26 August 2018

For Germany and the EU, a Summer Respite Nears Its End

By Adriano Bosoni

A U.S. push to include agricultural products in its trade negotiations with the European Union would lead to frictions between Germany and France that would reduce the chances of a deal. France will persist with its plans to reform the European Union, but countries in Northern Europe will present a common front to tone down or postpone many of Paris' proposals. Italy's expansive economic reforms will raise questions about its commitment to keeping a balanced budget, which could generate volatility in the financial markets. Politicians will replace technocrats and take control of the Brexit process, creating room for compromises between the European Union and the United Kingdom. But this could come at the price of incomplete deals that postpone solving problems.

It's summer in Europe, and many politicians are enjoying their vacations. European Union leaders should get as much rest as they can, because after the season ends, several problems that were temporarily put on hold will come back to confront them, paving the way for a hot autumn on the Continent. From trade disputes with the United States to the debate about reforming the European Union to an increasingly chaotic Brexit, the final months of 2018 will be hectic in Europe. As the bloc's main economic and political player, Germany will be at the center of the debates, and Berlin's decisions will be felt across Europe.

The Big Picture

The final months of 2018 will present multiple sources of political and economic risk for the European Union, including higher U.S. tariffs, deeper political fragmentation in Europe and a disorderly Brexit. In the coming months, EU leaders will have to make choices on issues that will have long-term implications.

Trade Disputes

Trade frictions with the White House will be at the top of Berlin's post-summer worries. As the European Union's No. 1 exports powerhouse, Germany stands to lose big in a trade conflict with the United States, especially if it involves cars, one of its main exports. In late July, U.S. President Donald Trump and EU Commission President Jean-Claude Juncker agreed to study ways to eliminate non-auto industrial tariffs and reduce non-tariff barriers to trade. The joint U.S.-EU task force plans to release a report by the end of the year; in the meantime, the White House has promised to refrain from imposing higher tariffs on EU cars.

The Trump-Juncker deal could soon prove to be a summer mirage. To begin with, it is only a cease-fire, not a peace agreement. The United States can still decide to raise its tariffs on European cars, which would hit the German economy particularly hard. The White House could also use the threat of higher tariffs on cars to force the European Union to open its agricultural market to American exports, something that some U.S. government officials have suggested. This would create discord between Germany, which wants to preserve its lucrative automobile exports to the United States, and France, which does not export cars to the United States and wants to protect its agricultural sector from hypercompetitive U.S. imports.

Trump has been accused of trying to break apart the European Union. He has praised Brexit, criticized Germany's massive trade surplus with the United States and allegedly told French President Emmanuel Macron that his administration was willing to offer France a substantial bilateral trade deal if Paris left the bloc. The threat of higher auto tariffs probably is connected more to Trump's ideology than to a specific plan to weaken the European Union, but regardless of Trump's motivations, this issue will test the unity of the Franco-German alliance, the most important bilateral relationship in Europe.

To make things more complicated for Germany, France is not the only country that would resist a U.S. trade deal that includes agriculture, because the Italian government is also skeptical of free trade agreements. Berlin therefore will find itself fighting against Paris and Rome to win approval of an agreement with the United States that could prove unpopular both in Germany and abroad. The alternative is equally harmful, because the European Union may end up having no choice but to impose its own counter-sanctions against the United States, which would impact bilateral trade and do little to ease trans-Atlantic frictions.
The Return of Europe's North-South Divide

Trade is not the only issue that will generate disputes between Germany and France this fall. Since taking office in mid-2017, Macron has made numerous proposals to reform the European Union. Some, notably those involving greater military and security cooperation, are already in the early stages of implementation. But plans to increase public spending and deepen financial risk sharing in the eurozone have been postponed, either because they were too controversial or because more urgent issues, such as migration in the Mediterranean, took precedence. This delay has allowed Germany to avoid making decisions on the creation of a special budget for the eurozone or on the introduction of a common deposit guarantee for eurozone banks. But Paris will insist on putting its proposals back on the EU agenda, forcing Berlin to take more concrete stances.

In the coming negotiations about EU reform, Germany will find that governments in Northern Europe are well-organized and willing to present a common front against many of France's plans. Countries including the Netherlands, Sweden, Denmark, Finland and the Baltic states have met several times in recent months to discuss the future of the European Union. They resist any attempts to transfer additional prerogatives to supranational institutions in Brussels, and they believe that financial risk has to be reduced before it can be shared. Their immediate goal is to resist France's proposals as much as possible, but they also have a long-term concern in mind, because they are worried that the United Kingdom's exit from the European Union will tilt the balance of power in the bloc toward the Mediterranean. EU reform will be the Continent's first post-Brexit debate, and Northern Europe is drawing its line in the sand. This will put Berlin in an awkward position, because while it shares most of the northerners' views, it also needs to preserve its alliance with Paris and give Macron something he can present as a victory at home.

In Germany's favor is the fact that Southern Europe is fragmented. France's natural partner for EU reform is Italy, but cooperating with Rome will not be easy. France and Italy are trying to improve their relations, but their bilateral ties are tense because of disagreements over migrants and Libya, as well as Rome's threat to cancel a high-speed rail project between Lyon, France, and Turin, Italy.

France and Italy have similar views on eurozone reform, but Italy's populist-nationalist government will be an awkward partner for France. Pressure from the financial markets probably will persuade the Italian government to moderate its plans to cut taxes and increase welfare spending. But Rome's expansive economic reforms, which will be announced in September and October, could still lead to volatility in debt markets. This would give additional ammunition to the Northern European camp, weaken France's cause and force Germany to decide between pressuring Rome to comply with EU fiscal responsibility targets (which would come at the risk of Italy taking unilateral measures) or seeking accommodation with Italy (which would irritate its friends in the north).

There is room for compromise between the north and the south, but it probably will come at the price of watered-down reforms and postponed plans. Projects that involve spending extra money (such as a eurozone budget) stand a better chance of being approved than ideas involving a greater share of financial risk (such as the completion of the banking union). At the same time, the European Union may have no choice but to let smaller groups of countries move ahead with some ideas while allowing others to opt out (this could end up being the case for proposals such as harmonizing corporate taxes on the Continent). This is not the debate that will break the European Union, but it will show just how flexible the bloc is to deal with its internal differences after Brexit.
A Half-Deal Brexit?

And speaking of Brexit, Britain will also keep Germany occupied after the summer vacations end. The United Kingdom is scheduled to leave the European Union in March, but many crucial decisions about its departure have yet to be made. According to the chief EU negotiator, Michel Barnier, the withdrawal agreement establishing the legal terms of Britain's exit is "80 percent complete." The problem is that the remaining 20 percent will be extremely hard to resolve, because the question of the future of the Irish border remains open.

To make things more complicated, both the British government and Parliament are internally divided between groups that want to keep close ties with the European Union and groups that want the cleanest possible exit. Even if Prime Minister Theresa May manages to keep her team together and sign a withdrawal agreement with the European Union, it's not a given that Parliament will back it.

In addition to the withdrawal treaty, the European Union and the United Kingdom are also supposed to sign a joint political declaration describing their future economic, political and security ties. While London has pushed for an ad hoc agreement, Brussels wants the United Kingdom to accept one of the existing models, which include membership in the single market, membership in the customs union or a traditional free trade agreement. The European Union is worried about the economic repercussions of a disorderly Brexit, but it is also terrified of signing a deal that is so beneficial for the United Kingdom that Euroskeptic political forces in other member states use it as inspiration for their campaigns to leave the bloc.

The European Union and the United Kingdom would like to reach a withdrawal agreement and a political declaration on future ties by the end of the year. But considering its complexity, the Brexit process could continue into the early weeks of 2019. Brexit watchers should expect marathon summits resembling those that took place when Greece's third bailout package was negotiated in mid-2015. And just as they did with the Greek bailout, politicians will eventually replace technocrats and take control of the process, which will create room for compromises. The European Union and the United Kingdom want to avoid a "no-deal" scenario, which would be highly disruptive for both. This will open the door for a "half-deal" scenario, in which the European Union and the United Kingdom agree on just enough issues to avoid a disorderly exit and allow for the enforcement of the transition period (the 21-month interval after Brexit during which the United Kingdom would remain in the EU single market), buying extra time to negotiate everything else.

It will not be smooth sailing, however. Several issues could lead to a collapse of the negotiations. Hard-liners could replace May as prime minister and walk away from the talks, or a rebellious Parliament could veto the agreement between the European Union and the United Kingdom. But if German Chancellor Angela Merkel, Macron and May take control of the negotiations, their main interest will be to reach a deal, even if it's a flawed, incomplete one that postpones solving problems.
When Problems Just Keep Piling Up

The final months of the year will present multiple sources of political risk for the European Union, including a negative effect on bilateral trade because of higher U.S. tariffs, the lack of agreement on EU reform and a disorderly Brexit. Germany and the most prominent EU states and institutions will be negotiating on multiple fronts to minimize any damage caused by these events, but the task ahead of them will not be easy.

Should the Trump administration insist on including agriculture in its negotiations with Brussels, it will be hard for Europe to give the United States what it wants, no matter how badly Germany pushes for a trade deal. Internal EU disputes will be easier for Berlin to handle, because the bloc has a long history of toning down, postponing or transforming controversial proposals to appease the conflicting interests of its members, even if the result is often inefficient or incomplete policies. On Brexit, a last-minute, face-saving and time-buying deal sponsored by Germany is possible, but political events within the United Kingdom can still derail the process. Regardless of the outcome of these disputes, one thing is clear. Summer may have given Europe, and Germany in particular, a sense of temporary relief. But come autumn, the problems will have to be addressed.

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