12 Nov Brexit Jeopardizes Fragile Euro Integration
Investors all over the world should be very concerned, even a little worried, about Britain’s exit from the European Union. Real turbulence will come from the impact on the euro. A severe breakdown in capital mobility across euro members could initiate massive EU disintegration as the euro is its Achilles’ heel capable of unleashing the “mother of all financial crises.”
Historians find comfort in the fact that history tends to repeat itself. With that in mind, it helps to jump way back to A.D. 100, when ancient Rome prospered with living standards similar to that of civilized Europe in 1800. Free movement of capital and labor crumbled with the fall of the Roman empire, plunging Europe to crawling growth.
During the centuries that followed, Europe struggled to consistently reach growth of at least 1.5% a year. The First Industrial Revolution then catapulted Europe and the world to rapid progress. With many countries in the late 19th century exuding similar strengths, a power struggle ensued across Europe. In the mid-20th century after several wars and isolationist trade barriers, Europeans shifted their thinking toward peace.
Steps toward integration first began in 1950, when France and Germany decided to create harmony in bilateral trade for coal and steel. This trade agreement led to the European Coal and Steel Community, later renamed with additional members as the European Communities — now the first of three pillars under the EU umbrella. The European Communities pillar focuses on “four freedoms” forming the basis of economic integration. These freedoms among the EU call for the unhindered movement of persons, goods, capital and services and forming a single competitive market.
Integration has been a slow, layered process over decades. The supranational institutions formed through this integration include the European Monetary Union, comprised of 19 of the 28 EU member countries. This clique of countries united under the euro currency formed to separate governments from central banking. After the euro launched in 1999, elimination of exchange rate risk attracted massive foreign capital, equalizing interest rates across euro countries. Lower interest rates fueled real estate booms.
A critical tradeoff to a currency union is the inability to devalue exchange rates when capital flees as the economy contracts. Falling exchange rates help make tradable goods more competitive in international markets. By increasing export demand, profits permeate to other domestic industries, lifting employment and returning growth. Under a common currency or fixed exchange rate, establishing growth after an economic shock hinges on timely adjustments to domestic prices and wages.
The 2008 global financial crisis popped the European real estate bubble and exposed fiscal mismanagement and corrupt lending practices. During the boom years, unions ratcheted up wages. When the crisis hit, wages were pegged, exacerbating a prolonged economic recession. Strong motivation for political integration saved the euro from collapse and prevented a full-blown debt crisis.
High labor costs and fiscal budget constraints have strangled many euro countries into near depression like circumstance. The only turnaround solution is inflation, which is why the European Central Bank has been injecting substantial capital into the financial system.
Brexit threatens to pressure the euro further in the coming years by significantly curtailing movement of capital across the EU. London is the major financial artery to the rest of Europe, with financial services accounting for nearly 20% of export trade to the EU. Curbing sizable capital flows at a time when euro countries are parched for money will be devastating. This additional strain could very well push several euro countries to break their commitment toward a united Europe.
Contagion is the big tail risk for investors all around the world. Take, for example, how the subprime mortgage crisis of 2007 revealed shady lending practices that later compounded and almost crippled the global financial system. Or consider how in 1997, Thailand was forced to devalue its currency, sparking an Asian financial crisis, in the wake of which a year later, Russia devalued its currency and defaulted on debt. Both events blindsided Nobel economists heading Long-Term Capital Management in the United States, which required massive bailouts to stop and avoid more major financial damage. Spillovers uncover hidden unknowns; while that may be a good thing, such information is often quite costly to nonparticipants.
Brexit will upend decades of European cooperation and ultimately jeopardize the fragile integration of the euro. A collapsing euro would almost surely cascade into disintegration. Only this time, contagion through global interconnectedness would cause the rest of the world to suffer. The promised Fourth Industrial Revolution could very well be delayed — indefinitely, should history repeat itself.