EUROPE COMPASS

WEEKLY UPDATE JANUARY 28, 2013

Uncertainty and complacency   Yesterday The New York Times published an editorial criticising UK Prime Minister David Cameron for the speech he gave last week on the future of the UK-EU relationship. The basic argument is that the United Kingdom will find it hard to renegotiate the terms of EU membership and that Cameron's referendum pledge "presages four or five years of costly uncertainty for potential investors". The first part of this criticism has merit. The United Kingdom's European partners may indeed resist any effort at renegotiation. However, the second part of the criticism is more open to question. There is no doubt that Cameron made a big gamble with this speech. His goal is to silence eurosceptics within his Conservative Party without shedding votes to the UK Independence Party (UKIP). Cameron also hopes to keep the Liberal Democrats inside the coalition while at the same time catching Labour leader Ed Miliband wrong-footed. His success on all these fronts was difficult to manage but still possible to measure, both before and after the fact. Cameron's advisors can talk to their back-bencher and coalition partners, they can take advantage of Miliband's public statements, and they can keep an eye on the polling numbers. They might yet fail despite all these efforts, but that is a risk the prime minister accepted. Uncertainty is something different because it is harder to measure (if not un-measurable altogether, in Frank Knight's use of the term in his classic book Risk, Uncertainty and Profit). A good example might be the uncertainty that surrounds efforts to ignore the UK electorate's growing disenchantment with Europe. Pollsters may show how this disenchantment explains UKIP's rise to prominence, but they have a harder time outlining other possible consequences for the United Kingdom's position within Europe (or, as Cameron pointed out during the question and answer that followed his speech,Scotland's position within the United Kingdom). This anti-European sentiment should not be allowed to fester, Cameron argued. Complacency over Europe is the real source of uncertainty. Hence, Cameron would rather take the risk of engaging in an open debate -- which could put an end to this uncertainty should Cameron win the next parliamentary election.

Beware complacency   Cameron is hardly alone in making the case against complacency. IMF Managing Director Christine Lagarde, also speaking on January 23, warned about complacency in her comments at the World Economic Forum in Davos. "We all know the imperative; keep up the momentum on the policy actions needed to put uncertainty to rest," she argued. The problem is that financial market conditions have improved even as the reform efforts (and employment, and economic growth) have fallen off pace. This is true both nationally and across Europe. The question is whether firms or consumers have noticed. Eurostat will publish the results of its latest business and consumer surveys on January 30. Then there is the danger of complacency among financial market actors. The first tranche of the ECB's long-term refinancing operations (LTROs) was eligible for repayment this January. Correspondingly, some 278 European financial institutions are scheduled to hand back just under 1.4 trillion euros (1.9 trillion dollars) to the ECB to pay back the three-year low-interest loans they took out in December 2011. Is this a good thing? Right now, much of that liquidity is not being used and is instead being parked on deposit at the ECB. That banks are able to repay the loans should be a sign of strength. Then again, early repayment may also be an attempt to avoid revealing continuing weakness, particularly on the part of banks in Italy and Spain. The FT Alphaville blog's Daniel Keohane surveys the running debate among bank economists, who worry about the negative consequences of handing back so much liquidity before the markets have fully recovered. If tensions should return to the markets, European banks will have to make do with much shorter-term ECB lending.

More skeletons in the closet?   The dangers of renewed tension continue to mount. Consider the upcoming elections in Italy and the recent turmoil surrounding the Monte dei Paschi di Siena (MPS), Europe's oldest bank. Here we see complacency on many levels. It started with the oversight that was given during the MPS's acquisition of Banca Antonveneta in November 2007. Much of the Italian media reports that this took place during the halcyon days prior to the onset of the financial crisis. In reality, the hole in US mortgage markets was already apparent and the run on the UK building society Northern Rock had just taken place. Nevertheless, MPS paid well above market value for the acquisition and no one complained at the time. Then the MPS started struggling to meet its financial obligations and used derivatives contracts to hide that fact from the regulators. Eugenio Scalfari explains in Sunday's La Repubblica how the accumulation of losses took place. Now Italy's politicians are using the MPS scandal to break open their own political contest. Centrist Prime Minister Mario Monti has accused the centre-left Democratic Party (PD) of being particularly implicated. PD leader Pier Luigi Bersani and his surrogates are attacking Monti for hypocrisy and double standards. Populist comedian Beppe Grillo is arguing that the whole scandal represents yetanother monumental failure of the ruling classes. Meanwhile, Italy's financial press is quietly worried that the global banking community will start to wonder what other skeletons the country may have hidden in its closets.

Complacent foreign policy?   Then there is the turmoil in Syria, Egypt and Mali. The first battery of NATO Patriot missiles has found its way to the Turkish-Syrian border, and two more will be added over the coming week. These facilities will help to protect the Turkish people and also provide a strong symbol of alliance commitment. They also increase the importance of coming up with a clear European policy towards the Syrian conflict. A similar point can be made about Egypt, where popular protests threaten to undermine state control. And the point can be made even more strongly about Mali, where French intervention has failed to restore order. These are areas where European engagement should be decisive rather than complacent. In Mali, for example, France and the United Kingdom should not be left on their own. The reason is not that the risks of involvement are minimal; rather it is because the uncertainty of allowing events to unfold beyond European influence will continue to grow.

I trust you have found this weekly Europe Compass note helpful. The Europe Compass is one element of Oxford Analytica's Europe Practice, which provides analytical insight and advice on the changing political economy of Europe and the implications for corporations, investors and public institutions in all markets and regions. I invite you to contact me or anyone at our Europe Practice with your queries or concerns.