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Brexit is a wake-up call to the EU, but so far it is not being answered. By Paul Sheard

Written by paul Sheard

The European Union is an inherently unnatural and unsustainable configuration of sovereignty-sharing, constructed in a way that defies economic and political logic, and hence is a lurking source of economic and financial (and therefore political) risk. The UK is not leaving a fixed political entity: it is leaving a political entity that is in flux. Instead of taking a political and flexible approach, the EU has taken an inflexible and technocratic one. This is often ascribed to fears that giving the UK a “good deal” would run the risk of other member states wanting to leave the EU too or negotiating some kind of bespoke arrangement. Such an attitude is a thin reed on which to build a Union, and likely will not work in the end.

The European Union is a fundamentally flawed political and economic entity, resting as it does on a selective and inconsistent sharing of sovereignty by 28 nation states. That is a harsh judgment, but it doesn’t make it any less true. The Brexit process needs to be understood and approached in that context. That it is not, on both sides, is a lost opportunity and is making the whole process all the more fraught.

In the Westphalian system of modern nation states, sovereignty, or political autonomy and legitimacy, resides and reaches its pinnacle in the nation state. Nation states issue passports to their citizens, and confer rights and responsibilities on them; nation states have borders and devote resources to controlling them; nation states conduct monetary and fiscal affairs; nation states enter into international treaties; national states have sovereign identity; and so on.

Sovereignty has several dimensions or manifestations, relating, for instance, to: political decision-making; constitutional rights and the legal system; the protection of external borders and maintenance of internal security; the maintenance and use of military power; the regulation of finance by the state (itself having three components: fiscal policy; monetary policy; financial system regulatory policy); and cultural affinity and identity.

Nation states take on different forms, such as federalist or unitary, and they can incorporate within them different configurations of political or “sovereign” units, such as countries (as in the case of the UK), states (as in the case of the US), provinces (as in the case of China), and municipalities (as in most nations). The various aspects of sovereignty are often manifest in different forms at the level of these sub-political units. However, all of the key aspects of national sovereignty tend naturally, as if by gravitational pull, to be aligned on the same political and territorial unit: the nation state.

Thus, the normal pattern is for a nation state to have its own national government and parliament, its own constitution and legal system, a geographical border and system of border controls, an internal police and security system, its own military, diplomatic corps and foreign intelligence agency, its own currency and monetary and fiscal system, including importantly the ability to tax its citizens and issue debt, and a set of national symbols and sense of shared identity and history.

The distinguishing feature of the EU is that the various aspects of sovereignty are shared or pooled at the supra-national level in a partial and inconsistent way (in EU-speak, this is called “variable geometry”). Certain dimensions of national sovereignty are pooled at the EU level; on those dimensions, it is as if the 28 member states (or in some cases a subset of them) are one nation state. But other dimensions of sovereignty are retained at the member state level; on these dimensions, it is as if the EU is just a loose affiliation of member states.

There are two aspects of this selective sharing of sovereignty that are particularly problematic, one relating to the monetary union, the other to the freedom of movement.

The EU is designed to be a monetary union but not a fiscal union. Other than for the UK and Denmark, EU members are supposed to adopt the euro and join the monetary union, and 19 of the 26 member states have done so. Constructing a monetary union that is not also a fiscal union defies economic and political logic, and is the source of the post-crisis poor macroeconomic performance of the euro area as a whole and is a lurking source of economic and financial (and therefore political) risk (the latest unemployment rate in the euro area is 1.1 percentage points above its pre-crisis trough, whereas the UK unemployment rate is 0.9 pp below its pre-crisis trough and the US rate is 0.4pp below; the latest level of real GDP in the US is 16.1% above its pre-crisis peak and that in the UK is 9.4% above, while that in the euro area is only 6.3% above).

The ability of a nation state to issue its own currency and operate its fiscal affairs (taxing, spending and issuing debt) in that currency is a core aspect of sovereignty. By design, the EU divorces one half of that sovereign right, usually called “monetary policy”, from the other half,  usually called “fiscal policy”, pooling sovereignty when it comes to the monetary half, but retaining sovereignty at the member state level when it comes to the fiscal half. This creates an inherently unnatural and therefore ultimately untenable and unsustainable configuration of sovereignty-sharing.

It also imposes considerable economic costs, for three reasons. Most importantly but least ecognized, being a monetary union but not a fiscal union creates a situation which is tantamount to members of the euro area issuing debt in a foreign currency, that is, a currency which they do not have the sovereign power to create (that power lies with the European Central Bank) (leaving aside Emergency Lending Assistance, over which the ECB also has the final say). To many, this might seem to be a desirable, Ulyssian-like design feature because taking the printing press away imposes the ultimate fiscal discipline on governments. But, it creates an inherently dangerous situation for sovereign borrowers: ask any emerging market government that is not able to issue debt in its own currency about that.

Secondly, the euro area not being a fiscal union severely hampers its ability to engage in meaningful counter-cyclical fiscal policy. By construction, there is no single fiscal authority to do this; in theory member states could coordinate fiscal policy expansions, but in practice, largely because of the next point, doing so sufficiently quickly and on a sustained enough basis is exceedingly difficult.

Thirdly, and adding insult to injury, the euro area, by design, imposes serious fiscal constraints on member states, hampering their ability to operate their own counter-cyclical fiscal policy. It is hard to conceive of a more badly designed system for speedily restoring lost aggregate demand, as became only too painfully evident in the wake of the financial crisis.

To see this point, consider a euro member that suffers from a sudden and large drop in aggregate demand (the condition faced by all euro area members in after the 2008 global financial crisis). The normal macroeconomic prescription in such a situation is to implement monetary and fiscal policy expansions sufficient to restore the lost aggregate demand, the monetary expansion in particular being likely to lead to a lower exchange rate. But a member of the euro area does not have its own monetary policy or exchange rate, and its ability to engage in a fiscal expansion is heavily constrained by rules and by the fact that any fiscal expansion has to be financed by issuing debt in what is in effect a “foreign” currency.

The welfare costs of this dysfunctional economic and monetary mousetrap are not to be dismissed lightly. Take, for instance, the case of Italy, the euro area’s third largest economy and the EU’s fourth. Real GDP in Italy is still 5.5% below its (first quarter 2008) pre-crisis peak level and its unemployment rate is 4.9 percentage points above its pre-crisis trough. The corresponding numbers for Greece are 24.8% below and 12.8pp above, respectively. These are truly shocking numbers.

Freedom of movement within the EU is similarly problematic, because it is not paired with the necessary degree of the pooling of national sovereignty when it comes to the definition and protection of the EU external border and when it comes to internal intelligence-gathering and maintaining internal security. For a set of nation states to agree to cede the right to control who comes into their country and who is able to live and work in that country to their supra-national level is to cede a core aspect of national sovereignty.

There is nothing wrong with that per se and it is a sovereign choice of the nation states to make, but it seems inconsistent with member states on the EU border maintaining control of their external borders and maintaining largely national internal security apparatuses, even arguably national defense systems. If people, not just EU citizens but in the case of the 22 EU members of the Schengen area anyone who has entered one of those countries, are free to traverse national borders at will, it would seem logical and fiscally equitable for the EU Leviathan to have responsibility for maintaining the external border.

Partial steps have been made, and are continuing to be made, in that direction with the recent upgrading of Frontex to the European Border and Coast Guard Agency. But, according to European Commission President Jean-Claude Juncker (2017 State of the Union speech), the Border and Coast Guard have only 1,700 officers compared with 100,000 national border guards. What sense does it make for EU member states to operate as (largely) one state when it comes to freedom of movement within the EU and as (largely) separate states when it comes to protecting the EU’s external border?

That, when it comes to the sharing of sovereignty, the EU is a work-in-progress, a metaphorical half-built house, is well recognized in Brussels and in other national capitals. The June 2012 “Four Presidents’ Report” and its successor June 2015 “Five Presidents’ Report”, both presented to and discussed at European Council meetings, among other vision-laden documents, have identified the challenges facing the EU, and the euro area in particular, and laid out a roadmap for addressing them over time. Considerable progress has already been made towards “completing the Economic and Monetary Union”, notably by establishing a European Stability Mechanism, by putting in place the building blocks of a banking union, and by the ECB crossing Rubicons to provide effective backstops (via its Outright Monetary Transactions and its Asset Purchase Program) for the monetary union. But the European Commission and the European Council are eyeing much more to be done.

Which brings me to Brexit. Three points bear highlighting. One, Brexit is all about the UK deciding to repatriate some, much or all of the sovereignty that it had previously shared with the other member states in the EU. That is, the decision by the UK to withdraw from the EU speaks to the fundamental nature of the EU: it is a political entity which rests on varying degrees of the pooling of the various aspects of sovereignty.

Second, despite Brexit being framed as a zero-one, in-or-out decision, there is a spectrum of possible arrangements, associated with varying degrees and forms of repatriation of sovereignty, that would satisfy the referendum result. The amount of sovereignty that the UK wishes to take back (as opposed to “may be able to take back”, given that it takes two to tango) is a decision for the British people to make, through their own democratic processes. “Hard” versus “Soft” Brexits, while convenient short-hands, do not capture the subtlety of this point. Given that it is the future of the UK as a sovereign entity that is at stake here, it is not surprising that Brexit is the subject of fierce public and political debate and contest in the UK. Viewed in this light, nor is it perhaps too surprising that, according to some commentary, the Brits have been too busy negotiating with themselves to be able to negotiate with Brussels.

Third, because the EU itself is struggling deeply with the question of its own future, with a view to “completing the EMU” and forging “ever closer union”, it would have made sense for the EU to have linked the issue of Brexit to that of its own future architecture. The UK is not, as an uninformed observer might infer, leaving a fixed political entity: it is leaving a political entity that is in flux. A critical aspect of crafting a mutually beneficial future relationship between the UK and the EU27 is to have a clear idea of what the EU27 itself will look like in the future. The two questions should have been, and still should be, dealt with in the same frame of reference.

That the EU did not take such an approach is even more curious when it is considered that, just four weeks before the UK triggered Article 50, the European Commission released a White Paper on the Future of Europe: Reflections and scenarios for the EU27 by 2025. This White Paper, which was grew out of the earlier Four and Five Presidents’ Reports, set out five scenarios for the future of Europe, although not necessarily couched in these terms, each implying different degrees and configurations of mutual sovereignty sharing: “Carrying on” (“The

EU focuses on its positive reform agenda”); “Nothing but the single market” (“The EU is gradually re-centred on the single market”); “Those who want more do more” (“The EU allows willing member states to do more together in specific areas”); “Doing less more efficiently” (“The EU focuses on delivering more and faster in selected policy areas while doing less elsewhere”); “Doing much more together” (“The EU decides to do much more together across all policy areas”).

The premise of the Commission’s White Paper, that the EU needs to decide on its future and that there are multiple visions on offer, was quite consistent with approaching the issue of Brexit through the same lens.

Instead of taking a political and flexible approach, the EU has taken an inflexible and technocratic one. Brexit and the future of the EU are issues crying out for political leadership and treatment, not handing off to technocrats and negotiators.

In this regard, the approach to the Brexit negotiations taken by the EU of refusing to discuss the nature of the future relationship before certain withdrawal issues were agreed upon, is particularly disappointing and puts the technocratic cart before the political horse. Article 50 states clearly that: “…the Union shall negotiate and conclude an agreement with [the Member State that is withdrawing], setting out the arrangements for its withdrawal, taking account of the framework for its future relationship with the Union.” [my emphasis] If anything, high level political discussions about the desirable and feasible nature of the future relationship, in the spirit of seeking solutions to the mutual challenges discussed above, should come first; the tackling of technical and operational details after.

The insistence by the EU that there be no “cherry picking” by the UK and that the so-called “four freedoms” (the free movement of goods, persons, services and capital) are indivisible lacks a defensible basis and is counter-productive. In a sense, the very basis of the EU is one of “cherry picking”, that is, the selective and partial pooling of sovereignty by member states. And the very fact that the EU has laid out visions and roadmaps for completing the European project, involving such aspects as completing the banking union, building a capital markets union, pursuing greater economic integration in the services area (such as a digital union and an energy union), and introducing a macroeconomic stabilization function and elements of fiscal union, and the fact that the EU is facing deep political challenges over uncontrolled migration, undercuts any notion that the four freedoms are complete or sacrosanct.

Because the starting point is the UK being in the EU (although not in the euro area or in Schengen), a more sensible (welfare-optimizing) negotiating stance of the EU would have been informed by the following question: what is the minimal amount of sovereignty we can allow the UK to take back, that will satisfy the UK’s wish to withdraw from the EU?

That the EU has not taken the above kind of approach is often ascribed to fears that giving the UK a “good deal” would run the risk of other member states wanting to leave the EU too or negotiating some kind of bespoke arrangement. But, to the extent that is the case, it is a thin reed on which to build a Union, and likely will not work in the end.

It is not too late for Brexit to be seized as an opportunity, on both sides of the English Channel, to reconfigure the sharing of national sovereignty in a more politically and economically sustainable way. That will require recognizing that the European project is about the transfer of sovereignty from the member state to the EU level and so, at heart, is a political project, and cannot proceed or succeed without obtaining and maintaining political legitimacy in the eyes of national electorates. It will also need political leaders to take on the mantle of statesman and stateswomen. Big ideas and big challenges call for big figures to step forth.

Paul Sheard is the former Vice-Chairman and Chief Economist of S&P Global, which includes the international ratings agency, Standard & Poor’s. 

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