European Union: indecision and delay

German industrial production

Source: Independent Strategy

So, after a brief rally, I reckon the euro is set to weaken again against the US dollar, moving towards parity. The European Central Bank will now be much less reluctant to cut interest rates in order to fend off EU recession. There's no justification for maintaining real rates of 2% to 2.5% when real GDP growth in the euro zone is sub-par and slowing and inflation below 1% and falling. Short rates could go 50 to 75 basis points lower by the year-end. That will help German Bunds and equities, which have underperformed the EU average by over 10% so far this year. That performance gap will narrow quite quickly.

Whether this leads to a sustained period of German equity outperformance, however, depends upon the extent to which the German chancellor, Gerhard Schröder, can seize the initiative and push through a more radical, pro-business, tax reform.

And then there are the unresolved problems brewing in the EU. The recent deal over agricultural subsidies hammered out by member states is being hailed as a great success. Sure, it's the most significant overhaul of the Common Agricultural Policy since the 1960s but this says more about the snail's pace of previous reforms than the substance of the current deal, which merely postpones an almighty showdown over EU finances.

The CAP soaks up half the EU budget, worth €81 billion ($100 billion) a year. This is unsustainable on several scores. First, all member states wish to limit their contributions. Second, CAP subsidies are increasingly running foul of World Trade Organization regulations. Third, CAP is riddled with corruption. Fourth, it cannot survive if central European states are ever to join the EU.

Germany, which holds the rotating EU presidency, also happens to be by far the largest net contributor to EU coffers, paying €11 billion every year. The Bonn government originally proposed to stabilize the EU budget at current levels and introduce a scheme to co-finance agricultural subsidies. This would have forced national governments to come up with some of the money spent on their own farmers and lower the guaranteed prices for agricultural produce, thereby exposing the sector to the full blast of market forces.

But opposition came from France, which gets the largest chunk of CAP money. The French argued that the German proposals - by forcing national governments to subsidize their own farmers according to their own priorities - would simply take the "common" out of CAP.

The deal will result in lower food prices throughout Europe, particularly on cereals and beef. Yet, on closer inspection, most of what could have been achieved was postponed. Once all the compromises are factored in, the CAP subsidy bill will remain at around €40 billion a year after 2001, roughly the same as now.

EU governments agreed earlier this year to halt the growth in central budget spending. This was based on the assumption that CAP reform would be much more radical. Since this has not materialized, the EU is now looking at a gap in its finances of about €7.5 billion a year.

Theoretically, this could be recovered by cutting the structural and regional funds (the separate pots of money given to subsidize poorer EU countries' living standards). The snag here is that the structural funds are much smaller and therefore will require bigger cuts - at least proportionally - if the shortfall is to be recovered. As such, structural funds are even more politically sensitive than CAP payments.

Schröder has staked his credibility on a cut in Gemany's contribution to the EU. This could have been achieved had CAP reform yielded some savings. But it required standing up to the French, something the Germans were evidently unwilling to do. So Schröder is faced with the trickier option of squeezing the British.

As part of a deal reached in the early 1980s, the UK gets an annual rebate worth some £2 billion ($3 billion) from its contributions to the EU, largely because it has a small agricultural sector. If CAP had been radically reformed, UK prime minister Tony Blair could have claimed that, since the reasons for the rebate had gone, so should the rebate. The difference to the British taxpayer would have been marginal.

But since the payments for CAP will continue unabated, Blair can no longer accept a reduction in the rebate without losing face. Any compromise would be seen as a great British defeat, scuppering Blair's chances of turning UK public opinion in favour of British participation in the single currency. Yet this is precisely what the Germans are still demanding.

It is very difficult to see how the negotiations on enlargement to include the countries of central Europe can begin until all these issues are resolved. CAP reform was the centrepiece of a wider overhaul of EU funding and spending under Agenda 2000. If EU members fail to resolve the remaining issues as well, the enlargement of the EU will have to be delayed.

David Roche is president of Independent Strategy, a research firm based in London. www.instrategy.com