Monday 20/05/2019

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Is Europe breaking bad?

Chief Economist

The Bremain scenario was our (very uncomfortable) base case scenario going into the referendum but now seems (because it's not 100% sure that an exit will happen) to be off the table. The effects of a Brexit both from an economic and asset allocation point of view are just impossible to ignore.




That said, while the outcome is highly unwelcome, this is not the end of the world. The global economic recovery is still weak and of course Brexit will make things harder but doom scenarios in terms of huge economic fallout seem exaggerated for now.  Moreover, European politics were already quite worrying even before this latest referendum.

The immediate sharply negative reaction was quite straightforward as financial markets had not anticipated this outcome. Looking forward, the effects of a Brexit look set to be very path dependent. This is where politics come into play.

Path dependency

In a short-term perspective, the impact on markets and the economy will primarily depend on how hostile or friendly the UK exit from the EU will be organized (in terms of trade negotiations and access to the common market). Political comments from both sides (UK and EU) will be indicative in this respect but there is a significant risk that the path forward is not immediately clear. Both  parties would benefit from constructive cooperation but a tough stance for negotiation purposes is definitely part of the game and should be expected.

In a medium to longer term perspective, the critical factor is whether Brexit will lead to further EU integration or disintegration. Actually, this question has been on the table for much longer. Brexit could play a catalyst role here. That said, the process looks set to take more time (matter of years perhaps). Could Brexit serve as an eye-opener in this respect to the extent that more decisive political action will be taken to strengthen Europe’s legitimacy? Perhaps, but this is far from guaranteed.

Underlying political and economic developments

Note that scepticism towards Europe is not a recent phenomenon. Research finds that only 51 % of EU citizens, across 10 EU countries surveyed, has a favourable view of the EU. Moreover, only 19% of this survey is in favour of transferring more power to the EU while 42% think some power should be returned to national governments. The EU’s handling of both the economy and the refugee crisis are two important sources responsible for this. Brexit or not, the underlying political developments we have seen throughout the years would always require more policy action sooner or later.

The European economy has been recovering over the past year against the back of important cyclical tailwinds (lower euro exchange rate, lower interest rates, lower commodity prices and less budgetary tightening). But until now, this has never been convincing and the labour market situation is still hugely disappointing. Brexit obviously doesn’t help and confidence indicators look set to be hit, potentially quite significantly. Monetary policymakers are expected to do their part of the job but it should be clear that they can only do so much in the current liquidity trap situation. What’s more, the instrument of more expansive fiscal policy never got the attention it deserved. Will this change now? Perhaps, but we shouldn’t bet on it.  

Meanwhile, structural headwinds are still strong. First, Europe still has to deal with a very difficult trilemma. How to position itself in this globalized world while at the same time reconciling the role of the nation state with democracy. Further lifting economic decision and spending power to a supra-national level makes sense in theory but political parties from left to right are hugely divided on this and EU citizens remain far from convinced that this a good idea. In general, younger adults across Europe seem to understand better that individual member states will prove unable to confront today’s challenging global political and economic backdrop. Second, on top of that, the monetary union is still far from completed so that existential challenges are still present (see here for example). Indeed, the Eurozone in its current form is unlikely to survive over time. True, we don’t need the Brexit vote to understand all this.

The immediate European political context, meanwhile, remains rather uncomfortable. Following Sunday’s elections in Spain, Italy will hold a referendum on constitutional reform in October. The Netherlands will see general elections in early 2017 immediately followed by Presidential elections in France in late April. Moreover, it’s not unthinkable that new referenda on EU membership will pop up across Europe even though the concept as such raises serious questions.

Concluding remarks

Brexit  as such is not the end of the world. It may be the end of the world as we know it. But also this statement may be exaggerated. The UK will remain a member of the EU for at least two more years from now. Underlying political developments had already become increasingly worrying since the Great Financial Crisis and the economic recovery remains fragile. The big worry now is that Brexit will play a negative catalyst role in all this. That may well turn out to be the case but it’s far too soon to know for sure. Also, even though the impact will be negative, warnings of huge economic costs are not particularly convincing. To be sure, both from an economic and political point of view, Europe and the Eurozone have never been out of the woods and an easy way out somewhere in the foreseeable future was never a plausible scenario in the first place. Europe is still breaking bad, and policy action is still needed to prevent it from breaking up over time.