Brexit — Now What?

brexit-The decision by referendum of the British electorate to depart the European Union — after a campaign in which facts and reason were overwhelmed by emotion and nationalism – was not only unexpected but an exceedingly rare thing.  It was a decision by a major country to withdraw from a major political and economic association with significant geostrategic implications, and to do so on its own, without a military defeat or political revolution. 

Charles Ries examines the history, recent events and possible challenges facing the UK. He is currently Vice President, International at the RAND Corporation and a Senior Fellow whose research has focused on the economics of development. Ries’ three decades in the U.S. diplomatic service include an assignment as Coordinator for Economic Transition in Iraq at the U.S. Embassy in Baghdad (2007–2008), U.S. Ambassador to Greece (2004-2007), and Principal Deputy Assistant Secretary of State for European Affairs (2000–2004). In earlier assignments, Ries was the Minister Counselor for Economic Affairs at the U.S. Embassy in London, and Minister Counselor for Economic Affairs at the U.S. Mission to the European Union. This article is based on remarks given to the Naval War College on September 8, 2016.

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Fog in the Channel, Continent Isolated

charles_p_riesWe live in interesting times.  That, of course, is an apocryphal Chinese curse, but strikes me as applicable to the past year, if not longer in our recent past.

Let’s put aside for now the vexed questions of how to defeat ISIS and deal with the mess in Syria.  Let’s not dwell on China’s militarization of atolls in the South China Sea.  Let’s not worry whether Ukraine can persevere as an independent country desiring to strengthen its relationships to the rest of Europe and the West more broadly.

Rather, I want to talk today about Brexit.  The decision by referendum of the British electorate to depart the European Union — after a campaign in which facts and reason were overwhelmed by emotion and nationalism – was not only unexpected but an exceedingly rare thing.

It was a decision by a major country to withdraw from a major political and economic association with significant geostrategic implications, and to do so on its own, without a military defeat or political revolution.

Poland, Hungary, Czechoslovakia, and the other Central Europeans broke away from the Warsaw Pact in 1990, but as a result of the implosion of Soviet power.  Japan and Germany joined alliance structures with the U.S., but as a result of military defeats.

A decision of this kind is so rare that in the Brexit case it was unexpected, apparently surprising even its advocates.  And as we’ll see, the advocates for Brexit did not have a considered plan for taking it forward, and in fact differed among themselves on what their desired future relationship with Europe should be, and how they might get there.

Today, I want to try to describe the antecedents of Britain’s Brexit phenomenon; give you a broader understanding of how it plays in the EU, including the relationship to the EU’s other troubles; discuss what happens now and what the ultimate outcome may be; and speculate a bit on what it all means for the U.S.

The United Kingdom’s history with the European Union (and the European Community before it) has been episodically ambivalent.  In 1957, at the time of the Treaty of Rome, Britain made clear it was not interested in joining six other countries (France, Germany, Netherlands, Italy, Belgium, and Luxembourg) in creating a customs union on the basis of the European Coal and Steel Community.

Britain (accurately) assessed that a European Economic Community (EEC) would require that it dismantle its Commonwealth preferential trading system based on its pre-World War empire, and feared that membership in the EEC would cost it its global power role.

However, in light of its own poor economic performance, Britain changed its mind quickly. It applied to join the EEC in 1961, but this application was vetoed – twice – in the 1960s by French President de Gaulle.  By the early 1970s, Britain was lagging seriously behind its European neighbors in economic growth and lacked the sense of progress the EEC conveyed.  Under Tory Prime Minister Edward Heath (and with de Gaulle finally off the scene), Britain finally succeeded in joining the EEC in 1973 along with Denmark and Ireland.

The Labour party was split on EEC membership, however, with unions fearful of the impact of membership on British workers.  To quell its internal debate at that time, the Labour government of Harold Wilson staged a 1975 referendum on whether to leave the EEC.  British voters supported membership by 67%, benefitting from strong support of the Tories, in general, and Margaret Thatcher in particular.   Nonetheless, Labour ran its 1983 national campaign against Thatcher (under leader Michael Foot) with a manifesto promising to withdraw (they lost).  That manifesto was memorably called the “world’s longest suicide note.”

thatcher reaganDuring the 1980s, while supportive of European Community  membership, Margaret Thatcher stimulated growing euro-skepticism in the Tory party by the positions she took towards Brussels.  In 1984, Prime Minister Thatcher demanded a better deal on net contributions to the EC’s budget, ultimately winning Britain a substantial “rebate” of its membership contributions.

And she was famously accused of undertaking a “handbagging” to get it.  In 1988, in a famous speech at the College of Europe in Bruges, Thatcher warned against a European “super-state.” In the Treaty of Maastricht in 1991 (under Prime Minister Major), Britain and Denmark insisted on an “opt-out” from a requirement to join the euro.

“New Labour” of Tony Blair took office in 1997 firmly in support of Britain taking a leading role in Europe.  Blair signed up the UK for the EU’s “social chapter.”  In 1998 Britain even joined with France at St. Malo to support a European defense identity separate from NATO, which was uncomfortable for the U.S.  But even so, then-Chancellor Gordon Brown firmly opposed giving up sterling for the euro.  And in the Tory party, euro-skepticism continued to grow.

The euro-crisis began in 2010 with Greece’s sovereign debt troubles.  Britain didn’t participate in the bail-out packages for Greece.  When the EU tried to adopt a new treaty to impose tough budget rules on member states, Prime Minister David Cameron tried to negotiate exemptions, but ended up vetoing it.

Euro-skepticism in Britain continued to grow with evidence of the EU’s fiscal problems, sensationalized tabloid press accounts of “eurocrat meddling,” and, after the 2008 global recession, sharp increases in legal migration to Britain by citizens of other EU countries looking for work in its (relatively) more vibrant economy.

In order to contain the euro-skeptic wing of the Tory party, and to help the party compete more effectively against the then-growing UK Independence Party, David Cameron promised in January 2013 that, in the term of the next Tory-led government, the UK would seek to negotiate new terms for its relationship with the rest of the EU – especially the right to constrain benefit rights for EU citizen-migrants – and, critically, that the new arrangements would be put to a national referendum.

Other Europeans scoffed at the commitment and the idea of Europe “a la carte” that was implied.  But when Cameron and his party decisively won the national election in 2015, the government was committed to the renegotiation and the referendum.

In February 2016, the other EU leaders agreed to make some minor, non-treaty commitments to Cameron on the applicability of the phrase “ever closer union,” ways the UK could constrain benefits to migrant families, and other matters of concern, and the referendum was scheduled for June 23.

The campaign was ugly and emotion-laden.  The Leavers now admit to have used fudged figures and exaggerations of Britain’s contributions to the EU budget. The Remain campaign pursued what critics called “Project Fear,” featuring economic estimates of dire consequences of leaving the EU.

It appears facts had little to do with voters’ decisions anyway.  In a strong rejection of the British elites and the business community, the results on June 23 were unambiguous:  52% for “Leave.”  The London area and Scotland strongly favored Remain, most of the rest of England voted for Leave.

David Cameron resigned the following day.  Brexit supporters had no real plans for how to proceed nor coherent ideas on what kind of future relationship they wanted with the EU.  Boris Johnson, London’s colorful ex-mayor and former  journalist, stood for Prime Minister, but was stabbed in the back by Michael Gove, his former colleague at the top of the Brexit campaign.

theresa-mayIn the end, Home Secretary Theresa May became Prime Minister in July.  Although she had softly favored “Remain” in the referendum, she immediately declared that “Brexit means Brexit,” – whatever that means — and appointed leading Brexit advocates David Davis, Liam Fox, and Boris Johnson to key ministerial positions in charge of the negotiations.

As was pointed out by the Financial Times even before the vote, Leavers are divided about what they are after:  prominent Tories like Liam Fox and Boris Johnson see a UK out of the EU as freed of EU regulatory burdens and more free to pursue a liberal, market-oriented future as the “Singapore of Europe.”

But polls and the results showed that many potential Leave voters also fear globalization and competition, and envision a Britain out of Europe as a Britain opting out of the world of free trade and competition as well as with drastically less immigration.  This dichotomy will affect the formulation and implementation of a coherent British strategy, making it harder for foreign investors and the financial community to calculate the outcome.

What is the EU?

Before elaborating on the Brexit-related choices and risks faced by Britain and its EU partners – and the U.S. – let me just digress a moment to highlight a few key points about the EU itself which are critical to an understanding of the debate.

First, from its origins in 1957 as the European Economic Community, the EU has been a customs union.  This means its members, from the original 6 to the 28 today, eliminated tariff barriers between them and adopted a common external tariff.  By contrast, free trade agreements like our NAFTA with Canada and Mexico eliminate tariffs between members but allow each country to set its own external barriers.

EU (1)In the early 1990s, the EEC became the European Union and went further, establishing a “Single Market,” which eliminated border controls, harmonized regulations, eliminated quotas and other non-tariff barriers, and provided for near-seamless provision of services across the EU.  This was especially important to the UK, given its preeminent financial services industry.

Second, again from its origins in 1957, Europeans agreed on free labor mobility for EU member state citizens, one of the basic four freedoms, with freedom of movement for goods, services, and capital being the other three.

For most of the EU’s history, this bedrock principle has not been very controversial, but beginning in 2004 when poorer Central European countries became members of the EU, freedom of movement has progressively become a bigger issue, nowhere more so than in island nation Britain, with its relatively strong economy and generous welfare benefits.  There are now 800,000 Poles resident in Britain, for example, almost all moving there in the last decade.  As I mentioned, this was a central concern for Brexit voters.

As in U.S., polls show that British voters are also concerned about the economic and security implications of immigration from other parts of the world.  This is so even though Britain has long had a multicultural society and a welcoming tradition for immigrants, especially from the British Commonwealth.

But though these concerns were bound up in the Brexit debate too, there is absolutely no basis for it, as Britain has always had full sovereignty over entry and residence for non-EU nationals, and elected from the outset not to participate in the Schengen Agreement, which eliminated immigration checks on travelers between many other European countries.

The Dog Caught the Car:  What Happens Now? 

For most of its history, the EU did not have an exit clause.  Members were assumed to have joined in perpetuity, consistent with the preambular clause in the Treaty of Rome committing the members to the pursuit of “ever closer union.”  But in the Treaty of Lisbon in 2007, the EU adopted an exit procedure, Article 50, which some thought would enhance the credibility of the Union.

Article 50 sets up a quite rigid process for exiting the Union, and one that has the deck stacked against the exiting member state.  The member state seeking to exit notifies the EU of its intention under Article 50.  It then has two years to negotiate the terms of withdrawal, including matters such as how to handle ongoing EU infrastructure investments, EU institutions in its territory, and personnel matters.

uk-eu-brexitEven if the exiting state and the EU do not agree on terms within the two-year period, unless the EU unanimously agrees to prolong the negotiations, the exiting state will no longer be a member, will not benefit from Single Market or Customs Union provisions, and will lose access to various types of EU funding.

So notify and you’re out two years later, with the impact maybe softened, if and only if, other members are willing.

But what will be a more important negotiation to the UK, or indeed any state seeking to leave the EU, will be the one that determine the terms for its continuing relations with the EU. Here the Treaty is silent.  The new member state must decide its objectives, and must bargain with the other member states.

Britain – and to some extent its EU partners – are at the stage of formulating objectives.  Prime Minister Theresa May held a “retreat” last week for her ministers, saying at the end that Britain will seek a “unique” relationship with the EU, and that it will insist on controls on EU migrants, but otherwise she was not being specific on what kind of an economic and political relationship with Europe the British will seek.

As I noted at the outset, the Brexiters themselves hadn’t thought through these critical questions and to the extent they discussed it before the referendum, they did so in platitudes.  Similarly, Britain’s European and international partners will have to balance very substantial interests and fundamental principles, and to do so in a volatile political environment.

What are the interests that have to be accommodated? Options to consider

What are those interests?  For the British, the other 27 member states of the EU are by far their largest export market, destination for 46% of Britain’s exports in 2015 although anemic growth in the rest of the EU in recent years has hurt the UK along with other EU trading partners.

Moreover, more than 11% of Britain’s economy is represented by its world-class financial sector, based in London.  The City of London dominates European financial markets, benefiting from the EU policy of according financial institutions based in member states with a “single passport” allowing them to offer banking, investment, insurance and other easily financial services throughout the rest of the EU.

And the economic benefits of full EU membership to Britain are worth more to the UK than just the exports of goods and services and the associated jobs.  Foreign investors from all over the world, including the U.S., have invested in Britain in order to serve the EU-wide market of 500 million people.  Typical of concern is the statement of the Japanese Foreign Ministry last weekend:

“Japanese businesses with their European headquarters in the UK may decide to transfer their head-office function to continental Europe if EU laws cease to be applicable in the UK after its withdrawal”, it said.  The statement noted that about half of Japanese firms that are active in the EU, such as car makers Nissan and Mitsubishi, or financial firm Nomura, had chosen the UK as a “gateway to Europe,” adding: “We strongly request that the UK will consider this fact seriously and respond in a responsible manner to minimize any harmful effects on these businesses.”

And for their part, the UK’s European trading partners also have substantial trading interests in Britain’s market.  The other 27 EU member states supply 54% of Britain’s imports, and Germany alone runs a trade surplus with Britain of some 51 billion euros.  There are a lot of BMW and Mercedes cars on Britain’s roads.

norway-euEven these trade measures understate the interconnectedness of Britain and the rest of the EU.  Much of the trade flows in fact are of component parts and equipment traded back and forth as part of the integrated European manufacturing value chain.

In view of these economic realities, one option for a future British relationship with the rest of the EU is to parallel the deal Norway has.  Norway, which last considered – and rejected by referendum – EU membership in 1994, nonetheless negotiated full reciprocal single market access to the EU for its goods and services.  It also pays a share to the common EU budget roughly equivalent to what it would have paid had it been a member, although it has no voice in setting the budget or common EU policies.

And in exchange for the economic benefits, Norway has agreed to allow free movement of EU citizens into its territory, for residence and employment.  Such a provision would be problematical for Britain in light of its referendum and its voters’ allergy to EU migrants.

Another model for Britain might be something along the lines of the “Swiss” model.  Switzerland has a complicated sector-by-sector agreement with the EU, which, like Norway’s deal, requires the Swiss to pay into the common EU budget.  The Swiss actually restrict EU banks from full access to their financial sector and have some other opt-outs from the EU single market, but do provide free movement for EU citizens.

However, in their own referendum last year, the Swiss voted to change the deal to restrict free movement into Switzerland by EU citizens.  The EU is not amused and is threatening to restrict the trade benefits in response, setting a deadline of 2017 to resolve the disputes.  So the Swiss model doesn’t have much to offer if obtaining restrictions on free movement is really Britain’s most important objective.

Some Brexit advocates have suggested that what they really would like is a “free trade” relationship with the rest of the EU, rather like the agreement recently concluded between the EU and Canada.  Such an agreement would eliminate tariffs on industrial goods, but not really touch agriculture or services.  Some Brexit advocates have envisaged Britain becoming a free market “Singapore of the Atlantic.”

But there are problems with this vision too:  while it would free investors from EU regulatory risk as Apple experienced in the recent Irish tax case, it would sacrifice the City of London insiders’ advantages in supplying financial services to the EU, and might put at risk the interests of existing foreign direct investors in the UK, as was articulated by the Japanese.

Even on migration, Britain has interests on both sides.  While the electorate wants to see constraints on free movement by Europeans into Britain, Britain has over two million of its citizens residing in other EU countries and it must be mindful of them as well.

The problems with these models no doubt underlie Prime Minister May’s comments about the UK seeking a “unique” relationship.

There are also political and security interests to consider.

NATOBritain’s membership in NATO, one of the cornerstones of transatlantic security, is of course not directly put into question by the Brexit process.

But the UK’s strong defense and security institutions have played a leading role in the development of the EU’s Common Foreign and Security Policy, and its defense identity and institutions.  Along with France a permanent member of the UN Security Council, Britain has given CFSP clout and coherence.

Britain benefits from the EU’s counter-terrorism cooperation and is one of the biggest beneficiaries of Justice and Home Affairs cooperation more broadly.  Britain is one of the biggest users of the EU common arrest warrant.

But if it withdraws from EU membership, Britain will have to find a new way to relate to its European partners on many of these issues.  For some matters, NATO councils will become more important, but for regulating data privacy, intelligence exchanges, and counter-terrorist operations, new mechanisms will need to be found.  And if Britain suffers a growth penalty for leaving the EU, it will have less revenue to spend on the common defense.

What Happens Now?

We are now in the “phony war” period of the Brexit process.  As I noted, the British are working to define their interests and created two new cabinet departments, one tasked with managing negotiations with the EU, and one separately responsible for talks with other trading partners.

There are few public clues about how the British will rank-order their interests, apart from repeated commitments that they must obtain control over migration flows.  But how much control, in what circumstances, remains to be defined.  In the latest news, Prime Minister May rejected the idea of a points-based system for regulating migration as the Australians do, leaving the strategy for this key issue unclear.

Other Europeans are setting out their objectives as well.  European institutions, such as the Commission or the Council, have been the most hard-line, seeing a risk that concessions to Britain may unravel the entire European construct.  Anti-EU parties in some member states including the Netherlands, Hungary, and France, have taken heart from Britain’s Brexit decision, and have begun to press in their own political systems for withdrawal decisions.

Angela Merkel of Germany, perhaps Europe’s pre-eminent leader, has been typically cautious, pushing back against Europeans plumping for starting the Article 50 process immediately after the British referendum.

But Merkel has her own problems, related to a different set of migrants, the asylum seekers fleeing turmoil in Syria, Iraq, and Afghanistan.  Her tolerant approach to these asylum-seekers in the summer and fall of 2015 energized far right challengers and just last weekend her party narrowly lost to the “Alternative for Germany” far-right party in her home state of Mecklenburg.

Both Germany and France have national elections next year.  I think it is reasonable to expect that serious negotiations about a post-Brexit relationship between the UK and the EU will only begin afterwards, no matter when the British should start the process with their Article 50 filing.

But resolution cannot take too long:  the EU is beginning formulation of its next 5-year budget, and foreign direct investors and banks will not wait long before making future-oriented decisions about their British subsidiaries.  Immediately after the June 23 vote, the pound sterling fell by 10% and it has not recovered.  Britain needs continued access to international capital to grow and prosper.

uk-eu-pptMy own feeling as to the ultimate outcome is that Britain will succeed in getting the “unique” relationship it aspires to, but it will come at some considerable cost compared to the status quo.

Such a unique relationship will involve industrial free trade, but not full “passport” rights for financial services firms in the rest of the EU.  Other leading European member states, especially Germany and France, may want to use their leverage to claw back financial industries from Britain.

Agriculture will not be included in free trade, and London will be left alone with the financial burden of supporting British farmers who have become accustomed to generous EU subsidies.

Poorer regions of the UK will lose access to EU regional funds, and will be dependent on London’s generosity.

The UK will obtain the ability to administer some sort of system for regulating or capping migration from EU citizens, but there will be constraints on how restrictive it may be.  It is conceivable that in the new UK permanent residence system, EU citizens would retain some advantage over non-EU citizens.

I think it is likely that the UK would continue to participate in the EU’s science and research programs, as other non-members such as Israel do.

And once the parameters of the UK’s economic and political relationship with the EU are clear, and perhaps even before the agreements take effect, I expect the UK will seek to negotiate free trade and investment agreements with the U.S., Australia, Canada and perhaps Japan.

What will be the impact on U.S. interests? 

Finally, it is worth asking what Brexit means for U.S. interests.  I think President Obama was right to signal during his visit in April that the U.S. believes its interests are best advanced with Britain as a full member of the European Union.  There are too many examples of European legislation or initiatives over the years that have been meaningfully improved by British diplomacy.

And American direct investors in Britain, with equity valued at almost $600 billion, and control of assets in the trillions, unquestionably have benefited from Britain’s full membership in the EU.

But if the British people, in accord with democratic principles, are deciding to withdraw from the EU, it is in the U.S. interest that the UK continues to have as close a relationship as possible, economically, politically, and strategically, with the European Union.  The EU’s continued strength and coherence, and its outward orientation, is consistent with U.S. interests in the European continent and globally.

british-army-troops-iraqFor without Britain at the table, EU security and defense cooperation, its common foreign policy, and European development assistance efforts will have less clout in the world.  The EU will be hard pressed to cooperate with the United States in tackling security challenges globally.  Moreover, without Britain’s pragmatic, global approach, the remaining EU members may drift in unpredictable directions on foreign policy, to the benefit of aggressive, at times hostile powers like Russia.

Economically, the conclusion of a free trade agreement with the European Union, the so-called Transatlantic Trade and Investment Partnership, continues to be strongly in the interests of U.S. and European businesses and consumers, even though it is challenged presently in the European political context.

Duty-free access to a European market of 500 million consumers, cooperation in regulation, and protection of our $2 trillion worth of investments in Europe is would be a good thing for us, as it would be for Europeans.  If the British withdraw from the EU, the UK could nonetheless join TTIP (the draft presently has an accession clause) and have access to free trade benefits in both directions.

And if, in the end, the Europeans balk at a TTIP, it would be in the U.S. interest to negotiate a free trade agreement with Britain, or alternatively to bring the UK into NAFTA.  It would be no substitute for Britain’s securing preferential trade access to the EU, nor would it replace the potential benefits of a TTIP for us, but if that’s the best we can do, we should do it.  And, in the uncertain political environment we face for trade in the U.S. now, Britain-in-NAFTA would be easier to achieve politically than either the Pacific Basin TPP agreement or the TTIP itself.  Maybe, to use the memorable phrase from the Sermon on the Mount , it would be “sufficient unto the day.”

So that’s my take on Brexit and what it means for Britain, Europe, and the U.S.