Economic Research: Brexit's Wake-Up Call To The EU: Selectively Sharing Sovereignty Is Unsustainable S&P Global Chief Economist: Paul J Sheard, New York (1) 212-438-6262; [email protected] Table Of Contents Sovereignty: A Single Concept With Multiple Aspects The Selective Pooling Of Sovereignty In The EU Monetary Union Without Fiscal Union Internal Security, Foreign Policy, And Freedom Of Movement The Game Plan--And What Went Wrong Two Visions For The Future Of The EU How To Get There Related Research Endnotes WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 22, 2016 1 1680149 | 301001947 Economic Research: Brexit's Wake-Up Call To The EU: Selectively Sharing Sovereignty Is Unsustainable (Editor's Note: The views expressed here are those of S&P Global's chief economist. While these views can help to inform the ratings process, sovereign and other ratings are based on the decisions of ratings committees, exercising their analytical judgment in accordance with publicly available ratings criteria.) The majority vote in the British referendum of June 23 to leave the EU shocked the world. It also dramatically raised the level of uncertainty about the future--not only of the U.K. but of the EU itself. Questions abound: Will "Brexit" actually happen, or will the U.K. hold a second referendum at some point that could overturn the result? Following the June vote, what kind of political arrangement will the U.K. forge with the remaining EU? Will the U.K. survive intact, given that majorities in Scotland and Northern Ireland voted to "Remain"? How will the EU evolve without the U.K.? Will Brexit be a catalyst for greater integration of the EU, or could it mark a historic turning point toward its widespread fragmentation or major realignment? Nobody can answer these questions with any degree of confidence. There are too many moving parts in the electoral politics of 28 nation states, and too many random-like events are conceivable that could push political and economic developments in one direction or another, with impossible-to-predict consequences and timelines. Overview • Sovereignty of a nation-state is a single concept, but it has multiple aspects, including national identity, the ability to regulate economic and social activity, the ability to create and regulate money, the control of borders, maintenance of internal security, and engagement in international affairs. • The EU's political and economic architecture is problematic because some aspects of sovereignty are shared, or "pooled," while others are not. • Sharing sovereignty via monetary union but not via fiscal union hobbles the ability of member states--and the euro area in aggregate--to flexibly deploy macroeconomic policy tools. • Sharing sovereignty at the EU level regarding freedom of movement is at odds with not sharing sovereignty to secure the external border and with member states retaining sovereignty when it comes to internal security, foreign affairs, and national identity. • A future EU that has reached its "steady state" will need to reflect a consistent alignment of the various aspects of sovereignty, implying ultimately a move toward a "United States of Europe" or the repatriation of some elements of sovereignty back to member states, or perhaps subsets of both. It is possible, however, to say something in advance about the basic structure of the problem and about the contours of a steady-state solution, where by "steady state" I mean a political and economic entity that is fully formed, well-functioning, and stable. The problem is this: The EU, as it's currently constructed and operates, doesn't embody a coherent "pooling" of the WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 22, 2016 2 1680149 | 301001947 Economic Research: Brexit's Wake-Up Call To The EU: Selectively Sharing Sovereignty Is Unsustainable various dimensions of nation-state sovereignty, and therefore it's unsustainable in its current form. The EU's leaders--and no doubt many of its citizens--widely accept this. Witness the 2012 "Four Presidents' Report" and the 2015 "Five Presidents' Report." Brexit can be seen as just one, rather rude, manifestation of the underlying incoherence of the current pooling. Indeed, in response to the Brexit vote, the European Council announced that the 27 leaders had "started a political reflection on the future of [the] EU with 27 states and will meet on 16 September … to continue talks." The contours of a steady-state solution to this problem must involve a realignment of the sharing of the various dimensions of sovereignty into a more natural, consistent, and coherent form. The EU that emerges in such a steady-state functional form will have to involve either a looser form of political and economic federation, in which member states take back some sovereignty, or a stronger form, in which aspects of sovereignty that aren't currently shared are ceded to, or more substantially shared at, the EU level. The steady-state form EU could include aspects of both more political integration and less, should nation-states end up realigning into two or more substantive groups. Sovereignty: A Single Concept With Multiple Aspects Without getting too bogged down in the finer points of international relations and law, the modern world is organized around the existence of "nation-states" or "sovereign states." The UN has 193 member states, all of which are considered to be sovereign states. For instance, the EU's 28 member states are all members of the UN (the EU has been an observer state at the UN since 1974 and has had enhanced "participation rights" since 2011). The essence of a sovereign state is that it has a polity (citizens who belong to it and participate in its governance) and a geography (national borders) within which it exercises control over political, legal, economic, and social affairs, and from which it conducts relations with other sovereign states and international bodies that recognize its legitimacy. The notion of sovereignty is basically a singular one in that each sovereign state is unique and identifiable as such. However, sovereignty has many dimensions or manifestations. While there are many shades of grey and exceptions to the rule, a typical sovereign state is likely to have the following characteristics (among others): • A national or cultural identity; • The ability to make and enforce laws, and to regulate economic and social behavior within its boundaries; • The ability to create, spend, and regulate money (operate fiscal and monetary policies); • Control over its borders and over the movement of people in and out of the country; • A capacity to ensure internal or domestic security and social order via policing, a judiciary, and internal intelligence services; and • A capacity to engage in foreign relations with other sovereign states and to protect its sovereignty from foreign threats by maintaining armed forces, foreign intelligence services, and a diplomatic corps. These different aspects of sovereignty are interconnected and mutually complementary. They go together conceptually and usually in practice.(1) When it comes to core aspects of sovereignty, it wouldn't make much sense for a sovereign state to retain certain aspects of its sovereignty but to share other ones. It would be more natural either to retain all or to share all. Because sovereignty is basically a single concept, the gravitational pull to keep its multiple manifestations together is strong. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 22, 2016 3 1680149 | 301001947 Economic Research: Brexit's Wake-Up Call To The EU: Selectively Sharing Sovereignty Is Unsustainable The Selective Pooling Of Sovereignty In The EU The EU is unusual in that it defies this gravitational pull: Member states retain certain key aspects of sovereignty and share other key aspects. Many would say this is so because, as a geopolitical or nation-state construct, the EU is still a work in progress. Take the six aspects of sovereignty identified above. When it comes to national identity, most citizens of the EU would self-identify as German, French, Italian, or whatever their nationality is first and as European second.(2) When it comes to internal security and foreign affairs, too, the primary locus is at the nation-state level.(3) When it comes to making laws and regulating economic activity, some aspects of sovereignty are retained at the national level (many national laws and trade in many services), while others are shared at, or ceded to, the EU level (EU law and regulations as made by the European Commission and European Parliament, and a common market for goods exists). When it comes to the freedom of movement of EU citizens in order to work, sovereignty is shared: This freedom is a fundamental principle of the Treaty on the Functioning of the European Union, as set out in Article 45 ("Freedom of movement for workers shall be secured within the Union") and developed in EU law. The Schengen Agreement, first signed in 1985 and becoming part of the EU framework in 1999, goes further for the 22 EU countries that are signatories by abolishing passport and border controls among them, not just for EU citizens but for anyone traveling between those countries once he or she is in one of the 26 Schengen Area countries.(4) When it comes to the sovereign right to create, spend, and regulate money, EU member states adopted a bifurcated stance, pooling sovereignty regarding monetary policy but not regarding fiscal policy. Actually, it's a little bit more complicated than that. The treaties establish that the euro is the EU currency. That is, the premise and much of the actuality (the euro area) is that the EU is a monetary union.(5) The treaties don't envisage the euro area becoming a full-fledged fiscal union, in the sense of the euro area being a "transfer union," having a central treasury with EU-wide taxation, spending, transfer, and debt-issuance powers.