Buried in this month’s “Annual Report on the Euro Area 2009″ from the European Commission is some absorbing material on competitiveness in the eurozone.  Some countries, above all Germany, Europe’s export champion, have consistently outshone others in terms of business competitiveness since the euro’s launch in 1999.  The result has been the accumulation of large current account deficits in countries such as Cyprus, Greece, Portugal and Spain - but also in Ireland, Malta, Slovakia and Slovenia.

As the Commission says, in impeccably understated language: “The build-up of large external liabilities has increased exposure to financial shocks…  In the current downturn, financial markets have become more responsive to the net external financial asset position for the euro area countries.  Even if to a large extent the net external position is related to the private sector, the public sector can be affected by private sector debt in the form of potential bail-outs and other fiscal implications.”

Put simply, the Commission is warning that the gap between Germany and other strong performers - such as Austria, Finland and the Netherlands - and the group of laggards poses a bigger risk to the eurozone’s stability than it did before the financial crisis.  If you are one of the laggards in competitiveness and your financial sector is in trouble, then the financial markets will start taking a close look at how sustainable your public finances are.  And because you share a common currency with 15 other countries, your problem is unavoidably their problem, too.

There is some evidence that the laggards are cutting their current account deficits.  Spain’s, for example, is projected to fall to 5 per cent of gross domestic product next year from 9 per cent this year.  But in general the countries that need to improve competitiveness most urgently are also those with the worst rigidities in labour and product markets.  As a result, unit labour costs in the laggard countries have risen by 2.5 per cent or more every year since 1999, whereas Germany’s unit labour costs have stayed more or less unchanged.

This problem clearly needs addressing before the strains on European monetary union (EMU) become intolerable.  What is to be done?  The Commission’s report is masterfully vague, saying: “Competitiveness developments warrant broader surveillance…  Effective functioning of EMU calls for an early detection of these external imbalances in order to prompt an adequate and timely policy response.”

Germany’s response, I reckon, would be more blunt.  The Germans would tell the laggards: “Put your houses in order, like we did after being hit with the gigantic cost of our country’s reunification in 1990.  Regain competitiveness.  If it means your citizens have to put up with stagnant living standards for a number of years, so be it.  Eurozone membership is not a free ride.”

The only thing is, I’m not sure this is what the laggards want to hear.

A couple of months ago, some European Union policymakers talked despairingly of how 2009 risked turning out to be “a wasted year”.  Now the EU is on a roll.  The impasse over José Manuel Barroso’s reappointment as European Commission president was removed last month when the European parliament stopped playing games and renewed his term of office.

And all of a sudden, it looks as if “a decade of deadening debate over the European Union’s institutional shape” - as British foreign secretary David Miliband puts it in today’s FT - will soon come to an end, after Ireland’s referendum on the Lisbon treaty produced a massive majority in favour.  It may not be long before the EU has its first full-time president, a new head of foreign policy and a new Commission with a five-year mandate serving under Barroso.

So is all rosy in the European garden?  Not quite.  The principal problem, as it has been for the past two years, is the financial crisis.  Time and time again, as I peek into the future, I find myself disturbed by the terrible condition of Europe’s public finances and the strains that this will put on the eurozone’s unity.

In a newly published report, economists at Barclays Capital look at the evolution of the eurozone’s public debt-to-gross domestic product ratio up to the middle of the next decade.  In one scenario, which assumes an annual fiscal adjustment of 2 per cent of GDP, 4 per cent inflation and 3 per cent economic growth, the eurozone’s average debt would be 65 per cent in 2016.  That is not bad (though it’s above the 60 per cent threshold set for new entrants into the eurozone).

But just look at the differences between the area’s member-states.  The German debt would be 40 per cent of GDP, the Dutch debt 37 per cent, the Finnish debt 12 per cent.  But the Greek debt would be 150 per cent, the Irish debt 126 per cent and the Portuguese debt 89 per cent.  In footballing terms, this would be like Barcelona and Chelsea playing in the same league as Atromitos Athens and the Tralee Dynamos.

This scenario, by the way, is not Barclays Capital’s “base case”, which is more pessimistic, estimating average eurozone debt at 90 per cent of GDP in 2016.  But the same enormous divergence between, say, Germany and Greece is evident: German debt would be 64 per cent, Greek debt 171 per cent.

With such bleak forecasts, it is entirely understandable that German policymakers dislike proposals for issuing common eurozone bonds.  But the financial crisis is testing to the limit the eurozone’s ability to conduct a properly co-ordinated fiscal policy.  When interest rates start going up again, as they will, this will present a far bigger challenge for the EU than getting Barroso reappointed or passing the Lisbon treaty.

Ireland’s referendum on the Lisbon treaty on Friday should in principle be about the treaty’s contents, not the state of the Irish economy.  But the economy’s collapse over the past 12 months compels both pro-Lisbon and anti-Lisbon forces to confront the question of whether membership of the European Union - and, specifically, of the eurozone - has helped (even saved) Ireland, made things worse, or not made much difference one way or the other.

An interesting angle from which to approach this question is to ask whether Ireland has fared better than another island off the north-west coast of Europe that was thrown into turmoil at almost exactly the same moment last year - namely, Iceland.  Iceland isn’t a EU member and doesn’t use the euro.  Has this accelerated Iceland’s recovery or held it back?

In terms of headline gross domestic product figures, Iceland comes out narrowly ahead.  Over the last four quarters, its economy has contracted by a cumulative 3.8 per cent, almost half Ireland’s 7.4 per cent, according to a Deutsche Bank study.  But the inflation numbers paint a different picture: Iceland’s consumer price index is up 10.9 per cent since August, Ireland’s is down 2.4 per cent.  Both countries, of course, have horrendously high budget deficits - 13.5 per cent of GDP predicted this year for Iceland, 12 per cent for Ireland.

Unquestionably, the main difference relates to each nation’s external exchange rate and, by extension, its international business competitiveness.  The Icelandic krona all but collapsed after the crisis broke out, whereas Ireland, using the euro, could not devalue.  The result is that Iceland’s unit labour costs have fallen by 29 per cent over the past 12 months and by an astonishing 45. 6 per cent from their peak in the fourth quarter of 2005.   

By contrast, Irish unit labour costs have dropped by only 4.3 per cent over the past year - and this has occurred more because of painful adjustments in the real economy (unemployment, reduced working time, reduced bonuses and wage cuts) than because of exchange rate factors (a falling euro).  Irish exports to the UK have been affected by the steep fall in the pound against the euro.

Of course, the geyser that is the Icelandic economy is still throwing up columns of noxious steam.  Iceland remains vulnerable because of the unparalleled damage inflicted on its financial sector and sovereign debt position.

But the hard truth is that Ireland - like fellow eurozone members Italy, Greece and Spain - has a long and hard road ahead to claw back its competitiveness.  And this is a lesson with even broader implications for Europe.  For when the dust settles, it may well emerge that the financial crisis has served to accentuate the differences in competitive advantage in the eurozone between, on the one hand, Germany and other star performers such as Finland and the Netherlands and, on the other, Ireland and the Mediterranean countries.

One day I’ll break the habit of only visiting Ireland when there’s a referendum on a European Union treaty.  It can easily mislead you into thinking that the Irish people like nothing better than a passionate ”national conversation” (as the latest faddish expression puts it) about Europe.  In fact, it is closer to the mark to say, as Eamon Delaney does in an article for the Irish magazine Business & Finance, that “Ireland is an island with a self-absorbed political culture which is not all that interested in overseas affairs”.

Be that as it may, I’m back in Dublin and the contrast with the political atmosphere of June 2008, when Irish voters rejected the EU’s Lisbon treaty on institutional reform, is pretty startling.  Fifteen months ago, businessmen and economists I talked with were in no doubt that Ireland was heading into a recession, but none predicted the whirlwind that has wrought unmatched havoc on the economy and come close to destroying the national banking system.

This means that on Friday, when the Irish people will be voting Yes or No to the Lisbon treaty for a second time, the context of the vote will be radically different.  Questions such as whether the treaty might compel young Irish men to serve in a European army (a false allegation that surfaced in last year’s campaign and damaged the pro-Lisbon camp) just do not seem relevant, given Ireland’s dire economic condition.

I have in my hand a leaflet produced by Ireland’s small Socialist party, and distributed this morning just off O’Connell Street in the heart of Dublin, which urges: “Reject the Lisbon treaty!  Defend workers’ rights!”  The leaflet’s argument is poorly presented, but its authors are nonetheless on to something.  They want to link the campaign to what is undoubtedly the central concern of most Irish people - how to get by at a time of falling wages, failing businesses and a jobless rate set to hit 16 per cent of the workforce next year.

The leaflet is also correct to draw attention to the much more active involvement of business interests on the side of the pro-Lisbon forces this time round.  The leftists’ language is intemperate - “Why would a viciously anti-union and anti-worker company like Ryanair be spending 500,000 euros to promote a Yes vote for a treaty that will supposedly defend workers’ rights?” - but they are right that business wants voters to reverse the verdict they passed on Lisbon little more than a year ago.

What does the Yes camp say in response?  As far as idealistic dreams of European integration go, very little - and you can see why.  The nation will vote this week with its economy and financial system being propped up, in the last resort, by the European Central Bank and Ireland’s eurozone partners.  This makes fear a potent argument for the pro-Lisbon forces.  As the economics commentator Cormac Lucey puts it: “If we were to vote No … it might make hazy sense for a drink-addled Father Jack swigging vigorously from a whiskey bottle, but it would be an act of collective insanity for Ireland.”

September’s prize for Headline of the Month goes to the sub-editor with the dry sense of humour who put these words at the top of a story about Silvio Berlusconi, the Italian prime minister: “Berlusconi is Best Leader in Italy’s History, says Berlusconi.”

The story itself quotes Berlusconi as telling a news conference in Sardinia, where he was hosting talks with Spanish premier José Luis Rodríguez Zapatero: “I sincerely believe I am by far the best prime minister Italy has had in its 150-year history.”  So the headline, if not the sentiment behind it, cannot be faulted for lack of accuracy.

I would like, however, to put forward a different idea and suggest that if anyone in the Italian government deserves praise, it is Giulio Tremonti, Berlusconi’s finance minister.  When the global financial crisis erupted a year ago, the challenge to Italy was daunting in the extreme.  Italy had the highest public debt (well over 100 per cent of gross domestic product) in the European Union, a reputation for occasionally wayward management of its public finances, and a long-term average economic growth rate that was among the lowest in the 27-nation bloc.

Given Italy’s reliance on exports, it was obvious that the crisis was going to strike Italy with especial force, and, sure enough, latest forecasts suggest the economy will contract this year by 4.8 per cent of GDP.  It would have been tempting last year to follow the example of France, Germany and the UK and indulge in some hefty emergency deficit-spending to mitigate the effects of the recession.

Instead, Tremonti saw the risk that such action would spook financial markets and raise Italy’s borrowing costs by increasing the yield on its government bonds.  The interest rate spread between Italian and German 10-year bonds, extraordinarily low in the early years of European monetary union, did indeed shoot up to about 170 basis points last January.  But with the return of calmer markets it now stands at between 70 and 80 basis points.  Tremonti has striven to be the soul of prudence, and traders have reacted accordingly.

For sure, Italy’s budget deficit is forecast to be 5.3 per cent of GDP this year and 5 per cent in 2010.  But these are relatively modest deficits in comparison with countries such as Ireland, Spain and the UK.  Tremonti is sticking to a cautious three-year plan, drawn up at the start of the crisis, which tries to take the politics out of Italy’s annual budget deliberations by taking no risks with either expenditure or taxes.

You can criticise some aspects of the Italian government’s economic policies - the latest tax amnesty being one example.  But the financial crisis dealt Tremonti a truly difficult hand to play, and he has played it well.

In December 1984 western governments detected the first signs of potentially far-reaching change in the Soviet Union when Mikhail Gorbachev, three months before he took over as Communist party leader, went on a trip to London.  Gorbachev greatly impressed Margaret Thatcher, the then prime minister, who saw him as an articulate, vigorous man with whom, famously, she could “do business”.

Is a Gorbachev moment about to happen in European-Chinese relations?  In two weeks’ time, Xi Jinping, China’s vice-president, is due to pay a visit to Europe and, among other activities, spend some time at the European Commission in Brussels.  The parallels with December 1984 are intriguing. Continue reading "A “Gorbachev moment” in European-Chinese relations?"

Since February 1999, when the Organisation for Economic Co-operation and Development’s anti-bribery convention came into force - with the aim of reducing bribery of foreign officials in international business deals - the US has brought 103 cases, Germany more than 40, France 19 and the UK just one.  So says “Global Corruption Report 2009: Corruption and the Private Sector”, a study published on Wednesday by Transparency International, the anti-corruption watchdog.

From a British point of view, the report makes uncomfortable reading.  “UK companies still have a long way to go to increase their awareness and adopt robust anti-bribery compliance programmes,” it says.

It adds that, in the light of the 2006 al-Yamamah affair,  when the authorities cited national security reasons to shut down a corruption investigation into a multibillion-pound British arms deal with Saudi Arabia, ”it is essential for the government to improve its enforcement of the [OECD] convention and bring more cases to court.  The government and companies need to raise their game.  Otherwise the United Kingdom will be perceived as a country that is not serious about fighting international corruption.”

Of course, other nations come in for a hammering in the report, too.  Take the so-called BRIC countries, supposedly jumping from strength to strength as the western world drowns in recession and debt.  Everyone from President Dmitry Medvedev to the man in the Moscow metro knows about Russia’s corruption disease, but it is particularly interesting to read what Transparency International says about the club’s other three members: “Firms from India, China and Brazil are regarded by their peers as among the most corrupt when doing business abroad.”

Has international business corruption increased since the global financial crisis exploded?  The report doesn’t really answer this important question.  But it does point to “the hazardous implications of corporate strategies that seek to exploit weak regulation, taxation and disclosure standards in some pockets of the global banking system”.  It also highlights “financial offshore structures whose lack of transparency, regulatory oversight and co-operation facilitate capital flight and tax evasion, while hindering the recovery of public assets stolen by corrupt rulers”.

Better regulation and more effective enforcement of existing rules are obviously the answer.  But let’s not forget what Tacitus, the great Roman senator and historian, said: “It’s the most corrupt state that has the most laws.”

The colourful posters on Hamburg’s streets tell the story of Germany’s 2009 election.  “We’re electing the chancellor” says the slogan of the Christian Democrats, next to a reassuringly maternal image of Angela Merkel. 

It is at once an idiotically simple but cleverly conceived slogan.  Because Merkel is the incumbent, it communicates the subliminal message to voters that her rivals, and the rivals to the CDU, are smaller in stature.  In particular, it diminishes the Social Democrats, the CDU’s coalition partner.  All the polls show that voters think Merkel makes a better chancellor than Frank-Walter Steinmeier, her SPD foreign minister and challenger, ever would.  Merkel is the CDU’s trump card.

At the same time, the posters neatly sum up the almost surreal absence of debate in this campaign about the real state of Germany’s economy and financial system.  Having been partners in government for the past four years, the CDU and SPD can hardly blame each other for what has gone wrong, because they would implicitly be pointing the finger at themselves.

As a result, it is easier to tell voters that the entire crisis originated in the US and had nothing to do with virtuous Germany, which is a victim of reckless, greedy Wall Street bankers and their British pups.  As an analysis of why the crisis struck Germany and the rest of Europe with such force, this would get a “fail” grade even at high school.

German banks were far more highly leveraged than US banks when the crisis blew up more than 12 months ago, and as the German finance ministry well knows, there remain huge weaknesses in the German financial sector that will need addressing as soon as the election is over.  However, the average German voter seems completely ignorant of the degree to which some of his country’s banks were outdoing their US counterparts in dicing with risk.

Many seem equally unaware of how the next government will have to dismantle emergency measures, such as the short-term work weeks that were introduced partly to prevent a pre-election leap in unemployment, and that the jobless rate is certain to shoot up.

It is not just the CDU and SDP that are avoiding the issues.  The Free Democrats, with whom Merkel would like to form a government, are tempting voters with an offer of tax cuts that they know in their hearts is utterly unrealistic, given Germany’s large budget deficit and the need to sort out the financial sector.

The Greens stick to their anti-nuclear power platform, even though it looks less and less suited to the demands of a modern energy policy.  As for the Left party, its talk of leading Germans into the promised socialist land is complete gibberish.

Perhaps one shouldn’t be too disappointed.  Elections in all western democracies seem these days to be more and more disconnected from reality.  But in Germany, once the new government is in place, voters will be brought to earth with a bump.