Britain’s Rocky Relationship With the European Union

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July 2016 – Investment Committee Update

European Integration
In the wake of two world wars, the idea of a more integrated Europe quickly established itself as the best way to avoid future conflicts.  In a speech at the University of Zurich in September 1946, Sir Winston Churchill called for a “kind of United States of Europe” and for the creation of a political structure that would aim to promote democracy, rule of law, human rights, economic development, and integration of regulatory functions.

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The 17 countries that are members of both the Euro Zone (a subset of countries in the European Union) and Schengen Area have adopted the deepest level of integration possible within the existing network of European associations.  In addition to adopting the policies set forth by the European Union, these countries have adopted the euro as a common currency and have eliminated border controls.  As differentiated from the American model, this framework does not (yet) provide for a federal government with the ability to tax and borrow money (i.e. there is no common fiscal policy).

Of the 30 countries that are not in the overlapping Euro Zone – Schengen Area, there exists two groups: those that do not yet meet the qualifications for deeper integration; and those that have opted out of tighter integration due to the opposition of specific EU policies or, more generally, skepticism towards the idea of a European superstate that may someday adopt a common fiscal policy, military, etc. (similar to the federal government of the United States of America).

While the vision of Europe has been to progressively move in the direction of closer integration, the existence of less intrusive associations and unions provides countries with some degree of flexibility with respect to the policies they adopt and reject in matters of trade, immigration, border controls, currency, etc.

However, it should be noted that countries cannot “cherry pick” policies that are beneficial only to themselves. For example, if a country is unwilling to adopt a policy of open immigration, it will not gain unfettered access to the Single Market in commercial activities (Note: The Single Market eliminates internal borders, trade barriers, and regulatory obstacles in the free movement of goods and services among member countries).

The United Kingdom
Although it was the former British Prime Minister Sir Winston Churchill who conceptualized and promoted the establishment of a European community, ironically, the United Kingdom and Europe have endured a rather contentious relationship throughout the years.

As the first formations of a European community started to take shape in the aftermath of World War II, the United Kingdom initially declined membership.  The United Kingdom first opted out of the European Coal and Steel Community in 1951, and then in 1957, the country declined participation in the European Economic Community and European Atomic Energy Community.

In the years following the formation of the European Economic Community (later to become the European Union), the six founding members (France, West Germany, Italy, Belgium, the Netherlands, and Luxembourg) flourished while the United Kingdom suffered continuous economic decline.  It was only after a successful period for the Community that the United Kingdom eventually sought entry.

But, membership did not come easily or quickly for the United Kingdom as French President Charles de Gaulle twice vetoed their entry, first in 1963 and then again in 1967.  It wasn’t until 1973, four years after de Gaulle stepped down from office, that Britain was finally granted entry as a member of the European Economic Community.

The United Kingdom’s membership in the European Union (formerly the European Economic Community) was initially motivated by economic gain, and largely remains so today.  The United Kingdom does not strive for political integration and is reluctant to transfer away any sovereign powers, as evidenced by the country’s decision to opt out of the Euro Zone and Schengen Area.  This mentality stands in contrast to the continental mindset of putting forward policies and legislation that seek tighter political integration in addition to collectively beneficial economic arrangements.

On the morning of June 24, 2016 the world woke up to discover that the United Kingdom had voted (in a non-binding referendum) to leave the European Union, its Prime Minister David Cameron had resigned, and Scotland was considering a referendum of its own to leave the United Kingdom in order to retain its ties t0 the European Union.

The 52-48 vote in favor of leaving the Union sent shockwaves through global financial markets as investors attempted to reconcile what this will mean for the future of the United Kingdom, Europe, and more generally the world, which has progressively become more “globalized.”  After all, the consensus among economists is that free trade, movement of capital, and movement of people across borders is a benefit to everyone in the aggregate; and the consensus among international relations scholars is that globalization brings interdependence, which in turn brings cooperation and peace.  To many observers, the vote to leave the European Union is seen as a step in the wrong direction.

In the lead up to the referendum, advocates for both groups—“Vote Leave” and “Vote Remain”—warned of dire consequences should the opposition win.  Before commenting on the potential implications of the outcome, which remain highly uncertain and speculative, let us first summarize the arguments put forth by both sides:

“Vote Leave”
The “Vote Leave” campaign was largely based around a “let’s take our country back” mentality:

  • As a member of the European Union, the United Kingdom does not have the power to make free trade deals with other countries. “Vote Leave” proponents suggest the country is losing out on opportunities to trade with fast growing economies like India and China.
  • 19 of the 28 European Union members are also part of the common currency Euro Zone, which the United Kingdom does not want to be a part of. With Euro Zone members holding a permanent majority in the European Union voting system, the United Kingdom is at risk of being outvoted by those who generally favor a deeper level of integration than the United Kingdom desires (although the most sensitive issues require unanimous agreement).
  • The United Kingdom is a net contributor to the European Union budget, as are other large economies like Germany and France. The money is used across Europe to ensure a level playing field for the Union’s poorer countries by being invested, for example, in new roads and broadband.  Politicians supporting the “Vote Leave” campaign promised to replace the contributions being paid to the European Union with increased domestic spending.
  • Freedom of movement of labor is one of the key principles of the European Union. Just as an American residing in Oklahoma can relocate to Washington for a better job, membership in the European Union provides for the freedom of movement between member countries. The United Kingdom, however, has experienced an unexpectedly high level of migration from several former Soviet bloc states, which has resulted in a high inflow of relatively low-skilled labor.  The ease of movement and the inability to selectively restrict migration has been attacked by the British for a number of reasons:
    •  The mass inflow of low-skilled workers is said to put a strain on public services, such as health care and schools.
    • Many of the country’s blue-collar workers feel threatened by the new, cheaper, source of labor.
    • The European Court of Human Rights is said to make it harder to deport foreign-born criminals.
    • The pace of migration is likely to increase as more countries join the Union in the future, thereby compounding the aforementioned issues.
  • If the United Kingdom wants to retain unfettered access to the Single Market, it will likely have to keep in place the free movement of labor. But, open immigration is largely what tipped the scale in favor of Britons voting to leave, so this is unlikely.  The United Kingdom is far more likely to restrict the number of low skilled workers entering the country and shift towards attracting more highly skilled workers.  This will require the United Kingdom and the European Union to negotiate new terms of trade.
  •  There are advantages for both the United Kingdom and the European Union in continuing a close commercial relationship—the United Kingdom is the second largest economy in the region, and the European Union is the destination for close to half of British exports. As such, a mutually agreeable trade agreement is likely to be reached (though it won’t come easily).
  • Even in a worst case scenario, in which the United Kingdom faces tariffs under the World Trade Organization’s ‘most favored nation’ rules, the outcome is not disastrous. Exporters will face additional costs of clearing customs and complying with EU ‘rules of origin’, but these factors will be more of an inconvenience than a major barrier to trade.  After all, the United Kingdom successfully sends the other half of its exports to countries outside the European Union, incurring the costs of clearing customs to do so.
  • Even if the United Kingdom’s trade with Europe does suffer to some degree, it is possible that any losses could be offset over the long-term by the opportunities created by leaving the European Union and establishing stronger commercial ties with other countries, such as India and China.
  •  The British government will save about £10b per year on its contributions to the European Union’s budget. However, a rather small economic disruption as a result of leaving the Union could easily offset these savings.  Likewise, the government may decide to compensate sectors of the economy and specific regions that currently benefit from European handouts.  In other words, voters who thought the government would be able to increase domestic spending (as promised) by the amount currently directed to the European budget are likely to be disappointed.
  • In the short-term, the British economy is likely to suffer from political uncertainty. Foreign companies, in particular, may take a “wait and see” approach before investing capital to expand overseas operations.  Any cutbacks in foreign direct investment would likely hit the commercial property market in London (as there would be lower demand for office space).
  • A number of high profile US financial institutions—Goldman Sachs, Morgan Stanley, JP Morgan, and Bank of America—issued a joint statement promising to work with the United Kingdom to help London retain its position as the leading international financial center. Given the importance of the financial sector to London, this vote of confidence is reassuring.

Given that most commentary surrounding the so-called Brexit is decidedly negative, we wanted to offer more of a neutral position.  While uncertainty has the potential to slow economic growth in the near-term, there are plenty of factors that could play to the favor of the United Kingdom down the road.  And, while many fear that the Brexit could result in a rise of “populist” movements across Europe that call for a dissolution of the Union; losing a member could just as easily strengthen the Union’s resolve and commitment to further integration and reform.  The negotiations set to take place between British and European officials are inevitably going to hit road blocks at certain points over the next several years, but ultimately, we expect cooler heads to prevail.  With global equity markets staging an impressive comeback after the initial sell-off, it would appear most investors agree.

“Vote Remain”
The “Vote Remain” campaign, meanwhile, highlighted the importance of the “economic alliance” with the European Union (and suggested that leaving the Union would cause economic devastation):

  • The European Union is the United Kingdom’s biggest trading partner, with member countries buying 44% of British exports. The United Kingdom also benefits from the free trade agreements the European Union has established with more than 60 non-member countries.  Leaving the European Union would require the United Kingdom to establish its own trade agreements, and UK officials may not be able to negotiate as good of terms.
  • The European Union is a political and economic force in the world; a club of democracies that gives Britain enhanced status at the global negotiating table. Together, the European Union is almost as large as the United States, and accounts for about 22% of world gross domestic product (GDP).  Individually, the United Kingdom accounts for less than 4% of world GDP.  It stands to reason that the collective power of the European Union can strike more favorable terms than any country individually.
  • Membership in the Single Market provides access to 500 million customers and an economy more than five times larger than Britain’s alone. Access to the Single Market makes it easier and cheaper for companies to sell their products outside the United Kingdom, creating jobs as a result.
  • Leaving the European Union could result in Britain losing its “passporting rights,” which allows British-based companies to sell into the rest of the Union without local subsidiaries. Losing these rights would pose a threat to foreign direct investment if international companies relocate within Europe, which in turn could hurt the London commercial property market (due to reduced demand for office space).
  • The uncertainty caused by leaving the European Union would likely put downward pressure on the value of the pound, which may result in higher prices for household goods, and by extension, lower living standards.
  • Membership in the European Union continues to make it easier and cheaper to travel abroad. For example, not only have airfares dropped 40%, but mobile phone roaming charges are set to be abolished within the Union next year.

“Observations, Thoughts, and Opinions”
In the lead up to the referendum, both parties warned the British public of dire consequences should the opposition party win.  To many voters, the choice came down to fears of (a) losing control of sovereignty, or (b) economic devastation.  Of course, as is often the case in polarizing political debates, the likely outcome is somewhere in the middle.  While there remains too much uncertainty to determine whether the long-term impact will be positive or negative, we offer below a number of observations, thoughts, and opinions that should serve to balance out the more “emotionally charged” viewpoints covered in the media:

  • There are countries with thriving economies and high standards of living (e.g. Switzerland, Norway) that sit outside the innermost circles of European integration (by choice). There is no reason to believe the United Kingdom cannot similarly succeed.
  •  The United Kingdom has never shared the same political commitment to European integration as other member countries. While the European Sovereign Debt Crisis has only strengthened British skepticism towards further integration, Euro Zone members now see deepening fiscal coordination as a necessary mechanism in managing the single currency during periods of stress.  A day of reckoning has long seemed inevitable.
  • If the United Kingdom wants to retain unfettered access to the Single Market, it will likely have to keep in place the free movement of labor. But, open immigration is largely what tipped the scale in favor of Britons voting to leave, so this is unlikely.  The United Kingdom is far more likely to restrict the number of low skilled workers entering the country and shift towards attracting more highly skilled workers.  This will require the United Kingdom and the European Union to negotiate new terms of trade.
  • There are advantages for both the United Kingdom and the European Union in continuing a close commercial relationship—the United Kingdom is the second largest economy in the region, and the European Union is the destination for close to half of British exports. As such, a mutually agreeable trade agreement is likely to be reached (though it won’t come easily).
  • Even in a worst case scenario, in which the United Kingdom faces tariffs under the World Trade Organization’s ‘most favored nation’ rules, the outcome is not disastrous. Exporters will face additional costs of clearing customs and complying with EU ‘rules of origin’, but these factors will be more of an inconvenience than a major barrier to trade.  After all, the United Kingdom successfully sends the other half of its exports to countries outside the European Union, incurring the costs of clearing customs to do so.
  •  Even if the United Kingdom’s trade with Europe does suffer to some degree, it is possible that any losses could be offset over the long-term by the opportunities created by leaving the European Union and establishing stronger commercial ties with other countries, such as India and China.
  • The British government will save about £10b per year on its contributions to the European Union’s budget. However, a rather small economic disruption as a result of leaving the Union could easily offset these savings.  Likewise, the government may decide to compensate sectors of the economy and specific regions that currently benefit from European handouts.  In other words, voters who thought the government would be able to increase domestic spending (as promised) by the amount currently directed to the European budget are likely to be disappointed.
  • In the short-term, the British economy is likely to suffer from political uncertainty. Foreign companies, in particular, may take a “wait and see” approach before investing capital to expand overseas operations.  Any cutbacks in foreign direct investment would likely hit the commercial property market in London (as there would be lower demand for office space).
  • A number of high profile US financial institutions—Goldman Sachs, Morgan Stanley, JP Morgan, and Bank of America—issued a joint statement promising to work with the United Kingdom to help London retain its position as the leading international financial center. Given the importance of the financial sector to London, this vote of confidence is reassuring.

Given that most commentary surrounding the so-called Brexit is decidedly negative, we wanted to offer more of a neutral position.  While uncertainty has the potential to slow economic growth in the near-term, there are plenty of factors that could play to the favor of the United Kingdom down the road.  And, while many fear that the Brexit could result in a rise of “populist” movements across Europe that call for a dissolution of the Union; losing a member could just as easily strengthen the Union’s resolve and commitment to further integration and reform.  The negotiations set to take place between British and European officials are inevitably going to hit road blocks at certain points over the next several years, but ultimately, we expect cooler heads to prevail.  With global equity markets staging an impressive comeback after the initial sell-off, it would appear most investors agree.

 

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