Reflections on Brexit and the future of the European Union

‘After experiencing political oppression and war in the first half of the twentieth century, Europe undertook to build a new order for peace, freedom, and prosperity.  Despite its predominantly economic content, the European Union is an eminently political construct.’

 Tommaso Padoa-Schioppa (2004): Economist and central banker who played a key role in the birth of the euro.

Following two world wars – which centred on Europe - in less than three decades and the Great Depression of the early 1930s, the rationale for Europe integration was fundamentally political: to create a system where nation states could no longer pursue destructive and unilateral policies.  The pooling of Franco-German coal and steel production in 1950 seen as the first step towards in the federation of Europe.  Despite best efforts, the push for a federation of Europe failed due to the high costs associated with political integration of heterogeneous groups under a common authority.  France rejected Great Britain’s initial application to the then European Economic Community in 1963, but successfully joined over a decade later. 

Political economy of heterogeneous populations

Political economists have long understand the challenges of political unification when members have diverse economic and social structures, identities, cultures and languages.  Ethnic heterogeneity has been linked to the under-provision of public goods at the local level, while linguistic diversity has a demonstrated negative impact on re-distribution.  When the ties that bind societies are weak, there is little support for strong welfare states that offer public goods and re-distribute income.  Due to the heterogeneity of peoples residing within Europe’s different regions and nation states, a European federation would likely to face significant political costs.

Professor Enrico Spolaore from Tufts University suggests that political integration across large and diverse populations usually takes place when dictatorial rulers are able to ignore the heterogeneity costs of the populations they conquer.  According to Professor Spolaore, the diversity of cultural norms and across Western Europe can account for the failure of the region to ‘form a federation even when faced with an existential threat from the Soviet Union and relied instead on an international alliance (NATO) where issues of undersupply and free riding were in part addressed by the dominant role of the United States.

Why the British confounded the consensus

The resounding victory of the ‘Leave’ campaign following last week’s UK referendum reveals a high level of antipathy that the British community has around ‘shared values’ with Europe, concerns around immigration policy and little perceived economic benefit. 

  • The British do not share the same language as countries in Western Europe, have a sense of isolation due the country’s island status and consider themselves to be more individualistic and less consensus bound than their Western European counterparts.
  • Concerns around immigration are intriguing, because the population share of immigrants and of native born offspring of immigrants is less than 25%, broadly in line with most other European countries (see chart).  But the long shadow of the financial crisis and flow of refugees from Syria and the Middle East have probably exacerbated anxieties around immigration. 
  • The rationale for economic integration – which was the key reason for the UK becoming a member of the EU in the 1970s - had become more tenuous in more recent times when growth in the UK and various other metrics of economic performance had outperformed Western Europe for over two decades.

     

 The 'domino effect'

The decision of Great Britain to leave the EU is unprecedented (for any country) so the process of investor learning surrounding the future implications for the EU could well be slow drawn out.  Of particular concern is ‘domino effect’; that the decision by the British to leave the EU will lead to a cascading of other secessions and ultimately the disintegration of the EU and dismantling of the single Euro currency. 

Ultimately, it is up to the people and governments in Europe to decide whether the benefits of political and economic union outweigh the costs.  Indeed, regaining power over monetary policy may well deliver long term economic benefits.  But the costs associated with exiting the single currency and re-establishing national currencies may well be deemed to be too high.

Beware risk assets

Whatever the outcome, Brexit has set into train a re-assessment of the balance of risks of European political and economic union.  Many have assessed that the response from stock markets to the referendum represented an over-reaction, particularly in the United States where the direct fallout from Brexit is considered to be small.  But the maths of valuation theory suggests that the 3.5% decline in the S&P500 may well have been small considering how the balance of future risks has changed.  The magnitude of the fall is equivalent to only a 10 basis point lift in the expected return from US stocks, assuming perpetuity growth in dividends of 5.5%pa has remained unchanged.

As investors continue to digest the fallout from Brexit and interpret the continued popularity of far right parties in Europe such as the National Front in France, Evidente expects risk assets to trade on lower multiples, reflecting three developments: a reduction in expected dividend growth, a lift in uncertainty around future growth, and a higher risk premium.  For investors with the luxury of a long investment horizon, Brexit ought to offer an invaluable buying opportunity.  For most other institutional investors at the coal face of shorter term performance pressures, Evidente expects there will be better buying opportunities in due course.