AEP on the Italy situation

Italy's insurgents defiant as bond spreads surge and EU threats build 

• Ambrose Evans-Pritchard

21 May 2018 • Daily Telegraph

The warnings are coming fast and thick. Fitch Ratings has issue a red alert, deeming Italy’s insurgent government a threat to market stability and sovereign solvency.

The conservative leader in the European Parliament, Manfred Weber, said Italians are “playing with fire” as anti-euro Lega nationalists and the alt-Left Five Star Movement join forces to smash the euro austerity regime - and to deport 500,000 illegal immigrants. “This could provoke another eurozone crisis,” he said.

France’s finance minister warns of a “Greek-like” disaster if the new government goes ahead with plans for a flat tax (15pc and 20pc), a monthly €780 basic income for the poor,  a reversal of pension reform and a VAT rise, and a “minibot” parallel currency that subverts the monetary control of the European Central Bank.

Citigroup estimates that these measures will cost 6pc of GDP, pushing the budget deficit towards double digits. The Lega-Grillini rebels aim to overthrow the new banking and bail-in rules, and halt the privatisation of Monte dei Paschi di Siena. They will ignore EU state aid rules for Alitalia and the steel industry. It is a total revolt.

The bond markets have woken up to the enormity of what is happening a country that cannot be easily crushed into submission “à la Grecque”, and that is big enough to destroy monetary union.

Risk spreads on Italian 10-year debt have jumped 65 basis points to 189 over the last three weeks. The worry has begun spreading to Spanish and Portuguese debt, a belated recognition that a euro rupture in Italy plausibly could not be contained. 

“Nobody has anything to fear from our economic policies,” said Lega strongman, Matteo Salvini, who prides himself on nonchalant defiance of market theatrics. Soaring growth will bring down the debt ratio though the magic of the denominator effect - he said - with help from the Laffer Curve.

The drama in the bond markets is still symbolic at this stage. Italy has ‘prefunded’ much of its borrowing requirement for this year. The European Central Bank is still mopping up much of Italy’s debt issuance through quantitative easing. The problem arises at the end of the year when the ECB turns off the QE spigot.

At that moment, Italy will no longer have a lender of last resort standing behind it. The country will be nakedly exposed to market forces again. A rescue will be available only if the country activates a formal bail-out (ESM-OMT) under draconian conditions, requiring a vote in the German Bundestag and Dutch Tweede Kamer.

There is zero possibility that the Lega and ‘Grillini’ would accept the terms. They would start to activate the parallel currency and set in motion a withdrawal from monetary union, restoring full sovereign control over the Bank of Italy and the Italian commercial banking system.

The EU-Italy showdown over spending plans is likely to come to ahead long before that. Claudio Borghi, the Lega economics chief, said threats from Berlin to cut off central bank liquidity and Target2 payments to Italy are very dangerous for Germany. The Bundesbank’s Target2 credits to the ECB system - mostly to Italy and Spain - are €927bn and rising.

“If they really want to play hardball, it will backfire. Germany is the creditor of Target2, not us, and it is they who will suffer the losses if we default. I would urge a little bit of caution,” he told the Telegraph.

“If anybody in Europe thinks they can push up the bond spreads and that we will be ousted, they are very wrong. We have been through all this before with Mario Monti in 2011. Everybody in Italy understands that political manipulation of the spreads is the way they enforce their austerity on us. We are going to have a very frank discussion with the EU,” he said.   

The new government was at last taking shape last night. The compromise pick for prime minister, Giuseppe Conte, is an unknown lawyer with no political experience. If accepted by President Sergio Mattarella, he will be a figurehead.

Power resides with the Lega’s Salvini and the hydra-headed Five Star led by Luigi di Maio. They plan a special body made up of the two parties to resolve disputes, arguably outside Italy’s constitutional structure.

Paulo Savona, the scourge of the Maastricht Treaty and the ‘German euro', looks poised to take charge of the finance ministry. A former minister from the 1990s - well-known in European capitals - he is in one sense a safe pair of hands.

But he long ago concluded that monetary union has trapped Italy in a bad equilibrium. “The country is being pushed deeper into economic under-development,” he wrote during the crisis 2011.

He called at the time for a “Plan  B” to leave the euro. “Accords that are badly constructed or signed by countries with hegemonic intentions do not last long,” he said. This is not a man likely to succumb meekly to EU demands at the first sign of pressure. He is in any case bound by the terms of Lega-Grillini “contract for government”.

Senator Alberto Bagnai, a Lega senator and a key economic strategist, said the new government will press ahead quickly with the minibot scrip currency to cover €70bn of state arrears to contractors and households. “We aim to start within a year and possibly as soon as this year. There are many companies in deep financial distress,” he said.

“The minibots have huge political appeal. People want them, and they will have them. If the EU says we can’t do it, we will do it anyway. France has been violating the fiscal rule for the last 10 years,” he said.

“If Germany or the EU authorities try to blackmail Italy, this will fuel nationalist resentment and people will vote for us massively. They are already very angry,” he said. The latest polls suggest that anti-EU populist forces would win a bigger landslide in a snap election.

The EU will have to tread with great care. It is already facing twin crises over Brexit and the authoritarian lurch in Eastern Europe. It risks a strategic rift with the US.  Europe may have to go along with more of what the Lega-Grillini are demanding than it lets on. “The appetite for a clash in Brussels is pretty much zero,” said Lorenzo Codogno, the former chief economist of the Italian treasury and now at LC Macro Advisors.

Italy is entering a maelstrom of two powerful and opposing currents. On the one hand, net fiscal stimulus of 2pc or 3pc of GDP implies a surge in economic growth as slack is used up and the output gap is closed. On the other, surging bond yields and capital flight hint an almighty crisis for a country with a public debt of 132pc of GDP.

It is far from clear which these conflicting stories prevails over the next two years. What is certain is that the EU cannot risk making any more mistakes.

You must have a handle on the Italian situation

As Italy has shown, the euro is a far bigger threat to Europe than Brexit 

• William Hague

21 May 2018 • 9:02pmhas shown the euro is a far bigger threat to Europe than Brexit

Italians are mad as hell about the permanent stagnation that the euro imposed on Italy

“In Britain, to govern is difficult. In Italy it is pointless,” said a senior Italian who called to wish me well when I became Foreign Secretary. I laughed, of course, at this charmingly honest assessment of a problem we find almost endearing: the inability of a country we generally adore to settle on any government for more than a few months.

The indifference of Italians to politics seems to fit well with being the home of the best combination of food, wine, weather and style anywhere in Europe. This week, however, the formation of the 62nd government since 1945 in Rome signals that the indifference may be over.

At the moment, the common assumption in the financial and political worlds is that the new Italian government will ultimately back down... I am not so sure

The two parties that have just jointly nominated a prime minister – the Five Star Movement and The League – are an entirely new combination, vehemently opposed to most of the policies pursued in their own country and the rest of Europe for the past few decades.

Together, these parties won 50 per cent of the vote in the recent general election, and polls suggest they would do even better if Italians had to vote again. They have long been hostile to staying in the euro, have promised to expel hundreds of thousands of illegal immigrants, and have adopted an economic programme considered crazy by conventional economists.

This includes – despite Italy being far more heavily in debt than any other major European country – big tax cuts and spending increases at the same time. They have pledged to introduce lower income taxes, a universal basic income for everyone and a lower pension age.

One thing we can know for sure is that this is going to lead to a very big disappointment. Left to its own devices, the new Italian coalition would soon discover that no sensible person would lend it the money to do this and that the economy is too big for anyone to bail it out. In some countries, governments with impossible spending promises just print money to get away with in the short term, but Italy, being in the euro, can’t even do that.

And that, strangely enough, is why these apparently suicidal ideas might pay off for the coalition politically. For, long before financial markets and economic reality prevent it from carrying out its programme, Italy is going to be told by everyone else in the EU, from the German Finance Ministry to the European Commission, that this is not on. The eurozone has strict rules against big budget deficits and Italy would be breaking them.

When Greece was in conflict with the euro, Greece had a problem. When it is Italy, the euro has a problem

Disappointment and anger can therefore be directed, not against a new ministry in Rome, but at Brussels and Berlin. It will be the EU that will be preventing Italians from receiving the benefits for which they voted – the very same EU that promised so much help with the huge flow of migrants across the Mediterranean and has then done very little. If the new political leaders want to trigger the bust-up that could lead to Italy leaving the euro, as so much earlier rhetoric from them has suggested they do, the stage will be perfectly set for it.

At the moment, the common assumption in the financial and political worlds is that the new Italian government will ultimately back down. Like the radical Greek Syriza party, it will end up toeing the line, screaming and protesting but eventually and dutifully implementing spending cuts and explaining the facts of life in a single currency to its despondent supporters. It will be a very difficult year, so it is thought, but the costs and risks of leaving the euro are so high that order will be preserved and the populists will be tamed.

I am not so sure. Talk to any 
Italian who is not part of the old parties or the financial elite and they are now incensed beyond measure 
by uncontrolled migration. As in elections in other parts of Europe 
and our own referendum, this then affects their attitude to everything else.

There are other key differences from what happened in Greece, too. This is a government of two large parties, jostling for position and credibility, and that will make it much harder for them to climb down than it was for the far-Left Syriza party in Athens with a single leadership.

Italy is also a major international economy, the third biggest in the Eurozone. When Greece was in conflict with the euro, Greece had a problem. When it is Italy, the euro has a problem. The people of bigger countries – again as British voters have shown – are more confident about taking matters into their own hands.

When the euro was formed, I pointed out why it would not work for countries like Italy and said it would be a burning building with no exits

Most crucially of all, when Italians blame the euro for many of their problems they are actually right. Matteo Salvini, the leader of the the League, might be wrong about many things but when he said in March that joining the euro had been a mistake and that it was a “bad currency” that was “destined to fail” he was spot on.

Joining the euro in 1999 imposed permanent stagnation on Italy, with a huge human cost of high unemployment and struggling businesses. It has meant no devaluation of its currency against the highly efficient German economy is possible, and made it harder to export to the rest of the world. For nearly 20 years, the economy has barely grown at all, while Germany has forged ahead.

Unless Italian workers somehow become as productive as Germans, this is always going to be 
the case. There are formidable 
political obstacles to leaving the 
euro – such as Italy having no provision for a referendum on international treaties – but having a government that can envisage doing so is a first and vital step.

When the euro was formed, I pointed out why it would not work for countries like Italy and said it would be a burning building with no exits. This Italian government is likely to start working out how to find, create or blast open an exit. It will not do 
it immediately but conflict with Brussels will lead it that way. It will make a plan in secret. And for the long-term interests of its people 
and in the absence of radical reform 
of how the eurozone works, it will 
be right.

None of this, unfortunately, will help the UK with the complex process of negotiating Brexit. The more the EU feels threatened, the less ground it will give. But it shows our departure in its proper perspective – not a one-off event, but as the beginning of a long, slow disintegration.

Normalising monetary policy Oct 2017

This article looks at the potentially monumental shift from highly loose monetary policy to a more 'normal' stance. It has some critical information for any essay on policy to manage the economy in its current state:

It puts unconventional monetary policy in perspective, and looks briefly at the current stance towards removing some of the easing. It contains important A-A* material.

The Courage to normalise Monetary Policy September 26 2017 Stephen S Roach

A decade after the onset of the global financial crisis, it seems more than appropriate for central bankers to move the levers of policy off their emergency settings. A world in recovery – no matter how anemic it may be – does not require a crisis-like approach to monetary policy.

NEW HAVEN – Three cheers for central banks! That may sound strange coming from someone who has long been critical of the world’s monetary authorities. But I applaud the US Federal Reserve’s long-overdue commitment to the normalization of its policy rate and balance sheet. I say the same for the Bank of England, and for the European Central Bank’s grudging nod in the same direction. The risk, however, is that these moves may be too little too late.

Central banks’ unconventional monetary policies – namely, zero interest rates and massive asset purchases – were put in place in the depths of the 2008-2009 financial crisis. It was an emergency operation, to say the least. With their traditional policy tools all but exhausted, the authorities had to be exceptionally creative in confronting the collapse in financial markets and a looming implosion of the real economy. Central banks, it seemed, had no choice but to opt for the massive liquidity injections known as “quantitative easing.”

This strategy did arrest the free-fall in markets. But it did little to spur meaningful economic recovery. The G7 economies (the United States, Japan, Canada, Germany, the United Kingdom, France, and Italy) have collectively grown at just a 1.8% average annual rate over the 2010-2017 post-crisis period. That is far short of the 3.2% average rebound recorded over comparable eight-year intervals during the two recoveries of the 1980s and the 1990s.

Unfortunately, central bankers misread the efficacy of their post-2008 policy actions. They acted as if the strategy that helped end the crisis could achieve the same traction in fostering a cyclical rebound in the real economy. In fact, they doubled down on the cocktail of zero policy rates and balance-sheet expansion.

And what a bet it was. According to the Bank for International Settlements, central banks’ combined asset holdings in the major advanced economies (the US, the eurozone, and Japan) expanded by $8.3 trillion over the past nine years, from $4.6 trillion in 2008 to $12.9 trillion in early 2017.

Yet this massive balance-sheet expansion has had little to show for it. Over the same nine-year period, nominal GDP in these economies increased by just $2.1 trillion. That implies a $6.2 trillion injection of excess liquidity – the difference between the growth in central bank assets and nominal GDP – that was not absorbed by the real economy and has, instead been sloshing around in global financial markets, distorting asset prices across the risk spectrum.

Monetary authorities have only grudgingly accepted this. Today’s generation of central bankers is almost religious in its commitment to inflation targeting – even in today’s inflationless world. While the pendulum has swung from squeezing out excess inflation to avoiding deflation, price stability remains the sine qua non in central banking circles.Normalization is all about a long-overdue unwinding of those distortions. Fully ten years after the onset of the Great Financial Crisis, it seems more than appropriate to move the levers of monetary policy off their emergency settings. A world in recovery – no matter how anemic that recovery may be – does not require a crisis-like approach to monetary policy.

Inflation fixations are not easy to break. I can personally attest to that. As a staff economist at the Fed in the 1970s, I witnessed first-hand the birth of the Great Inflation – and the role played by inept central banking in creating it. For years, if not decades, after that experience, I was convinced that renewed inflation was just around the corner.

Today’s generation of central bankers has dug in its heels at the opposite end of the inflation spectrum. Wedded to a “Phillips curve” mentality conditioned by the presumed tradeoff between economic slack and inflation, central bankers remain steadfast in their view that an accommodative policy bias is appropriate as long as inflation falls short of their targets.

This is today’s biggest risk. Normalization should not be viewed as an inflation-dependent operation. Below-target inflation is not an excuse for a long and drawn-out normalization. In order to rebuild the policy arsenal for the inevitable next crisis or recession, a prompt and methodical restoration of monetary policy to pre-crisis settings is far preferable.

A failure to do this was, in fact, precisely the problem during the last pre-crisis period, in the early 2000s. The Fed committed the most egregious error of all. In the aftermath of the bursting of the dotcom bubble in early 2000, and with fears of a Japan scenario weighing heavily on the policy debate, it opted for an incremental normalization strategy – raising its policy rate 17 times in small moves of 25 basis points over a 24-month period from mid-2004 to mid-2006. Yet it was precisely during that period when increasingly frothy financial markets were sowing the seeds of the disaster that was shortly to follow.

In the current period, the Fed has outlined a strategy that does not achieve balance-sheet normalization until 2022-2023 at the earliest – 2.5-3 times as long as the ill-designed campaign of the mid-2000s. In today’s frothy markets, that’s asking for trouble. In the interest of financial stability, there is a compelling argument for much speedier normalization – completing the task in as little as half the time the Fed is currently suggesting.

Independent central banks were not designed to win popularity contests. Paul Volcker knew that when he led the charge against raging inflation in the early 1980s. But the approach taken by his successors, Alan Greenspan and Ben Bernanke, was very different – allowing financial markets and an increasingly asset-dependent economy to take charge of the Fed. For Janet Yellen – or her successor – it will take courage to forge a different path. With more than $6 trillion of excess liquidity still sloshing around in global financial markets, that courage cannot be found soon enough.

Stephen S. Roach, former Chairman of Morgan Stanley Asia and the firm's chief economist, is a senior fellow at Yale University's Jackson Institute of Global Affairs and a senior lecturer at Yale's School of Management. He is the author of Unbalanced: The Codependency of America and China.

Technology diffusion & globalisation - FT

Very useful info on productivity, and how important innovation is.

Let knowledge spread around the world

It is not in the west’s interests to stop developing countries from innovating Martin Wolf April 24, 2018 Financial Times

In the long run, as the Nobel laureate Paul Krugman has written, productivity is almost everything. But what drives productivity? The answer is know-how. It is because humanity has discovered, developed, deployed, and disseminated useful knowledge that an ever-rising proportion of the world’s population is at last escaping the “poor, nasty, brutish and short” lives of our ancestors, pithily described by the philosopher Thomas Hobbes in the 17th century.Knowledge is also somewhat paradoxical. It is most productive when freely available. But the incentive to create it depends on the ability to restrict its use. The former consideration justifies dissemination. The latter justifies control. How, then, is this balance working?The latest World Economic Outlook offers an illuminating chapter on how globalisation has been helping to spread useful knowledge. This analysis sheds light on the contemporary landscape of innovation, on the current diffusion of knowledge, on what is happening to productivity, on the role of global value chains and on the impact of competition on creation and use of knowledge.

Perhaps the most significant conclusion is on the shift in the location of innovation. If this is measured by what are called “patent families”, by which is meant patents filed in more than one jurisdiction (a measure of their significance), the US, Japan and the big three European economies (Germany, France and the UK) are still dominant. China is already second in terms of spending on research and development, only a little behind the US. In the aggregate stock of patents, China is also already ahead of the UK. Strikingly, the annual rate of patenting is stagnant in the big five advanced economies, while it is soaring in the emerging world, and above all in China. (See charts.)

The slowdown in patenting and, to a lesser degree, spending on research and development in the high-income countries parallels the slowdown in productivity. There is much debate on the causes of the latter. Some argue that the latter will naturally reverse. Others suggest the flow of good new ideas is slowing at the productivity frontier for more fundamental reasons: it is simply harder to make big breakthroughs.

Meanwhile, emerging economies are benefiting from applying already developed ideas within their own economies. That is how the diffusion of economic growth has worked since the industrial revolution (indeed, before). Globalisation, it appears, has accelerated the rate of diffusion by lowering the obstacles. This has occurred via foreign direct investment and via the unbundling of production via global value chains. Access to foreign know-how fertilises invention: thus, the greater the knowledge inflow, the stronger becomes domestic patenting. This is not only true for emerging countries. It is also true for those at the knowledge frontier.

Access to foreign knowledge also promotes productivity, as one would hope. Not surprisingly, this effect is particularly important for emerging economies. Yet, unfortunately, the growth of labour productivity has slowed almost everywhere since 2004, perhaps because of the global financial crisis.

A particularly important conclusion of this analysis is that greater competition — one of the benefits of economic globalisation — accelerates the diffusion of technology across countries and even the rate of innovation itself. One explanation for the latter might be that returns to innovation are increased by access to a bigger global marketplace.

What do these findings tell us about the state of the global knowledge economy and appropriate policy towards it? The most important conclusion is that the global diffusion of knowledge is an important benefit of globalisation. Over time, this adds significant new contributors to the development of useful knowledge. The addition of hundreds of millions of minds must be a good thing for all. This is now the case with China, as it once was with the entry of Japan and South Korea into the business of creating new knowledge.

Unfortunately, what is happening today is not just the entry of new innovators, but an apparent slowdown in the rate of innovation and productivity growth in the advanced countries. This is yet another reason why their voters, business leaders and politicians have become more defensive. Yet if there is one lesson from two centuries of unprecedented economic growth it is that old knowledge ultimately becomes a widely-available commodity. The most important task for the advanced countries is to create useful new ideas. On that will their futures ultimately depend. Achieving this will require not just well-designed intellectual property rights, but government support for fundamental science and breakthrough technologies, as was the case for the internet some decades ago.

A particularly important aspect of the globalisation of useful knowledge is the relationship of the west with China. One of the tragedies of the Trump administration’s blunderbuss approach to trade policy — leave no friend untargeted, usually for no good reason — is that it has alienated potential allies in its attempt to tackle the forced transfer of know-how by China. Yet even Chinese policymakers understand that the future of their economy depends on incentives for developing and disseminating new IP. The US should be pushing on an open door.

Above all, it is not just about protecting IP. It is also about recognising that it can be an obstacle to competition. It is still more about focusing on the future. A world in which innovation is more widely shared is both inevitable and desirable. This is a future we ought to want. The old monopoly is gone. Good.
martin.wolf@ft.com

German fiscal surplus

Things are never straightforward - has Germany achieved a budget surplus through fiscal prudence, or is it squeezing spending that is causing problems elsewhere? This fits in to a European stability, fiscal prudence/austerity or government spending question:

Germany’s Great European Heist

May 15, 2018 Adam Tooze ,  Shahin Vallée

Two seemingly reasonable principles guide German thinking about eurozone integration: responsibilities and control must be aligned; and legacy risks must be settled before any pooling of risks among euro members takes place. But what if France applied Germany’s approach to eurozone integration to the question of mutualizing defense commitments?

NEW YORK – Two mantras guide German thinking about eurozone integration: responsibilities and control must be aligned (so no mutualization of risk without shared jurisdiction); and legacy risks must be settled before any pooling of risks among euro members takes place. Since 2010, these two refrains have shaped the entire discussion of how to shore up the euro, and they largely account for the anemic progress being made on the creation of a European banking union. Germany is ready to embark on a common future, its leaders say, but only if Europe starts from a clean slate.

At first sight, that proposition seems reasonable enough. But to understand its full implications, try applying the same logic to another policy field: security and defense.

What if France applied Germany’s approach to eurozone integration to the question of mutualizing defense commitments? What if the French were to insist, as an absolute precondition for further security cooperation, that Germany not only increase its defense budget immediately, but also make good on its accumulated backlog in defense spending from recent decades?

Germany has not always been a free rider on other people’s defense spending. West Germany was a reliable player in NATO’s Cold War system of burden sharing, and the Bundeswehr in the 1980s was a capable force. For better or worse, it stood in the tradition of German armies since the Kaiserreich. National service was the norm. Defense spending ran at 3% of GDP.

Then came the fall of the Berlin Wall in 1989. Germany embraced the peace dividend with a vengeance. Reductions in Germany’s armed forces and disavowal of weapons of mass destruction were written into the treaties that reunified Germany. But demilitarization also reflected societal shifts. Something in the political culture of the Federal Republic had changed.

More and more young men chose civilian over military service. In 2011, conscription was suspended. As a practical matter, that decision probably should have come sooner. Today’s best-functioning militaries are professional, not conscripted. But, in Germany, no positive image of the Bundeswehr’s new role emerged from the end of the Cold War model. Morale and functional capacity collapsed along with spending.

At NATO meeting after NATO meeting, Germany would commit to spending 2% of its GDP on defense. It never delivered. Spending slumped toward 1% of GDP, with the majority going to salaries and pensions. The latest NATO data show German spending on defense equipment and on research and development running at only 0.17% of GDP in 2017, compared to 0.42% in France and 0.47% in the UK.

Germany’s dearth of military investment has created a daunting gap between its defense capacity and that of the rest of Europe. Only a fraction of Germany’s weapons and military vehicles are operational. On Europe’s eastern border, only nine of the 44 tanks promised for the Bundeswehr unit that is supposed to anchor NATO’s 5,000-strong rapid-reaction force in the Baltics next year are fit for use. The unit also lacks other equipment essential for the mission, such as tents, winter clothing, night vision equipment, and body armor.

For the German left, which opposes the use of hard power, there is no reason to lament this lack of resources. But the gutting of the Bundeswehr also disables Germany’s ability to exercise soft power. In 2014, Germany’s humanitarian team to deliver assistance to Ebola-stricken Liberia was stranded in the Canary Islands. The German Navy’s large supply ships – those most useful for refugee rescue operations in the Mediterranean – will be out of commission for 18 months, owing to a lack of spare parts.

If the Bundeswehr’s guns don’t work, its frigates are in dry dock, and its logistical capacity is zero; what other commitments might the French taxpayer be taking on? By agreeing, year after year, to the mutualization of defense costs, what sort of incentives is France providing to Germany to undertake reform?

If the French were to apply a simple spending rule, they would find that since 1990 they had cumulatively spent 30% of GDP more than Germany on defense. If what the Germans are most interested in is France’s nuclear deterrence, the costs over the same period total approximately 4.5-5 % of French GDP.

So the legacy issues are considerable. Furthermore, given Germany’s ingrained post-military habits, backsliding is to be expected. What is French President Emmanuel Macron to make of the German budget announced earlier this month, which shows a marginal increase in defense spending but not enough to meet the NATO target, let alone to close past deficits?

German Chancellor Angela Merkel’s new grand coalition government may not look like a reliable security partner, but does that mean France should hold out until Germany has made good on its legacy defense debt before considering defense investments and mutualization in Europe?

Europe’s need to develop a twenty-first century security strategy is urgent, not only because Donald Trump’s America is unreliable, but also because humanitarian emergencies demand it. It must develop a shared culture and build democratic governance to decide on the deployment of its defense forces. That will involve deep cultural and political adjustments on all sides. Both Germany’s habit of free riding and France’s tendency toward trigger-happy postcolonial forays will have to be debated.

These issues are at the heart of developing a European sovereign, backed by democratic institutions and decision-making processes that enable the common use of force. But Europe cannot start from some imaginary tabula rasa. It must start from the place to which history has brought it. The quid pro quo that France should demand for cooperation on security policy is that Germany recognizes the same reality with regard to economic policy.

Here, too, the past must be taken as given. Starting positions are unequal and incentive structures are imperfect. But Europe must agree to move forward together nonetheless, or risk being torn apart.

Adam Tooze

EU/US Steel tariff update

From The Times Friday 18th May. Good analysis of the options open to the EU, which is great material for an essay:

Time is running out at the EU’s trade department. Donald Trump has promised that by June 1 he will make a final decision on whether to grant the EU an exemption from his steel and aluminium tariffs. In public Brussels has been talking tough, refusing to consider concessions in return for a reprieve from Washington. Behind the scenes, however, member states are considering just how much ground to give.

Mr Trump wants the EU to impose voluntary export restraints (VERs) on its steel producers, forcing them to send less steel to the US than at present. Washington has managed to strike this sort of deal with South Korea, which secured an exemption from America’s steel tariffs in return for a promise that it would cut steel exports to roughly 70 per cent of current volumes.

Some in the industry would not mind a carefully managed export restraint but a cynic would say that a VER is just a state-sponsored cartel. In private some European steel executives have suggested that the EU adopt a fallback along these lines: agreeing to restrict tariff-free exports to the volumes of the past few years. The French government is said to be open to the idea.

Brussels beware. Economists hate VERs and for good reason. Not only do they distort the market — Peter Holmes at the University of Sussex said the old web of VERs for textiles was “a form of Stalinist central planning” — but by placing the burden for restricting trade on the exporters’ government they create opportunities for rent seeking. If the European Commission starts doling out export licences to specific companies the potential for pork barrel politics is huge.

Lawyers hate VERs even more. “You can construct legal arguments for them but none is very convincing,” Holger Hestermeyer, of King’s College London, said. “There is a very specific prohibition in WTO law”.

To grant the US its VERs would, therefore, dent the EU’s diplomatic brand as a defender of the rules-based system. It would also send a dangerous message. Mr Trump could come back with new demands.

A better idea, says Germany, would be to subsume the conversation about steel into new scoping talks on a slimmed-down US-EU trade deal covering only some goods. No one believes that a trade deal is just around the corner but the hope is that this might work as a delaying tactic. By the time negotiators got past scoping, say EU officials, there would be a new commission in Brussels and, probably, a new president in the White House. Problem solved.

The Americans have signalled that they will not bite. In that case there are two options left. The EU could just do nothing: let the steel tariffs fall where they may, offer assistance to the worst-hit companies and hope that the industry can bear the pain until Trump disappears. Retaliation is not worth the risk of a trade war, according to this theory. Italy, politically rudderless as it has been of late, is reported to favour this approach, but few others agree. It would be too great a loss of face.

The final approach is the purist’s. The US has probably broken the law. This licenses the EU to retaliate with tariffs of its own while pursuing a challenge at the WTO. When the EU did this in response to George W Bush’s steel tariffs in 2003, Bush caved. This is how the rules-based system is supposed to work and if Europe wants to defend that system, Europe must use it.

The European Commission has been pushing that argument since day one. In truth, though, an issue like this is above the commission’s pay grade. Hosuk Lee-Makiyama, a Brussels trade wonk, said that the decision had been pushed up to the principal member states, even to heads of government. Those politicians are used to disappointing purists. They want a deal.