As almost all European governments are cutting spending, it is hardly a surprise that the EU’s budget is under fire. The European Commission has rather optimistically proposed a real terms increase of five per cent in total spending over the next budget period, which runs from 2014 to 2020. This amounts to 1.05 per cent of projected EU GDP over that period. Most of the countries that pay more into the budget than they get back reject this proposal. Germany and Ireland want the budget limited to one per cent of EU GDP (which means that as Europe’s economies grow, the budget can grow too, but at a slower rate than the Commission wants). However, British Prime Minister David Cameron wants to go further: he has promised to veto anything but a freeze in real terms. It may be difficult to back down from this position in budget negotiations: the opposition Labour party combined with backbench Conservative rebels to win a parliamentary vote last week that called for a cut to the budget, defeating the government. Cameron would be unlikely to get a larger EU budget through the UK’s parliament if he compromises at the summit, on November 22nd.

Britain is not the only budget hawk: Sweden and the Netherlands have also demanded big cuts to the Commission’s proposal. But neither has demanded a freeze. The UK is likely to be further isolated in Europe, after its veto of the fiscal compact in December last year, if Cameron refuses to compromise. Amid the politicking over the size of the total budget, Westminster has paid little attention to the potential costs to the Exchequer of the proposals on the negotiating table, and how much extra the UK could pay. This note offers some answers, and in doing so allows us to judge whether UK obduracy is likely to achieve very much.

How much does the UK currently pay, and how much does it receive?
As a comparatively rich country with a small agricultural sector, the UK has in recent years been a net contributor to the EU budget. The UK passes tax revenue to Brussels, and receives less expenditure in the form of Common Agricultural Policy (CAP) payments, regional development funds, and other transfers in return. But it has a rebate from Brussels – a reduction in its contributions negotiated by Margaret Thatcher in 1984, which many other EU countries consider to be unfair now that Britain is one of the richer members of the club.

Britain’s net contribution is how much it pays in, less how much it receives back, in EU spending and the rebate. In most budget negotiations, British governments try to reduce wasteful and iniquitous farm spending and the size of the budget, and protect the rebate. Tony Blair’s 2005 agreement to cut the rebate to help pay for the costs of EU enlargement is the exception that proves the rule: even Blair, a pro-European prime minister at the height of his power, did so reluctantly, and fought hard for CAP reform.

Given that any country can veto the EU budget, member-states must build alliances to succeed. The UK is isolated after its veto of the fiscal treaty, and so would do well to be cautious if it wants to reduce spending. Britain wants the budget frozen at its 2011 level. But if the talks collapse, which is a distinct possibility, the 2013 budget will simply be rolled over to 2014, but with inflation added. The budget would end up far larger than 2011.

If the UK really wanted to cut wasteful spending and promote growth, it could accept the German proposal for a budget capped at one per cent of EU GDP, in exchange for cuts to the CAP and a transfer of that money into infrastructure and regional development spending. France has threatened to veto any budget that does so, but they could be isolated if Britain were prepared to make concessions, which President Hollande may wish to avoid, given the difficult negotiations over the euro.

But such a deal may be difficult for Cameron, who has chosen to make budget cuts his priority. The UK’s net contribution grew by three-quarters between 2006 and 2012, from £3.9 billion to £7.4 billion (€4.8 to €9.2 billion). The UK’s transfers to Brussels were low in 2008 and 2009 because it suffered a larger recession than other member-states, and in 2010 and 2011 payments were larger because its economy made a (small) recovery. On the expenditure side of the ledger, European Social Fund and Regional Development Fund spending in the UK is falling over time. These funds provide support for struggling regions with an income less than three-quarters of the EU average. Over the course of the last budget, Brussels has phased in the poorer newer members in Central and Eastern Europe, so that a greater proportion of structural funds go to these countries. These two factors explain most of the rise in the UK’s net contribution.

As regional funding has declined, agricultural payments have become the large majority of EU spending in Britain. This change in the composition of spending explains why Cameron is in a difficult negotiating position. Switching money from the CAP to regional spending would mean that the UK’s net contribution would rise, as fewer regional funds are disbursed in Britain, thanks to enlargement. If Cameron were to try to offer up more of the rebate to convince France to reform the CAP, the UK’s net contribution would rise even further. Thus, Cameron can either try to limit the UK’s contribution to the EU or try to improve what it is spent on. The best policy would be the latter, but the best politics – at least in domestic terms – is the former.

How much could the UK contribute to the next budget?
Britain’s net contribution to the next budget will not be decided before the negotiations at the summit in late November – and quite possibly not even then. But we can make some assumptions about how much more the British taxpayer might end up paying. The UK’s fiscal watchdog, the Office of Budget Responsibility, assumes that the UK net contribution is going to stay at around the 2012 level as a percentage of the total EU budget – five per cent. This seems right, for the following reasons. The UK is unlikely to give up or reduce its rebate. British economic growth is projected to be around the EU average: if it grew faster than other countries, the budget arithmetic would mean it would become a bigger net contributor. Finally, regional development funding is not coming back to the UK: Central and Eastern Europe will remain poorer than Western Europe between now and 2020. Given that the UK contribution should stay at around the same level, as a proportion of the total budget, we can then project forward how much it is likely to contribute, given the three main proposals on the table.

* A budget freeze (UK proposal: the British Parliament’s vote for a cut is only advisory, and this remains the UK government’s position)
* A budget capped at one per cent of EU GDP (the German position)
* A five per cent increase in the budget, as a proportion of EU GDP, to 1.05 per cent (the Commission proposal)

"When I use a word," Humpty Dumpty said, "it means just what I choose it to mean – neither more nor less." 
"The question is," said Alice, "whether you can make words mean so many different things." 
"The question is," said Humpty Dumpty, "which is to be master – that’s all." 
(Lewis Carroll, Through the Looking Glass, Chapter 6)

The underlying purpose of the ‘European project’ has always been clearer than its ultimate destination. Its purpose – to escape a traumatic past disfigured by dictatorship and war – has never been particularly contentious (what sane European would want a return to that?). But the same cannot be said of the EU’s final destination. For much of its history, the EU has hidden behind the foggy ambiguity of its aspiration to build an “ever closer union among the peoples of Europe”. The trouble is that this worthy aspiration has always meant very different things to different people. Those of a minimalist disposition, often to be found among the British, have usually understood it to mean little more than the removal of cross-border barriers to the free movement of goods, services, capital and people. Those of a more ambitious bent, more often to be found in continental Europe, have seen the ultimate goal of the project to be some sort of ‘political union’ (however understood).

The eurozone crisis has once again exposed the gulf between British and continental visions of the EU. But it has done a lot more. It has also forced European leaders to speak a little less airily about ‘political union’ than they have become accustomed to in the past. All agree that the single currency must be embedded in a real ‘political union’ if it is to survive. But they are being forced to define their terms. Roughly speaking, two schools of thought have emerged. One (mostly northern European) school thinks that the crisis resulted from errant behaviour. For it, political union means tighter rules, more strictly enforced. The second school believes that the architecture of the eurozone is flawed. For it, political union means transferring a number of critical responsibilities from national to European level. If the first school frets about moral hazard, the second worries about a dearth of solidarity. The first school emphasises collective discipline, the second mutual burden-sharing.

Which of the two schools has the better story to tell? Although Greece is a convincing poster child for the first school, the balance of evidence weighs heavily in favour of the second. To start with, compliance with rules before 2008 turned out to be a poor predictor of countries’ subsequent plight. Like Mark Twain’s stories, the eurozone had its good little boys to whom bad things happened and its naughty boys who prospered. (Ireland never broke the fiscal rules before 2008 but is now in a slump, while Germany did and is not.) Second, despite having lower levels of debt in aggregate, it is the eurozone, not the US, which has been in the eye of the storm – strong evidence that it is the eurozone’s architecture, rather than the behaviour of its constituents, which is to blame. Third, the more the principle of collective responsibility has been asserted, the worse the eurozone’s plight has become: efforts to instill discipline have signally failed to restore confidence in the eurozone.

The symptoms of this failure are numerous. Financial markets within the union have fragmented as private-sector capital has drained out of countries in the ‘periphery’. Long-term borrowing costs inside the union have become unsustainably polarised, pushing systemically important countries such as Spain and Italy perilously close to insolvency. Target 2 balances within the European System of Central Banks have ballooned as public-sector capital flows have replaced private ones. Countries experiencing private-sector capital flight have been forced to pursue self-defeating policies of fiscal austerity. Sound banks domiciled in countries with stressed sovereigns have become vulnerable to depositor flight. And so on. The countries under strain partly have themselves to blame. But they are also victims of the eurozone’s structure: Spain’s borrowing costs are vastly higher than those of euro ‘outs’ such as the UK, even though Spain’s public finances are in no worse shape.

European policy-makers have been slow to accept that the eurozone’s institutional configuration makes it structurally unstable. But in June 2012, the so-called ‘Gang of Four’ – a group consisting of the presidents of the European Council (Herman Van Rompuy), the European Commission (Jose-Manuel Barroso), the European Central Bank (Mario Draghi) and the Eurogroup (Jean-Claude Juncker) – submitted an important plan to set the eurozone on a more stable long-term footing. It marked an important departure, because its focus shifted to correcting the eurozone’s architectural flaws rather than the behaviour of its members. The policy areas covered – banking supervision, resolution regimes, deposit protection – may have been dry and technical. But the plan was deeply political. It proposed that the stabilisation of the eurozone required key functions to be moved from national level to European level. It was, in other words, a plan to federalise the eurozone.

Why is the federalisation of certain functions necessary to restore confidence in the eurozone? The answer is not that the tasks concerned will necessarily be carried out more competently at European level (the reverse may even be the case). It is that the existence of federal powers and instruments is both a symbol and a guarantee of member-states’ commitment to the union. The reason the eurozone faces an existential crisis while the US does not is not the result of a financial market conspiracy orchestrated by Anglo-Saxons (as some Europeans darkly claim). It is that the eurozone’s decentralised configuration raises doubts about individual states’ commitment to the union. Unlike in the eurozone, bank failures in the US did not push any of the constituent states (such as Delaware) into insolvency, because the associated costs were mutualised. No one thinks that the parlous state of California’s public finances will result in its exit from the US (unlike, say, Greece from the eurozone).
  
A currency union embedded in a fiscally decentralised confederation, it turns out, has been a highly unstable arrangement (particularly in the aftermath of a financial crisis). The adoption of new rules that constrain national sovereignty have not really helped to restore confidence or stability. Indeed, as new rules have proliferated, the eurozone has come to look less like a single currency and more like a rigid fixed exchange rate system on life support. For much of the past two years, redenomination risk has stalked the eurozone. So the Gang of Four is right. The eurozone needs a degree of federalisation to persuade investors and depositors that its members are committed to the currency union’s integrity and survival. Far from being some obscure technocratic fix, a banking union is better understood as an essential pillar of the sort of political union that the eurozone needs if it is to endure and prosper. The question, then, is whether the member-states now accept this.

The answer is that they are still split. The recent report by EU foreign ministers on the future of Europe (the ‘Westerwelle report’) hinted at a number of unresolved arguments between confederal and federal visions of Europe. A striking feature of the report was the number of reservations placed by certain member-states on the proposals of the Gang of Four. On the subject of a banking union, for example, the report said that “some members of the group underlined the importance of a common deposit protection scheme and of a restructuring and resolution scheme”. By implication, other member-states still think that such steps are unnecessary. Indeed, the impression created by the Westerwelle report is that there is more agreement among member-states about the need to develop the foreign policy than the economic dimension of political union. If this is what EU leaders end up doing, they risk creating a Potemkin village rather than a political union that stabilises the eurozone.

Alice’s question to Humpty Dumpty was spot on. Words can be made to mean very different things. Since the onset of the eurozone crisis, two meanings of political union have done battle. The first has emphasised collective discipline, or the need for rules that bind member-states. This is the language of confederalism. The other has emphasised mutualisation, or the need for solidarity and common institutions. This is the language of federalism. For much of the past two years, the language of confederalism has dominated: reforms have focused on improving behaviour rather than on fixing the eurozone’s flawed structure. But a more federal language is starting to emerge. There is more acceptance now than there was two years ago that rules may be necessary to curb moral hazard, but that they are insufficient to eliminate redenomination risk (and so restore confidence in the eurozone’s stability). This view, however, is still far from being universally shared by the member-states

Philip Whyte is a senior research fellow at the Centre for European Reform

Before becoming French president, Franҫois Hollande did not appear to take much interest in the EU. However, in his youth he was a protégé of Jacques Delors, the French left’s great European, and his instincts seem to be broadly pro-EU. Hollande’s arrival in the Elysée has not led to dramatic changes in France’s EU policy, but a new approach is emerging. Compared with Nicolas Sarkozy, Hollande is less hostile to EU institutions, more willing to work closely with the southern European member-states and, most crucial of all, keener to demonstrate that France does not slavishly follow German wishes.

Hollande knows very well that a strong Franco-German relationship is indispensable to sorting out the problems of the eurozone in particular and the EU in general. But, as officials in the Elysée, the finance ministry and the foreign ministry made clear during recent conversations, Hollande wants a more balanced Franco-German relationship.

These officials emphasise that the ‘Deauville’ model of Paris-Berlin relations has been scrapped. At the Franco-German summit in Deauville in October 2010, Chancellor Angela Merkel made Nicolas Sarkozy, the then French president, accept the principle that private-sector holders of sovereign bonds of countries needing a bail-out should suffer losses. At an EU summit a few days later, the ‘Merkozy’ duo imposed that principle on their fellow leaders, who feared that its adoption would destabilise sovereign bond markets (which is exactly what happened).  At many other summits, too, Merkel and Sarkozy set the agenda or delayed decisions while they consulted each other. This upset other member-states and the EU institutions.

Hollande understands what drove Sarkozy towards followership vis-à-vis Merkel: for several years the German economy had out-performed France’s – notably on unit labour costs, employment, export performance and growth – so that the relationship had become unbalanced.

Hollande has therefore sought to strengthen France’s position relative to Germany in a number of ways. One is to consult other countries – especially Italy and Spain – and the European Commission on key issues. Sarkozy avoided getting too close to ‘problem’ member-states, lest the financial markets associate France with southern Europe. But Hollande does not have that hang-up. At his first summit, when he lined up with Italy’s Mario Monti and Spain’s Mariano Rajoy, the Germans were not amused, but they have now – according to the French – seen that a more inclusive system of leadership is in their interests. Hollande’s officials claim that he has not been and will not be so crude as to try and put together a bloc to counter Germany.

Hollande’s second way of strengthening French influence is to retain the austere fiscal targets that he inherited, notably by limiting the budget deficit to 3 per cent of GDP in 2013. Some government officials believe that this and the budgetary targets adopted by other EU governments – partly because of German pressure – are excessive and counter-productive. They nevertheless say that France needs to stick to 3 per cent in order to win credibility in Berlin. They think that as long as economic growth this year holds up to the predicted 0.8 per cent, the target is feasible. Although the current emphasis is on shrinking the budget deficit through tax rises, in future years spending cuts will predominate, officials say.

The third way of raising France’s standing is to improve the country’s competitiveness. Outside France, the president and his ministers are not perceived as being particularly committed to structural economic reform. During the presidential election campaign, Hollande avoided the subject. But some of the key officials in Paris say that the government is determined to reduce unit labour costs and to reform labour markets. If the current negotiations between the social partners on labour market reform break down, they say, the government will legislate. Many previous French governments have declared their commitment to such reforms, only to back down in the face of street protests. But Hollande’s people are adamant that he will stand firm – and it is arguable that over the past 30 years, Socialist governments have reformed more boldly than Gaullist governments.

Having got off to a rocky start with Merkel – who refused to meet him before the French presidential election – Hollande now has a good working relationship with her, his advisers say. Although personalities matter much less than interests in Franco-German relations, this pair may end up with a more affable relationship than Merkel and Sarkozy had. The dour Merkel, who likes to move slowly and cautiously, and the mercurial Sarkozy, who is impatient and partial to bold initiatives, were not natural soul-mates. Hollande, however, tends to be soft-spoken and a consensus builder – as is Merkel.

French officials claim that Hollande helped to persuade Germany’s leaders to shift their thinking on the euro crisis. For example, Merkel and Wolfgang Schäuble, her finance minister, have rallied behind Mario Draghi, the president of the European Central Bank (ECB), and his scheme to intervene in bond markets to lower the borrowing costs of peripheral countries (but the French worry that Jens Weidmann, the Bundesbank president who opposes the scheme, is winning the public relations battle inside Germany). The German government has also made clear that – like France – it wants Greece to stay in the euro, for fear of the consequences of its departure.

But many tensions remain between Paris and Berlin. The French support the Commission’s proposals for an EU-wide system of bank supervision that would cover all Europe’s banks; the Germans want only the largest, cross-border banks to be covered – apparently oblivious to the fact that many of the problems in European banking emerged in small or medium-sized banks. Germany seems to want to slow down an agreement on EU banking supervision, although the European Stability Mechanism (the permanent bail-out fund that will soon be operational) cannot help banks in difficulty until the new supervisory regime is in place. Furthermore, the German government is counselling Spain not to activate the Draghi mechanism to intervene in bond markets, perhaps because it fears a vote in the Bundestag; the French believe that the mechanism must be used soon, lest the financial markets cease to believe in its potency.

On longer-term issues of eurozone governance, too, there is a huge distance between Paris and Berlin. The French worry about the incoherence of the way the eurozone is managed – nobody is in charge, and governments do not know what different leaders have said to each other. They want the Eurogroup (the regular meetings of eurozone finance ministers) to provide some of the missing leadership by appointing a full-time president and by introducing majority voting. But some Germans worry that a stronger Eurogroup could erode the independence of the ECB.

The French think that, because they have swallowed the painful medicine of the fiscal compact – that they will soon ratify – and thus given away some of their cherished budgetary sovereignty, Germany should be keener to discuss ‘eurobonds’ (the mutualisation of European debt), pan-European bank deposit insurance and a bank resolution regime. But Germany still says no to those ideas, since they would cost it money.

Another broad disagreement is over the woolly concept of ‘political union’, which is moving up the EU’s agenda. On September 12th, José Manuel Barroso, the Commission president, called for a “federation of nation-states” when he spoke to the European Parliament. He promised proposals for a new EU treaty before the 2014 European elections.

In Berlin, there is much talk of ‘more Europe’, treaty change and political union. Indeed, a reflection group led by Guido Westerwelle, the German foreign minister – with the participation of eight other foreign ministries – published a report on September 17th on Europe’s future. This proposed classic federalist solutions to the EU’s problems: majority voting on foreign policy, a stronger role for the High Representative for foreign policy, a European army, an elected Commission president, a stronger European Parliament and a new system for ratifying treaties (to prevent small countries holding back everybody else). Many of the report’s proposals would require treaty change. However, several ministers taking part in the Westerwelle group have dissociated themselves from certain proposals, and some of the governments not involved have reacted coolly.

In Paris there is no enthusiasm for the concept of political union. Although France was involved in the Westerwelle group – sending a junior minister, rather than the foreign minister – some French officials talk disdainfully of it. “When the EU is in crisis, the Germans have a Pavlovian reaction and call for political union, without really meaning it,” said one. Another opined that Merkel did not support many of the ideas in the Westerwelle report and that the Germans did not know what they wanted from treaty change (in many other capitals, too, there is scepticism about Merkel’s commitment to the report).

The negotiation of a major new EU treaty would have to be preceded by a convention on the future of Europe (“a nightmare”, in the words of one French official) and followed by ratification in every member-state, with some holding referendums. The French are in no hurry to re-open institutional questions. In the words of one key official: “The EU spent the last decade dealing with treaty changes and institutions, when it should have been worrying about the ‘Lisbon agenda’ [on competitiveness] and the flaws in eurozone governance”. The EU’s priority, the French believe, should be fixing the euro: the 17 that use it should agree on whatever arrangements are necessary, and then allow others that wish to join the euro to participate later.

Some French officials think they can postpone a major new EU treaty for two or three years. But others, notably in the finance ministry, are less hostile to treaty change; they know that neither a stronger Eurogroup nor EU-wide deposit insurance can be established under the current treaties.

Despite their wariness of political union, French officials are thinking about the future of EU institutions. They recognise that the increasing centralisation of decision-making on eurozone issues creates a greater need for democracy and accountability at eurozone level. Some officials talk of a new body of national parliamentarians and MEPs that could approve key appointments and hold to account eurozone decision-makers such as the Eurogroup president, or the ECB body that will be responsible for bank supervision. That idea is similar to a recommendation in the Westerwelle report, as is the view of many French officials that MEPs from countries outside the euro should not be allowed to vote on euro issues.

In general, the people around Hollande and finance minister Pierre Moscovici are less inter-governmentalist than were Sarkozy’s advisers. Some of them view the European Parliament quite sympathetically, though they do not think that in its current form it can play much of a role in eurozone governance. They are less keen than Sarkozy was to give national parliamentarians a role in EU decision-making. They criticise the Commission less viciously than Sarkozy’s people, though they complain about the quality of its leadership and its tendency to interfere on little things that should be left to member-states. They accept, albeit reluctantly, that the Commission must play a role in supervising the economic and budgetary policies of eurozone member-states. Hollande’s relatively communautaire approach puts him closer to traditional German thinking than to Gaullist thinking.

So far, Hollande’s new approach to Germany – working closely with it, but not following slavishly – seems to have been moderately successful. But in the long run, if he wants French influence in the EU to approach that of Germany, he will have to deliver on his promise to boost the competitiveness of the French economy.