Europe’s shape-changing crisis changes again

Introduction

One of the features of the European Crisis over the last 3-4 years has been its ability to defy simple analysis and one-dimensional solutions. Every time the political leadership of Europe has sought to contain the crisis, it has broken out in a new area.  Like toothpaste in a tube, no sooner is it squashed into one corner of the politico-economic landscape than it crops up afresh in a wholly different one.  Commentators as well – and we have not escaped this – have found it hard to identify exactly what the root of the crisis is;  in our various essays of the last few years on the subject, our considerations have ranged from the construction of the common currency to banking crises to sovereign indebtedness to the role of the state, and yet the crisis still defies both a simple description and a comprehensive solution.

This process shows no sign of exhaustion and events of the last month or so have added a new twist to the tale. And like most chapters in the saga, the latest mutation of this shape-changing crisis adds a new level of complexity and danger.  And once again, existential questions are being asked about whether EMU, and indeed the European Union itself, is strong enough to overcome them.

The nature of the European Crisis

Europe’s Crisis is now approaching 4 years old. Initially it was a banking sector crisis, as the Irish banking system found itself over-extended in the aftermath of the Global Financial Crisis. It became a fiscal or sovereign debt crisis as Greece admitted that its fiscal position was dire and beyond its own resources to handle.  This caused doubts to rise about the sustainability of the finances of some other peripheral member states, and led to a market crisis as the markets withdrew liquidity and support from stressed sovereigns and confidence in the wider EU banking system started to evaporate.

By the end of 2011 it had become a full-blown political crisis as questions were repeatedly raised about the ability of Europe’s political class to solve the challenges that the Eurozone faced.  The governance of the EU was shown to be too weak, too slow and too out of touch with the electorate to address the Union’s problems.  Democracy itself was brought into question:  the crisis had caused the suspension of democratic leaderships in two states and was the leading issue in domestic elections in others.  Only the ECB was seemingly able to act with decisiveness, and even then, there remained unease and doubts as to both the wisdom and indeed the legitimacy of some of its actions.

By June of last year, therefore, Europe’s Crisis had changed its form several times, had defied the best efforts of the political class to pin it down and resolve it, and had engulfed its banks, its economic and monetary union, its governments, its politics and its citizens.

It is against this backdrop that the developments of the second half of last year should be seen. To many people’s surprise, and the EU leadership’s obvious relief, Greece stopped just short of the cliff-edge and elected a government that was committed to working with its EU partners.  Then the EU’s June 2012 Summit was unreservedly positive:  President van Rompuy’s report to the Summit, setting out the four necessary building blocks of a stronger and more durable economic and monetary union, was well received and approved, and showed for the first time that Europe’s leaders not only understood what was at stake but were prepared to discuss the issues in public.

The good news kept coming. The ECB followed this diplomatic activity with a “statement of intent” when Draghi promised to “do whatever it takes” to support the euro (and, he added, “believe me, it will be enough”). Now this language had been heard before: Merkel and Sarkozy used this formula repeatedly. But Draghi followed this with the Plan for Outright Market Transactions (OMT), which was both comprehensive and credible, and calmed markets significantly.  The German Constitutional Court gave its (qualified) approval to the European Stability Mechanism (ESM), and then in September the Dutch election returned two pro-EU centrist parties as the main winners.

In short, the tide seemed to have turned. For the first time in 3 years, news consistently surprised on the upside, and markets responded by repricing peripheral states’ bonds and easing concerns over liquidity and credit.  Suddenly, the political class seemed to be driving events rather than being driven by them, creating the solutions (such as a banking union) rather than reacting to the problems.

Indeed, it was possible to build a narrative that explained not just the new dynamism but also the previous hesitancy. There have always been, the analysis went, two corner-solutions to the euro’s crisis:  fiscal union to accompany the economic and monetary union, or economic and monetary state sovereignty to accompany the states’ fiscal sovereignty.  Much of the period to June 2012 was spent trying to find a solution – any solution – which avoided the latter (ie break‑up) without demanding the former (ie a federal structure in which state autonomy is considerably reduced).  The true measure of the sea-change in the middle of last year is then seen as the growing acceptance – reluctantly perhaps – that although a closer federation is nobody’s first choice, it may turn out to be the least unpalatable of the options Europe faces.

Not that this means the solution is easy to implement. But with the acceptance of the van Rompuy report and the agreement on the basic building blocks of a stronger economic and monetary union, Europe seemed to have made the decisive change from wondering what to do, to wondering how to do it.

Enter the Commission

Van Rompuy’s blueprint for a stronger union is in 4 parts. It requires, he says

(i) An integrated financial market (the “Banking Union”)
(ii) An integrated budgetary framework
(iii) An integrated economic policy framework
(iv) Enhanced democratic legitimacy and accountability

This is a significant programme of work; in effect, as we explained in our previous essay “For Want of a Nail”, it is close to the construction of a federal state. For a normal state, the expectation would be that only a strong political leadership could both plan and then carry through such a project.

But the EU is not a normal state. There is no strong central political leadership, something that over the last 3-4 years has been seen again and again and that is usually considered to be a key weakness of the Union.  Paradoxically, though, this great weakness of the EU is often its greatest strength, and at the start of 2013 it seemed just possible that this old truism would once again come to the fore, and that 2013 could turn out to be a year of dramatic progress.  To understand this, we must examine how modern democratic states work.

In most systems of democratic government there are three parties: the Executive, the Legislature or Parliament, and the Permanent Civil Service.  Typically the Executive proposes, the Legislature approves and the Civil Service merely has the task of implementation.  However, the EU has a weak and divided Executive (the 27 heads of government acting collectively) and a weak Parliament (by design), and as a result power in the EU resides to an unusual extent with the Civil Service – the European Commission.  The Commission is much more powerful than most civil services.  Indeed, the EU is unique among major democracies in that civil servants can propose and initiate legislation as well as implement it. Democratically, this is not ideal.  But administratively, it can be very effective – once the Commission is authorised to act, it usually gets the job done.

And so Europe began the task of building its solution.  Not a federal state – for which there is no democratic mandate, in any of the 27 member states – but what some commentators have called a “shadow state”, a system of ever closer union between the member states, mimicking in many ways the elements of a more federal state but driven by and created by intergovernmental agreement rather than formal treaty.

It seemed in fact as if Europe had found a uniquely creative way of solving the dilemma of an irresistible force (the necessity of the move to a closer union) meeting an immovable object (the lack of electoral consent).  Empower the Commission, and watch it all take place without troubling the voters at all.

Until the events of early 2013 once again changed the nature of the crisis completely.

The message from Italy

The first shock to Europe’s complacency was the Italian election.  Commentators have been quick to analyse the result of the Italian general election as a frivolous response from an electorate unable to face reality.  How else can one interpret a result in which more than 50% of the votes were given to either a discredited former leader with several unresolved court cases hanging over him or a comedian with no political experience at all?  Neither Berlusconi nor Grillo put forward any constructive policies for Italy’s predicament:  how could a vote for either of them be serious?

This analysis is unfair to the Italian electorate. In fact the electorate voted entirely rationally, as they seem to have decided to treat their general election in the same way that the voters in countries like the UK traditionally treat a by-election: a chance to cast a protest vote, safe in the knowledge (or perhaps the despair) that it will not really change things that matter.

The true message of the Italian vote is that Italians no longer consider their general election to be an opportunity to choose their policy-makers or shape the direction of their country’s policies. The message is that for all except a few states, national general elections are not about choosing leaders any more – policy isn’t made in Rome, or Athens, or wherever, but Brussels and Frankfurt and possibly Berlin.  Elections and political accountability may still take place at the nation state level, but power and policy-making no longer does.  In a very real sense, Europe is moving into a post-democratic state where the voice of the voters may still be heard but can safely be overridden and ignored.

This is extraordinarily risky. For democratic societies to suspend their democratic ideals is unusual and fraught with danger. It is true that they can do so when faced either with existential crisis or extreme opportunity, and this has happened twice in Europe in the last 65 years. The first was 1945-1960: Europe faced the existential crisis that if the continent’s habit of civil war was not addressed, the next conflict could have destroyed everyone. So the continent’s leaders had to find a way – with electoral consent if possible but without it if necessary – of stopping the conflict between France and Germany. That was the challenge facing the generation that survived the war, and to this day, people of that generation will say “At least the EU brought peace”. And they are not wrong to do so.

The second great moment was 1989-2004, when there was a one-off chance to bind the continent’s wounds and heal the divide. Again, the moment was so urgent that usual democratic principles could legitimately be overruled and put to one side. And they were, and people of the first post‑war generation still praise the EU for reuniting the continent “from Stettin in the Baltic to Trieste in the Adriatic”.  And they too are not wrong to do so.

But while to overrule your democratic instincts once or twice may be survivable, to make a habit of it is dangerous, and we now have a political class who have lost touch with the people and have become used to ruling by decree not with consent. The current moves to solve the crisis have no underpinning of popular consent, and the political elite is unwilling to invest in the hard work and dialogue to create that consent. And the electorate is noticing, and its willingness to accept this state of affairs is rapidly evaporating.

The warning from Cyprus

If the Italian election discomfited the political class in Europe, the travails of Cyprus have had a far larger impact.  The initial proposals caused shockwaves across the Eurozone, as the authorities were widely seen to be stepping back from two key commitments made earlier in the crisis.  The first of these was the principle, enunciated after the restructuring of Greece’s debt in early 2012, of no further private sector involvement in financing bailouts, and the second was the guarantee that small depositors with under €100,000 in deposits would be kept whole in any bank resolution.

The attempt to position the levy on small depositors as a “tax”, and thus claim that it did not undermine the guarantee of deposits, did nothing to defray the explosion of anger in Cyprus and concern further afield, and indeed the very disingenuous nature of the move – a sleight of hand that fooled no-one – further undermined confidence that the EU’s word would be honoured in all future circumstances. Nor did the later cancellation of the levy on small depositors restore trust:  the precedent had been set and depositors in Eurozone banks now know that the EU views them as a legitimate source of reconstruction finance.  And if there was any remaining doubt about this, follow-up statements by Jeroen Dijsselbloem, chairman of the Eurogroup, have clarified in icily precise tones that the wealthier parts of the Eurozone no longer have the appetite to finance state rescues of failing banks alone.

As the EU views the damage to its single monetary area (Cyprus has been forced to erect exchange controls between itself and the rest of the Eurozone), to its banking union (common deposit insurance and bank resolution seem ever more distant) and to its credibility with depositors, it is necessary not only to reflect on the outcome of the Cyprus crisis, but also on the process.  For alongside everything else, the undemocratic nature of decision-making at the summit of the EU, and the dominant role of Germany in dictating what is and is not acceptable, has once again been made abundantly clear to all.

And perhaps the most concerning thought of all is that either the Germans knew that this was a likely outcome of their initial proposal that first weekend, which is deeply worrying because it suggests that the most important country in the Eurozone is not concerned with what happens to other member states;  or they did not, which is terrifying because it implies that they do not understand how banking works.

Europe’s disconnects

Europe is a project with many levels: the nation state, the Eurozone, the Schengen zone, the EU itself (and even beyond that the EEA).  But somehow the division of power, duties and responsibilities across these levels has gone badly wrong.  There are no less than three major disconnects in the EU, where actions which should be part and parcel of the same system are instead split awkwardly between the national and EU level.

Firstly, in the realm of banking, we have Mervyn King’s famous observation that banks are “international in life and national in death”. Recent history has shown this does not work and leads to financial system fragilities.

We know the solution to this: banks which operate throughout the EU should be supervised on an EU-wide basis, should be backstopped by an EU-wide deposit insurance scheme and should be subject to an EU-wide resolution regime. This is the heart of the Banking Union, but the EU is only now, and only slowly, beginning to put in place the first of these three; the other two remain for the moment in the “too difficult” box.

Secondly, in the realm of EMU, we have Eurozone-wide monetary policy and national fiscal policies. Again, recent history has shown this does not work and leads to budgetary fragilities.

The solution to this is also now obvious. Monetary policy and fiscal policy must be handled at the same level. Note though that this can be done in one of two ways: either monetary policy returns to the nation states, or fiscal policy is moved to the Eurozone level. The first requires the resumption of national currencies and the abandonment of the euro, and no serious EU politician wants this to happen. So the second – federalisation of fiscal policy, or at the very least firm federal oversight of national fiscal policy – is unavoidable.

And lastly, in the realm of politics, we have Power and Policy-making without Political Accountability at the EU level, and Politics without Power at the national level. The consequence is that more and more national elections will be seen as protest votes that change nothing.

As for the other two disconnects, the solution is brutally clear. The EU has to reconnect Power and Political Accountability. That can only be done by returning policy-making to the national level (ie break-up of the EU, which again no serious politician wants) or by cementing politics and electoral consent at the federal level (in particular, this will need a proper elected federal executive which the people of Europe can hold accountable for their actions).

Unless these three disconnects – the first seemingly only technical, but the second fundamental to the EU’s economies and the third the heart of Europe’s democracies – are put right then there is a very real risk that the EU will tear itself apart.

A version of this essay was first published by State Street Global Advisors as part of their Insight programme