Brexit Delay - A danger to Germany's economy

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Brexit was widely projected to be catastrophic for the U.K.’s economy. For a while after the 2016 referendum, it did not appear to have anywhere near the effects feared. But that might finally be changing. The economy contracted by 0.1 percent in the previous quarter, and the latest surveys show business confidence falling sharply. Yet what the forecasts didn’t fully appreciate was the damage that would be done to the economies across the channel, most importantly Germany’s, and what that could do to the European Union’s negotiating position on Brexit.

The ongoing trade war between the U.S. and China, the world’s two largest economies, has shaken confidence everywhere, but it hasn’t been disastrous for export-dependent countries like Germany. To be sure, German exports to both markets (especially China) aren’t increasing as quickly as they were, but in general Germany has benefited from trade diversion. There have, however, been much greater fluctuations in Germany’s trade with the United Kingdom. In the second quarter of 2019, German exports to the U.K. – its fifth-largest export destination last year – were down nearly 15 percent compared to the same quarter in 2018. Not coincidentally, German gross domestic product also contracted in the second quarter by 0.1 percent. Exports contributed minus 0.7 percent to quarterly GDP.

The question of trade

Data from the past year is similarly enlightening. In the third quarter of 2018, exports to the U.K. were down 6.9 percent year over year, and German GDP followed, shrinking by 0.1 percent. Conversely, in the first quarter of this year, when U.K. businesses were hurriedly stockpiling in anticipation of Brexit, German exports to the country rose by nearly 6 percent year over year, and the economy as a whole grew by 0.4 percent, tying its best quarterly growth number since 2017. To be sure, there are other factors at play, but for an economy as dependent on exports as Germany’s (net exports accounted for about 6.7 percent of German GDP in 2018) trade fluctuations with a major partner matter. In fact, a repeat of Brexit stockpiling over the next few months could be the thing that keeps Germany from slipping into a technical recession this quarter.

If the U.K. were to leave the EU on Oct. 31 without a transition agreement that would effectively keep the current trade relationship in place for a brief period, the German economy would be on the front line of those hit hardest by new tariffs and supply chain disruptions. The Halle Institute for Economic Research predicted that a no-deal Brexit would cost 100,000 German jobs. Manufacturing centers in southern Germany could be particularly affected. The International Monetary Fund estimated last year that Germany’s GDP would be 0.5 percent smaller by 2030 if the U.K. left without a deal than if Brexit didn’t happen.

Significant softening of the Irish backstop

These assessments don’t account for the damage caused by prolonged uncertainty and the consequent dampening effect on investment. The managing director of the Federation of German Industries, or BDI, the country’s powerful industrial lobby, said in January before the first Brexit extension that German businesses had mixed feelings about a delay, and before the second extension in April, the BDI said, “The negative effects of each new extension are coming dangerously close to the potential damage of a disorderly Brexit.”

Given the German economy’s exposure to the U.K., its ongoing manufacturing sector slump and the increasing agony of being stuck in Brexit purgatory, one might expect Berlin to be turning up the pressure on Brussels to strike a viable transition deal with London, whatever the cost. This would entail a significant softening of the Irish backstop or possibly its removal from the withdrawal agreement. Germany is indeed among the more dovish member states when it comes to Brexit. But there are four significant obstacles to a major policy reversal by the Germans.

Why Germany is holding fast

First, a volte-face would devastate European unity at a critical moment. The most pessimistic forecasts in the immediate aftermath of the Brexit vote saw the U.K. as the first domino in the dissolution of the European bloc. (Michel Barnier, the bloc’s chief Brexit negotiator, has recounted how Brexiteer Nigel Farage told him at one point that “after Brexit, the EU will no longer exist.”) Instead, the member states rallied together and, for the most part, have stayed united in the face of what is perceived as an assault on the entire integration project.

For Germany to lead a change of course, it would have to get several other member states on board, most importantly France and Ireland. Convincing Paris would be a monumental challenge given French strategic interests, but moving Dublin without a very public bullying campaign would be impossible. The backstop is an existential concern for the Republic of Ireland; acceptance of a border on the island would undo the significant progress Dublin has made, after centuries of struggle, toward its strategic imperative of full control of the island with the 1998 Good Friday Agreement. Were the Germans to steamroll a member state on such an important strategic matter, they would shatter EU unity and confidence in the benefits of membership.

Italy could be emboldened to join the U.K.

Second, Germany depends on the frictionless trade of the EU’s single market as much as any member state. Its exporters’ supply chains span the Continent and extend into the U.K. Leaving open the single market’s external border in Ireland risks undermining the integrity of the whole project. Other countries that have trade agreements with the EU, such as Turkey or Ukraine, would demand the same treatment. What’s worse, other, more euroskeptic member states like Italy could be emboldened to join the U.K. in heading for the exit with the expectation that they, too, would not lose their single market access.

Moreover, the European Union and Germany worry about the long-term effect of giving the U.K. seamless market access without forcing it to play by the same rules as EU economies. It’s an imperfect parallel, but an unpublished European Commission analysis, for example, concluded last year that EU GDP would be as much as 9 percent lower after 15 years (compared to the status quo) if the U.K. aligned with EU rules on goods but diverged on services. Such an outcome would enable the U.K. to gain a competitive advantage and undercut European producers in a variety of sectors. Compare this to the damage of a no-deal Brexit, which the IMF gauged to be about 1.5 percent of GDP for the EU by 2030.

No incentive for Berlin or Brussels to cave

Third, the EU negotiating position is popular in Germany. A survey in January by German public broadcaster ZDF found that 73 percent of Germans opposed any further concessions by the EU, with only 20 percent in support. Similarly, after the second extension of Brexit talks in April, 60 percent of Germans told ZDF that the delay was a bad thing – suggesting that a majority believed no deal would have been preferable to more uncertainty – versus 32 percent who supported it. The BDI’s public statements indicate that business shares this sentiment. Essentially, the German government is not under significant domestic pressure to back down, despite the potential costs.

The final obstacle to a German push for concessions on Brexit has to do with British domestic politics. There is no confidence that removing the backstop would be enough to win support for the withdrawal agreement in Parliament. The last time the EU softened the backstop at the request of the British government, which promised the compromise would help it push the deal over the line in the House of Commons, it accomplished nothing. (In fact, it was probably counterproductive, leading to charges that the EU was plotting to trap the entire U.K. in a customs union to kill off the “global Britain” vision.) In addition, the most hard-line Brexiteers in the ruling Conservative Party have vowed to vote against the withdrawal agreement even if the backstop is dropped. And the European Commission said on Tuesday that the U.K. government had recently demanded other changes to the terms of the agreement. Given this uncertainty and the damage to the EU associated with the first and second obstacles, there’s no incentive for Berlin or Brussels to cave.

The Political Calculus

Germany’s economy is wobbling on the edge of recession. An orderly resolution to the extended dispute with its fifth-largest export destination would go a long way toward resuming growth. But just as calculations in the U.K. are not only about economics, the same is true in Germany.

Germany may be the most powerful country in Europe, but it’s surrounded by other strong states and not powerful enough to dominate all of them. Above all else, it must prevent the formation of European coalitions against it. In this sense, the European integration project has been one of the most successful foreign policy accomplishments in German history. Germany has achieved unprecedented peace and prosperity, along with a semi-hegemonic role in Europe, all without turning its neighbors against it. It would take much more than what Germans expect would be the sharp but short-lived shock of no deal to convince Berlin to risk a strategy in Europe that has succeeded for almost 70 years.

A closer or looser relationship?

But neither is the U.K. in a position to back down, first and foremost because it’s in no position to agree on anything. A significant part of the problem is that large segments of the populations of Scotland and, to a lesser extent, Northern Ireland appreciate the ways in which EU membership dilutes England’s dominion over them and are unenthused by the prospect of total English supremacy after Brexit. On its own, however, this cannot fully explain why Parliament has been unable to pass a withdrawal agreement, seeing as large numbers of English Conservative lawmakers and Northern Ireland’s Democratic Unionist Party (which, until Tuesday’s rebellion, gave the Tories their parliamentary majority) have voted repeatedly against the existing deal.

The more fundamental issue is that the Brexit vote was indicative of the fact that roughly half the population, and more than half in England and Wales, favored some level of detachment from the Continent. But each attempt to define the degree of detachment costs the Brexit movement one or more of its factions that prefer a closer or looser relationship. A no-deal scenario might come closest to achieving consensus, but that is mostly based on the misconception that it would settle the question (it wouldn’t; it’s untenable over the medium term for the U.K. not to have some sort of economic relationship with the Continent) or that it would somehow give the U.K. greater leverage over the EU.

Danger of alienating even pro-Europe Britons

With both sides stuck, the obvious solution is another election in the U.K., as is being discussed – except there’s little reason to think another vote would propel any of the factions in Parliament to a majority capable of pushing through a deal. What it might do is garner enough support for no deal, though again this solves none of the problems. Alternatively, the moment may be approaching – not next month but in the near future – when the grinding cost of endless uncertainty for business and for policymakers convinces the European Union to refuse another delay. This remains a distant possibility, in no small part because of what it could mean for the Irish border and because of the danger of alienating even pro-Europe Britons. But it isn’t as unthinkable as it once was, and that in itself is significant.