There has been an enormous amount of ink and intellectual capital deployed in recent weeks in the wake of the United Kingdom’s (UK) historic referendum decision to leave the European Union (EU). In thinking about what might come next, it is helpful to take a look at the EU’s current state of affairs and consider what it might tell us about the future of Europe and the global investment landscape. The EU is a political and economic union consisting of 28 mostly geographically connected nations, with the notable exceptions of Norway and Switzerland. It is widely believed to have been conceived to promote free trade, the free movement of people, and economic interdependence between Europe’s disparate countries for the noble purpose of preventing a return to the nationalist forces that led to two devastating wars in the 20th century. The EU is also credited with promoting liberal economic reforms in its newer member states, including those formerly behind the Iron Curtain such as Poland and the Czech Republic. Many of the EU’s members—19 of them, sometimes referred to as the eurozone—now share a common currency, which further promotes economic and financial interdependence.
To truly grasp the events unfolding on the continent at present, one must also understand that the current structure of the EU has many flaws and counterproductive elements. Importantly, besides being a trade union, the EU is also a regulatory union. While there are some arguments to be made that common regulations reduce friction within a federal structure, this tends to be a double-edged sword. To the extent that one believes competition between countries can lead to optimal policy outcomes through experimentation, it is not difficult to understand why layering mounds of red tape onto all countries counterproductively levels the playing field, reducing the benefits to the country that chooses the best policies. This is why a soccer team playing a far superior opponent will hope for terrible weather, as it will reduce the advantage afforded to the superior team by its preparation and conditioning efforts. Similarly, a labyrinth of red tape can reduce the advantages of a country that has undertaken reform and conducted sensible, business-friendly economic policy. As far as developed economies go, the EU countries certainly have their share of self-inflicted red tape, as measured by various categories in the “Ease of Doing Business” rankings from the World Bank. While these are of course not all caused by EU-specific regulations, the extra layers do not help when there is already a plethora of barriers to entrepreneurship.
As investors, rather than have the bad weather known as excessive regulation bring the “good teams” down, we would like to have the laggards observe the results of business-friendly reform and become motivated to follow suit. A recent example of positive results from policy reform is the outperformance of the German labor markets since reforms implemented in the mid-2000s. These measures rendered the labor market more flexible by essentially allowing companies to price labor appropriately, while also reducing social safety nets and encouraging people to work. These developments, combined with the relatively productive and cooperative nature of relations between companies and workers’ unions, have made it possible for Germany to show a remarkable degree of wage restraint over time. Germany’s relative labor price competitiveness has made it more economical for companies to produce in the country. Moreover, having clusters of smart engineers working in one country across the supply chain has no doubt been a factor in incubating the dynamic economy that Germany has today. The performance of the German labor market—as well as the more flexible UK labor market—clearly reflects the power of business-friendly reform when compared to other less-reformed and less-flexible European countries.
Rules and red tape dictated from a supranational, unelected bureaucracy can lead to resentment, feelings of a loss of sovereignty and self-determination, and what is probably the EU’s most irreconcilable flaw: its lack of democratic legitimacy. If one can envision how this dynamic could cause resentment, then it is easy to see how years of austerity, perceived by the EU member electorates to have been imposed from Brussels, could stir even more passion. After all, citizens are unlikely to acutely feel or even notice the effect of burdensome regulation in their daily lives, but they can certainly feel the pain from their higher tax bills or reduced benefits. Often national politicians add fuel to the fire by refusing to make the case for budget responsibility, instead attempting to shift the blame to foreign creditors, including EU institutions. The context of all of this is equally important; when economic growth was robust, many of these flaws went unnoticed, but in a slow-growth environment they can be laid bare and quickly metastasize. Therefore, the economic environment post-financial crisis has proved to be fertile ground for the formation of new scapegoats and a renewed focus on old grievances. Perhaps nowhere is this more evident than in the rise of anti-immigration sentiment across the continent.
All of these ingredients have created the toxic cocktail of centrifugal forces pulling the EU apart. We believe these forces have been intensifying for a few years now. Nevertheless, the UK’s decision to opt for a different path was a surprise to us and markets. While there are numerous ways that “Brexit” could play out from here, and there is still no guarantee that the advisory (non-binding) referendum will even be fully implemented, we can say that it has unleashed considerable uncertainly into an already precarious economic backdrop. We expect that eventually this uncertainty will be somewhat self-fulfilling as businesses and consumers delay major spending decisions. For now, we believe it is important not to get caught up in all of the noise and focus on the few developments that matter most. These include the UK’s domestic political landscape (where we have received some additional clarity with the Conservative Party backing Theresa May for Prime Minister), the response from Europe, political polls in other countries (for signs that anti-EU sentiment is spreading), and of course the economic consequences of Brexit.
In regard to the response from Europe, it is perhaps the most complicated and most unclear aspect of the situation, since it represents the confluence of today’s headlines and the long-term structural flaws inherent in the EU. This is where things go beyond Brexit. We say this because Europe is stuck between choosing an economically prudent path that would minimize costs to both the UK and EU and punishing the UK to prevent moral hazard. Economically, while arguments can be constructed to show that one side “needs” the other more, the reality is that the UK and EU economies have become intertwined, and both would be damaged by the emergence of a more restrictive trade regime. To illustrate the interdependence, it is useful to take a high-level view of what has been going on since 2011-2012, the acute period of the European sovereign debt crisis.
Since the crisis, the German trade surplus with its eurozone peers has shrunk. This has corrected some of the imbalances in the system and acted as a tailwind to peripheral growth; Germany’s increasing its trade surplus outside of the eurozone has provided an engine for eurozone growth while simultaneously correcting intra-eurozone imbalances. One thing that made this possible was Germany’s running a larger trade surplus with the UK (who is not a member of the eurozone). Therefore, as a large net importer, the UK has acted as a tailwind for eurozone growth and enhanced the efficacy of the currency union. Being hard on the UK out of principle would be cutting off the EU’s nose to spite its face.
Of course, the response from Europe will not be based purely on economic factors. Despite the well-developed ability of European politicians to kick the can down the road, there will be longer-term factors at play. We are already witnessing friction within the EU created by past instances of kicking the can down the road. While European Central Bank (ECB) President Mario Draghi’s pledge to do “whatever it takes” to save the euro—along with unprecedented ECB asset purchases—has undoubtedly bought some time for the eurozone, it has also reduced the urgency for countries to take action to correct their budget imbalances. In fact, the latter is probably an understatement. Since there has been essentially no market-based discipline on these countries, many of them have consistently, and predictably, missed budget targets. Spain has missed its target every year since 2011 despite the benefits of lower financing costs. Recently there had been chatter about the EU implementing sanctions on Spain and Portugal, but that did not happen. Even if it had, symbolic slaps on the wrists are not going to reverse the current moral hazard and lack of enforcement mechanisms.
Perhaps a more important explanation for the perceived diminishing returns on kicking the can down the road is the fact that yet another potential flashpoint is already visible on the horizon. While not directly related to Brexit, there has been increased focus on the ongoing rot in the Italian banking system, along with the potential political ramifications associated with Italy’s upcoming referendum. The referendum will ask voters to weigh in on a change to Italy’s constitution that would reduce the power of the Senate, a change that most commentators agree would lead to more effective governance, and upon which Prime Minister Matteo Renzi has staked his political future. The problem is that Italy’s banks are saddled with bad debt and require a large amount of new capital, but new EU rules require a “bail-in” of junior bondholders before taxpayer money can be used to rescue a nation’s banks. It seems reasonable that with the ECB buying Italian debt, they wouldn’t want to see a massive increase in Italy’s debt load. However, a large segment of the bondholders who would be affected are Italian citizens who bought the bonds on the assumption that they were essentially as good as deposits, rendering “bail-ins” seemingly even more unpopular in Italy than “bail-outs.” Renzi is stuck between a rock and a hard place—a bail-in might damage his popularity, the chances of a referendum win, and his political future. Likewise, using taxpayer money would put Italy in direct conflict with EU rules. Doing nothing does not appear to be an option.
Meanwhile, the EU is in the all-too-familiar predicament of having to walk a middle ground between enforcing the rules on one hand and riling a member country electorate on the other, this time with the decidedly less EU-friendly Five-Star Movement waiting in the wings if an Italian election needed to be called. This negotiation process has become just as important to watch as that concerning Brexit. While we hesitate to jump to the conclusion of some market commentators that the Italian referendum will be a de facto decision on Italy’s future in the EU and eurozone, the stakes are nevertheless high. Recent history suggests that the Italian government will come to some sort of compromise with the EU in order to prevent a euroskeptic party from seizing power in a major EU country. However, such an outcome would be yet another kicking of the can since, at the end of the day, a system that is predicated on preventing the most popular party in any country from winning an election is unsustainable within the constructs of democratic legitimacy.
While the consequences of the UK leaving the EU and Italy leaving the eurozone represent an apples-to-oranges comparison in terms of financial market implications, these two developments lay bare the fundamental flaws of the EU and eurozone. They highlight the contradictions inherent in a system that was conceived, even if out of the noblest of intentions, as a top-down solution to bind together a heterogeneous group of countries. For a democracy to function, there needs to be a willingness to live together and some sense of togetherness shared by citizens. Despite the current state of political rhetoric, the United States works precisely for these reasons. For those who doubt this fundamental difference, one can easily imagine the stark difference in reactions from locals one might receive for desecrating a U.S. flag in the southern United States versus doing the same to an EU flag in southern Europe.
More than anything, recent developments highlight the need for reform of the EU system of governance. Italy will certainly not be the last referendum or populist revolt with EU-wide implications. Both France and Germany will hold elections next year, with populist parties in each showing varying degrees of popularity. Europe will need to redesign on the fly a system that can be flexible enough to bend so as to prevent an ultimate breaking. There is certainly a lot to fight for. Despite its flaws, Europe is a bastion of democracy and prosperity that is surrounded by countries with a glaring lack of such characteristics. Its member-states are living proof to its neighbors that respect for freedom, human rights, and capitalism can lead to economic prosperity and a higher quality of life. The EU has undoubtedly played an important role in the spread of these ideals. Just ask the former communist countries. Europe is home to some of the best universities and most innovative and well-run companies in the world. All of this is worth preserving no matter what form the eventual solution takes. If the members of the EU can heed the call of the current centrifugal forces pulling them apart and return to the cooperative competition that led to their thriving for the past 500 years, then the world will be much better for it.