No plan and even less of a clue

"Kein Plan” is an expression used particularly by younger German speakers to indicate that they don’t know the answer to a question. It is a perfect description of the current status of Brexit negotiations. For the second time in a week, industrialists have issued a plea for clarity to the British government with regard to their Brexit preparations, which appear to be going nowhere. The FT reported last week that a delegation of executives from big international companies met prime minister Theresa May and Brexit secretary David Davis and highlighted the difficulties involved in making planning decisions under current levels of uncertainty. According to one delegate, “we are not going to invest in the UK until we see what the outcome is.” The Guardian picked up on a similar theme this morning following a meeting of the prime minister’s business advisory council.

At the heart of the matter is the nature of future customs arrangements with the EU. With a major EU summit looming on 28-29 June, the government assured us that it would release a white paper in advance, which would detail how it plans to treat customs issues and form the basis for an agreement with the EU27. We are not going to get it until after the summit, primarily because the government remains at odds over the future plan. It has been obvious for a long time that the Brexit process is not going well, but there is a sense that with each month that passes the sense of frustration is growing. Business has been remarkably patient so far but with less than 10 months until the UK is due to leave the EU it is time to stop pussy-footing around.

Two weeks ago, the Campaign Director of Vote Leave, Dominic Cummings, wrote a long blog piece highlighting the government’s failures since the referendum (here). Cummings pointed out two key problems: (i) triggering Article 50 without due preparation was “stupid” and (ii) implementing it without prior discussions with the EU27 “and without a plan would be like putting a gun in your mouth and pulling the trigger.” As he put it, “the Government effectively has no credible policy and the whole world knows it.” Cummings is dead right on all counts: The difference between us is that I (and many others) were saying this BEFORE the referendum. And just because Cummings now sees the downsides of leaving does not excuse him from his role in the disinformation campaign that he oversaw prior to the referendum. His testimony before the Treasury Select Committee in April 2016 was a fake news masterclass that has to be seen to be believed (here).

To compound the increasing sense of surrealism around the whole Brexit debate, the head of HMRC, the body charged with collecting taxes on the government’s behalf, recently suggested that the “max fac” customs arrangement favoured by Brexiteers which relies on technical solutions and trusted trader schemes, could cost up to £20bn per year. The additional costs, which arise as a result of the extra bureaucracy associated with the scheme, would amount to roughly double the UK’s net annual contribution to the EU budget. Naturally, it was dismissed by the Brexit side as another element of Project Fear. Even supposing that the costs are exaggerated by 100%, the scheme would still swallow up an amount equivalent to the UK’s annual EU budget contribution. There goes the £350 million per week that Vote Leave promised that we would be able to spend on the NHS. Still, we will now get blue passports!

More seriously, the longer Brexit drags on without any resolution in sight, the more likely it is that a cliff-edge Brexit could imperil the economy. According to reports drawn up for DExEU, a "doomsday" style Brexit could see the country grind to a halt within a fortnight. One of the key concerns is that without a deal on customs, ports will become so clogged that it will be virtually impossible to get goods into or out of the country. The Freight Transport Association was quoted today as saying that “the industry’s frustration with the lack of progress is building daily … Of the eight demands in FTA’s list of essentials to ‘Keep Britain Trading’ . . . not a single one has been progressed.” To compound the problems, ports on both sides of the channel cannot build infrastructure to implement a system that has not yet been agreed upon.

All this may be a bit melodramatic and we would hope that these represent extreme outcomes which have a low probability of occurring. But low probability, high impact events have huge ramifications as we saw during the market collapse of 2008.  It is not part of Project Fear to concern ourselves with what might happen: We simply cannot afford to trust to luck. As it is, on the assumption that the transition deal is implemented we will have a little more breathing space until end-2020. But even that is not yet signed, sealed and delivered. In any case, we are only 30 months away from that date and if we make as much progress in the next two years as we have done in the last two, we may merely be postponing the cliff edge rather than avoiding it.

UK austerity: An American view

The New York Times’ UK correspondent, Peter Goodman, recently published a piece which took a close look at the impact of austerity on the UK. In common with the best journalism on this subject – the piece by Sarah O’Connor in the FT last year made a similar point – it highlighted the human costs of austerity. In Goodman’s words, “a wave of austerity has yielded a country that has grown accustomed to living with less, even as many measures of social well-being — crime rates, opioid addiction, infant mortality, childhood poverty and homelessness — point to a deteriorating quality of life.” He goes on to point out that “Britain is looking less like the rest of Europe and more like the United States, with a shrinking welfare state and spreading poverty.”

There have been big cuts in spending before, with the share of spending in GDP falling sharply in the late-1980s, but the economy was growing much more rapidly so we did not notice as much. Moreover, the recession of the early-1990s resulted in a significant turnaround in outlays which soon returned to mid-1980s levels as a share of GDP.  Back in 2010, the Conservative-led coalition government announced budget plans which were underpinned by “a commitment to fairness” and it would “seek to build over the long term a fair tax and benefit system that rewards work and promotes economic competitiveness … [with] … measures to encourage people to take personal responsibility for their actions by rewarding those who work hard work and save responsibly for the future.” Running through the government’s budget plan was the message that the state benefit system was damaging work incentives and that it was their intention to rectify this problem.

All the signs were there that policy was aimed squarely at the welfare bill. And as one of the charts in the June 2010 Budget publication made clear, the bottom 10% of households by net income were hit harder than any group other than the top 20% (see chart). But what exactly was the point of all the austerity? Even before he was appointed Chancellor, George Osborne penned an article in The Telegraph suggesting that the parlous state of public finances threatened to send the UK the way of Greece, and he returned to this theme on a number of subsequent occasions. This is, of course, nonsense. Greece borrows in a currency which it does not control and has a poor record of managing its public finances. The UK issues in its own currency and has never technically defaulted on its obligations since the Act of Union brought the UK into being in 1707.

I assume that the man appointed to manage the nation’s finances knew this and I am inclined to treat the Greek comparison as a cover story for a more ideological assault on the role of the state. Goodman suggests that “from its inception, austerity carried a whiff of moral righteousness, as if those who delivered it were sober-minded grown-ups. Belt tightening was sold as a shared undertaking, an unpleasant yet unavoidable reckoning with dangerous budget deficits.” He juxtaposes Osborne’s 2010 claim of “Prosperity for all” with the reality that “Eight years later, housing subsidies have been restricted, along with tax credits for poor families. The government has frozen unemployment and disability benefits even as costs of food and other necessities have climbed” and highlights that many of those seeking to transition to the new benefits system “have lost support for weeks or months while their cases have shifted to the new system.” If such a piece had been written by a local journalist, they would no doubt have been accused of having an axe to grind. The fact that it was written by an American with no skin in the game gives it a lot more punch.

This all comes at a time when the UK will increasingly have to face up to some unpleasant fiscal truths in the years ahead, especially when it comes to funding the NHS. Paul Johnson, director of the Institute for Fiscal Studies, has pointed out that over the last 60 years “health spending has more than doubled as a fraction of national income, but total spending has been flat. Cuts to defence, housing and debt interest made space for health and welfare. This is not going to be an option for the future.”

Maybe the cuts to the welfare bill, which successive governments have implemented over the last eight years, will give them a bit more leeway to deal with the problem. However, the fact remains that the government will need to open a debate about raising taxes to provide for some of these needs. It will be politically difficult: After almost a decade of cutting services, the government will be pilloried for asking for more money. But without it, still further cuts may be necessary.

Italy redux

A few days ago, I noted that the formation of a populist government in Italy exposed many of the fault lines in the single currency area. I stand by that – except in one crucial respect: The government deal we thought had been ratified came undone after the president vetoed the selection of a Eurosceptic finance minister. So now it is a domestic political crisis as well as a problem for the single currency area. Should we worry?

In my view, it is highly unlikely that Italy would ever leave the euro zone. It may allow policymakers to take back control of monetary policy but as the Brexiteers discovered in the UK, “taking back control” is an illusory concept. The first thing the Italians would have to worry about in the event of reintroducing their own currency is how far would it fall, which provides a partial answer to the second question: by how much will real incomes be squeezed? Moreover, although the bulk of Italian debt is held by domestic investors, foreign investors would dump whatever they have and the stock market would also take a beating. And the already-fragile banking system would come under further strain. For the foreseeable future, Italy will remain in the single currency area. The alternative is too awful to contemplate.

But plans by French President Macron to try and get the euro zone back on track appear to be running into the sand. Macron proposes more inclusive solutions including establishing a European finance minister; a fund to support investment and turning the European Stability Mechanism – established in 2012 as a system to provide financial assistance for member states in difficulty – into a European IMF. In order for him to make progress with these plans requires German political support but following last year’s general election which weakened Angela Merkel’s position, she seems less inclined to support Macron’s efforts.

A letter from 154 German academics, published in the Frankfurter Allgemeine Zeitung last week demonstrated the depth of German opposition. They warned that the euro zone should not be turned into a liability union and listed five main arguments opposing Macron’s plans: (i) The use of the ESM as a backstop for the bank recovery programme will reduce the incentives to clean up banks' balance sheets; (ii) If the ESM is transformed into a "European Monetary Fund" (EMF), it will be under the influence of countries that are not members of the euro zone which will reduce the controlling influence of the Bundestag; (iii) A common bank deposit guarantee scheme will socialise the cost of previous mistakes made by banks and governments; (iv) The planned European Investment Fund for macroeconomic stabilisation would lead to further transfers and loans to euro zone countries that have failed to take necessary reform measures in the past; (v) establishing a European Minister of Finance with power over fiscal policy would further politicise the role of the ECB.

They conclude that “the liability principle is a cornerstone of the social market economy. The liability union undermines growth and threatens prosperity throughout Europe … It is important to promote structural reforms instead of creating new lines of credit and incentives for economic misconduct .... The euro zone needs an orderly insolvency procedure for states and an orderly withdrawal procedure.” We should not dismiss these views out of hand – after all, AfD started as a project backed by some members of the academic community. It is somewhat ironic that the academics endorse the proposal of the prospective Italian government that an orderly withdrawal procedure be set in place. But the letter also laid bare that the signatories are as much concerned with looking after the German national interest as with laying the foundation stone for a stronger euro zone – note in particular point (ii).

And this is a problem that lies at the heart of the euro zone – indeed, the whole of the EU. It is what drove Brexit and prompted the Italian electorate to vote for a populist government. EU citizens simply do not see why they should make further sacrifices for a project that appears very remote to them. Admittedly, they can touch euro notes and coins, so in that sense monetary union is tangible. But the political sacrifices required to make it work are seen as an unnecessary step.

Perhaps – as I noted in a post last summer – the single currency was simply a step too far for the EU. There again, European politicians have never made a sufficiently compelling case for the EU. It has been taken for granted for too long. If Brexit was a wake-up call for politicians to sell the European vision, they are taking a long time to learn the right lessons. And so far they are failing.

Italy exposes the fault lines (again)

We knew that the Italian election, held almost three months ago, had the potential to cause problems in the euro zone but having survived the French and German elections last year, most investors thought we would be able to muddle through in Italy. It seems we were wrong. Although the Five Star (M5S) populist movement won the most votes, it was widely assumed they would not be able to get anyone else to work with them to form a government. In the end they managed to stitch up a deal with the far-right League, which had previously existed as the Northern League and campaigned for separation of northern Italy from the south, to form a coalition that most investors believed to be the worst possible outcome.

Italy now has a very inexperienced government which has discussed implementing a tax-and-spend policy which has been estimated in some quarters to cost up to 3.5% of annual GDP. Not surprisingly, this has sent alarm bells ringing in Brussels and Berlin as the Italian government prepares to drive a coach and horses through the fiscal rules that underpin the single currency. There was even a suggestion a couple of weeks ago that Italy would ask the ECB to wipe out €250bn of debt as well as set up procedures allowing EU member states to exit the euro, which is of a piece with the Eurosceptic views of M5S . Having experienced a near death experience in 2012 with a rerun in 2015, it is hardly surprising that serious questions are being raised once again about the stability of the euro.

In truth, Italy has always been the fault line running through the single currency project. Not only were its deficits flattered by financial accounting manoeuvres to get it below the 3% of GDP threshold in order to qualify for EMU, but its high debt levels were completely ignored. Recall that debt was supposed to be below 60% of GDP, or falling at a sufficiently rapid pace, in order to meet the qualifying standard. Neither was met (see chart). However, this was not a problem for the first decade of EMU – but then the crash of 2008 happened. To think that the problems in Greece almost brought the single currency to its knees. Given the vast size of the Italian debt market, problems in Italy could shake the project to its core.

However, much of the admonishment heaped on Italy, particularly from Germany, misses a vital point. EMU will not survive in the longer-term without a system of fiscal transfers – something that German taxpayers are dead set against. It is understandable that thrifty northern Europeans do not want to see their tax contributions used to bail out the more profligate. But without such a mechanism, differences in economic performance between nations will shake the euro zone apart in the same way as fixed currency systems such as the Gold Standard and Bretton Woods ultimately collapsed. The fact that the euro is underpinned by the ECB gives EMU a safety mechanism that neither of the other systems had but, short of the monetary financing of debt, it cannot provide sufficient long-term support to offset the strains in the system.

Whilst Italy clearly does require growth-boosting reforms – it has been one of world’s worst economic performers since 1999 in terms of GDP growth – it is not unreasonable for governments to think about how to use fiscal policy as an active policy instrument once again. We may question whether some of the government’s policies are feasible or desirable (a summary of the policies can be found in this FT article) but politicians are right to ask whether they should continue to operate a fiscal policy which is subordinate to the needs of monetary union.

Perhaps the biggest danger the Italian situation poses is that it really could pose an existential threat to the single currency. Italy is bigger and far more economically important than Greece and cannot so easily be bullied into accepting policies imposed from outside. If, for example, it were to set up a procedure to exit the single currency this would cause investors to be highly concerned about the long-term stability of the project, even if it were never implemented. As it is, Asian investors already do not go near Italian debt – they might be more wary of any euro debt if there is a threat to the currency’s existence.

Italy will not exit the euro, of course: The self-imposed damage this would cause would far outweigh any benefits. But unlike 2012, when the ECB promised to do “whatever it takes” to preserve the single currency, it may be less willing to act as a backstop this time around. Six years ago, the problems were largely the result of prevailing global conditions in the wake of the global financial crisis. Any shocks to the system triggered by conscious Italian policy decisions are unlikely to be met with such unequivocal support, for this would send a signal that countries can ignore the rules with impunity and still be bailed out. Brexit demonstrated that the unthinkable can become reality. We should not be too complacent about the wider implications of Italy’s populist government

More Frankenstein's Monster than Schrödinger's Cat

Last week, the cabinet agreed to a ”backstop” that would see the UK aligned to EU tariffs after 2020 if the two sides cannot agree on customs arrangements. Predictably, the Brexiteers in government were concerned that this might represent an attempt to remain in the customs union, although the prime minister appears to have convinced them it is a backstop that is unlikely to be triggered. I would not be so sure about that.

The government essentially has two plans on the table ahead of the EU summit in late June. Theresa May’s preferred plan is the customs partnership in which the UK collects external tariffs on behalf of the EU. Under this option, goods would cross borders with tariffs levied at the highest of the UK or EU rates with refunds claimed at a later date (in the same way as VAT is treated today). This would require far more cross-border tracking than is currently necessary, which would hugely increase the administrative burden. This plan has been dismissed by EU negotiators as “magical thinking” and it is opposed by Brexit supporters who view it as maintaining ties with the EU that they wish to see ended.

Consequently, they favour the so-called maximum facilitation (max fac) option in which the application of technology and the implementation of a “trusted trader” scheme will obviate the need for a physical border. But the technology to ensure that such a procedure can be implemented does not yet exist. Moreover, it would require the EU to put a similar system in place in order to work and it has been dismissed out of hand.

On the assumption that neither the customs partnership nor the max fac plans are acceptable to the EU, the backstop certainly has its attractions. Whilst it would give the UK a bit of breathing space to iron out its own internal difficulties, it may not be an easy sell in Brussels. Although the prime minister’s plan assumes that current arrangements can continue beyond end-2020, the EU may well decide to play hardball since it regards the border problem as a Northern Irish issue and appears to have no interest in applying a UK-wide solution in order to resolve it. In addition, it would fly in the face of the EU’s desire to set a limit on the transition period. But a more serious objection from the EU’s perspective is that it would allow the UK to remain a “quasi member” of the EU and thus escape the adverse consequences of a hard Brexit.

It is thus pretty obvious that a resolution to the Irish border problem is not imminent. Moreover, the UK government appears to be furiously back-pedalling on its more aggressive positions because it realises the intractability of the problem. But there is nothing new in any of this. I recently came across a filmed presentation that I gave in March 2016 when I explicitly warned that a Brexit vote would simply swap one set of problems for another and that no thought had been given by Brexit supporters to the consequences of their actions. Almost two years on from the referendum, the questions I am increasingly asking myself are “who owns Brexit” and “what do its supporters want out of it?” It seems to me that government rhetoric has pandered to the demands of those who want to pull up the drawbridge against the outside world whilst simultaneously trying to placate those who believe Brexit is a great opportunity to promote free trade. The trouble is that no one is satisfied – primarily because no-one in government is prepared to take responsibility for implementing a policy which is likely to have major adverse economic consequences.

What the government wants is a Schrödinger’s Brexit where we are simultaneously both in and out of the EU, thus delivering all the benefits of membership and all the gains from being outside. Schrödinger’s Cat was, of course, a thought experiment. And the further away we move from the heated rhetoric of spring 2016, the more it looks like the referendum exercise was a giant experiment in how not to conduct policy. More Frankenstein’s Monster than Cat.