Thursday, 21 July 2016

How to prevent Brexit from damaging the EU

The UK has a new government under the leadership of Theresa May. The mandate of the new government, as the new prime minister stated, is to "make a success of Brexit". Although the detail of what success here means is unclear, there can be no doubt about what it means in general. It should be interpreted as keeping access to the EU single market while gaining concessions from the EU about the rights of the United Kingdom to control immigration. In other words: trying to square the circle. Something the Brexit campaigners have led millions of British citizens to believe can be done easily.
What negotiation strategy should the European Union take? Here is the choice that must be presented to the UK. Either the UK government takes over the Norwegian model or it stands alone and negotiates new trade agreements with the EU and about fifty other countries (or group of countries) in the framework of the rules of the World Trade Organization (WTO). The EU must make it clear that there is nothing between these two choices. There can be no "special deal" with the United Kingdom.
If the UK accepts the Norwegian model, it retains full access to the single market. In that case there are no obstacles for British goods and services in the EU and for EU goods and services in the UK. But the price the UK pays in this model is the free movement of EU citizens in and out of the UK. Without the free movement of people there can be no free movement of services. This is the core of the single market. Moreover, the Brits will have to accept two other things in the Norwegian model.  First, they will have to abide by the rules on standards, health and safety that are decided in Brussels without being involved in the decision making process. Secondly, they will have to contribute to the European budget.
It is very unlikely that the UK government will accept this model. The Brexit camp considers free migration and Brussels legislation as diabolic and will revolt if the UK government accepts these conditions. True there is an important faction in the new government that is attached to maintaining full access to the single market and sees few problems in accepting free movement of people and Brussels regulation. But this faction is probably too weak to counter the demands of  Brexit supporters.
I assume, therefore, that the British government will reject the Norwegian model and will try to obtain concessions from the EU that reduce migration flows, while ensuring access to the single market. Here, the EU must make it clear that a special deal with the UK is excluded. The EU must insist that the only other option for the UK is to stand on its own feet, and to start negotiating new trade deals with the EU and other countries after Brexit is completed. In other words, the UK must be treated like the US, China, Brazil, etc., i.e. as sovereign nations that insist on maintaining full sovereignty over their trade agreements. The trade negotiations between the UK and the rest will take years, if not decades. Their outcome is uncertain. It is not clear, for example whether the UK will be able to maintain free movement of services with the EU as this freedom is intimately linked to the free movement of people. But that is a problem for the Brits who have chosen to embrace full sovereignty.
Here are the reasons why the EU should not accept to be dragged down in negotiating a special deal with the UK. Some EU-countries are tempted today to also organize referenda. I have no problem in principle against such referenda. If citizens of a country dislike being member of a club, they should be able to leave. This will be better for all. There is no point in living together with people who intensely dislike each other. However, it is in the interest of both parties that the terms of the divorce should be made clear in advance.
That is why the EU should make it clear what potential exiters should expect. It will be either the Norwegian model or a “standalone-model” in which the newly sovereign nations will face the difficult task of establishing new trade agreements on their own. Clarity is essential for those who consider leaving the EU. This clarity can only be achieved by excluding a privileged trade agreement with the United Kingdom.

When the UK joined the EU in 1973 its main strategy was to prevent the union from becoming too strong. The UK political elite decided that this could best be achieved from inside the union. Now that the UK is departing the century old British strategy remains the same, i.e. to weaken the forces that can make Europe stronger. The UK can achieve this by insisting on a special deal between the UK and the EU whereby the UK maintains the benefits of the union while not sharing in the costs. Such a deal, if it comes about, will signal to other member countries that by exiting they can continue to enjoy the benefits of the union without the costs. Such a prospect would fatally weaken the European Union.

Friday, 1 July 2016

The EU should take the side of the losers of globalization

How should the European Union react to the decision of the British people to withdraw from the union? This is the question that is at the center of the political debate in Europe.
The starting point in trying to answer this question is the observation that the European Union has a very negative image today, not only in the UK but also in other parts of the EU, leading to dissatisfaction about the European project. I will argue that this dissatisfaction has to do with the inability of the European Union to set up a mechanism that protects the losers of globalization. Worse, the EU has reduced the capacity of national governments to take on the role of protector, while little has been done to create such a mechanism at the EU-level.
Free trade creates an incredible dynamic of innovation and material prosperity. That prosperity, however, does not benefit everyone. Many are better off thanks to globalization. But many others are not. Some even see their welfare decline because they lose their jobs or because their incomes fall.
As globalization creates material welfare in the countries that participate in it, it is in principle possible to compensate the losers from globalization. That is the argument that most economists find strong enough to defend globalization. But the political obstacles against organizing redistribution towards the losers of globalization are large. This is a problem in most industrialized countries, but it is made even more intense in the EU.
The European institutions have become major promoters of globalization. The single market and the trade agreements reached by the European Commission have widely opened up the European gates to globalization. There is nothing wrong with that per se. Except that there is a complete failure to organize the necessary compensation towards the losers of the globalization. The European institutions have no power over social policy, which has been kept in the hands of the national authorities. However, the hands of these authorities have been shackled by the same European institutions’ fiscal rules.
The European fiscal rules not only make it extremely difficult to compensate the losers from globalization. What is worse, they have amplified the hardship of the losers from globalization. Since at least five years the European Commission has pushed all member-countries of the Eurozone into an austerity straightjacket that has produced economic stagnation and rising unemployment mainly of those who had already been hit badly by globalization. It will be no surprise that many turn their backs towards the European institutions that are seen as cold and ready to punish when millions live in hardship.
Not only the fiscal rules but also the structural reforms that have been imposed by the same European institutions are to blame for the rejection of the European Union by millions of people.  European policy makers have adopted the neo-liberal discourse. According to this discourse, workers must be flexible (read: they should be happy when their wages fall, when they can be dismissed quickly and when they receive less unemployment benefits). The neo-liberal policymakers that now dominate the European Union preach that social security is unproductive and should be downsized. These policies are euphemistically called structural reforms. They are imposed on millions of people, mostly the losers of globalization, by European institutions and national governments alike.
The problem of the European Union today is that, instead of helping those who suffer from globalization, it has set up policies that hurt these people even more. It is no surprise that the losers revolt. If the EU continues with austerity and structural reforms, revolt will spread and will take the form of attempts to exit the Union. It is time the European Union takes the side of the losers of globalization instead of pushing for policies that mainly benefit the winners.
This can be done in two ways. The first one is to stop imposing structural reforms on the member-states. The rationale for these structural reforms has been that they promote economic growth and therefore should benefit everybody. The empirical evidence of a positive link between structural reforms and economic growth, however, is very weak. Recent econometric analysis of the OECD countries fails to find evidence that reforms in the labour markets and in the product markets boost economic growth (De Grauwe and Ji(2016), IMF(2015)). These studies, however, find that investment, both private and public, has a strong positive effect on economic growth.
The latter result points the way to the second change in economic policies that the European policymakers should initiate. This should consist in boosting public investment. The latter have suffered severe collateral damage from the ill-conceived austerity programs imposed by the European institutions.
A boost in public investment can only be achieved by changing the fiscal compact that imposes structural budget balance in the member-states of the Eurozone. This compact has the unfortunate implication that public investment can only be financed by current revenues. A more destructive rule for economic growth has rarely been imposed.  When politicians are told that the cost of public investment should be fully borne by present taxpayers (voters) while the benefits will accrue to future taxpayers (voters) it will not surprise that the political incentives to engage in public investment will be weak. This is what happens today. Thanks to an ill-conceived rule, public investment in the Eurozone is at a historic low level.
It is often said that allowing public debt to increase will saddle our children with an unbearable debt burden. This criticism confuses gross and net debt. When productive public investments are undertaken by issuing government bonds, our children will inherit both productive assets and government bonds. Today the cost of issuing government bonds is close to zero in many Eurozone countries. If governments manage to invest in productive assets that have a return higher than zero, our children will inherit assets that create revenues exceeding the cost of borrowing. As a result, their net debt burden will have declined. They will not understand why we have not increased public investment when borrowing was so cheap.
I am a proponent of more political integration in Europe. But today grand schemes for “more Europe” should be put on the back burner. Instead European politicians should change their economic policies and, in so doing, show in the facts that the European Union can produce welfare, also for the losers of globalization.  
De Grauwe, P. and Ji, Y., (2016), Crisis Management and Economic Growth in the Eurozone, Chapter 2, in Francesco Caselli, (ed), Prospects for Growth in the European Union, Oxford University Press.

IMF World Economic Outlook, (2015), Ch. 3, Box 3.5 on The Effects of Structural Reforms on Total Factor Productivity, 104–7.

Monday, 22 February 2016

Why the European Union will benefit from Brexit

The discussions about Brexit have centered around the question of whether it is in the national interest of the United Kingdom to remain in the EU or to leave it. It appears today that the British public is split about this question, so that the outcome of the referendum remains highly uncertain.
The question of whether it is in the interest of the EU that the UK remains a member of the union has been discussed much less intensely. The conventional wisdom in Brussels is that the answer to that question is positive.  The UK should remain a member of the EU. A Brexit would be very harmful for the future of the European Union. But is that so?
There is a deep-seated hostility of the British media and large parts of the political elite against the European Union. This hostility has found its political expression in the Brexit movement. The proponents of Brexit cannot accept that the UK has lost sovereignty in many areas in which the EU has competences. They abhor the fact that Britain has to accept decisions taken in Brussels, even if it has opposed these. For the Brexit-camp there is only one ultimate objective: to return full sovereignty to Westminster.
Those who believe that a referendum will finally settle the issue have it wrong. Let us suppose that the Brexit-camp is defeated and the UK remains in the EU. That will not stop the hostility of those who have lost the referendum. It will not reduce their ambition to bring back full sovereignty to the United Kingdom.
Having found out that they cannot leave the EU, the Brexit-camp  will shift its strategy to achieve the objective of returning power to Westminster.  It will be a Trojan horse strategy. This will imply working from within to undermine the union. It will be a strategy aiming at shrinking the area of decision making with majority rule and replacing it with an intergovernmental approach.  The purpose of the British enemies of the EU will be a slow deconstruction of the union so as to achieve the objective of returning power to Westminster.
One may argue that having lost the referendum, the Brexit-camp will lose influence. That is far from certain. The agreement achieved by Cameron with the rest of the EU has not transferred a shred of sovereignty back to Westminster. This will be seen by the Brexit-camp as a huge failure, leading them to intensify their deconstruction strategy.
I  conclude that it is not in the interest of the EU to keep a country in the union that will continue to be hostile to “l’acquis communautaire” and that will follow a strategy to further undermine it.
I therefore also conclude that it will be better for the European Union that the Brexit-camp wins the referendum. When Britain is kept out of the EU it will no longer be able to undermine the EU’s cohesion. The EU will come out stronger.

Britain will be weakened and will have to knock at the door of the EU to start negotiating a trade agreement. In the process it will have lost its bargaining chips. The EU will be able to impose a trade deal that will not be much different from what the UK has today as a member of the EU. At the same time it will have reduced the power of a country whose ambition it is to undermine the cohesion of the union. 

Wednesday, 2 December 2015

QE and public investment

Since the start of this year the ECB has been applying “quantitative easing” (QE), i.e. a program injecting large amounts of money in the economy. Every month the ECB is buying 60 billion euros of government bonds and in so doing injects the same amount of money in the economy. Up to today the total amount of liquidity injection approaches 700 billion euros.
There can be little doubt that this massive injection of liquidity by the ECB has had a positive effect on exports. It led to a depreciation of the euro vis-à-vis the major currencies (dollar, pound sterling) and boosted competitiveness of Eurozone exporters to the rest of the world.
However, it becomes increasingly clear that QE alone is insufficient to pull the Eurozone economies out of their lethargic growth. In fact, in the second quarter of this year, growth slowed down again. There is a fear that in the next few years economic growth will remain subdued. An expanded version of QE will not solve this problem.
All this should not come as a surprise. Economists have been warning for a long time that when interest rates are close to zero, quantitative easing alone will not be able to stimulate the economy. The reason is that when the interest rates are close to zero the liquidity that the central bank is creating does not easily filter into the real economy. Most of it is hoarded because the opportunities to find attractive rates of return are limited. Many financial institutions then prefer to accumulate the extra liquidity created by the ECB without doing anything productively with it. This is the well-known liquidity trap.
Thus while QE was and is necessary, it is insufficient. It has to be seconded by fiscal policies. Here is the real problem in the Eurozone. Fiscal policies are not helpful. First, too many countries continue to be kept into the austerity straightjacket. Second, and most importantly, public investment continues to decline. But it is public investment that is key to the recovery in the Eurozone.
There are two reasons why public investment is central for promoting economic growth. First, the private sector is still very risk averse and fails to invest enough. This has to do with the lack of confidence in the future. The way to deal with this is for the public authorities to show the way and to kick-start public investments. This will increase economic growth and create more confidence in the future which will stimulate private investment.
Second, public investment is needed to achieve long-term objectives of a green economy. The latter requires investment in alternative energy sources and in public transportation.
Unfortunately, public investment is discouraged by a stupid rule that the members of the Eurozone have imposed on themselves, i.e. that public investment cannot be financed by bond issue. It has to be financed by current tax revenues. This prevents public investment from taking off, from sustaining the recovery and from developing a green economy. 
It is often argued that public authorities should not increase their debt; on the contrary that they should reduce it. Some countries of the Eurozone periphery undoubtedly have limited capacities to add to public debt. But other countries, like Germany, France, Belgium and the Netherlands surely can. The governments of these countries today can borrow at very long maturities almost for free. There are certainly many investment projects that have a rate of return of more than 0%.
A government that issues bonds at close to 0% and channels the money into projects that will have rates of return by far exceeding 0% promotes economic growth and makes the future repayment of the debt easier.
Put differently, what matters in not gross debt, but net debt of governments. Debt issue that makes it possible to invest in assets with a much higher rate of return than the cost of borrowing (now close to 0%) will reduce net debt in the future. Unfortunately, Eurozone countries continue to be mesmerized by gross debt numbers and as a result fail to do the obvious.
It is often said that governments today should not issue more debt because this will place a burden on our grandchildren. The truth is that our grandchildren will ask us why we did not invest in alternative energy and public transportation, and thereby made their lives miserable, when we faced historically favorable financial conditions to do so. 

Monday, 23 November 2015

The Euro and Schengen. Common flaws and common solutions

What do the Euro and Schengen have in common? Both are projects that have the same flaw: they're unfinished business. And therefore they risk falling apart. 
The Eurozone is a monetary union, with one currency, the euro circulating in the Union and managed by one central bank, the European Central Bank. What’s wrong with that? One may ask.
The fundamental problem of the Eurozone is that national governments have their own budgets and issue their own debt. When recession strikes, the system gets into trouble. During a recession government budget deficits automatically increase. Countries that are hit hardest by the recession show larger budget deficits and debt increases. Financial markets that are fully integrated in a monetary union are lurking, ready to strike when observing signs of weakness. Countries hit hardest by the recession experience “sudden stop”: investors massively sell the government bonds, raising the interest rates and pushing these countries into illiquidity. The other countries in the system profit from this, as investors in search of a safe haven buy these countries’ government bonds. Thus during recessions, free capital movements destabilize the Eurozone and plunge the weaker countries into a “bad equilibrium” of ever deeper recession and rising unemployment.
What about Schengen? As the Eurozone, it is an unfinished project. The residents of the Schengen Area move freely within the area. The problem is that the architects of that area forgot to integrate the police and the intelligence services. Moreover, they forgot to transfer the authority to control the external borders to one European body.
As a result a problem arises in the Schengen Area that is similar to what happens in the Eurozone. Criminal gangs move freely within the area. They commit burglaries in one country and flee to another one. In contrast police forces have to stop at borders. Terrorists are planning from Brussels how to attack Paris and escape from the radar of the national police forces and intelligence services. National police forces and intelligence services are not integrated and can no longer guarantee the security of their citizens.
The danger of unions that are unfinished is that they will disintegrate. Without a fiscal union free capital movements will create great instability when the next recession strikes the Eurozone. In the long run, governments that can no longer guarantee a minimum of economic stability to their citizens will be tempted to leave the Eurozone.
In the absence of integrated police and intelligence services, nation states in the Schengen zone can no longer take care of the safety of their citizens. They will be tempted to opt out of the zone. In fact this is already happening today.
The choice we have today is simple. If we want to keep the Euro we will have to create a fiscal union. This implies that a significant proportion of national budgets and national government debts will have to be centralized. A formidable transfer of sovereignty from the nation states to European institutions. If we want to preserve the Schengen area, we will have to integrate police forces and intelligence services while creating a joint control at the external borders. Failure to integrate further dooms both projects, the Eurozone and the Schengen area.

The Eurozone and the Schengen area have fundamentally weakened national governments while nothing has been put into place at the European level to offset this loss of power of nation states. The euro and Schengen can only be saved if we create European institutions that can do what national governments no longer can do, i.e. to ensure economic stability and security for the citizens of Europe.