Federalism is the greatest threat to the future of Europe

by Anders Borg, Chair, World Economic Forum’s Global Financial System Initiative, 6 July 2016

The world after the Brexit referendum is fundamentally different. It will take decades before we will see the full consequences for Great Britain and the European Union. The process of negotiating a way forward for the co-existence of the United Kingdom and the European Union will take time and it will be a complicated process.

My starting point is that it is in the interest of the European Union to build a strong link to the United Kingdom. During the eight years I served on the EU’s Economic and Financial Affairs Council (ECOFIN), I noticed that power games are often allowed to dominate our common European interests. We cannot allow that to happen this time.

It is clear that growth in the European Union will be higher the more open the trade relationship with Great Britain is. A free trade agreement with the UK can minimise the damage of Brexit for both parties. It is particularly important that this includes financial services.

Weathering the storm? London must remain a financial centre Image: REUTERS/Toby Melville
London is the only global financial centre in Europe. Growth in Europe will be weaker if London cannot fulfill its role as the financial centre for Europe. For at least the next 10 to 20 years, neither Frankfurt nor Paris will be able to compete with New York or Honk Kong as financial centres. The banking sector in the Eurozone will grow in importance after Brexit, but it is still necessary for Volvo, Siemens or Total to have access to London to be able to compete with Toyota, GE or Exxon.

Damage control

Also on the political side, it is important to take an attitude of damage control. A close political cooperation is in the interest of both the EU and the UK. The more divided we are in Europe, the weaker our global influence will be. Europe is currently contending with the most difficult security environment since the end of the Cold War. Putin’s increasing pressure on Russia’s neighbours, the rise of IS and other islamistic terror groups, the refugees coming over the Mediterranean from North Africa will all have to be dealt with after Brexit referendum, and the United Kingdom will be EU’s most important partner in our neighbourhood.

A constructive dialogue is also important for cooperation at NATO to function. The EU needs the political clout of the UK as much as the UK needs Europe. It is better to recognise this and try to find the closest possible partnership.

The negotiation strategy needs to be hammered out in the ECOFIN council and the European Council. The overall goal should be to find a solution that minimises the potential damage to growth in Europe.

I do not want to downplay the consequences of the disastrous Brexit vote. It has caused permanent damage, and we cannot go back to the world before Brexit. However, to try to ignore the fact that Great Britain is about to initiate a process to leave the European Union can only be dangerous.

The biggest damage from Brexit is to our common political mindset. It has transformed our understanding of the political narrative, and that will have big negative economic consequences in the long run. The changes are broader and more profound than just Brexit, which is only the latest symptom of a new and dangerous political syndrome.

From the Berlin Wall to Brexit

If we go back a decade or two, the common understanding was that politics was gradually recovering its health after the fall of the Berlin Wall. The political system would over time become more pragmatic and centric. Strong centre-right and centre-left parties would take turns at the helm of government to gradually trim the engine of the market-oriented welfare state. Politics would almost evolve into a form of social engineering to perfect a model inside a universally accepted combination of markets, democracy and welfare.

As the middle class expanded in China, India and other emerging markets, this narrative would slowly become a hegemonic global norm. As citizens became better educated and had better access to information, class-based voting would diminish in importance. Information and rational discussion would produce a more mature democratic conversation based on a common social liberal value structure. The key voters to win over in the political competition were the young and urban digital natives.

Today the world looks dramatically different. Migration was a key factor in the referendum in the United Kingdom. Traditional technocratic arguments about growth and the importance of global cooperation were overpowered by a wave of anti-establishment sentiments. Regaining control over borders, re-establishing a sense of sovereignty and reducing the contributions to the European Union were held to be more important the risk of lower economic growth.

This is a shift in the value framework that is much broader than the United Kingdom. All over Europe, we see rising support for Right and Left-wing political parties. In the United States, voters are angrier than they have been for decades. The political debate seems to be focusing on winning over the voters who are most dissatisfied.

A European Union flag is held in front of the Big Ben clock tower in Parliament Square during a ‘March for Europe’ demonstration against Britain’s decision to leave the European Union, central London, Britain July 2, 2016. Britain voted to leave the European Union in the EU Brexit referendum. “This is a shift that is much broader than the United Kingdom.” Image: REUTERS/Paul Hackett
“History tells us to avoid such a scenario at any cost”

This is a shift that will not go away. The fundamental driving forces are growing economic insecurity, a slow growth of real wages and a stagnating living standard reinforced by raising inequality. As long as we do not find a way of fixing our broken economic model we will not be able to fix our political model. Therefore the political risk in our economies has increased. Elections are more unpredictable and traditional tools such as opinion polls and odds from the betting firms have failed to give guidance.

Thus, taking a confrontational stance and talking about teaching the UK a lesson in would only make matters worse. In the current political milieu it could be potentially devastating to choose the path of conflict. It is in the common interest of both the European Union and the Great Britain to build as strong relationship.

With more nationalistic sentiment coupled with less support for international co-operation, it is easy to see how a conflict could escalate. History tells us to avoid such a scenario at any cost. The same factors that produced Brexit would make it more complicated to de-escalate a conflict. Therefore it is wise to invest great effort to try to build a new cooperative culture between the UK and EU.

The answer is not ever-closer union

How should the EU respond to the new political environment after the Brexit-referendum? Some argue that the answer is always more Brussels. I consider Jean-Claude Juncker, the President of the European Commission, a good personal friend, but Europe should not listen to his and other federalists’ call for an ever-closer union. I would argue that this is dangerous road that would increase the risk of other countries being forced to leave the EU. Both for economic and political reasons it would be a mistake to initiate a process of deeper cooperation with increased authority and budget resources for Brussels institutions.

The economic argument for closer cooperation tends to be that a common fiscal policy – which would harmonise tax decisions – is necessary for countries which use the Euro. I would disagree for two reasons.

First of all, the fundamental economic problems in Europe are structural. Low productivity growth can only be met with a reform strategy that increases competitiveness and reduces barriers to competition.

What is necessary are reforms – lower marginal taxes, tighter eligibility criteria for access to benefits, tighter requirements for job searches, more resources for active measures to retrain people, and less restrictive employment protection regulation – to make the labour market more flexible. To counter the growing populism it is necessary increase living standards for ordinary people, and that requires higher productivity growth.

The second reason is that most of the benefits of a common fiscal policy can be achieved without centralised decision-making. With a stronger coordination and bigger fiscal buffers, fiscal policy can function more efficiently. If all countries increase the efficiency of their fiscal policy, stabilisation would improve. The IMF calculates that fiscal policy in the Nordic countries stabilises GDP three times more than German or French fiscal policy. There is no reason to think that it is impossible to reform the policy process in France and Germany.

It is difficult to understand why Europe should take the risk of fuelling political populism when there is a pragmatic solution available. Why risk new referendums when there is so much low-hanging fruit that is ripe for harvesting.

We disregard public opinion at our peril

A more fundamental argument is, however, political. There is no political support for increased taxation or spending cuts to build up common resources for fiscal policy. Efforts to disregard public opinion and push forward with fiscal integration would backfire and fuel populism.

In the new political narrative, such policy would increase the criticism of Brussels for wasting tax-payers’ money. Even in Germany and France, the support for cutting expenditure or increasing taxes to strengthen demand in weaker countries is very low.

There is no political mandate for an ever-closer European Union, and the risk is that if the Commission is pushing in this direction it will fuel disillusionment. It cannot even be ruled out that support for leaving the Euro and the EU would increase in the Netherlands, France and Germany. Federalism is the greatest threat to the future of the European Union. We need a stronger Europe that stands united, not new political super-structures.