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A stabler union

26 October 2015 By Hugo Dixon

The main takeaway from Mark Carney’s speech last week on Britain’s European Union membership was that it is good for economic dynamism but creates challenges for financial stability.

The Bank of England governor’s first point is right; his second point needs qualification. Although EU membership creates challenges for stability, it also gives the UK opportunities to make its economy steadier. If Britain grasps these, the EU can act as a shock absorber.

Membership of the bloc has made the UK more open to trade and more closely linked to other EU economies. As a result, Britain is more exposed to shocks coming from across the English Channel. But membership can also dilute the effect of domestic shocks, as these reverberate across the EU and further afield rather than being contained within its shores.

Britain’s exposure to EU problems is fairly obvious in the wake of the still-fresh euro crisis. Given that 40 percent of UK exports are to the euro zone, recession there acted as a drag on the British economy.

There was financial contagion too. UK banks suffered losses because they lent to euro countries. Meanwhile, euro zone banks cut their lending to Britain as they retrenched, increasing the impact of the credit crunch.

EU membership, which gives UK financial firms a “passport” to operate across the 27 other countries, is also one reason its banking industry has grown so rapidly in the past generation. While this has created wealth, Britain was hit especially hard during the global financial crisis because of its dependency on the industry.

The UK’s ability to share its pain with the rest of the EU is less top of mind. But it is no less real.

When Britain suffers a decline in domestic demand, its companies can find alternative sources of business across the Channel – softening the impact on incomes and employment at home. The EU can provide what Carney calls a “second engine”.

Britons can also take advantage of free movement of labour to find work abroad. At present, EU citizens are coming to the UK because it is generating lots of jobs. But, in future, the tables could be turned.

Free movement of capital helps in a downturn too. Because British savers don’t have all their eggs in the domestic basket, the impact on their wealth and income is cushioned.

The EU’s single market is not perfect. So Britain’s ability to spread shocks to other parts of Europe is not as effective as, say, California’s ability to share its pain with the rest of the United States. But the EU economy is becoming more integrated, in part because of initiatives such as capital markets union, energy union and extending the single market to the internet. So, if Britain stays in the EU, it will find it an increasingly effective shock absorber.

EU membership has also helped make the UK more efficient and fleet of foot, according to Carney, fostering dynamism. This makes it resilient when there is trouble.

A final factor that determines stability is effective financial regulation. Although neither Britain nor the EU did a good job in the runup to the credit crunch, the regime is now better. The UK has had a big influence on those rules: both via its EU membership and because it has weight in global standard-setting bodies in part because it can often bring along the rest of the EU with it.

Carney pointed out that some new EU regulations are not appropriate. The UK doesn’t always get its way. In particular, the bankers’ bonus cap makes it harder to claw back compensation when things go wrong – meaning financiers may have less incentive to take care in the first place.

The governor also argued that closer union among euro zone countries will require more harmonisation of their financial regulations. If so, it will be important to ensure that inappropriate rules aren’t imposed on the UK. Avoiding that risk is rightly one of the government’s priorities as it seeks to renegotiate the country’s relationship with the EU.

On the other hand, the UK benefits from having a single set of high-quality financial rules across the EU. This means it can have reasonable confidence that EU banks operating in Britain are properly regulated.

If the UK were to quit the EU and wanted its banks to operate across the Channel, it would still have to follow the bloc’s financial rules. But it would have less influence on what those rules were, increasing the risk that they were lower quality and less suited to its needs. It would move from being one of the main rule-makers to being a rule-taker.

Carney acknowledged many of these points. But his conclusion downplays some of the positives of being part of the bloc. Provided the UK fights to improve financial regulation and the single market’s shock-absorbing capacity, EU membership will be good for stability as well as dynamism.


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