Ian Stewart is  Deloitte’s Chief Economist in the UK. This is his Monday Briefing, a succinct and eclectic weekly take on economics and finance.

Where can the EU go from here?

The Brexit vote has set the UK on a new path. The form Brexit takes will take time, possibly years, to emerge. But there is another, and for me, more fundamental question facing Europe.

2017 marks the sixtieth anniversary of the foundation of the European Union. Its founding principle was progress to “ever closer union”.  Today, amid challenges created by low growth, migration, the growth of insurgent political parties and Brexit, this principle is in question as never before.

Concern about the direction of the EU has spread from the fringe to the mainstream. Angela Merkel, a politician not given to hyperbole, has said that Europe is in “a critical situation”. In his state of the Union address last September the President of the European Commission, Jean-Claude Juncker, talked of the “existential crisis” facing the EU.

Donald Tusk, the President of the European Council, analysed the crisis in stark terms, “the spectre of a break-up is haunting Europe….Obsessed with the idea of instant and total integration, we failed to notice that ordinary people, the citizens of Europe do not share our Euro-enthusiasm. Disillusioned with the great visions of the future, they demand that we cope with the present reality….Today, Euro-scepticism, or even Euro-pessimism have become an alternative to those illusions. And increasingly louder are those who question the very principle of a united Europe”.

This is a far cry from the rapid political and economic integration of the 1990s and early 2000s. For most of its existence the EU has responded to crises with further integration. The EU’s response to the underperformance of Europe’s economies in the 1980s was to double down on creating a free market in good, services, capital and labour. The launch of the Single Market in 1992 marked a new phase of speedy integration and was followed by the Schengen Agreement of 1997 which created free movement of people across most borders and, in 1999, the launch of the Single Currency.

The high water mark of EU integration came in 2004, with the biggest single expansion of the EU in its history, with ten new countries, mainly in central and eastern Europe, joining the Union. In 2007 Romania and Bulgaria became members.

Since then institutional enthusiasm and capacity for integration has receded. Deep recessions in some euro area countries and tensions in the operation of the Single Currency and have sharpened concerns about the ability of the EU to deliver growth. Borderless travel in Europe has been imperilled by the re-introduction of border controls to reduce migrants and refugee flows in several countries, including Sweden, Austria and Hungary. Dissatisfaction with the status quo has fuelled the rise of Eurosceptic political parties across the EU. Populist parties of the extreme left and right in France, Germany, the Netherlands, Denmark and Italy are calling for referenda on EU membership in their countries.

In the years of integration before 2008 financial markets focussed more on the performance of the euro area as a whole than the countries within it. The creation of the Single Currency, and the view that it, and economic integration, were forever, led to a convergence of borrowing costs for governments across the euro area. Countries with traditionally high borrowing costs, such as Italy or Greece, saw interest rates plummet to near-German levels. The Single Currency convinced investors that the risks attached to lending to the Italian or Greek government were not significantly different from the risks of lending to the German government, one of the world’s most creditworthy. Investors took the view that integration was irreversible. But that assumption has been under pressure since the financial crisis and bond yields have de-converged as investors try to protect themselves against the risk of countries leaving the euro. Today Germany’s annual cost of borrowing, at just 0.3%, is near an all-time low. Greece pays more than 20 times as much to borrow.

The challenges of recent years have revealed important differences of opinion within the EU. The views of central and eastern member states on migration have tended to diverge from those of the Commission and western countries. The euro crisis underscored the tension between Germany’s commitment to sound finances and low inflation and the needs of the indebted, recession-stricken economies of southern Europe. Today Germany opposes a Europe-wide system of deposit insurance to protect investors in banks. To its supporters in the Commission deposit insurance is vital in guarding against future financial crises. Germany worries that it could be left to foot the bill for reimbursing depositors in failed banks in other euro area nations.

In its response to Europe’s malaise the EU sought initially, as it has in the wake of previous crises, to double down on integration. The Five Presidents’ Report, published in June 2015, provided a roadmap to achieve a fiscal and, ultimately, political, union. Rising Euroscepticism and divisions of opinion between member states have put a brake on such plans. As one commentator has noted, just 18 months on from its publication, “the Five President’s Report reads like a science fiction novel. Even Mario Draghi, the President of the European Central Bank, and Jean Claude Juncker, President of the European Commission, the main backers of deepening the economic and monetary union, have toned it down” (euroactiv.com, 11th October 2016).

For the first time the EU is likely to be in a phase of simultaneous contraction and expansion. The focus seems to be on getting institutions to work and deliver for voters. In some areas, as with Brexit or perhaps with borders, there may be a rolling back of the EU. It is conceivable that, in time, some members of the euro area leave. In other areas, particularly defence and security cooperation, the EU wants to push forward. But this sort of pragmatic reform may struggle to deliver the fundamental, and often politically difficult, changes which could strengthen the EU.

Another feature of the new order is a growing role for nation states in decision-making. Cooperation between governments, rather than proceeding as one, is the order of the day. This is not wholly new. The single currency marked a leap forward for integration but it excluded the UK, Sweden and Denmark at birth and now excludes most of the new members in central and eastern Europe. The UK and Ireland opted out of the Schengen passport free zone. The campaign to topple Libya’s Colonel Gaddafi was a NATO operation, though Germany and the central European nations did not contribute forces. More recently over migration and the euro crisis it has been heads of states, not the European Commission, who have been in the driving seat.

The difficulty of achieving agreement between 28 member states – 27 without the UK – points to more cooperation between like-minded nations to achieve shared aims.

Paradoxically, many supporters of greater integration think such an approach would keep alive the dream of political and economic union by enabling an inner group of countries to press ahead with integration. France’s former president, Valéry Giscard d’Estaing, recently described the six founding members of the EU, along with Spain, Portugal and Greece, as “real Europe” which, he said had the “European spirit”. Giscard did not see the UK and the Scandinavian, central and eastern European nations as having the same centrality or commitment to the European venture.

An EU in which all members states proceed in unison may well have passed. The one size fits all approach looks out of step with today’s reality. But if “ever closer union” has run out of steam what will replace it? My guess is that it will be flexible coalitions of willing states. The future direction of the EU, not Brexit, is for my money, the biggest question facing Europe today.

Markets & News

The FTSE 100 ended the week up 1.7%, a record 12th consecutive closing high as shares in housebuilders rallied.

Here’s our take on what we think are the big economic stories of the week:

Global economics and politics

* The World Bank forecasts that global growth will pick up from 2.3% in 2016 to 2.7% this year.

* The German economy grew by a faster than expected rate of 1.9% in 2016, up from 1.7% in 2015. Government spending was up by 4.2%, partly because of an increase in spending to assist asylum seekers.

* French industrial production rose faster than expected in November pointing to an acceleration in French growth at the end of 2016.

* World food prices rose in 2016 for the first time in four years.

* The UK’s Institute of Fiscal Studies reports that after taxes and benefits income inequality in the UK has declined in the last 20 years.

* Apple announced plans to build a significant new business in original TV shows and movies, potentially making it a major Hollywood player.

* The United Arab Emirates plans to invest $163bn in projects to generate half of the nation’s power needs from renewable energy.

* Billionaire US investor George Soros has reportedly lost $1bn since Donald Trump’s election victory having staked significant amounts on equity markets falling on the vote.

* French presidential candidate Marine Le Pen praised the “economic patriotism [and] intelligent protectionism” of Mr Trump, saying “[Trump] is putting in place measures I have been demanding for years.”.

* Amazon announced plans to create over 100,000 new jobs in the US over the next 18 months.

* A group of Members of the European Parliament called for a universal basic income to be “seriously considered” to counter job losses from automation and artificial intelligence.

* Leisure firm Whitbread announced that revenues for their London hotels rose by 23% on a year earlier at the end of 2016 as a weaker pound boosted tourism.

* Rhodium Group and the Mercator Institute for China Studies report that Chinese investors spent four times as much on acquisitions in the EU in 2016 as European companies spent in China. The report has added to concerns about unequal access to markets as “Chinese interest is growing rapidly in sectors that remain restricted to foreign investors in China.”

Brexit and European politics

* In a major speech on Brexit on Tuesday 17th January UK Prime Minister Theresa May will set out plans for controlling migration and identify priorities for the negotiation.

* The main lobby group for the City of London, CityUK, has dropped its previous commitment to “passporting” financial services into the single market and is now arguing for “equivalence” rules that would allow UK businesses to operate within the EU if they offer the same similar protection as EU rules.

* According to the outgoing US ambassador to the EU Donald Trump’s transition team have called EU leaders asking which country will be next to leave the EU.

* Ratings agency Fitch said that UK businesses across all sectors will remain resilient after Brexit, even in the event of a “hard” Brexit
* Following a series of meetings with Republican congressional leaders, British foreign secretary Boris Johnson claimed that the UK is “first in line” for a post-Brexit trade deal with the US.

* Chancellor Philip Hammond said that the UK may be forced to “change its economic model” if it was locked out of the single market after Brexit.

* Bank of England governor Mark Carney said that the immediate risk posed by Brexit to the UK economy have declined but remain “elevated”. He said that the biggest concerns are that Brexit could “amplify” dangers to the UK economy from mounting consumer credit, a weaker commercial real estate market, the current account deficit and a falling pound.

* Mr Carney also said that while Brexit holds risks for the UK’s finance sector the risks to financial stability from Brexit are greater for the EU than for the UK.

* Numbers of asylum seekers to Germany fell significantly in 2016, with a drop of more than 600,000 on the previous year attributed to the closure of the Balkan route and the migrant deal between the EU and Turkey.

* Up to a quarter of German businesses expect to see benefits from business being diverted from the UK, compared to fewer than 10% who are seriously concerned about negative effects from Brexit according to the Cologne Institute of Economic Research.

* The president of the BDI, the German employers’ federation, publicly backed Berlin’s tough stance on Brexit negotiations, telling journalists there could be no question of Europe bowing to British demands for immigration controls.

* The UK will remain under the rules of European courts well into the 2020’s, according to the prime minister of Malta, who claims the European Court of Justice would have to continue “dishing out judgements” if the UK wanted transitional arrangements after Brexit.

* The UK’s first centre for Brexit studies will be launched by Birmingham City University, which claims to be the first UK region to broker experts from government, the private sector and academia to study the consequences of the vote

And finally…

* A US businessman in dispute with the Department of Motor Vehicles has paid his $3,000 tax bill using five wheelbarrows containing 300,000 coins. These took staff, working until late, at least seven hours to count – Grand Heft Auto.

Ian Stewart is  Deloitte’s Chief Economist in the UK. His Monday Briefing can be subscribed to here