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Brexit’s Doom Spirals

Posted by hkarner - 9. November 2016

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Harold James

Harold James is Professor of History and International Affairs at Princeton University and a senior fellow at the Center for International Governance Innovation. A specialist on German economic history and on globalization, he is a co-author of the new book The Euro and The Battle of Ideas, and the author of The Creation and Destruction of Value: The Globalization Cycle, Krupp: A History of the Legendary German Firm, and Making the European Monetary Union.

NOV 8, 2016 Project Syndicate

LONDON – Financial markets are giving a thumbs-down to Brexit, and they are right to do so. But because it is finance, not democratic civil society, that is pushing back against the United Kingdom’s decision to leave the European Union, the Brexit debate will become more bitter, and the fallout more severe.

The June referendum’s initial economic effects were negligible, and may even have been slightly positive, now that the UK’s post-referendum growth figures are being revised upward. But the British pound is sinking, the cost of financing UK government debt is rising, and the process of actually withdrawing from the EU could be highly destructive.

Having decided to leave the EU, it is in the UK’s interest to manage withdrawal in a way that minimizes short-term adjustment costs and long-term adverse effects. Likewise, it is in the EU’s interest to mitigate not only the economic impact, but also the reputational damage implied by the loss of a major member state.

Ideally, participants in a conflict think coolly and rationally about their long-term interests, and act accordingly; unfortunately, they rarely do. Just as a married couple’s divorce often leads to bitterness and pitched battles that benefit only lawyers, the UK’s divorce from the EU will almost certainly descend into acrimony. As hostility rises, an amicable settlement will become less likely, and everyone will end up losing more than they have gained.

There are three potential doom spirals already baked into the UK-EU divorce proceedings. First, there are political and structural risks to the EU if more member states leave. When the bloc loses a single member state, it looks like a misfortune that can be attributed to the departing country’s domestic peculiarities. But if the bloc loses more member states, it starts to look like negligence, mismanagement, or a fundamental design flaw. Thus, the EU has a strong incentive to make Brexit as painful as possible for the UK, in order to discourage countries such as the Netherlands, Sweden, or Finland from following the British example.

Opinion polls show that support for the EU has surged in many member states since the UK’s referendum. But this is not because the EU is suddenly functioning better. Rather, many Europeans share the view that former British Prime Minister David Cameron blundered by calling for a referendum on EU membership.

Immediately after the referendum, German Chancellor Angela Merkel beseeched Europeans not to be needlessly “horrid” (garstig) when thinking about the EU’s divorce terms for the UK. But, because the UK knows that the EU fears disintegration, it will inevitably read vindictiveness into any position the EU takes. UK negotiators will have to assume that their EU counterparts are trying to make the path out of the EU as economically and politically rocky as possible.

British negotiators will then respond to EU negotiators’ domino-theory logic by trying to make the process as painful as possible for the rest of the EU. Indeed, the UK’s “Leave” constituency already firmly believes that the UK would be better off on its own, and that Brexit will hurt Europeans much more than it hurts Britons. This means that the Leave camp has a powerful incentive to fulfill its own prophecy.

The second doom loop applies to the UK’s domestic political economy. Britain cannot simply start beating the Europeans at their own game by reviving its automobile industry, or by making its own wine to rival French and Italian producers. The principle of comparative advantage demands that the UK emphasize its service industries, and especially financial services.

The City of London already drives the British economy, and one post-Brexit scenario has London’s role as a global financial center actually increasing. To make that happen, the British government would have to establish a regime of low taxes, light regulations, and favorable treatment toward both skilled and unskilled immigrants working in and around financial services. But every part of this plan conflicts with the government’s goal of reining in the finance industry and limiting migrant flows.

Indeed, strengthening fat-cat capitalism is precisely the opposite of what British Prime Minister Theresa May promised to do when she succeeded Cameron. In fact, the Leave camp is dominated by people in England and Wales who feel cut off from the gains of globalization, and voted against the privileges and riches of the glittering global megacity of London. Thus, one of the UK’s most effective negotiating strategies would deeply divide Britain itself, and especially the governing Conservative Party.

That points to the third doom loop: migration, which weighed so heavily on the outcome of the Brexit referendum. The May government now must demonstrate to voters that it is doing something about migrants and foreign workers in the UK. But as long as Britain has a dynamic economy, it will attract immigrants, regardless of whether they are formally admitted. The government can guarantee less immigration only by wrecking the economy, which would then be blamed, naturally, on European viciousness.

Meanwhile, if the UK becomes a low-cost offshore financial center that sheds jobs, it could pose a danger to its neighbors. Continental Europe might be tempted to reject financial capitalism altogether, in favor of a growth strategy based on large state-driven investment projects.

Ultimately, Brexit could come to resemble the dismemberment of a body, with the British financial head separated from the European real economy. Britain would appear less attractive, Europe would withdraw into itself, and each side would blame the other. That would be a bad outcome for everyone. But it also adheres to the bitter logic of divorce – which is why most couples opt for counseling.

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