Europe Teeters on the Brink

David Long
September 28, 2018

Teresa May set off for Salzburg in a confident mood last week. Despite blistering criticism at home from all sides, May had engineered a binary option: her beleaguered Chequers plan or no-deal. Time, or the lack thereof, was her primary weapon and the threat of no-deal her shield. The combination had successfully kept both Remainers and Brexiteers at bay back home. Now she would use the same tactic with Europe. This was to be her moment of victory.

The EU may have been deeply uncomfortable with the plan and it no doubt required significant revision in places but having rejected all other approaches to Brexit through the weaponisation of the Irish boarder, the EU had boxed May into a corner of their own making. Now faced with the reality of no-deal, the change of mood and tone across Europe ahead of the Summit seemed palpable.

Trusting the advice of her Brexit Permanent Secretary, Ollie Robins that Chequers was a ‘game-changer’ in Brussels, the Prime Minister took to her feet to address the EU27 at the pre-Summit dinner.  ‘Delaying or extending these negotiations is not an option’ she stressed before warning the EU to stop forcing through an ‘impossible’ solution to the Irish border, and threatening that they must reach agreement by November or the UK will walk away without a deal.

Twelve hours later the response of the EU was brutal and humiliating. To sharp intakes of breath Donald Tusk announced that Chequers ‘will not work’. Angela Merkel said ‘substantial progress’ was needed and, in scenes reminiscent of General de Gaulle’s veto of the UK’s entry to the EU in 1967, Emanuel Macron stuck the knife in. He declared that the UK’s proposals were ‘not acceptable’ before mocking the choice of the British people and cursing those that had pushed for it as ‘liars’.

Tereasa May was left visibly furious. Where next for the embattled Prime Minister just days ahead of the Tory Party Conference? Ironically, this was a rare moment of clarity in an otherwise bewildering process. There can be no fudge, it is either in or out. While I doubt the cries for a re-run of the referendum will prevail, I rather suspect the UK would vote a second time to leave in greater numbers. Where there was doubt before, it must now be clear to all but the most strident Remainers that the EU is not a club working in the common interest of its members; it is a gang prepared to go to any lengths to get what it wants and prevent others from leaving.

A no-deal exit or perhaps a blind-deal exit now seem likely outcomes. Undoubtedly this will present plenty of short term pain as the UK economy adjusts, and it may be that the EU exacerbate this by making it as painful as possible, although the extreme exclamations of Project Fear are little short of laughable.

But it is not the UK economy that worries me. It is in pretty rude health, is highly dynamic and has the necessary policy and currency levers available to see a fairly rapid adjustment and subsequent recovery from a no-deal Brexit.

It is the EU that concerns me.

Despite or perhaps because of all the rhetoric and vitriol, I fear that the EU has grossly miscalculated the vulnerability of its position. The continent’s economy remains on life support, with negative interest rates and quantitative easing still pumping €30bn a month into the banking system. The ECB’s balance sheet has more than doubled to €4.5trn since 2015.

Despite this, it has taken the best part of a decade to recover the lost ground following the financial crisis with 0.8% annualised real growth rate over the past 10 years. Most of this has come in the last three years as the economy has started to gain traction, but unemployment remains in excess of 8%, twice that of the UK or US and youth unemployment in some southern states is close to 40%.

The European banking system remains in a fragile state and has been the least willing or able to recognise bad loans for fear of knock-on consequences, while debt levels remain uncomfortably high. On top of this, Europe has yet to grapple with the migrant crisis that has stressed European infrastructure and institutions to breaking point, or come up with any meaningful response to the rise in popularist politics and anti-EU sentiment across the continent. To cap it all, Donald Trump has taken aim at Europe’s protectionist trade policies and threatens an all-out trade war.

Europe teeters on the brink as we approach the top of the longest period of uninterrupted post-war global growth. Any significant downturn could tip the EU over the edge. With interest rates already negative there is little ammunition left in the monetary policy toolbox and the Euro straight jacket prevents economies from adjusting through foreign exchange movements.

Despite this, its leaders are determined to pursue the hardest of Brexits on the basis that it proves a point and dissuades others from leaving. Rather than fix the problems by reforming EU institutions and freeing up the European economy, in classic European style, the EU has chosen to play a game of chicken, seemingly in the hope that the UK can be persuaded to overturn the referendum and return to the EU fold.

It is an absurdly dangerous strategy that raises the very real prospect of a full-blown European crisis over the next few years that would send shock waves reverberating around the global financial system. Indeed this is a far greater threat to the UK’s long term prospects than the immediate implications of a no-deal Brexit. Pragmatic leadership is now desperately required in Europe, or showboating politicians will be guilty of fiddling while Rome burns.

Disclaimer: The views thoughts and opinions expressed within this article are those of the author, and not those of any company within the Capital International Group (CIG) and as such are neither given nor endorsed by CIG. Information in this article does not constitute investment advice or an offer or an invitation by or on behalf of any company within the Capital International Group of companies to buy or sell any product or security.

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