call for Europe to think about its place in the world. This week’s NATO summit in London was a chance for western leaders to get together, which is useful in itself, and even though no great decisions were taken it appears to have passed off cordially enough (the ongoing spat between Donald Trump and Justin Trudeau notwithstanding). But although forward-thinking European politicians will have to rethink what kind of Europe they want, there simply are not enough politicians who share Macron’s vision. Germany may be the economic powerhouse, but Angela Merkel is coming to the end of her tenure as Chancellor and her coalition government is more fragile than it was following the election of the Borjans-Esken duo as leaders of the SPD, both of whom are opposed to continuing the coalition with the CDU/CSU. Nor is the German economy currently in great shape as the economic motor splutters in the wake of the US-China trade dispute. The bottom line is that we should not expect Germany to contribute much to reshaping the EU in the next couple of years – like many countries, it is too preoccupied with domestic political issues.

But the problem is more than just political: The EU will have to focus on the kind of economic model it wants to pursue in future. As I pointed out long before the Brexit referendum, the EU has benefitted from the market-oriented model designed to enhance competitiveness which the British have helped to push in Brussels. However, the UK’s departure will significantly change the nature of the EU. For one thing it will change the balance of voting power. Around 80% of EU laws are ratified by qualified majority voting, meaning that they must be passed by 55% of member states representing at least 65% of the total EU population. Germany, the Netherlands, Austria and Finland, together with the UK, currently represent just over 35% of the EU population which gives the northern nations a blocking minority on policy matters. This will change once the UK leaves and concerns have been expressed, particularly in Germany, that countries opposed to market-oriented solutions could press for a weakening of EU competition policy, which has traditionally been dominated by ideas from the northern countries. This in turn would weaken the EU’s economic competitiveness.

Then there is the nature of the economic difficulties facing France which are likely to sap Macron’s energy to pursue EU-wide solutions. The latest wave of public dissatisfaction revolves around reform of state pensions, which has met with huge resistance and a wave of strikes brought the transport sector to a virtual standstill earlier this week. There is no doubt that an overhaul of the state pensions system is required, since it offers very generous state payouts to workers in certain sectors (railways, merchant seamen, energy workers and some niche workers at the likes of the Banque de France and l’Académie Française). Drivers on the Paris Metro, for example, are able to retire at 52 with an average monthly pension of €3500 whereas private sector workers, who retire at 62, receive only €1360 per month. All told, these special provisions cost the taxpayer €8bn per year (around 0.3% of GDP).

We have been here before, of course. A year ago, Macron’s efforts to impose a carbon tax met with huge resistance in the form of the Yellow Vest protests, which prompted him to put the policy on hold. Efforts in 1995 to reform the French economy were abandoned in the face of massive public protest. As the population ages, the state simply cannot afford to underwrite special privileges for any one group but it is a hard sell to get the electorate to understand that a system that has worked for the last 70 years will not fly in the 21^st century. I have a lot of time for Macron’s ideas but I do not believe that he will be successful in delivering domestic reforms on the scale he desires – there is simply too much resistance. This is not to say that he will not be partially successful – after all, things have changed since 1995 – but it may be left to a future generation of politicians to get where he wants to go. 

All this matters because Europe does not have the luxury of time to decide in which direction it wants to go. Indeed, the more I see how slowly reform is proceeding in France and Italy, the more I am convinced that the EU will be forced to concede that not all countries will be able to move forward at the same pace. Ironically this is the form of EU that the British would have been more comfortable with than the push towards a federalist system that grew out of the hubris of the 1990s. But as the world moves towards a world in which the US and China act as the poles of the geopolitical system, Europe cannot simply afford to pick one side. And this is where Macron is right – US and European interests are diverging, and the EU will have to steer its own course. NATO has to stand for more than “No Action, Talk Only”.

As the dust settles, the battles begin

This year’s European Parliament elections were a big deal and generated a lot of coverage across the continent. There was certainly a lot to digest. As predicted in advance, the European People’s Party (centre-right) remained the largest faction but it lost a significant number of seats (down from 221 to 177, or from 29.4% to 23.6% of the total). The representation of the centre-left S&D bloc also declined, from 187 seats to 149 (24.9% to 19.8%). This means that the two main groups that have dominated the European Parliament since direct elections were introduced in 1979 now have a combined vote share of less than 50%. The big winners were the centrist Liberal alliance (ALDE) and Greens, but also the Eurosceptics and nationalists (comprised of three separate blocs).

Whilst the swing away from the nationalist parties was not wholly directed towards the Eurosceptics, which probably did less well than they might have hoped, they nonetheless found a lot of support, taking almost a quarter of the total number of seats. Such parties topped the polling in three of the largest EU countries: Italy (where they took 58% of the votes); the UK (44%) and France (36%) whilst they also did well in Hungary, the Czech Republic and Poland (62%, 54% and 54% respectively).

We should thus be under no illusions that the electorate in a number of countries has expressed dissatisfaction with the status quo and that it will be difficult to continue along the same path that we have been following for the past forty years. No one group can dominate the European Parliament, and a number of what might in the past have been seen as strange coalitions will have to be formed. The EPP will need the support of the Greens and Liberals, but even these three blocs will not be sufficient to command a parliamentary majority without the support of at least one of the smaller groups. This highlights just how difficult things are going to get in dealing with many of the big issues which confront Europe. On the one hand it is going to be difficult to find common cause on geopolitical relationships with the likes of the US, China and Russia. Then there are economic problems such as the environment and dealing with competition issues. If Europe has struggled with these issues before, life is about to get far tougher.

The horse trading that has already begun over the numerous positions in European institutions does not fill me with confidence. Key positions, such as the President of the European Commission, are supposed to be filled via the Spitzenkandidat (or leading candidate) principle. This principle was first established following the 2014 elections in which the candidate proposed by the leading political faction was in pole position to take over as Commission President. This is how Jean-Claude Juncker got the gig in 2014 despite opposition from the British and Hungarian governments. On this basis, Manfred Weber (EPP) would be expected to be one of the front runners. But the French have decided that they don’t like the idea of Weber getting the job, with President Macron apparently in favour of someone else (though we are not quite sure who).

Having put the Spitzenkandidat principle under strain, it raises the justifiable concerns of those who see the process of appointing the EU’s top jobs as a Franco-German carve-up, which will certainly not go down well with the large number of Eurosceptics in parliament. This dispute will also have implications for other jobs which are up for grabs. If Weber fails to get the job as Commission President, it would not be a surprise if Germany put forward Jens Weidmann as the new ECB President in succession to Mario Draghi who leaves in November. That would certainly not be welcomed in southern European countries, given Weidmann’s opposition to unconventional monetary measures such as QE. The more we look at the job allocation process, the messier it becomes.

All this comes against the backdrop of further disquiet on the part of the European Commission regarding Italy’s fiscal position. The Commission today wrote a letter to the Italian government warning that “Italy is confirmed not to have made sufficient progress towards compliance with the debt criterion for 2018.” This could trigger another excessive deficit procedure against Italy, following last year’s issues which were ultimately resolved when the Italian government softened its position a little, and which might ultimately lead to financial sanctions. Bearing in mind that the Italian electorate voted on Sunday for parties with a strong anti-EU bias, this will not go down well in Rome. It also puts the various actors in this drama in a tricky position. On the one hand, it is likely to reinforce Italian resentment regarding the actions of the EC to stifle GDP growth, which has averaged just 0.4% per annum during Italy’s membership of the single currency. On the other hand, the likes of Germany are becoming increasingly intolerant of Italy’s fiscal position and it continues to push for the southern European nations to play by the rules. This fault line running through the euro zone shows signs of growing wider, rather than narrowing, as the splits between federalists and nationalists and northern Europe and southern Europe grow wider.

Then, of course, there is the issue of Brexit. At the EU level, the change in the composition of parliament might have some bearing on whether it is possible to reopen negotiations between the UK and EU as some prominent UK politicians believe. A change in the Commission President could have a similar effect, whilst the departure of Donald Tusk as European Council President will rob the UK of a staunch ally in Brussels. As for what the election results meant domestically, everyone has a view based on their prior belief. Brexiteers argue that since the Brexit Party got the largest number of seats of any party, this is a strong signal that the UK should get out of the EU as quickly as possible. Remainers argue that the total vote share accounted for by Remain-supporting parties was larger than that of the Brexit Party and that the number of votes obtained by the Brexit Party (5.2 million) was smaller than the number signing a petition calling for Brexit to be stopped (5.8 million signatures). Both arguments have some validity but as we saw in 2014, it pays not to extrapolate the European election results too far.

But however we look at it, the events of the past few days have highlighted that the EU has a lot of soul-searching to do. It does need to do more to convince the people of Europe that its direction of travel is the right one. This parliamentary session will thus prove to be the most important in recent history as the EU figures out how to proceed. It is important to get it right, for otherwise it is easy to foresee rising tensions putting further strains on the workings of the single currency and the fabric of the EU itself.