The UK referendum vote to exit the European Union has brought to the foreground unmistakable problems within the 28-member bloc. They were there before the Brexit, were probably the motivation behind the UK decision to leave the EU, and they are the primary obstacles that could have prevented it.

Perhaps the most important issue is that economic growth has stalled – especially since the ‘great financial crises’, but more critically since the inception of the euro.

The EU’s founders had predicted that aggregating European economies together would foster the most important economic trading union in the world. Instead, EU GDP stumbled and, in spite of its relative large land area, population and the enormous number of its members, the EU economy today is smaller than that of the US and China.

On top of this are other persisting problems. Austerity, as a macroeconomic policy decision, has been a failure. Aggressive monetary policy accommodation from the European Central Bank (ECB) has proved insufficient to stimulate greater economic growth. The population of the EU is slowly shrinking and aging. Consequently, the growth in the labor force is gradually diminishing. There are too many restrictive labour rules that inhibit hiring decisions. Recent productivity improvement has been miniscule.

This combination has caused the EU economy to slide into a long-term deflationary spiral. The EU now faces secular stagnation unless it can make critical revisions to its labyrinth structure.

The EU began as a noble experiment by the six largest countries in Western Europe to build a more peaceful future through a mutually beneficial economic trade agreement. Over many decades this initial trade agreement led to a series of treaties that gradually shifted political power from nation states to the European Union’s institutions. So what went wrong?

Politics of discontent

dominoesWill the UK vote trigger a series of exits?Together with the expansion of countries joining the EU and the enlargement of its combined GDP, the ambitions of the leading EU elites expanded as well. One critical ambition was to expand the original idea of a free flow of goods across national boundaries to include people.

Naturally this led to vast migrations of people from poorer member countries to the richer, older original members. Schengen visas also opened the door to the free movement of immigrants from areas outside the borders of the EU.

While migration from Africa and the Middle East may mitigate some of the problems from the decline in the indigenous population, it comes with a high political cost. The migrants have even less commonality with their European hosts than the differences among the Europeans.

Following the UK’s exit, anti-migration sentiment within Europe will rise and reinforce the politics of discontent. Eventually this will lead to more disruptive national elections, and greater anti-globalization sentiment.

One of the few cardinal principals of international economics, and one shared by nearly all economists of different orientations, is that free trade benefits all nations. So what distorted the benefits from free trade by the EU members?

Economic reason gave way to political manipulation that favoured greater and greater integration among a very disparate social and cultural group of peoples.

The multiplication of member economies led to a vast increase in the number of regulations created at the EU power centre in Brussels. These regulations were sufficiently different from the rules and customs of many divergent societies, making implementation difficult and time consuming.

Designed to tie together different economies, they instead began to strangle productivity and growth everywhere.

Greatest blunder

In 1998 the EU embarked upon its greatest blunder: the euro. A common currency among 19 nations with hugely divergent economic abilities, vastly different productivities, and incredibly dissimilar income levels complicated the ability of the poorer countries to improve their economic plight.

euroThe euro delivered a lengthy period of economic stagnation and a massive divergence in standards of living.

A common currency meant a single interest rate structure, which has been largely determined by the richest country: Germany. With its edge in productivity and skills in manufacturing, Germany benefitted enormously from a common currency at the expense of other members that could not devalue their currencies to gain competitiveness.

As a result, until the start of 2016 real GDP in the euro zone increased by only 0.5% from the start of 2008, when the recession in the US began. Moreover, real GDP per capita increased by an estimated 11% in Germany while it stagnated in France and fell by nearly as much in Spain and Italy.

To be sure GDP growth in the euro zone did increase faster than in moribund Japan, but it fell well behind China, India and the other emerging markets, especially those in Asia.

A common currency and a common monetary policy whose singular objective was to prevent inflation led to considerably lower levels of interest rates throughout the euro region.

Poorer countries initially benefitted from lower rates and borrowed heavily. Then they were saddled with massive amounts of debt when the great financial crisis came in 2008. The elites in the EU decided that fiscal austerity would be the way out from under the collapse of their economies and the threats from over borrowing.

The EU powers long recognized that the biggest missing link in their desire for greater economic harmony was the absence of fiscal authority. Individual members controlled their own budgets that were determined by the political will of the people of those nations.

Consequently, the EU created the infamous Maastricht treaty: it set a number of fiscal rules that member nations had to abide by.  The most prominent rule was that national debt should not exceed 60% of GDP.

Brink of bankruptcy

ThinkAloud4Of course few member nations did and the EU chose to ignore the occasions when the older, richer nations broke the rules. Consequently, the euro zone’s composite debt ratio has climbed up to approximately 90% of GDP. Moreover, every member nations’ debt ratio has steadily grown over the past 18 years.

When the great financial crisis came, the egregious debt ratios by the neediest nations screamed out for help. Instead the EU chose discipline – forcing a policy of austerity that has left Greece on the brink of bankruptcy and at the doorstep of itself quitting the union; the so-called Grexit.

In Athens the treasury is rapidly running out of funds, and the Greek public is running out of hope. The unemployment rate is astronomical and the government’s debt levels are dangerously high.

Moreover, the EU’s agreements with Turkey and Austria have left Greece with an unmanageable multitude of immigrants. In a country with a scandalously high unemployment rate, the arrival of more poor, low skilled unemployed workers will raise the indigenous population’s ire. This probably will provoke greater tensions and expedite their exit from the EU.

The Brexit vote, after all, has set a precedent.

Meanwhile since 2008 the unemployment rate in virtually every euro member country except Germany has risen. As a result, the euro area’s aggregate unemployment rate has climbed above 10% at the end of 2015.

At the same time the mountain of debt in some member countries is beginning to attract the attention of financial markets and to cripple the ability of national governments to finance future economic expansion.

After Greece, Italy and Portugal are the most egregious debt offenders of the Maastricht rules. Unpaid debt and bankruptcies are already weighing heavily on the stock prices of EU banks, which increase the headwinds that EU economies have to face in order to stimulate greater economic growth.

No ‘free ride’

The EU leadership faces another dilemma in handling the aftermath of the UK referendum and path to Brexit. Administrators do not want to create an economic ‘free ride’ for the UK by granting it a favourable trade deal. That would create another dangerous precedent for countries to exit in the future.

Nevertheless, the UK is a huge trade partner, accounting for slightly more than 10% of all the internal EU trade in 2015.

Because economic progress should be the primary goal and since the UK is such a large trade partner, this strongly suggests that the EU and UK will seek some mutually favourable trade agreement.

A deal similar to the one between the EU and Norway would probably benefit both the EU and UK. However, it would require open borders with the UK as Norway has agreed.

Switzerland provides another possible option for the UK. The Swiss decided by referendum to have closed borders for people and therefore accepted a more restrictive trade agreement with the EU than Norway.

Ultimately, the EU will have to overlook its animosity and reach for economic enhancement that healthy trade with the UK will afford. Nonetheless negotiating such an advantageous agreement would probably take many years.

In the meantime, economic growth in the EU is likely to be slowed by Brexit and the uncertain time interval before the creation of a new trade agreement with the UK.

The latest IMF GDP growth estimates indicate only a slight reduction (one to three tenths) in the EU’s previous forecast of 1.6% GDP growth for 2016 and 1.4% for 2017. However, the full impact of the UK’s departure will not be felt until they have formally left.

Loss of confidence

Meanwhile financial markets are already signalling a loss of confidence for the EU’s economic growth as compared with markets in other economies.

The most important market response to Brexit was the significant depreciation of the pound against both the dollar and the Euro. This added some competitiveness to UK exports, and thus softened the blow to the UK upon exit.

Nevertheless, most pundits believe the UK will suffer significant economic losses over the next few years.

To continue to derive economic benefit from free trade the EU must revise its central character by reversing its present direction.

In contrast, the common theme presently discoursed within the EU to confront its problems is to create greater homogeneity among countries with heterogeneous cultures, languages, aspirations, education levels, and legal systems.

For example the IMF in its first post-Brexit review of the EU recommends a series of measures, including:  creating better incentives for growth friendly structural reforms; strengthening the fiscal framework while expanding centralized fiscal support; and accelerating balance sheet repair and completing the banking union.

Yet while these are useful improvements, they do not tackle the major problems.

The UK’s exit has opened the door to an indigenous pullback from more strenuous EU efforts to create greater integration. Political frustration from the threats of immigration, economic stagnation, and income disparity are rising and could bubble over leading to more exits in the future.

Instead of trying to generate greater political integration therefore, the EU elites should consider less integration as a solution.

Perhaps, even a roll back to a simple free trade agreement among the present 28 EU members such as the one that the EU had at its origin.

Such a trade association, that would be similar to the North American free trade association (NAFTA), would eliminate the need for greater – but impossible – political integration, and achieve the economic benefits from free trade.

Of course taking this decision would not preclude an option for a smaller select group of core EU members to voluntarily choose greater political integration.

This combination of options would be the most opportunistic strategy for all present EU members.