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Special Report

Twenty Questions on the Future ofEurope:

The EU after "non" and "nee"

June 2005

The Economist Intelligence Unit15 Regent St, London SW1Y 4LRUnited Kingdom

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Twenty Questions on the Future of Europe www.eiu.com June 2005

Twenty Questions on the Future of Europe

The rejection of the European Union's constitutional treaty by Frenchand Dutch voters has sent a shockwave throughout the enlarged EU,upsetting plans for further deepening and casting doubt over futurewidening. The fact that two founder members that have been central toEuropean integration, rather than the UK, rejected the treaty makes thesituation profoundly different to that in the wake of previous referendumdefeats for EU treaties in Ireland and Denmark.

Here we offer a briefing on the EU's situation in the wake of theconstitution's rejection, covering short-term questions around the fate ofthe constitution itself and medium-term implications for importantissues and institutions such as the euro zone, enlargement and the 2007-13 budget. We also examine the established drivers of Europeanintegration up to now�the Franco-German axis, the success of theEuropean economy and the appeal of supranationalism�and assesswhether they are still up to the task. Our 20 questions conclude with alook at where the EU might go from here, answered in the form of fivescenarios.

The questions:1. Why did the French and Dutch vote no?

2. Is the constitution definitely dead?

3. Can any elements of the constitution be salvaged?

4. Can a 25- or 27-member EU function effectively on the basis of theNice treaty?

5. Does this mark the end of Europe's federal project?

6. Can the UK presidency lead the EU out of its current crisis?

7. What will be the impact on the euro zone?

8. What are the implications for the 2007-13 budget?

9. What are the implications for the new member states?

10. Enlargement I: will Bulgarian and Romanian entry to the EU bedelayed?

11. Enlargement II: what about Croatia, the western Balkans, Turkey andthe CIS?

12. Is this the end of the Franco-German axis?

13. How serious is Europe's economic underperformance and its impacton the EU's political malaise?

14. Will "Anglo-Saxon liberalism" necessarily triumph over "the Europeansocial model"?

15. Does this signal the rehabilitation of the nation state?

16. Does Europe still have a voice in the world?

17. What are the implications for US-European relations?

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18. Who will fill Europe's leadership vacuum?

19. What effect has the rejection of the constitution had on the EU"legitimacy deficit"?

20. Where does the EU go from here?

1. Why did the French and Dutch vote no?In both France and the Netherlands, many of the "no" campaigners'arguments had little to do with aspects of the constitution itself�thoughgiven the complexity of the treaty this is perhaps unsurprising. Therewas, however, a vigorous debate not just about the constitution butabout the broader direction of the EU. The campaigns exposed threefissures running through French and Dutch politics: between rich andpoor; between government and citizens; and between these twocountries and some of their partners in the EU.

In France, by far the most important reason why voters rejected thetreaty was anger at the government, particularly over the rate ofunemployment, which is above 10%. Despite the fact that theNetherlands' government is also unpopular, opinion polls suggest thatthis was not a major reason for the "no" vote. Instead, the mostimportant of many reasons was long-running resentment over the factthat the Netherlands is the highest net contributor per head to the EUbudget.

In both countries there was also considerable concern over the perceivedconsequences of EU enlargement, in terms of an influx of cheap labourfrom eastern Europe and an outflow of investment in the oppositedirection. However, the main concern in relation to the EU in France wasthe view that it is becoming a vehicle for importing "neo-liberal Anglo-Saxon" reforms rather than for exporting French values. Indeed, theswing of normally pro-European left-wing voters against the constitutionwas instrumental in its defeat in France. If less prominent, a feeling thatthe EU was adopting a right-wing agenda was also important in theNetherlands, where the majority of "no" voters were also found on theleft of the political spectrum.

In addition the referendum results have been widely interpreted as aprotest against plans for further EU enlargement, especially to includeTurkey. Although a majority of the electorate in both countries is atpresent against Turkish membership, the evidence of the polls impliesthat the results would have been no different if the issue did not exist.

2. Is the constitution definitely dead?The constitution is dead, although no country wants to admit as much.European leaders insisted all along that there was no "Plan B" in theevent of a "no" vote�and this has become evident. Legally, the treaty hasto be ratified by all 25 member states to come into force. However, EUleaders struck a political agreement that if by October 2006 (two yearsafter the signing of the treaty) four-fifths of the member states hadratified it but one or more had failed to, the European Council wouldmeet to find a solution. Given that most people expected problems toarise in the UK, or other traditionally Eurosceptic countries, the most

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likely solution would have been to ask the country to reconsider, orconsider its future in the EU. With the "no" votes coming from twofounding members of the Union this no longer seems plausible.

The EU has a limited number of options. It could continue with theratification process�as favoured by Jacques Chirac, the French president,and Gerhard Schröder, the German chancellor�on the grounds that twocountries alone cannot decide the fate of the constitution. However, sucharguments cut little ice in the UK, where achieving a "yes" vote wasalways going to be a difficult proposition, if not an impossible one. Thereis little appetite to waste time, money and political capital campaigningfor a treaty that is already perceived to be a non-starter. Continuing withthe ratification process would also increase the risk of further "no"votes�in the Czech Republic and Denmark, for example�because thepolitical costs of rejecting the treaty have fallen.

Crucially, there remains the question of how France and the Netherlandswould eventually ratify the treaty. Denmark and Ireland voted twice overthe Maastricht treaty and the Treaty of Nice, respectively, but specificassurances were given that justified another attempt. It is difficult to seehow these could be given for the constitutional treaty, which is primarilyconcerned with institutional rules of engagement. Neither does it seemplausible that the treaty could be amended to meet French concerns. Anychange to place more emphasis on an EU social model would berejected by the UK and others.

That leaves the EU with no option but to suspend the ratificationprocess�sooner or later. Although there will be resistance to abandoningthe treaty (and Mr Chirac will be reluctant to hand Tony Blair, the Britishprime minister, a convenient way out of his predicament), the difficultiesof ratification in France appear insurmountable. Pressing ahead with theprocess in other countries would simply delay the point when the EUmust administer the last rites to the constitution. To labour under theillusion that the treaty can be passed in its current form would onlyprolong the agony over the EU's future direction.

3. Can any elements of the constitution besalvaged?Yes, but only with difficulty. Any attempt to implement select parts ofthe constitution is likely to run into problems, as it must negotiate twohurdles. First, there has to be agreement among the member states. Thisis likely to be difficult because the constitution represents a grand bargainbetween the EU25. Cherry-picking the treaty would probably leave somemembers happy but others disappointed; as such, it would not have theuniversal support of member states necessary for approval in theEuropean Council.

Second, many of the changes proposed in the constitution require formalchanges to existing treaties and as a result cannot be adopted withoutEU-wide ratification, in some countries by referendum. For France andthe Netherlands in particular, presenting to their electorates a scaled-down version of the constitution is not an option for the foreseeablefuture. Indeed, all member states would risk credibility if they were seen

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to be rushing through bits of a treaty that had been decisively rejected bytwo of the founding member states.

Some elements of the constitution do not require formal treaty changes,however, and of those the less controversial ones could be adopted. Forinstance, there are proposals to create a European "foreign minister" and,through merging the relevant sections of the Council Secretariat and theCommission, a supporting ministry (to be called, in classic euro-speak,the External Action Service). Member states could also introducemeasures to increase transparency and accountability, such as openingCouncil meetings and involving national parliaments in the legislativeprocess at an early stage.

4. Can a 25- or 27-member EU functioneffectively on the basis of the Nice treaty?Yes in the short term, but less obviously so in the longer term. Perhapsthe main impetus for the constitutional treaty was a belief that the EUcould not function under existing rules once it had 25 or more members.The main solutions were to create a permanent, Brussels-basedpresidency and to raise the threshold for groups of countries to formblocking minorities.

The loss of the institutional innovations in the constitution is a setback:the EU would have worked better if they had been adopted. It may notbe disastrous, however. It is evident from the past 13 months�since the"big bang" enlargement�that a Union of 25 members can function underexisting treaties and institutions. It remains possible to introduce newpolicies.

The evidence of the past 13 months is not conclusive, however. For partof that time the EU was working under transitional arrangements; theNice treaty provisions only entered into full force in November 2004. Nordoes the fact that there have been no major problems to date guaranteethat the institutional arrangements will work well in the future, whenmore controversial matters may be addressed.

5. Does this mark the end of Europe's federalproject?By rejecting the constitution, the peoples of France and the Netherlandshave essentially called a halt to the process of "deepening" the EU for thenext few years. In particular, any future extension of majority votinglooks very difficult indeed. In any case, moves towards "ever closerunion" have slowed sharply since the Amsterdam treaty was concludedeight years ago.

The fact that deeper integration seems to be off the agenda does not,however, mean that the EU is finished. The "bicycle theory" ofintegration�that the EU must keep pedalling forward or else fall over�iswide of the mark. The EU is robust enough, we believe, to survivewithout perpetual forward motion. The defeat of the constitution neitherchanges nor invalidates the EU's existing institutions, which are built ona series of treaties starting with the 1951 Treaty of Paris.

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Moreover, pro-federal forces remain influential and they have not givenup hope of making progress towards the Rome treaty's goal of "evercloser union". For the next few years, however, they will have toconcentrate on devising a new approach or on exploiting more fully theexisting treaties. Yet despite this, a federal element remains integral to theEU. It was accepted early on that EU law had precedence over nationallaws and that the European Court of Justice had the power to makebinding judgements that interpret EU law and thus had precedence incertain areas over national courts. Since the 1986 Single European Act,majority voting has applied in a range of legislative categories affectingthe single market.

6. Can the UK presidency lead the EU out of itscurrent crisis?The prospects for the UK "rescuing" the EU during its six-monthpresidency depend partly on whether Mr Blair can shift his approach toEuropean policy and his European partners. Leadership within the EU isvery different to leadership in a national context, and currently the issueof national prerogatives and identities is particularly sensitive. The Britishare not the only Europeans that resent being told what to do byoutsiders. The role that the UK assumes on July 1st is really more a formof chairmanship than presidency. Small countries, because they havefewer illusions over their ability to impose an agenda reflecting theirown interests, are often more successful in the role than larger countries.

To succeed, UK policy must change with regard to style and substance.Mr Blair and Gordon Brown, who as finance minister will be just asimportant as the prime minister, have often adopted a hectoring tone inrelation to their EU counterparts, which in the current circumstances willbe as unsuitable as it has been counterproductive in the past. Evenwhere, as in the case of labour market reform, they have good reason tobe convinced that a higher degree of flexibility in hiring and firing wouldhelp create jobs, they need to argue their case tactfully. It would also behelpful if they acknowledged that by considerably increasing publicexpenditure in recent years, they have moved the UK closer to other EUmember states.

With the 2007-13 budget a leading item on the agenda, the UK's task ofseeming to act in the common interest will be made very difficult if itrefuses to make concessions on the British budgetary rebate. The UK isfinding it increasingly difficult to defend the rebate, which was agreed inthe 1980s at a time when�unlike today�the country was poorer and hadmore economic problems than other big contributors such as Germanyand the Netherlands. Mr Blair, however, insists that the rebate is justifiedbecause the UK receives far less benefit from the common agriculturalpolicy than countries of a similar size, in particular France. For the UK,the rebate can only be discussed as part of a broader reform of EUfinancing. Any successful EU policy requires that member states can seebeyond their own narrow interests to a broader common interest, so ifthe UK cannot set an example on this it cannot provide leadership orexpect to achieve much.

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If these changes were made, the UK government should have anopportunity to influence the direction of the EU at a time of greatuncertainty. Of the governments of the six largest member states, it is theonly one whose domestic position is secure for several years ahead.There is certainly some distrust of the UK in view of its erratic record inrelation to the EU, but clearly it is now not the only country with asceptical public, and the rancour over the Iraq war has subsided. If theUK's leaders can build on recent co-operation with fellow EU states�seeking to promote peace in the Middle East and to dissuade Iran fromdeveloping nuclear weapons, implementing and promoting the Kyotoprotocol and other international agreements, and trying to help Africatackle poverty and disease�then there is a chance that its presidencycould be a success. At present, however, the odds are against the UKmanaging to give the EU a new roadmap in the wake of the failedreferendums.

7. What will be the impact on the euro zone?The rejection of the constitution has already had an impact on the eurozone, depressing the value of the single currency against the US dollarand stoking speculation that Italy or another member could seek to quit.The notion that accession to the euro area is irreversible has beendented; as a result, bond yield spreads between member countries haverisen.

In the longer term, Dutch and French voters have reduced further anyhopes of a move towards more co-ordinated economic policy within theeuro area, including substantial transfers to dampen cyclical differencesbetween member states. Some believe that this is essential for thefunctioning of the EU's currency union in the long term. Of moreimmediate concern is the risk that, in the wake of the Dutch and Frenchreferendum results, voters will not tolerate monetary policy in their owncountry being tighter than necessary. Certainly, there is now morepressure on the European Central Bank (ECB) to cut interest rates.

On the future of the euro zone, the first reaction to the "no" votes centredon the possibility that Germany may want to ditch the single currencyand restore the D-mark. For Germany, however, the economic benefits ofexit are not particularly large and do not outweigh the political costs.Current real interest rate differentials overstate the problem; anticipatedbond yield differentials, based on inflation expectations, are morerelevant and they are lower. Also, Germany's euro area membershipprobably dampened the impact of the dollar's decline. Politicians maytry to use the euro as a scapegoat for Germany's economic difficulties,but culturally Germany is still reluctant to put its own national interestfirst and is wary of destabilising the "European project" in any way.

French politicians and voters have fewer qualms about fighting for whatthey see as their national interest. Serious cyclical problems in Francealone�possibly as a result of a housing market bubble�could lead tocalls for a return to the French franc. In Italy a prolonged slump causedby unfavourable industrial specialisation, which has pitched the countryinto fierce competition with east Asia, has also increased nostalgia for thelira. However, risk premiums for these countries and most of the smaller

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member states would be much higher outside the euro area,strengthening the incentive to stay put.

The "no" votes were partly caused by concerns about competition fromnew EU member states in eastern Europe. France and some other westEuropean countries may now push much harder for these countries toraise corporate taxes, and could threaten to veto euro area accession.However, the focus on technical criteria and the decision-makingprocedure for euro area membership�which only requires approval byfinance ministers, the European Commission and the ECB�mean that allnew member states will probably be allowed to join eventually. Thatsaid, markets will look more nervously for any sign of a lack ofenthusiasm for further enlargement of the euro zone from currentmembers or the EU's new member states, all of which are obliged tojoin.

8. What are the implications for the 2007-13budget?There are three key aspects to the debate on the EU budget: its size, itsdistribution between different policies and its impact in terms of netcontributions or receipts among member states. The prospects before thereferendum results in France and the Netherlands were already bleak�with a high risk for immobility on all three fronts and for the stalemateto be accompanied by acrimony between member states.

At first reading, the post-referendums situation would appear, if possible,to be even worse. In the Netherlands resentment at the country's statusas the EU's highest net contributor per head, thanks to the quirks of thebudgetary system, was reported in an opinion poll to be the mostimportant single factor prompting the majority of voters to reject theconstitution. French net contributions are not particularly high becauseof France's substantial receipts from the common agricultural policy, andwere not an element of the "no" vote. Still, the result there could, andprobably will, be interpreted by politicians as indicating that the Frenchpeople want French interests to be defended more tenaciously and thiswill include anything related to the EU budget.

Currently total expenditure of the EU budget is running at very close to1% of gross national income (GNI), well below the agreed limit of 1.24%of GNI. The Commission has proposed that the guideline ceiling for the2007-13 framework period be 1.14%, but the main net contributors haveall insisted it be kept at 1%, despite the fact that the new member statesadd considerably to expenditure but only marginally to GNI.

A 2002 agreement between France and Germany, which will be hard toundo, allows agricultural spending to rise by 1% a year in nominal terms:this implies a slight reduction relative to GNI but only a very slow one. Ifthe budgetary limit is fixed at 1% of GNI, spending will be dominated bythe common agricultural policy and much of the rest will be taken up byregional fund commitments to help poorer member states. Thus therewill be very little available for other important policies, such as boostingresearch collaboration (much valued by research institutes) or developingthe new European neighbourhood policy, which has been designed asan alternative to continued enlargement.

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There is, however, one slight hope: that the newly re-elected UKgovernment, not now having to hold a referendum, should be in aposition to make concessions on the British budget rebate. While theother members focus on the rebate alone, the UK is only likely to agreeto changes as part of a broader reform of EU spending. One possible wayforward is to establish a generalised rebate for high net contributors. TheCommission has already made such a proposal, although this wouldmake the UK the highest net contributor per head and so has no chanceof being accepted. Still, it should be possible to devise a variation that isfair to all net contributors.

If the UK were to compromise on the budget, this would remove a thornfrom relations with other members and provide for modest concessionsby other countries. If the right kind of concessions were forthcoming, itcould lead to an overall settlement whereby the budget is used topromote the EU interest rather than just being a battleground for nationalinterests. Unfortunately the indications are that any such a move on theUK's part is unlikely.

9. What are the implications for the newmember states?The speculation about the future of the euro�even if the concerns turnout to be greatly exaggerated�could weaken efforts to prepare the newmembers for entry to the currency union, and thereby undermine themain reform anchor now that EU accession has been secured. This mayalso dampen financial markets' enthusiasm for these countries, as muchof it has been driven by "convergence plays" and expectations that thenew members will all join the euro zone over the next few years.

The new members, having striven so hard and for so long to enter theEU, will be disheartened that the electorates of two founding membersare profoundly dissatisfied with the Union. For governments, there willbe a concern that dissatisfaction with the EU in the western memberscould spread eastwards, making their job of further EU harmonisation,through unpopular reforms, more difficult.

Although their fears are not necessarily correct, many leaders will beconcerned that the turmoil caused by the double "no" vote will leadeventually to the creation of a multi-tiered EU in which they will beexcluded from the inner core. Another concern, albeit one from a slightlydifferent direction, is that the advocates of a "social" Europe could seek toadd to the rules governing the euro, for instance to harmonise corporatetax and labour legislation. This would present the new member states ineastern Europe with a dual problem, as they have an obligation to jointhe euro area but are opposed to measures that would undercut theircompetitiveness.

Also, the economies of the new member states are deeply dependent onthe largest euro area economies and so there is a risk of an adverseimpact if the EU constitutional troubles hit business confidence in "old"Europe. Growth in many of the new members is slowing perceptibly andweak governments in the region�many of which are faced with theneed for politically difficult fiscal consolidation�will dread furtherweakening of the pace of economic growth. The outlook for economic

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reforms, arguably also a key requirement for buoyant growth over themedium term, now looks very poor as the UK and France prepare tolead rival camps fighting over the future direction of the EU. In particular,the prospects for pushing on with the EU's Lisbon Agenda of reformnow look bleaker than ever, as do the new members' chances of gettinggenerous treatment in the 2007-13 budget round.

10. Enlargement I: will Bulgarian and Romanianentry to the EU be delayed?Membership for Bulgaria and Romania still looks highly likely, eventhough the rejection of the constitutional treaty clearly poses potentialproblems for future enlargements. Given that a major cause ofopposition to the constitution was the perceived negative impact of thenew member states�through competition for jobs and investment�thisraises concerns that future expansions may be harder or even impossibleto push through. The French constitution had already been amendedearlier in 2005 to require referendums to ratify any enlargement after2007.

Despite these problems, Bulgarian and Romanian accession seems a safebet. Their membership is included in the Nice treaty, and they havealready signed accession treaties. Entry could possibly be delayed fromthe planned 2007 by one year, as the EU takes a stricter line on themimplementing EU rules. There is a small possibility of an even worseoutcome, however. It is not inconceivable that an existing member state,facing an anti-EU groundswell from voters, could exercise its veto�something that would have been unimaginable prior to the French andDutch "no" votes.

11. Enlargement II: what about Croatia, thewestern Balkans, Turkey and the CIS?Expect a slowdown, but not an abandonment. The potential backlash ismuch greater for the rest of the Balkans, which were pretty muchpromised eventual membership at the EU's Thessaloniki summit in 2003.Beyond issuing general reassurances, the EU is unlikely to spell outwhere it stands on future enlargement. The EU will be reluctant to shutthe door even on the western Balkan laggards for fear of losing influenceover these countries and creating potential risks to political stability;furthermore it has no substitute for its only effective foreign policy toolof a conditional offer of eventual membership.

To say "yes" to Bulgaria and Romania, but "no" to candidate countryCroatia, already on the verge of talks, would be harsh. However, toaccept Croatia but close the door on EU applicant Macedonia, whosegovernment is awaiting an Opinion on its application later this year, orSerbia and others, would be seen as provocative and could destabilisethe region.

After the "no" votes there is clearly a risk that steps towards EUintegration�stabilisation and association agreements, formalCommission opinions on candidate status, and then accessionnegotiations�could take longer or be made more conditional. Instead of

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saying "no" outright, the EU could string the potential candidates alongsuch a tortuous and demanding accession path that it would amount toexclusion in practice.

It is now very unlikely that Turkey will join the EU in 2015, the unofficialtarget date. Assuming Turkey extends its customs union agreement to thenew member states, including Cyprus, EU accession negotiations areexpected to open, as agreed, in October 2005. This will give Turkey'sgovernment and pro-EU forces a major boost. Negotiations will be open-ended with no guarantee of conclusion, however. The idea of a"privileged partnership", short of full membership, advocated by thoseopposed in principle to Turkish accession will gain support within theEU. If Turkey keeps its side of the bargain and the existing member statesdecided to renege on the agreement to open negotiations in October2005, it would seriously damage the credibility of the EU and itsrelations with Turkey as well as end any hope of settling the division ofCyprus for the foreseeable future.

The referendum results have set back, perhaps irreparably, the hopes ofUkraine and other former Soviet states of EU membership. Membershipnegotiations were hardly a realistic near-term prospect even before theFrench and Dutch votes, although the possibility�and hope�haveundoubtedly influenced developments in Ukraine and elsewhere in theregion. Now, the cold realisation that this option is off the agenda couldhave various repercussions. These include a possible re-examination ofintra-CIS ties, a demoralisation of reformists and greater uncertaintyabout the prospects of European-style change. What is certain is thatsubstitutes for the carrot of membership�such as the EU's fledgling anddeeply flawed neighbourhood policy�give the EU very little realopportunity for influencing directly developments in the region. One by-product, however, could be to defuse or at least postpone a serious EU-Russia clash over influence in the region.

12. Is this the end of the Franco-German axis?Not entirely; it's weakened but not broken. The ability of France andGermany to work together has always been vital to the EU, for severalreasons. The spur to the initial treaties was Franco-Germanreconciliation, they are the two largest countries in the core of Europe,and�negatively�one or other, particularly France, was the member mostlikely to reject any project. In general, the other four original memberstates were happy to benefit from the area of stability and more opentrade that Franco-German reconciliation allowed.

Although others have contributed, French and German leaders have ledEuropean integration efforts since the 1950s. Under Messrs Chirac andSchröder, however, this leadership has turned mainly negative, with thetwo countries holding up further developments with the importantexception of enlargement. They have lagged behind most members inimplementing EU legislation, weakened the stability and growth pact,and resisted changes to the budget necessary to strengthen a range ofpolicies from research to relations with neighbours.

This makes the defeat of the constitution especially relevant, because itwas the one issue where Germany and France were acting together on a

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new initiative rather than attempting to weaken EU authority. The defeatis a major blow to Franco-German leadership of the EU because it comeson top of other failures.

Where does it leave the EU? The negative importance of France andGermany to the future of the EU remains. While in theory it would bepossible to over-ride French and German opposition to legislation, inpractice it is very unlikely. Any initiatives that did not involve all EUstates, like the single currency or the Schengen agreement to removeborder controls, would hardly count as European without French andGerman participation.

For the next two years, however, until there is a new French president,no new initiative is likely to come from France. It will be preoccupiedwith a more narrow defence of its perceived interests. In Germany, thesituation is different. Mr Schröder's decision to hold an early generalelection means that the Christian Democrats are almost certain to controlthe government after September, with Angela Merkel as the newchancellor. Party spokespeople have already indicated that, ingovernment, they intend to use Germany's huge potential for influenceto make changes in foreign policy, at least two of which may not bewelcomed by France: to improve relations with the US and to be morecritical of Russia.

Ms Merkel will want to build alliances across the EU, includingparticularly Germany's eastern neighbour, Poland, and will have to workwith the UK presidency that will run from July to December 2005. Thedefeat of the treaty does not permanently rule out positive Franco-German leadership, but by fatally weakening what was left of MrChirac's authority it provides an opportunity for Germany and others totry to lead, although they will still need to win over the French.

13. How serious is Europe's economicunderperformance and its impact on the EU'spolitical malaise?It is not difficult to recognise that there is something rotten at the core ofthe euro zone economies. Productivity performance has been poor,unemployment is stuck at high levels and the current cyclical recovery isexceptionally weak. One does not have to be an economic determinist tosuspect that much of the political dissatisfaction with the EU stems fromeconomic decline.

Performance among Europe's economies has been diverse. But thesuccess stories�Ireland and the Nordic countries�are all small states,with models that are difficult to replicate. Three-quarters of the euro areais made up of the poorly performing big three (Germany, Italy, France)and the Netherlands. The big three have lagged in embracinginformation technology and vibrant service sectors. Problems have beenmade worse by the ability of interest groups to obstruct change, thedifficulties of macroeconomic management associated with the euro,and in Germany by the burden of reunification.

The gap with the US has been steadily widening. Annual average realgrowth in GDP per head (the single best measure of economic

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performance) reached 2.3% in the US in 1996-2004, compared with 1.7%in the euro area. The results since 1995 are extraordinary, given thataverage income per head in the euro area remains far behind the USlevel. After the long period of catch-up following the second world war,the ratio of euro area to US GDP per head is not just stagnant, as it wasfor a long period from the late 1970s, it is falling (to less than 70% in2004).

Underpinning growth in GDP per head is growth in labour productivity,the single most important driver of long-term potential output and livingstandards. Previous catch-up by Europe meant that average levels ofoutput per man-hour had by 1995 even slightly surpassed the US level.But since then, the US advantage has been restored and is widening.Since 1995 average productivity growth in the US has been almostdouble that of the euro zone.

A better-performing European economy would not necessarily havesmoothed the path to "yes" votes in France and the Netherlands.Nevertheless, disappointment with economic performance seems to be amain source of Europe's political malaise. The arguments about theoptimal degree of integration would still be there, but conducted underfundamentally different circumstances. The outlook for furtherenlargement would look far better; there would be a greater tolerance ofBrussels' inefficiencies and arrogance; and immigration would not beenseen as such a threat or be as powerful an issue for populist forces toexploit.

14. Will "Anglo-Saxon liberalism" necessarilytriumph over "the European social model"?Neither the "Anglo-Saxon model" nor the "European social model" willtriumph in the enlarged EU. The Anglo-Saxon model (as exemplified inEurope by the UK) is coherent, with its defining features being economicopenness, deregulation, highly flexible labour markets and moderatetaxation. However, this is very unlikely to become Europe's dominantmodel.

UK performance has hardly matched the hype and the model is notattractive to many Europeans. The UK's faster growth rate over the pastdecade has been on the basis of employment expansion alone. Whilethis is desirable, many of the new jobs have been very low-wage and,crucially, productivity growth has remained very disappointing; the UKhas not come near to matching the performance of the US. Its relativeeconomic success in European terms is thus unsustainable. Also, there islittle evidence of any big growth returns to product market deregulation,very liberal labour markets or low taxes. And in terms of the quality oflife, the situation is far worse. The Economist Intelligence Unit's qualityof life index ranks the UK bottom among the EU15 states because of itshigh rates of social and family breakdown, and poor public services.

The chances that the "European social model" will prevail are evenlower. It is not even clear what this incoherent idea means�except adesire to enjoy a generous welfare state, benign employment conditionsand to control globalisation. Should this translate into rejection of allreform and return of protectionism, the ensuing economic implosion

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would occur well before even the looming European demographic crisiskicks in.

Nor is any other existing model likely to be widely copied. Currently, the"Danish model" is much in vogue�characterised by a combination offlexible hiring/firing practices and high social welfare provision. But thiscan only be sustained by extremely high tax rates, and probably requiresthe small country cohesion that cannot be replicated in big states.

So what model will characterise the big continental economies? Theanswer has to rely on forecasting trends. Labour market reforms couldfollow recent German examples and emphasise greater flexibility ofwages and working practices in exchange for the preservation of arelatively high degree of employment protection. There will be far morecorporatism and a stronger role for trade unions than any liberal wouldfeel comfortable with. The model will involve a significant role for thestate�not only the state promotion and financing of R&D, education andinfrastructure, but also to a limited extent in areas such as industrialpolicy. On the other hand, there would be some deregulation andreduction of red tape. There would be no rollback of the single market, agradual movement in the area of services, and progress in World TradeOrganisation talks on trade liberalisation (especially on agriculture).

There is no guarantee of such an evolution. France may simply dig inand refuse to budge at all. In that case, the prophecy attributed to aFrench official from 30 years ago may prove uncannily accurate. "Francewill be European as long as Europe is French. When that ceases to apply,France will dispense with Europe."

15. Does this signal the rehabilitation of thenation state?"You cannot take nation states seriously. They are the past." This has beenthe universal sentiment among the Brussels elite. The state has beenequated with backwardness and nationalism, in contrast with theprogressive, "post-modern" European political entity that has gainedpowers through the erosion ("pooling") of national sovereignty. Politicalcircumstances, however, dictated that the constitutional treaty had to beput to the voters.

It has been a rude awakening. And once again, the rumours of thedemise of the nation state have proved to be exaggerated. The rejectionof the constitution, by two traditionally very pro-European foundermembers, amounts to a rejection of further moves towards integrationand of the derogation of decision-making by the nation state. It hasaffirmed a long-standing trend revealed by EU-wide opinion polls, of adecline in voter satisfaction with the EU, which is seen as distant, costlyand interfering.

The nation state is hardly healthy: it suffers from uncertain identity, ischallenged from below by regionalism, and is beset by a loss ofconfidence and trust and a culture of fear. Yet it remains central to thelives of its citizens in a way that the EU is not.

Although many "no" voters in the Netherlands and France wereapparently motivated by reasons not directly related to the constitution,

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there was a lengthy and detailed debate on the treaty in both countries.Voters were well-informed. The double rejection is therefore testament tothe inability of "yes" campaigners to persuade voters that the EU is orcan be a route to security and prosperity. Instead, they relied on stokingfear to an even greater extent than the "no" camp.

Citizens have confirmed that they owe their primary allegiance to thenation state and that is how they define their identity. Democracy andaccountability cannot be divorced from issues of identity, shared loyaltiesand traditions. France's Nicolas Sarkozy, the front-runner to succeed MrChirac, was commended for having ostensibly struck a rare chord with"yes" voters in the French referendum by telling them that Europe hadgiven them cheap mobile phones and budget airlines. Rather thansignifying a refreshing departure from the era of grand visions, thisunderscored the flimsy basis for a supranational European politics.Democracy is the language of the nation state; "governance" is the termused in Brussels.

16. Does Europe still have a voice in the world?Yes, but a slightly shakier one. The EU's role in international economicrelations�trade, aid and monetary affairs�has been and will remainglobally important despite the constitution's demise, both because thedocument contained no innovations in these areas and because the EU isthe largest economic bloc in the world.

Europe's weight in non-economic international affairs is considerablylower. Efforts to change this, by developing common positions onforeign, security and defence policy, have accelerated since the 1990s butthe subsequent proliferation of policies has not much increased the EU'sinternational role. One objective of the constitution was to remedy thisby strengthening institutional capacity in external relations�it wouldhave created a new position of "foreign minister" and merged the parallelbureaucracies in the Council Secretariat and the European Commissionto form an External Action Service. The effect of the rejection is thatthese changes which, in combination, would probably have allowed formore coherent policy formulation and implementation, will not comeinto effect as and when anticipated. A second consequence of the failureof the constitution project has been the damage to the EU's internationalprestige after so much political capital had been invested in it over such along period.

Indirectly, the rejection of the constitution raises other questions for theEU's external relations, most notably about future expansion to includecountries to the east of the EU's existing borders. This is becauseopposition to enlargement emerged as an issue in the referendums, andthere is also a belief that without the reforms contained in theconstitution, further expansion would make decision-making moredifficult. The prospect of membership has proved to be the EU's mosteffective foreign policy instrument by generating a commitment amongpolitical elites to democratic and market reforms (among the mostimportant, if not the most important, reason for the relatively smoothtransition from communism in central and eastern Europe). However, asthe power of the membership incentive is directly correlated with the

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credibility of its fulfilment, the increased uncertainty over futureenlargement can only reduce the influence of the EU in the region.

17. What are the implications for US-Europeanrelations?The US has supported the deepening of European integration since theproject was launched in the 1950s, believing that Europe, as the region ofthe world that most closely shares its values, would become not astrategic challenger but a valuable partner, capable of sharing the burdenof maintaining and advancing liberal democratic values in the world.Support for integration wavered during the first term of President GeorgeW Bush, as divisions over the Iraq war led some in the USadministration to advocate focusing on bilateral relations with individualcountries in Europe to maximise US influence and frustrate collectiveanti-US action. However, as relations have started to normalise post-Iraq,the US has reverted to its long-standing pro-integration position, asdemonstrated by Mr Bush's endorsement of the constitution. Theconstitution would have strengthened the EU's capacity to act in theworld but not have transformed it, thus limiting any increase in burden-sharing with the US.

On another level, the rejection of the constitution may have preventedsome deterioration in transatlantic relations. The UK and France are ateither end of the spectrum of EU opinion on how to manage relationswith the US. The former holds that maintaining very close ties with theUS and avoiding any public confrontation maximises influence, whilethe latter believes that US power in international affairs needs to bechecked sometimes, even if this requires open conflict with the US. HadFrance not rejected the constitution, it is very likely that the UK wouldhave done so in a referendum it was scheduled to hold in 2006. Thiswould have marginalised the UK, or even precipitated its withdrawalfrom the EU, allowing France a stronger leadership position in the EU,which, in turn, might have led to a more conflictual style of relationswith the US�the general pro-US slant of the new members notwithstanding.

18. Who will fill Europe's leadership vacuum?The clear lesson in the wake of the French and Dutch referendums is thatthere has been too much leadership at the European level during the pastfew years: neither governments nor electorates much like being toldwhat to do by people in other countries. Still, the next couple of yearswill see a new cohort of leaders take to the European stage.

The first of the current generation to fall is likely to be Mr Schröder inSeptember this year. His successor, Angela Merkel, the candidate of thecentre-right CDU/CSU, is well placed to bridge the gap between the"Anglo-Saxon" world and those pushing for a more "social" Europe, beingtied to neither side of the debate. Germany's CDU/CSU strongly supportsan extensive social welfare system, but at the same time its leaders andmany of its core voters have realised there is a need for substantialreforms. A swing to the centre-right is also expected in the election inPoland later this year, as the caretaker government of Marek Belka is

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replaced by a coalition of the economically liberal Civic Platform and theright-wing Law and Justice party.

Silvio Berlusconi will face Italian voters early in 2006. Given theemphatic defeat of his Casa coalition in recent local elections, he is likelyto be replaced by a centre-left coalition led by Romano Prodi. As theformer president of the European Commission Mr Prodi's Europeancredentials are second to none, and he will place greater emphasis on co-operation with Italy's partners within the EU institutions, rather thanthrough bilateral relations, which has been Mr Berlusconi's preferredapproach. But disagreements among the parties of the left will keep MrProdi busy at home, limiting Italy's influence in the European arena.

At some point over the next few years Mr Blair will step down, probablyhanding over to his finance minister, Gordon Brown, who has neverreally shown much interest in the EU. Perhaps the greatest uncertaintyover the leadership of Europe's large states is who will emerge as thesuccessor to Mr Chirac if, as seems almost certain, he decides againststanding for a third term in 2007. Mr Chirac's preferred choice is hisnewly appointed prime minister, the flamboyant Dominique de Villepin.However, the cards are stacked in favour of Mr Chirac' s former protegeturned arch-rival, Nicolas Sarkozy, the leader of the ruling UMP. Althoughthe centre-right is by no means guaranteed victory, Mr Sarkozy-who is byfar France's most popular politician-has two years to consolidate hisposition while the opposition Parti socialiste seeks to heal the rifts left bythe recent referendum campaign.

With the French political scene in turmoil following the referendum,France is likely to make an awkward partner for other EU leaders for thenext two years. Ms Merkel will�subtly�try to distance her governmentfrom the French administration, while seeking closer ties with the UKand other EU governments, as well as the US administration. But lookingfurther ahead, she may find an ally in Mr Sarkozy. The two share asimilar platform with regard to Turkey's bid for EU accession: both areopposed. Mr Sarkozy is also one of the few French politicians to havequestioned the country's "social model", although he is certainly not theeconomic liberal that some have portrayed him to be.

19. What effect has the rejection of theconstitution had on the EU "legitimacy deficit"?Since the early 1990s EU-wide opinion polls have shown a decline invoter satisfaction with membership, and wide-ranging consensus existsthat voters are "disconnected" from an EU that can appear distant,unaccountable, costly and interfering. Along with making the entitywork better, the second major objective of framing a constitution was adesire to close this legitimacy deficit. The rejection of the constitution intwo of the three countries in which it was put to a vote (Spain voted infavour in February) suggests that it did not succeed in this.

However, the constitution's most significant contribution to boosting theEU's legitimacy may be in the manner of its demise. Provided no attemptis made to implement the integrationist measures contained in thedocument by other means, the rejection in two of the EU's foundingmembers may reassure voters that it is citizens who ultimately determine

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the pace of integration. The rejection is also likely to cause advocates ofintegration to work harder to make their case.

20. Where does the EU go from here?The EU is at a crossroads. It will continue to be shaped by the interplayof three inter-related forces�the outcome of the struggle in the EUbetween federalists and "nation-statists"; economic performance; and theefficiency and legitimacy of the functioning of the EU's institutions.

We consider five possible scenarios:

• Status quo�40% probability.

Integration grinds to a halt but is not rolled back. Struggles between pro-and anti-federalist visions continue, but result in stalemate. EUinstitutions are discouraged from new policy initiatives but existing lawsare broadly respected. Most policies affecting economic performance orsocial objectives continue to be decided at the national level. In duecourse, there is some limited cherry-picking of elements of the EUconstitution to make the functioning of the expanded Union feasible ormore efficient. Economic performance sees a moderate improvement inline with the Economist Intelligence Unit's existing forecasts.

Enlargement talks with both Turkey and all western Balkan states moveahead, but in fits and starts and are punctuated by periodic crises. By2020 Turkey and possibly some western Balkan states, other thanCroatia, still remain outside of the EU. Although the probability weassign to this "muddling-through" scenario is, at 40%, higher than for anyother, there is a significant risk that the assumed agreement to freeze thepresent balance between EU and national competences proves elusive.There are also some doubts about the sustainability of the euro zone atpresent levels of fiscal and political integration. Thus the probability thatthe EU will move in the direction of one of the other scenarios is higherthan 50%.

• Europe unbound�20% probability.

Many powers return to the national level, aside from those directlylinked to the functioning of the single market, for which regulations arestreamlined and simplified. The common agricultural policy is drasticallyreformed or eliminated altogether. Budget cuts, reducing EU spending toless than 0.5 percentage points of EU GDP, and a reduction in red tapehave broad appeal and take the sting out of criticisms of the EU. Theprotectionist tide gradually recedes, increasing the prospects for pro-growth policies at the national level. Economic performance exceeds ourbaseline forecast.

Institutionally, there is loose co-ordination of foreign and environmentalpolicy while member states co-operate to push forward tradeliberalisation at the WTO. Enlargement proceeds relatively smoothly,with Turkey, the western Balkans and Ukraine all members by 2020, andtalks with Russia, Moldova and Belarus underway. Federalist forces inEurope would put up stiff resistance to this type of evolution, supportedby some states that fear the removal in many areas of the present EU's

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protective umbrella. A key risk to the scenario is the threat to theviability of the euro zone. No currency risk helps market integration andhence growth, while the process of breaking-up of the euro area wouldcreate uncertainty and damage confidence.

• Europe unravelled�15% probability.

A fundamental principle of the EU's functioning thus far�a readiness tocompromise and take account of broader EU interests when defendingnational positions�is destroyed. A decline into the aggressive defence ofnarrow national interests stymies half-hearted efforts to revive parts ofthe constitution and deadlocks the 2007-13 budget, as well as furthermarket liberalisation. Indeed, rules underpinning the single market areflouted and the institutions upholding it paralysed. Economicperformance deteriorates further, creating a vicious spiral of calls for yetmore protection.

Bulgarian and Romanian accession to the EU is halted and enlargementis stopped in its tracks. The big budget contributors withhold payments,curtailing regional and other policies. In the euro area, fiscal disciplineerodes and pressure builds for one or more members to quit. Theultimate collapse or unravelling of the EU is unlikely, but not anunimaginable outcome. Too many forces in Europe have a stake in thepreservation of the EU, and governments would be likely to act to stemthe descent towards chaos and disintegration. Fear of the consequenceswould reinforce this.

• Back to the core�15% probability.

A group of states determined to uphold "social Europe" use existingtreaties to create a more tightly knit core group that will be surroundedby a more loosely integrated layer. The core group implementsprotectionist policies that penalise corporate relocation and establish anew minimum wage. Pressure for fiscal harmonisation results inalignment of corporate tax rates. Transitional periods on free movementof labour are extended and tightened.

On this basis, enlargement�to the outer ring of the EU�would proceed.By 2020 Turkey, all the western Balkans and Ukraine are members, alongwith remaining members of the European Free Trade Area (EFTA).Although elements of this scenario look feasible and an attempt to createa core is a strong possibility, it would be unlikely to survive�primarilybecause it does not offer a prospect of economic improvement. It alsodefies a number of EU-wide laws, and the scenario supposes a highdegree of Franco-German co-operation.

• Europe revived�10% probability.

After a period of uncertainty, argument and indecision, the EU finds anew way forward that leads to some continued deepening of integration,but based less on institutional change and more on effective policies.This includes minimum standards on social protection, increased co-operation against tax avoidance and agreement on a minimum rate forcorporate tax. The internal market is deepened, notably throughdirectives that gradually open markets for all services. The common

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agricultural policy, meanwhile, continues to support farming but its shareof EU spending diminishes gradually. As a result, the EU is able todevelop research and education policies that boost economic growth.

Institutionally, the union forms a common diplomatic service.Enlargement proceeds, with the western Balkan countries joining overthe course of the 2010-20 decade, while Turkey and Ukraine make goodprogress. The Stability and Growth Pact is revived while internal marketdeepening and performance-enhancing policies make for better thanexpected economic growth. This scenario, however, depends on memberstates being prepared to make more sacrifices for the common good�something that goes against existing trends and the two "no" votes, henceits low probability.

twenty questions on the future of europegraphics.eiu.com/files/ad_pdfs/eu_special.pdf1 twenty...

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