Sunday, February 15, 2015

15/2/15: European Federalism: Principles for Designing New Federal Institutions

This week, I was honoured to have been invited to participate in a discussion panel of the Future of Europe at the Trinity Economic Forum 2015.

Here are my extended speaking notes on the subject of European Federalism and the challenges of building future European institutions.

The Global Financial Crisis, the Great Recession and the Euro Area Debt Crisis exposed structural weaknesses in the political, economic and social institutional designs of the European Union. As the result of these weaknesses, today, we are increasingly faced with a Union of the few (the ever-shrinking in numbers European ‘core’), with the membership of the many (the growing ‘periphery’ excluded from the decision-making within the EU, and the stand-alone Eastern Europe, largely left to its own devices and pursuing own objectives that increasingly represent a confluence of geopolitical aspirations and the interests relating to achieving capital and economic convergence with the core).

As the result of continued build up in the relating economic and social imbalances, the deepening twin challenges of restoring both the viability and the cohesion within the Union present an existential threat to the EU. But beyond the fear of political and social disruption, the same challenges represent an opportunity to renew institutions of participatory democracy and cooperative governance that can harnesses the power of social, political, economic and cultural  heterogeneity of the Member States to deliver a renewed EU.

Currently, the European nations and their voters are being presented with two alternatives for addressing structural weaknesses of the EU, exposed by the crises. On the one hand, European Intergationism offers an ever accelerating and deepening concentration of decision making within the EU in the hands of technocratic institutions of the European Commission, the European Council, the Eurogroup and the ECB. On the other hand, Euroscepticism calls for a radical devolution of power and greater autonomy in favour of the member states, opposing any idea of federalisation of the EU or within the EU.

This is a false dichotomy, based on the ossified political ideologies no longer sufficient in the modern world of rapid change, amplified risks and social and economic disruptions. In my view, gradualism, coupled with institutional design from below, from the level of European demos, are the twin approaches that can deliver effective evolutionary process for building future European institutions.

A combination of internal and external challenges and on-going changes that acts to force a disruption to the status quo ideologies, politics and institutions of Europe is substantial. These include:
On-going technological revolution that started with rapid computerisation and automatisation of economies in the 1980s and to-date has witnessed the EU member states falling far behind the productivity growth curve that has propelled North American and Middle Income economies growth during the 1990s and 2000s. The same technological revolution drives both, radical changes in the traditional models of enterprise development and the labour-capital relations which the European economies and European institutions are not equipped to address.
Global economy shift away from traditional North-South globalisation axis of development toward much greater and growing regionalisation of trade, investment, savings and human capital flows, and, thus, greater regionalisation of growth drivers. These changes increase marginalisation of the ‘platform’ or ‘gateway’ models for trade and investment, as well as for human capital on-shoring on which many European economies rely today.
Amplification and acceleration of shocks and traditional business cycles, including the ever-rising complexity of risk propagation and contagion channels across financial markets, real economy and public finances.
Demographic challenges represented by ageing populations, declining labour force and rising unfunded liabilities. These challenges not only threaten the traditional social democratic model of income and services provision to the older populations, but also the supply of investment (in physical and human capital) and other drivers of future growth in the aggregate demand. They also weaken European economies and societies to innovate and adopt innovation.
Decline and fracturing of the traditional body of politics and ideologies in the post-crisis environment – a challenge compounded by the changing nature of public discourse (social and alternative media), as well as by the rising power of direct democracy. One, immediate, manifestation of this is the decline of the traditional European Centre in politics and the rise of the more extremist parties and groups. But beyond that, there is also a far more threatening trend of reducing political participation and undermining democratic mandates of the Governments increasingly elected on the basis of shrinking and more concentrated segments of the demos.

To survive and succeed in this new and constantly changing environment, the EU needs to develop institutional structures that combine the benefits of both, traditional systems of governance (based on technocratic capabilities), and direct and open democracy structures (based on public discourse, sourcing of ideas and participation), while minimise their respective costs and risks.

Consider the economic and monetary policy institutions as a laboratory for testing this process of institutional transformation.

Eight years into the crises, it is now an accepted wisdom that the European leaders have failed to see even the basic risks arising from the rules-based compulsory monetary integration. The crises have highlighted deep divisions within the European Monetary Union (EMU) on matters as diverse as inflationary preferences, demographics-anchored economic expectations, legal systems regulating the financial markets, and fiscal transfers.

These differences underlie the reality that common currency cannot be successfully deployed across a vastly heterogeneous base of economies, demographics and institutions without, ex ante, federalising the political and fiscal systems. Nor can the lack of supportive political and institutional systems be remedied by the purely managerialist solutions.

In fact, it remains an open question whether federalisation itself is a sufficient or even feasible condition for addressing these challenges. The crises exposed the fallacy of European integrationism – a doctrine that closer and closer harmonisation of institutions between the member states should be the desired objective of the Union. Shocks impacting the euro area since 2008 have been asymmetric in nature, geographic distribution and magnitude, as well as heterogeneous across the economic sub-systems. This is true today, eight years into the crises, and it was true at the points of the individual crises impact. While German economy runs extremely low levels of unemployment, Italian unemployment is hitting historical highs and the French and Spanish unemployment figures remain stubbornly close to their crisis peak. Meanwhile, all four economies see government bonds yields at or near historical lows. While all four economies differ in terms of their external balances, all four share in terms of stagnant domestic demand and the resulting risks of deflation. Meanwhile, stagnation in the real economies is now contrasted by an asset bubble in the public debt markets, just as Europe’s capacity to use fiscal policy to stimulate short term growth is being exhausted by already high public debt levels. And it is being reinforced by another asset bubble emerging in risk-based equity markets, just as Europe’s real investment remains stagnant.

In this environment, no singular monetary policy can even in theory match the economic objectives of the EMU members. The integrationist’s solution to this problem is to enhance fiscal coordination and use debt federalisation and fiscal spending to compensate for the side-effects of monetary failures. Alas, that too is an impossible balancing act. Based on the IMF estimates, Euro Area’s General government gross debt stood at almost 97 percent of GDP at the end of 2014. With Euro Area Government revenues amounting to nearly 48 percent of GDP, and public spending running at close to 51 percent of GDP, there is simply no room for a ‘federalised’ Europe to pump more debt into the Member States’ economies.

Worse, looking at the net Government debt across the Euro Area, one quickly arrives at the conclusion that harmonising fiscal policies cannot be and should not be an objective even within a fully federalised EU. In 2014, net Government debt in the Euro Area ranged from -47.6 percent of GDP in the case of Finland to +168.8 percent of GDP in the case of Greece. And in terms of external balances, Euro Area remains fragmented across three dimensions, the fragmentation that persisted from the 1980s on through today. While ‘core’ Euro Area economies (Austria, Belgium, Finland, Germany, Luxembourg and the Netherlands) average current account surplus for 1980-2014 runs at 3.25 percent of GDP, delivering a cumulated average surplus of 91.3 percent of GDP over the period, the ‘peripheral’ Euro Area states (Cyprus, France, Greece, Ireland, Italy, Malta, Portugal and Spain) experienced average current account deficits of 3.2 percent of GDP and have cumulative average current account deficit of 102.2 percent of GDP over the same period. The third dimension to this fragmentation is the presence of the deficit-generating Eastern European Accession States (Estonia, Latvia, Slovak Republic and Slovenia). In simple terms, net borrowers remain net borrowers, net lenders remain net lenders and this situation remains ‘sticky’ over the last 35 years.

Federalised Europe may be a necessary condition for addressing these imbalances, but it is hardly sufficient, as increasing degree of policies and institutions harmonisation has not delivered any real convergence to-date. Clear example of this failure is the creation of the Euro itself. Since the formation of the common currency, none of the Euro Area ‘peripheral’ states have managed to shift from the regime of running perpetual current account deficits to a regime of generating surpluses.

European leaders’ diagnosis of the problems compounds them. Instead of treating the actual malaise (the attempt to view harmonised policies across the heterogenous economic, political and social systems as efficient solutions to the problems of combining under singular institutional umbrellas vastly heterogeneous and even divergent national systems), the EU is attempting to treat its symptoms (the lack of credit transmission from one economy to another, or the mismatch in debt financing costs across the economies, or deflationary pressures, or fiscal divergences and imbalances, and so on).

Having confused causes and effects, the EU is naturally confusing poison for cure.

Continued enhanced harmonisation of the European institutions, absent ex ante deep reforms of these institutions, risks weakening Europe’s ability to respond to the future crises by increasing systems’ rigidity in the face of the future shocks, and, thus, systems’ fragility. The Banking Union, the Genuine Monetary Union, fiscal harmonisation (the Fiscal Compact) and the Political Union – all are replicating the very same error of centralising command, control and supervision over diverse national systems in the hands of technocrats. This implies further weakening of democratic buy-in for future crisis-related policies, amplified memory of the lack of such buy-in from previous crises policies and, subsequently, reduction in the political spectrum that remains un-tainted by the previous participation in shaping unpopular policies. But beyond these already powerful forces, the increased harmonisation approach to dealing with institutional weaknesses fails at an even more basic or fundamental level: all top-driven harmonisation and consolidation efforts at reforming our institutions either de facto or de jure (and in majority of the cases – both) assume perfect foresight of the future crises and perfect wisdom of the one-solution-fits-all answers to such crises.

The main lesson of the Euro area crises should be that artificially centralised systems, such as the EMU, create own risks that compound external shocks, while adding complexity to the shocks- and risks-transmission mechanisms. When such systems are imposed onto structurally heterogeneous political and economic institutions, even smaller shocks (e.g. to the euro ‘periphery’) become systemic.

Instead of rigid umbrella institutions that standardise responses to shocks, Europe needs to develop more agile, adaptable and de-centralised institutions that encourage policy experimentation and learning, while setting robust downside controls and collective insurance. In financial markets, these twin approaches are known as diversification principle for portfolio allocation and stop-loss rule, respectively.

To achieve this, the EU needs to evolve a federalist superstructure that simultaneously draws on a direct democracy mandate, maximises cooperative policy formation and deployment, and is based on bottom-up approach to policy innovation.

By definition, such a structure cannot supersede the Member States’ except in the core competencies that reflect cross-shared values of all members of the Union. These competencies have been well-defined in the European polity and electorates as securing free trade, free mobility of capital and labour, and common markets. These, then, should once again become the sole competencies of the Federal EU.

The Federal system should be bi-cameral, with directly elected Parliament and nationally-elected, member states’ representative, upper chamber. Its executive should be headed by the directly elected President, and funded by a designated federal tax. The best basis for such a tax can be each member state GDP per capita, with the common tax rate controlled by the upper chamber of the legislature.

The model for balancing the referenda-based direct democracy, the national and Federal legislative and executive mechanisms across the EU can be Switzerland.

On the EMU side, Europe needs to create a functional and well-defined mechanism for member states to exit the EMU without jeopardising their membership in the EU itself. The EU will also need to abandon the requirement for its members states to progress toward membership of the EMU. This does not mean that Europe will move to pre-EMU fragmentation of its currencies. Instead, in many EU states, Euro can coexist – in circulation and deposits – with domestic tender. But it does mean that some of the states will be free to pursue their own monetary and exchange rate policies. These states should be facilitated in transitioning to a new currency set up. Such transition should allow parallel circulation of the Euro and domestic currencies for a period of time, with strict control from the ECB in terms of monetising Euro denominated liabilities.

There are many other reforms that will be required, beyond the main principles outlined above. But the core principles remains:
1. European federalism can only evolve on the basis of drawing strength from the diversity and pluralism that define Europe, not by undermining or displacing it.
2. European federalism cannot be imposed from above nor can be spread via technocratic reforms across an ever-widening space of competencies. Instead, it must build on the foundations of participatory democracy and pluralist approach to policy debate and formation.
3. Gradualism, beginning with a handful of core competencies areas of common agreements, should take precedence in building up federal European systems and institutions.

Thursday, February 5, 2015

5/2/15: Gazprom's Nord and South Streams: Lessons Learned, Strategy Changed

An interesting paper from Oxford Institute for Energy Studies, titled "Does the cancellation of South Stream signal a fundamental reorientation of Russian gas export policy?" (January 2015:

It is a very insightful and interesting paper worth a read. Here are some extensive quotes, occasionally with my own comment.

In 2006, Gazprom and the Italian company ENI, subsequently joined by the French EdF and German Wintershall, announced South Stream project – two gas "pipelines, each 930 km in length to be laid from Anapa on the Russian Black Sea coast to Varna in Bulgaria in water depths of up to 2,250 metres." Note the timeline: 2006. Following January 2009 Russia-Ukraine gas dispute/crisis, the project was doubled from 2 lines to 4 lines and capacity of 63 Bcm/year. First line was scheduled to come into production in Q4 2015, second line by the end of 2017 and all four lines by 2020. Note: doubling of the pipeline, in theory, allowed for a partial offset for gas flows currently transiting Ukraine. Permitting for growth in the Turkish market (supplied via link via Bulgaria) and for expected growth in demand for Russian gas across Europe, South Stream at full capacity could have reduced Russian gas transit via Ukraine by around 40-50%.

Per paper, "From 2008-10, Russia signed intergovernmental agreements with seven European countries… The total cost of South Stream …was estimated at around $40 billion in mid-2014, comprising: $17 billion for the Russian Southern corridor; $14 billion for the offshore section and $9.5 billion for the onshore European sections." In other words, Russia agreed modalities and permissions for construction with all EU member states involved. Some estimates put the cost at EUR50 billion (see here: once feed-in pipelines were to be included, of which EUR 40 billion was supposed to be Gazprom own share, large portion of which would have been unrecoverable (sunk) cost if South Stream were to proceed to on-shore landing at Varna.

In the end, Gazprom held 50% of South Stream shares (excluding feed-in pipes), Eni owned 20%, and Wintershall Holding and EDF had each 15% shares. These only broadly corresponded to the final cost breakdown as well, with the Russian side was required to supply in excess of USD20 billion worth of own funding to the project, raised predominantly via debt to be assumed by Gazprom. No participant to the project required any access to the pipeline for any other party or for project shareholders, other than Gazprom. The pipeline was conceived, planned and funded absent any other suppliers than Gazprom and no participant in the project objected to this.

So what happened from the date of enthusiastic European engagement with Gazprom till the day of its cancelation of the entire project in early December 2014?

Well, a lot. The key change was regulatory volatility induced by the EU. The Oxford paper is straight on that: "The regulatory environment worsened dramatically for Gazprom, following the introduction in 2011 of the EU’s Third Energy Package (TEP).The TEP mandated regulated third party access (TPA) to pipeline capacity …unless an exemption from these rules is granted by an [National Regulatory Authority] NRA and approved by the European Commission (EC). Thus the TEP created major problems for Russian gas exports to EU countries in terms of compliance with the changing regulatory environment both in respect of existing and new pipeline capacity."

Recount that: five years after the initiation of the project, EU unilaterally demolishes the regulatory basis for the project. This, in Brussels' view, is how one does business involving decades-long capital commitments. Proceeding with South Stream, therefore, post-2011 meant that Gazprom would sink tens of billion into infrastructure to supply own gas, based on several decades of expected revenues, and EU could hold a stick of barring Gazprom access to its own infrastructure, built on its own money, at a whim.

You think I am exaggerating? Oxford paper describes another case where Gazprom fell a victim of the EU regulatory caprices: the OPAL line. In the OPAL case, as Oxford study details, EU agreements were not worth the paper they are written on, and EU National Regulators have been found to hold no power to even exercise the power legally granted to them by the EU. All of this was already in play before the Ukrainian crisis.

Similar happened in the case of the South Stream pipeline. But as an even bigger farce. EU Commission argued that national-level agreements signed by Gazprom with member states violated TEP. Here's what Oxford paper says on that: "The TEP (in)compatibility argument, which was the main reason for the South Stream cancellation, is somewhat flawed as the TEP in its current form does not contain any rules for construction and utilisation of new pipeline capacity, but only rules for existing pipeline capacity."

Yep, Russians made a major mistake. "Given this regulatory void in respect of new capacity, which would not be filled until the second half of the 2010s, Gazprom and the Russian government should have recognised and acknowledged much earlier in the process that South Stream could not proceed on its original timetable." In other words, Moscow should have canned South Stream back in 2011-2012 and opted for the Turkey Stream instead (but see more on this latter bit below).

Only after all this TEP brandishing as a lethal sabre in front of Gazprom does the Ukrainian crisis enter the frame: "…following the Ukraine crisis and Crimean annexation, relations between the EU and Russia on all gas issues were “frozen”, creating great difficulty in even scheduling meetings between the two sides. …The inability of the parties to even negotiate, let alone reach a compromise, on regulatory issues ultimately led to the South Stream cancellation."

Was Ukrainian crisis a convenient excuse for the EU to bully Gazprom? Was, at the same time, arbitrariness of the EU regulatory process applied to Gazprom as the means for assuring that Russian gas deliveries to Europe remain subject to control by Ukraine? Is Gazprom transit being treated by the EU as a direct subsidy to Ukraine? I don't know nor do I want to speculate - the powder keg of Ukrainian conflict geopolitics makes any rational discussion impossible, given the proliferation of policy trolls and the vitriolic pseudo-intellectual debate being promoted by all sides to the conflict. But are these questions legitimate, given the timing and nature of events pre-dating Ukrainian conflict? Should they be asked?

There are many examples of absurdity of the EU position, were one to be tempted to explain it from the rational / logical point of view:

  • One: EU aims to secure Russian gas deliveries without interruptions. Would this objective not be best served by cutting out middle men from the transaction and allowing delivery via more pipelines than less? In finance, South Stream completion would have been equivalent to portfolio diversification. 
  • Two: What happens when the majority shareholder in Gazprom and the CEO of Gazprom simultaneously announce a strategy change? "On December 1, 2014, …president Putin and Gazprom CEO Alexey Miller announced that South Stream had been cancelled due to the combined failure of the Bulgarian government to provide assurances that the pipelines could be laid; and the European Commission to provide assurances that gas would be allowed to flow through them." What does the EU Commission do in response? It "notes" the “currently unofficial nature of this announcement”. Unofficial announcement? By the President of the country that owns Gazprom and Russian gas? By the CEO of the company itself? How more official can it get? Clarify what? Do the EU Commission boffins know the word "No"?

Meanwhile, Russia was left nursing serious losses and had to redeploy allocated funding to a different route.

Again, from Oxford paper: "While one strand of opinion was that the real reason for the cancellation was a recognition from the Russian side that, due to economic problems stemming from sanctions and a falling oil price, the project could no longer be afforded, this seems unlikely… By the time the project was cancelled, Gazprom had already spent $4.7 billion on the offshore and European sections, most of which would have been for the offshore pipe and the charter of the barge; and a similar amount on pipe and compressors for the Russian Southern Corridor. This represented approximately 40% of the $20 billion of capital investment required for the first two lines (approximately 30 Bcm/year of capacity). … once the pipe was on the seabed, then the Russian side would be completely dependent on Bulgarian and EU decisions to monetise its considerable investment. Hence ...the timing of the decision was crucial." In other words, the costs were about to become 'sunken' or, rather, full hostage to the EU meddling with the project, and by extension, to the Ukrainian geopolitics of the EU.

Turkey Stream announcement allows Gazprom to recover much of the capital already allocated. And, according to the Oxford paper, Turkey Stream replacement for South Stream makes business sense. For all parties concerned, not just Gazprom. "The cancellation of South Stream and adoption of new pipelines arriving in a non-EU member state remove a major problem in EU-Russia gas relations..."

However, the sticky point is, you guessed it - Ukraine. "…as a result of the events of 2014, the EU political agenda expanded to include maintaining a gas transit role for Ukraine, and this is also important for maintaining reverse flows to Ukraine…" In other words, forget the Energy Security blabber and the rest of the EU agendas. The core objective is to retain Gazprom capture by the Ukrainian transit system. Chain that bear!

Here is the take on the Russian-Ukrainian game of energy poker: "The Ukrainian government led by Arseny Yatseniuk has expressed a determination to phase out Russian gas imports (replacing them with LNG and pipeline gas from other sources), but a willingness to continue transit. On the Russian side, …Alexey Miller reiterated the claim that transit of Russian gas across Ukraine would be phased out, but a willingness to continue supplying the country. The positions of the two countries on supply and transit are fundamentally in conflict, and appear equally unrealistic."

The problem, folks, is that it is Russian gas, not Ukrainian. It's up to Russia to say who it sells it to and to agree terms on which it is sold. Not Ukraine's. Ukraine has a right, under existent contracts, to receive gas it pays for. And it has the right to negotiate its terms for receiving this gas. It also has a right to refuse buying Russian (or anyone else's) gas. But it has no right to demand Russian transit via its territory.

More crucially, however, is the overall change in Gazprom business strategy that underlies the Turkey Stream announcement and other developments in Russian-European gas markets.

Again, as Oxford paper states, "All of this is consistent with the announcement by Alexey Miller that the company is abandoning its long held strategy of direct sales to European end-users: “The principle of our strategy in relation to the European market is changing. The decision on stopping South Stream is the beginning of an end to our operation model of the market within which we oriented ourselves towards supplying [gas] to the end consumer… But you can’t win love by force. If the buyer doesn’t want the purchase to be delivered home, well then perhaps he needs to get dressed and go to the store, and if it happens in winter, get dressed warmer. Well he could also take some package… which can well be the Third Energy Package, but what counts most is that it should not be empty. In our case the store is certainly the delivery point on the Turkish-Greek border.”"

In other words, if a grocery store is not allowed to deliver directly to consumers' homes, consumers will have to go to the grocery store, where it is located.

Per Oxford analysis: "This firmly closes the door on any possibility of a `strategic partnership’ between Russia and Europe on gas, and places the trade at the level of a `commercial partnership’ i.e. if Russia has gas to sell and Europe wants to buy then trade will take place, but there will be no deeper economic or political commitment to facilitate trade." Question is, is Europe Europe ready to engage in commerce instead of political 'partnership' games that are designed to assure a 'revenue cut' for the Ukraine? Time will tell…

Is "an ironic result of the 2014 crisis - a much more logical commercial strategy for Russian gas exports?" ask the Oxford analysts. And their answer (and I agree with it) is 'Yes'. "US and EU sanctions, limiting the availability of finance for Russian energy companies and threatening the possibility of an embargo on LNG technology, have accelerated both a move into the Asian market by Russian companies and a shift away from Russian LNG to pipeline gas projects. ...Abandoning South Stream, which looked very complicated from a regulatory point of view, in favour of direct undersea pipelines to Turkey, prioritises Gazprom’s second biggest market, and its only European market with major expansion possibilities over the next decade. Refocussing on pipeline gas – where Gazprom has decades of experience, compared with LNG where it has very little - looks like an entirely sensible strategic move."

Do note the LNG threat. If Russia was allowed to develop LNG capabilities, it could have serviced some of the European markets (e.g. Italy) via LNG supplies. By threatening this capacity, the US and EU are de facto forcing Russia to push gas via pipelines. Coupled with the EU opposition to South Stream, it means that the US and EU were forcing Russia straight into the monopoly hands of Ukraine as transit route. Does this make any sense? No. Instead of diversifying supply routes, it retains them at the point of highly volatile geopolitics and domestic Ukrainian politics. Why, someone should ask, would EU want this outcome?

"…an irony of the post-Ukrainian crisis period may be that a combination of western sanctions, EU regulation and the breakdown in EU-Russia relations, may have pushed Russia and Gazprom into a much more logical commercial strategy for gas exports." And delivered to China long term strategic partnership-based access to gas and oil from Russia.  Congratulations, Brussels.