European monetary union and free movement of peoples from impoverished East to the rich West will likely be twins in death as they were at birth. It has been a slow but steadfast journey from the Paris-Berlin accords on monetary union and EU enlargement in the 1990s to the biggest symptom yet of disintegration — the UK referendum win for Brexit. Now the train is set to speed up with a high likelihood of crashing along the way. The fantastic bubble in government bond markets which has just got larger will likely add to the severity of the crash and of the related global damage.
The start of the ill-fated journey toward enhanced European integration was marked by the fall of the Berlin Wall. The German government (Chancellor Kohl) wanted a rapid timetable for expanding the EU into Eastern Europe but a long staged timetable for European Monetary Union. In Paris the priorities were the reverse. And so a compromise was reached on an accelerated timetable for both. Yes, there were Cassandras who warned against initiating monetary union or an extension of free movement of peoples to include Eastern Europe in advance of political union. But the eurocrats promised that they had overcome natural sequencing — monetary union and free movement of peoples would force Europe into a political union.
Britain was not a party to the Grand Compromise, choosing to opt out from monetary union. But the UK played an absolutely essential role in its implementation. The appeal of the UK as an English-speaking country with a flexible labour market to the East European peoples fleeing domestic poverty and insecurity was a vital ingredient in EU enlargement. The rapidly rising remittances from the UK made membership of the EU viable without an extreme level of subsidy support (large in any case). German industry ran up large export surpluses with the new member states courtesy of the inflow of expatriate cash from London and of a boom in loans into those countries — one component of the 2002–07 credit bubble.
When the bubble burst, including its Southern European component, taxpayers from the North European members of the monetary union provided a backstop. But for many the cost has been hidden from view by the endless monetary and accounting tricks of the establishment — which essentially shuffled those obligations on to the next generation. Even so many could see that all was not well, as evidenced by the rising resentment in Germany against the visible consequence of the transfers such as zero or negative interest rates.
In the case of the UK, a sea of resentment against the consequences of the enhanced European integration of the past two decades has had multiple sources. Most powerful has been the bulge in immigration, but also important is widespread concern about the ultimate potential burden of EMU implosion on the British taxpayer (albeit less than for euro-members). During the referendum campaign, admissions that the official numbers had vastly understated the true extent of East European inflows along with disgruntlement about the squeeze this has created in public services (chiefly health and education) and housing boiled into a Leave win.
In principle, the UK popular anxiety could have been assuaged by a special deal to allow London to limit immigration from the EU. The East European EU member governments were understandably in the forefront of opposition to any such concession. And there was never any serious effort by Berlin and Paris to override East European objections. Free movement of people is canon of Europe Integration from the Treaty of Rome onward. In any case, monetary union between countries without free movement of labour would be a flawed concept. Yes, Britain as outside the monetary union could have been made an exception. But Berlin doubtless feared that this would be the catalyst to other EU governments limiting the onward migration of Middle Eastern refugees now in Germany.
The outcome of EU exit negotiations will most likely involve some combination of restrictions on EU immigration and a paring back of UK financial institutions’ access to the Single Market. The scenario in which Brexit would set the UK on a course of liberal (i.e., free market) reform which would challenge the EU status quo of high taxes, burdensome regulation and monetary instability, has already faded from view amidst the implosion of the Conservative Party’s “Thatcherite wing” and the installing of a government under the centrist and “non-ideological” Teresa May. Meanwhile the anti-euro anti-immigration Right in France, Germany, Italy, and Netherlands, are all fighting national elections within the next year. They could gain momentum from the UK referendum result. Their possible election successes add to the likelihood of a deep euro crisis.
German Chancellor Merkel’s CDU party will push back against any new deal to bail out weak banks and sovereigns, most ostensibly in Italy. Any such aid could accelerate the hemorrhage of their voters to the AfD which was already winning up to 15 percent of the vote in regional elections earlier this year. Yes, opinion polls since Brexit indicate that “Mutter Merkel” has experienced a re-bound in support from a low-point in the spring and that the AfD has experienced some setback amidst infighting and scandal. But these poll blips most likely do not signal a change in trend.
And so next time could be different. In every sovereign debt and banking quake since the first Greek crisis in 2010, Merkel has agreed to the ECB chief trampling on the Maastricht Treaty and imposing new burdens on North European taxpayers for the greater good of European integration. But now in the run-up to the October 2017 elections in Germany Merkel’s political calculations will probably rule out a repeat.
Alongside a hardening in attitude to Southern debt delinquents, Merkel is likely to delay signaling any ”grand deal” for the UK ahead of the spring 2017 elections in France out of fear that this could trigger support for the anti-euro Right. Some analysts are suggesting that in consequence UK would be best to defer exit negotiations till beyond then, hoping for the victory of the Centre-Right. Contrary to such hopes, a socialist president disinclined to deal might again reside in the Élysée Palace as a result of divisions on the Right. But then there might be such despair about the French economic outlook that Paris would no longer be a player in the negotiations given its grown financial dependence on Germany. The Berlin-Paris axis would break, to be replaced by the German hegemon.
In front of all these political calculations, an earlier hazard looms for the euro-train. In response to immediate fears in financial markets as provoked by the Brexit “shock,” central banker comments from the UK, Europe, and the US about further “accommodation” have caused prices in the long bond markets to reach the sky in early July. Who is buying bonds at these crazy low yield levels? The answer is only central bankers, or in the case of Japan, international arbitragers who convert the government paper into dollar bonds offering handsome spreads. The real question is why any investors are holding on to bonds at such low levels rather than liquidating for cash. The answers involve some combination of fooling the stakeholders (who may want to be fooled) and speculation that the price could go higher first before inevitably sinking (the irrational bubble hypothesis).
No one knows for sure when the bond bubble will burst. But when it does the spin-off into all risk-markets, including the weak sovereign European and bank debt markets, is to be feared. Then Europe could be back to the drawing board, with the UK lucky to have been first out. Whether there is a future for European integration will depend on whether next time it starts with political union and is confined to just two nations — France and Germany.