Finance & Fury: What happens if the EU collapses?

What happens if the EU collapses?

Nov 30, 2018

Welcome to Finance & Fury, the Furious Friday edition. For the past few weeks we’ve been talking about the EU and this week we’ll finish up by looking at the flow on effects of the EU breaking up. There’s no way to be 100% sure of what will occur but having a look on a country by country basis will help to break down what the flow on effects might be.

The EU is simply a collection of countries so looking at the individual countries and consequences of them leaving is a good place to start.
Also, we will have a look at the collective overall and how it redistributes wealth within its budget nature, and how this will help or hurt nations if they leave.

If you haven’t already listened to the previous two Friday episodes, it might be worthwhile having a look at them here and here, as we covered a lot of the history of this topic in those episodes. If you aren’t interested, that’s fine too it won’t really hurt.

First, we’ll take a look at Britain and “Brexit” which has been a mess from the start

Designed to fail from day one, Brexit has been nothing but poor negotiations – making nobody happy.
The hurdle - Negotiating the treaties which would replace the existing Single Market and Customs Union.

The Single Market

The Single Market seeks to guarantee the free movement of goods, capital, services, and labour – the "four freedoms"

Goods & Services: Tariffs and the Customs Union
- All goods and services attract the same rules regardless of where they were produced.
- No customs checks during trade between members of the union and no customs duties are paid on goods moving between EU Member States (all apply a common external customs tariff for goods imported from outside the EU).
- Some argue however, that the Customs Union increases costs and undermines economic growth as some nations can’t afford to maintain the regulatory standards it imposes. This prices these nations out of the export game. At the same time a WTO study posited that the costs of conforming to the rules of origin are negligible.
- Free Trade Agreements are a viable option – NAFTA and other free trade deals work better than the Single Market. The issue is that Britain will need to negotiate new individual agreements with each of the nations within the EU. This is difficult, especially with the likes of Spain who are resistant.
Capital: Single currency and Monetary policy
- Doesn’t have to worry about this as much as they have their own currency
Services: Applies to people who provide services "for remuneration"
Labour: The free movement of people between member states for work. Labour and services aren’t as much of a concern as the single markets and custom union

Payments to the EU

Estimated at 50bn pounds to leave – why? It was part of their agreement. Member countries have to make payments to the EU.
EU Budget – 158 billion Euros in 2017 paid in by the member nations.
This is then spent on EU policies and the EU’s 5 areas of spending.

The EU’s 5 Areas of Spending

Preservation and management of natural resources – 37% of the budget. Includes the common agricultural policy, common fisheries policy, rural development and environmental measures. The objectives of this:
- To increase productivity, by promoting technical progress and ensuring the optimum use of the factors of production, in particular labour; to stabilise markets; to secure availability of supplies; to provide food at reasonable prices.
- Common Agriculture Policy (CAP) – (Where most of the budget is spent) Works by maintaining commodity price levels within the EU and by subsidising production. The mechanisms are:
  - Production and Import quotas: Sets the amount of goods required to be produced, restricts goods imported to the EU and exported from the EU.
  - Market Controlled: CAP mandated demand for some produce is at a higher level than free market
  - Import levies for goods imported to the EU - set at a level to raise the world market price up to the EU target price, and this renders nations outside of the EU uncompetitive.
  - Prices are set at the maximum ‘desirable prices’
  - Trump/US and EU trade negotiations to reduce some of the tariffs
  - Internal intervention prices: If the market prices fall, EU buys up goods to raise the price.
    1. Spent 3 bn Euros in 2017 buying oversupplied food and on selling to other nations.
    2. Incentivises producers to overproduce (they still get paid) but it floods international markets and drops international prices.
    3. In a free market when producers overproduce, prices drop and/or production reduces over time.
    4. At one point 70% of the EU budget was buying over produced food supplies, which they then dumped onto the world market.
    5. Reduced prices hurt 3rd world producers whose costs of production are higher. For example, in 2007 3.5m hectolitres of under demanded wine (which the EU bought). In 2009 2.3m hectolitres of wine (hectolitre = 100 litres).
  - Subsidies to farmers – based around the area of land growing crops. Naturally the largest subsidies go to the biggest players (20 of 100 are billionaires already). This increases reliance on government handouts – but what happens when the money runs out?
  - Who’s getting the handouts? France – 9.7m, Germany – 6.4m, Italy – 5.9m. This hurt the UK.

Citizenship, freedom, security and justice – 3% of Budget
- Freedom, security and justice: justice and home affairs, border protection, immigration and asylum policy.
- Citizenship: public health, consumer protection, culture, youth, information and dialogue with citizens.
EU as global player - Covers all external action ("foreign policy") by the EU – 6%
Administration Cost - Covers the administrative expenditure of all the European institutions, pensions and EU-run schools for staff members' children ("European Schools") – 6% of the budget
Smart and inclusive growth – this is the biggest “spend” at 48%
- Competitiveness for growth and employment - research and innovation, education and training, trans-European networks, social policy, economic integration and accompanying policies.
- Economic, social and territorial cohesion –convergence of the least developed EU countries and regions, EU strategy for sustainable development outside the least prosperous regions, inter-regional cooperation = 34% of budget
- Mass redistribution and corruption – 6% error rate/waste
  - A lot is spent on resorts and golf courses – 5.5m on Beach city, 5.1m for culture club in Luxembourg

EU Flow of Funds

Current state of EU: Who is looking to leave and why?

Looking to leave – Commonality is Poland, Hungary, Czech Republic and Slovakia.
- These countries are some of the biggest receivers from the EU payments
The irony is that if the biggest net recipients leave the EU it kills any argument that the EU is a force for good or beneficial to a country
These are the next countries talking about leaving: Netherlands, France, Denmark, (Not Germany) – All the ones it is costing through flows of taxation

The breakdown of the EU: The likely result on the market

Fear of the unknown creates volatility
Share market: Movements up and down in prices due to this volatility. This can hurt in the short term.
- But will it hurt the underlying companies? Well this depends on the negotiation. If there are free trade agreements put in place then no, it won’t hurt the companies, although they may lose a small percentage on currency conversion. But trading in other currencies allows free markets to take over = under performing countries currency drops making their goods competitive.
Bond market: 6 trillion market cap of Government borrowings that is in Euro denominations
- Likely cause pressure on the bond yield and volatility in the Euro itself
- Need to unwind the bonds or retain Euro for the duration of bonds.
Economic growth without the flow of funds: Some nations’ GDP will drop through loss of Government Spending
- Removal of economic waste: GDP isn’t a great measure of economic health when it is from redistribution of payments. It’s like saying you got out of Credit Card debt by doing a balance transfer.
- EU Area: GDP growth is 1.7% (low) and unemployment is over 8% (high) - all with a 0% interest rate. Policies are not working!
- Interbank rate and deposit rates are negative. Consumer confidence is -4 (it hasn’t been positive in 30 years). To put this in perspective, Australia is positive, at 104 – with the worst at 65 in the early 90s

The Benefit of Diversifying Risk

Chance of a long-term global collapse is reduced
Each Country is getting more into debt
EU Debt to GDP ratio gone from 65% to 87% in under 10 years.
Lower growth and reliance/interdependence.
If one country collapses it pulls whole region into chaos.
For example – Greece was worth 2.5% of the EU’s GDP in 2008, now it’s worth 1.5%...and only 0.2% of global GDP. The ‘debt crisis’ created uncertainty, and share markets dropped due to EU worries.

Once a country collapses there is little it can do to pick itself back up under the EU system.

Restricted on Monetary policy – no adjustment mechanisms
Greece is over a barrel – having to accept large payments to prop up their economy

The Long and Short

I think it would be good long term
- Would cause some ‘teething’ issues throughout the global markets
- Comes from uncertainty and investors not wanting to lose funds, but markets do rebound
Most of the benefits can be gained through trade and other agreements
- Allows individual countries to negotiate between each other and opens up more flexibility and trade
- Rather than having to limit imports or do what the EU wants, each country can do what is right for their economy
Brexit - better to leave with no deal than remain and skip the 50bn pound payment
Less of a monolith where there is less competition, less free trade, less free pricing, less freedom
- Less extraction from productive countries to underperforming which doesn’t actually increase growth
Insulate the global economy more. One country’s mess rather than a continental crisis
- Deleverage the risk of a global recession – One country in EU can crash the EU, or stunt the growth through bailouts