EU's Next Challenges Are Geopolitical

Until recently, the greatest risks to European stability were internal. The euro-zone debt crisis triggered tensions between and within member states that at various times looked likely to lead to serious social unrest and even a breakup of the currency union. 

Those risks haven't gone away, as was clear from the European Parliament elections in May, which delivered big gains for euroskeptic parties. Even so, the probability that domestic economic conditions will lead to an extreme outcome in the euro zone has clearly fallen markedly since 2012.

Instead, the most pressing threats to European stability are now external. 

The shooting down of Malaysia Airlines Flight 17 with 298 people on board has dramatically raised the stakes in the war between the government of Ukraine and the pro-Russia separatists in the Donetsk region on the EU's eastern border. If Russian involvement is proved, calls for a far tougher European response than has so far been contemplated will surely be impossible to resist.

Meanwhile, the EU faces massive instability along its southern border in Syria, Israel and the Palestinian territories, Egypt and Libya. European leaders have also been anxiously looking at recent political unrest in Turkey. 

No wonder investors cited geopolitical risks as the second-biggest threat to the U.K.'s financial stability—after a collapse in the housing market—in a recent survey for the Bank of England. 

Yet there is little sign of this anxiety over geopolitical risks in financial markets. Markets barely budged in the wake of the Flight 17 disaster. Indeed, financial conditions have rarely been more buoyant. The Bank of England notes that at short horizons, measures of volatility are at, or are below, precrisis levels in equity, currency and interest-rate markets. Spreads on corporate bonds over benchmark government bonds have tightened to just above 2003-06 levels.

Are markets being complacent? In the short term, perhaps not. There are two main channels of contagion. 

The first is directly through trade. But these linkages are already well understood and European companies and investors have taken steps to limit their exposure to Russia and other conflict zones. German economic growth has softened as a result of the impact of sanctions on Russia, causing Berenberg Bank last week to downgrade its growth forecast for the euro zone in 2014 by 0.1 percentage point, to 1.5%. Fresh sanctions promised by the EU last week before the downing of Flight 17 will clearly hurt growth in countries most directly exposed to trade with Russia, including Germany and the U.K., but they wouldn't likely derail the nascent European recovery. 

The second channel for potential contagion is via financial markets. The risk of a market seizure has been heightened by postcrisis reforms to the banking industry, which have sharply reduced liquidity in financial markets. Bank of England officials estimate that inventories of financial assets held for market-making have fallen by two-thirds since the crisis, reflecting higher capital charges. 

Regulators argue that the core financial system is now more resilient to shocks and that there are now improved facilities to provide emergency liquidity. But these facilities are untested and steep falls in asset prices in response to a shock can't be ruled out. However, such a shock doesn't yet seem likely, nor is it clear how the market should price this tail-risk. 

But while the short-term risks from geopolitical instability on Europe's borders may be manageable, the long-term challenges are sizable. Violent upheavals in the eastern and southern Mediterranean are already creating refugee crises across southern Europe. In Greece and Italy in particular, the challenge of dealing with large influxes of migrants is a hot political issue. 

Thanks to the principle of free movement of people enshrined within the EU's single market, the borders of countries on the periphery of EU are the borders of the EU itself. That means that tensions on the periphery are quickly transmitted to the core, as migrants head to the richer north, fueling support for right-wing, anti-immigrant euroskeptic parties. Yet the EU has no common policy to police its borders, the burden of which falls on countries often least able to afford it—a point made forcibly by Italian Prime Minister Matteo Renzi in a recent speech to the European Parliament. 

Instability on the EU's borders also fuels instability within the EU. There are concerns in northern European countries such as France and the U.K. at the domestic impact that Middle East conflicts are having on elements of their large Muslim communities. Similarly, Eastern European governments with large ethnic Russian minorities worry about the destabilizing local consequences of the war in Ukraine. 

Until recently, the EU was able to stabilize its borders by holding out the prospect of membership or privileged market access to a queue of other countries knocking at the door, including Turkey, Ukraine, Armenia, Georgia, Moldova and Serbia. 

But concerns over the consequences of free movement within the single market and the crisis in Ukraine have shown that the EU has reached the limits of this approach. Incoming European Commission President Jean-Claude Juncker said last week that no new members would be admitted over the next five years. Yet the EU is struggling to identify an alternative relationship that it can offer its eastern and southern neighbors to enable them to coexist harmoniously.

Besides, soft power alone is unlikely to stabilize the EU's borders. The U.K. government argues that the greatest risk to European security is the failure to defend the principle of national sovereignty. One reason why the situation in Ukraine has escalated out of control is that the EU struggles to exert pressure. EU foreign-policy decisions require a unanimity among the 28 member states that is hard to achieve, given competing priorities. 

At the same time, the EU's defense capabilities are weak. Europe spends only 1.4% of gross domestic product on defense, the lowest of any region in the world, and a lack of coordination among member states further reduces its effectiveness. The result is that the EU lacks credible deterrence capability of its own.

Ultimately, these geopolitical risks could represent a threat every bit as severe as the euro crisis to Europe's cohesion and financial stability. And as with the euro crisis, the solution is likely to lie in closer integration. But the fact that integration is necessary doesn't make it any easier to achieve.

THE WALL STREET JOURNAL, 20/7/2014