Brexit and the pound

Economics is the study of how people make choices under varying degrees of certainty. But it is the lack of certainty which concerns us at present as global geopolitical considerations impact on investors’ assessment of asset valuations. Here in the UK, the issue of Brexit further adds to the mix. We hear a lot about how this raises the risks to UK financial assets. However, we have to make a distinction between risk and uncertainty. As the economist Frank Knight put it almost a century ago in one of the earliest and most influential works on investment risk-taking, “there is a fundamental distinction between the reward for taking a known risk and that for assuming a risk whose value itself is not known.”

The valuation of risk underpins the insurance industry where actuaries have some idea of the possible range of outcomes. But there are some risks which we cannot hedge because we have no idea of the possible range of outcomes. Brexit falls into this category. Although there has been much concern about the fall in the pound in recent weeks, as anyone who has recently been on holiday abroad can testify, in truth it has traded in a relatively narrow range over the past three years after the initial post-referendum decline. The Bank of England’s trade weighted index, which is a broad measure of sterling’s value against a basket of currencies, has traded in the range 73 to 80 compared to a wider range of 79 to 94 in the three years prior to the referendum. Admittedly, it has traded at multi-year lows against both the EUR and USD of late but given the magnitude of the risks involved, it still surprises me that the pound has not traded even lower. Ten-year gilt yields have traded at all-time lows in recent weeks, in line with global trends, suggesting that the bond market has no real concerns about the UK government’s creditworthiness.

If we were to infer what was happening in the UK purely from watching market moves, we would not conclude that it was going through the most dramatic political crisis of modern times. One explanation for this apparently paradoxical reaction is that the markets cannot price what form Brexit is likely to take, let alone what happens in the event there is no deal, and are holding fire as a result. In other words, markets are trading an uncertain environment rather than a risky one. But we can gain some idea of currency market concerns by looking at trends in implied FX volatility, which is a measure of how much the market expects the pound to move. Three month implied GBP/USD vol has recently traded above 14% (chart above) – ahead of the 2016 referendum it was at 16% (and reached 18% in the wake of the referendum outcome). Aside from the period following the Lehman’s crash in 2008, when global assets were priced for the worst, we are close to the highest recorded levels of idiosyncratic sterling FX volatility.

Of course, the one thing that volatility measures cannot tell us is in which direction the currency is likely to move. But it is accepted that in the event of a no-deal Brexit, sterling will depreciate sharply. Since it is impossible to give any accurate assessment of how big the move is likely to be, we are reduced to taking the volatility measures as a guideline and applying a significant degree of judgement (or guesswork, if you prefer). Forecasting exchange rates is difficult enough at the best of times and these are not the best of times, so the indicative levels shown here should be treated as no more than that.

In the case of no-deal, my guess is that the GBP/USD rate will stabilise around 1.15 (a decline of around 5% from current levels) although it could initially go sharply lower to somewhere around 1.10 before recovering, if the experience of June 2016 is anything to go by. As has become evident in recent days, there is plenty of scope for upside in the event that a no-deal Brexit can be taken off the table. In the extreme case where the UK revokes the Article 50 notification the pound can be expected to rally strongly. Indeed, a simple model based on expected interest rate differentials suggests that fair value for the GBP/USD rate is around 1.50. The chart above shows that since 2016, the exchange trade has traded outside the model’s one standard error bounds which we can attribute as the risk premium baked into the currency since the referendum. Using this model as a benchmark, I reckon that this risk premium results in sterling being approximately 20% undervalued versus the dollar. 

To the extent that the currency acts as a barometer of the market’s assessment of a country’s economic health, the recent slide in sterling reflects the downbeat assessment of the UK’s prospects. But whatever happens in future, it is unlikely that current market levels reflect a stable equilibrium. Either the situation with regard to a no-deal Brexit gets worse, in which case the pound might be expected to fall further, or it improves in which case sterling’s fortunes will also recover. The events of the past few days, in which the prospect of a no-deal Brexit has at least been temporarily been put on the back-burner, suggests that there is some room for optimism. But a more sustainable recovery is unlikely until a permanent solution to the problem is found.

We all need to chill

UK parliamentary proceedings yesterday produced yet another night of high drama with MPs delivering a bloody nose to Boris Johnson who has learned a harsh lesson in the Realpolitik of Brexit. However, it only succeeded in raising as many questions as answers. Will there be a general election? If so, what would it resolve? Will the UK really leave the EU on 31 October, and if so, with or without a deal? What is the future of the Conservative Party following the expulsion of 21 MPs? All of these are interesting questions and will undoubtedly be looked at the weeks and months to come.

But what perhaps concerns me most of all is the increasingly short-term nature of the way the UK has handled the Brexit problem. Although we went through many nights of high drama under Theresa May’s premiership, her main objective was to buy the UK some time in order to minimise the economic risks. Johnson’s government has shown no interest in such a strategy. He is focused purely on the politics of delivering Brexit without a second thought for what will follow. Dragging the UK out of the EU at any price will have economic consequences which will be reflected at the ballot box. That said, I am not sure that Remain supporters have given much thought to the future either. Their objective is simply to prevent a no-deal Brexit, which is laudable, but what happens thereafter? They presumably cannot ignore the referendum result forever. And what happens if the 21 Tory MPs expelled from the party are replaced with fellow-travellers who ultimately allow Johnson’s government to pursue its goal of a clean Brexit?

One of the key lessons we have learned over the past three years is that the British political system is incapable of dealing with the Brexit question. As I have pointed out on numerous occasions, the fact that the Conservatives have “owned” Brexit means (a) failure to deliver reflects badly on them and (b) the divide between parties, which was already considerable, has widened further which makes cross-party cooperation difficult. Watching politicians from both sides of the political divide engaging in the adversarial process which passes for debate, it is evident that oratorical skills and points scoring are more highly valued than rational consideration. Only this afternoon, Chancellor Sajid Javid’s speech delivering the government’s spending review was twice brought to a halt by the Speaker who admonished the Chancellor for being overtly partisan in what was supposed to be a dry speech about public spending. I do not recall that happening during any parliamentary speech by any Chancellor.

The theatrical nature of parliament further encourages adversarial behaviour. As the blogger Chris Dillow highlighted in a post recently, presenting politics as theatre is dangerous because it allows journalists to focus on style rather than substance. As a number of other commentators have pointed out, this focus on style over substance has produced an environment in which the media seems less interested in the facts of the matter than whether it generates an engaging debate. In a fascinating article on pro-Brexit bias at the BBC, Chris Grey argues that the BBC has inadvertently stoked the partiality of the debate by giving equal air time to both sides. 

As Grey put it, “the overwhelming balance of opinion amongst economists, including those employed by the Government, is very clear: Brexit will be economically damaging and the main debate is the extent of the damage. Yet ‘balance’ suggests that the pro-Brexit minority of economists be given equal billing with the anti-Brexit majority.” The consequence of this is that people believed that the economic merits of leaving were as strong as those of remain. Worse still, “almost all of the factual arguments made by the Leave campaign were untrue (£350M a week for NHS, Turkey is joining the EU etc.), but ‘balance’ required the BBC to treat them as being as valid as the opposing arguments.”

Imagine a debate between pro- and anti-climate change supporters. The pro lobby is backed up by a scientific body of evidence compiled by highly qualified people who do not say that human activity is causing climate change but that it is highly probable. The antis do not have anything like the same degree of scientific credibility but shout louder. Should their arguments receive the same prominence? Most rational people would argue not since it is better to believe the experts and be proved wrong than listen to the deniers if they are wrong. But with Brexit it seems we are quite content to ignore the economics.

A number of factors have thus come together to create a climate in which it is no longer possible to have a rational debate about Brexit: Political miscalculation; an adversarial political system and misguided media attempts to ensure an unbiased debate are but three factors. So poisoned has the political climate become that amongst the 21 Tory MPs stripped of their party membership after their vote against the government’s Brexit policy are two former Chancellors of the Exchequer (Ken Clarke and Philip Hammond). But the greatest irony is that the grandson of Winston Churchill, Boris Johnson’s great political hero, is another of the victims. In his speech to parliament this afternoon, Sir Nicholas Soames sarcastically thanked the prime minister, whose “serial disloyalty has been such an inspiration to so many of us.” He ended by saying that “it is my most fervent hope that this House will rediscover the spirit of compromise, humility and understanding that will enable us to push ahead with vital work in the interests of the whole country.”

He speaks for many of us, lamenting the inability to engage in rational political discourse on matters of national importance. By continuing to reduce the space for evidence based policy, we run the risk of making bad political and economic decisions. As Soames’ grandfather said in 1938, “The stations of uncensored expression are closing down; the lights are going out; but there is still time for those to whom freedom and parliamentary government mean something, to consult together. Let me, then, speak in truth and earnestness while time remains.”

No good options (only bad ones)

Regular readers will know that I am no fan of Boris Johnson, having been critical of his actions over the past three years. Johnson has a long history of lying when it suits his interests (here for a list of issues which renders him sufficiently untrustworthy to take his public pronouncements at face value). Brexit has brought out the worst in him: Remember the weekly savings of £350 million splashed all over the side of that bus? Or what about the fact that he constantly undermined his prime minister whilst sitting in her cabinet?

Despite all of this – or perhaps because of it – I have been of the view that Johnson does not want a no-deal Brexit. Even last week’s execrable decision to prorogue parliament could be justified as an attempt to put pressure on MPs to sign up to the much derided Withdrawal Agreement. As I pointed out in my last post, one interpretation of the strategy was to ensure that it was impossible to reach a deal with the EU so as to put pressure on MPs to ratify the Withdrawal Agreement and dare Labour to block it, knowing that they could be blamed for a no-deal Brexit in any subsequent election. I still think that is a plausible strategy.

But over the weekend, it has become evident that the government is prepared to trample over democratic norms to an extent that was previously unthinkable. We had the unedifying spectacle of Michael Gove refusing to commit the government to complying with any laws passed by parliament. This was followed up by the threat to deselect any Conservative MP who votes against the government in order to block a no-deal Brexit. I do not want to describe what is happening as a coup – a word which has been bandied around a lot recently – but there is a new strain of authoritarianism in British politics, the likes of which we have not seen before (at least in peacetime). This is not the Conservative Party of Margaret Thatcher or Winston Churchill (Johnson’s political hero). 

The sheer hypocrisy of the deselection policy beggars belief. As Tory MP Alistair Burt pointed out in response to the government’s call for MPs to support its Brexit policy, “I did. I voted for the conclusions of the negotiations brought to Parliament in the WA [Withdrawal Agreement]. JRM [Jacob Rees-Mogg], his friends and current Cabinet members did not. Why am I, having loyally supported, now being threatened and not them?” It is hard to dispute the logic of this claim. On 15 January, 118 Conservative MPs voted against the government’s stated policy of ratifying the Withdrawal Agreement. On 12 March this number was reduced to 75 and by the time of the final vote on 29 March there were still 34 recidivists. The 196 Tory MPs who voted with the government on three occasions will not be inclined to be threatened by those who have consistently showed a lack of loyalty to the former prime minister. What comes around goes around, and Johnson’s lack of loyalty in the past means he cannot count on the support of those who he has previously let down. 

Nor does the deselection tactic make a lot of immediate sense. The government has a majority of one: withdrawing the whip from Conservative MPs means that they are effectively excommunicated from the party, increasing the likelihood that they will vote against the government on a range of other issues. But if the ultimate objective is to hold an election sooner rather than later, there may be some method to the madness – why else would a government want to operate without a working majority? As David Gauke MP said in a radio interview this morning, “I think their strategy, to be honest, is to lose [an attempt to rule out a no-deal Brexit] this week and seek a general election having removed those of us who are not against Brexit or leaving the EU but believe we should do so with a deal.” Indeed, newspapers this afternoon were full of headlines suggesting that Johnson would be prepared to trigger an election if he lost a vote ruling out a no-deal Brexit. However, an election can only occur if the government loses a vote of no confidence in parliament or if two-thirds of MPs vote for it. Either way, it will require the consent of Labour MPs.

Former PM Tony Blair has warned Labour leader Jeremy Corbyn against falling into the “elephant trap” of calling for an election. Blair’s words should be heeded. As much as people are opposed to Brexit and the way in which Johnson has ridden roughshod over the British constitution, there is no guarantee that voters will flock to Corbyn as an alternative. In fact, I am pretty sure they won’t. Obviously Corbyn does not see it that way but I would be prepared to bet that he will not improve on the relative success of the 2017 election result.

If Corbyn really wants to put pressure on Johnson, his strategy should be to get as many Tory rebels as possible to sign up to a motion which commits parliament to ruling out a no-deal Brexit, whilst refusing to rise to the bait of any vote which would trigger a general election. This has the disadvantage that if Brexit can be delivered without collapsing the economy it will hand Johnson an electoral boost. But a more likely outcome is that since the EU will not cave in on the Irish backstop, which the hardliners in the Conservative Party will not be able to accept, a disciplined Labour Party can hold the Tories’ feet to the flames for a much longer period and possibly even force the party to split which would be to Labour’s electoral advantage.

Unfortunately, this would mean a continuation of the political wrangling that has characterised the last twelve months – and that is definitely not in the electorate’s interest. But an election is not in the country’s interest either. The Fixed-term Parliaments Act of 2011 was designed to prevent governments controlling the timing of elections for their own purposes (which it spectacularly failed to do in 2017). If the terms of the Act had been adhered to, we would not have had an election since 2015 and would not have to face the prospect of another one until summer 2020. The 2017 election was a device to suit the government’s convenience – as will any plebiscite in 2019. If there is another election this year, it will further undermine the claim that a second EU referendum would be to disrespect the “will of the people.” 

Is there a way out of this political nightmare? It is hard to see one. We are paying the price for a litany of past mistakes – from the decision to hold a referendum at all; to drawing red lines around membership of the single market and customs union, to Johnson’s plan to resolve the issue by 31 October.  Whatever happens now, half the electorate will be left disaffected and angry. There are no good options – only bad ones.

Prorogation over negotiation

Like many people, I was initially horrified by the news that Boris Johnson is prepared to suspend parliament in order to deliver Brexit by 31 October. It certainly put a damper on the last day of my summer holiday and the Douaumont Ossuary near Verdun was a good place to ponder the stupidity of politicians and the consequences of their actions which impact on the ordinary citizen. But on reflection, I do not buy the kneejerk reaction of those who believe Boris Johnson’s government is intent on driving the UK to a no-deal Brexit. Instead I view it as a gambit to try and force a break in the impasse that has characterised the last two years. This is not to say that the actions of the government should be condoned. It is taking a major risk and those who play with fire run the risk of getting badly burned.

The constitutional aspects

Obviously, I am not a constitutional lawyer but the general consensus of opinion from the experts appears to be that the Johnson government is taking a major risk that could have profound consequences. The UK's constitutional system is based on a democratically elected parliament whose primary role is to hold government to account. Moreover, the British constitution is uncodified and many of the rules which guide it are based on tradition rather than a fixed legal process. Governments have traditionally always played by the unwritten set of rules but a departure from this principle threatens the basis of the current system. As a number of constitutional experts have pointed out, if norms and traditions are not respected they cease to exist and will lead to calls for constitutional change. I would thus not be at all surprised if at some point there are calls to codify a written constitution to prevent this kind of abuse from occurring in future.

Of course the biggest irony is that Brexit was all about taking back control. Whatever happened to that?  In one fell swoop, the Brexiteers have undermined their case, with the scrupulously fair David Allen Green (no Remainer, he) accusing the government of “constitutional cheating”. He goes on to argue that “It is beginning to look as if there will be a constitutional crisis. So far we have not had one about Brexit. There has been a political crisis, and much constitutional drama, but each tension so far has been resolved between the elements of the British state. This prorogation, however, is a direct attack by the executive on parliamentary democracy. It is a cynical device for the government to escape parliamentary scrutiny in the crucial few weeks before a no-deal Brexit is likely to take place. Nothing good can come of this. It is a divisive act when consensus is needed. It is a gross abuse of the constitutional powers of the prime minister. And it breaches a principle far deeper than any constitutional norm — that of fair play.”

Green also makes the point in another Tweet that whilst the government has generated a lot of fake outrage over the reaction to its prorogation decision, there is a whole host of other “constitutional outrages” that have been perpetrated in the name of democracy which have been ignored by politicians and the press.  It has indeed been evident since 2016 that the government is determined to deliver a Brexit at any cost and has ridden roughshod over the UK’s democratic norms in order to deliver it. But this is the only way that it can take a near 50-50 vote split in June 2016 and turn it into something realisable. The damage will only become evident in the longer term. One of the underlying forces driving the Brexit vote was the belief amongst a large section of the population that they had been ignored by politicians. Although the government was never likely to win over hard-core Remainers, its recent actions are likely to alienate reluctant leavers – those who don’t like the idea of Brexit but can live with it if the pain can be minimised. There will be a reckoning from the newly ignored.

History teaches us that it could be profound, albeit a long time coming. One of the most famous prorogations in English history was that by King Charles I in 1629 who ruled for 11 years without a parliament. This was a major contributory factor to the triggering of the English Civil War in 1642 which ultimately resulted in the execution of King Charles and placed significant limits on the power of the Monarchy following its restoration in 1660. It was a long time ago and so what? It is, however, a demonstration that constitutional decisions taken in haste can have huge unintended consequences.

Has no-deal become more likely?

Yes and no. I maintain that Johnson does not want a no-deal Brexit. If even half the concerns pointed out by the leaked Operation Yellowhammer documents are realised, the economic consequences of Brexit could be profound. This is not a good platform for a general election, which I still believe is a likely prospect before year-end. So why is Johnson prepared to take such a gamble?

I may be guilty of applying logic to an illogical situation, but here goes. Johnson was elected as Tory leader on a platform to deliver Brexit. If he fails, his credibility is shot but if he delivers without a deal, his chances of winning an election are also shot. So he either has to get the EU to change its mind on amending the Irish backstop or persuade MPs to vote for the Withdrawal Agreement that has already been rejected by parliament on three occasions. His strategy of apparently excluding parliament from Brexit discussions may partly be designed to send a message to Brussels that he is serious about leaving without a deal. In my opinion this is unlikely to be sufficient to persuade EU leaders to change their mind at the summit starting on 17 October. It is likely they will take the view that a no-deal Brexit is a bigger problem for the UK than for the EU27, so if Johnson wants to plunge the UK over the cliff edge, that is his problem.

Parliament will of course be in session again by this time (it is scheduled to reconvene on 14 October). At this point, Johnson says that the only way the UK can avoid a hard Brexit is if MPs agree to ratify the deal negotiated by Theresa May (perhaps made more palatable by some tweaks at the summit). Unless MPs can somehow force the government to take a no-deal Brexit off the table, they may have little choice but to comply. Cue the triumph of Johnson diplomacy which he celebrates by calling an election, campaigning on the basis of the PM who delivered Brexit. We thus should view the prorogation as a signalling device to terrify MPs as much as sending a signal to Brussels.

This is a high stakes poker game and the higher the stakes the bigger the chance of losses. It is thus possible that it could backfire if the EU refuses to bend, or an insufficient number of MPs are prepared to play along. After all, why should Labour MPs want to give Johnson his triumph? There again if they don’t support the Withdrawal Agreement, Johnson holds an election anyway and blames Labour for failing to support the plan. 

Viewed in these terms, the prorogation device is very neat and it has the fingerprints of Johnson’s special adviser, Dominic Cummings, all over it. He has outmanoeuvred the opposition very cleverly. However, Cummings does not have to face the electorate. Johnson does, and when push comes to shove he may be forced to blink to prevent the worst case outcome. Cummings is unconventional and politically fearless. But by dragging the unwritten constitution into the spotlight, he is undermining the UK’s reputation for political pragmatism and tolerance, built up over centuries. This vandalous act is the work of a zealot and the world will not forget. Nor will the British electorate.

From the sublime to the ridiculous and beyond

Just when you thought that we have reached bottom in the Brexit debate, reality has a habit of showing us that things can always be worse than we thought. The Tory Party anointment of Boris Johnson as Prime Minister a month ago was already a step beyond the surreal, given his past record, but his rhetoric regarding a no-deal Brexit is taking the UK down a dark road from which recovery may be very difficult.

This was highlighted at the weekend by the leaked details of the government’s Operation Yellowhammer (chart – zoom in to see the details) which highlights the extent of the planning required to combat “a catastrophic collapse in the nation’s infrastructure.” Amongst the contingencies for which the government may be forced to prepare are the imposition of hard borders with the Republic of Ireland and at Channel ports, which will lead to significant disruptions in trade flows and which could severely disrupt the imports of food and medicine. None of this should come as a surprise. The government and Bank of England produced analysis last November which looked at the impact of a no-deal Brexit on GDP, and my own contribution was to sketch out some back-of-the-envelope calculations for the impact on cross-channel traffic which look close to those outlined in the Yellowhammer documents.

Whilst the true believers in Brexit dismiss this as Project Fear, an inside source with knowledge of the planning categorically stated, “this is not Project Fear – this is the most realistic assessment of what the public will face with no deal. These are likely, basic, reasonable scenarios – not the worst case.” Indeed, this is coming from inside government: from a civil service which is charged with implementing the policies of the government it serves, not from those who are diametrically opposed to Brexit and have an incentive to derail it. If a modern day Rip Van Winkle were to awaken after a four year nap and see the extent of the government’s preparations, he could be forgiven for thinking that the UK was preparing for war. 

In a way, it is – it’s just not clear who the enemy is. Half the population seems to believe that the plucky UK is facing off against the bullying EU whilst the other half believe the government is visiting a catastrophe on its own people. The United Kingdom has never been more disunited and its own government is stirring the pot. Irrespective of how people voted in June 2016 they certainly did not vote for this. They were sold a vista of sunny uplands in which the UK would benefit from tapping into the more rapidly growing regions of the world rather than being shackled to the moribund EU. Gerard Lyons, who has reportedly been interviewed for the post of Bank of England Governor, is one of the few respectable economists who believes that breaking trade relations with the UK’s most important trading partner will improve its prosperity.

But the view is total and utter rubbish and is based on the sort of analysis which gives economics a bad name. It is founded on a textbook idea of how free marketeers believe international trade is conducted, rather than the realpolitik on which it is actually based. The majority of the economics profession understands that the bigger partner in trade negotiations holds the balance of power. The only way that the UK will be able to close trade deals that the EU has somehow failed to achieve is to roll over and sell out its interests in favour of the more powerful partner – something the EU has refused to do. Anyone who believes differently is urged to sign up today as a trade negotiator – your country needs you! 

A bigger obstacle to the Brexiteers dream of a Britain driven by fantastic new trade deals is that the world has changed significantly in the past three years. Globalisation is in retreat as economic nationalism moves to centre stage, thus removing the central plank upon which their model depends. Donald Trump has torn up NAFTA and is engaged in a trade war with China from which nobody will emerge unscathed, as the basis of the global trading system over the last seven decades is slowly pulled apart. This is the very worst time in the post-1945 period for a country to throw itself on the mercy of the international trading rules. 

Brexiteers believe that the UK can perform well under WTO arrangements. But this is not a strategy – it is a default. So good are these arrangements that the only country in the world that trades solely on WTO rules is Mauritania – everyone else has made supplementary trade deals. Nor is it clear that the WTO will be in any position to enforce its own rules in future. The WTO’s Appellate Body is composed of seven members who serve for four-year terms. But as the terms of serving judges have expired, new appointments have been blocked by the Trump administration and it is currently down to three – the minimum required for a quorum. With two of them set to leave at end-2019, further blocking by the US means the WTO will be in no position to hear any disputes brought before the court. That is not a basis for the new trading relationships that the UK hopes to forge in a post-Brexit world.

Doubtless, those who continue to believe in the purity of Brexit will accept nothing less than departure at any cost. Unfortunately, those who continue to point out the pitfalls in the argument are labelled Remoaners (or worse). But this is not just about Leave or Remain – delivering a Brexit which does great economic harm will permanently damage the credibility of the Brexit case. If influential Leave politicians have any interest in remaining relevant beyond Brexit, they need a plan of how to deliver without crashing the car and the vexed issue of the Irish backstop is not the ditch they should be prepared to die in. I believe they know this, which is why I don’t take their rhetoric at face value. But if I am wrong, and the government really is intent on jumping over the cliff on 31 October, they will almost certainly be pursued by a vengeful electorate armed with ballot papers.