Five years on

Five years ago today the world awoke to find that the British electorate had narrowly voted in favour of leaving the EU. The pre-2016 era feels like another world: in many ways it was, not least because Covid has had an even more transformative effect on the political and economic landscape. Looking back, the impact of the Brexit shock remains vivid and neither Leavers nor Remainers have since covered themselves in glory. Regular readers will know I regret the decision to leave the EU, largely on economic grounds but also because the UK is no longer part of a block which amplifies its voice on the world stage. However, it makes little sense to replay the debates of the past five years.

A quick retrospective

Nonetheless, this week marks a good time to assess the impact of Brexit, giving rise to a number of retrospectives in the British press. One of the best commentaries I have seen is this one by always excellent Fintan O’Toole, who points out that the Remainers never had a big idea which could overpower the simple narrative of taking back control espoused by the Leavers. As he put it, “Leave offered some kind of an answer [to the question of what defined British identity] – albeit a very bad one. Remain barely recognised the question.” He also argues that the project was not subsequently weakened by the “political discourse [which] ought to have doomed it … [because] uncertainty about what Brexit would mean in reality allowed it to sustain its character as a gesture.”

As a summary of what has happened over the last five years that just about nails it. As an economist, my mistake was to try and offer economic arguments against Brexit – not that they are wrong, but the simple but powerful notion of “controlling our own laws and our own borders” was a much more compelling vision. The fact that this was and is complete tosh is irrelevant – it is difficult to argue against a messianic vision with mere facts. The bigger concern is not so much the losing of the referendum but the way the process of departure was subsequently conducted, as the government tied itself in knots to reconcile many of the irreconcilable arguments made during the campaign.

A consultative (non-binding) referendum was treated as a winner-takes-all event with little attempt to engage with the near-half of voters which opposed the outcome. Three years of intense political debate eroded trust in the political process and far from lancing the boil of Euroscepticism which David Cameron feared would swamp his Conservative Party, the divisions opened up by the referendum have if anything grown deeper. This in turn has weakened the ties that bind the United Kingdom and given support to Eurosceptic movements in continental Europe. As the historian Timothy Garton Ash has pointed out, we find ourselves in a lose-lose position and it appears that the culture war which has largely been confined to the US for the last 25 years has now washed up on European shores.

A look at the economics

From an economic perspective there are no good arguments in favour of Brexit. Imposing barriers to trade with our biggest trading partner has no merit. The government has been telling us since 2016 that the UK will be able to strike better trade deals with third countries than those drawn up by the EU. There is little evidence so far that this is bearing fruit. Most of the agreements that have been struck so far represent a rolling over of existing EU trade arrangements. The first trade agreement to be drawn up from scratch was the recently-announced deal with Australia. However the government’s own figures suggest that this will increase UK GDP by just 0.02% over the next 15 years which is, to all intents and purposes, zero. On the basis that “the additional trade barriers associated with leaving the EU” will subtract around 4% from UK GDP over that period, Britain needs 200 Australia-type trade agreements merely to offset what has already been lost. To the extent that distance is one of the biggest obstacles to goods trade, the Australia trade deal is a largely meaningless exercise.

That said, most people have not really noticed the economic impact of Brexit (though in fairness, most people have not travelled abroad since the Covid crisis hit). But many exporters have highlighted the difficulties resulting from the erection of trade barriers and although year-on-year comparisons are distorted by Covid effects, a pattern is emerging whereby trade with the EU has fallen by far more than with the rest of the world. A recent report by the Food and Drink Federation noted that UK food and drink exports to the EU in Q1 2021 were 28% lower than a year ago whilst remaining unchanged to non-EU markets. On a more positive note, ONS aggregate data suggest that trade flows are slowly normalising but there is no doubt that UK-EU trade has taken a hit.

A synthetic control assessment

To obtain a handle on the joint impact of Brexit and Covid I have attempted a synthetic control exercise which constructs a synthetic (or “Doppelgänger”) GDP index for the UK based on trends in a panel of 23 other countries. The rationale behind the analysis is to use GDP outcomes in the control group to approximate what might otherwise have happened in the UK. When I conducted the analysis two years ago, I concluded that UK GDP was around 2.5% below what might otherwise have been expected which I attributed to Brexit-related uncertainty. Latest estimates suggest that GDP in 2021 Q1 was almost 10% below the synthetic indicator.

As can be seen from the chart, the UK began to underperform during 2017 as Brexit-related uncertainty kicked in and by Q1 2020 GDP was 4% below the synthetic control index which is in line with estimates made in 2016. However this pales into insignificance compared to the impact at the start of 2021. It is likely (but not certain) that the Covid-related output collapse contributed most to this underperformance and we will only be able to assess the impact of Brexit once the Covid shock dissipates.

Markets giving the benefit of the doubt

Despite this poor performance, markets have given the UK the benefit of the doubt with sterling trading at around 1.39 against the USD versus 1.36 at the start of the year (a gain of around 2%). In a similar vein, GBP is up around 5% versus the EUR whist the BoE’s broad effective exchange rate has appreciated by 4.1% since the start of the year. Sterling is still a long way short of where it was on 23 June 2016 (6.3% down on an effective basis) but it does seem to be moving in the right direction. UK stocks also continue to look cheap on an international comparative basis and there has been much discussion in recent months that the relative post-Brexit stability represents a good time to buy into the UK market.

To the extent that Brexit has not represented a seismic shock, there are good reasons why international investors might want to dip their toe in a market they have shunned in recent years. To the extent that much of the recent underperformance was the result of self-inflicted policy errors, so long as the government can avoid the mistakes of the last three years there may be some scope for catch-up. But the truth is we do not know how Brexit will pan out nor what the final balance of costs and benefits will be. Whilst Brexit has not proven to be a seismic economic event it may well prove to be a boiled frog problem with the cumulative effects building up over time. As it fades from the forefront of our consciousness and ceases to be the headline-grabbing event that has shaped the news agenda over recent years the devil will continue to make its presence felt in the economic detail.

Much heat, not much light - yet

Media coverage focuses on privately developed cryptocurrencies …

The debate over digital currency has proceeded by leaps and bounds in the last couple of years. Although Bitcoin (BTC) continues to grab the headlines, largely due to its position as the original disruptor, I have long maintained that it is unlikely to be the currency of the future. Indeed I pointed out in 2017 that although there may be a future for digital currencies, BTC may go down as the currency equivalent of the Betamax video system – the first mover which was supplanted by a cheaper, more flexible alternative. Nothing that has happened in the interim has caused me to change my view.

The price of BTC has fluctuated in line with comments by high profile proponents such as Elon Musk, further making it hard to take its claim seriously to be a currency that will one day supplant the fiat money issued by central banks. Earlier this year I noted that a reasonable guess for BTC “fair value” was somewhere below $10,000. Although it has subsequently fallen by 40% from its mid-April highs, it remains well above these levels at just below $40,000.

But the real action in the digital currency space has concerned Dogecoin (DOGE) – currently the sixth largest digital currency by market cap which has increased by a factor of almost 67 since the start of the year versus 33% for BTC, and whose price versus the USD has massively outstripped that of BTC (chart). Ironically, DOGE initially began life as a spoof with the purpose of breaking the stigma surrounding cryptocurrencies. It is designed to be unattractive to investors by keeping a permanently low value due to its mining algorithm which is unlike BTC in that it is not subject to a limit for the number of coins mined. It is also more energy efficient, both in the amount of computing power required to mine each unit and the power consumed in doing so. Although DOGE is accepted as a means of payment by a small number of merchants, it is hard to see it making significant ground as a challenger to BTC let alone conventional forms of money.

… But there are more cons than pros

At the current juncture digital currencies face great difficulty in breaking out of the niche position which they currently occupy largely because they are regarded as extremely volatile vehicles for speculative investment. BoE Governor Andrew Bailey told a parliamentary committee earlier this year, “I'm sceptical about crypto-assets, frankly, because they're dangerous and there's a huge enthusiasm out there.” He went on to say “they have no intrinsic value” and investors should “buy them only if you're prepared to lose all your money.”  

This has not stopped El Salvador from adopting BTC as legal tender, partly to facilitate foreign remittances which are equivalent to 20% of GDP. However, the IMF has pointed out that there are “macroeconomic, financial and legal issues that require very careful analysis.” There certainly are! As this article in Foreign Policy notes, “El Salvador runs on physical cash; 70 percent of the adult population don’t even have a bank account … Only 45 percent of Salvadorans have internet access, and around 10 percent in rural areas.”

… And it may be that central banks will be the saviour of digital currencies

Whilst cryptocurrency proponents continue to extol the virtue of a currency system outside the control of central banks, it is difficult to avoid the conclusion that their breakthrough into the mainstream will be facilitated by central banks themselves. China has already begun experimenting with a digital yuan, having expanded its pilot programme in the spring. Central banks in the UK, US and euro zone are running much more slowly, largely because financial systems are rather more sophisticated and as a result there are huge implications for settlement systems, the nature of the banking  system (issues such as funding costs and balance sheets) and the smooth operation of financial markets – and that is before we consider privacy concerns.  

The BIS recently published a paper which argued that any central bank digital currency (CBDC) should be “minimally invasive.” This is an important issue because a digital currency “represents a claim on an intermediary, [whereas cash] is a direct claim on the central bank” thus changing the fundamental nature of the claims process. As the BIS points out, the Wirecard fraud last year highlights the problems of relying on an intermediary.

Whilst a CBDC would avoid relying on an intermediary it would create other problems. For one thing the conditions required to ensure that a central bank can guarantee the security of a digital asset would be very onerous (quite the opposite of “minimally invasive”). Secondly, as I highlighted last year, the adoption of a CBDC could lead to increased systemic volatility if asset holders opt to seek the safety of central bank-backed assets at the expense of bank deposits at times of financial stress. Faced with these concerns, it is perhaps no surprise that central banks are being forced to proceed relatively slowly.

The race to be first

My view a year ago was that the case for a CBDC was weak from a consumer perspective. However, there are good reasons why central banks in the industrialised world do not want to get left behind in the race with China to develop one. For one thing there are concerns that a digital yuan could undermine the dollar’s role as the global reserve currency. A large proportion of international transactions use the dollar as an intermediate currency which requires access to the SWIFT system. In recent years, the US has increasingly politicised access to SWIFT and efforts to bypass it by using a digital currency such as the yuan would reduce US leverage over the global payments system, particularly since China is the biggest trading partner for a growing number of countries.

In addition, it is clear that there is a demand for digital currencies but they are subject to all sorts of security concerns which would be better managed in the public interest if central banks had a stake. There is also the not-inconsiderable threat that if digital currencies were to increase in popularity, they could threaten the control that central banks are able to exert via traditional monetary policy instruments. As it happens, this is not an argument that rates high on the list of central bank concerns but it cannot be totally discounted.

It is clear, however, that the race to develop a CBDC has gained momentum in recent months and it is not a topic to be dismissed lightly. I remain of the view that Bitcoin will not be the digital currency of the future and agree with the BIS that careful consideration has to be given to the design of a CBDC. But if digital currencies are a fad which is not about to disappear, I am increasingly of the view that society is better off if they are regulated by central banks rather than allowing even less accountable market forces to make our monetary choices for us.

Bordering on the bizarre

Editorial policy at the Financial Times has taken a strange tack of late. A sensible, sober newspaper has published two opinion pieces in recent weeks illustrating the lack of knowledge displayed by policymakers on matters of real economic importance. Last week’s piece by former German finance minister Wolfgang Schäuble on euro zone fiscal issues was followed by UK Brexit minister David Frost’s call for a rethink of the Northern Ireland protocol (NIP). The latter is part of a government media blitz to convey the message that the NIP has not panned out as expected. It is difficult to buy that view given the warnings which were issued ahead of Brexit.

All this was very predictable

To remind people of what was said at the time the agreement was signed, the deputy leader of the Democratic Unionist Party warned in October 2019 that, “You are really in danger here of causing real problems with the Belfast agreement … and political stability in Northern Ireland.” The charity Fullfact.org reported in December 2019 that Boris Johnson’s claim that there will be “no checks on goods going from GB to NI” was false. They also reported that “it’s not correct, as Mr Johnson said, that if there are any terms of the Withdrawal Agreement that people in Northern Ireland don’t like that they would lapse automatically after four years.” Everything that has happened in recent weeks was thus entirely foreseeable. 

I noted in April that “the contradictions inherent in the Brexit deal regarding Northern Ireland are becoming more evident by the week.” Of all the problems inherent in Brexit, the Northern Irish border issue can be laid directly at the door of Boris Johnson’s government. British MPs simply would not sign up to the “backstop” arrangement negotiated by Theresa May’s government. Johnson’s alternative, which was acceptable to parliament because it prevented the UK from being trapped in the EU’s embrace, imposed a border where previously there was none. Indeed the one thing which the British government has always refused to acknowledge is that there must by definition be a border between UK and EU customs territories. In this case it runs down the middle of the Irish Sea. Anyone who thought otherwise is being disingenuous.

The government adopted a "sign now, deal with it later" approach

According to Frost, “when we agreed this new protocol in 2019, we did so in order to remove the old disastrous “backstop” and to enable Brexit to happen, but to do so in a way that maintained our overriding priority of protecting the Belfast (Good Friday) Agreement and avoiding a hard border.” As to whether it was “disastrous” the Irish government did not think so, nor did Northern Irish nationalist politicians who won more seats than unionist politicians at the 2019 general election. Unfortunately, nobody thought to directly ask the Northern Irish people (who, by the way, voted 56-44 in favour of remaining in the EU in 2016). The protocol was passed through parliament primarily by English Conservative MPs because this was the least objectionable option “to enable Brexit to happen.” 

Frost goes on to say “we underestimated the effect of the protocol on goods movements to Northern Ireland.” Again, I am not sure who is the “we” referred to but the government was warned for years, both before and after the referendum, that imposing frictions to cross-border EU trade would come at a cost. Frost concluded his missive by suggesting that “we agreed … to control certain goods movements within our own country and customs territory. If that situation is not to be totally unsustainable we need to be able to do so in ways which do not disrupt everyday life and which respect everyone’s identity and interests. We continue to work for negotiated solutions which achieve this.” Most rational people believe that the protocol represents just such a negotiated solution and it increasingly looks like the UK government signed on the dotted line simply to get Brexit “done” with the intention of trying to renegotiate the details later.

And now it is paying the price

The international community has little sympathy for the UK’s position. Unsurprisingly, Emmanuel Macron is not to be moved. As he told journalists earlier this week, “We have a protocol. If after six months you say we cannot respect what was negotiated, then that says nothing can be respected. I believe in the weight of a treaty, I believe in taking a serious approach. Nothing is negotiable. Everything is applicable.” More seriously news reports have emerged to suggest that the US government privately rebuked the British for endangering the peace process over the NIP, although both sides have been careful to keep this out of the public domain.

Many of the more deluded on the Brexit spectrum cannot bring themselves to admit that there are big costs associated with their signature policy and continue with the narrative that the NIP was somehow “imposed on the UK by Brussels at the moment of our greatest weakness” (I will leave it to you to decide whether it is fortunate or unfortunate that it is behind a paywall. Ironically the same author extolled the virtues of the NIP less than two years ago). It beggars belief that the British government finds itself in such a position. Johnson promised “an oven ready deal” just 18 months ago which was meant to lead us to the sunny uplands. Instead we find that the deal does not do what it said on Johnson’s tin. To add insult to injury, Frost is not an elected politician – he is an unelected (recently ennobled) member of the House of Lords. The British government has thus appointed an unelected trade novice to oversee trade policy. Brexit is not yet at the stage of devouring its own children but the pot may be about to be readied.

A wider problem is that if the government has treated major issues such as trade policy in such a cavalier fashion, can it be trusted on other issues? As the OECD put it, “trust is the foundation upon which the legitimacy of public institutions is built and is crucial for maintaining social cohesion.” So far there has not been any significant loss of domestic trust with Johnson’s act continuing to play well at home but the UK’s reputation in international dealings is not exactly being burnished by recent events.

The EU is not blameless either but the UK government must shoulder the blame

This is not to say that the EU is entirely blameless. Its actions regarding the NIP reflect a tendency to hide political problems behind technical issues, arguing that the purity of the single market must be protected at all costs. This intransigence is what caused the Swiss to recently walk away from seven years of negotiations to achieve a framework deal with the EU to replace the patchwork of deals currently in place. Of course, one of the great ironies of the current situation is that Brexiteers always argued that the EU was an excessively bureaucratic institution that the UK was well advised to leave whereas the truth was that as a member, the UK was shielded from the worst of it.

We can debate the extent to which the EU needs to change its policy towards its neighbours – and this argument is not without merit. However, the recent spat demonstrates that the UK government’s casual approach to legal details over the past five years does have consequences. I have made it clear for many years that there is no such thing as British exceptionalism, which appears to be the leitmotif of many hardline Brexiteers. As it is, the Northern Irish problem, serious as it is, affects a relatively small proportion of the UK population. Over time, a larger proportion of the population may begin to become aware of the damage that Brexit has inflicted upon them. Only then might we start to have the debate we should have been having five years ago about the price of the policy.