The Lessons of Little States: Small countries show the way through Brexit

Michael O'Sullivan & David Skilling

Foreign Affairs

The United Kingdom's exit from the European Union will set the countries of the United Kingdom (England, Northern Ireland, Scotland, and Wales) and Ireland on new economic paths. England and Wales will need to navigate the shocks of the Brexit process and seek new opportunities for trade around the world. Scotland, which may pursue a second independence referendum in the coming years, will have to strengthen its economic base and the institutions to support it. Northern Ireland, whose relationship with Ireland may be transformed by Brexit, must wean itself off its state-supported economy and streamline its political system. And although Ireland is an independent state, its fortunes, too, will be profoundly affected by Brexit.

As these countries chart their courses into their post-Brexit futures, there is a model they can follow. Over the past 30 years, small, developed states-from Sweden to New Zealand-have tended to outstrip their larger peers in terms of economic growth and quality of life, among other measures of social wellbeing. There is no single template for their success, but the standouts have a few things in common. They invest in education and training for their citizens-from compulsory, vocational, and university education to lifelong-learning programs. (For instance, Switzerland's apprenticeship programs are the bedrock of its small-to-medium-sized business sector.) They boost their competitive strength by, for example, investing in high-quality infrastructure, as the Nordic countries have done to support their information technology sectors. And because small countries are vulnerable to external economic shocks, successful ones protect themselves-through measures from strong social-insurance systems to conservative fiscal policies that give them breathing room to stimulate their economies during downturns.

Scotland

Scotland has most of the elements one would associate with a stable, prosperous European democracy, except political independence. It has a strong international reputation and, among other economic strengths, a well-developed financial sector. But it has work to do to develop its economy-from filling the gaps left by its declining oil and gas sector and further developing the finance and financial technology sectors, to generating more income from tourism and building high growth, innovative firms. Scotland also needs to significantly strengthen its public finances and develop the institutions that would support another bid for independence after Brexit.

The broadest lesson from the world's small, developed states is that economic success depends on what can be called intangible infrastructure: a set of factors including education, institutional health, regulation, the rule of law, technology, and coherent economic policies that leverage a country's particular advantages. The challenge for Scotland is to improve itself in these areas. It could do so by investing in areas of existing strength, such as renewable energy and finance, and by crafting regulations and tax policies that would make Scotland an attractive platform for companies seeking to do business with the EU. The country is well positioned to improve its financial, life-sciences, renewable-energy, and tourism sectors, and it should also develop new markets in areas such as aquaculture (as Norway has) and focus on technologically driven sectors, like financial technology.

Then there is the question of Scotland's independence. The debate around the 2014 referendum was fought largely over economic issues-one of which was whether Scotland should use the pound, the euro, or a new Scottish currency pegged to the pound if it became independent. Scotland does not need to settle that question now: an independent Scotland could easily retain the pound, at least at first. In the meantime, the country should set up a monetary authority, which in the run-up to independence would allow for the development of a group of technocrats who could learn about the technical aspects of managing a currency.

A monetary authority would permit Scotland to gain important expertise and would create an institution around which it could develop other financial functions. Here, too, other small economies could offer guidance. In recent years, the central banks of Denmark, Sweden, and Switzerland have had to creatively set monetary policy to offset the side effects of quantitative easing in the eurozone, by, for example, introducing negative interest rates. (While this maintained economic stability, it has also led to strong growth in housing prices in those countries.) If Scotland were to become independent and set up its own currency, Scottish policymakers should study such cases, since they provide useful examples of how small states can navigate international forces often beyond their control. They should also look closely at historical episodes of new currencies, such as that of independent Singapore in the mid-1960s, in order to better understand the practicalities of launching a new currency.

Two other lessons are worth considering. One is the way states such as Norway have used sovereign wealth funds to grow their fossil-fuel resources into long-term sources of prosperity. The value of Scotland's oil economy has fallen recently, but the country is rich in other resources-particularly wind and wave energy. These natural resources, together with the potential offered by aquaculture, could be developed through state-backed investment and could eventually feed into a sovereign wealth fund. Switzerland, meanwhile, has carefully managed its financial sector, mapping out its growth and ensuring that the state can muster the resources-from regulatory changes to physical infrastructure-to ensure its health. If Scotland becomes independent, it should act similarly, since its financial sector would be essential for supporting the financial flows that would follow from the creation of a new currency.

Northern Ireland and Ireland

There are a few anomalies among the small, successful countries of the developed world. Northern Ireland is among them. It differs significantly from the other small, developed countries in Europe in terms of its relatively low human development rankings and the very large footprint of the state in its economy.

Brexit will transform Belfast's relationships not only with London and the EU, but also with Ireland, its southern neighbour and an EU member-state. The chief economic risk is that London will disengage from Northern Ireland. That there will be more economic and social interaction between Northern Ireland and Ireland is a growing likelihood.

So U.K., Irish, and European policymakers should jointly take action to energize Northern Ireland's economy, funding the kinds of programs that have been successful in other small countries. The United Kingdom and the EU should put aside a small portion of the so-called Brexit bill that London will pay to the EU to back a development plan for Northern Ireland. For instance, EU and U.K. officials could collaborate to design skills-based apprentice programs, as Austria and Switzerland have done, to provide the human capital for developing new businesses. They could also manage the housing sector through social-impact investing, as Belgium does, to develop new residential areas. Such a plan might also back the kinds of cultural projects that bring communities together.

As for Ireland, that country's modest geopolitical standing and relatively high degree of social cohesion (among other factors) mean that it has more in common with states such as the Netherlands and Singapore than with Germany or China. And indeed, Ireland is a prominent member of the club of successful small countries. Today, Irish officials are working with their counterparts in other small EU states, such as Denmark, to develop a common position on European affairs as Brexit becomes a reality. The potential for Brexit to, at some point, produce an investment and consumer confidence shock in the United Kingdom will carry through to Ireland, as will the implications of post-Brexit currency volatility. (Those costs will perhaps be offset by benefits to Ireland, as the country attracts inward investment that leaves the United Kingdom.)

Brexit should be an opportunity for Irish policymakers to focus on the structure of Ireland's economy. As a Eurozone member, the country has limited flexibility in terms of monetary and fiscal policy. But it could and should emulate Sweden and Switzerland's efforts to support medium-sized businesses-which are the bedrock of those economies and are the missing link in Ireland's economic engine. If its medium-sized businesses flourish, Ireland will have less need to worry about multinational firms abandoning it for countries with corporate tax rates that are even lower than its own. Ireland should also carefully cool its runaway housing market, as Singapore and Switzerland have. A deeper issue is that Ireland needs to develop more acumen in its management of state-related enterprises and institutions-for example, in the areas of healthcare and transportation. Ireland will soon have a new Taoiseach, or prime minister, and possibly a new government. Instead of tackling each of its domestic problems on a case-by-case basis, the Irish state should broadly examine its approach to governance and public services.

The election of Emmanuel Macron as French president and the likely re-election of Angela Merkel as German chancellor this autumn could lead to more fiscal uniformity across the Eurozone. Ireland should push for it and other small Eurozone states to retain their flexibility over fiscal policy, since the essence of small countries' economic success is their ability to set policies in ways that makes them distinctive-and that includes the choice of tax rates. That may require establishing a coalition of small Eurozone states that could learn from one another and develop policies together-and such an arrangement would, in turn, make a longstanding economic trend into a new configuration in international politics. Brexit will cause many aftershocks in the United Kingdom and Ireland, and as these economies respond to this new world, there will be much that they can take from the experience of other small economies-from the need to build high-quality institutions to the value of investing in areas in which they have a competitive advantage.

Michael O’Sullivan is Chief Investment Officer in the International Wealth Management Division at Credit Suisse; David Skilling is Director of Landfall Strategy Group.