How did it come to pass that at four in the morning in Brussels last Friday, David Cameron received what the FT called a "diplomatic kick in the teeth" from French president Nicolas Sarkozy?

This is not strictly speaking an engineering or science story, but it affects Britain's economic future so I have decided to write about it. Science and technology legislation does not take place in a vacuum, so it would be strange if I did not from time to time write about the larger trends.

Newspapers, politicians and commentators have called last week's summit a showdown moment, the most significant turning point in the EU for years. Strangely, the bust up is not directly concerned with the main issue of the summit - about saving the euro from collapse - which the summit outcome actually did little to advance. It was about the future EU more generally. France has been unhappy with the direction of the EU for at least a decade, and the conflict between Britain and France is, of course, as old as the hills.


German development


Let us look at the economic background to the euro crisis, which is a tale of two economies: the German and Mediterranean. Back in the early 2000s, Germany was still known as the Sick Man of Europe. The economy was flat; the labour market was rigid and the country was still reeling from the costs of paying for the restructuring of East Germany.


Then, a change:


A number of reforms, named Hartz reforms, were put in place. They lowered compensation for the unemployed and put into place several schemes to get them back into work. The unions promised to moderate their wage demands while governments promised employment security. Germany also held back from introducing minimum wage legislation. The result of these reforms was that Germany became increasingly competitive. The growing economic success of India, China and other developing economies also helped Germany - even though these, too, were export economies.


Germany succeeded by complementing China in the export market, not competing directly with it. Germany's Mittelstand - small and medium sized family enterprises - specialise in the machine tools that the developing markets need to produce their own manufactures for export. The other jewel in Germany's crown is the car industry, responsible for 20% of GDP. They sell extremely well even at very high prices to the global market, because they command a brand premium and because of their extremely superior quality. A further reason has been Germany's extremely internationalist approach: managers speak English while, as I found researching a feature on German engineers earlier this year, companies are actively combing the world employment market for Indian and Chinese engineers they can employ to help them understand these cultures and ways of doing business.

The Club Med

So that is the German story, according to the Germans themselves - a story of backs-to-the-wall hard work to compete in a tough world. The story of the Mediterranean member states is familiar by now. Entry into the euro allowed firms and governments in these countries to borrow at low "German" interest rates. In the first half of the 2000s, there were huge sums of investors' money sloshing around the globe, looking for yield.

Much of this money came from China, which had lots of money to spare because of its export success but whose own financial system was too underdeveloped to channel investors' money. The southern European markets looked like a good bet. Their bonds offered low interest rates, but still higher yields than offered by German or US Treasury bonds. (US treasuries being the traditional safe haven.) They also seemed risk free because these countries were part of the "unbreakable" euro.


An additional benefit was the ability to park the Club Med's bonds with the European Central Bank as collateral in return for cash paid for at a lower interest rate than the yield offered by the Greek and Spanish bonds: the perfect arbitrage opportunity. You pay X euros for the Greek bonds, get X euros from the ECB by placing it as collateral there, and get a free income from the higher interest that the Greek bonds pay out, minus the lower interest from the ECB loan.

The Greek government therefore attracted a bonanza of funding, and lavished the money on benefits for cronies and loyal voters.

Corruption, as everyone knows by now, is pretty common in Greece. The ease-of-doing business index is below that of Bangladesh or Paraguay. The Common Agricultural Policy has long been a siphon of funds from the European taxpayer to the Greek farmer, claiming for tobacco fields he did not actually farm. In fact, a few years ago journalists were given a presentation of a European satellite that would zoom in and ensure Greek farmers had not cheated on their land claims. I am not sure it was successful: it is said that one agricultural county in Greece has the highest proportion of Porsche Cayennes in the world. Cohesion funds for wind farms are another ruse, as detailed in a recent BBC documentary. Most such technology projects require cofunding from national budgets before a matching sum from the EU is awarded. So what local entrepreneurs would do would be to switch the same funds from project to project, saying it was different sets of government money, and getting EU cofunding for each of these projects. This also goes on in Italy: there, inevitably, the mafia is involved.

In Spain and Ireland, it was the private sector that borrowed heavily, mainly funding construction projects. Households also took out big, cheap loans to buy consumer products and cars, many made in Germany. In normal times, these would have been unaffordable for Club Med consumers, as their currencies would constantly have been readjusting downwards to cope with their lower competitiveness than the German economy.


We all know what happened next: the Greeks admitted they had a far larger budget deficit than they had earlier claimed; Greece had a new government, and it had decided to come clean. The high deficit raised doubts about the Greek government's ability to service and pay back these debts. As the perceived risk of default grew, the cost of borrowing for the Greeks rose.


This further exacerbated the Greek situation, making them even less likely to be able to refinance their loans. The Greek government instituted a widespread austerity package: lower salaries for government workers, reduced welfare benefits. It promised more efficient and honest tax collection. The sharp reduction of demand this has entailed is proving to be very damaging for the Greek economy. European loans at lower rates than the market currently offers have tidied Greece over, from its refinancing problems; further, European governments are now forcing the international banks that have lent to Greece to write off some of their loans.

Ireland and Spain meanwhile suffered from private sector property busts, and soaring unemployment, leading to increased state outlays and severe liquidity problems.

If Spain (and Italy) left the euro and redenominated their currencies, domestic savers would lose out, as the new currency would fall like a stone against the euro - so even the fear of an imminent exit would trigger a cascade of withdrawals that alone would make the exit more likely. With exit would probably come defaulting on foreign loans, as these would be much harder to pay off with the very weak new peseta, the new drachma.

The loss to French, German and British banks that have invested very heavily in Spain and Italy would then be very great, sparking off a cascade of loan redemptions elsewhere to finance the losses in way that could cause a crash similar to the one in 2008.

The controversial under-the-counter insurance policies known as CDSs, that were set up to manage risk, could just make it worse by spreading large costs to banks outside the immediate circle of lenders. That is what happened in 2008. And nobody wants this cascade of defaults to happen again.

Summit problems

All this brings us to last week's summit. The EU has promised to back up the Club Med's needs for refinancing their loans at reasonable interest to rescue them from the spiral of increasing borrowing rates linked to a reduced ability to pay but also making the ability to pay even worse - thus averting a cascade. There is a short term problem with this in the fund set aside for this may not be enough for the big Club Med economies, designed as it was for Greece alone. And it wasn't boosted at the summit.

In fact, last week's pact may have done little to save the euro in the short term - and, as of this article being written, indeed little to save it in the long term.


The long term future of the Club Med in the euro requires them to make their economies much more competitive, lower their salaries relative to Germany, or to receive permanent, continual transfers from the richer countries in the same way richer regions permanently subsidise poorer ones within the member states. Some of this already goes on, mind, you, in the cohesion funds and the agricultural policy.


The possibility of these transfers of this was not on offer in last week's Stability Pact, a German-inspired thing that would require EU countries to put their budgets before Brussels and have them signed off, with automatic penalties if they breach the budget commitments. In return, the loans will open to them.

Cameron rejected this pact, even though Britain would not have been affected by the budget constraints, as it is not a member of the euro. (The pact would also apply to countries planning to join the euro - so six more non euro states are opting in, while non euro Sweden almost definitely and non euro Czech Republic possibly will be staying outside.)


But we have to be careful to qualify what it was he rejected. The deal will still go ahead, through without British and others' participation, and outside the European institutions. That means the European Court of Justice and the Commission will not police the national budgets. The EU 23 will have to set up a different structure. There has been talk that Cameron might even veto the use of the EU buildings for this purpose - though it would probably be diplomatically suicidal for him to do so.

Why did Cameron do it? It might not have done anything to save the euro, but if it was insufficient, it was not directly harmful, and the Germans wanted it. It would have been a cost-free exercise.

The British negotiating team's story goes I believe something like this. All countries have their red lines. The French their agricultural policy, the Germans, the independence of the European Central Bank. The British wanted a guarantee, a hand brake, that the legislation currently passing through Brussels would not harm the City. The City is unpopular in Britain, as many of you know. But changing City practices is a generational project. Dismantling it too quickly is manifestly not in Britain's interest, as it is one of the country's remaining world class industries and a major generator of national income.

But Cameron did not connect with other European leaders. Sarkozy was apparently behaving demagogically at the meeting, and many of the Continental leaders would have lent a sympathetic ear, so great is the unpopularity of the City on the Continent. It was 2.30 am when Cameron started making his rather technical speech about City regulations, and attention from other leaders was weak. Perhaps Cameron had an emotional moment after the hectoring French president had provoked hm.

Anyhow, the Germans are said to be upset. They appreciate British pragmatism and concern about the lack of budget discipline elsewhere. The friendship between France and Germany is not as close as politically correct official wisdom goes. Nor is Germany as willing to lead the world as British commentators with their stupid Fourth Reich demagoguery seem to think. They mainly want to export. Merkel is annoyed that, thanks to Cameron's move, the new stability pact will have be on an intergovernmental basis, not anchored in a European framework, making it harder to enforce.


French joy

However, judging by the French media and the blogs, and Sarkozy's smile on the morning, the French are overjoyed: their dream is of a closer European union with a quiescent Germany that provides the economic heavy lifting and France calling the political shots on behalf of Europe as a player on the world stage.

Even some German commentators believed that Merkel played her hand badly, and the French played well. With the Brits out of way the French could be hoping that Eurobonds, guaranteed effectively by the German taxpayer, will be easier to push through at a summit in the future.

Perhaps the new grouping of 23 (ie EU minus UK, Sweden and one or two others) will go much further and indeed decide to go ahead and pass decisions on tax raising and tax spending to a new central authority, though that big step that faces deep problems with the European electorates. Even if federalist reform will be difficult with the electorates, it will be easier without the Brits as an additional obstacle.

The French have long been irritated by the influence Britain gained in Europe when Scandinavia and then the East Europeans joined, in 1995 and 2004, as these were more sympathetic to British culture and way of thinking than France's traditional Mediterranean allies that were already members of the EU.

As for the City of London? The comments on Friday from various City types suggest many are worried: and with reason. London will still be susceptible to the wave of legislation coming its way from within the EU framework, passed with qualified majority - that is, 72% of votes in the Council of Ministers. Britain used to have a blocking minority with some allies such as Finland, Sweden or the Netherlands, but there are fears these countries will move away because of Britain's weakness after the Cameron veto.

New threats

And the new debt pact structure may evolve into an EU-within-an-EU that makes its own rules on financial regulation. So; a possible two pronged attack. Things may change - the euro may still collapse over the next few months, as British analysts point out, as, as said, all the measures the Europeans are introducing are medium to long term. The seriousness of intent though may satisfy the bond markets. But, anyhow, never has the rationale been stronger for the UK to diversify itself beyond a finance based economy.

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Pelle Neroth -- EU correspondent

Edited: 13 December 2011 at 08:33 AM by Pelle Neroth