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
