So who is eating Argentina’s lunch now?

Cristina Fernández de Kirchner, the President of Argentina, was on fire that day, almost exactly a year ago, when she introduced the bill that would enable the government to grab the controlling stake in YPF, the energy firm, held by the Spanish Repsol Group.

An economic populist moulded in the country’s Peronist tradition, the President was not deterred by the barrage of international criticism hitting Argentina when rumours surfaced that the government considered expropriating YPF. Nor did Ms Fernández tremble at the thought of confiscating resources from Argentina’s largest foreign investor – and in a crucial sector in obvious need of foreign direct investment to fund expansion of especially its big shale reserves. Like her predecessor, her late husband Néstor Kirchner, the President was determined to undo flagship reforms during the liberal leadership of the country in the 1990s, this time the denationalisation of YPF in the early 1990s.

Yet the expropriation has been a complete failure. On all the charges that the government threw against Repsol, the current situation is worse. Neither Argentina’s nor YPF’s production has increased as consequence of the asset grab. While the government waxed lyrical about an alleged 2.5-percent increase in YPF’s oil production in 2012, any discerning observer will soon detect that total output in 2012 cannot be compared with total output in 2011.

Strikes in Santa Cruz severely disrupted YPF’s oil production between April and July in 2011. The drop in production makes total production for 2011 an unreliable benchmark for output in 2012. If, however, production in the last quarter of 2011 is compared to the same period last year, YPF’s production fell by about 8 percent in 2012, according to statistics form Argentina’s Department of Energy. Total oil production in Argentina followed the same path.

Nor did the Argentina close its trade deficit in energy, which the government had promised. President Fernández accused the former owners of YPF for throwing away Argentina’s self sufficiency in energy, and blamed them for the 3 billion US dollar energy trade deficit in 2011. Before 2011, Argentina had been running an energy trade surplus and the government now suggested the energy reserves of the country to be evidence enough for why the country should run a surplus.

Yet the energy surplus had been withering away for several years, and nothing suggests it has changed after the government grabbed the controlling stake in YPF. On the contrary, forecasts for 2013 suggest the energy deficit to climb up to 5 billion US dollars, partly (but far from only) because of the recent damages by flood and fire in YPF’s La Plata refinery. According to the same estimate, the country’s energy import went up by almost 50 percent in the first two months this year, compared with the same period last year.

None of this is surprising. Current oil production in Argentina is primarily based on old discoveries with shrinking reserves. The main problem for the sector is rather that energy policy has deterred investment into new fields by artificially depressing energy prices and an uncertain system for license approvals. And the most damaging consequence of the confiscation is that the government has undermined efforts to fund new production in the giant oil shale reserve, Vaca Muerta, discovered by Repsol in 2010.

The expropriation has created a very uncertain investment environment, to say the least, for potential partners in Vaca Muerta. The costs for production are high because of the technical and geological difficulties to extract the oil, and the previous owners had started forming partnerships with other oil firms to start full production. The government did not like this strategy, and generally claimed the company should have invested its profits rather than paying dividends to shareholders. Never mind the dividends were part of a deal engineered in 2007 by the Kirchners to get Petersen Inversiones to take up a minority stake in YPF, Argentina now claimed it could radically boost investment into the new fields.

However, the government has had to back down from this brazen attitude, and is now back to the strategy employed by the former owners to get other investors to join in. But that strategy is not exactly going stellar. A few international firms have pledged to invest smaller sums with YPF for pilot projects in Vaca Muerta, but the big deal between YPF and Dow concerns the gas reserves. Still, they – and others – remain wary of teaming up with a company whose owners may well confiscate their assets once the big investments have been made.

A rational populist would have postponed the expropriation until the point when foreign investors had put their money into Argentina. Now the government is in a position where the way to lure some investors into the project is to offer so good returns that they are prepared to take the political risk. But such a strategy is self-defeating. President Fernández pushed the confiscation of assets because she charged the former owners for eating Argentina’s free energy lunch. Now she may have to give even more of it away.

Freeing up transatlantic trade

Last week European leaders endorsed the launch of negotiations between the EU and the US over a bilateral trade agreement. Leaders said that they reiterated ”support for a comprehensive trade agreement which should pay particular attention to ways to achieve greater transatlantic regulatory convergence.” And yesterday President Obama gave the US endorsement for the talks in his State of the Union speech. President Obama said: “And tonight, I’m announcing that we will launch talks on a comprehensive Transatlantic Trade and Investment Partnership with the European Union...”

This is good news. A transatlantic agreement freeing up trade between the EU and US can give a significant contribution to economic growth on both sides. It can also establish a good framework for incentivising trade liberalisation by other countries, provided that a new transatlantic agreement will be open for other countries that wish to join on equal terms and that the results will support rather than thwart ambitions by other countries to reform non-tariff barriers and regulations to be compatible with transatlantic ambitions.

Yet it is also a trade agreement that will face serious obstacles – political and technical obstacles. Here are a couple of random comments about these obstacles – and how to tackle them.

First, ambition sometimes bites the nails of success. Or to put it differently: too grand ambitions will erode the chances of reaching an agreement. Negotiations should aim for an ambitious agreement, and it is important that the EU and the US move out of the depressing format of negotiations in the Transatlantic Economic Council, which clearly suffered from being to narrow and lacking context. But the point now is that too many of those offering sundry views about a transatlantic FTA have unrealistic ideas about what can be achieved. Some talk about a “transatlantic single market”, which clearly is beyond reach. There is not a complete single market in the EU – and many sectors in the US are fragmented by regulations by US states. Others take aim for regulatory harmonization of a kind that simply is impossible. There are plenty of regulations on both sides that will be too difficult to address in trade negotiations, and there is no point spending time on them.

An ambitious agreement would eliminate close to all tariffs, foster a good number of mutual recognition agreements and more generally converge (but not harmonize) regulations in many sectors, reduce direct market access restrictions in most service sectors, improve rules on subsidies and state-owned enterprises, and establish a framework for progressive improvements of the agreement.

Second, it will prove a challenge to get independent authorities in the US and member states authorities in the EU to sign up to necessary MRAs and regulatory convergence. Pressure will in particular have to come from business associations and individual companies that today suffer from regulatory divergence. A good number of business associations have already stated their preferences for the negotiations, but I think they will have to go a step further and actually start to flesh out actual agreements. In other words, negotiations on regulatory convergence should initially be privatised. Sectoral associations on both sides should be tasked to negotiate the actual agreement. It is an exaggeration to say they should negotiate the agreement – in many sectors, business associations on both sides are made up of the same companies. Those companies that are big in the EU in one sectors are usually also the ones that are big in the United States. The problem for them is not that they have diverging views about what should be accomplished in a trade agreement. Nor is the problem that they prefer regulatory divergence as a means to protect themselves against foreign competition (in some sectors, that is the case, but not in many). A bigger problem is often that regulatory divergence protects regulators, and that they are unwilling to change even the most silly type of regulatory differences because that would hurt their authority.

Third, there are two things that are important with the regulatory negotiations. The first is to reduce the levels of non-tariff barriers and regulatory difference in services sectors. The emphasis is on reducing them, not eliminating them. The size of an NTB is often constituted by many different obstacles, and all of them are not very important. For some sectors, it does not make sense to aim for elimination of an NTB – perhaps not even to go for a really serious reduction. The important thing may rather be to just take away the most egregious parts. This points to the need to approach negotiations in a pragmatic way, looking at the actual details rather than using formulae or aggregated notions.

The second part is to set in motion processes of deregulations rather than taking away the differences between regulations. There are on both sides plenty of silly regulations that just should be eliminated. Excessive regulations in the past years have amplified that problem. They make up a good part of the aggregate levels of NTBs, but the main economic gains will come from eliminating them rather than just reducing the difference between them in the EU and the US.

Lastly, and following on the third point, both sides are entering the talks with deflated aspirations about deregulations and economic reform. The expectation is rather than gains will come without any serious efforts to reform the economies on both sides. If that will be the spirit of the negotiations, leaders will waste an opportunity to boost economic growth and give new energy to the agenda for global trade liberalisation.

Rebalancing the Eurozone: The Role of Northern Fiscal Policy

The Eurozone crisis muddles forth. Growth will be stagnant or even decline in 2012. Employment prospects remain bleak as unemployment rose by 2.6 million in the last year alone. In September, the ECB announced its Outright Monetary Transactions programme in an attempt to ease sovereign debt pressures and in December EU leaders tentatively moved towards an EU-wide banking union. But what role, if any, could Northern fiscal policy play to reduce EU-wide macroeconomic imbalances? A recent report by the EU Commission sheds light on this issue.[1]

In 1999, the European Union embarked on its most ambitious project yet: the establishment of a common currency. The shortcomings of the Euro are often heard these days, but they are worth repeating here. Economists have long argued that the Eurozone does not constitute an optimal currency area. For a common currency area to work, they argued that the business cycle and key economic variables such as growth and inflation would need to be in sync across the area. They warned that, in abandoning their national currencies, European countries would lose the necessary policy levers to deal with the inevitable asymmetric shocks that would arise after the Euro’s introduction.

A common interest rate policy, for instance, meant that immediately after the Euro’s introduction monetary policy was too restrictive for a struggling Germany, and too expansive for the booming peripheral economies of the South. This in turn fuelled consumption in the South, as well as inflation in assets and wages. And indeed, between 1996 and 2010, wages grew at disparate rates across the Eurozone. In Germany and France, unit labour costs increased respectively at just 8% and 13%. Meanwhile in Southern Europe, labour costs rose 24% in Portugal, 35% in Spain, 37% in Italy and an immense 69% in Greece.[2] Uneven wage inflation across the EU harmed the competitiveness of the Southern economies of the EU and increased their trade deficits vis-à-vis the fiscally prudent countries of the North. In Greece alone, the current account deficit soared from 6% of GDP in 2004 to 15% of GDP in 2007.

Without the Euro in place, balance of payment issues would have led to currency devaluations that in turn would have allowed the GIIPS countries to regain competitiveness relative to the rest of the world – in the process, remediating trade imbalances within the EU. But with no recourse to devaluation, some economists have begun to propose alternative ways in which the Eurozone economy and specifically intra-EU trade deficits could be rebalanced. A common policy suggestion is for Northern countries to increase fiscal spending in order to counter-act the depressive effects of austerity measures in the South. This argument often also takes on another form, where policy makers suggest wage increases in the North would have a similar effect on intra-EU trade. But could a Northern fiscal expansion or wage inflation rebalance EU trade?

A new report by the European Commission for the Directorate-General for Economic and Financial Affairs sheds light on this issue. Olli Rehn, the Commissioner for Economic and Monetary Affairs, argues that the impact of such proposed fiscal measures should not be over-estimated. A quick examination of the empirical data proves his point. Indeed, increases in German demand would have a much greater impact on its nearby trade partners than it would on the large deficit countries of the South. Countries to the East of Germany, such as the Czech Republic, Slovakia and Hungary would stand to benefit the greatest gains. Ironically, an increase in German imports would drive Northern surpluses upwards more than it would drive Southern deficits down. For instance, a 1% increase in German demand would have the largest effect on surplus-countries Austria and The Netherlands, where exports would respectively grow at 0.19% and 0.16% of GDP. In comparison, a similar increase in German demand would increase Spanish exports by 0.06% and Greek exports by 0.05%. Moreover, because increases in German demand would also boost German production, the actual trade balances of Spain, Italy and Portugal would only improve “by around 0.02% of their GDP, and the Greek balance even less.”[3]

Those in favour of a Northern fiscal expansion or wage inflation nevertheless argue that “alongside the described positive demand effect, deficit countries could further benefit from Germany rebalancing through yet another channel as the competition from German exports would decline.”[4] This would restore the competitiveness of Southern products at home and in third markets. Arguably, the latter would benefit countries like Spain and Italy more than it would Greece, as the former two have “a relatively high degree of overlap with German exports” whereas such similarities do not exist between Greece and Germany.[5] However, this can hardly be considered an optimal strategy, as it has the ultimate effect of making the whole of the EU less competitive on a worldwide basis. It would be more sensible to recognise that the bleak economic outlook in EU deficit countries reflects poor competitiveness relative to the rest of the world, “rather than [due to a] lack of demand from the core Euro area.” [6] Hence, policy should focus on rebalancing the competitiveness of the Southern European economies relative to its Northern neighbours. Progress is being made on this front, and Olli Rehn writes that Greece, for instance, has recouped its wage “competiveness losses in 2001-09 - expressed in terms of unit labour costs.”[7] Wage costs have similarly fallen in Ireland, where unit labour costs decreased 12.7% between 2008 and 2012.

But more can be done. Several economists have put forth the idea that trade deficits could be rebalanced through a process called fiscal devaluation.[8] A fiscal devaluation refers to the idea of instituting a VAT/payroll-tax swap, or an increase in the VAT level and a similar decrease in employers’ social security contributions. It would have a similar effect as a currency devaluation, in that it makes imports more expensive and exports cheaper. First of all, VAT increases would increase the costs of imports. Second of all, as exports are exempt from VAT changes and as lower social security contributions would lower wage costs for domestic producers, exports would become more competitive on the world market. Milton Friedman famously argued in favour of flexible exchange rates: why negotiate a price change for thousands of wage contracts, when a similar result can be more easily achieved by an exchange rate depreciation? In that sense, a fiscal devaluation has similar benefits to a currency depreciation, in that it targets all prices at once. The effect of a VAT/payroll-tax swap, meanwhile, would be tax neutral and the increased exports would have the potential of generating additional tax revenue. Naturally, certain sectors will benefit more than others, particularly the labour-intensive sectors and those where competition is the highest. Meanwhile, the risks associated with attempting a fiscal devaluation are very low, as studies have shown that a heaver reliance on income rather than consumption taxation is growth-distortive.[9]

VAT rates are already high in many European countries, and an unofficial commitment between EU countries not to surpass the 25% mark may suggest that there is little scope for further increases. However, IMF economists Mooij and Keen argue that “considerable more revenue could be raised from the VAT even without increasing the standard rate.” [10] This is especially true for the Southern European economies such as Greece, Italy and Spain where non-compliance with VAT rules is especially high. They calculate, for instance, that if compliance levels in Italy were “of the level found in France, it would increase VAT revenue by about 1.2% of GDP.”[11] Several countries have implemented fiscal devaluations in the recent past. Germany, for instance, raised its VAT in 2007 from 16% to 19% while simultaneously cutting “employers’ contributions to social insurance from 6.5% to 4.2%.”[12] France meanwhile implemented similar measures in 2012. The Southern economies of the EU should follow suit.

In any case, it is important to emphasise that no single measure will be the silver bullet that will rid the Eurozone of all its imbalances. The Eurozone crisis is a multi-faceted crisis that will require a whole slew of reforms, from labour market reforms to banking reforms as well as a strategy to create growth. Nevertheless, the effects of Northern fiscal policy on rebalancing intra-EU trade should not be exaggerated, and increasing the competitiveness of the Southern economies should remain the primary objective of policy reforms. Perhaps a fiscal devaluation offers one potential avenue through which the latter can be achieved.

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[1] European Commission, Current Account Surpluses in the EU, 2012

[2] Farhi, Emmanul; Gopinath, Gita; Itskhoki, Oleg, Project Syndicate, A Devaluation Option for Southern Europe? 1^st of March 2012

[3] European Commission, Current Account Surpluses in the EU, 2012, 109

[4] Ibid

[5] Ibid

[6] Ibid, 99

[7] Olli Rehn, European Voice, The Re-balancing of the Eurozone, 20^th of December 2012

[8] Mooij and Kleen, ‘Fiscal Devaluation’ and Fiscal Consolidation: The VAT in Troubled Times, 2012, 24

[9] OECD Economic Department Working Paper, Tax and Economic Growth, 2008

[10] Mooij and Kleen, ‘Fiscal Devaluation’ and Fiscal Consolidation: The VAT in Troubled Times, 2012, 24

[11] Mooij and Kleen, ‘Fiscal Devaluation’ and Fiscal Consolidation: The VAT in Troubled Times, 2012, 24

[12] Farhi, Emmanul; Gopinath, Gita; Itskhoki, Oleg, Project Syndicate, A Devaluation Option for Southern Europe? 1^st of March 2012

Cameron's Speech

David Cameron’s speech on Europe is no game changer for the European Union. His new strategy on Europe will not be a source of reforms in the EU. And therefore, it cannot be a viable strategy for Cameron to bridge the divide in his own party, or the British electorate, over Britain’s membership in the EU.

It was in many ways a refreshing speech, but it cannot be compared to Margaret Thatcher’s famous 1988 lecture in Bruges. While Thatcher, too, expressed euro realism she offered leadership and visions of integration in Europe – profoundly different to the euro-federalist idea of an unstoppable, inevitable, march towards ever closer political integration. Cameron’s offer is to move the Tory battlefield on Europe, and how it can win the next national election, to other EU members. They are now being asked to agree on a new settlement that would increase the chances that the referendum supports UK membership in the EU. Equally important, they are in effect being asked by Cameron to silence those who believe that he has to run on a Eurosceptic platform in the next general election to fight the threat from the UK Independence Party.

But this is why the Prime Minister’s strategy eventually will bite him in his back. It is highly unlikely that he will get a new settlement that profoundly changes the terms of membership. Such a settlement would come by the courtesy of other countries that want to reform the EU – they are the ones that are most keen for the UK to remain in the EU – and they do not like Cameron’s gambit. Most of them would privately understand the call for an in-or-out referendum – but not if the referendum itself, and the case for Britain remaining in the EU, is hinged upon a new settlement. Worryingly, they believe that Cameron’s strategy also reduces the chances that there could be real improvements in EU policy and the way that countries, with different views about how far they want to take EU integration, could cooperate more flexibly with each other.  

Cameron’s speech offered a sensible analysis of problems in the EU as well as in many of its member states. Europe needs to be much more open to the world. It is time for yet another big push to liberalise markets and reform ossified public sectors. Taxes and government expenditures should come down. But Cameron is not alone in this view of Europe. There is among political leaders in Europe a solid majority supporting it – or taking it even farther. Britain is no longer a lonely nation fighting for free-market reforms in Europe against a continent where corporatism or dirigisme prevail.

In fact, the UK is no longer an outlier. It is no longer the champion in the EU for free trade. It is not the country that makes the most persistent and radical proposals for reforming agricultural subsidies, the EU budget, or cutting red tape. Several countries believe noxious regulations, especially environmental regulations, are being pushed down their throat with the strong support of Britain. Rightly or wrongly, quite many on Europe’s centre-right see today’s Tory party as wimpish on economic policy and as a non-ally in the opposition to Keynesian macroeconomics. 

So, imagine you are heading a reform-friendly government in Helsinki, Stockholm, Tallinn, Warsaw, Amsterdam, Vienna, or Berlin: how would you respond to Cameron’s invitation to become a peacemaker in the Tory party? You would most probably say no – and distance yourself from him. While Cameron’s new strategy may calm sentiments in his own party, it is also poisoning his standing among other promoters of reform. 

Open trade and its discontents

The following article was also published as an op-ed in the December 6th issue of the European Voice under the title ’Open trade is a two-way street’

The decision by the EU trade ministers to open free trade negotiations with Japan arrived on Thursday, after years of deliberation. Karel De Gucht, the European Commissioner of Trade, is unapologetically focusing on free trade agreements (FTAs) with the world’s largest trading nations – not out of bravery or foolhardiness, but out of necessity. The commercial attractiveness of the Single Market has always been the mainstay of Europe’s soft powers, which is inarguably in decline – Europe’s share of global economic output will be halved in fifteen years, and the EU is racing to secure FTAs while it still holds a leverage.

But the EU, despite being in trance to the mantra of growth and jobs, has so far struck free-trade agreements with countries that account for only 5% of its trade. Just three other countries in the same weight class – namely, the US, China and Japan (each with a gross domestic product of more than $5 trillion, or €3.8 trillion) – would have a meaningful impact on European recovery.

But large-scale trade liberalisation comes at a cost. The EU has so far been content negotiating trade agreements with countries far smaller than itself like Korea and Peru who could accept EU rules and standards on a wholesale basis, while not a single piece of EU legislation has been reformed. Such one-sided liberalisation simply won’t fly when European negotiators lock horns over product standards with the regional standard-setters like the US and Japan. Also, the EU's protectionist concern for the car industry – the sector that accounts for the EU's largest trade surplus with the world – gives rise to bemusement. This concern is the biggest hurdle against the EU-Japan FTA (although the EU runs a hefty half billion surplus against Japan), and some of the European affinity for a EU-US deal comes from a gleeful relief that Fiat and PSA would not complain about being exposed to more competition.

It is starting to dawn on European policymakers that the first priority for Chinese, Japanese or US businesses may not be to further open up zero-growth EU markets – the Obama administration puts the Trans-Pacific Partnership (TPP) above the Transatlantic High Level Working Group on Jobs & Growth; Japan, in its pre-election jitters, focuses on its Asian neighbours while the public support for TPP has also reached critical mass. In response, the new Chinese Politburo (the first where economists outnumber civil engineers) invited Korea and Japan into a three party trade agreement, putting a blind eye to recent territorial disputes. The China, Japan, Korea (CJK) agreement will merge with into a free trade area with ASEAN, India, Australia and New Zealand. By any estimates, both CJK and TPP will divert European exports to the extent which cannot be compensated Europe’s own FTAs – the infamous pivoting to the East is turning the once offensive EU trade strategy in a fierce battle to maintaining its market share.

Yet, the EU member states have failed to respond to Wen Jiabao’s offer to settle all their disagreements in a free trade agreement. That agreement is admittedly controversial for both sides. However, qualms about Japan's ability to deregulate its markets were not the only cause of a recent face-off over a mandate on Japan – some European leaders have also misgivings as to whether the Common Commercial Policy is really in their short-term political interests. However, promote openness only when it benefits Europe and turn to mercantilism – a classic case of “do as we say and not as we do” – undermines their own long-term interests by legitimising the same behaviour against Europe.

Economic facts do not cease to exist because they are ignored. The EU is far better to grasp globalisation as it really is, than to remain in the past, however satisfying and reassuring it was.