One potential response to Europe's refugee crisis could lead to 'the worst possible outcome'

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The refugee crisis has been turning Europe upside down.

In light of an ongoing influx of migrants and recent security threats, there has been an increased possibility that the Schengen agreement — which allows free movement across a wide swathe of Europe — would be suspended.

Some governments have already introduced temporary controls at their borders, including Hungary at its short border with Slovenia and France at its borders with several countries following the Paris terrorist attacks.

Most recently, Greece was given three months starting in mid-February to tighten its border controls — or else the EU would reintroduce border controls "at all or at specific parts of their internal borders as a matter of last resort."

HSBC's Chief European Economist Karen Ward and her team argued in a recent note to clients they aren't exactly sold on the idea of suspending the Schengen agreement, as it wouldn't aid either refugees or the EU economy.

Ward writes:

Reinstating national borders would not resolve the problem in our view. Indeed it might be the route towards the worst possible outcome in which a large number of migrants still arrive, but they are not able to travel to where their chance of employment is greatest and are forced to live 'underground' without any possibility of officially integrating into society and labor markets. Economics and government tax receipts will not truly benefit and national discontent could rise even further.

As for the rest of the EU economy, she writes that if the Schengen agreement were suspended, "this would harm trade in an already weak economic environment and, once again, raise questions about Europe’s capacity for deeper integration."

Although suspending Schengen doesn't mean that businesses and workers can't move around Europe at all (there would be passport and vehicle checks at borders), the following charts shared by Ward suggest that its suspension could still have a noticeable impact on EU trade and tourism.

The first chart shows exports of Germany to France against those with Austria, another country that shares a large land border but was not part of the original Schengen agreement.

There's a notable acceleration with France relative to Austria in the years immediately following 1985, when the agreement was first signed, observes Ward:

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Similarly, here we have exports from France to Germany against those of Spain, another big neighbor that wasn't part of the original Schengen agreement. Interestingly, once the Schengen agreement was expanded in 1997, the difference became less stark:

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"Although it is hard to draw strong conclusions, or indeed quantify the precise effect, our view is that dismantling Schengen would have a notable impact on EU trade," writes Ward.

"And this at a time when the Eurozone economy is already sluggish."

However, the notable exception to Ward's argument is the UK, which has preformed well in trade with the EU (until recently). Moreover, Ward cites the Mastercard Global Cities Index data which says that London is the most visited city in the world, suggesting that the visa requirement isn't a huge deterrent.

Still, there is also the potential ideological impact from the potential Schengen suspension.

In other words, how this could affect the EU's understanding of "European-ness."

Again, here's Ward:

"For some Schengen is symbolic of the benefits of Europe — according to the latest Eurobarometer the free movement of people is the second most appreciated concrete achievement of the EU ... so an argument could be made that this is a further step away from closer integration and a sense of being 'European.'"

Ultimately, the crux of the issue here is whether or not the EU can be incentivized to work as a cohesive unit, rather than as individual states, argues Ward.

"The lack of political and fiscal union posed a threat to EU’s greatest endeavor –monetary union – at the time of the Greek crisis," she wrote.

"The same issue now also challenges Schengen free trade, and raises further questions about whether Europe really has the capacity for deeper integration."

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