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To rescue Europe, our leaders need a new sense of resolve

Our limited resources won't stretch far without determination.

The two most important questions for the future of Europe are, first, what the euro area must do to rescue itself and, second, whether it has a strategy. The first question arises because the euro crisis has exposed grave design flaws. It is these flaws, compounded by repeated tactical mistakes in responding to market alarms, that explain at least as much as failures to enforce rules why Europe has reached the point at which the very existence of its currency is at stake.

Monetary union in its first 12 years relied on a series of assumptions that were ultimately proved wrong. To start with, it was assumed that, beyond the European single market, a common currency required only the delegation of monetary authority to a common central bank and ensuring that governments abide by fiscal discipline rules. According to this view – in effect, a variant of the Lawson doctrine – there was no need to monitor privately determined external imbalances and credit booms and there was no need for a euro-area financial policy.

Even in the late 1980s, this was disputable. The absence of a financial component to the euro was raised by the Bank of England in the negotiation of the Maastricht Treaty but the seriousness of this omission became clear only with the debacle of Ireland and Spain, whose fiscal records were apparently impeccable, and the sudden arrest of north-south capital flows within the euro area. Another related, erroneous assumption was that, apart from monetary policy, governance had only to rest on rules. This amounted to pretending that effective arms control makes an army redundant.

Uncharted territory

Finally, there was an assumption that as all EU countries would join at some point – at least all those without a waiver – the complexities inherent in the coexistence of countries inside and outside the currency area would disappear. The functioning of the euro could therefore be based on a relatively narrow set of specific provisions and arrangements. This assumption, however, is no longer credible, if it ever was. If the euro survives its crisis (which is still likely), it will be seen as a coalition of the willing, not the currency of the EU. In such conditions, there must be a much clearer distinction between what belongs to the 27 and what belongs to the 17.

Reform has started. For two years, the euro area has painfully built financial and operational crisis-management capabilities. In the process, it is creating a sort of government that is able to take decisions based on judgement and has the ability to act upon them – at this stage admittedly still a rather awkward one. A messy but undisputable process of rebuilding has begun with the adoption of eurozone-specific legislation and a new fiscal treaty. There are plans to monitor internal imbalances and credit developments. At the euro summit in June, there was a recognition that in order to be financially resilient, the euro area must equip itself with a banking union.

The euro-area countries have thus embarked on a journey into new territory. Even something as apparently technical as a banking union has far-reaching implications. It involves cutting incestuous ties between banks and governments at the national or regional level. It implies giving a European authority the power to close down banks and distribute losses between shareholders, creditors, depositors and taxpayers – an inherently political choice. It makes it indispensable to secure access to tax revenues, so that the ability to act in a crisis is not hampered by a lack of resources. It entails the risk of large-scale, cross-border transfers in the event of a banking crisis affecting part of the area only. It requires representation of taxpayers and the accountability of supervisors.

In effect, a banking union is a sort of off-balance-sheet fiscal union. Its off-balance-sheet character is a source of complexity but it magnifies rather than diminishes its fiscal character. One should never forget that the median fiscal cost of a banking crisis is 5 per cent of GDP in advanced economies and that for Ireland it has reached 40 per cent.

Yet the process lacks credibility. Markets are being told there is agreement on strengthening governance but what has emerged from the recent ministerial meeting is another unconvincing compromise; they are being told a banking union is in the making but neither the agenda nor the timetable for building it; they are being told that the European Stability Mechanism could buy Italian debt but neither how much nor when; they are being told that leaders will do whatever it takes to maintain the integrity of the euro area but preparations are being made for a Greek exit. The markets cannot be blamed for emulating Saint Thomas and believing only what they can touch. They cannot be blamed for asking if words will be followed by deeds.

Part of the process

Lack of credibility is lethal because it makes the solution to any problem much more demanding than it should be. Italy is a case in point: last year, it had a structural primary surplus of 2 per cent of GDP on its budget, more than any other euro-area country. But self-fulfilling market doubts are putting its solvency at risk.

In this context, the first thing needed is a precise agenda for negotiation on banking union and other systemic reforms, such as debt mutualisation. Leaders should not pretend to concur on issues they have not even discussed but should rather initiate a thorough, time-bound and credible process of discussion among ministers. Markets can be patient if they are assured that such a process has started in earnest and will deliver results within a certain time frame.

The other and no less urgent thing leaders should do is to adopt a coherent stance on problem countries. One strategy is to keep the euro area together and make sure all participating countries are given the chance to recover within it. This implies doing more for Greece, setting a framework for giving assistance to Spain and protecting Italy. Another, more adventurous strategy is to kick out Greece and ring-fence the countries that are to remain part of the euro. Either is conceivable. But a choice must be made, policies must be coherent with it and it must be supported by appropriate means. To enter the battle with limited resources and, worse, lack of resolve to use them is a recipe for defeat.

Jean Pisani-Ferry is the director of Breugel, a think tank based in Brussels


This article first appeared in the 16 July 2012 issue of the New Statesman, Age of Crisis

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Q&A: What are tax credits and how do they work?

All you need to know about the government's plan to cut tax credits.

What are tax credits?

Tax credits are payments made regularly by the state into bank accounts to support families with children, or those who are in low-paid jobs. There are two types of tax credit: the working tax credit and the child tax credit.

What are they for?

To redistribute income to those less able to get by, or to provide for their children, on what they earn.

Are they similar to tax relief?

No. They don’t have much to do with tax. They’re more of a welfare thing. You don’t need to be a taxpayer to receive tax credits. It’s just that, unlike other benefits, they are based on the tax year and paid via the tax office.

Who is eligible?

Anyone aged over 16 (for child tax credits) and over 25 (for working tax credits) who normally lives in the UK can apply for them, depending on their income, the hours they work, whether they have a disability, and whether they pay for childcare.

What are their circumstances?

The more you earn, the less you are likely to receive. Single claimants must work at least 16 hours a week. Let’s take a full-time worker: if you work at least 30 hours a week, you are generally eligible for working tax credits if you earn less than £13,253 a year (if you’re single and don’t have children), or less than £18,023 (jointly as part of a couple without children but working at least 30 hours a week).

And for families?

A family with children and an income below about £32,200 can claim child tax credit. It used to be that the more children you have, the more you are eligible to receive – but George Osborne in his most recent Budget has limited child tax credit to two children.

How much money do you receive?

Again, this depends on your circumstances. The basic payment for a single claimant, or a joint claim by a couple, of working tax credits is £1,940 for the tax year. You can then receive extra, depending on your circumstances. For example, single parents can receive up to an additional £2,010, on top of the basic £1,940 payment; people who work more than 30 hours a week can receive up to an extra £810; and disabled workers up to £2,970. The average award of tax credit is £6,340 per year. Child tax credit claimants get £545 per year as a flat payment, plus £2,780 per child.

How many people claim tax credits?

About 4.5m people – the vast majority of these people (around 4m) have children.

How much does it cost the taxpayer?

The estimation is that they will cost the government £30bn in April 2015/16. That’s around 14 per cent of the £220bn welfare budget, which the Tories have pledged to cut by £12bn.

Who introduced this system?

New Labour. Gordon Brown, when he was Chancellor, developed tax credits in his first term. The system as we know it was established in April 2003.

Why did they do this?

To lift working people out of poverty, and to remove the disincentives to work believed to have been inculcated by welfare. The tax credit system made it more attractive for people depending on benefits to work, and gave those in low-paid jobs a helping hand.

Did it work?

Yes. Tax credits’ biggest achievement was lifting a record number of children out of poverty since the war. The proportion of children living below the poverty line fell from 35 per cent in 1998/9 to 19 per cent in 2012/13.

So what’s the problem?

Well, it’s a bit of a weird system in that it lets companies pay wages that are too low to live on without the state supplementing them. Many also criticise tax credits for allowing the minimum wage – also brought in by New Labour – to stagnate (ie. not keep up with the rate of inflation). David Cameron has called the system of taxing low earners and then handing them some money back via tax credits a “ridiculous merry-go-round”.

Then it’s a good thing to scrap them?

It would be fine if all those low earners and families struggling to get by would be given support in place of tax credits – a living wage, for example.

And that’s why the Tories are introducing a living wage...

That’s what they call it. But it’s not. The Chancellor announced in his most recent Budget a new minimum wage of £7.20 an hour for over-25s, rising to £9 by 2020. He called this the “national living wage” – it’s not, because the current living wage (which is calculated by the Living Wage Foundation, and currently non-compulsory) is already £9.15 in London and £7.85 in the rest of the country.

Will people be better off?

No. Quite the reverse. The IFS has said this slightly higher national minimum wage will not compensate working families who will be subjected to tax credit cuts; it is arithmetically impossible. The IFS director, Paul Johnson, commented: “Unequivocally, tax credit recipients in work will be made worse off by the measures in the Budget on average.” It has been calculated that 3.2m low-paid workers will have their pay packets cut by an average of £1,350 a year.

Could the government change its policy to avoid this?

The Prime Minister and his frontbenchers have been pretty stubborn about pushing on with the plan. In spite of criticism from all angles – the IFS, campaigners, Labour, The Sun – Cameron has ruled out a review of the policy in the Autumn Statement, which is on 25 November. But there is an alternative. The chair of parliament’s Work & Pensions Select Committee and Labour MP Frank Field has proposed what he calls a “cost neutral” tweak to the tax credit cuts.

How would this alternative work?

Currently, if your income is less than £6,420, you will receive the maximum amount of tax credits. That threshold is called the gross income threshold. Field wants to introduce a second gross income threshold of £13,100 (what you earn if you work 35 hours a week on minimum wage). Those earning a salary between those two thresholds would have their tax credits reduced at a slower rate on whatever they earn above £6,420 up to £13,100. The percentage of what you earn above the basic threshold that is deducted from your tax credits is called the taper rate, and it is currently at 41 per cent. In contrast to this plan, the Tories want to halve the income threshold to £3,850 a year and increase the taper rate to 48 per cent once you hit that threshold, which basically means you lose more tax credits, faster, the more you earn.

When will the tax credit cuts come in?

They will be imposed from April next year, barring a u-turn.

Anoosh Chakelian is deputy web editor at the New Statesman.