An Ever Closer Union

With their currency's survival at stake, Angela Merkel and Nicolas Sarkozy write a new economic script for the continent.

When Angela Merkel and Nicolas Sarkozy tabled a proposal at Feb. 4's European Union summit for more closely harmonizing Europe's economic and social policies -- for "strengthening the euro zone's economic governance" in Euro-speak -- they confirmed the two basic truths about European integration.

First, France and Germany are always the drivers of the process. Decisions may require consensus among the member states, but France and Germany have always been the ones shaping that consensus.

Second, whenever the status quo proves untenable, Europe, rather than turning back, forges ahead toward deeper integration. After more than 50 years, regional integration is integral to the identity and worldview of Europe's leaders. When the going gets tough, they instinctively redouble their efforts to deepen and strengthen the European project.

That's not to say, of course, that this latest plan resolves the root causes of Europe's economic problems. In fact, it leaves some of the major issues unaddressed.

What the French and German governments offered last Friday was an unprecedented proposal for more closely coordinated economic policies. Tax and public expenditure policies will be more closely harmonized. Pension costs will be contained by raising the retirement age to 67, the standard set by Germany. To prevent labor costs from getting out of line, Brussels will exercise oversight over the structure of wage bargaining.

Predictably, Belgium and Luxembourg screamed about the proposal to eliminate wage indexation, while Ireland objected to the proposal to harmonize tax rates. To reach the necessary consensus, France and Germany will now have to make some concessions. But it is clear once again that the two countries have set the integrationist agenda.

This outcome is a rebuke to the many skeptics who have repeatedly predicted the euro's collapse. When the crisis erupted in 2010, these supposedly astute observers said that European countries would never contemplate tax harmonization because it would infringe on national sovereignty. They claimed that Brussels would never be given the right to interfere in national wage-setting arrangements. But in a region as deeply integrated as Europe, sovereignty is only meaningful -- it can only be used to achieve something -- when pooled. European leaders understand this, even if their North American critics do not.

On the question of whether this type of "economic governance" will resolve the euro's current struggles, the answer, inevitably, is yes and no. Making Europe's monetary union work requires finishing what remains incomplete. Economists, if not politicians, have known from the start that an effective monetary union requires institutions to ensure fiscal discipline, because member states no longer have the option of printing money to bail themselves out of budgetary difficulties. That's why, in the United States, 49 of 50 states have self-imposed debt and deficit limits.

An effective monetary union similarly requires arrangements to keep regional wage differentials from exceeding those justified by productivity differentials. To achieve this in the United States, the country has similar contracting arrangements across states and large flows of labor from low- to high-employment regions.

Europe will now have its own mechanisms for achieving similar ends. Each member state will adopt policies inspired by a German measure limiting deficits to 0.35 percent of GDP. There will also be similar wage-contracting arrangements across member states and strong oversight of national wage trends by the European Commission, which should compensate for the relative lack of labor mobility that Europe, with its various languages and national cultures, is burdened with. To all of this, the proponents of monetary union can only say "about time."

But one item is prominently absent from the new agenda: financial regulation. Aside from Greece, whose problems reflect years of fiscal profligacy, the euro crisis is fundamentally a banking crisis. Although the European Union activated three new "financial regulators" for banking, securities markets, and the insurance industry on Jan. 1, these new entities have limited powers. They mainly act to coordinate the periodic meetings of national regulators.

In a monetary union, the idea of leaving financial regulation in the hands of individual countries is madness. Given the interconnectedness of national banking markets in the European Union, the actions taken by any one national regulator -- say, Ireland's permitting its banks to borrow huge volumes of foreign money to engage in all manner of reckless property speculation -- can have serious repercussions for the rest of the European Union. Why Friday's summit wasn't used to propose the creation of a single powerful EU or euro-area bank regulator is a mystery. If one didn't know better, one might suggest that Germany, whose banks are exceptionally highly leveraged and poorly capitalized, was cowed by certain special interests.

There is a positive take-away from Friday's summit. It suggests that there will soon be consensus, even if there isn't already, on how to strengthen the institutions of the monetary union. That would be enough, were it only possible for the euro area to reboot and start over. Unfortunately, the year is 2011, not 1999. The monetary union in 2011 is saddled with a very heavily indebted periphery. Debts in Greece, Ireland, and Portugal have soared to high levels and are scheduled to move still higher. With governments engaged in draconian spending cuts, which stifle growth, it's dubious that those debts are sustainable.

European leaders are clearly aware of the debt problem. On Friday, France and Germany also signaled that they would agree to expand the 440 billion euro rescue fund for indebted EU member states, the European Financial Stability Facility (EFSF). But bigger is not necessarily better. Piling more debt in the form of expensive new official loans on top of the existing debts of the crisis countries is no solution.

Everyone knows that a Plan B is coming. It will involve a debt restructuring in which the bonds of troubled countries like Greece are exchanged for new discount bonds. The new bonds, carrying guarantees funded by the EFSF, will have the same face value as the old ones to avoid blowing a hole in bank balance sheets. But their interest rates will be greatly reduced, and their maturity will be significantly lengthened. (Non-bank investors will be offered separate, even less favorable exchange terms.) Overall, the "haircut" for investors will be roughly 30 percent. It may prove a painful process, but clearing up the debt problems in this manner is the only way that Europe can get the fresh start it needs.

Unfortunately, the true extent of Europe's financial problems wasn't acknowledged on Friday. With their plans for common economic governance, European leaders have taken only one of the two steps needed to resolve the crisis. Will they ultimately take the other? The experience of six decades of European integration says they will. It just doesn't say when.


K. Subrahmanyam: A Tribute

For almost 40 years, his far-reaching influence over India's strategic thinking came not from a title but through the power of his ideas.

K. Subrahmanyam, who died at the age of 82 in New Delhi, on Feb. 2, 2011, was the doyen of India's strategic community. India's Prime Minister, Dr. Manmohan Singh, described him to The Hindu as "an outstanding public servant, visionary and thinker who will be missed by the generations ... who were inspired and influenced by his thoughts."

He founded India's Institute of Defense Studies and Analysis (IDSA) in 1968 and served as its director until 1975.  After serving as the chairman of India's Joint Intelligence Committee and the secretary in the Ministry of Defense responsible for defense production, Subrahmanyam returned to lead the Institute in 1980 until he retired in 1986. He continued to write and speak prolifically on strategic issues in India in retirement.

For almost 40 years, his real influence came not from a title or government post but through the power of his ideas and the vigor of his intellect. The discipline of strategic writing and analysis in India emerged and grew under his influence. A sharp and forceful thinker and writer, he also mentored many of India's leading strategic thinkers. In discussion and debate he was formidable, and his mastery over facts and details would invariably leave a profound impression on those who interacted with him for the first time.

Subrahmanyam's life and influence is testament to the power that clear ideas and argumentation can wield in a democracy. His role in shaping policy and strategic thinking in India only grew throughout his lifetime, even though he never held an office of critical responsibility within the government during his last three decades. He was seen and accepted as an expert across the political spectrum and successive prime ministers and their key aides turned to him for advice and counsel.

He was guided by a hard-headed appreciation of power and its role in contemporary affairs. This was combined with a passionate commitment to the dream of India's "tryst with destiny" as articulated in 1947 by Prime Minister Jawaharlal Nehru in a speech marking the country's moment of independence; Subrahmanyam was then just 18. When he first began discussing and analyzing the role and importance of hard power in India, it was something new -- a marked contrast to the prevailing framework of idealism that marked the country's peaceful freedom movement, a time when politicians and activists espoused the high moral principles of peaceful coexistence, distance from power blocs and universal disarmament. Subrahmanyam's prodding role was timely. The consequences of India's neglect of hard power were clear in the border conflict of 1962.

He came to champion India's right to acquire strategic capabilities, including nuclear capabilities. When India became nuclear in 1998, he argued for responsibility and restraint. The principles he articulated of "no first use" and having only a minimum credible deterrent are today part of India's nuclear doctrine.

He was also one of the earliest and strongest proponents of closer ties between India and the United States. He was ahead of the curve in seeing the growing convergence of interests anchored in our shared commitment to the values of democracy and open markets. The characterization in 2010 by Prime Minister Manmohan Singh and President Barack Obama of the India-U.S. relationship as "one of the defining partnerships of this century" is an outcome for which Subrahmanyam worked tirelessly over his last decade, even as he battled cancer and other ailments.

I had the good fortune of working with him as a young Foreign Service officer and knew him closely for 30 years. He represented the best in the Indian scholastic tradition in being genuinely indifferent to creature comforts, wealth, formal recognition, and positions. He enjoyed living in the world of ideas and had little patience for small talk. When a visiting scholar asked him what exercise he did to keep fit, he responded with the quip, "jumping to conclusions"! He was also truly democratic in his outlook. If you disagreed with him he would argue and debate fiercely, but treated you as an equal and expected you to respond as one, and if you did, he respected you for it. In this, he embodied a refreshing contrast to the prevailing ethos of strong hierarchies demanding deference to rank and to traditional discomfort with debate and clear articulation of differences.

He had great moral and intellectual courage and was willing to go against the tide. He gladly paid the price for standing out on more than one occasion, without ever expressing any regrets.

Few who only saw his writings and heard him speak at seminars in recent years could have imagined the continuous, painful, and difficult struggle he had with cancer and the extraordinary willpower and tenacity that he displayed in coping with it and still being so productive and prolific. In my visits to India as ambassador serving overseas over the last five years, I would inquire from mutual friends about the state of his health -- before I knew it, we were often meeting for a spirited discussion over lunch or dinner.

He was a giant of a man. India will miss him.