Article IV Consultation with the United States of America: Concluding Statement of the IMF Mission


A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.

The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.

 
The United States economy is, overall, in good shape. A total of 2.4 million new jobs were created over the past year and unemployment has fallen to 4.7 percent, its lowest level since the eve of the “Great Recession.” Inflation remains contained, and the U.S. economy has repeatedly demonstrated its resilience in the face of financial market volatility, a strengthening dollar, and subdued global demand.

Despite these important achievements, the U.S. faces potentially significant longer-term challenges to strong and sustained growth. Concerted policy actions are warranted, sooner rather than later. The latest IMF review of the U.S. economy—the 2016 Article IV Consultation—explores these policy challenges, focusing on the causes and consequences of falling labor force participation, an increasingly polarized income distribution, high levels of poverty, and weak productivity. The IMF’s staff recommends the following policy actions to alleviate these long-running supply side issues:

• Increase state and federal infrastructure investment.

• Adopt comprehensive skills-based immigration reform.

• Expand the Earned Income Tax Credit combined with an increase in the federal minimum wage.

• Upgrade social programs for the nonworking poor.

• Deepen and improve family-friendly benefits including paid family leave and childcare assistance.

• Increase funding for training programs, vocational partnerships, and early childhood education.

Raise the effectiveness of spending on science, technology, engineering and mathematics programs.

• Comprehensively reform the corporate income tax.

• Ratify the Trans Pacific Partnership, conclude a trade and investment treaty with Europe, and resist all forms of protectionism.

Insofar as these measures require additional fiscal resources, they should be funded from new revenues or a reallocation of spending priorities and fit within a path for the fiscal deficit that ensures a steady decline in the public debt-to-GDP ratio.



1. The past few quarters have seen a temporary growth setback. The U.S. is entering its seventh consecutive year of expansion. The unemployment rate has fallen to 4.7 percent, household net worth is close to pre-crisis peaks, and inflation remains contained. Nonetheless, the past few quarters have been characterized by a deceleration that is attributable to a continued contraction in energy sector investment; weak non-energy, non-residential investment; and a persistent drag from net exports (linked to weaker global growth and the strength of the U.S. dollar). Although it is more difficult to find proximate causal factors, consumer demand has also slowed. However, real household disposable income is growing at 3 percent, the housing market appears solid, and both household and corporate balance sheets are in generally good shape (aided by historically low interest rates).

Weighing these various forces, growth is forecast to be 2.2 percent in 2016 and 2.5 percent in 2017.

The output gap is expected to close by end-2017 and PCE inflation is expected to rise slowly toward 2 percent. At today’s levels of the real effective exchange rate, the current account deficit is expected to rise above 4 percent of GDP by 2020, pointing to the U.S. dollar being overvalued by 10-20 percent.

2. There are two-sided risks to the growth outlook. The latest jobs report raises concerns that U.S. growth may be losing momentum. However, jobs data is typically a lagging indicator. Indeed, high frequency indicators point to activity already reaccelerating in the second quarter. Going forward, the U.S. dollar represents a symmetric risk to growth and there are upside risks from oil—both in terms of a delayed effect on consumption (given the rise in the saving rate) and a lesser drag from oil-related investment. The slowdown in non-oil corporate investment, though, is not well understood and may continue to weigh on the outlook in the coming quarters. Downside risks to global growth may also be a headwind. A more complex risk to judge is the possibility that the recent weaker activity numbers actually reflect a lower potential growth rate and a smaller output gap than previously estimated. If true, this would mean the U.S. economy could increasingly bump up against capacity constraints. Further, it could imply that, with less slack in the economy, the near-term will see more pronounced inflationary pressures, necessitating a more assertive increase in policy rates, even in the face of weaker growth. If realized, this risk could have important negative spillovers to the global economy through both lower U.S. growth and higher interest rates.



 3. Despite the ongoing expansion, the U.S. faces a confluence of forces that will weigh on the prospects for continued gains in economic well being. A rising share of the U.S. labor force is shifting into retirement, basic infrastructure is crumbling, productivity gains are scanty, and labor markets and businesses appear less adept at reallocating human and physical capital.

These growing headwinds are overlaid by pernicious secular trends in income: labor’s share of income is around 5 percent lower today than it was 15 years ago, the middle class has shrunk to its smallest size in the last 30 years, the income and wealth distribution are increasingly polarized, and poverty has risen.

4. These secular forces both interact and reinforce each other. Demographic changes are slowing potential growth, delaying the renewal of business equipment, and depressing labor force dynamism.

Reduced dynamism in the corporate sector has the potential to diminish innovation, deepen the loss of middle income jobs, and further polarize the income distribution. Income polarization itself can prevent productivity-improving investments in education by poorer households, lessen social mobility, add to economic insecurity, and limit consumption prospects. The causes of and interactions between these various forces are complex and not well understood. However, what is clear is that these trends are coinciding with a well-documented decline in potential growth (from above 3 percent in the early 2000s to below 2 percent today) that is being mirrored across a range of advanced and emerging economies. If left unchecked, these forces will continue to drag down both potential and actual growth, diminish gains in living standards, and worsen poverty.




5. There is an urgent need to tackle poverty. In the latest data, 1 in 7 Americans is living in poverty, including 1 in 5 children and 1 in 3 female-headed households. Around 40 percent of those in poverty are working. A more generous earned income tax credit (including eligibility for workers without dependents, those under 25, and older workers that are not yet eligible for social security) combined with a higher federal minimum wage would help alleviate poverty.

These two measures would have strong complementarities. The improvements in the EITC can work in tandem with the minimum wage to ensure a meaningful increase in after-tax earnings for the nation’s poorest households. Upgrading social programs to support the nonworking poor would also be a step forward. Efforts to improve K-12 education, investing in early childhood education, subsidizing childcare for lower income families, and expanding needs-based support for tertiary and vocational education can have important effects, over a longer horizon, in reducing the inter-generational persistence of poverty.

 

6. Falling labor force participation is an inevitable consequence of an aging society but those demographic effects can be mitigated. Improvements in the EITC, discussed above, will help encourage work. It will also be important to:

• Adopt family-friendly benefits, particularly as a policy lever to slow the downward trend in female labor force participation. These would include providing means-tested support for childcare and introducing paid family leave in line with standards in ILO conventions.

• Rework the disability insurance program to provide incentives for beneficiaries to work part-time (rather than drop out of the labor force).

• Finally, perhaps the largest effect on the labor supply would come from an agreement on an immigration reform that is skill-based, changes the underlying demographic trends, reduces the dependency ratio, and raises the average level of human capital in the labor force.



7. Raising productivity and bridging the skill divide will be essential. Since the boom of the late 1990s, total factor productivity has slowed significantly. This appears to be a global trend that is not confined to the U.S. Notwithstanding this, public policy tools could help facilitate innovation and technological progress, and support efficiencies in private activity:

 
 


Expanding infrastructure investment. The public capital stock is aging and has been declining as a share of GDP for some time. New investment is urgently required to improve the quality and reliability of infrastructure, particularly for surface transportation. This will help remove bottlenecks and congestion and add to the productivity of private activity. Public projects to upgrade infrastructure technologies (e.g. in high speed rail, ports, or telecommunications) would be particularly valuable. In parallel, innovative solutions should be sought to facilitate the financing (both public and private) of U.S. infrastructure. It is estimated that such investments could cost about 5–8 percent of GDP over the next 10 years.

• K-12 education. There is a clear need for better spending on education so as to raise educational outcomes. This could include prioritizing funding for early childhood education (including financing of universal pre-K) and supporting science, technology, engineering, and math programs.

• Vocational education. Closing the skills gaps would be facilitated by greater federal support for state-level training as well as the expansion of partnerships between industry and higher education institutions to facilitate apprenticeships and vocational training.


 


Trade integration. The free exchange of goods and services has been a hallmark of American economic success. New trade agreements, such as the Trans Pacific Partnership (TPP), cement and extend this principle by going beyond the removal of tariff barriers—which are already low—and include rules on investment, competition policy, intellectual property rights, and regulations. By preserving a level playing field in future growth areas, such as services, the TPP has the potential to set a new standard and pathway for international economic cooperation. It would also aid the U.S. economy by capitalizing on its strength in the fast growing area of tradable services. Resisting all forms of protectionism will also be essential. There will likely be transition costs, to both jobs and incomes, from greater trade integration as well as potential effects on income polarization. The consequences for trade-affected U.S. workers should be taken into account and policy efforts should be taken to mitigate the downsides through training, temporary income support, and job search assistance, including the deployment of the existing trade adjustment assistance program.

Since many of the policies needed to boost growth and tackle poverty will have implications for federal and state budgets, their costs should fit within a deficit envelope that achieves a sustained downward medium-term path for public debt.



8. Near-term fiscal and monetary policies have been well-calibrated to the prevailing economic circumstances but demographic trends and rising interest rates will lead to larger fiscal imbalances over the medium-term. This will cause the federal debt to begin rising in 2019 and exceed 80 percent of GDP by 2022. Regrettably, the U.S. continues to lack a detailed medium-term fiscal consolidation plan to prevent this renewed rise in the public debt. Such a plan would need to target a medium-term federal government primary surplus of about 1 percent of GDP (a general government primary surplus of about ¾ percent of GDP). Achieving this and creating space for supply-side reforms will require actions on multiple fronts:

• Tax reform. A comprehensive reform of the U.S. tax system should aim at removing exemptions, simplifying the system, rebalancing from direct to indirect taxes, and reducing statutory rates for individual and corporate income taxes. Reform of the corporate income tax is badly needed and could help revitalize business dynamism and investment. In addition to rate reduction and a streamlining of business tax expenditures, tax avoidance opportunities should be reduced by tightening income-stripping rules through limits on interest deductions.

For outbound investment, the U.S. corporate tax system should adopt a territorial system but impose a minimum rent tax on the foreign earnings of U.S. corporations. There should also be a mandatory tax on the existing stock of un-repatriated, foreign-sourced earnings (with payment spread over the next several years). For the personal income tax, the structure could be made more progressive so as to help mitigate income polarization and assist the working poor. This could involve capping itemized deductions, including for mortgage interest, to lessen the tax benefit for the most well off. Finally, as has been advocated in past consultations, additional revenues should be generated through the introduction of a federal level VAT and a broad-based carbon tax, including an increase in the federal gas tax (which has been 18 cents per gallon since 1993).

• Pension reform. The expected depletion of the social security trust fund calls for early steps toward fundamental reform of the pension system. These would include raising the income ceiling for social security contributions, indexing benefits and contribution provisions to chained CPI, raising the retirement age, and instituting a greater progressivity in the benefit structure.

• Healthcare cost containment. Recent reforms were accompanied by a slowdown in cost and premium increases. However, more is needed to sustainably lower the path of future healthcare costs. This could be achieved through better coordination of services to patients with chronic conditions, greater cost sharing with beneficiaries, innovations in efficiency technologies (e.g. electronic health care records, remote consultations with doctors, international outsourcing of some diagnostic functions), and changing incentives away from remuneration per procedure and toward payments for achieving specified health outcomes. Higher Medicare premiums would also help address financial imbalances in the publicly-funded health system.

9. Steps should be taken to avoid self-inflicted wounds from future disagreements on the path for fiscal policy. Whatever gains could be achieved in supporting growth through the supply-side measures described above could be easily dissipated by a repetition of past political brinkmanship over appropriations and the debt ceiling. Near-term uncertainties have certainly been diminished by the passage of the Bipartisan Budget Act of 2015, the Protecting Americans from Tax Hikes Act, and the Fixing America’s Surface Transportation Act. However, it will be important to identify more lasting institutional solutions. One possibility would be to replace the debt ceiling with a bipartisan agreement on a clear, simple medium-term fiscal objective (with an integrated view of all budget functions and numerical goals for both debt and deficit).

Alternatively, a legislative process could be introduced that adjusts the debt ceiling automatically, consistent with whatever agreement is struck on the broader budget parameters.

Consideration could also be given to more permanently shifting to a budget cycle where annual spending levels are agreed for a two-year period (helping to divorce budget decisions from the electoral calendar).

10. Evidently, monetary policy should remain data dependent. At this point in the cycle, there is a clear case to proceed along a very gradual upward path for the fed funds rate, conscious of global disinflationary trends and confirming along the way that wage and price inflation are indeed maintaining their steady upward momentum. Given the likelihood and severity of downside risks to inflation, the potential for a drift down in inflation expectations, the Fed’s dual mandate of maximum employment and price stability, and the asymmetries posed by the effective lower bound, the path for policy rates should accept some modest, temporary overshooting of the Fed’s inflation goal to allow inflation to approach the Fed’s 2 percent medium-term target from above. Doing so will provide valuable insurance against the risks of disinflation, policy reversal, and ending back at a zero fed funds rate. The Fed should be clear in communicating its intentions and emphasize that its medium-term inflation goal is symmetric and that inflation could well approach their target from above. If either wage or price inflation becomes visible at a faster pace than is embedded in staff’s current forecasts, interest rates should be raised on a more front-loaded timetable.

11. Regulatory reforms, improved risk management practices, and changing business practices have strengthened the U.S. banking system. Nevertheless, a small number of non-systemic banks with a high portfolio concentration in distressed sectors (notably energy and mining) are likely to see increases in loan losses. Furthermore, a potential worsening of credit quality for auto and commercial real estate loans could create a broader increase in provisioning needs. All in all, though, these downsides represent pockets of vulnerability but are unlikely to prove systemic.

12. Intermediation activity is further migrating from banks to nonbanks and is likely to continue to do so as policy rates increase. For instance, mortgage origination and servicing have, to a large extent, moved off of bank balance sheets into specialized entities that sell the loans for eventual securitization by government sponsored agencies. As the structure of the housing finance industry evolves, the associated risks bear close examination. Many of the policy recommendations for this and other segments of the nonbank system made during the 2015 Financial Sector Assessment Program remain pertinent today. But two areas are worth reiterating:

• Asset managers. To adequately analyze the evolution of interconnections, exposures, and potential buildup of risks among asset managers, there is a strong case to accelerate the work on building a more complete and transparent data landscape of the asset management industry. This should go hand in hand with a structured effort to implement comprehensive stress testing programs for the asset management industry that focus on liquidity and counterparty risks.

• The life insurance industry. The absence of harmonized national standards or consolidated supervision makes any assessment of risks in the industry necessarily tentative and incomplete.

A coordinated, nationally consistent approach to regulation (particularly valuation and solvency requirements), supervision, and stress testing is needed with regulatory oversight assigned to an independent agency with a nation-wide mandate, operational independence, and appropriate powers and accountability. For designated institutions, enhanced prudential standards should be implemented without further delay.

13. The gains made in improving financial oversight need to be preserved. Over the past several years a series of decisive measures were put in place to lessen the potential for financial stability risks, including enhanced capital and liquidity requirements, strengthened underwriting standards in the housing sector, greater transparency to mitigate counterparty risks, and limits on proprietary trading. The Dodd Frank Act requirements have stimulated supervisory intensity, with increased emphasis on banks’ capital planning, stress testing, and corporate governance. The Federal Reserve’s Comprehensive Capital Analysis and Review process has proven to be particularly valuable.

However, eight years after the inception of the financial crisis, political support behind the reform of the financial system has clearly ebbed and there is a danger that the indispensable progress that has been made may stall or be rolled back. Of course, it is natural to recalibrate some aspects of the oversight system as changes are seen in action. Nevertheless, it will be important to oppose any wholesale or broad-based efforts to dilute the provisions of the Dodd-Frank Act.

14. The withdrawal of correspondent banking relationships has created prospective spillover risks for some countries, particularly those that are unable to substitute to other financial connections in a timely manner. As in other jurisdictions, a number of globally active U.S. banks have been reducing their correspondent banking relationships with counterparts in a range of countries. There is a confluence of factors potentially driving this phenomenon—including shortcomings in the anti-money laundering / combatting the financing of terrorism (AML/CFT) framework in recipient countries, higher supervisory scrutiny, the changing global economic environment, profitability concerns, low margins in correspondent banking, changing liquidity and capital requirements, a broader reorientation of bank business models, insufficient regulatory clarity, reputation concerns of the banks, possible conflicts in regulations (e.g. with data privacy laws), and economies of scale in compliance. Adherence to the international standards on AML/CFT and the sharing of tax information would help to alleviate concerns about the adequacy of controls at recipient institutions.

On the U.S. side, the legal framework for sanctions, AML/CFT, and tax information sharing appears to be applied in a manner that is proportional to the seriousness of the violation. Nevertheless, regulators should continue their investments in outreach and in the ongoing clarification of regulatory expectations. While the risk-based regulatory approach should strive to provide more clarity, there should be no expectation that U.S. regulators and enforcement agencies are able to offer either certainty or “safe harbor”. The U.S. should continue its efforts to assist recipient countries to build capacity and work with other jurisdictions to foster global and bilateral solutions to data privacy impediments. It is worth exploring mechanisms for U.S. financial intermediaries to lessen the fixed costs of compliance and risk management by pooling resources and exploiting economies of scale (e.g. utilizing specialist transfer and clearing services, building common platforms, and sharing information on clients). There may also be scope for U.S. banks to vary more the risk-pricing of correspondent services so as to factor compliance costs into their fee structure and make the risk-return profile more efficient.

15. A more structured, uniform and complete solution is needed to the current lack of transparency in beneficial ownership in the U.S. Given that corporate registration and trusts are governed by the states under a variety of statutes, this will require federal legislation to make beneficial ownership information readily available to regulatory and law enforcement bodies.
 

IMF COMMUNICATIONS DEPARTMENT


The Future of Europe After Brexit

The Continent is facing a new reality and a dysfunctional union.


Summary

The British people voted on June 23 to leave the European Union, and now we ask: what comes next for the bloc? The vote is not the cause of Europe’s challenges, but rather a symptom of Europe’s growing fragmentation.

The European Union is at its core a project to contain nationalism by attempting to boost economic interdependency and prosperity. Nevertheless, the EU’s structural weaknesses, the financial crisis, divergences across the bloc, migration challenges, and socioeconomic and generational gaps within member states have led to the rise of anti-establishment and anti-EU forces across Europe.

We forecast that, over the coming years, the bloc’s ability to function will deteriorate. A new model of European geopolitics will emerge. The nation-state will return as the fundamental organizational principle of Europe, and with it ad hoc alliances and treaties designed to allow nations to pursue their interests on the basis of temporary arrangements of convenience. Germany, which depends heavily on exports, will weaken significantly. In the east, the Russians will move to stabilize their geopolitical situation and attempt to recover Ukraine as a buffer against what they see as Western aggression.

Meanwhile, Islam will play a bigger role in European politics. In the economic realm, new trade blocks and regional alliances will emerge across Europe. At the same time, an intensification in Italy’s economic problems will have ripple effects across Europe’s major economies, potentially negatively impacting the euro, European banks and exporters. Moreover, Europe’s multiple crises and the threat from Russia will drive Central and Eastern European states to seek new partners and allies.

The U.S. will respond to Brexit and the fragmentation of Europe by continuing to strengthen bilateral and regional relationships in order to achieve its strategic objectives on the European Continent.

Introduction

The United Kingdom’s vote to leave the European Union has caused an upheaval in Europe and concern around the world. For most, it was completely unexpected. From our point of view, the European Union has been fragmenting for several years. It couldn’t be forecast how the British vote would go, nor that the U.K. would be the place where the EU’s fragmentation would be made obvious to the world. We were confident that the fracturing European Union would at some point experience an event that would finally make it clear that the EU is facing the abyss.

The crisis came, and the British vote announced it with authority, but it had been unfolding for a long time. The core problem is that the founders of the EU could not decide on clear rules for the authority of the EU versus the authority of the nation-states. As with the founding of the United States, there was a central authority and constituent states, each claiming authority.

There was no consensus in either founding about the relations of the whole to the parts. In the United States, this led to the Civil War. There will be no civil war in Europe. The American Civil War was fought over conflicting moral principles that men would die for. There is no such passion for the EU. Europe will escape the tragedy of the American Civil War, but will also not settle the questions of sovereignty and authority that are tearing it apart.

There were two breaking points: recession and immigration. Europe’s inability to recover from the 2008 crisis was, in the end, due to the fact that no nation wanted to be responsible for the well-being of another. This was rooted in the weakness of the moral bonds between member states. There was no sense of shared fate or obligation. So the Greek crisis was Greece’s fault and its problem. It was not Germany’s. A union so constituted cannot long endure.

The American regime faced the abyss over the question of slavery. Europe faces it over the question of migration. Who determines if there will be new inhabitants of Europe and where they will go? Will it be the EU or will it be the member states? And who will take responsibility for the consequences – not just financial, but cultural – of migration?

Here, the problem becomes not only between the EU and constituent nations. It becomes a crisis between those who favor immigration but are well positioned and wealthy enough to distance themselves from the economic and cultural frictions that result, and those who cannot distance themselves and are on the front line. The elite saw immigration as a moral issue. The lower classes saw it as a moral issue for which they would have to bear the cost.

Economic and social crises are part of our lives. But the EU, which cannot be a nation, could not survive these crises, because those who wrote the Maastricht Treaty compromised on the core question, as did the American founders. Sovereignty is the essential issue. Which institution is sovereign and how is it answerable to the people? Would there be European self-determination through a democratic process or would there be national self-determination?

The EU answered “both,” and that doesn’t work.

Everyone is focused on the vote in the U.K. They didn’t see that the tension between the EU and Greece, Hungary, Poland and Italy, among others, was the precursor to Brexit. The Brexit vote is not only the most recent of such divergences, but the forerunner of many more. In the end, Europe is a continent of nations, and those nations attempted a vast and historic compromise between two sovereignties. As with the United States, a compromise was not possible. Unlike the United States, the moral foundation of the EU is wealth and safety at minimal cost. It was clear 10 years ago that it could not work. Now, it isn’t working. It is time to imagine the future.

Forecast for Europe to 2020

Ever since the Maastricht Treaty went into effect, the world began to speak of Europe as if it were a single entity governed by the European Union. This was never really true. Nevertheless, the world began to take it for granted, though European countries differed in their approach to the bloc.

This was always a tenuous position, more psychological than institutional. We have long regarded the ambiguity in governance to be the Achilles’ heel of Europe’s political arrangements. This was partly because it was difficult to understand and agree on the boundaries of the EU’s authority and that of the nations. But even more, the Achilles’ heel was that the Europeans were incapable of clarifying the EU’s role. They couldn’t clarify it, because they didn’t agree on what it should be. Nor could they.

The EU was a series of compromises between irreconcilable views. And inevitably, at some point, one of the members would throw up their hands and leave, revealing the basic truth of the EU: it is neither a federation nor a confederation. It is simply a treaty organization that can only survive as long as its internal contradictions don’t become unbearable.

Our forecast on the EU said that it would last until about 2020. We hold with that, in the sense that the EU continues to function. But we see over the next few years that the bloc’s ability to function will deteriorate, followed by the onset of a new European reality that is actually an old one. The nation-state will return as the fundamental organizational principle of Europe, and with it ad hoc alliances and treaties will emerge, designed to allow nations to pursue their interests on the basis of temporary arrangements of convenience.

It is important to understand what a failed institution is. It does not mean the EU will cease to exist. It simply means that it will be irrelevant to developments in Europe. The League of Nations became irrelevant in the 1930s although it continued to exist. The Holy Roman Empire was irrelevant by the 18th century, but it continued to exist. So too, the European Union will exist in some form, but will no longer be a decisive force. The EU began to decline when it failed to deal with the 2008 crisis and when nations began ignoring EU regulations during the refugee crisis.

We forecast two directions for the EU’s trajectory leading up to 2020. There will be increased indifference to its decisions. In addition, other trade and investment relationships will emerge.

These will develop within regions – in northwestern Europe, in Central and Eastern Europe, in Mediterranean Europe and among the Nordic states and Britain. These will not be exclusive groupings nor will they be confined to economics. They will be dynamic in terms of scope and commitment. However, these new entities will be the locus of international coordination.

The EU will still exist and may even have a council and commission, with presidents and staff.

But it will not have an independent reality. Following 2020, events will unfold as described in “The Next 100 Years.” European fragmentation will increase, and the declines of Germany and Russia will thrust new powers, like Poland, into positions of authority.

It should not be assumed that the fragmentation of Europe will change economic patterns. The EU did not create the trade and investment patterns that dominate Europe. Had there been no EU, trade between countries would have developed much as it did. Patterns of investment, within Europe and outside of Europe, developed not out of some institutional framework, but around the economic needs and reality of tens of thousands of businesses and millions of people.

London was the center of finance for centuries before there was an EU. And since Europeans will still want financing, and since the infrastructure and relationships that London maintains are still its value, the pattern will remain largely the same and will change not when there are policy shifts, but when the structure of the international financial system demands it. Just as United Nations resolutions have become irrelevant to national decision-making, so will the EU.

The features of the European economy that will change will do so as a result of structural instability. The greatest unstable power in Europe is Germany, and it faces disaster when the next U.S. recession occurs, which will be sometime in the next two years. The Germans maintain their internal social stability by relying on exports for 45 percent of their GDP. Nearly half of their economic value thus derives from exports. In fact, the country has increased its dependence on exports since 2008. Germany relies so heavily on exports because its production exceeds domestic consumption. It is therefore in danger if trouble strikes, as German customers will not be able to replace export demand. Every 5 percent decline in exports reduces Germany’s GDP by roughly 2.25 percent.

Right now, the U.S. is a critical customer and the rest of the world is at best maintaining a stable level of imports. In the next recession, not only will the U.S. reduce consumption, but so will all other countries selling to the U.S. German exports will drop, so will its GDP, and the result will be a dramatic rise in unemployment. At this point, Germany’s ability to manage the European system will further evaporate. Large but dysfunctional economies are weaker in some ways than smaller ones.

The Russians, facing a different economic crisis revolving around low oil prices, will move to stabilize their geopolitical situation, in particular by attempting to recover Ukraine as a buffer against what they see as Western aggression. As in the 1980s, it will be a race involving strategic goals and economic decline. The fragmentation of Europe will be an opportunity for the Russians to develop relationships with nations no longer bound by the EU (but still by NATO, which is also losing relevance). They will succeed in most cases. However, we continue to expect that Russia will weaken around and after 2020 to the point that Moscow’s ability to control its own system will be dubious.

The U.S. will remain the dominant global power, with a reasonably functioning economy. Fearing the possibility of alignment between Russia and Germany, it will increase its activity in the Baltics, Poland and Romania. It will also develop even closer economic relations with the U.K. and with selected other countries, particularly military allies. These relations will be outside of NATO, since NATO will fragment along with Europe.

The Emergence of a Troubled European Bloc

The European Union emerged out of a project to contain nationalism and limit prospects for another major war on the Continent by aiming to boost economic interdependency and prosperity. Nevertheless, structural weaknesses, economic troubles, imbalances in the bloc and divergences in the interests and outlooks of voters within European states have undermined the EU’s legitimacy and contributed to a rise in nationalism across the Continent.

Today’s European Union has its roots in post-war French fears about Germany, post-war Germany’s aspirations and U.S. strategy for managing a balance of power on in Europe. The precursor to the EU, the European Coal and Steel Community (ECSC), was founded in 1952. It laid the foundations for close trade and economic ties among Western Europe’s leading economies and was designed to prevent any future hostilities between historical rivals France and Germany. France’s steel industry depended on coke and coal imports from Germany, and the creation of the ECSC meant the two countries’ economies were undeniably intertwined. As French Foreign Minister Robert Schuman wrote when proposing the ECSC, pooling coal and steel production would make war between France and Germany “not merely unthinkable, but materially impossible.”

After World War II, France initially wanted to ensure that West Germany would not become a dominant power in the region. Binding the German and French economies and creating political structures where Paris could to some degree influence German policy-making thus became important. West Germany, meanwhile, wanted to grow economically and become an accepted international player, and thus saw the European project as a vehicle for achieving its aspirations. The U.S. encouraged European integration because Washington regarded greater economic interconnectivity and decision-making through European structures as tools that could help maintain a balance of power on the Continent.

The ECSC evolved into the European Economic Community and, later, the European Union. Each successive institution had more areas of responsibility than the previous. Proponents of European integration saw the free movement of labor and capital, common democratic and rule of law principles, unhindered competition, uniform regulations and a common currency as the core building blocks of a prosperous and peaceful European Continent. Achieving these aims would require national governments giving up a range of prerogatives and empowering a central body – the EU.

Underlying Structural Problems

Support for European integration currently, however, varies significantly, both across the bloc and within member states. The EU’s structural weaknesses, the financial crisis, imbalances within the bloc and socioeconomic and generational gaps within member states have contributed to the rise of anti-establishment and anti-EU forces across Europe.

The bloc’s basic structural problems have undermined the legitimacy of European institutions in the eyes of many European citizens. The EU has a large bureaucracy, including the European Commission, the European Council (made up of member states’ leaders) and the European Parliament. However, the EU has little democratic legitimacy. Only the European Parliament is directly elected by citizens, and much of the critical decision-making happens through negotiations among member states’ governments and inside the bloc’s various technocratic bodies.

In addition, the difficulty of navigating the interests of all member states often leads to gridlock. The bloc has grown from six Western European founding members to 28 members across the Continent. Moreover, EU institutions have weak enforcement powers. The bloc has the power to impose sanctions, withhold funds or take away a member state’s voting rights. However, the bloc often shies away from imposing consequences on member states that violate rules, and no country has ever lost its voting rights.



The 2008 financial crisis exacerbated the existing concerns regarding the bloc’s legitimacy, gridlock and inability to enforce decisions. The crisis did not impact all parts of the bloc evenly, with weak eurozone economies like Cyprus, Greece, Spain and Ireland bearing the brunt of the initial crisis and the years of painful austerity measures and high unemployment rates that followed. Germany, Europe’s largest economy, had a disproportionately large role in shaping the bloc’s response to the economic crisis.

At the same time, many Europeans, particularly in southern economies, came to resent European institutions and large European economies. The latest opinion poll by Eurobarometer, conducted in November 2015, reveals the enduring impact of the financial crisis on the relationship between southern economies and the bloc. People in Cyprus and Greece, which underwent painful bailouts and today still have among the highest unemployment rates in the EU, feel the least attached to the EU.



Indeed, there are signals that public opinion across Europe is turning against the bloc. For example, a poll conducted by Ipsos in March and April found that 55 percent of French voters would support holding a referendum on EU membership, while 41 percent would vote to leave the bloc. As Europe’s problems intensify and EU institutions become increasingly irrelevant, more Europeans will call for leaving the bloc or empowering national governments.



Migration and Social Polarization

These underlying issues were in place before Britain’s referendum campaign began; it was the migration issue that tipped public opinion in favor of Brexit. Beginning in 2011, the impact of the economic crisis and increased immigration led to discussions of a referendum. With the refugee crisis hitting Europe in 2015, the vote ultimately came down to people’s perceptions of the impact of immigration.

Two issues need to be considered in order to understand further evolutions in Continental Europe: the rise in nationalism and social polarization. Both refer to the divide between the elite and the masses – which has dramatically intensified as the EU confronted the economic crisis.

The financial and refugee crises have revealed the divergence between the European elites and the masses. The Brussels elite are composed of highly educated bureaucrats who have addressed urgent matters by implementing slow and gradual changes, such as the European Border and Coast Guard that was meant to help states deal with the refugee crisis. Their distant management approach to Europe has been influenced by the member states’ representatives and other politicians who are part of the elite.

Before the financial crisis, politically correct national politicians were supportive of anything coming out of the Brussels’ bureaucratic machinery. In the post-Cold War period, politicians could win elections with a pro-European, pro-integration approach. But once the economic crisis hit and social problems appeared, traditional politics and politicians’ approach towards Brussels changed.

High unemployment rates in southern Europe led people to immigrate to other EU countries. This was happening while emigration continued from the Eastern European countries that joined the EU about a decade ago. The prospect of higher income and better working conditions in Western Europe is appealing for Eastern Europeans. The refugee crisis only intensified socio-economic and security concerns.

In the U.K., a major argument for the “leave” campaign was that Brexit would allow more control over immigration from the rest of the EU. Britain’s population has grown from 57 million in 1990 to 65 million in 2015, despite a low native birth rate – mostly due to migration. While the migration flow is now almost equally divided between non-EU and EU countries, the number of EU-born people living in the U.K. has more than doubled since 2004, reaching about 3 million in 2015. The share of EU nationals grew from 1.8 percent to 6.3 percent of adults aged 16 to 64. The vast majority are economic migrants. While the majority of European immigrants initially came from the new EU member states in Central and Eastern Europe – including Poland and Romania – migrants from southern European countries also started to arrive after 2008.

The main concern for those supporting Brexit was that immigration reduces the salary expectations and job opportunities for Brits. At the same time, the migrants were perceived as benefiting disproportionately from the U.K. welfare system, with hospitals and schools becoming crowded. Moreover, the “leave” campaigners have underlined that migration has also had a negative effect on housing. Properties in London and other major cities are owned by rich migrants who outbid British buyers, while poor migrants are willing to crowd into dwellings that British residents find too congested.

The agreement between the EU and the U.K. negotiated in February by the British Prime Minister David Cameron would have allowed Britain to impose a four-year emergency brake on in-work benefits for European migrants residing in Britain – a policy that would be in place for seven years. However, this failed to alleviate the fears of the electorate. The way the EU, and in particular Germany, has managed the refugee crisis since mid-2015 has increased the worries of the U.K. population and strengthened the “leave” campaign. The elites and the masses saw this crisis very differently and distrust between the two mounted.

Furthermore, stark generational and socioeconomic gaps in perception of the EU have emerged. Eurobarometer polling data reveals that, across Europe, 55 percent of young people between the ages of 15 and 24 say they feel attached to the EU, compared to only 45 percent of Europeans over the age of 55. Levels of attachment also vary between socioeconomic groups, with the upper-middle class expressing greater attachment to the EU than the middle and lower-middle classes.

The masses experiencing the negative effects of the financial crisis throughout Europe have made it possible for new political movements to gain support at the expense of the traditional elitist (but mainstream) parties, which many feel no longer protect their interests. The new anti-system parties have promised better governance and more respect from Brussels for their national interests.

In some countries, established parties — like Poland’s Law and Justice Party and Hungary’s Fidesz – have promoted Euroskeptic views. In others, right-wing anti-establishment forces like the National Front in France and the Alternative for Germany party have challenged EU integration, garnering a growing amount of support. In parts of southern Europe, opposition to the bloc’s policies has come from the left, and parties like Greece’s Syriza and Spain’s Podemos. However, in the U.K., while the top leadership of the establishment parties were supportive of remaining in the EU, a third faction drawn from both parties supported leaving.

Economic problems in Europe have intensified social polarization, which has supported the rise of nationalism. The “us vs. them” divide has widened. Both sides of the debate on EU membership are growing increasingly stringent and extreme in their views, leaving little middle ground. “Remain” supporters have become hostile toward “leave” supporters. In essence, European society has again become tolerant of intolerance.

Imagining the New Europe

In the coming years, the EU will take on a new shape. But certain regions and areas of integration will be more affected than others. Here, we look in depth at the future of the free trade zone, Germany, Russia and southern and Central Europe, as well as the impact Muslim migration will have on the Continent.

The Free Trade Zone

Before 2008, it was believed that Brussels could establish a single market – a space where the free movement of goods, services, capital and people is guaranteed. However, there hasn’t been a free flow of capital within the EU – during the economic crisis negotiations, when countries negotiated based on their national interests, the structural problems of the eurozone were evident.

Germany has seen its national interest threatened as the EU weakens. Considering its dependency on exports and the free trade zone, Germany had to get involved in negotiating a solution to the banking crisis and the economic fallout in the south. It exerted a leadership position that it didn’t want, but had to take. At the same time, the sovereignty of countries like Greece and Cyprus has been under threat, as they submitted to the EU’s control. But, ultimately, the goal was to keep the free trade zone intact.



Trade is driven by economic need, not by regulations. Businesses see opportunities for trade and drive nation-states to facilitate their endeavors. Trade between the U.K. and EU members will continue after Brexit. However, while most countries’ exports to the EU increased after becoming members, the U.K. and Ireland have seen a drop, particularly since 2008. Unlike Germany, the U.K. is also almost equally dependent on the EU and non-EU markets.



Most member states have two or three European partners to which they export more than 50 percent of their total exports. The proportion of trade between geographically closer partners has increased. This highlights another post-Brexit trend we can expect to see. As Germany’s influence in the EU weakens, countries within the same region that share similar views on economics and/or security will likely increase trade and investment among themselves. Countries in northern Europe, Mediterranean Europe, Eastern Europe and Western Europe may group together to enhance their trade relations.

Furthermore, following the EU’s fragmentation, special agreements on trade and investment may appear between EU countries and non-EU countries. Similarly, countries that choose to leave the union will be able to take their own path and engage in bilateral and multilateral arrangements based on their own national interest. Countries like France and Germany will probably enhance relations with Russia. Central European countries like Romania and Poland may choose to increase bilateral economic relations with the U.S. Countries may choose to have better economic ties with neighboring non-EU countries. All in all, Europe will see a rise in the politics of international trade.

The EU was built on the idea that free trade would support prosperity. In seeking to establish a single market while also expanding it, the EU tried to take over regulatory functions that would normally belong to nation-states. One of the Brexit “leave” campaigners’ main arguments was the fact that Brussels’ excessive red tape was negatively affecting small businesses. Non-tariff barriers made it hard for small British companies to sell their products and services within the EU. The barriers include technical regulations, standards and conformity assessment procedures, labeling rules and sanitary measures. These barriers contribute to dilution of the free trade area and are likely to increase after Brexit. Just as national labor codes make it hard for both investors and workers to consider the EU a uniform labor market, such barriers are proof that trade within the EU is not actually “free.”

Another, less visible, claim from the “leave” campaign was that, due to the limits imposed on the deficit (members are obligated to keep deficits below 3 percent of GDP) and the public debt (below 60 percent of GDP without diminishing at an adequate rate), the U.K. couldn’t make its tax system competitive. This links to the long-standing argument that the U.K. gets less than it gives to the EU, as a net contributor to the EU budget.

Complaints about the negative effects of EU regulations on national economies have increased since the financial crisis. Until 2008, the EU saw nationality as a cultural rather than political phenomenon and, therefore, took over certain issues from national governments. That model worked until it was clear the bureaucrats in Brussels could not provide solutions to the economic crisis. In negotiations over how to address the crisis, member states prioritized their countries’ national interests.

Germany

As Britain leaves the bloc and European economies struggle, Europe’s economic powerhouse – Germany – will face its own crisis. This relates to the central strategic question that has plagued Europe for well over a century: what is the role and extent of German power in Europe? The Franco-Prussian War, World War I and World War II were all about the extent of German power, as Germany sought to dominate the Continent and the various coalitions of forces seeking to deter Germany from this goal.

As we have discussed, Germany is dependent on exports. Almost half of its GDP comes from exports, and Germany has thus far compensated for drops in its exports to China and the rest of Europe by depending on the U.S. and the U.K. But the U.K. is now leaving the EU and the U.S. cannot pick up the slack indefinitely.

As a result, Germany will be facing rising domestic unemployment. It will be in direct competition with surrounding countries that are in its supply chain like the Czech Republic, Hungary, Poland and Slovakia. Its clout in Central and southern European states will diminish along with its ability to hand out loans to these states. It will have an increasing number of migrants that it will have to provide for, having accepted them into the country. It will face crises in countries like Greece and Italy, which were integral parts of the German economy. They will be less likely to adhere to austerity strictures from Berlin unless Germany is willing to shell out the money necessary to bail them out – which Germany has never wanted to do and will be less able to do over time. Germany will also be desperate to find countries to buy German goods.

At this point, the priority for Germany will be survival and satisfying the domestic population, rather than propping up the European system or going along with U.S. foreign policy objectives. The EU, it must be remembered, was designed in the first place to tame Germany. Berlin was able to use the EU to enable its own economic success. The decline of the EU raises the question of what will happen when the system is no longer rigged to either declaw or enrich Germany.

This issue will be the center of gravity of European geopolitics. As Germany weakens, another great power of the 20th century will also be weakening: Russia. And while Russia faces a number of serious challenges, ranging from low oil prices to declining fertility rates and historically high mortality rates, great powers are most dangerous when their backs are up against the wall. And that is where Russia finds itself today, and will continue to find itself in the next few years.

Russia

The groundwork for this conflict has already been laid. The expansion of NATO has diluted its mission and strategic purpose, but it has also made the Russians very uncomfortable. The protests in Ukraine that set off a revolution and led to the annexation of Crimea were supported, though not directly, by Germany, France and the United States. This angered the Russians, as Ukraine was part of the historical buffer region that protected Russia from threats emanating from Western Europe.

Germany has been in the anti-Russia camp in recent years. Germany’s foreign minister was in Russia with the French and Polish foreign ministers when the pro-Russia Ukrainian President Viktor Yanukovych was booted from power in 2014. And Germany has held the line thus far when it comes to sanctions against Russia. But as Germany turns inward to deal with its own issues, it will lose some of its endurance in standing so strongly against Russia. And as Germany comes into conflict with other European countries, and as the EU’s writ continues to decline throughout the Continent, Russia will see an opportunity.

Russia will have more space to build relationships and influence in Europe. As power becomes more concentrated in regional blocks and national capitals, countries will no longer have to think about Brussels as they make their decisions, but rather what is best for them at that particular time. For some, that may include cooperation with – or at least a lack of opposition to – Russian moves in Eastern Europe. Ukraine’s future is more important to Russia than it is to any other European country or the United States. Russia will do whatever it can to, at minimum, prevent Ukraine from moving squarely into the U.S. camp, and at maximum to exert as much control as it can over the country.

Southern and Central Europe

Southern Europe’s weak economies are already a big challenge for the EU. Greece’s debt crisis raises questions over the sustainability of the eurozone, but growing economic woes in Italy – as well as continued challenges in Spain and Portugal – signal that a far more significant southern European economic crisis is underway. Italy is grappling with high rates of non-performing loans, on top of low growth and high unemployment. An Italian crisis has much more far-reaching implications than Greece’s, since Italy is the third largest economy in the eurozone. As a result, an intensification in Italy’s economic problems will have ripple effects across Europe’s major economies, potentially negatively impacting the stability of the euro, European banks and exporters.



Europe’s fragmentation will intensify Central and Eastern Europe’s security challenges. European governments have long floated plans for greater EU-wide defense cooperation, but the bloc’s growing challenges make this project more unlikely. With the U.K. – the largest spender on defense in Europe – leaving the bloc, and other European states increasingly occupied with their economic troubles, states along the EU’s eastern edge will grow apart from the rest of Europe. Central and Eastern European states will look for new economic partners and defense allies, as Russia will push to boost its influence in the region.

Muslim Migration

Intersecting all these issues is the role that Islam will play, and indeed already has played, in Europe’s geopolitics. The map below uses data released by the Pew Research Center to identify the relative Muslim population in European countries in 2010.



We used 2010 data because it was the most recent and reliable, but it should be noted that the map above does not take into account the refugee crisis, which began in earnest only after 2010. Syria descended into civil war in 2011, and the Islamic State’s rise and the concurrent breakdown of Iraqi governance occurred after this data was gathered, so these events were not factored into Pew’s estimates for Muslim population in Europe in 2020 and beyond. Germany accepted more than 800,000 migrants in 2015, and a study by the Central Council of Muslims in Germany estimated that 640,000 of those were Muslim, which puts the number of Muslims living in Germany at around 6 million.

The reasons for Brexit are many, but one of the key reasons “leave” beat “remain” in the end was the migrant issue. In the summer of 2015, Germany was still committed to opening its borders to refugees and was trying to pressure other EU members, including Britain, into accepting more refugees. At one point, German officials were all but threatening that Cameron would not be able to negotiate new terms with the EU if Britain did not pull its weight in accepting more refugees.

Britain already has a population of over 3.5 million Muslims. Numerous attacks carried out by Islamic extremists in recent years, most notably the 2005 London Underground bombings, raised fears among some British voters. At the same time, as with migration from eastern members of the EU, many working and middle class Brits feared that an influx of migrants would harm their job prospects or impact salary levels. Many British citizens were not prepared to accept Germany’s demand that they accept more refugees or suffer the consequences. One of the most basic qualities of sovereignty is the ability to control one’s borders, and even the notion that this authority would have to be discussed in a committee in Brussels was one of the driving forces that encouraged British citizens to vote “leave.”

In this sense, the Muslim population of Europe, which, not counting the recent surge in migration, was forecast to reach 10 percent of Europe’s total population by 2050, has already begun to reshape European geopolitics. Recent migration could push this number higher much faster than anticipated, which will have an effect across Europe. In the U.K., Brexit probably would have been defeated without the conflagrations in the Middle East, the subsequent migration to Europe, the inability of the EU to respond to the migration, and the attacks on European soil like those in Paris. In Germany, which has an aging population, the influx of young Muslim men from the Middle East could have unforeseen long-term effects. Germany and Russia in fact have two of the largest Muslim populations in Europe and those populations are growing more rapidly than other demographic groups.

These changes will also be affected by the continued resilience of IS, Syria’s civil war, closer cooperation with Turkey (a Muslim country that in previous incarnations ruled much of the Balkans and southern Europe) to contain Russia and stem the flow of migrants, Libya’s continued instability and other unforeseen developments in the Middle East. As nation-states assert themselves and as nationalism rises, there will be a ready-made “other” increasing rapidly in those states, and a small but consequential minority of those “others” believe Western civilization needs to be destroyed. The EU cannot address this issue at a continental level, and each state will likely deal with it in its own way.

Europe and the United States

In this fragmented Europe – where Germany must look to its own interests and Russia is looking to re-establish itself in its traditional buffer regions while it still has the capability to do so – the British vote to leave the European Union makes sense. The U.K. has been balancing between the United States and the European Continent. There is an illusion in the mainstream that by voting to leave the EU, Britain has effectively left Europe. However, Britain cannot leave Europe.

The U.K. does not have to be in the EU to be part of Europe. It will always be a part of Europe. That said, unlike most other European countries, the U.K. is not as tied up with the Continent. It has options. That does not mean it can ignore Europe, and it won’t. The trading relationship between Germany and the U.K., for example, is an imperative for both. The U.K. has been pulling closer to the U.S. in recent years, and both countries will continue to share their interest in preventing the rise of a regional hegemon on the European Continent.

France is also part of this equation and has always tried to assert its independence from U.S. strategic initiatives. But France is also on the front line of many of these issues and will have to remain in the British and American orbit while preserving enough power and independence to stand on its own two feet. France was the original core power of the European Union, and to the extent that it can, it wants to preserve some of the EU’s residual power to maintain as level a relationship with Germany as it can.

U.S. President Barack Obama said he wanted the U.K. to remain in the European Union. Obama also probably wants the Chicago Bulls to win the National Basketball Association championship every year, but that doesn’t mean it will happen. Europe has already begun to fragment, and this has defined U.S. policy in recent years.



U.S. Secretary of State John Kerry has said NATO can be a stabilizing force now that the U.K. has left the EU. This is mostly wishful thinking. The most consequential U.S. relationships on the European Continent will increasingly be bilateral and regional and will develop outside the auspices of the old institutions. The Intermarium is the idea of an alliance of countries between the Baltic and Black seas that will work with the United States to block Russian influence into Europe. The U.S. will continue to work closely with Poland and Romania, and its relationship with Turkey will also become more complicated and important to both sides. The U.K. has already played a part in this, with British fighters and troops stationed in the Baltics. It continues to play an important role, and increasingly these moves will happen outside of NATO.

Following Brexit’s Logic

The fragmentation of Europe poses other unique challenges across the Continent. It is these that pose the greatest challenge for the United Kingdom.



The United Kingdom is not a nation-state. It is made up of four nations – England, Wales, Northern Ireland and Scotland. And London is so politically and culturally distinct from the rest of England that it could almost be considered a city-state at this point. Britain voted to leave the European Union. The same logic could be used by Scotland or Northern Ireland to leave the United Kingdom.

The problem with this is how deeply embedded Northern Ireland and Scotland are in the United Kingdom. It makes sense that both voted to remain in the European Union – historical memory dictates that both should prefer to trust the European Continent over their English neighbors. But Scotland and Northern Ireland have enjoyed in the economic success of the United Kingdom over the centuries. Scotland, for example, approved the Articles of Union in 1707 because it was on the verge of insolvency and it was in its best interest to join the United Kingdom.

Even if Scotland were to get approval to hold a second referendum on EU membership (which it must by law) and even if it voted to leave, it could not leave the U.K. as simply as the U.K. can leave the EU. Scotland uses the pound. Scottish soldiers serve in the British army. Separation would be far more complicated. This is fundamentally uncharted territory, and there might be potential for some kind of compromise, in which Scotland remained part of the United Kingdom but was given more autonomy and freedom to determine its relationship with the EU.

The imperatives keeping the United Kingdom together may be weakening, but even so, they are far stronger than the imperatives keeping the EU together. In any case, it will take years for Britain to untangle itself from the EU. Even if, in the next year or two, Scotland or Northern Ireland held a successful independence referendum, it would take longer to untangle themselves from the U.K. By that point, things in the EU might be so bad that joining won’t seem like a feasible option anymore.

This is not a strictly British challenge. The map above should be striking for the number of areas and peoples that it lists. Basque Country and Catalonia are fairly well known, but Occitania is bigger than both, with over 16 million people with their own language spread across three countries (France, Italy, Spain), and with a sense of national distinctness.

Europe has gone through these cycles – of small distinct local areas being consolidated into large states or empires – in the past. The opposite is happening now, and while those that will be most vocal in pursuit of more independence will be the topic of a future study, it suffices to say that European nation-states will face the same kinds of challenges that the EU does from dissatisfaction with political elites and rising national pride. Of course, many of these states have much more history and interests in common than the various nation-states have with the European Union. But even so, they will not be immune to these forces.

The fragmentation of Europe does not just mean the fragmentation of the EU. The EU is the biggest and most consequential part of this. But Britain’s example has opened up a host of possibilities for redefining the way Europe works at the national level. It also means the continued existence of the United Kingdom or even the Kingdom of Spain as currently constituted is an open question.

The U.S. then will respond to Brexit and the fragmentation of Europe as it already has – by strengthening bilateral and regional relationships in order to achieve its strategic objectives on the European Continent. Great Britain will remain one of America’s closest allies, and will move even closer to the U.S. as it seeks to find its place between the Old World and the New.

The British vote did not cause these geopolitical forces toward fragmentation to emerge any more than policy did. They were already at work on the Continent. George Friedman forecast these developments almost a decade ago, and that forecast for the most part stands. It’s just happening even faster than we thought it would.


The Future of Europe After Brexit

The Continent is facing a new reality and a dysfunctional union.


Summary

The British people voted on June 23 to leave the European Union, and now we ask: what comes next for the bloc? The vote is not the cause of Europe’s challenges, but rather a symptom of Europe’s growing fragmentation.

The European Union is at its core a project to contain nationalism by attempting to boost economic interdependency and prosperity. Nevertheless, the EU’s structural weaknesses, the financial crisis, divergences across the bloc, migration challenges, and socioeconomic and generational gaps within member states have led to the rise of anti-establishment and anti-EU forces across Europe.

We forecast that, over the coming years, the bloc’s ability to function will deteriorate. A new model of European geopolitics will emerge. The nation-state will return as the fundamental organizational principle of Europe, and with it ad hoc alliances and treaties designed to allow nations to pursue their interests on the basis of temporary arrangements of convenience. Germany, which depends heavily on exports, will weaken significantly. In the east, the Russians will move to stabilize their geopolitical situation and attempt to recover Ukraine as a buffer against what they see as Western aggression.

Meanwhile, Islam will play a bigger role in European politics. In the economic realm, new trade blocks and regional alliances will emerge across Europe. At the same time, an intensification in Italy’s economic problems will have ripple effects across Europe’s major economies, potentially negatively impacting the euro, European banks and exporters. Moreover, Europe’s multiple crises and the threat from Russia will drive Central and Eastern European states to seek new partners and allies.

The U.S. will respond to Brexit and the fragmentation of Europe by continuing to strengthen bilateral and regional relationships in order to achieve its strategic objectives on the European Continent.

Introduction

The United Kingdom’s vote to leave the European Union has caused an upheaval in Europe and concern around the world. For most, it was completely unexpected. From our point of view, the European Union has been fragmenting for several years. It couldn’t be forecast how the British vote would go, nor that the U.K. would be the place where the EU’s fragmentation would be made obvious to the world. We were confident that the fracturing European Union would at some point experience an event that would finally make it clear that the EU is facing the abyss.

The crisis came, and the British vote announced it with authority, but it had been unfolding for a long time. The core problem is that the founders of the EU could not decide on clear rules for the authority of the EU versus the authority of the nation-states. As with the founding of the United States, there was a central authority and constituent states, each claiming authority.

There was no consensus in either founding about the relations of the whole to the parts. In the United States, this led to the Civil War. There will be no civil war in Europe. The American Civil War was fought over conflicting moral principles that men would die for. There is no such passion for the EU. Europe will escape the tragedy of the American Civil War, but will also not settle the questions of sovereignty and authority that are tearing it apart.

There were two breaking points: recession and immigration. Europe’s inability to recover from the 2008 crisis was, in the end, due to the fact that no nation wanted to be responsible for the well-being of another. This was rooted in the weakness of the moral bonds between member states. There was no sense of shared fate or obligation. So the Greek crisis was Greece’s fault and its problem. It was not Germany’s. A union so constituted cannot long endure.

The American regime faced the abyss over the question of slavery. Europe faces it over the question of migration. Who determines if there will be new inhabitants of Europe and where they will go? Will it be the EU or will it be the member states? And who will take responsibility for the consequences – not just financial, but cultural – of migration?

Here, the problem becomes not only between the EU and constituent nations. It becomes a crisis between those who favor immigration but are well positioned and wealthy enough to distance themselves from the economic and cultural frictions that result, and those who cannot distance themselves and are on the front line. The elite saw immigration as a moral issue. The lower classes saw it as a moral issue for which they would have to bear the cost.

Economic and social crises are part of our lives. But the EU, which cannot be a nation, could not survive these crises, because those who wrote the Maastricht Treaty compromised on the core question, as did the American founders. Sovereignty is the essential issue. Which institution is sovereign and how is it answerable to the people? Would there be European self-determination through a democratic process or would there be national self-determination?

The EU answered “both,” and that doesn’t work.

Everyone is focused on the vote in the U.K. They didn’t see that the tension between the EU and Greece, Hungary, Poland and Italy, among others, was the precursor to Brexit. The Brexit vote is not only the most recent of such divergences, but the forerunner of many more. In the end, Europe is a continent of nations, and those nations attempted a vast and historic compromise between two sovereignties. As with the United States, a compromise was not possible. Unlike the United States, the moral foundation of the EU is wealth and safety at minimal cost. It was clear 10 years ago that it could not work. Now, it isn’t working. It is time to imagine the future.

Forecast for Europe to 2020

Ever since the Maastricht Treaty went into effect, the world began to speak of Europe as if it were a single entity governed by the European Union. This was never really true. Nevertheless, the world began to take it for granted, though European countries differed in their approach to the bloc.

This was always a tenuous position, more psychological than institutional. We have long regarded the ambiguity in governance to be the Achilles’ heel of Europe’s political arrangements. This was partly because it was difficult to understand and agree on the boundaries of the EU’s authority and that of the nations. But even more, the Achilles’ heel was that the Europeans were incapable of clarifying the EU’s role. They couldn’t clarify it, because they didn’t agree on what it should be. Nor could they.

The EU was a series of compromises between irreconcilable views. And inevitably, at some point, one of the members would throw up their hands and leave, revealing the basic truth of the EU: it is neither a federation nor a confederation. It is simply a treaty organization that can only survive as long as its internal contradictions don’t become unbearable.

Our forecast on the EU said that it would last until about 2020. We hold with that, in the sense that the EU continues to function. But we see over the next few years that the bloc’s ability to function will deteriorate, followed by the onset of a new European reality that is actually an old one. The nation-state will return as the fundamental organizational principle of Europe, and with it ad hoc alliances and treaties will emerge, designed to allow nations to pursue their interests on the basis of temporary arrangements of convenience.

It is important to understand what a failed institution is. It does not mean the EU will cease to exist. It simply means that it will be irrelevant to developments in Europe. The League of Nations became irrelevant in the 1930s although it continued to exist. The Holy Roman Empire was irrelevant by the 18th century, but it continued to exist. So too, the European Union will exist in some form, but will no longer be a decisive force. The EU began to decline when it failed to deal with the 2008 crisis and when nations began ignoring EU regulations during the refugee crisis.

We forecast two directions for the EU’s trajectory leading up to 2020. There will be increased indifference to its decisions. In addition, other trade and investment relationships will emerge.

These will develop within regions – in northwestern Europe, in Central and Eastern Europe, in Mediterranean Europe and among the Nordic states and Britain. These will not be exclusive groupings nor will they be confined to economics. They will be dynamic in terms of scope and commitment. However, these new entities will be the locus of international coordination.

The EU will still exist and may even have a council and commission, with presidents and staff.

But it will not have an independent reality. Following 2020, events will unfold as described in “The Next 100 Years.” European fragmentation will increase, and the declines of Germany and Russia will thrust new powers, like Poland, into positions of authority.

It should not be assumed that the fragmentation of Europe will change economic patterns. The EU did not create the trade and investment patterns that dominate Europe. Had there been no EU, trade between countries would have developed much as it did. Patterns of investment, within Europe and outside of Europe, developed not out of some institutional framework, but around the economic needs and reality of tens of thousands of businesses and millions of people.

London was the center of finance for centuries before there was an EU. And since Europeans will still want financing, and since the infrastructure and relationships that London maintains are still its value, the pattern will remain largely the same and will change not when there are policy shifts, but when the structure of the international financial system demands it. Just as United Nations resolutions have become irrelevant to national decision-making, so will the EU.

The features of the European economy that will change will do so as a result of structural instability. The greatest unstable power in Europe is Germany, and it faces disaster when the next U.S. recession occurs, which will be sometime in the next two years. The Germans maintain their internal social stability by relying on exports for 45 percent of their GDP. Nearly half of their economic value thus derives from exports. In fact, the country has increased its dependence on exports since 2008. Germany relies so heavily on exports because its production exceeds domestic consumption. It is therefore in danger if trouble strikes, as German customers will not be able to replace export demand. Every 5 percent decline in exports reduces Germany’s GDP by roughly 2.25 percent.

Right now, the U.S. is a critical customer and the rest of the world is at best maintaining a stable level of imports. In the next recession, not only will the U.S. reduce consumption, but so will all other countries selling to the U.S. German exports will drop, so will its GDP, and the result will be a dramatic rise in unemployment. At this point, Germany’s ability to manage the European system will further evaporate. Large but dysfunctional economies are weaker in some ways than smaller ones.

The Russians, facing a different economic crisis revolving around low oil prices, will move to stabilize their geopolitical situation, in particular by attempting to recover Ukraine as a buffer against what they see as Western aggression. As in the 1980s, it will be a race involving strategic goals and economic decline. The fragmentation of Europe will be an opportunity for the Russians to develop relationships with nations no longer bound by the EU (but still by NATO, which is also losing relevance). They will succeed in most cases. However, we continue to expect that Russia will weaken around and after 2020 to the point that Moscow’s ability to control its own system will be dubious.

The U.S. will remain the dominant global power, with a reasonably functioning economy. Fearing the possibility of alignment between Russia and Germany, it will increase its activity in the Baltics, Poland and Romania. It will also develop even closer economic relations with the U.K. and with selected other countries, particularly military allies. These relations will be outside of NATO, since NATO will fragment along with Europe.

The Emergence of a Troubled European Bloc

The European Union emerged out of a project to contain nationalism and limit prospects for another major war on the Continent by aiming to boost economic interdependency and prosperity. Nevertheless, structural weaknesses, economic troubles, imbalances in the bloc and divergences in the interests and outlooks of voters within European states have undermined the EU’s legitimacy and contributed to a rise in nationalism across the Continent.

Today’s European Union has its roots in post-war French fears about Germany, post-war Germany’s aspirations and U.S. strategy for managing a balance of power on in Europe. The precursor to the EU, the European Coal and Steel Community (ECSC), was founded in 1952. It laid the foundations for close trade and economic ties among Western Europe’s leading economies and was designed to prevent any future hostilities between historical rivals France and Germany. France’s steel industry depended on coke and coal imports from Germany, and the creation of the ECSC meant the two countries’ economies were undeniably intertwined. As French Foreign Minister Robert Schuman wrote when proposing the ECSC, pooling coal and steel production would make war between France and Germany “not merely unthinkable, but materially impossible.”

After World War II, France initially wanted to ensure that West Germany would not become a dominant power in the region. Binding the German and French economies and creating political structures where Paris could to some degree influence German policy-making thus became important. West Germany, meanwhile, wanted to grow economically and become an accepted international player, and thus saw the European project as a vehicle for achieving its aspirations. The U.S. encouraged European integration because Washington regarded greater economic interconnectivity and decision-making through European structures as tools that could help maintain a balance of power on the Continent.

The ECSC evolved into the European Economic Community and, later, the European Union. Each successive institution had more areas of responsibility than the previous. Proponents of European integration saw the free movement of labor and capital, common democratic and rule of law principles, unhindered competition, uniform regulations and a common currency as the core building blocks of a prosperous and peaceful European Continent. Achieving these aims would require national governments giving up a range of prerogatives and empowering a central body – the EU.

Underlying Structural Problems

Support for European integration currently, however, varies significantly, both across the bloc and within member states. The EU’s structural weaknesses, the financial crisis, imbalances within the bloc and socioeconomic and generational gaps within member states have contributed to the rise of anti-establishment and anti-EU forces across Europe.

The bloc’s basic structural problems have undermined the legitimacy of European institutions in the eyes of many European citizens. The EU has a large bureaucracy, including the European Commission, the European Council (made up of member states’ leaders) and the European Parliament. However, the EU has little democratic legitimacy. Only the European Parliament is directly elected by citizens, and much of the critical decision-making happens through negotiations among member states’ governments and inside the bloc’s various technocratic bodies.

In addition, the difficulty of navigating the interests of all member states often leads to gridlock. The bloc has grown from six Western European founding members to 28 members across the Continent. Moreover, EU institutions have weak enforcement powers. The bloc has the power to impose sanctions, withhold funds or take away a member state’s voting rights. However, the bloc often shies away from imposing consequences on member states that violate rules, and no country has ever lost its voting rights.



The 2008 financial crisis exacerbated the existing concerns regarding the bloc’s legitimacy, gridlock and inability to enforce decisions. The crisis did not impact all parts of the bloc evenly, with weak eurozone economies like Cyprus, Greece, Spain and Ireland bearing the brunt of the initial crisis and the years of painful austerity measures and high unemployment rates that followed. Germany, Europe’s largest economy, had a disproportionately large role in shaping the bloc’s response to the economic crisis.

At the same time, many Europeans, particularly in southern economies, came to resent European institutions and large European economies. The latest opinion poll by Eurobarometer, conducted in November 2015, reveals the enduring impact of the financial crisis on the relationship between southern economies and the bloc. People in Cyprus and Greece, which underwent painful bailouts and today still have among the highest unemployment rates in the EU, feel the least attached to the EU.



Indeed, there are signals that public opinion across Europe is turning against the bloc. For example, a poll conducted by Ipsos in March and April found that 55 percent of French voters would support holding a referendum on EU membership, while 41 percent would vote to leave the bloc. As Europe’s problems intensify and EU institutions become increasingly irrelevant, more Europeans will call for leaving the bloc or empowering national governments.



Migration and Social Polarization

These underlying issues were in place before Britain’s referendum campaign began; it was the migration issue that tipped public opinion in favor of Brexit. Beginning in 2011, the impact of the economic crisis and increased immigration led to discussions of a referendum. With the refugee crisis hitting Europe in 2015, the vote ultimately came down to people’s perceptions of the impact of immigration.

Two issues need to be considered in order to understand further evolutions in Continental Europe: the rise in nationalism and social polarization. Both refer to the divide between the elite and the masses – which has dramatically intensified as the EU confronted the economic crisis.

The financial and refugee crises have revealed the divergence between the European elites and the masses. The Brussels elite are composed of highly educated bureaucrats who have addressed urgent matters by implementing slow and gradual changes, such as the European Border and Coast Guard that was meant to help states deal with the refugee crisis. Their distant management approach to Europe has been influenced by the member states’ representatives and other politicians who are part of the elite.

Before the financial crisis, politically correct national politicians were supportive of anything coming out of the Brussels’ bureaucratic machinery. In the post-Cold War period, politicians could win elections with a pro-European, pro-integration approach. But once the economic crisis hit and social problems appeared, traditional politics and politicians’ approach towards Brussels changed.

High unemployment rates in southern Europe led people to immigrate to other EU countries. This was happening while emigration continued from the Eastern European countries that joined the EU about a decade ago. The prospect of higher income and better working conditions in Western Europe is appealing for Eastern Europeans. The refugee crisis only intensified socio-economic and security concerns.

In the U.K., a major argument for the “leave” campaign was that Brexit would allow more control over immigration from the rest of the EU. Britain’s population has grown from 57 million in 1990 to 65 million in 2015, despite a low native birth rate – mostly due to migration. While the migration flow is now almost equally divided between non-EU and EU countries, the number of EU-born people living in the U.K. has more than doubled since 2004, reaching about 3 million in 2015. The share of EU nationals grew from 1.8 percent to 6.3 percent of adults aged 16 to 64. The vast majority are economic migrants. While the majority of European immigrants initially came from the new EU member states in Central and Eastern Europe – including Poland and Romania – migrants from southern European countries also started to arrive after 2008.

The main concern for those supporting Brexit was that immigration reduces the salary expectations and job opportunities for Brits. At the same time, the migrants were perceived as benefiting disproportionately from the U.K. welfare system, with hospitals and schools becoming crowded. Moreover, the “leave” campaigners have underlined that migration has also had a negative effect on housing. Properties in London and other major cities are owned by rich migrants who outbid British buyers, while poor migrants are willing to crowd into dwellings that British residents find too congested.

The agreement between the EU and the U.K. negotiated in February by the British Prime Minister David Cameron would have allowed Britain to impose a four-year emergency brake on in-work benefits for European migrants residing in Britain – a policy that would be in place for seven years. However, this failed to alleviate the fears of the electorate. The way the EU, and in particular Germany, has managed the refugee crisis since mid-2015 has increased the worries of the U.K. population and strengthened the “leave” campaign. The elites and the masses saw this crisis very differently and distrust between the two mounted.

Furthermore, stark generational and socioeconomic gaps in perception of the EU have emerged. Eurobarometer polling data reveals that, across Europe, 55 percent of young people between the ages of 15 and 24 say they feel attached to the EU, compared to only 45 percent of Europeans over the age of 55. Levels of attachment also vary between socioeconomic groups, with the upper-middle class expressing greater attachment to the EU than the middle and lower-middle classes.

The masses experiencing the negative effects of the financial crisis throughout Europe have made it possible for new political movements to gain support at the expense of the traditional elitist (but mainstream) parties, which many feel no longer protect their interests. The new anti-system parties have promised better governance and more respect from Brussels for their national interests.

In some countries, established parties — like Poland’s Law and Justice Party and Hungary’s Fidesz – have promoted Euroskeptic views. In others, right-wing anti-establishment forces like the National Front in France and the Alternative for Germany party have challenged EU integration, garnering a growing amount of support. In parts of southern Europe, opposition to the bloc’s policies has come from the left, and parties like Greece’s Syriza and Spain’s Podemos. However, in the U.K., while the top leadership of the establishment parties were supportive of remaining in the EU, a third faction drawn from both parties supported leaving.

Economic problems in Europe have intensified social polarization, which has supported the rise of nationalism. The “us vs. them” divide has widened. Both sides of the debate on EU membership are growing increasingly stringent and extreme in their views, leaving little middle ground. “Remain” supporters have become hostile toward “leave” supporters. In essence, European society has again become tolerant of intolerance.

Imagining the New Europe

In the coming years, the EU will take on a new shape. But certain regions and areas of integration will be more affected than others. Here, we look in depth at the future of the free trade zone, Germany, Russia and southern and Central Europe, as well as the impact Muslim migration will have on the Continent.

The Free Trade Zone

Before 2008, it was believed that Brussels could establish a single market – a space where the free movement of goods, services, capital and people is guaranteed. However, there hasn’t been a free flow of capital within the EU – during the economic crisis negotiations, when countries negotiated based on their national interests, the structural problems of the eurozone were evident.

Germany has seen its national interest threatened as the EU weakens. Considering its dependency on exports and the free trade zone, Germany had to get involved in negotiating a solution to the banking crisis and the economic fallout in the south. It exerted a leadership position that it didn’t want, but had to take. At the same time, the sovereignty of countries like Greece and Cyprus has been under threat, as they submitted to the EU’s control. But, ultimately, the goal was to keep the free trade zone intact.



Trade is driven by economic need, not by regulations. Businesses see opportunities for trade and drive nation-states to facilitate their endeavors. Trade between the U.K. and EU members will continue after Brexit. However, while most countries’ exports to the EU increased after becoming members, the U.K. and Ireland have seen a drop, particularly since 2008. Unlike Germany, the U.K. is also almost equally dependent on the EU and non-EU markets.



Most member states have two or three European partners to which they export more than 50 percent of their total exports. The proportion of trade between geographically closer partners has increased. This highlights another post-Brexit trend we can expect to see. As Germany’s influence in the EU weakens, countries within the same region that share similar views on economics and/or security will likely increase trade and investment among themselves. Countries in northern Europe, Mediterranean Europe, Eastern Europe and Western Europe may group together to enhance their trade relations.

Furthermore, following the EU’s fragmentation, special agreements on trade and investment may appear between EU countries and non-EU countries. Similarly, countries that choose to leave the union will be able to take their own path and engage in bilateral and multilateral arrangements based on their own national interest. Countries like France and Germany will probably enhance relations with Russia. Central European countries like Romania and Poland may choose to increase bilateral economic relations with the U.S. Countries may choose to have better economic ties with neighboring non-EU countries. All in all, Europe will see a rise in the politics of international trade.

The EU was built on the idea that free trade would support prosperity. In seeking to establish a single market while also expanding it, the EU tried to take over regulatory functions that would normally belong to nation-states. One of the Brexit “leave” campaigners’ main arguments was the fact that Brussels’ excessive red tape was negatively affecting small businesses. Non-tariff barriers made it hard for small British companies to sell their products and services within the EU. The barriers include technical regulations, standards and conformity assessment procedures, labeling rules and sanitary measures. These barriers contribute to dilution of the free trade area and are likely to increase after Brexit. Just as national labor codes make it hard for both investors and workers to consider the EU a uniform labor market, such barriers are proof that trade within the EU is not actually “free.”

Another, less visible, claim from the “leave” campaign was that, due to the limits imposed on the deficit (members are obligated to keep deficits below 3 percent of GDP) and the public debt (below 60 percent of GDP without diminishing at an adequate rate), the U.K. couldn’t make its tax system competitive. This links to the long-standing argument that the U.K. gets less than it gives to the EU, as a net contributor to the EU budget.

Complaints about the negative effects of EU regulations on national economies have increased since the financial crisis. Until 2008, the EU saw nationality as a cultural rather than political phenomenon and, therefore, took over certain issues from national governments. That model worked until it was clear the bureaucrats in Brussels could not provide solutions to the economic crisis. In negotiations over how to address the crisis, member states prioritized their countries’ national interests.

Germany

As Britain leaves the bloc and European economies struggle, Europe’s economic powerhouse – Germany – will face its own crisis. This relates to the central strategic question that has plagued Europe for well over a century: what is the role and extent of German power in Europe? The Franco-Prussian War, World War I and World War II were all about the extent of German power, as Germany sought to dominate the Continent and the various coalitions of forces seeking to deter Germany from this goal.

As we have discussed, Germany is dependent on exports. Almost half of its GDP comes from exports, and Germany has thus far compensated for drops in its exports to China and the rest of Europe by depending on the U.S. and the U.K. But the U.K. is now leaving the EU and the U.S. cannot pick up the slack indefinitely.

As a result, Germany will be facing rising domestic unemployment. It will be in direct competition with surrounding countries that are in its supply chain like the Czech Republic, Hungary, Poland and Slovakia. Its clout in Central and southern European states will diminish along with its ability to hand out loans to these states. It will have an increasing number of migrants that it will have to provide for, having accepted them into the country. It will face crises in countries like Greece and Italy, which were integral parts of the German economy. They will be less likely to adhere to austerity strictures from Berlin unless Germany is willing to shell out the money necessary to bail them out – which Germany has never wanted to do and will be less able to do over time. Germany will also be desperate to find countries to buy German goods.

At this point, the priority for Germany will be survival and satisfying the domestic population, rather than propping up the European system or going along with U.S. foreign policy objectives. The EU, it must be remembered, was designed in the first place to tame Germany. Berlin was able to use the EU to enable its own economic success. The decline of the EU raises the question of what will happen when the system is no longer rigged to either declaw or enrich Germany.

This issue will be the center of gravity of European geopolitics. As Germany weakens, another great power of the 20th century will also be weakening: Russia. And while Russia faces a number of serious challenges, ranging from low oil prices to declining fertility rates and historically high mortality rates, great powers are most dangerous when their backs are up against the wall. And that is where Russia finds itself today, and will continue to find itself in the next few years.

Russia

The groundwork for this conflict has already been laid. The expansion of NATO has diluted its mission and strategic purpose, but it has also made the Russians very uncomfortable. The protests in Ukraine that set off a revolution and led to the annexation of Crimea were supported, though not directly, by Germany, France and the United States. This angered the Russians, as Ukraine was part of the historical buffer region that protected Russia from threats emanating from Western Europe.

Germany has been in the anti-Russia camp in recent years. Germany’s foreign minister was in Russia with the French and Polish foreign ministers when the pro-Russia Ukrainian President Viktor Yanukovych was booted from power in 2014. And Germany has held the line thus far when it comes to sanctions against Russia. But as Germany turns inward to deal with its own issues, it will lose some of its endurance in standing so strongly against Russia. And as Germany comes into conflict with other European countries, and as the EU’s writ continues to decline throughout the Continent, Russia will see an opportunity.

Russia will have more space to build relationships and influence in Europe. As power becomes more concentrated in regional blocks and national capitals, countries will no longer have to think about Brussels as they make their decisions, but rather what is best for them at that particular time. For some, that may include cooperation with – or at least a lack of opposition to – Russian moves in Eastern Europe. Ukraine’s future is more important to Russia than it is to any other European country or the United States. Russia will do whatever it can to, at minimum, prevent Ukraine from moving squarely into the U.S. camp, and at maximum to exert as much control as it can over the country.

Southern and Central Europe

Southern Europe’s weak economies are already a big challenge for the EU. Greece’s debt crisis raises questions over the sustainability of the eurozone, but growing economic woes in Italy – as well as continued challenges in Spain and Portugal – signal that a far more significant southern European economic crisis is underway. Italy is grappling with high rates of non-performing loans, on top of low growth and high unemployment. An Italian crisis has much more far-reaching implications than Greece’s, since Italy is the third largest economy in the eurozone. As a result, an intensification in Italy’s economic problems will have ripple effects across Europe’s major economies, potentially negatively impacting the stability of the euro, European banks and exporters.



Europe’s fragmentation will intensify Central and Eastern Europe’s security challenges. European governments have long floated plans for greater EU-wide defense cooperation, but the bloc’s growing challenges make this project more unlikely. With the U.K. – the largest spender on defense in Europe – leaving the bloc, and other European states increasingly occupied with their economic troubles, states along the EU’s eastern edge will grow apart from the rest of Europe. Central and Eastern European states will look for new economic partners and defense allies, as Russia will push to boost its influence in the region.

Muslim Migration

Intersecting all these issues is the role that Islam will play, and indeed already has played, in Europe’s geopolitics. The map below uses data released by the Pew Research Center to identify the relative Muslim population in European countries in 2010.



We used 2010 data because it was the most recent and reliable, but it should be noted that the map above does not take into account the refugee crisis, which began in earnest only after 2010. Syria descended into civil war in 2011, and the Islamic State’s rise and the concurrent breakdown of Iraqi governance occurred after this data was gathered, so these events were not factored into Pew’s estimates for Muslim population in Europe in 2020 and beyond. Germany accepted more than 800,000 migrants in 2015, and a study by the Central Council of Muslims in Germany estimated that 640,000 of those were Muslim, which puts the number of Muslims living in Germany at around 6 million.

The reasons for Brexit are many, but one of the key reasons “leave” beat “remain” in the end was the migrant issue. In the summer of 2015, Germany was still committed to opening its borders to refugees and was trying to pressure other EU members, including Britain, into accepting more refugees. At one point, German officials were all but threatening that Cameron would not be able to negotiate new terms with the EU if Britain did not pull its weight in accepting more refugees.

Britain already has a population of over 3.5 million Muslims. Numerous attacks carried out by Islamic extremists in recent years, most notably the 2005 London Underground bombings, raised fears among some British voters. At the same time, as with migration from eastern members of the EU, many working and middle class Brits feared that an influx of migrants would harm their job prospects or impact salary levels. Many British citizens were not prepared to accept Germany’s demand that they accept more refugees or suffer the consequences. One of the most basic qualities of sovereignty is the ability to control one’s borders, and even the notion that this authority would have to be discussed in a committee in Brussels was one of the driving forces that encouraged British citizens to vote “leave.”

In this sense, the Muslim population of Europe, which, not counting the recent surge in migration, was forecast to reach 10 percent of Europe’s total population by 2050, has already begun to reshape European geopolitics. Recent migration could push this number higher much faster than anticipated, which will have an effect across Europe. In the U.K., Brexit probably would have been defeated without the conflagrations in the Middle East, the subsequent migration to Europe, the inability of the EU to respond to the migration, and the attacks on European soil like those in Paris. In Germany, which has an aging population, the influx of young Muslim men from the Middle East could have unforeseen long-term effects. Germany and Russia in fact have two of the largest Muslim populations in Europe and those populations are growing more rapidly than other demographic groups.

These changes will also be affected by the continued resilience of IS, Syria’s civil war, closer cooperation with Turkey (a Muslim country that in previous incarnations ruled much of the Balkans and southern Europe) to contain Russia and stem the flow of migrants, Libya’s continued instability and other unforeseen developments in the Middle East. As nation-states assert themselves and as nationalism rises, there will be a ready-made “other” increasing rapidly in those states, and a small but consequential minority of those “others” believe Western civilization needs to be destroyed. The EU cannot address this issue at a continental level, and each state will likely deal with it in its own way.

Europe and the United States

In this fragmented Europe – where Germany must look to its own interests and Russia is looking to re-establish itself in its traditional buffer regions while it still has the capability to do so – the British vote to leave the European Union makes sense. The U.K. has been balancing between the United States and the European Continent. There is an illusion in the mainstream that by voting to leave the EU, Britain has effectively left Europe. However, Britain cannot leave Europe.

The U.K. does not have to be in the EU to be part of Europe. It will always be a part of Europe. That said, unlike most other European countries, the U.K. is not as tied up with the Continent. It has options. That does not mean it can ignore Europe, and it won’t. The trading relationship between Germany and the U.K., for example, is an imperative for both. The U.K. has been pulling closer to the U.S. in recent years, and both countries will continue to share their interest in preventing the rise of a regional hegemon on the European Continent.

France is also part of this equation and has always tried to assert its independence from U.S. strategic initiatives. But France is also on the front line of many of these issues and will have to remain in the British and American orbit while preserving enough power and independence to stand on its own two feet. France was the original core power of the European Union, and to the extent that it can, it wants to preserve some of the EU’s residual power to maintain as level a relationship with Germany as it can.

U.S. President Barack Obama said he wanted the U.K. to remain in the European Union. Obama also probably wants the Chicago Bulls to win the National Basketball Association championship every year, but that doesn’t mean it will happen. Europe has already begun to fragment, and this has defined U.S. policy in recent years.



U.S. Secretary of State John Kerry has said NATO can be a stabilizing force now that the U.K. has left the EU. This is mostly wishful thinking. The most consequential U.S. relationships on the European Continent will increasingly be bilateral and regional and will develop outside the auspices of the old institutions. The Intermarium is the idea of an alliance of countries between the Baltic and Black seas that will work with the United States to block Russian influence into Europe. The U.S. will continue to work closely with Poland and Romania, and its relationship with Turkey will also become more complicated and important to both sides. The U.K. has already played a part in this, with British fighters and troops stationed in the Baltics. It continues to play an important role, and increasingly these moves will happen outside of NATO.

Following Brexit’s Logic

The fragmentation of Europe poses other unique challenges across the Continent. It is these that pose the greatest challenge for the United Kingdom.



The United Kingdom is not a nation-state. It is made up of four nations – England, Wales, Northern Ireland and Scotland. And London is so politically and culturally distinct from the rest of England that it could almost be considered a city-state at this point. Britain voted to leave the European Union. The same logic could be used by Scotland or Northern Ireland to leave the United Kingdom.

The problem with this is how deeply embedded Northern Ireland and Scotland are in the United Kingdom. It makes sense that both voted to remain in the European Union – historical memory dictates that both should prefer to trust the European Continent over their English neighbors. But Scotland and Northern Ireland have enjoyed in the economic success of the United Kingdom over the centuries. Scotland, for example, approved the Articles of Union in 1707 because it was on the verge of insolvency and it was in its best interest to join the United Kingdom.

Even if Scotland were to get approval to hold a second referendum on EU membership (which it must by law) and even if it voted to leave, it could not leave the U.K. as simply as the U.K. can leave the EU. Scotland uses the pound. Scottish soldiers serve in the British army. Separation would be far more complicated. This is fundamentally uncharted territory, and there might be potential for some kind of compromise, in which Scotland remained part of the United Kingdom but was given more autonomy and freedom to determine its relationship with the EU.

The imperatives keeping the United Kingdom together may be weakening, but even so, they are far stronger than the imperatives keeping the EU together. In any case, it will take years for Britain to untangle itself from the EU. Even if, in the next year or two, Scotland or Northern Ireland held a successful independence referendum, it would take longer to untangle themselves from the U.K. By that point, things in the EU might be so bad that joining won’t seem like a feasible option anymore.

This is not a strictly British challenge. The map above should be striking for the number of areas and peoples that it lists. Basque Country and Catalonia are fairly well known, but Occitania is bigger than both, with over 16 million people with their own language spread across three countries (France, Italy, Spain), and with a sense of national distinctness.

Europe has gone through these cycles – of small distinct local areas being consolidated into large states or empires – in the past. The opposite is happening now, and while those that will be most vocal in pursuit of more independence will be the topic of a future study, it suffices to say that European nation-states will face the same kinds of challenges that the EU does from dissatisfaction with political elites and rising national pride. Of course, many of these states have much more history and interests in common than the various nation-states have with the European Union. But even so, they will not be immune to these forces.

The fragmentation of Europe does not just mean the fragmentation of the EU. The EU is the biggest and most consequential part of this. But Britain’s example has opened up a host of possibilities for redefining the way Europe works at the national level. It also means the continued existence of the United Kingdom or even the Kingdom of Spain as currently constituted is an open question.

The U.S. then will respond to Brexit and the fragmentation of Europe as it already has – by strengthening bilateral and regional relationships in order to achieve its strategic objectives on the European Continent. Great Britain will remain one of America’s closest allies, and will move even closer to the U.S. as it seeks to find its place between the Old World and the New.

The British vote did not cause these geopolitical forces toward fragmentation to emerge any more than policy did. They were already at work on the Continent. George Friedman forecast these developments almost a decade ago, and that forecast for the most part stands. It’s just happening even faster than we thought it would.