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Brexit

Brian J. Friedman , CFA, CBE, President, Co-Founder, Chief Investment Officer | June 30, 2016

Voters in the United Kingdom shocked the world by voting to leave the European Union (E.U.) after 43 years of membership. Exiting the E.U. has profound financial, economic, and political implications. Economists – particularly American Economists – tend to view the European Union as a free trade zone. As such, they worry that the U.K. vote could be a step backward for global free trade and very costly to British exports. Portfolio managers are disturbed by recent currency turmoil and political analysts wonder whether more countries will exit in the coming years. Others see parallels with rising populism in the United States. In this moment of shock, most commentators seem to look at Brexit in an ominous and foreboding light. By putting Britain’s decision into its historical and institutional context I hope to explain why both the United Kingdom and the European Union should benefit in the long run.

The U.K. was often at odds with core E.U. principles

Unlike West Germany, France, Italy, Belgium, the Netherlands and Luxembourg the United Kingdom was not a founding member of the European Economic Community (E.E.C. – the predecessor to the E.U.). In fact, France twice vetoed British membership until the U.K. was finally admitted in 1974. Over the years the E.E.C. evolved from a “Common Market” to a more integrated political entity. As the push for political and legal integration gained momentum alongside the original economic goals, the United Kingdom often found itself at odds with key E.E.C. and E.U. principles.

To accommodate their very different legal framework and to retain their participation, the British were given a number of exemptions from core European Union doctrines. For example, British courts do not recognize the “Charter of Fundamental Rights of the European Union,” which is meant to be the E.U. equivalent to our “Bill of Rights.” Just four of 28 member states negotiated an exemption of any type from major European Union rules and Denmark is the only other country with as many opt-outs as the United Kingdom.

In the aftermath of World War II and in the environment of the Cold War, European leaders pushed the envelope of European integration. While some viewed the economic aspects of integration as paramount, many others believed economics could lay a solid foundation for eventual political unification. Most agreed that a gradual shift toward a unified currency could bind Western European countries in a tighter embrace.

The British financial system is incompatible with the euro

In 1979 the European Economic Community took a major step in this direction with a regime of fixed currency exchange rates called the European Exchange Rate Mechanism (ERM). At the time all E.E.C. members joined the ERM – except the United Kingdom. Britain did finally link the pound sterling to the ERM in 1990 but was forced to exit just two years later in the midst of a currency crisis.

In early 1992, the Maastricht Treaty rechristened the E.E.C. as the European Union and formalized the endeavor to create a supranational or federal structure encompassing common political and legal institutions as well as a common defense and foreign policy alongside the existing trade and economic agreements.

The most important provision of the Maastricht Treaty was an agreement to adopt the euro as the common currency of a unified Europe. The Maastricht Treaty required euro adopting countries to converge their fiscal and monetary policies and encouraged lagging countries such as Italy, Spain or Greece to develop higher quality governance institutions like those found in Germany. Britain’s fundamentally different financial system, legal system and painful experience with the ERM discouraged it from adopting the euro.

The British financial system is more similar to the United States than its partners in the European Union. The British financial system is a variegated smorgasbord of financial institutions linked together through dynamic stock, bond and other capital markets. As a result, the British own more financial assets, trade more frequently, experience much larger international financial flows and endure greater market volatility than the rest of Europe where financial markets are less developed.

Except for Ireland and perhaps the Netherlands, the financial system of every other European Union country is dominated by traditional commercial banks. Financial markets and alternative financial institutions play a much smaller role than in the U.K. For legal and historical reasons, many of the commercial banks in core E.U. countries such as Germany, Italy and Spain are government owned whereas British banks are overwhelmingly privately owned.

British Common Law is incompatible with European Civil Law

Differences between the British financial system and the financial systems of other E.U. countries are rooted in their very different approaches to the law. Of the 28 member countries in the European Union, only the U.K. and Ireland are Common Law countries. The remaining 26 countries share a Civil Law heritage. The Common Law approach is to generally allow any contractual relationship that is not expressly prohibited in law. Civil Law tends to take the opposite approach whereby contractual relationships are considered illegal unless authorized by code or statute. As a result, financial innovation is rare in countries governed by a Civil Law system whereas the greater contractual freedom in a Common Law system can be highly conducive to alternative financial institutions and products.

Legal development within the European Union is heavily influenced by the language, institutions, structure and philosophy of Civil Law. How could it be otherwise when just 70 million people out of more than 500 million living in the European Union are familiar with the Common Law? Globally there are more than 150 countries with a Civil Law system, encompassing more than 60% of the world’s population. Common Law countries comprise 35% of the world’s population, but less than half of that total if India’s 1.3 billion people are excluded from the calculation.

The legal system which is so crucial to American prosperity and global innovation is actually quite rare by international standards. It is no accident that a small number of countries with a Common Law heritage – Great Britain, America, Canada, Australia, New Zealand, Ireland, Israel, Singapore and Hong Kong – lead the world in terms of economic activity, financial innovation and technological development.

To British ears the language of a Civil Law project like the European Union often sounds statist and vaguely ominous. Civil law requires explicit legislation governing every aspect of economic life because the courts do not recognize precedent. Unlike Common Law courts which act as an independent and co-equal source of law making authority, Civil Law courts tend to be subservient to the legislature. In Britain, America and other Common Law jurisdictions legislation is typically more general with details settled over time through accumulated court decisions. Judges and courts do not play this role in Civil Law societies, so legislation must anticipate which activities the law seeks to authorize in greater detail.

The average person on a British street may not fully articulate these legal, financial, and economic divergences, but many Brits have a sense that the European Union seems much more top-down than the United Kingdom, with greater regulation and far less economic flexibility and freedom. Participating in this system was fine as long as Britain could have its cake and eat it too with appropriate opt-outs and exemptions, but the economic and financial crisis in the Eurozone accelerated the E.U.’s trajectory.

The European Union is approaching a “make or break” moment

Bank failures in Spain and Greece resulted in massive recessions with unemployment exceeding 25%. Fragile and undercapitalized banks throughout the E.U. – including weak states such as Italy, but also some in France and Germany – forced the European Central Bank (ECB) into the limelight as the only European Union institution capable of decisive action in a crisis. On a political level, default leadership fell to Germany without any well-conceived democratic check or balance within the E.U. governance structure. The crisis revealed obvious flaws that must now be rectified to preserve the euro and perhaps the European Union itself.

The European Union is reaching a “make or break” moment in its history. The common currency linked financial systems together. Financial system failure requires a unified governance structure to muster the financial, regulatory and political resources necessary to fix the problems. Governments can no longer be completely free to determine their fiscal policies in isolation if their monetary policies are linked together through the euro and the ECB.

The financial crisis engulfing the euro region requires the creation of state-like institutions to better manage their common economic fate. Even more importantly these institutions must ease the heavier regulatory burden found in Civil Law societies to achieve faster economic growth. Failure to do so could further fan populist politics and unravel the Eurozone. British exit will hopefully inject a greater sense of urgency into the timid decision making within the E.U.

British exit could prove healthy in the long-run for both the U.K. and the E.U.

As an island the United Kingdom stands apart from Europe physically. Perhaps this physical detachment allowed the British legal, financial and economic systems to develop along a different trajectory from its continental counterparts. During the era of looser political commitments prior to the euro crisis, Great Britain could benefit from free trade without compromising its governance methods. Perhaps it could have maintained this aloof posture indefinitely, but the winds of change are blowing the euro countries toward much tighter integration. These same winds are probably also blowing most of the remaining European Union countries toward adopting the euro, something Britain was very unlikely to do in any foreseeable future.

A European Union without Britain can create a more unified system around Civil Law core principles and procedures. Britain is a trading nation and the Brexit vote did not repudiate its free trade stance. Hopefully, the other powers within the E.U. will not approach the exit negotiations vindictively, but there are limits to their power. Britain remains a member of the World Trade Organization (WTO). Under WTO rules American companies are not materially disadvantaged relative to E.U. member companies. Britain would enjoy the same status.

Britain’s exit certainly increases the risk of trade war and collapse within the European Union, and financial markets are trying to assess this increased risk. It also creates an opportunity to renegotiate the constitutional principles undergirding the European Union while Britain preserves its more economically dynamic traditions. Although it might contain ominous elements at present, Britain’s exit was likely inevitable and probably healthy for the U.K. as well as the E.U.


Investment Insight is published as a service to our clients and other interested parties. This material is not intended to be relied upon as a forecast, research, investment, accounting, legal or tax advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The views and strategies described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only. Past performance is no guarantee of future results.

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