© REUTERS/Reinhard Krause

Germany’s six month presidency of the European Union in the second half of this year could hardly come at a more important moment. As the EU’s largest and most financially powerful member, Germany must rediscover its earlier role as leader and mediator. By doing so, it can help hold the organization together, something also very much in its own interests.

To do this, however, Berlin must face up to the EU’s conflicts, both internal and external. Germany faces three challenges in Europe, all given new urgency by the coronavirus pandemic. It must reestablish cohesion within the EU, bridging the gaping divide between its northern and southern member states; it must stand up for democracy and the rule of law; and it must strengthening the EU’s international role.

Germany’s six month presidency of the European Union in the second half of this year could hardly come at a more important moment. As the EU’s largest and most financially powerful member, Germany must rediscover its earlier role as leader and mediator. By doing so, it can help hold the organization together, something also very much in its own interests.

The presence of COVID-19 in Europe was confirmed early this year. However, since the EU had no relevant powers in health policy, early countermeasures took place on local, regional, and national levels. Basic freedoms of movement within the EU were restricted overnight, in partial contravention of European law. Twelve countries, including Germany, closed their borders. In early March, Berlin imposed an export ban on personal protective equipment (PPE) for medical staff, while the French government requisitioned face masks. The absence of declarations of solidarity, let alone practical assistance, gave rise to profound political disappointment. The early response, in other words, was dominated by national unilateralism, bringing back memories of the eurocrisis.

However, the EU has shown itself capable of correcting course. Management of the outbreak was quickly taken up at the highest levels, more rapidly than during the financial crisis. The European Commission instituted weekly coordination meetings. There were joint rescue flights for European citizens stranded overseas. Coronavirus patients were transferred between EU countries. Once common rules on exporting medical supplies outside the EU had been established, most governments lifted export bans within the single market. European companies began to manufacture face masks and ventilators, while the Commission introduced the joint procurement and stockpiling of medical materials.

As with the financial and migration crises, the early months of the COVID-19 crisis showed that removing internal EU borders only works when accompanied by policymaking at a European level.

Basic Freedoms at Risk

The EU’s “common area of freedom, security, and justice” was created to support cross-border mobility and interconnection. For this integrated space to survive intact, health protection must be guaranteed as a pan-European public good, with open borders balanced against the need to protect the public.

If common health policy instruments are lacking and national health systems cannot successfully deal with the pandemic, the basic freedoms of the internal market will be cancelled out. Moreover, the EU will lose public trust if it can neither defend against dangers to public health nor come to the aid of struggling member states, helping them to help themselves.

Now, as Angela Merkel put it, the EU must confront “the greatest test it has faced since its foundation.” Insufficient preparedness in public health will now be followed by the continent’s most serious economic crisis since the Great Depression of 1929. All industrial nations seem likely to fall into recession in the first half of 2020, with long-lasting and painful consequences for their social fabric.

In March alone, Spain lost over 800,000 jobs, with unemployment expected to soon approach 18 percent. Italy, too, will likely face unemployment well above 10 percent. In France, after four weeks of lockdown, a quarter of all private sector workers are on reduced hours, with half of the economy at a standstill. The crisis threatens to hit Central and Eastern Europe just as hard.

Strengthening the Economy

Cushioning the economic crisis and the resulting social damage will thus be another crucially important responsibility of the German EU presidency that starts in July. This will initially mean rolling back restrictions on the internal market and ensuring that crisis-driven health policy does not undermine the EU. Some governments will take a greater role in industrial policy, seeking to guarantee essential food supplies and critical infrastructure. This could mean a new wave of nationalizations, as well as a more flexible interpretation of EU subsidy rules.

Despite facing the greatest economic crisis in the history of European integration, the EU needs to develop common approaches and principles in order to minimize national protectionism and reestablish European competition principles once the virus dies down. At the same time, it will be all the more important for a united EU to pursue its own global interests, with member states acting together as a common currency area, as well as on trade policy and investment regulation.

The German presidency must also address the question of additional financial cushioning. Short term liquidity has been made available through the European Central Bank and €500 billion in new financial instruments at the disposal of the European Commission, the European Investment Bank and the European Stability Mechanism. Nonetheless, fresh money will probably need to be put on the table to prevent a resurgence of tensions between northern and southern European states. Negotiations on the EU’s next “multiannual financial framework”—due to be finalized under the German presidency—may see a revisiting of more expensive policies, triggered by the COVID-19 crisis. Any revision to the EU budget would likely prioritize investment in research, technological competitiveness, and health protection, as well as measures against climate change.

Finally, the German presidency will also look to use greater international cooperation to alleviate the negative impacts of national austerity. Defense policy will be one such key area. Uncoordinated budget cuts could weaken the pooling of national defense capacities, as they did in the aftermath of the 2008 financial crisis. For this reason, Berlin will likely encourage its NATO partners and the EU to focus on defense capability, the arms industry, and their general technological competitiveness in light of the pandemic.

Social Resilience

In spite of the financial efforts undertaken by the EU, it is quite possible that the virus’s economic and social effects will promote political instability and undermine social resilience. That will intensify Europe’s vulnerability to hybrid threats. The post-2008 era saw populists, many opposed to the EU and to globalization, take their place in parliaments and even in governments. The Hungarian prime minister Viktor Orbán has used the coronavirus as a pretext to strengthen his autocratic power. Like Hungary, Poland is the subject of an EU investigation, triggered by its judicial reforms. Former Italian prime minister Enrico Letta has warned that his country could become the “Hungary of the eurozone” if Europe fails to offer adequate assistance. Even before the crisis, popular support for the EU in Italy was on the decline. In Spain, the position of Pedro Sánchez’s minority government could be significantly weakened.

At a time of increasing political polarization, weakened social resilience and  burgeoning foreign influence, basic democratic principles and the rule of law must be more actively protected across Europe. Along with existing European procedures against member states, the EU budget will be a key instrument: spending should be dependent on states upholding human rights and democratic principles, in addition to the rules of the internal market. At the same time, we must keep close tabs on how technology is used to monitor the virus, ensuring it complies with basic European rights. The definition of common criteria for ending the state of emergency will be another concern.

Europe’s vulnerabilities will need particular attention if the European economy collapses while China enjoys a comparatively rapid recovery. In a bid to boost its foreign influence, China could make liquidity available to selected European companies, banks, and governments, buying up strategic elements of European supply chains, including in Germany. The question of how much protection the EU and national governments should offer domestic companies will thus be highly political.

The coronavirus has made Europe’s international context even harder to assess. Under Donald Trump, the United States continues to undermine the structures of the international order, for example by the president’s recent decision to stop US funding for the World Health Organization. Meanwhile, reaction to the crisis has sharply highlighted the systemic conflict between China and the West. Its ongoing power struggle with China is taking the United States further down the path of isolationism. But Europe must also think about its own future supply chains, deciding which elements should be based on its own territory, particularly in pharmaceuticals and other systemically vital sectors.

No Way Around Conflict

As the international system continues to gradually unravel, the pandemic has shown the importance of close cooperation on health policy. When Germany takes over the EU presidency on July 1, it faces the acutely important task of driving short-term crisis management in the EU and among its member states. But it must also continue to develop European and international instruments able to cope with the challenges confronting us. The aim should be for Europe to emerge strengthened from the crisis. To achieve this will inevitably mean conflict, both within the EU and in its relations with other countries.

For this reason, Berlin cannot limit itself to the role of honest broker, the typical approach of the country holding the EU presidency. Germany, France, other members states, and the presidents of the various EU institutions must all energetically promote European interests and the core principles of the Union. Only in this way will it be possible to lead the EU through these complex and testing times.

The post Testing Times appeared first on Berlin Policy Journal - Blog.

© REUTERS/Kai Pfaffenbach

Given the economic environment and prevailing uncertainty, there is a growing debate in Europe and in Germany about fiscal rules, or more precisely: the insistence on balanced budgets and avoiding debt.

Given the economic environment and prevailing uncertainty, there is a growing debate in Europe and in Germany about fiscal rules, or more precisely: the insistence on balanced budgets and avoiding debt.

The European Fiscal Board, an independent advisory board of the Commission, for example, has made a number of recommendations to European finance ministers for reforming the Stability and Growth Pact and promoting investment. However, these recommendations have fallen on deaf ears, mostly because Germany both in Europe and at home refuses to have this sensitive discussion, and because many prefer the constructive ambiguity of the current framework. There is therefore a strange alliance of all parties who either support or disagree with the rules in principle, but who both coalesce as a matter of fact on their “flexible” application because they share the fear that reform could make things worse.

But this ambiguously constructive compromise is at odds with the legal and political weight that these rules have carried in Germany since the 2009 constitutional reform that elevated the Schuldenbremse (“debt brake”) into the German constitution. And it deters policymakers from considering ways to amend the rules in order to make them more suited to the challenges of our times.

Four Objectives

Indeed, a modern and effective fiscal rule should achieve, at the very least, the four following objectives:

First, while it should foster the stability and sustainability of public finances, it should allow sufficient stabilization during downturns and recognize that this may require discretionary expansion over and above the simple use of automatic stabilization.

Second, it should be robust enough to meet the investment needs that are required to achieve energy and climate transition. Indeed, fiscal sustainability cannot take precedence over environmental sustainability. There is not much sense in having low debt for the future if there is no future on the planet to start with.

Third, in a federal (or quasi-federal) system, it should allow for sufficient allocation and transfers between different parts of the federation so as to ensure its economic and political integration.

Fourth, it should be transparent and democratic so as to guarantee appropriate parliamentary checks and balances on the fiscal policy of the government, both at the federal and state level. In other words, in the case of Germany, the budgetary rights of the Bundestag constitute an eternal clause in the constitution and therefore take precedence over abiding by the fiscal rules.

The reality is that Germany’s Schuldenbremse performs very poorly against these four sensible objectives. Limiting the maximum structural deficit to no more than 0.35 percent of GDP only works in a world of great moderation where economic cycles are small and automatic stabilizers are sufficient to counteract a slowing economy. In the real world, where trade and currency wars, financial crises, and technological disruptions can create large swings in economic activity, a more active fiscal policy is required.

In today’s world, where Germany needs to prepare for a profound transition of its economic model, these rules are potentially preventing the country from undertaking the appropriate fiscal and economic policy.

Climate Protection

The Schuldenbremse also treats all fiscal expenditure the same and as such is blind to public investment needs in general and in particular to the immense investments required to achieve the necessary energy transition. For example, the cost of moving away from coal alone is estimated to be in the range of €40 billion by 2038. But when the German government put together its “climate package” in September, it showed no sign of reconsidering either its political commitment to a balanced budget or the debt rule.

It is shocking that politicians would choose the appearance of fiscal sustainability over the very possibility of sustainable life on earth. At a minimum, fiscal policy should introduce a golden rule to protect public sector investments and, even more importantly, a green rule to ensure that climate mitigation and energy transition policies never get abandoned for an elusive debt reduction objective.

What is more, it is striking that in Germany fiscal rules are not only applicable to the federal government in Berlin, but also to the 16 federal states (the laender). Indeed, the Schuldenbremse was as much a reform of German federalism―with the explicit objective of centralizing more economic and political powers in the hands of the federal government―as it was a fiscal rule. One motivation for the centralization was to reduce the transfers from the federal government to the states. But more fundamentally, centralization was an effort to reduce the tensions between “rich” and “poor” states regarding transfers. The illusion persist that each state could stand on its own feet provided it kept its house in order.

This illusion ignores the fundamental workings of economic agglomeration: without transfers economic regions will diverge, provoking political disruption. Indeed, the very foundation of Germany’s unity is the solidarity between its more dynamic and less advanced regions. A federation that attempts to operate in violation of this fundamental solidarity principle is doomed to fail. This is the central reason why the Schuldenbremse in its current form will have to go.

In fact, lawmakers have already started discretely rewriting the Schuldenbremse, for example with the Constitutional reform of 2017 which (i) basically renewed the Laenderfinanzausgleich by allowing transfers (potentially permanent) to Saarland, Bremen, and Berlin implicitly acknowledging that they won’t be capable of meeting the balanced balance budget rule in 2020 and thereafter; (ii) extending the outsourcing of autobahn and other infrastructure (from 2020 onward the domain of the government in Berlin) to public-private partnerships so as to optically limit the debt of the federal government and the laender. Another example of such a work-around would be Economy Minister Peter Altmaier’s proposal to set up a Citizens’ Climate Foundation to finance green initiative without breaking federal debt rules. Each of these amount to stealthily undermining the “debt break” rules rather than opening a debate about its reform.

Time for an Honest Debate

This is not the economic and political debate that the German and indeed the European public deserves. The current approach of preaching the status quo and reforming by stealth risks obfuscating much-needed changes in economic policy and obscuring an essential aspect of it from oversight by the Bundestag. This is endangering both Germany’s prosperity and democracy.

Living the “debt brake” lie is also holding back a critical debate about fiscal rules and governance in the eurozone. Indeed, so long as a proper discussion about fiscal federalism in Germany is lacking, we are unlikely to have an informed debate about fiscal union in Europe. If Germany cannot accept the principles of stabilization and transfers inside its own federation, it won’t accept them in the European monetary union. For Europe to go forward, this has to change.

The post Living a Lie appeared first on Berlin Policy Journal - Blog.

© REUTERS/Toby Melville

As Europe was preparing to introduce the euro in the 1990s, the American Nobel Prize winner for Economics, Milton Friedman, wrote a short essay in which he addressed the plans for a common currency. A common currency would not unite the continent as Europeans hoped, but rather divide it—for it would all of a sudden make processes of economic adjustment that “would have been easy to handle by changing exchange rates” difficult to manage.

In retrospect, it’s safe to say Friedman was right. The common currency was supposed to bring economic stability to the continent; it did the opposite. In the first ten years after its introduction, the euro brought an unhealthy boom to the south and a long-lasting slump to the north—above all to Germany. These tensions eventually exploded into a great crisis that nearly broke up the currency union. So it’s no surprise that there are warnings galore about the next crisis in Europe, even if the continent is not so badly positioned, in economic terms, as many make out.

The main problem of the European and every other currency union is that membership is an economic straightjacket. It limits the options available to a nation because the national currency can no longer be devalued in order to rebalance the economy. This is particularly difficult when economic imbalances emerge between the member states—when, for example, wages in one country increase too quickly compared to those in the others, making industry in the country no longer competitive.

The necessary corrections must then come in the form of wage reductions, which carry much greater political and social costs than a currency devaluation. On top of that, a member state in a currency union no longer has at its disposal a central bank that can, in a crisis, act as a creditor of last resort for the public sector. Therefore, economic difficulties, when paired with a capital flight of private investors, can quickly endanger the supply of liquidity. That’s exactly what happened during the eurocrisis and contributed significantly to its escalation.

Rules Are Not Enough

This structural shortcoming cannot be redressed by a national policy of reform, no matter how ambitious. It must therefore be offset on the supranational level, through instruments that reduce the costs of adjustment. That has happened, at least partially. First and foremost, there is the European Stability Mechanism (ESM) established in 2012. It offers, in exchange for reforms, emergency loans to countries in danger of losing their access to capital markets. That all seems very technical at first glance, but the ESM has in fact changed a central point of the eurozone architecture. The Treaty of Maastricht—the founding document of the common currency—conceived of the currency union as a system of rules: whoever didn’t follow them would have to live with the consequences, which in turn was meant to have a disciplinary effect on political decision-makers, so that they wouldn’t get into a situation where they needed to apply for outside help in the first place.

The founding of the ESM—and the Germans who filed a suit against it at the country’s highest court correctly recognized this—is an admission that trust in the power of rules as an organizing principle for the monetary integration of countries that are sovereign yet economically closely aligned is not enough. The European Central Bank (ECB) has also in essence followed this logic with its crisis policies. By buying bonds, the central bank can react to financial distortions in individual member states, stabilizing these countries. From the perspective of the affected countries, it is carrying out to some extent the function of the national central banks they lost with the introduction of the euro.

In comparison with other federal entities, the member state-centric structures of the eurozone certainly do no more than meet the minimum requirements. When there’s a crisis in the United States, for example, centralized unemployment insurance ensures that money effectively flows from less-affected to more-affected regions. Germany even possesses an instrument (the Länderfinanzausgleich) for aligning standards of living independently of cyclical fluctuations. The currency union won’t have anything like this in the foreseeable future because there is simply no political majority for the necessary transfer of sovereignty to the supranational level. And without such a centralization of political decision-making power, financially solid countries won’t agree to American- or German-style transfer mechanisms, because they fear they will have to pay for the economic policy missteps of other countries.

Reducing the Danger

But maybe the issue can be scaled down. At the moment, EU member states are discussing the introduction of a Europe-wide unemployment reinsurance and the expansion of the ESM into a European Monetary Fund with additional credit lines. An embyronic common budget for eurozone member states has already been agreed, despite resistance from northern European countries. Such reforms make the currency union less susceptible to crises—and they come with significantly lower legitimacy preconditions than would more extensive federalization on the US model. This also applies to the planned completion of the banking union, a step by which an important financial contagion channel would be closed. Countries like Ireland, for example, get into difficulties because the collapse of large national banks drags the whole economy into the abyss. A collaborative clean-up of the credit institutes—and having bank creditors bear a greater share of the associated costs—reduces this danger.

In this context, it should not go unmentioned that the eurozone doesn’t need to shy away from comparisons with the other big currency zones. The budget deficit in the eurozone amounted to one percent of GDP last year; in Japan it was 3.7 percent; in the US four percent. Public debt in the eurozone amounts to 86 percent of GDP; in the US it is 105 percent; and in Japan it is a whopping 229 percent. Nowadays the unemployment rate is sinking even in the countries of southern Europe, while in the north some regions enjoy almost full employment. And the economic differences between the prosperous regions in America’s coastal cities and the left-behind regions in the Midwest may well be—at least if socio-economic indicators like access to healthcare are included—bigger than those between Portugal and Germany.

Politics, Not Economics

The problem with the debate about crises in the currency union is that it generally operates with binary solutions. The assumption is that the eurozone can only survive if it is either built into a sort of European super-state, or if competences are comprehensively transferred back to the member states. In fact, it is entirely possible that it has a future as a hybrid entity that unifies governmental and regulatory elements, provided it finds the right balance between these two methods of political management. In any case, the US example shows that having the characteristics of a national state does not protect against economic irrationality.

Of course, that doesn’t mean that in Europe everything is in great shape. In countries such as Italy or Greece, the high level of public debt limits the fiscal room for maneuver, which is why the money for urgently needed investments isn’t there. There are still too many bad loans on the books of many southern European banks. If the ECB ends its ultra-loose monetary policy—as it will do sooner or later—then exactly these heavily indebted countries will suffer. And the budget plans of the populist Italian government, which went against European budget regulations, show how fragile the economy recovery is. For now, Rome seems to be backing down. But the recent worries are a salutary reminder of how an escalation of the crisis in Italy would affect the entire eurozone. Given the size and economic importance of the country, such a crisis could not be overcome with the existing instruments.

If the confrontation over Italy’s budget teaches us one thing, it is this: Europe’s real problem is not the economy but politics. After all, it’s not impossible to cut down excessive public debt if, as is the case in Italy, the population possesses considerable private wealth. Nor is it impossible to reconcile national priority-setting with European requirements as long as both sides are prepared to compromise.

You could also say it this way: there is no reason why the next great crisis has to originate in Europe. Unless it is willfully brought about.

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