Downing Street cred

Yesterday’s announcement that Theresa May will, for the first time, countenance the possibility of an extension of the Article 50 deadline came not a moment too soon. To recap, the PM announced: (i) that she will offer a second meaningful vote on the Withdrawal Agreement no later than 12 March; (ii) if parliament rejects it yet again, then the government will table a vote no later than 13 March to ask MPs if they accept leaving without a deal; (iii) if they do not, parliament will be asked to vote on 14 March whether it will vote for an extension of Article 50 beyond 29 March.

Theresa May's credibility dwindles by the day 

I have been pointing out for months that an Article 50 extension was the most sensible outcome given parliament’s failure to agree what it wants, and it is good to see that reason finally appears to have penetrated 10 Downing Street. A bigger question is what took the PM so long to understand the reality of the UK’s position? It is understandable that she wants to get parliament to accept the Withdrawal Agreement negotiated in November, but her strategy of insisting there was a choice only between her deal and no deal was never realistic.

More than anything the decision confirmed the impression of a prime minister whose authority has disappeared like a badly fixed wig in a hurricane. Over the past two years May has promised that the government would decide the timing of Article 50, until the Supreme Court determined that it was a matter for parliament. She gambled on a general election and lost her parliamentary majority. She promised that “we will take back control of our laws and bring an end to the jurisdiction of the European Court of Justice” but is now pushing an Agreement with the EU in which “the UK’s domestic courts and authorities will be required to have due regard to the case law of the Court of Justice of the European Union.” May has also faced down a leadership challenge in which one-third of her party’s MPs failed to support her and when the Withdrawal Agreement was put to the vote it was defeated by the biggest majority inflicted on any government since 1924. Then there is the small matter of the parliamentary rebellion two weeks ago by members of her own party, which failed to offer support for the negotiating position with the EU that they had instructed her to take. And now, the prime minister who has promised parliament more than 100 times previously that the UK will leave the EU on 29 March is prepared to renege on that commitment as well.

This lack of credibility matters for what happens next. A three-month postponement of the Article 50 deadline will nominally give the PM more time to renegotiate with Brussels. But the EU has already stated that it will not renegotiate the Irish backstop arrangement, which is such a sticking point for Brexit-supporting MPs. Nor is it likely to grant major concessions to a leader who cannot guarantee that they will be passed by parliament. In addition, May cannot simply replay the trick of telling MPs that if they do not pass her Withdrawal Agreement the UK will crash out of the EU at the end of June without a deal, given that she has already blinked in the face of reality.

Nor is the economics credible

As if we needed reminding of the damage that a no-deal Brexit could cause, DExEU yesterday published a summary document outlining the difficulties that the economy would face. In short, it highlights the lack of preparedness with government departments reported as “being on track for … just over two thirds of the most critical projects.” The UK has signed trade agreements with only one of its major trading partners (Switzerland which was the 12th largest export market in 2017) though does have arrangements in place with Chile, the Faroe Islands, members of the Eastern and Southern Africa (ESA) Economic Partnership Agreement, Israel and the Palestinian Authority (which makes me wonder what Liam Fox has been doing since autumn 2016). 

In addition, DExEU also speared one of the options put forward by Brexit supporters that Article XXIV of the General Agreement on Tariffs and Trade (GATT) will allow tariff-free trade with the EU for a ten-year period. As DExEU pointed out, “This is a misunderstanding of what the rules are … [since] it would require the agreement of the EU.” And as the Secretary of State for International Trade told the House of Commons on 14 January this year, the “suggestion would not deal with all the regulatory issues—the non-tariff barriers—that are so important to many businesses.”

DExEU also pointed out that “there is little evidence that businesses are preparing in earnest for a no deal scenario, and evidence indicates that readiness of small and medium-sized enterprises in particular is low.” Other gems include the nugget that 30% of the UK’s food supply comes from the EU and “the potential disruption to trade across the Short Channel Crossings would lead to reduced availability and choice of products” with the result that “food prices are likely to increase, and there is a risk that consumer behaviour could exacerbate, or create, shortages in this scenario.” The report goes on to point out that the “service sector (which makes up around 80% of UK GDP) is supported by free movement of people and a range of cross-cutting regulation such as mutual recognition of qualifications. In a no deal scenario … the UK would risk a loss of market access and increase in non-tariff barriers.” It concludes that a no-deal Brexit on 29 March “does not allow Government to unilaterally mitigate the effects of no deal.”

None of this comes as any surprise to the economics profession, which has been warning of these issues for more than three years. Given the complexity of the issues outlined in the report, matters will be no different on 30 June. Of course much of this can be avoided if the UK signs the Withdrawal Agreement. But this would make the UK an EU rule taker, which is (i) a much worse position than the one we enjoy today as an EU member and (ii) not a position the Brexiteers have shown any willingness to sign up to. That said, in an interview this morning in the Financial Times, Jacob-Rees Mogg, the keeper of the Brexit flame, suggested he was prepared to back down from his hardline position on the Irish backstop. Perhaps he now realises that if he blocks the Withdrawal Agreement, the bad Brexit that would result may be the only one he will get given that the Labour Party has moved towards backing a second referendum which may reverse the 2016 result.

Those suggesting we should just “get on with it” because “that’s what the people voted for” are wrong. There are no good outcomes – only less bad ones. But it would help if certain politicians, starting with the prime minister, were more honest about the trade-offs that Brexit entails. That way, voters might be able to make less ill-informed choices rather than relying on slogans painted on buses.

Doing the splits

Although I am not a political commentator, it is impossible to look at the biggest issue(s) in British economics without concerning ourselves with the political context against which they are being taken. None of these issues comes bigger than Brexit, although it increasingly seems as if the debate has little to do with leaving the EU and is more the battleground on which various factions are fighting to try and reshape the domestic political debate. Quite where the chips will fall once the fighting is over remains to be seen.

The first steps toward reshaping came this week with the news that 12 MPs have resigned from their parties (9 Labour and 3 Conservatives), with 11 joining a new movement calling themselves The Independent Group (TIG). As I noted on Monday, Labour MPs decided to leave their party for a variety of reasons but Brexit was very much at the heart of their decision. The three Conservative MPs who jumped ship on Wednesday were very explicit about the fact that the government’s handling of Brexit was the decisive factor in their decision. Anna Soubry, the redoubtable (former Conservative) backbench MP was clear about her reasons for leaving (for those with 24 minutes to spare, this Times podcast is well worth a listen). It  is evident that she does not have much time for Theresa May as prime minister, arguing that she is out of her depth, and in a TV interview earlier in the week Soubry went so far as to suggest that May has “a problem with immigration” which explains her antipathy towards the single market. That is quite a bold allegation but Soubry can point to the “Go Home” campaign carried out in 2013 by the Home Office, when May was Home Secretary, as evidence.

Obviously we are in the realms of the speculative here so it pays not to push it too far. However, it would explain why the PM has been so keen to give in to the ERG which is increasingly described as “a party within a party,” and I have long questioned the PM’s commitment to the Remain campaign that she nominally supported. Given the small number of ERG MPs, I have never understood why the PM did not try and face them down earlier if she was so opposed to their views. If there is even the slightest grain of truth to Soubry’s allegation, it calls the whole basis of the government’s Brexit strategy into question for it implies that the ideological considerations of a small proportion of Conservative Party members, which number around 124,000, are being placed ahead of the economic wellbeing of the 66 million people living in Britain.

Ideology is not, of course, confined only to the Conservatives. The opposition Labour Party is arguably the most ideologically oriented party to sit in parliament in many a year. Even in the 1970s, when Labour was swinging to the left at a rapid rate of knots, there were sufficient heavyweights in the political centre who were able to slow efforts by activists to take over the party machinery. Simply put, Jeremy Corbyn is the most left wing leader of a major political party in the post-1945 era (you can check out his voting record here). Interestingly he has “generally voted for more EU integration” – 60 votes for, 24 votes against, 47 absences, between 2006 and 2019. But he opposed remaining in the EU in 1975 and the ratification of the Maastricht Treaty in 1993, whilst backing a Conservative proposal in 2011 calling for a referendum on the UK’s withdrawal from the EU.

Whilst the right-wing of the Conservative Party wish to leave the EU to further a free-market agenda, Corbyn has been critical of the EU’s role in protecting workers’ rights. He is thus open to the charge of enabling the wishes of the Tory right via a diametrically opposed left-wing stance. Back in 2015, just after he was elected leader of the party, a senior aide was quoted as saying “I don’t think that Jeremy is going to find very many people supporting him in the idea that we should leave the European Union.” (Link here to Reuters story but it does not work in Firefox though seems to be OK in Explorer). Younger people who voted for Labour in 2017 as a protest against the Conservative’s handling of the Brexit issue have been sadly disappointed.

Despite the government’s apparent ineptitude, Labour trail the Conservatives by 4 points based on an average of the last 10 published opinion polls. At the end of December, the two parties were running neck-and-neck. Although the gap is not statistically significant, the trend is noticeable. It will be interesting to see how the recent political defections change the balance. A poll carried out before the defection of the three Tory MPs gave TIG a 14% share versus 38% for the Conservatives; 26% for Labour and just 7% for the LibDems. One poll does not represent a trend but the initial numbers suggest that Labour and the LibDems may struggle if TIG ever becomes a fully-fledged political party.

But we may not get to find out. If TIG damages Labour more than the Conservatives, and on the assumption that (i) the government can deliver a soft Brexit (this week’s votes will be interesting and may force the government to delay the Article 50 deadline) and (ii) the number of defections to TIG is limited, a sensible strategy on the government’s part might be to try and hold an(other) early election. There is certainly lots of chatter suggesting that a summer election is a possibility. It would, of course, make a mockery of the Fixed Term Parliaments Act, designed to prevent governments from controlling the timing of elections, but that did not prevent just such an outcome in 2017. As a reminder, the Act requires two-thirds of MPs to vote in favour which, given that Labour have been pushing for such an election, is likely to be achievable. If TIG proceed to split the Labour vote it might allow the Conservatives to regain the parliamentary majority they squandered in 2017 whilst also seeing the nascent TIG all but wiped out as they lose their seats to representatives from the main parties.

If this strategy does play out it will simply reinforce the political status quo and leave those voters hoping for an alternative to the ideological convictions of the main parties with nowhere to go. Moreover, a third general election in four years would be too much for most voters to swallow. But much as Brexit gives a uniquely British dimension to the political debate, the tectonic plates are shifting in many other countries too. They say that the four most dangerous words in markets are “this time it’s different.” But as regards politics today, this time it really is.

Assessing recession probabilities

Over recent months I have spent far more time than is healthy looking at political issues and I will return to them again. But for a pleasant change I wanted to look at some economics, specifically some quantitative analysis of the outlook for the UK. Brexit considerations aside, the UK faces headwinds from the global economic cycle which has lost significant momentum in the last couple of months – indeed the slowdown has come upon us more quickly than imagined. Within Europe, Italy fulfils the technical definition of recession, having posted two consecutive negative quarters of GDP growth in the second half of last year whilst Germany has only just avoided the same fate, with a flat Q4 growth rate following a contraction in Q3 2018. Despite all the concerns regarding the gilets jaunes protests, France did not do badly with quarterly growth of +0.3% in each of Q3 and Q4. The UK did even better, with a +0.6% rate in Q3 followed by a more modest expansion rate of 0.2% in Q4.

But that is all in the past. What about the outlook for the remainder of 2019? Obviously Brexit remains the elephant in the room as far as the UK is concerned, so it is impossible to be precise about what is likely to happen. In terms of what the evidence tells us so far, we know that business fixed investment fell in each of the four quarters of 2018, and in the second half the pace was particularly rapid with spending down 2.6% in real terms in Q4 relative to Q2. By end-2018 the volume of activity was thus the lowest since Q3 2015, and the second lowest quarter in four years. It is possible that it will rebound in the absence of a no-deal Brexit but latest CBI survey evidence continues to suggest that companies are likely to cut capital investment over the next twelve months.

However, declining business investment is not necessarily a good indicator of what will happen to overall GDP. In 14 of the last 53 years business investment has actually fallen at the same time as GDP has expanded. For four consecutive years between 2001 and 2005, when GDP growth averaged 2.7% per annum, business investment declined at an average annual rate of 2.8%. It is thus illustrative to look at the information content in other data to see what it tells us. In doing so, I have relied on the literature on qualitative choice models which tries to find leading indicators to predict recession probabilities (see this New York Fed paper for insight into how such models have been applied in the context of the US).

In applying the analysis to the UK, the object of the exercise is to find indicators which have decent predictive power. I finally opted for the CBI’s business optimism index and the Conference Board’s leading indicator, which is in turn comprised of eight variables (order books, expected output, consumer confidence, bond prices, equity prices (All Shares), new orders, productivity and corporate profits). Although the leading indicator does contain financial variables, equities have a weight of less than 4% so I added a series for real equity prices (using the consumer spending deflator as the relevant price index) to specifically account for the fact that markets often spot downturns in the economic cycle more quickly than the published economic data.

As noted above this methodology uses models of qualitative choice. Such techniques are used to model outcomes where the dependent variable takes a binary 0,1 value depending on the contingent state. In this case the dependent variable is the year-on-year rate of real GDP growth which takes the value 1 when it falls into negative territory and 0 otherwise. Thus what the model tries to do is assess the likelihood that annual growth will turn negative [1]. Based on data back to 1973, we have 184 quarters of data, and on 25 occasions GDP growth turned negative. Using a basic probit model, I estimated a relationship between lagged values of the three explanatory variables and the binary dependent variable to give an assessment of recession probabilities six months ahead.

As the chart shows, on the four occasions since 1973 that growth has gone into negative territory, the model has predicted this six months ahead of time with an accuracy rate of at least 90%. The model suggests that on the basis of current data there is a probability of around 33% that GDP growth will turn negative by mid-2019. In order for that to happen by Q3 would require a sluggish Q1 growth rate and modest declines in Q2 and Q3 (i.e. a technical recession). Absent a Brexit-related collapse, this would appear to be a stretch. Thus the model likelihood of around one-third appears reasonable – an unlikely, but not impossible, scenario.

In contrast to conventional forecasting techniques, we do not attempt to quantify the rate of GDP growth. But the probabilistic approach outlined here gives a sense of the risks surrounding the outlook and thus some steer on how much preparation may be required to offset the worst-case outcomes. Obviously, the analysis is based on the information content in current data and is subject to changes resulting from random shocks. Brexit could thus significantly change the picture, but that is a subject for another day.

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[1] Strictly speaking we ought to be looking at quarterly GDP growth to define those periods where there are two consecutive quarterly declines, but there is such a lot of noise in the quarterly data that the equations do not fit the data particularly well.

Truce or dare?

With every day that passes the economic case for Brexit crumbles before our eyes. Sensible politicians look on in horror as the zealots pursue a Brexit that satisfies “the will of the people” despite the fact that the Brexit they are proposing is nothing like the one promised almost three years ago. People were asked to vote on where they wanted to go, but not how they expected to get there. As we are now learning, the journey is likely to prove far more damaging than they were led to believe. I, for example, would very much like to climb Everest and would happily cast my vote for someone who could promise to get me there easily and safely. I am less keen on slogging up 8848 metres in the teeth of some of the worst weather on the planet whilst running the risk of hypoxia.

The events of today have made it clear just how the path towards the sunlight uplands of Brexit is crumbling beneath our feet. Let’s start with the politics and the news that seven MPs have resigned from the Labour Party to set up The Independent Group. This is a measure of the sheer helplessness felt by many Labour MPs who see their party drifting away on a sea of left-wing irrelevance following Jeremy Corbyn’s unwillingness to use his position to stand up to the damaging form of Brexit proposed by many on the opposition benches. Let us not forget that in summer 2016 Labour MPs called a vote of no confidence in leader Jeremy Corbyn following the EU referendum, which he lost by 172 votes to 40. However, he remained as party leader by a margin of 61% to 39% following a ballot of all party members in September 2016.

But we have been here before. In 1981 four MPs left the Labour Party as it drifted inexorably to the left, to form the Social Democratic Party. Whilst this was instrumental in forcing Labour to confront its internal issues, it was a multi-year process which succeeded in splitting political opposition to the Conservative Party which remained in office until 1997. As it is, current opinion polls suggest that the Conservatives are marginally ahead and unless the new political centre can rapidly gain significant momentum it is hard to see how this will change the political dynamics, unless it can gain support from Conservative dissidents (which currently looks unlikely).

It is far from sure that this will have much impact on the Brexit debate either. Seven MPs are hardly enough to change the world and there are just 39 days (936 hours) until the default option is triggered which will force the UK out of the EU unless something changes radically. Perhaps they will be able to put forward parliamentary amendments (e.g. attempts to postpone the Article 50 deadline) which will be easier to accept on a cross-party basis as they are seen to come from independent MPs and not those attached to any of the major political parties. But I will not be holding my breath. Nonetheless, as I noted in my previous post, today’s move is a belated recognition that the established political parties are more interested in appealing to the ideologues who form the core of party membership than the interests of centrist voters (something which is true of both parties).

However, it was the news that Honda is planning to shut its Swindon plant in 2022 that really should cause eyebrows to be raised. Local MP Justin Tomlinson noted in a tweet that Honda “are clear this is based on global trends and not Brexit, as all European market production will consolidate in Japan in 2021.” I refuse to accept that it has nothing to do with Brexit but there is a very good reason why Honda might want to consolidate production at home: Towards the end of last year Japan signed a trade deal with the EU that removes the 10% import tariff on Japanese cars and the 3% tariff on most car parts. So they don’t need the UK any more. And don’t say you weren’t warned. I pointed out in 2015 that “international companies already have to carefully balance the net benefits of operating in the UK given that business operating costs are higher than in the EU8 countries. Brexit may make this calculation more clear cut.”

Without wishing to compare the ideologies underlying the two processes or trivialise historical events, I have been struck in recent months by the logistical parallels between the progress of the Nazi invasion of Russia in 1941 and the Brexit process. Both were the product of an ideologically motivated desire to achieve bigger goals (the defeat of Communism/throwing off the yoke of the EU), which were preceded by intense planning but both were under-resourced campaigns (logistically in the Russia case; intellectually in the Brexit case). You can argue that both campaigns started well, achieving many of their initial goals, before becoming bogged down by harsher conditions (weather/economic reality) and the sheer weight of the opposition (Soviet troops/the EU’s economic heft). But the key point is that the military campaign ran out of steam following defeat at the Battle of Stalingrad when the magnitude of the task facing the Wehrmacht became startlingly clear.

I wonder whether the Brexit campaign has yet reached its Stalingrad moment. The Nazis clearly learned nothing from Napoleon’s attempt to invade Russia in the same way the Brexiteers appear not to have learned the lesson of those countries which tried to throw their weight around with the EU. Just to push the parallel further, both campaigns kicked off in June (almost to the day). Thirty two months after the start of the Russian campaign the tide had decisively turned in the Soviets favour, although it was to be another 15 months before the whole episode was concluded. After a similar period since the EU referendum, Brexiteers also appear to be fighting a losing battle and whilst they clearly will not give up, they cannot win. They might force the UK out of the EU without a deal, although I still maintain that they will be prevented from doing so, but they cannot deliver on their promise to deliver an economically brighter future.

Each decision by the likes of Honda or Nissan to scale back production or to abandon expansion plans represents potential jobs that will not be created. Each decision by politicians to abandon the ideological path which their leaders are trying to follow represents a step away from the cliff edge. Rather than fight Brexit battles which threaten to damage the economy, it is time to call a truce.

In search of a third way

Much has been said and written over the years about the need to find a third way in politics which advocates a synthesis of policies from both sides of the political divide. It was a term I first came across during the Swedish political debates of the 1980s but it was popularised more widely in the UK by Tony Blair’s government of 1997. It sounds like a great idea in theory but in practice it has generally only been adopted by politicians from the Social Democratic end of the spectrum and tends to fall out of fashion when they are replaced by politicians from the opposite side of the left-right divide. But now may be the time to find a genuine third way given the apparent inability of the political establishment to find solutions to the electorate’s current woes.

Andrew Heywood, in his book Key Concepts in Politics and International Relations, describes left-wing views as supporting interventionism  and collectivism whilst right-wing views  favour the market and individualism, though as he notes, “this distinction supposedly reflects deeper, if imperfectly defined, ideological or value differences.” Writing in their book The Government and Politics of France, Andrew Knapp and Vincent Wright argue that the main factor dividing the left and right wings in Western Europe is class, with the left seeking social justice through redistributive social and economic policies, while the right defends private property and capitalism. But political thinkers are increasingly questioning whether this distinction is adequate for modern industrialised economies. After all, we no longer operate in the extreme world of capitalists and serfs from which these class distinctions sprang (although it may sometimes feel like it).

Philip Collins made a very similar point in The Times last week with regard to the UK. In his view, “For most of the general elections since 1945, if an observer understood the class status of a voter then it was a relatively simple matter to predict their political allegiance.” But after the 2017 election, this view was no longer seen to work. “Party affiliation now matters less than cultural outlook and a better way to understand politics is to ask a person’s view on multiculturalism, immigration, globalisation, feminism and gay marriage.” And this goes to the heart of the problem facing politics in the developed world today – the options on offer no longer appeal to a sufficiently broad base with the result that nearly all countries in Europe are formed of coalitions. Even in the UK, which has traditionally enjoyed the luxury of a majority government, we have had a minority government for seven of the past nine years (and the one majority government delivered us the shambles that was the EU referendum).

Not only do incumbent government parties hold little appeal for voters but opposition parties have not been able to offer a viable alternative either. In 2017, German voters may have been disillusioned with Angela Merkel’s CDU-led government but they were not prepared to reward the traditional SPD opposition party with their votes, with the result that the AfD made up a lot of ground. This is not untypical. A study carried out for The Guardian last year shows that the share of votes gained by populist parties in Europe has tripled in the last 20 years with 1 in 4 voters now casting their ballot in favour of such parties. In other words, the political centre is being squeezed and traditionally moderate parties are increasingly finding themselves marginalised.

All this suggests that a reordering of the political spectrum is increasingly required. It has already happened in France where Emmanuel Macron’s La République En Marche swept its way to the French presidency and to victory in the 2017 parliamentary elections. Of course, things have not exactly gone his way since, with polling evidence suggesting that bar the unfortunate Francois Hollande, Macron is the most unpopular president in the last twenty years at this stage of their tenure. But that does not mean that restructuring is not required. They do say that elections are generally won from the centre of the political spectrum and as the Brexit debacle has shown, neither of the two main parties in the UK inhabit the centre ground occupied by the vast majority of voters.

Back in 1981, disaffected members of the Labour Party went off to form the SDP – a move which is today considered to have been a failure because the SDP quickly lost political momentum and was forced to join forces with the Liberal Party in 1988 to form the modern day Liberal Democrats. Collins argues that the SDP failed to build on its initial support because “it had to compete directly with [Labour] in an electorate still organised, essentially, by class structure.” I would argue that maybe the formation of the SDP was not the failure that is often painted. Even though it did not live up to initial expectations, it quickly boosted the representation of the third party to its highest since the 1930s and by 2010 it had gained sufficient momentum to post its highest representation since the last gasp of the old Liberal Party in 1923.

Today more than ever, when both the UK’s main political parties are riven with ideological zeal – the Conservatives leaning right and Labour tacking to the left – the political soil would appear to be sufficiently fertile to support a centrist party able to capture the centre ground. Confidence in politicians took a battering in the wake of the financial crisis – perhaps unfairly – but it has been justifiably shredded by the way in which Brexit negotiations have been handled. There are sufficient political dissidents in the Labour Party who might be tempted to find a new home. And as I have argued previously (here) the Conservatives also need a root-and-branch reform of their political ideology.

Inertia may be one of the most powerful of political forces. But according to one recent poll, 72% of respondents (here, see Table 43) suggested that the British political system needs a complete overhaul and 75% indicated that politicians are “not up to the job.” Those politicians so keen on listening to the will of the people might want to reflect on these findings. Surely we deserve better than a choice between hard-line right-wing free marketeers and socialists determined to create a Marxist paradise. If ever a time was ripe for a third way, it is now.