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Brexit, EU Reform and the Crisis of Globalization

Martin Schulz
Senior Research Fellow

Thursday, July 14, 2016

On June 23, British voters decided to leave the EU (a.k.a., the “Brexit”), which immediately threw markets into chaos. Fearing major disruptions to trade, the British pound and the euro dropped while the yen appreciated as a global safe-haven currency. Japanese companies with businesses in Europe saw their stock prices drop by as much as 10% and rushed to their planning boards to review their EU strategies. Policymakers in the UK and EU are now facing years of frustrating negotiations and decision making, but they are also pressed to deliver convincing plans for reform and growth in their countries much sooner than anybody would have expected. Now that Britain’s exit has pushed the EU’s governance deficits into the open, a restarting of the integration process towards more future-oriented reform and growth strategies provides an important opportunity for recharging globalization policies in general.

Why did public sentiment turn against the EU so strongly?

As the turmoil among UK policymakers has clearly shown, Brexit did not evolve as a well-thought-out government strategy to leave the EU for better opportunities, but rather as a “Braccident,” due to policymakers badly misreading the depth of negative public sentiment towards the EU. In contrast to public opinion, the government and most corporations remained largely in favor of EU membership. EU membership, after all, not only guarantees unconditional access to the world’s largest market but also closely integrates the rather small British economy with its closest partners. The UK also had a strong say in the union’s future direction and was provided with a scapegoat for necessary but unpopular (i.e. competitiveness-related) reforms.

Overall, as one of the most dynamic and liberal member states in the EU, Britain seems to have gained strongly from investment and innovation related to FDI inflows (which increased from 16% GDP in 1995 to 56% today; UNCTAD Data). The UK economy has grown tremendously as a result of hosting the EU’s financial center in London, and the country has developed market-leading business services, which drive exports, investment and technology. Additional regulatory burdens from EU membership, on the other hand, seem to be limited, as the UK’s economy is ranked at the top of most indicators of liberal market regulation and ease of doing business. (The World Bank’s ease of doing business indicator ranks the UK above the US in 6th place, while Luxembourg, for example, ranks only 61st.)

After economic growth collapsed during the global financial crisis in 2008 and the EU struggled to rescue its banks by building a much more tightly regulated banking union around the European Central Bank, the EU project seemed to have become intertwined with the fate of the Euro and the Eurozone, which alienated British voters. Over the last two years, an immigration and refugee crisis at a time when public sentiment has been turning against immigration has only deepened the rift, as immigration lies at the heart of the EU Single Market project (where it is actually not seen as immigration, but as mobility of EU citizens). Ironically, it did not help that the UK was one of the most vocal supporters of immigration from Eastern Europe before the financial crisis, when foreign labor was seen as a necessary ingredient for strong growth.

Furthermore, the EU seems to be failing to deliver on promised non-economic benefits: United, the EU was supposed to be a stronger global player than each of its small and mid-size member-countries on their own. During the Middle East and Ukrainian crises, however, the union failed to have a sizable impact, and the Syrian refugee crisis demonstrated the limits of internal coordination and burden-sharing. Finally, confusion surrounding the EU’s responses to terrorism and security threats seems to have made the EU less safe than an independent and determined nation state might be. Together, these different threats helped to create the perfect storm for the future of EU integration.

How relevant is the Brexit crisis for Japan?

Despite initial uncertainty, fear and volatility, the negative impact on EU trade and increasing business costs for foreign investors should remain quite manageable. Beyond the noise and obvious frustration about what some see as a “betrayal” of the EU integration project, governments on both sides have strong incentives to move very gradually and avoid disruptions as much as possible. Think tank estimates of the negative economic impact on the UK economy are ranging from a rather low -1% GDP, due to increasing trading costs, to around -6% GDP by 2030 if dynamic factors, such as a slowdown in investment activity, are taken into consideration. Indeed, experience with (less complex but also less urgent) FTA negotiations tells us that negotiating new trading terms between the UK and the EU and its other main trading partners would last about a decade. During this period, Britain would probably have to settle for an intermediate regime as some kind of “associated” economy to the EU, based on the general European Economic Area (EEA, of which Norway is a member), which would give full market access but provide neither independence nor influence.

Japanese investors, however, who are among the top international investors in the EU and, in particular, in the UK, have to consider making additional adjustments to their EU-wide strategies. For most companies, London serves as the financial center and gateway to the larger EU market. Over the last two decades, English-speaking London has become the top location for headquarter functions, related services and R&D, which served as a basis for servicing the increasingly harmonized “EMEA” market (see Table 1). In contrast, Germany and many other locations on the continent saw most investment go into manufacturing, technology, and distribution services. For Japanese investors, therefore, Brexit not only affects the outlook of current businesses in the UK, but threatens long-term investment plans and strategies in Europe in general.

Table 1: Japanese M&A cases in UK and Germany (2011-2016)

U.K.
No.
Germany
No.
Commercial Services
13
Chemicals
11
Internet
10
Electronics
11
Food
9
Computers
9
Holding Companies
9
Machinery-Diversified
9
Computers
7
Auto Parts & Equip
8
Alt. Energy
7
Commercial Services
5
Advertising
6
Misc. Mfg.
4
Software
6
Pharmaceuticals
4
Entertainment
4
Biotechnology
3
Misc. Mfg.
4
Hand/Machine Tools
3
Total
139
Total
109

Source: Bloomberg as of May 2016

While Britain’s departure affects the overall organizational structures of Japanese companies in the EU, rushing to escape from the UK market into another EU country in order to mitigate the impact is not an immediate option, because the locational advantages of London cannot easily be replaced. Only in the long run—and depending on the political dynamics in the UK and the EU post-Brexit—would investors start to draft new business strategies for the overall EU market, which might include significant relocations. Perhaps even more than local companies, Japanese international investors will now have to engage much more actively in keeping the UK market as open and as connected as possible. Switzerland, for example, has already demonstrated that it is possible to become a model case of successful globalization and integration in the EU without being an active member. In many ways, the UK will have to follow this model, which includes remaining open for immigration and supportive of foreign investors.

Japanese companies and the government will also have to support the continuation of the EU integration process as much as possible, not only to keep one of their most important markets from disintegrating, but also to keep the mostly successful European globalization, cooperation and integration model alive. After all, Japan increasingly depends on successful globalization for its products and investment as well, and it needs the EU not only as a market, but as a successful model for Asian integration, too. Cooperating with the EU on future-oriented policies in research, innovation and education, student exchange, regional peace and ODA initiatives, as well as trade agreements and international standards development should therefore become even more important than before.

The Future of EU Integration Policy

In contrast to manageable trade relations, the biggest problems for the UK and the EU will emerge from shaping new market frameworks and growth policies that reestablish confidence in the long-term potential of an independent Britain and a weakened Eurozone. The post-Brexit government in the UK will have to stabilize the pound and increase the competitiveness of the UK economy with probably quite restrictive policies, while having to limit immigration and endlessly negotiating with all its main trade partners. This policy situation will look quite different from the rosy independence scenarios most Brexit proponents have been hoping for, and it will almost certainly limit market dynamism and growth prospects until a new set of “offshore center” policies for the London market and regional policies for the UK have been found.

Companies will almost certainly have to rethink their investment plans in the UK under these new conditions. While it is almost impossible to make reasonable forecasts in the current situation, it seems safe to expect England, with London at its center, to emerge from the crisis as a leaner economy that continues to compete well in increasingly global high-end services (finance, ICT and business services). Regionally, the situation in the UK will look much more difficult. Regional policy very much depended on successful EU integration, which brought more independence to the regions when the role of national governments declined. Scotland and Northern Ireland are now threatening to leave the UK entirely, which will require a restructuring of regional economies and relationships no matter what their future courses might look like.

On the EU side, after a long and quite successful phase of European integration, which has turned the market into one of the world’s most attractive investment targets, the EU now faces a threat from disintegration pressures, as many other countries in the EU have also grown averse to further integration. “Ever closer union” is not an “irreversible” policy proposal anymore, and policymakers will struggle to anchor policies in a new foundation. It is this threat to EU integration—and in many ways to globalization in general—which most concerns governments and companies around the world. Indeed, if the Eurozone and the euro currency are starting to disintegrate, the world economy might face a shock well beyond the “Lehman Shock” of 2008, which triggered the global financial crisis.

Governments in the EU, and particularly in the Eurozone, are therefore hard at work to deliver comprehensive reform and growth initiatives well beyond the crisis management which has haunted the EU ever since the global financial crisis undermined its banks and exposed severe structural imbalances in competitiveness and government finances. As a result, many pundits and policymakers see Europe at a crossroads between risky federalism, i.e. Brussels and ECB-dictated centralization, and a newly emerging nationalism, which might ultimately destroy the EU integration project. Such a binary view of EU risks, however, seems to be too deeply rooted in a purely national interpretation of policy options, which ignores the achievements of EU market and policy integration and the development of the EU’s institutions, as well as the actual direction EU governance has taken over the last decade.

EU federalism, in particular, has already been on the backburner for more than 15 years, ever since the introduction of the euro and the failed attempt to implement a European constitution turned governments against additional political integration. Eurozone policy essentially has focused on developing effective supranational institutions, such as the European Central Bank, the European Court, and the (mostly inter-governmental) European Stability Mechanism. Management of the global financial and euro crisis, on the other hand, has been concentrated in the increasingly busy inter-governmental EU Council, the forum of EU heads of state. Furthermore, the EU Commission, which is the single most important source of EU regulation, has lost some of its influence over the integration process since centralized regulatory changes became seen more as replacing existing national standards rather than providing significantly to common opportunities. At the same time, all of these institutions have become scapegoats for necessary but often painful structural reforms that national governments could not achieve on their own.

Rather than having to reinvent itself or face disintegration, the EU will have to build and reinforce these supra-national institutions at its core by better using them for intergovernmental policy targets which can no longer be managed by single governments, such as managing the refugee crisis, advancing border control, and stabilizing European banks. At the same time, the EU’s institutions will need the full support of national governments when unpopular structural reforms have to be implemented. While this would mostly be a change in policy style rather than content, the EU would also need a set of more forward-looking, positive integration targets which provide its institutions with a policy agenda beyond breaking up outmoded national standards and structures. Only by focusing on future-oriented gains and achievements from increased integration and ongoing globalization can public support be won after a long period of crises and structural reforms.

Lessons from the EU crisis for the future of globalization

The UK’s departure from the EU should not be viewed in isolation. In Southern Europe, structural reforms to increase competitiveness are resented because they increased unemployment and put intense pressures on employees. In Eastern Europe, countries are being overwhelmed by rapidly changing cultural norms and immigration, and in Northern Europe countries fear an attack on their living standards from poor immigrants, monetary transfers and a weakening of their currency. Even in the US, voters have been turning against immigration, free trade, and further global integration, as seen by the support for Donald Trump as the republican presidential candidate.

Much of this new resistance to globalization is certainly fueled by lower growth in fast ageing societies, which has caused ageing voters and entire communities to turn against the increasing competition from immigrants and against the winners of globalization in the “establishment.” Not surprisingly, most Brexit supporters are in their 60s or older, a generation which rushed to the ballot boxes in large numbers and easily outvoted the largely pro-EU younger generations. This creates a major problem for governments and corporations, who rely on globalization as an essential part of reform and growth policies. Globalization, after all, expands markets for existing products and technologies while bringing in new ideas and initiatives, which reduces the risk of status quo stagnation and provides opportunities for the younger generation. Stopping or even slowing globalization, therefore, is hardly an option in advanced, fast ageing economies if growth is to continue. European governments will have to get back on a sustainable globalization track as quickly as possible after analyzing what went wrong.

One issue facing globalization stands out. The progress and gains of globalization have come to be seen as an inevitable trend among politicians and corporate management (who also personally gained in terms of influence and incomes), while voters have grown increasingly skeptical. Even more importantly, policymakers and international corporations seem to have been unaware of how much entire regions and industries are feeling left behind as income disparities rise. As a result, during the Brexit debate, most of the arguments in favor of EU membership focused on historical achievements and potential losses if EU integration were to stop. Brexit proponents, on the other hand, focused on future opportunities at a time when older voters were no longer seeing economic gains and younger voters had not yet realized that fighting for future opportunities might be necessary.

In the UK, but also in the US and many other countries, a strong emphasis on globalization in the service industries resulted in enormous gains in high-income banking, finance and professional services, and relentless price pressures in low-value added services even before the arrival of more immigrants. In manufacturing and traditional industries, on the other hand, jobs have moved overseas, and increasing skill requirements have left an older generation behind. Other than Germany and, to a certain extent, Japan, it seems that surprisingly few countries have managed to deliver enough positive opportunity and income gains in the particularly challenged manufacturing industries to avoid significant voter backlash.

Figure 1: Labor compensation by sector

20160714

Note: 2000=100, based on compensation in euros. Exchange rate changes affect international comparison, but not valuations of sectoral performance.

Source: Data from EU Ameco Database (2016).

As the graph of relative income gains above shows (Fig. 1), the gap between services and manufacturing incomes has been widening in the US and the UK, with significant gains in the service sector driven by financial and business services in the UK. In the US, manufacturing has suffered from strong offshoring and competition. Japan, on the other hand, kept sectoral income disparities at bay, but it paid a price in terms of economic performance. Germany also avoided significant income disparities and even managed to keep overall wages growing by implementing the most comprehensive globalization strategies, which boosted its exports to unprecedented highs. In all of these countries, globalization has been a strong force for the development of technologies, markets and opportunities, but it has also created imbalances that require new approaches.

Future-oriented globalization policies

Post-Brexit, successful globalization policies will avoid being used predominantly for the forceful introduction of structural reforms and increasing competition, and instead deliver the benefits of globalization into the living standards of the old and the potential of the young. Not only for the EU but in other countries as well, a successful transition towards a new positive set of integration policies which support technological innovation in manufacturing, healthcare, infrastructure and government systems can create a new case for integration and globalization.

Encouraging youth mobility, educational initiatives, and digitization are already core-policies in the EU, but they need further support from national governments and support for local initiatives. Such policies existed for a long time, but they tended to remain as side-shows to structural reforms while the benefits have been internalized by national governments as national, non-integration-related achievements. Globalization, on the other hand, has become a scapegoat for breaking up the old instead of helping to shape the new in a positive way. To change this, however, government action will not be sufficient. Companies need to realize that they are playing an important role in spreading globalization gains, supporting innovation in their communities and drafting successful reform strategies together with the government and local stakeholders.

An excellent example of such “new” globalization-oriented reform initiatives, which promote long-term growth, is Germany’s “Industry 4.0”. The initiative started in the IT industry, spurred by concerns that Germany was falling further behind in the digital economy and the Internet of Things. Instead of simply asking the government for a “digital agenda,” however, the initiative was coordinated among various industries (machinery, cars, automation, etc.) and their associations, as well as think tanks. Based on the development of convincing (whole economy) scenarios, industry organizations made strategy recommendations which won the support of the government and became rolled into a national strategy.

On back of this initiative, long stagnant government policies, such as country-wide broadband internet rollout, vocational training reforms (“Education 4.0”), cooperation between universities and companies, and even labor market reform (“Work 4.0”), were triggered and implemented much faster and with less opposition than before. Such a positive and corporate-sponsored approach toward globalization initiatives will become much more important in the future.

list of 2016