Auction stations

A few days ago I heard someone describe the Brexit process in terms of the dollar auction problem and was immediately struck by how accurately it described the current state of affairs. The dollar auction problem was formulated by the late economist Martin Shubik, as a non-zero sum sequential game to illustrate how a series of rational choices can still lead to irrational outcomes.

In the original thought experiment, an auctioneer sells a dollar bill with two participants engaged in the bidding process. The caveat is that the person making the second highest bid must pay a penalty equivalent to the amount that they bid – unlike a real auction where there is no penalty for a failed bid. Suppose that bids increase in increments of 5 cents. If the first participant bids 5 cents for the dollar bill, a discount of 95% relative to the face value, the second person has an incentive to raise the bid to 10 cents because they still obtain the banknote at a 90% discount. Player One rebids because they can still make a significant notional gain and so it goes on. By the time Player One bids 95 cents, Player Two has to raise their bid to the face value of the dollar bill. They clearly make no profit but at least they avoid the 90 cents penalty from their failed bid. But Player One is facing a 95 cents penalty so it is in their interests to raise their bid to 105 on the basis that if they win, they will only lose 5 cents versus 95 cents if they do not bid. But Player Two has an incentive to bid again and the bidding round continues. In theory, it could continue forever so long as both players remain committed to winning.

Shubik designed this game to demonstrate how people can become obsessed with the idea of avoiding losing, even though the cost of winning can be so great as to leave them worse off – in effect, they lose whatever happens. This strikes me as a brilliant exposition of the underlying problems facing the two sides in the Brexit debate. We can think of the EU27 as the auctioneer determining the nature of the UK’s relationship with the EU, whilst the Leavers and Remainers bid against each other to ensure that their plan is accepted. Just as the bidding actions in the dollar auction game are determined by the action of the previous bidder, so the Leavers and Remainers have reacted to the plans made by the other side over the past two years.

We are now at the stage where Theresa May’s Chequers Plan represents the one dollar bid. It will not make the UK any better off but it will minimise the damage to the UK if accepted. But so committed are the Brexiteers to not losing the right to “take back control” that they are prepared to vote down any such plan. In their eyes, the economic losses are offset by the right (in the words of Dominic Raab) to take back control of “our borders, our money and our laws.”

Over the coming days and weeks, we will see whether the prime minister is willing to amend her plan in order to satisfy  the auctioneer’s requirement that a solution be found to the Irish border problem. Latest leaked reports suggest the government is prepared to back down on its opposition to new checks on goods moving between the British mainland and Northern Ireland. In exchange, May’s team would ask the EU to permit the whole of the UK including Northern Ireland to stay in the bloc’s customs regime (as I suggested here). At that point the Brexiteers may respond with another crazy bid, arguing that remaining in the customs union is to ignore the “will of the people” (it isn’t!)

The dollar auction game teaches us three lessons about escalation strategies: 

1. Perhaps the most obvious lesson is not to enter in the first place. But if you do, make sure you cut your losses early (too late for that I fear). 
2. It is possible to game the auction via cooperation. In the dollar auction,  the best outcome is derived if one person bids 5 cents and the second player refrains from bidding on the understanding that they will receive an equal share of the profits, in which case both end up better off. Again, it might be possible to achieve a smooth Brexit if all sides are prepared to compromise. 
3. The auctioneer is the only winner, especially as the stakes are raised.

Unfortunately, the dollar auction game can go on forever but the Brexit auction game can now only run for less than six months. Time, perhaps, to look again at option (2)
.

Left or right?

Party conferences are usually best avoided apart from those with a genuine interest in the minutiae of party politics. This does not prevent the UK media from dissecting the speeches of senior figures for clues as to what policies are likely to be presented (or more likely ignored) by the time the next general election comes round. But this year is different. The world’s media paid attention to last week’s Labour Party conference, and will focus on next week’s Tory conference for the same reason: They want to understand what the UK political establishment plans to do about Brexit.

Dealing first with the Conservatives, because that is the easiest part, we pretty much know that Theresa May will sound hawkish to reassure the party faithful that her government has no intention of backing down in the face of intimidation from Brussels. Expect a show of bravado with the underlying theme of “no surrender”, partly because that is what the party wants to hear but also because May is under pressure to save her political skin following repeated attempts by Boris Johnson to convince the electorate that he is the man to deliver Brexit (yawn!).

But Labour’s conference was a genuinely fascinating affair as it struggled to deal with the Brexit question. It is well known that leader Jeremy Corbyn is a Eurosceptic but a large majority of party members are opposed to Brexit. To complicate matters further, a large proportion of voters in Labour’s strongholds outside London were in favour of Brexit. Consequently, the party has struggled to come up with a coherent policy over the past couple of years. Last weekend, there was apparently much heated discussion as senior party officials wrestled with a compromise wording for the conference Brexit motion. Eventually, Labour agreed to keep a second referendum on the table but there was disagreement as to whether this included an option to remain in the EU. The shadow chancellor, John McDonnell, who is regarded by many as the keeper of the socialist flame, insisted that a referendum would only be called on the terms of any deal agreed with Brussels. But Keir Starmer, shadow Brexit secretary, won a standing ovation from the conference when he declared in an off-script speech that “no one is ruling out Remain.” So that’s all clear. Or not!

Irrespective of what is actually on the ballot paper, Labour appears to be committed to a referendum on something. There again, Tony Blair promised a referendum on euro membership that never happened. Indeed, it made it into Labour’s 1997 election manifesto. This has heightened the widespread belief that what Labour really wants is to get its hands on the levers of power – quite rightly, as that is what politicians are supposed to want. But at what price? Corbyn has spent 35 years in parliament protesting against the status quo. So whilst we know what he is against, voters do not know what he stands for.

John McDonnell’s speech to the conference this week revealed a radical economic platform. There is a general belief within the Labour hierarchy that the Conservatives’ social policy plans are so unpopular that Labour can afford to be upfront about its economic plans (they are probably right about the former but I am less sure of the latter). McDonnell outlined a compulsory share ownership scheme under which 10% of the equity in the UK’s large companies would be gradually handed over to workers. In addition, he announced plans to give workers one-third of the seats on company boards, and offered fresh details of proposals to nationalise utilities in the water industry. It is an agenda designed to frighten corporate Britain and the dilemma for many voters is whether this radical agenda is a price worth paying for reversing Brexit. For sure, the worst of all possible economic outcomes would be Labour’s economic plans AND Brexit, and the polls suggest that neither Labour nor the Conservatives are able to command a lead. Voters appear to be turned off by Tory infighting over Brexit and their inability to deliver what they promised, but equally they do not trust Labour in key areas of policy.

The international press also took a sceptical view. The respected Neue Zürcher Zeitung spoke for many by suggesting that Labour is putting a desire for power ahead of the national interest. Corbyn’s inability to articulate what he wants from a second referendum suggests it is a prospect to be dangled in front of the electorate in order to realise his true objective of taking Britain in a new direction. Le Monde also questioned whether the chaos of Brexit could indeed bring Labour to power.

Perhaps more than anything, the events of the past two years reveal the extent to which the policy failures of successive governments have been laid bare. Brexit was in part the result of the failure of governments to listen to the electorate on a wide range of issues, against a backdrop of extreme austerity. This has created a policy vacuum in which policies advocated by extreme free-marketeers and old-style socialists compete with each other in a way we have not seen for 40 years. It sometimes feels that taking back control really means taking the UK back to the 1970s. But much as I enjoyed that decade - it defined the music I grew up with for one thing - I would much rather look forward than backwards.

EU may see it differently

Although the British government was given a bloody nose following last week’s Salzburg summit, events of the past few weeks act as a reminder that Brexit is one of the few issues on which the EU27 is able to present a united front, since almost all the leaders of the larger nations are facing mounting domestic difficulties. 

Nowhere is this more evident than in Germany where Angela Merkel is facing what looks to be a significant fracturing of the political consensus. In summer 2017, the CDU/CSU coalition was running at 39% in the opinion polls with the SPD polling 25% and the AfD 8%. Latest polls put the CDU/CSU at 28%, the SPD at 17% and the AfD at 16%. In the 20 years that the Emnid weekly poll has been running, the share of the CDU/CSU and SPD, which together represent the main German political factions, has never previously fallen below 50%. That the AfD and SPD are running neck-and-neck in the polls is an indication of how things have changed. The fact that the AfD has maintained its polling status even after the riots in Chemnitz is another illustration of that fact.

The ousting this week of a long-term Merkel ally as head of the conservative bloc's parliamentary group is an indication that her domestic opponents have been emboldened by apparent signs of political weakness. With Merkel already one year through her four-year term, and unlikely to stand as Chancellor at the next election, the beginning of the end of her time on the stage is apparently unfolding before us. 

Not that Emmanuel Macron has much to be satisfied with. According to latest polling data, only 28% of French voters are satisfied with his performance – down from 35% in July and compared with 60% in summer 2017. This puts him on a par with Francois Hollande’s polling ratings after a similar period in office, and way behind Nicolas Sarkozy. Macron’s problems are: (a) he does not enjoy as much support as his landslide election win suggested – many voters simply chose him because he was not the right wing Marine Le Pen; (b) he has been unable to deliver on his promise of a domestic political revolution, and (c) promises to cut taxes remain so far unfulfilled (see this BBC article for a closer look at Macron’s woes).

As I have noted previously (here), Italian politics has been in flux since the spring election as the League and Five Star parties continue to share an uneasy alliance. Current negotiations regarding the 2019 budget have been dragging on for weeks, with the technocratic finance minister Giovanni Tria under pressure to increase the budget deficit to accommodate the expensive election promises of the populist coalition government. There are concerns that a deficit in excess of 3% of GDP would be a problem for the European Commission, provoking a row over fiscal policy that would result in another general election next year. Whether or not this materialises is not the point: It is yet another distraction that Italian voters – and indeed the EU as a whole – can do without.

Factor in the ongoing problems between Brussels and the governments in Budapest and Warsaw, and the news that the Sweden’s  centre-left prime minister has been forced out by the centre-right bloc after an inconclusive election earlier this month, and the scale of the political problems facing EU leaders becomes evident.

Thus, when the British newspapers obsess about Brexit as if it were the only game in town, you can be sure that they have it all wrong. The trials and tribulations faced by Angela Merkel over recent months highlight the extent to which the old order is crumbling. When even the German Chancellor faces mounting domestic problems as a result of the EU migration crisis, it is pretty evident that something is wrong. The likes of Italy and Spain feel that they have been left alone to cope with the waves of migrants arriving on the EU’s doorstep whilst countries such as Austria, which are located on the main land route towards Germany, are concerned that migrants should exit their territory as quickly as possible.

Indeed, immigration is the fault line running through European politics. It was one of the key issues in the Brexit campaign – this was, after all the topic which most exercised UKIP under Nigel Farage – and played an important role in Dutch, French and Italian elections over the past 18 months. There is clearly no easy fix. Aside from any irrational prejudices that people may have, the economic issue is what effect will large migration numbers have on public finances, wages and per capita incomes. The UK evidence does not suggest that there has been any significant adverse impact on the economy. Indeed, much of the empirical work conducted over the last decade suggests that immigration has had no significant negative impact on the job prospects of UK natives. The evidence of its impact on productivity is less clear cut but due to the fact that the skill levels of those entering the UK are generally high – notably those coming from the EU – the empirical studies conclude that a 1 percentage point in the migrant share of the working age population raises productivity by anything between 0.4% and 2%.

But this cuts no ice with electorates which believes this all to be fake news. The fact that populists continue to squeeze the political centre is a concern for those politicians looking for traditional European solutions, involving compromise and rationality, to these 21^st century problems. Too many European politicians are fighting their own battles against populists to care too much about what the UK wants. If British politicians want to engage constructively with the EU27, it might help to recognise that the UK is not unique in any way – apart, that is, from being stupid enough to open a Pandora’s Box, in the form of a referendum, that will not easily be closed.

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.”

Some thoughts on China

It has been an interesting week on the China front following the news that the US is to impose a tariff of 10% on $200bn of Chinese imports with effect from next week. The timing of a series of discussions this week on Chinese economic prospects with some experts in the field thus proved fortuitous, and whilst they reinforced the little I do know, they also served to put the subject in a wider context.

To start with the trade issues, the primary reason for US action against China can be traced to the strategic plan unveiled in 2015, Made in China 2025, which intends to place China at the forefront of technological advancement and which was described by the US Council on Foreign Relations as a “real existential threat to U.S. technological leadership.” More problematic for the US, and indeed many other western nations, is that China is seeking self-sufficiency via technological substitution i.e. switching foreign technologies for those developed at home, which would shut the US FAANG industries out of one of the world’s largest consumer and business markets. Not only is there a growing belief that Made in China 2025 violates WTO rules by setting targets for self-sufficiency, but there is a real concern that China is seeking to achieve its goal of technological supremacy by expropriating western technology via fair(ish) means (forced technological transfers in return for permission to operate in China) or foul (espionage).

The view from non-Chinese Asia is that US actions to clamp down against technological expropriation are understandable, but the way the US has handled the situation leaves a lot to be desired. The US would be in a better position to get China to take heed of its position if it had all its allies onside first – after all, the technology transfer issue is common to all western nations – but it has instead succeeded in antagonising the EU and Canada by threatening trade sanctions against them. Failure to present a united front may thus undermine US efforts to force China to the negotiating table. Equally, however, there is a view that China perhaps ought to recognise that it has been one of the main beneficiaries of its accession to the WTO, and that it can afford to be more magnanimous rather than pursue its goal of simply “making China great again.”

Another question that was raised in this week’s discussions is the extent to which China can afford to retaliate in any trade war. It is well known that the US imports more from China than China does from the US, and as a result the trade sanctions will initially hurt the Chinese most. Due to this factor alone, China will struggle to match the US in a tit-for-tat escalation. But there is a more fundamental political problem. Next year marks the 70^th anniversary of the foundation of the People’s Republic of China, which will be marked with great fanfare, and in 2021 the Chinese Communist Party will celebrate its centenary. The Chinese authorities have no desire to spoil the party by creating additional economic difficulties. Indeed, it is arguably in their short-term interests that the world economy remains strong so as not to damage export prospects which would risk spoiling the party.

Moreover, as I noted earlier this year, simulation analysis conducted by Bloomberg Economics suggests that the optimal economic response is for China not to respond to the US actions. The rationale for this is that whilst China will take a hit, it will suffer even more if the trade war escalates, since this threatens to spill over into other important Chinese export markets, depressing global trade and making life even more difficult for China.

Having grown rich and powerful on the back of an export- and investment-driven growth model, China is attempting to redress the balance by developing a more consumption-driven economy. But there are some clouds on the horizon. One is that demographics are turning against China. The population aged 15-64 peaked in 2015 and within a decade it will have declined back to levels prevailing at the turn of the century. Japan hit peak labour force in 1995. But at the time, its GDP per head in per capita terms was around $43,000 – more than three time current levels in China (~$12,000). This is not to say that per capita incomes will not increase further. As the chart shows, real per capita incomes in Japan have continued to rise even though working age population is falling – it just becomes much harder. Moreover, the Chinese economy is heavily indebted, with the non-financial sector operating under a debt burden equivalent to 250% of GDP – about the same size as in the US, but with more unfavourable demographics and lower incomes, and much larger than other developing markets (Brazil is at 150% and Russia 80%).

One way to boost incomes, of course, is through technological innovation – hence the Made in China 2025 programme, which is where we came in. But what exactly is the underlying motivation for the policy? One argument is that the primary objective of Chinese leaders down the ages has been simply to feed its vast population. It is thus not interested in the rest of the world for any other reason than as a means to keep the show on the road. This has been made relatively easy in recent decades by the industrialisation and urbanisation programme which has allowed China to put labour to use in higher value added activities, thereby boosting incomes. But this process may be about to become more difficult, which is where the politics starts to get tricky.  Historically, China has relied on strong leaders at such times who can marshal the economy’s resources and if Xi Jinping is anything, he is a strong leader. Accordingly, we perhaps ought to view the recent push to restore China to its rightful position at the top table as an attempt to give the country a unity of purpose at a time when economic conditions may be turning less favourable.

I do not pretend to be a Chinese expert but I found some of these thought-provoking ideas very interesting. As a parting shot, it is notable that China is led by a strong populist leader, in much the same way as the US, and both have similar goals for their country (and indeed for themselves). It is thus ironic that the US and Chinese leadership should find themselves on opposite sides of the negotiating table when in fact they have much in common.

A decade on ...

It is exactly ten years since the Lehman’s bankruptcy set off a chain reaction in the financial markets that prompted the biggest economic collapse since 1929. Perhaps if the regulatory authorities had been aware of the disruption that would follow in the wake of their decision to declare Lehman’s insolvent they would have thought twice about it. It proved to be the catalyst for the deepest global recession in 80 years and prompted the monetary authorities to step in to prop up the global financial system.

The prime cause of the bust was excess leverage that had built up in the banking system, aided and abetted by some irresponsible activity by banks and lax oversight by the regulatory authorities. Thanks to an unprecedented degree of monetary easing, the fallout from the crisis proved to be far less disruptive than the Great Depression of the 1930s but it nonetheless exposed the limits of the pre-2008 financial system. Despite all the hype suggesting that risk had been tamed, the opposite was true. Instead banks merely learned to hide risk using off-balance sheet vehicles, and when banks ceased to trust each other because they were not sure how much balance sheet risk their counterparties were exposed to, financial markets seized up.

It was evident during the meltdown that the motto of the London Stock Exchange “my word is my bond” counted for nothing. Trust evaporated faster than an ice cube in a heatwave. Whilst banks were clearly the catalyst of the crisis, I hold the view I expressed at the time that the whole episode reflected a systemic collapse in which regulators, central banks, governments and indeed private households all played a part. I was also initially puzzled as to why the authorities allowed Lehman’s to go to the wall when the Fed brokered a deal with JP Morgan after a similar fate befell Bear Stearns in March 2008. I rationalised it by suggesting that having acted as a backstop for the US financial system to that point, the authorities took the  view  that  they  could not continue  to  bail  out  failed  institutions  and thereby  continue  to promote  risk  taking. Which was fine, but a couple of days later they stepped in to bail out AIG.

It was nonetheless obvious on 15 September 2008, the day markets reopened after the Lehman’s announcement, that the risks to the economy had significantly risen. I noted on the day that  “On previous occasions when the US financial industry has suffered major shocks, the authorities have responded by implementing major legislative changes … We  might expect a similar legislative backlash in future with any legislation likely to focus on improving the transparency of banks' risk positions.” That proved to be an understatement. The Basel III legislation, unveiled in 2010, was a comprehensive overhaul of the financial sector which changed the way in which banks operated. The first element of this policy required banks to hold much more loss-absorbing capital, with a required minimum capital buffer of 7%-8.5%  compared to an effective pre-crisis buffer of 4%. A second element of the legislation focused on enhancing the consistency and comparability of banks’ risk weighted, assets to impose a much greater degree of uniformity thus enhancing transparency.

Although we will never fully know how successful the new legislation proves to be until it is tested in a crisis, regulators’ regular stress tests give grounds for optimism. Balance sheets have changed significantly in the past decade with a higher proportion of the asset base comprised of loans at the expense of trading securities whilst deposits make up a larger share of liabilities. But as the BIS has pointed out, a crucial area of banking resilience is profitability since this determines the extent to which banks can recover from losses. Although much progress has been made to weather-proof bank balance sheets, profitability – particularly in Europe – has not recovered. Admittedly, pre-2008 profit levels may be an inappropriate benchmark given the significant degree of risk required to generate them, but market pricing based on metrics such as price-to-book ratios suggest that investors are not very optimistic with regard to a profit recovery.

From an economic standpoint, economic prosperity is clearly growing more slowly than before the great recession. In the ten years to 2007, UK real household incomes grew at an annual average rate of 3%; over the period 2008 to 2017 the rate slowed to 0.8%. The experience across the euro zone has been similar, with average annual growth of 1.9% in the seven years prior to the crash but 0.2% in the decade thereafter.

A perception that living standards are not improving at the same pace as pre-2008 has resulted in a backlash against globalisation – a view that has been fuelled by the rise of China, which is viewed in some quarters as getting rich at the west’s expense.  Rising economic nationalism has placed limits on the EU’s ambition and although the single currency has survived intact, it survived a near-death experience in the wake of the Greek debt crisis and highlighted that a fixed exchange rate system needs much more than a single monetary policy to survive. Arguably, the problems in the EU coupled with a backlash against immigration gave rise to Brexit, whilst mounting concerns about the rise of China was the catalyst for the rise of Trump.

Just as many lessons were learned from the crash of 1929, so economic historians will have a field day with the Lehman’s bust. Perhaps the biggest lesson was that self-regulation does not work. The idea prevailing in the preceding 20 years that aligning incentives would ensure optimal market outcomes proved to be hopelessly naïve (as indeed many of us said all along). Few bankers are fans of the enhanced regulatory regime subsequently introduced but it is a necessary price to pay to ensure that 2008-style outcomes are not repeated. After all, the imposition of Glass-Steagall legislation in the US in 1933 successfully prevented banking crises until after it was repealed in 1999.

But one lesson has remained unlearned. Many believed that the Keynesian policy prescriptions which worked well in the 1930s, coupled with massive monetary easing, would help economies to recover relatively quickly. Although we got the monetary easing, governments have conducted a prolonged period of fiscal austerity after a brief stimulus. The economy has thus struggled to recover and financial markets are less dependent on the economic pickup than on the cheap liquidity provided by central banks. In that respect perhaps we will only know the extent to which we have fully recovered from the crash of 2008 when we see how markets and the economy cope with monetary tightening. The US seems to be doing fine on this front but Europe remains a long way behind.

Jacob's adventures in Wonderland

The Economists for Free Trade (EFT) group (formerly Economists for Brexit) today released their latest unfortunately-named  publication  “A World Trade Deal – The Complete Guide” which is not much of a guide and is in no way complete. Moreover “A World Trade Deal” is no deal – it is the default option in the event that the UK is unable to agree an arrangement with the EU. Given this starting point, expectations for the rest of the publication were pretty low and it more than lived down to them. But let’s focus on some of the details.

Trading under WTO rules implies imposing tariffs on EU trade where there are currently none. This is in no way a “deal” as EFT would have us believe: The WTO represents nothing more than a lowest common denominator set of rules to reduce trade frictions. EFT also believe that the UK can simply continue trading on the basis of these rules as soon as it exits the EU. There are one or two issues to iron out, such as agreeing on the division of quotas for goods which have already been agreed at the EU level (the US, Australia and NZ have already objected to the proposed divvying up of agricultural quotas). Incidentally, EFT believe this “should not cause great difficulties … the EU and the UK have been working harmoniously in this regard for some time” although The Guardian reported in the spring that “in recent months the united EU and UK front has splintered.”

EFT then poses the question “Does the WTO require physical customs checks, meaning lengthy delays at our ports and borders?” and in their view the answer is negative. But the delays come when other countries impose customs checks on goods entering foreign markets, and then some! According to the WTO, “high levels of bureaucracy and unnecessary costs” result from document requirements that lack transparency and involve duplication; a lack of cooperation between traders and customs agencies and lack of automatic data submission with the result that “at some border crossings, cargo can take up to 30 days to be cleared.”

Against this backdrop, EFT continue to argue that the economic gains to Brexit outweigh the costs. “Those who have modelled a Clean Brexit properly report long-term gains from free trade alone of 2%-4% of GDP.” You have to laugh at the chutzpah. Those who have modelled Brexit “properly” certainly do not include EFT. “The long-term negative outcomes claimed by the Treasury and the January Cross Departmental Brexit Analysis were produced by assuming implausibly high (and illegal) frictional UK-EU border costs.” Yet the bulk of the academic evidence finds that border costs are far higher than often supposed. It is not tariffs that are the problem; rather the costs associated with transacting across borders (legal, contract enforcement, transport and distribution expenses). Indeed, they are generally larger than the marginal costs of production[1].

Then EFT simply descend into fantasy. They reckon that in addition to the positive effects of free trade, the UK will save “approximately £12 billion a year” by cutting payments to the EU. Finally, “because we will be doing all this without the encumbrances and constraints of the Withdrawal Agreement … we can … withhold most or all of the estimated £39 billion divorce payment.” The upshot will be a “long-term gain to GDP of …  about 7% over the next decade and a half” which will “allow enhanced spending on public services and tax cuts by the early 2020s, further boosting the economy.” To sum this up, EFT reckon that a system of imposing additional tariffs on EU trade is going to somehow boost GDP and find a Brexit  dividend that the OBR says does not exist. As the kids would say, LMAO.

And we’re not done yet. EFT argue that “the economically optimal trade strategy in most circumstances for the UK would be to eliminate all tariff and non-tariff barriers unilaterally with respect to all our trading partners.” The elimination of all non-tariff barriers implies the complete deregulation of all product standards. And since non-tariff barriers exist primarily due to differing regulations between trading partners, unless we suddenly converge on a set of global standards (e.g. China and the US adopt the same standards), it will be impossible for the UK to eliminate non-tariff barriers on all imports. Moreover, there is no reason why the rest of the world should reciprocate, particularly if the UK is a relatively small export market (which it is for most countries).

There are numerous other dodgy assertions but I will reserve some final flak for the idea that losing access to the EU market will not damage the financial  services industry. Without going through it point-by-point, I would question the assertion (provided without a reference) that “only 9% of the City’s revenues are vulnerable to the loss of passporting.” More than half the revenue generated by the City is generated from the rest of the EU according to TheCityUK, and initial estimates suggest that 20% of London revenues could be at stake. Moreover, some of the solutions proposed by EFT such as “setting up small entities in the EU that trade with EU customers and those entities entering into mirror, or “back-to-back” trades with the UK parent” would run fall foul of the ECB, which has ruled out boiler plate operations. Anyone who believes that Brexit will not have adverse consequences for financial services would do themselves a favour by talking to people in the industry who are already making their post-Brexit arrangements.

Eurosceptic MPs, operating under the guise of the European Research Group, promised earlier this month to produce an alternative to the Chequers plan but backed down when it became clear that some of the proposals were of “dubious quality.”  Given that Jacob Rees-Mogg lent his support to the EFT proposals but was not prepared to back the ERG plans, you really do have to wonder how bad they were. As trade expert David Henig tweeted this afternoon, the EFT analysis “isn't in any way a serious document. Media should treat the report, and any MPs citing it approvingly, as having nothing useful to say on the subject of post-Brexit trade.” As a drowning man clutches at straws, so the Brexiteers continue to hang their hat on sub-standard analysis such as this. They’re losing the argument because they haven’t got one.

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[1] Anderson, J. E. and E. van Wincoop (2004) “Trade Costs” Journal of Economic Literature (42), pp. 691-751