Can the European Union Survive? Economic and financial integration must be accelerated

UEDA Kenichi
Faculty Fellow, RIETI

A comparison of the United Kingdom and Greece reminds us that "each unhappy family is unhappy in its own way" (Leo Tolstoy). Greece fell into a critical situation as the handling of its debt overhang became far too complex. In comparison, the United Kingdom is entangled in its unique problems with the European Union (EU) on top of facing challenges common to all advanced economies.

Although Brexit is widely seen as a political event, there is no denying that economic problems are the underlying cause. Deep underneath, there are two trends—globalization and liberalization—that are intertwined with one another. This is a universal phenomenon.

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One consequence of globalization is a global convergence toward equal compensation for equal services. Wages and salaries are the compensation for services that are the provision of labor (work), whereas interest rates and dividends are that for the provision of funds (investment).

Globalization enables businesses in advanced countries to take advantage of cheap labor in developing countries, either directly by relocating their own factories or indirectly by outsourcing to those countries. At the same time, they can suppress wage levels for factory workers in their home countries. Meanwhile, investors in advanced countries can earn high returns by investing in equities and other instruments in countries with high growth potential. Because of this, globalization is seen as a factor driving inequality in advanced countries.

On the other hand, for developing countries, globalization means more jobs and higher wages. Also, productivity rises as enormous capital investments are made and advanced machines are deployed extensively. However, profits for companies with exporting capabilities often grow more exponentially than wages for workers. Due partly to a tendency for the concentration of business ownership in developing countries, as exemplified by the presence of conglomerates, globalization is seen as a factor driving inequality in developing countries as well.

Nevertheless, in emerging economies such as China and India, globalization and liberalization have resulted in a significant increase in per capita income, which is now coming close to matching the levels observed in advanced countries. This is also the road Japan took in the past. By significantly raising the average income in poor countries, globalization and liberalization have steadily reduced global inequalities, albeit at the cost of growing inequality within respective countries.

Therefore, opposing globalization and liberalization on the grounds of increasing domestic inequality is a narrow-minded way of thinking that would put the brakes on the ongoing trend of reducing global inequality. Still, one can argue that, in reality, advanced countries are confronted with strong oppositions from within. But, globalization and liberalization bring the resources to overcome the oppositions. They can improve productivity and raise the level of national income, for instance, by making incessant efforts for technological development and quality improvement through international competition, focusing on strategically important business areas, and reforming the organizational structure.

A caveat is that the fruits of globalization and liberalization are distributed mainly to those people with money to invest or highly-paid jobs. However, the net gains from globalization and liberalization for an advanced country are positive. Thus, what is required of political leaders is to adopt and implement policies to conciliate opponents to globalization and liberalization, for instance, through partial redistribution of such fruits from those who have them to those who do not.

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Why did this apparent resolution fail to occur in the United Kingdom? As one of the world's financial centers, the greatest beneficiary of globalization and liberalization is the financial industry. By mobilizing their abundant financial resources and power to influence politics, financial institutions could have supported the government with measures to appease the anti-globalization sentiment and help win the Brexit referendum, but failed to do so. As it appears, with some weaknesses of the EU already visible in the industry, financial institutions were not convinced of the advantage of staying in the EU so much as to take aggressive steps.

The EU is at the forefront of internationalization in terms of allowing for borderless economic activities within the region. When it comes to the financial industry, however, the EU has been—at least in some way—treading on a path contradictory to liberalization.

In the wake of the financial crisis from 2007 onward, banks' moral hazard—i.e., lax risk management and excessive lending counting on government bailout in the event of emergency—was called into question. This prompted the tightening of financial regulations all across the world. All in all, the regulatory changes made in this process were necessary ones. However, the EU has gone further to introduce additional, more stringent regulations under the initiative of Germany and France.

The UK financial industry, though not under the direct supervision of the EU regulators, has been influenced by EU regulations both overtly and covertly. In the traditionally liberal financial community of London, there was a widespread concern that the city might lose its competitiveness as a global financial center even if it maintained its status as the center of financial transactions within the EU.

When Brexit happens, UK financial institutions will cease to be able to freely provide services to their customers in the EU, but they will still be able to serve those customers by setting up subsidiaries within the EU. This means that some jobs in London will be transferred to the EU. However, in the medium- to long-term, UK financial institutions may attain unique competitiveness comparable to that of their counterparts in Switzerland and Singapore as a result of being liberated from EU regulations.

Another important element to be successful as a global financial center—that is, apart from a favorable regulatory environment—is taxation. Simply put, the United Kingdom would be able to attract the global and regional head office functions of multinationals by setting lower corporate tax rates than other countries. In this regard, too, breaking free from EU regulations will help enhance its international competitiveness. For instance, relaxed regulations and lower tax rates would be a big advantage for shadow banking firms including fast-growing hedge funds. These are most likely the reasons why the UK financial industry did not make all-out efforts to campaign against Brexit.

As such, the United Kingdom has its own circumstances. But the same holds true for each and every EU member state including Greece. Will the EU be ready to cope with this?

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The EU already has a blueprint for its future, as shown in the so-called "Five Presidents' Report" published in 2015 under the names of the presidents of five European institutions, i.e., the European Commission, the European Council, the European Parliament, the European Central Bank (ECB), and the Eurogroup. The report states that the EU needs to strengthen its union to prepare for the future, and sets forth four paths toward that goal.

The first is an economic union, which calls for stronger policy coordination among member states on top of ensuring the free flow of trade, capital, and labor. Monetary policy is already under the unified control of the ECB, and the EU intends to move toward greater coordination and integration of fiscal policies as well as of labor market policies including unemployment insurance programs.

The second is a financial union, which refers to achieving integration in two segments: a banking union and a capital markets union. As to the banking union, regulations and supervisory authorities have substantially transferred to the EU level, and the establishment of a single deposit insurance system is envisaged as a future step. The integration of capital markets is somewhat delayed, but work is underway toward integration in regulatory and other aspects.

The third is a fiscal union with the ultimate goal of collecting taxes and deciding fiscal expenditures at the EU level. For the time being, however, integration on this front will be limited to responses to a crisis in member states, for instance, through the European Stability Mechanism (ESM) and investments through the European Investment Bank (EIB) and other institutions. This is because no citizen in EU member states would support a public finance regime that is beyond control of their democratically elected politicians.

Hence, the fourth is a political union, which aims at enabling the direct election of the president of the European Union as well as of European Parliament members. At the moment, however, the (institutional and emotional) hurdles seem so high that it is unlikely for the EU to reach this goal any time soon.

Following the recent Brexit decision, European practitioners and intellectuals recognized the need to accelerate the realization of the blueprint. In particular, the EU must expedite the reform process for the economic and financial unions, where the hurdles are relatively low, to address institutional flaws that triggered—and could retrigger—financial and fiscal crises.

Obviously, the devil is in the detail. For instance, EU financial regulations might be seen as lowering competitiveness, as discussed earlier. Also, the EU's strict bank rescue rules under its forward-looking regulations do not sit well with the reality that some of its member states, such as Italy, are still in need of emergency measures to avert a possible banking crisis. Still remains to be seen is how will the EU solve the sovereign debt problems in Greece and some other countries. Moreover, deep-seated discontent prevails among those who have little to gain from globalization and liberalization.

Overall, however, the EU is clearly moving in the direction of forging a stronger union, with practitioners and scholars leading the momentum. A key to a successful future probably lies in just a few issues: how will the EU, with good and sensible politics, manage to make its union stronger and yet keep it open? And how will it make people recognize the benefits of deeper integration and stem the rise of populism?

>> Original text in Japanese

* Translated by RIETI.

July 29, 2016 Nihon Keizai Shimbun

September 14, 2016

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