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Four scenarios for Europe - scenario 1: ‘Muddling through’

Economic Report

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Europe muddles along without really solving problems

To overview page future scenarios for Europe

  • The EU and the eurozone continue to exist, but cooperation between Member States becomes increasingly difficult
  • Problems are repeatedly addressed with half measures, creating new unrest and crises, and popular dissatisfaction continues to grow
  • Economic growth remains limited and unemployment declines at a slow rate
  • Over the long term, this scenario is not sustainable and will ultimately lead to a different scenario: Further Integration, Disintegration or Two-Speed

Keynote: Continuing unrest

The European Union struggles, but without real success. Politicians continue to deal with new problems with gimmicks and half measures whereby the sharp edges will be blunted but nothing will really be solved. Cooperation and coordination will be strengthened in some areas (external border security), but weakened in others (budgetary policy, agricultural policy). The important point is that on balance there will be no substantial further integration. The only measures will be of the sticking-plaster variety. Serious tensions will thus remain in the system under the surface. These tensions and half solutions will lead to new hotbeds and turmoil, resulting in high volatility in both the financial markets and confidence. This volatility will in turn negatively affect consumer spending and business investment.

The operation of the Single Market will increasingly lose effectiveness. Among other things, because the common agricultural policy will be undermined (see box) and an increasing group of countries will introduce border checks, whether temporary or not. They will do this to obstruct refugees and to be able to screen refugees more effectively. Various countries that have already moved to protect their borders are keeping borders closed for the time being and the temporary border checks in countries such as Denmark and Germany will be extended. This will lead to queues at these borders and increase the costs of transport.

Economic growth will remain moderate due to the high volatility and obstructions in the Single Market. This will result in rather slow and limited growth of employment. Moreover, limited investment will lead to ageing production facilities and delays in the introduction of innovations. Productivity growth and labour productivity growth will decline and the structural growth of production potential will subside to a lower level. There will be little increase in prosperity.

Monetary policy will remain accommodative for a long time in this scenario and the European Central Bank (ECB) will continue its quantitative easing. Continuing low to extremely low interest rates will mean that pension fund coverage ratios will remain under pressure, which in the Netherlands will mean a continuing series of contribution increases and curtailments of pension benefits. Policy measures such as monetary financing - whether via the intervention of the EIB or not - will remain off the table. Because unrest will continually recur mainly in the weaker Member States, they will on occasion have to cope with higher interest-rate risk spreads on government bonds, despite an accommodative monetary policy.

The negotiations on the proposed Brexit (see Prins et al., 2016/2017) will degenerate into a lengthy, difficult and acrimonious process. Over the lengthy negotiation period, feelings will run high with many bitter exchanges. Through these years, there will be much uncertainty regarding the final outcome, even though it will be abundantly clear that there can be no outcome that is positive for all the parties involved. This is bad for confidence, investment and economic growth, both in the EU and especially in the UK. Ultimately the UK will leave the EU with unsatisfactory agreements, thus avoiding a domino effect leading to the further disintegration of the EU (de Groot, 2016). The British will lose some of their access to the Single Market and the European passport rights for banks located in the UK from the EU will be weakened. The UK economy will enter a slower growth path, direct investment in the UK will dry up and reverse over time, and dozens of banks will move their European head offices from London to a financial centre in the EU. On the other hand, the British will gain more sovereignty with respect to migration policy.

In the prelude to and during the negotiations, other Member States will become aware that leaving the EU is an extremely expensive option. In the Netherlands, the PVV will become one of the largest parties, but it will not win an absolute majority in both houses of parliament (Groenewegen and Vrieselaar, 2016). Marine Le Pen will not become president of France. At the same time, there will be no powerful pro-EU government or president to breathe new life into European integration. There will be no referendum on membership of the euro in Italy. The Five Star movement now no longer considers this to be a top priority. The new party hopes that this approach will avoid the need for a lengthy process of constitutional amendment and win greater support from the centre ground of the electorate. Even Greece will remain in the eurozone. When push comes to shove, there will continue to be enough money lent to the Greeks to enable them to muddle through. The result will be one crisis after another, with repeated unrest throughout the eurozone and negative effects on general confidence in the European cooperation. Further integration will be unlikely.

There will be only minor progress in the area of security of the EU’s external borders and military cooperation between the EU Member States. There will be no EU army, but there will be partially collective border controls on Europe’s external borders. The countries around the Mediterranean will remain individually responsible for protecting their borders and returning illegal refugees. This will mean continuing heavy pressure on the EU Member States on the periphery.

The agreement to allocate refugees across the Member States will also not decisively succeed; compliance with the agreements made will be only cursory. The deal with Turkey will moreover not completely prevent irregular refugees entering Greece and making their way into other European countries. The flow of refugees will sporadically increase again. More and more will choose the Italian route and the border controls there will also not be fully adequate for the time being. A deal similar to the Turkish deal with North African countries is not currently a possibility, although this cannot be ruled out in the future.

Europe will also be shocked by terrorist attacks from time to time. While these attacks have little to do with the refugee problem, they have a negative effect on general sentiment towards foreigners. In other words, the refugee crisis will continue to cause Europe problems and boost anti-EU sentiment because the EU will not be able to come up with a real solution to the problem.

The European agricultural policy will also come under pressure. In practice, this will mean renationalisation of agricultural policy in difficult areas where no compromise can be found. Ultimately, this will lead to less of a level playing field between the various countries (see box). Competitive relationships will be increasingly distorted and the Single Market will come under increasing pressure. Over time, there are two important trends. Firstly, we will have a ‘race to the bottom’ with respect to quality standards and secondly, there will be a ‘race to the top’ with national subsidies for domestic agriculture. Although traditionally less disposed to granting subsidies and more inclined to favour quality standards, the Northern Member States will also come under pressure from their agricultural grass roots to participate. Internal tensions will increase, leading to growing dissatisfaction with Europe and the Single Market. This will be expressed for example in an increasing number of protests against imports of agricultural products from other Member States.

Box: How the introduction of genetically modified crops has turned into chaos

Even now, we can already see that inadequate cooperation can lead to high costs. Previously, the admission of genetically modified crops always required the approval of the European Food Safety Authority (EFSA) and the European Council (of ministers, in this case of agriculture). The European Council is however unable to reach agreement on this issue due to divisions between the Member States. The decision-making has therefore been changed, with far-reaching consequences. Now, after approval from the EFSA, Member States may decide themselves whether they will actually introduce and/or allow genetically modified products. After approval by EFSA therefore, each country can make its own decision to grant approval, whereby social aspects can also be included in the decision-making. Over time, this will almost certainly lead to permission to cultivate GMO crops in one Member State while this is prohibited in another Member State. This raises new complications, since this situation means that the trade in these crops between Member States will be under pressure because the free movement of ‘prohibited’ products between Member States will have to be regulated. This will create further complications and will disrupt internal competitive relationships. There will also have to be more detailed labelling of products. This shows how indecisiveness in one area can affect many other areas.

A similar scenario is possible with respect to income support for agriculture. It is likely that the EU budget for agriculture will contract after 2020 and that there will be more room for Member States to compensate for this decline at national level. This will further disrupt competitive relationships.

The EU is also marking time on the Banking Union. While we will keep the agreements we already have (Loman and Wijffelaars, 2016), there will be no further integration. Up to 2023, the banks will pay into the common settlement fund that took effect on 1 January 2016 as agreed. But there will be no further completion to the structure of the Banking Union. There will accordingly be no fully-fledged European deposit guarantee system, since the Northern Member States take the view that banks in Southern Europe are less solid and that supervision is less effectively organised in that region. They do not want to pay for failing financial institutions in the south. The current negotiations between the Member States will thus result in a compromise that will not meet the original objective of a European deposit guarantee system.

This means that the unhealthy financial nexus between national governments and banks in the Member States will to some extent continue. The introduction of bail-in guidelines and strict regulation on state support (a bail-out) will after all not prevent a situation in which a national government will have to compensate depositors of ‘national’ banks if these banks fail. The absence of an overall European deposit guarantee system moreover means that the financial landscape in Europe will remain fragmented. The result is that the funding of banks and therefore the funding of the private sector will remain more expensive in the south than in the north. This in turn means that the profitability of banks and business investment in the south will be under more pressure than otherwise would be the case, while the reverse applies in the financially stronger countries.

There will also be no fully-fledged capital markets union. The entire process remains stuck in global guidelines for matters such as securitisation and reporting, but a properly integrated capital markets union will not get off the ground. This will prevent the development of alternative sources of funding for SMEs and SMEs will thus continue to have limited access to bond finance (Van de Hei and Treur, 2016). The funding of the private sector will thus continue to depend mainly on the banks, and the economy will continue to be exposed to bank crises.

Budgetary policy meanwhile will muddle along. There will be no centralisation of budgetary policy in Brussels, or collective financing of government deficits using Eurobonds and no transfer union. Economic policy is also still a national matter, with no significant development of cooperation. The Macroeconomic Imbalance Procedure (MIP) remains a toothless paper tiger (Loman and Wijffelaars, 2016). Furthermore, the Stability and Growth Pact (SGP) and the MIP are still separated, making it impossible for the European Commission to compel reforms and investment in return for additional budgetary flexibility.

The SGP still exists on paper, but many countries are failing to meet the agreements. The agreements are amended to some extent now and again to allow for deviations, but in fact the pact is dead. The rules are thus no longer credible. Ultimately, this leads to increasing doubts over the long-term sustainability of government finances in countries such as France, Italy, Spain, Portugal and possibly Belgium. These doubts will surface fully once the ECB’s bond-buying programme comes to an end and yields on government bonds are once again set by the financial markets. This will mean diverse government bond yields and widening spreads.

The ECB will try to prevent spreads widening too far by the threatened or actual purchase of government bonds under its Outright Monetary Transactions programme. If this fails, policymakers in the problem countries will accept a loan from the European Stability Mechanism (ESM). They will be prepared to a certain extent to meet the conditions (conditionality) attached to this assistance. Readiness to reform and cut spending will then however decline once the tensions are eased. The tensions will then return in due course, just as we have seen happen in Greece in recent years. Ultimately, one cannot rule out the possibility that a number of Member States will be forced to a partial write-off or restructuring of their government debt.

The strong action by the ECB and the operation of the ESM means that the sustainability of government debt in Member States with sound government finances will not be at issue, and the euro, the European Union and the EMU will not completely lose credibility. The continually recurring pattern of crisis and half solutions will however create social unrest and anti-EU sentiment in both the problem countries and the ‘healthy’ countries. In the former, because spending cuts and reforms will hit household and business income. In the latter, because once again money will have to be given to ‘weaker and disobedient Member States’.

The Macroeconomic Imbalance Procedure (MIP) remains a toothless paper tiger. The existing macroeconomic imbalances will thus remain. These include large deficits or surpluses in the current account of the balance of payments of the individual Member States, the very poor international investment position of the former crisis countries, the high level of unemployment (especially among younger people) in Southern Europe and the high level of private and public debt in various Member States. The union as a whole remains exposed to shocks as a result of these imbalances, since the individual Member States have to absorb asymmetrical shocks on their own. Ultimately, there could be a shock at any time that calls the sustainability of high private and/or public debt into question, for instance when the ECB ceases its quantitative easing programme. Certainly, in countries that depend heavily on foreign funding as a result of large net foreign obligations (that is, a very negative net international investment position) this could lead to new crises because external funding will dry up. The former crisis countries are exposed in this respect, as they continue to be very sensitive to sentiment in the international financial markets.

A proper internal shock-absorbing system will thus not be put in place, especially now that cross-border movement of people (and thus labour) will be increasingly regulated (by means of border controls).

Since the EU is not really able to solve its problems and is lurching from one crisis to another, its position in the world and multilateral organisations is gradually declining, even though it is still the world’s largest economy. The exit of the UK from the EU will significantly damage the political and diplomatic importance of the EU in the rest of the world. Agreement between all Member States on what stance to take in international negotiations is still difficult to achieve. There has been no progress made on the strengthening of a coordinated foreign policy. Even regarding trade policy, which is still negotiated at central EU level, there is still little progress since individual states can block everything with a veto. The EU is thus increasingly seen as an unreliable partner in negotiations.

 Summary of the ‘Muddling Through’ scenario

  • Europe muddles along with an accommodative but increasingly less effective monetary policy
  • Economic growth remains limited and unemployment declines at a slow rate
  • No powerful boost to spending, but budgetary discipline declines
  • The Stability and Growth Pact continues to exist on paper, but is increasingly less effective
  • The Single Market becomes less efficient as border controls increase
  • Brexit degenerates into a messy divorce, and the UK enters a slower growth trend
  • Difficult progress on Brexit makes other countries less inclined to leave the EU
  • The refugee problem continues to be a divisive issue
  • Neither the Banking Union nor the Capital Markets Union will be completed, and there will be no European DGS
  • High unemployment in some Member States will undermine support for ‘Europe’
  • Over time, the situation will become unsustainable

Consequences for the Netherlands

  • The economy struggles along, averaging 1.4 per cent annual economic growth
  • Unemployment falls slowly
  • The Netherlands continues to be the gateway to Europe
  • Pension fund coverage ratios remain low, and curtailments remain present
  • No currency losses on foreign assets

In the longer term, this scenario of continuing unrest and dissatisfaction with no really effective policy will not be sustainable. It will thus ultimately turn into a different scenario. If the tide does not turn, the EU will head for ‘disintegration’ (if cooperation between the Member States remains poor and political integration therefore fragments). If however cooperation between the Member States improves, the tide can be turned, although there are still several possible outcomes. This is elaborated in the scenarios of ‘further integration’ (if cooperation improves and there is a growing consensus that political integration in the EU has to be deepened), or ‘two-speed’ (if cooperation between the Member States clearly improves and people want to maintain economic cooperation and cooperation in a number of other crucial areas, but also as far as possible want to return decision-making powers in other areas to the national level).

Figure 1: Four scenario’s for the future of Europe
Figure 1: Four scenario’s for the future of EuropeSource: Rabobank

Literature

Baarsma, B.E. & D. van Schoot (2016), Vrijhandel blijft middel om welvaart voor allen te creëren, Het Financieele Dagblad, 4 November 2016

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Boonstra, W.W. (2012), Conditionele Eurobonds als overgangsregime, Economisch Statistische Berichten, 2 March 2012, pp. 134 - 137

Boonstra, W.W. (2016a), Breaking up is hard to do, Rabobank Special.

Boonstra, W.W. (2016b), De voor- en nadelen van Eurobonds, Rabobank Special.

Groenewegen, J. & N. Vrieselaars (2016), Is the Netherlands nex(i)t , Rabobank Special.

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Loman, H. & M. Wijffelaars (2016), The eurozone – completing the monetary house eurozone, Rabobank Special.

Mundell, R. (1961), A Theory of Optimal Currency Areas, American Economic Review, 51(4), pp.657 – 665.

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Shambaugh, J.C. (2012), The Euro’s Three Crises, Brookings Papers on Economic Activity, Spring 2012, pp. 157 – 231.

Smit, H. (2016), De Nederlandse land- en tuinbouw heeft groot belang bij de EU, Rabobank Special.

Teulings, C.N., M. Bijlsma, G. Gelauff, A. Lejour & M. Roscam Abbing (2011), Europe in Crisis, CPB Boek 4, published by Uitgeverij Balans, 14 November 2011.

Van de Hei, L. & L. Treur (2016), SME financing in the Netherlands: an increasingly diverse landscape, Rabobank Special.

Wijffelaars, M. & H. Stegeman (2014), European Commission kijkt toe terwijl Europe uit balans blijft, Rabobank Special.

Wijffelaars, M. (2014), Europese begrotingsregels: feit of fabel?, Rabobank Special.

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Author(s)
Wim Boonstra
RaboResearch Global Economics & Markets Rabobank KEO
+31 30 21 62666
Martijn Badir
RaboResearch Netherlands Rabobank KEO
+31 30 21 62666
Elwin de Groot
RaboResearch Global Economics & Markets Rabobank KEO
+31 30 21 69012
Carlijn Prins
RaboResearch Netherlands Rabobank KEO
+31 30 21 60033
Daniel van Schoot
RaboResearch Netherlands Rabobank KEO
+31 30 21 62666
Maartje Wijffelaars
RaboResearch Global Economics & Markets Rabobank KEO
+31 30 21 68740
Nic Vrieselaar
RaboResearch Netherlands Rabobank KEO
+31 6 2216 2257

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