Moody and petulant

Over the course of recent months I have expressed concerns at the quality of governance, particularly in the UK, and nothing that has happened recently has prompted a change of view. If anything, quite the opposite. These concerns were picked up by the ratings agency Moody’s following Friday’s decision to downgrade the UK’s sovereign credit rating by another notch to Aa3, citing the “fractious policy environment.” As a rule I do not set much store by the macro views of ratings agencies, largely because they tell us what we already know. More importantly their raison d’être is to assess the likelihood of default, and whatever else might be wrong with the UK it is less likely to default than any euro zone country because it issues debt in a currency it controls whereas euro zone countries do not. That said, we should take the comments on governance seriously.

According to Moody’s, the UK’s failure “to manage change in a predictable and confidence-building manner is evident with respect to the UK’s approach to Brexit, in its inability to achieve an outcome which meaningfully replicates the benefits of EU membership and in its approach to implementing the agreement reached with the EU to date.” It went on to add that “Even if there is a trade deal between the UK and EU by the end of 2020, it will likely be narrow in scope, and therefore the UK’s exit from the EU will … continue to put downward pressure on private investment and economic growth.” Anyone who has read anything I have written on this subject will know that this has long been my view, so on the one hand I ask myself what took them so long to catch up, although on the other it is nice to be vindicated. 

The great bluff revisited 

It is no coincidence that this downgrade took place on the day the British government announced that the UK should prepare for EU trading arrangements “that are more like Australia’s, based on simple principles of global free trade.” In other words, a no-deal Brexit. But as Simon Hix of the LSE pointed out in a Tweet, “Australia has a range of agreements with the EU. No Deal is more like an ‘Afghanistan style deal’.” Anyone who thinks that a no-deal Brexit is a good outcome has not been paying attention. Indeed back in 2017 the then-trade secretary Liam Fox argued that securing a trade deal with the EU would be the “easiest in human history” and only last year Boris Johnson promised the electorate that he had “an oven ready deal”.  There are doubtless some who still believe that leaving the EU at any price is worthwhile but mainstream politicians have gone rather quiet on this front and a no-deal Brexit is welcomed only by those who don’t know any better.

For all my reservations about Johnson and his suitability for the highest office, I do not believe he is a stupid man (even though he often acts like one). Accordingly I still maintain that this action represents the highest stakes yet in a campaign of brinkmanship that has characterised the whole negotiating process. But what is a cause for concern is that Johnson’s statement risks triggering a miscalculation which makes a no-deal Brexit outcome more likely. After all, the EU only has to take him at his word and end negotiations and the whole edifice comes crashing down around the UK’s ears. As if to illustrate this, media reports suggest that the UK’s decision to break off talks are the result of a misunderstanding. This followed the EU’s decision to delete from the statement issued after last week's summit a pledge to intensify negotiations. According to the EU, this was designed to reduce the pressure on Michel Barnier to find a breakthrough in the discussions. The British side saw it as unwillingness on the EU’s part to make concessions. 

France and fisheries 

Matters have not been helped by comments by the French government. Having inflamed tensions by suggesting that UK has a choice between accepting the EU’s conditions or getting no deal at all, Emmanuel Macron reminded us that “The British, no matter what was said to them during the referendum campaign, need the European single market … They are much more dependent on us than we are on them.” Whilst this is not news to anyone it does nothing to assuage the hardliners in the British government who refuse to accept they are the weaker partners in the negotiations.

Fisheries remain one of the key sticking points. For the French, Dutch and Belgian fishing industries based in Channel ports, access to UK territorial waters is vital to their continued survival and the French government has increasingly adopted a hard line on this issue. It does seem a remarkably trivial issue over which to scupper a trade deal but this is the strange world of Brexit where rationality long since departed the stage. The German government has reportedly tried to intercede in order to persuade the French government to soften its position but apparently has had little impact so far. It may require some deft diplomacy on the part of the EU to take matters forward, as my reading of the German position is that they see little point in allowing negotiations to fail over a fishing dispute.

Quite why fisheries occupy such a totemic place in the Brexit debate has always escaped me since they account for less than 0.1% of UK GDP. But for those who care about these things they are a symbol of the EU’s encroachment on the ability to set domestic policy. The setting of quota limits in Brussels has coincided with a decline in the British fishing industry over the past 40 years. But the industry would have struggled anyway due to the fact that overfishing would have reduced the catch. Nonetheless, blaming the EU is a convenient narrative. Interestingly, one of my colleagues, who I should point out is an ardent Remainer, recently suggested to me that he had some sympathy for the position of the Brexiteers. As he pointed out, there seems little point in taking back control of your sovereignty if you are forced to concede access to French fishermen. But this is to miss the point. The British are seeking tariff free access to the wider European market and have to give something back in return. In my view, fishing concessions have such a small aggregate economic impact that it is a price worth paying to ensure the continued survival of the car industry. 

Domestic politics will force the UK to do a deal 

A no-deal Brexit is unlikely to play well at home.  On the one hand the survey evidence suggests, for what it is worth, that a rising proportion of those surveyed believe that the decision to leave the EU was wrong (see chart below). Even more significantly, like other European countries, the UK is suffering from a sharp rise in Covid infection rates. Not only is the government’s handling of the Covid crisis causing significant domestic political tension but the prospect of additional lockdown measures will place an additional burden on the economy, with current policies setting us up for a big rise in unemployment. Some simulation analysis I conducted in 2018 suggested that a no-deal Brexit could result in a 1.5% decline in GDP in the first quarter after leaving the EU. Adding the Covid burden on top of this would result in economic outcomes that would almost certainly hit the Conservatives at the ballot box by the time of the next election. A rational government would surely not want to take that risk.

The fact that the EU plans to continue talks with the UK next week suggests that a deal can be salvaged in the coming weeks. My long held view is that the UK has no interest in walking away without one. But the atmosphere of mistrust on both sides might act as an obstacle to progress and there is always a risk that at some point the EU may call the UK’s bluff. However, with both sides having narrowed their differences on many other issues (aside from fisheries) it is likely that they will try to keep negotiating lines open. On the basis that in EU negotiations “nothing is agreed until everything is agreed” they may yet surprise us.

Theresa and Florence

Theresa May's speech in Florence yesterday was supposed to be the big one – a chance to articulate what Britain wants from Brexit. Perhaps because it was so hyped up in advance it failed to live up to expectations. For my money, it was a grade C: Not absolutely terrible, but nowhere near good enough. Journalists have convinced themselves that they heard the PM promising to stay in the EU for a two-year transition period and the promise to pay into the budget during that period. I heard her asking the EU27 for a transition period and no mention of any figures.

As for the speech itself, it was long on waffle and short on content. To be sure, it was less strident than her dreadful performance to the Tory faithful last October and the Lancaster House speech in January. But it contained many of the same appeals for unity: "If we were to ... be divided, the only beneficiaries would be those who reject our values and oppose our interests." So we should all get behind Brexit because otherwise you don't share "our" values? As for the "concrete progress on many important issues" during the negotiation period, this amounted to a recognition that "there are unique issues to consider when it comes to Northern Ireland." As Michel Barnier noted in his response, that does not amount to providing any solutions. There was one jaw-dropping phrase which acts as a reminder why the PM managed to alienate large chunks of the electorate in June: "throughout its membership, the United Kingdom has never totally felt at home being in the European Union." The PM may speak for many in the Conservative Party, but she clearly does not speak for the near-half of those voters who took a totally different view 15 months ago.

However she was more emollient on the granting of rights to EU citizens in the UK and there was a recognition that the ECJ judgements should still be taken into account by British courts. Although the PM suggested that neither EEA membership nor a Canadian style free trade agreement are appropriate for a future relationship, May did not outline what sort of relationship she does want. EEA membership was ruled out because it "would mean the UK having to adopt ... EU rules ... over which, in future, we will have little influence and no vote." Meanwhile, an FTA is a far less beneficial arrangement than the UK enjoys now. Of course, many of us have been pointing this out all along. Everything that was wrong with the speech was summed up in the PM's phrase "We can do so much better than this." Unfortunately she neglected to explain how.

With regard to the transition period, it seemed to be apologetically sneaked into the speech near the end: "a period of implementation would be in our mutual interest. That is why I am proposing that there should be such a period after the UK leaves the EU." Substitute “proposing” for “asking” and we are closer to the mark. As the PM noted, this "can be agreed under Article 50." However, that is true only if there is unanimous agreement amongst the EU27. And that is not guaranteed. So far as budget commitments are concerned, the PM said “the UK will honour commitments we have made during the period of our membership.” Whether that covers contributions during a transition period or a nod to the exit bill is unclear to me. What it most certainly was not was a commitment to pay a figure of €20bn, as many journalists have assumed.

The Daily Mail didn't like it. "May is accused of BETRAYING referendum by effectively keeping Britain in EU until 2021 as she climbs down on citizens' rights and borders with €20bn bung for Brussels in bid to revive Brexit talks." The rating agencies didn't like it either with Moody’s downgrading the UK’s credit rating by one notch to Aa2 – two below the AAA rating it enjoyed for 35 years until 2013.

Both are wrong in their assessment but it is a reflection of the rock and a hard place dilemma facing the government. The Daily Mail appeals to the hard Brexit end of the spectrum but the reality is that the head bangers who wish to see Brexit at all costs fail to see the damage that it will cause. Or don’t care. Either way, the PM could not possibly repeat the same message as she did before triggering Article 50 as she has fewer cards to play and even less authority to call the shots. That said, the hard Brexiteers in her cabinet probably prevented her from being more conciliatory than perhaps she would have liked, and Boris Johnson’s intervention last weekend may have played a role here.

The action by Moody’s was frankly a joke. I am reminded of the words of Paul de Grauwe who in 2009 posed the question “How can these agencies, which were systematically wrong in the past, have any credibility in whatever risk analysis they make?” According to Moody’s “the outlook for the UK's public finances has weakened significantly since the negative outlook on the Aa1 rating was assigned.” Just as a reminder, since Moody’s downgraded the UK from AAA in February 2013 the UK’s public deficit has fallen from 7.2% of GDP to 2.3%. On the basis of the evidence for the first five months of fiscal 2017-18, the UK deficit is running slightly below the corresponding period in 2016-17. And as one of the more pessimistic longer-term forecasters of UK public finances, I still reckon it is possible to bring it below 2% on a five-year horizon.

Furthermore, the rating agencies consistently fail to account for the fact that the UK issues debt in its own currency. There is virtually no default risk. Admittedly the political risk is higher but we don’t need a ratings agency to tell us that. If investors get cold feet, they will simply stop buying. In any case only 25% of gilts are held by foreign investors – demand amongst domestic pension funds remains high and they will continue to buy in order to match their long-term assets and liabilities.

In summary, therefore, the Florence speech was a disappointment. But hemmed in by the needs of business and those who want Brexit at any cost, the PM was always on a hiding to nothing. However, it does nothing to change the economics. If anything, a longer transition period to Brexit should be seen as a positive – if the EU 27 agrees. In that light, the actions of Moody’s should be dismissed as the irrelevance that it clearly is.