Hugo Dixon

It is perhaps too much to expect Britain’s Conservative-led government to lead any initiatives on Europe, such is the orgy of self-destruction in the party over whether the UK should stay in the European Union. But, insofar as David Cameron manages to get some respite from the madness, he should launch a strategy to enhance the City of London as Europe’s financial centre.

Britain has in recent years been playing a defensive game in response to the barrage of misguided financial rules from Brussels. It now needs to get on the front foot and sell the City as part of the solution to Europe’s problems. The opportunity is huge both for Britain and the rest of Europe.

The chance of getting the EU to swing behind a pro-City strategy may, on the face of it, seem pie in the sky. Many people blame financiers for the financial crisis. So how could they be part of the solution? What’s more, Continental Europeans have long tended to be suspicious of financial markets.

Hence, the plan by 11 EU countries (not including the UK) to apply a tax on all financial transactions. Hence, too, the recent decision to cap bankers’ bonuses thoughout the EU (against London’s objections) and a scheme, so far not agreed, to do the same for fund managers.

The oddity about these rules is that they do nothing to address the causes of the financial crisis. Trading in financial instruments wasn’t responsible for the crisis. Nor were fund managers. And while banker compensation does bear some of the blame, the so-called solution is cock-eyed. Banks will react to bonus limits by pushing up fixed salaries – something which will make their finances more vulnerable when the next crisis hits.

Quitting the European Union would be bad for Britain. Membership of even an unreformed EU is better than “Brexit”. Quitting would mean either not having access to the single market – at a huge cost to the economy – or second-tier membership.

The debate over Brexit has moved into high gear in the past 10 days, after the UK Independence Party – which wants Britain to pull out of the EU – performed well in English local elections. The Conservative party, which rules in coalition with the pro-European Liberal Democrats, has been thrown into turmoil because UKIP has been winning votes largely from the Tories.

What’s more, many Conservatives would like Britain to quit the EU too. Last week Nigel Lawson, one of Margaret Thatcher’s finance ministers, argued the case for Brexit. Boris Johnson, the mayor of London who is the Conservatives’ most popular politician, also shuffled a little further in a eurosceptic direction – although he stopped short of calling for an exit.

By Hugo Dixon

(Hugo Dixon is Editor-at-Large, Reuters News. The opinions expressed are his own.)

The UK Independence Party will not come close to winning Britain’s next general election. The populist anti-Europe, anti-immigration party may not even win a single seat, despite last week’s surge in English local elections where it won nearly a quarter of the vote – running a close third to Labour and the Conservatives. That’s how the maths of Britain’s first-past-the-post voting system works.

Nevertheless, the rise of UKIP could have profound consequences for British politics and business – in particular, for the UK’s relationship with the European Union. This is because UKIP is mainly taking votes away from David Cameron’s Conservatives. A calculation by Sky News suggested that, if the local election results were translated into a general election, Labour would win an overall majority. Even though UKIP might win no seats itself, its popularity would damage Cameron’s prospects for reelection in 2015.

The austerity debate misses half the point. It is true that governments, especially in the euro zone, shouldn’t chase an austerity spiral ever downwards. But they can’t just sit on their hands. They must drive even harder for structural reforms.

The last few weeks have witnessed a sea-change in the debate over fiscal austerity. A seminal academic paper by Carmen Reinhart and Kenneth Rogoff, which purported to show that economic growth was impaired if government debt levels exceeded 90 percent of GDP, has been discredited.

Meanwhile, the European Commission has softened its line on the merits of further deep budget cuts in peripheral economies. Spain, for example, looks like it will get until 2016 to bring its deficit down below the European Union’s magic number of 3 percent of GDP. Portugal, Greece, Italy and France are also being shown greater leniency by Brussels. One of the first things Enrico Letta, Italy’s new prime minister, said last week was that country needed to focus on growth not austerity.

Greece is not yet out of the woods. But there is a credible path that could lead the country back into the sunlight. That’s the main conclusion of a week I have just spent in the country.

Although the economy will have a terrible 2013, next year should be better. But the outlook is fragile: political crisis could yet rear its ugly head, tax evasion is rife and there’s the risk of external shocks.

Look first at the good news. Antonis Samaras’ coalition government has held together surprisingly well since it came to power last June following a period of political chaos, despite pushing through extremely unpopular measures. Samaras’ centre-right New Democracy party is neck and neck in the opinion polls with the radical left Syriza, the main opposition party. Samaras hasn’t suffered the plunging support of Spain’s Mariano Rajoy or France’s Francois Hollande.

Italy could do with some market pressure. Rome’s bond yields are now lower than they were before February’s inconclusive election. But as the politicians scheme, the economy burns. With markets calm, there is insufficient urgency to crack on with long-needed economic and political reform.

The fall in 10-year bond yields, which were 4.3 percent on Friday compared to 4.4 percent just before the election, is attributable to two factors. First, nobody wants to bet against the European Central Bank which has promised to do whatever it takes to preserve the euro. Second, the Japanese central bank’s pledge to buy gigantic quantities of bonds at home has buoyed asset prices elsewhere, including in Italy.

The backdrop to the current political crisis is starkly different to that in November 2011, when a sharp increase in bond yields created a panic which led to Silvio Berlusconi being forced out of office. Now none of the three main political blocs – Berlusconi’s centre-right group, the centre-left Democrats and Beppe Grillo’s 5-Star Movement – can govern on its own. But seven weeks have been wasted without a coalition being formed.

Cyprus is no longer centre stage. Nicosia has agreed a 10 billion euro bailout deal with its euro zone partners and the International Monetary Fund. A visible bank run has been averted by stringent capital controls. International markets, which only ever suffered a mild bout of jitters, have calmed down.

But it would be foolish to forget about Cyprus. The small Mediterranean island is edging towards euro exit. Quitting the single currency would devastate wealth, fuel inflation, lead to default and leave Cyprus friendless in a troubled neighbourhood. Even so, the longer capital controls continue, the louder the voices calling for bringing back the Cyprus pound will grow.

President Nicos Anastasiades is against Cyprus leaving the euro. But the main opposition communist party wants to pull out. A smaller opposition group wants to stay in the euro but kick out the troika – the European Commission, the European Central Bank and the IMF. The country’s influential archbishop is also critical of the troika.

The “resolution” of Cyprus’ banks is a bad joke. Resolution is one of the new buzzwords in financial regulation. The practice is supposed to stop taxpayers having to bail out banks, while imposing pain fairly on shareholders and creditors.

In Cyprus, Greek deposits and favoured groups at home are exempt from haircuts, while other groups of depositor are hammered even harder. It’s anything but fair.

The resolution of Cyprus’ banks doesn’t matter just for those directly affected. It is one of the most ambitious cases of cross-border resolution since the financial crisis began. So a bad result here is hardly a good advertisement for the technique.

The Cypriot catastrophe shows just how far away the euro zone is from creating its much-touted “banking union”. There was no euro zone supervision of Cyprus’ big banks, no transnational approach to put them into controlled bankruptcy, no common deposit insurance and no flow of bank rescue funds from abroad.

Instead, there was weak supervision by the Central Bank of Cyprus and a mad scramble to carve up the banks’ assets on national lines. Nicosia was left to shoulder the whole cost of protecting small depositors and the euro zone said that none of its bailout cash could be injected into the troubled banks.

Optimists hope the fiasco will provide the euro zone with the impetus to complete its banking union. But it is equally possible that core countries such as Germany, Finland and the Netherlands will become even more reluctant to absorb the liabilities of bust peripheral banks.

Cyprus’ capital controls are an “omnishambles”. If the Argentine-style “corralito” really can be lifted in seven days, the damage could be contained. But that doesn’t seem credible. Extended controls could spawn bribery, sap confidence, further crush the economy, spread contagion and ultimately lead to the country’s exit from the euro.

The lesson of capital controls elsewhere is that, once they are imposed, they are hard to remove. Iceland’s curbs are still in place five years after they started. In Argentina, they lasted a year.

There’s little reason to suppose it will be much different in Nicosia. After all, the restrictions – which limit both the amount of money people can take from their banks and the amount they can transfer abroad – have been imposed because the lenders do not have enough access to ready funds. If there’s not sufficient liquidity today, why should anybody believe there will be enough in a week, a month or even a year?