Just a little respect

The late great Aretha Franklin demanded, and indeed commanded, respect. After a difficult 24 hours during which the EU27 decisively rejected Theresa May’s Chequers plan at the Salzburg summit, the prime minister was only able to demand it. It was not her finest hour! The EU’s rejection should have come as less of a surprise than the British press made out. It was less an “ambush” (as even the normally sober FT described it) and more a failure of the British government to correctly interpret the EU’s stance during the summer months.

Perhaps some EU politicians and officials did give the impression there were things in the Chequers plan that they liked which lulled the British government into a false sense of security. But even at the start of this month there were clear signs that the Irish border problem was not going well. Moreover, as I noted in July (here) the UK was always running a risk by asking for restrictions on the freedom of movement whilst calling for an association agreement which, to all intents and purposes, was a request to remain in the single market (at least for goods). Chequers was a cherry-picking plan par excellence and the UK government knew it. 

The way ahead has now become a lot less certain. European Council President Tusk announced that the “moment of truth” in Brexit talks would come at the EU summit on 18 October, by which time the EU expects to see a credible proposal for the Irish border issue. Recall that the October deadline was supposed to be the point at which the EU and UK would agree on the terms of the post-March 2019 arrangements, which would in turn be put to EU governments and the EU Parliament for ratification. That is now off the agenda. The hope is that an emergency summit in November will be the point at which these details can be thrashed out. But as Tusk noted, only if there is progress next month will the EU even agree to a November summit. Thus, October has become a critical deadline but for the wrong reasons – and failure to make progress here would substantially raise the risk of a disorderly Brexit next March. 

Domestic politics remains a major sticking point. Theresa May will next week have to face the Conservative Party’s annual conference without any support from Brussels and in the knowledge that domestic opposition to her Chequers plan is mounting. It is in this context that we should assess her extraordinary speech this afternoon in which she called for the EU to show more “respect.” The suggestion that “the EU is still only offering us two options” is actually the situation which UK voters faced in June 2016, and the choices are stay or go.

In the PM’s view, “the first option would involve the UK staying in the European Economic Area and a customs union with the EU … [but] that would make a mockery of the referendum we had two years ago.” She’s not often right but she’s wrong again!  Unless we all missed something, the decision to leave the single market and customs union was never on the ballot paper. Indeed, we were promised by many prominent leave supporters that exiting the single market was not an option. This interpretation of the vote is used by Brexiteers to justify their subsequent actions. However, it is –  to be blunt – a lie; fake news of epic proportions. And what is worrying is that this lie is being peddled by the PM. But whilst at first glance the PM appears not to understand the dynamics of the Brexit negotiations, which says a lot about her or those advising her, there is another interpretation. It is an appeal to the hardliners in her party ahead of next week’s conference. Simply put, this was Theresa May pleading for her job! 

The PM’s problem is that having set so much store by Chequers, it is difficult for her to abandon it. The Brexiteers have long opposed the Chequers plan because in their view it does not put sufficient clear water between the UK and the current EU arrangements. This highlights the British government’s dilemma: It cannot put together a plan that simultaneously satisfies both the EU and Leave supporters, and efforts to find a compromise have merely angered both sides. Recent suggestions by prominent Brexiteers that any deal agreed could be unpicked by a future government  or that the UK will not pay its financial obligations if there is no deal have done nothing to bolster the UK’s credibility in Brussels.

It is increasingly obvious that the simplest solution to many of the problems will be to postpone departure from the Customs Union – a policy which never made any economic sense. It will help to reconcile the objectives of reducing trade frictions whilst limiting the free movement of labour and is the only sensible solution to the Irish border problem. As it currently stands, the EU’s solution to the Irish border problem only  involves making provisions for Northern Ireland and not for the UK as a whole, which is (rightly) unacceptable to the UK government as it implies an internal UK customs border. But the UK’s backstop proposal envisages remaining in the Customs Union beyond 2020 (assuming a transition agreement is signed first).

Proposing to remain in the Customs Union would anger the Brexiteers. The question is whether the PM has the backbone to take them on. Only the Brexit ultras support leaving the Customs Union and my guess is that if she were to make this proposal to parliament, she would have the numbers to carry it through. At issue is whether she is prepared to demonstrate the leadership qualities required of a prime minister to make choices in the national, rather than the party, interest. I am not hopeful! 

As for Theresa May’s own position, speculation will mount that she is unlikely to survive too much longer, particularly since Boris Johnson is effectively mounting a leadership challenge via his weekly column in the Daily Telegraph. Consequently, the rhetoric at the party conference next week will sound as hawkish as ever with no talk of compromise. But make no mistake, that will come later – it has to! In any case, it is not clear that a change of leader resolves anything. May remains in post only because nobody else really wants the poisoned chalice. There is thus a good chance that she will remain in office until March but thereafter anything is possible.

But Johnson would be the worst possible candidate to try and negotiate with the EU following Emmanuel Macron’s comments earlier this year that “Nigel Farage and Mr Johnson are responsible for this crime [Brexit]: they sailed the ship into battle and jumped overboard at the moment of crisis.” In the words of one UK official quoted this morning in the FT “Now it’s getting real.”

Brexit: According to custom(s)

Discontent with the Brexit process has gathered momentum in recent weeks as the EU Withdrawal Bill is debated in the House of Lords. There are two key areas where the Lords disagree with the government’s vision of a post-Brexit Britain, having voted against that part of the bill which seeks to withdraw the UK from the customs union and also against the legislation which peers believe will result in an erosion of workers’ rights. None of this means that the government will necessarily water down its position, since the role of the Lords is primarily to scrutinise legislation and challenge anything proposed in the House of Commons and it cannot block legislation indefinitely. But it may embolden MPs in the lower house to rethink their position on many elements of the Withdrawal Bill.

The customs union issue is particularly important and has proven to be an area where Brexit protagonists have demonstrated that they do not fully understand the implications of their actions. A customs union implies the abolition of customs duties between member states and the imposition of common tariffs against those not in the union. That is not the same thing as the free movement of goods which is enshrined within the EU single market. For one thing, a customs union may not necessarily cover the full range of goods. For example, Turkey is part of a customs union with the EU but the deal does not cover food or agriculture, services or government procurement.

But failure to secure some kind of customs arrangement with the EU will almost certainly mean significant border delays. Those claiming that the Swiss and Norwegian examples show how a customs union can proceed without any such frictions are wrong. Switzerland and Norway are in the Schengen Area (chart) which allows individuals to move easily across borders, but neither are in the customs union so there can be significant delays as goods are transported across the border into the EU.

Moreover, most of the empirical work which utilises trade gravity models to look at trade flows draws the conclusion that leaving the single market or customs union will lead to a reduction in trade between the UK and EU. Such models explicitly incorporate the zero-tariff option, which can be  controlled for in simulations designed to show the counterfactual where tariff barriers exist. A customs union would, of course, be a second best solution compared to what the UK enjoys now. But it is better than no deal at all, and would go a long way towards resolving the Irish border problem.

What is particularly ironic is that the customs union has only become an issue following the referendum. It has been seized upon by those leavers who believe that it is an obstacle to signing trade deals with third countries, but was barely mentioned during the referendum campaign and was certainly not on the ballot paper. There is a sense that some in government are beginning to understand the difficulties involved in the customs union discussion with rumours earlier this week that the prime minister would seek to back away from her previous position (which were denied, of course). This would be the sensible economic decision, although so closely is Theresa May identified with this policy that it would likely spell the end of her tenure in Downing Street. But her departure may be a small price to pay to secure the national interest.

Looking at the issue from outside the UK, financial services remain an area of contention. Two senior EU officials this week rejected the UK’s case for continued post-Brexit access to EU financial markets under something approximating current rules. The EU’s chief Brexit negotiator, Michel Barnier, argued that since the UK would no longer be within the EU’s single market, it would not be covered by its regulations and oversight – a view reiterated separately by Valdis Dombrovskis, the European Commission’s finance chief. This may all be part of the normal poker playing during negotiations, but it highlights that despite the late-March optimism that we may be close to an agreement on a transition period, there are still plenty of areas of disagreement.

Indeed, the Bank of England recently concluded that the transition period would allow non-UK financial institutions operating in the UK to conduct business until the end of the proposed transition period (end-2020) without any change in their regulatory status. But there has been no reciprocal arrangement from the ECB, so firms licensed in the UK are not guaranteed to be able to conduct business in the EU under the current passporting arrangements after March 2019. If ever we needed a reminder that nothing is agreed until everything is agreed, this is it.