Snatching defeat from the jaws of victory

Brexit has been the dominant theme of this blog for the past 30 months. It was not meant to be this way, but it is a measure of the fact that the political forces impacting on economic decision making have dominated the agenda of policy makers and investors. Nationalism has become one of the biggest political and economic challenges of our time and has found expression across the whole of Europe, not to mention the US.

Brexit is merely the tip of this nationalist iceberg. Indeed, the fact we have spent 30 months discussing what form it should take means we have spent more time debating the issue after the referendum than we ever did beforehand. If we think back 30 months before the referendum, we are transported back to the innocent days of early-2014 when the debate was dominated by the aftermath of the euro zone debt crisis, the extent to which the global economy was recovering and how rapidly interest rates would be normalised (for the record, I expected UK Bank Rate to be at 3% by now).

But now it is crunch time with the vote on the Withdrawal Agreement due next Tuesday. MPs are widely expected to reject it, which means that much of the negotiations and effort put into this debate are likely to count for nothing. If the last 30 months have taught us anything it is that there are no simple answers to complex questions – a point that Mark Carney repeatedly made in testimony before the Treasury Committee this week when pressed to explain some of the issues in simpler terms.

I was also struck by an excellent Twitter thread by Seamus Nevin, head of  policy research at the Institute of Directors, who made a comparison between the situation facing Theresa May’s government today and that facing the Irish independence movement in 1921 when a smaller entity made a bid for independence from a larger body. As he pointed out, it is ironic that Northern Ireland loomed large during both campaigns. Back then, of course, the north was the industrial powerhouse which was cut out from the rest of the island. Today the roles are reversed, with the Republic a much stronger economic force than Northern Ireland.

To quote Nevin: “The Anglo Irish Treaty fell far short of the Irish separatists’ demands for full sovereignty. The Treaty Michael Collins negotiated meant Ireland would not be fully independent but a ‘self-governing dominion of the United Kingdom’ … Leavers wanted the north to exit on the same terms as the rest of the country. Business interests argued that leaving the customs union would cause great damage to northern Irish industry. Just as the UK is finding now, leaving a customs union is not without political difficulty. The deal, reached after long and hard rounds of talks, was imperfect … But as Collins argued back then to his frustrated and disappointed party colleagues, the deal ‘gives us freedom, not the ultimate freedom that all nations desire, but the freedom to achieve it.’”

This latter point goes to the heart of the Brexit problem. Leavers want a perfect Brexit which gives the UK all of the economic upsides but with the added benefits of controlling its own borders free from interference from the ECJ. As I am bored of repeating, but it cannot be stressed enough, this is a fantasy that can never be realised. The deal on the table is probably the best that the UK can expect to achieve. As Nevin puts it, Theresa May has to “convince her colleagues that to reject the negotiated agreement risks jeopardising the very thing the Brexit leavers, like their Irish separatist predecessors, have fought so hard to achieve: freedom from that neighbouring union.” If Brexiteers reject this deal, they may just have kissed goodbye to their chances of achieving any form of Brexit.

In the event that parliament rejects the Withdrawal Agreement, MPs will then take over the Brexit process and it is widely assumed that they will do whatever it takes to avoid a no-deal outcome. This will likely involve a form of accommodation with the EU that precludes the Brexit ultras from being able to achieve the degree of independence they have fought so long to achieve. If they want any form of independence from the EU, it might be better for them to accept an imperfect Brexit than none at all. Of course, the UK gains very little independence from the current deal, as the release of the government’s legal advice this week made clear.

Nonetheless, it would be the bitterest irony for the likes of Boris Johnson, David Davis and Jacob Rees-Mogg that they won the referendum against the odds but then threw away their best chance of victory (or at least a draw) at the last minute by pushing for a better outcome.

Brexit turbulence increases

It has been an interesting day, to say the least, as the UK parliament prepares itself for next Tuesday’s all-important vote on the EU Withdrawal Bill. It started with the ECJ Advocate General who opined that the UK may be able to unilaterally rescind its Article 50 notification. It ended with parliament beginning the first of five days of parliamentary deliberation on the Withdrawal Agreement and the government suffering some major defeats on legislative matters.

Although the ECJ Advocate General, Manuel Campos Sanchez-Bordona, merely expressed his opinion, which is not the same as a legal ruling, the suggestion that the UK may be able to unilaterally rescind its Article 50 notice was significant. In order for this to become law, it would have to be ratified by the judges but it is generally believed they will back the Advocate General’s stance. What is important is that although the law currently requires unanimity between the negotiating partners in order to extend Article 50 beyond the default two year period, it says nothing about the process to be followed in the event that one or more party wishes to withdraw the notice.

But in the view of Mr Sanchez-Bordona, there are a number of caveats. It would have to be conducted in accordance with the UK’s constitutional arrangements, which in effect means it would require an Act of Parliament – the government cannot simply decide by itself. Moreover, the UK would have to act in “good faith.” This means the UK cannot withdraw its Article 50 application simply to improve its bargaining position. Nonetheless, this offers the UK a potential get-out-of-jail card in the event that it is unable to secure an acceptable Brexit. More importantly, it is perhaps the first sign that the EU is prepared to offer the UK a face-saving way to remain a member should the need arise.

Domestic events were dominated by the parliamentary debate on the Withdrawal Bill. Prior to the debate taking place, the government was defeated on key ballots which highlight the extent to which parliament is taking control of the Brexit process from the government. In the first instance, parliament won a vote allowing MPs to instruct ministers on how to proceed in the likely event that the government loses next week’s vote. This will effectively give MPs the power to look at alternatives to a no-deal Brexit (the government’s apparent “Plan B” at present) which can only be good news since it reduces the chances of crashing out of the EU without a deal.

Equally significant was the fact that the government was held “in contempt of parliament” (in other words, a charge of obstructing the working of parliament) for failing to reveal the confidential advice given to ministers regarding the Withdrawal Agreement. This information will now be released to parliament tomorrow and it will clearly highlight a lot of the unattractive features of the deal, notably the limited extent to which the UK has room for manoeuvre in its dealings with the EU under the present terms of the Agreement.

What is particularly concerning is the extent to which government lawyers believe the UK will become trapped by the Irish backstop. Recall that the backstop agreement envisages the UK remaining in the European customs union and that in the absence of another solution, the UK will only be able to leave with the consent of the EU. Moreover, the UK will not legally be able to negotiate free trade agreements with third countries so long as it remains in the customs union, so in effect the UK will only be able to pursue FTAs with the consent of the EU. Anybody who thinks that the terms of the deal are unattractive now will surely be confirmed in their view by the legal advice. Although the contempt charge probably sounds a lot worse than it is, today marks the first occasion that ministers have been charged with this ancient offence. By forcing the government to reveal the full extent of its legal advice, this reinforces the view that government is losing control of proceedings.

It is, of course, easy to be sucked into the media frenzy that occurs when big parliamentary events take place. But if we have learned anything today, it is that Theresa May’s chances of getting parliament to pass her deal have receded further. The ECJ’s legal opinion may embolden MPs to believe that the choice of May’s deal or no deal does not represent the full spectrum of events. For what it is worth, I continue to believe that an extension of the Article 50 period is very much an option. A week from now, we should know which way the vote has gone. If the deal is rejected, expect a new debate to begin about what kind of Brexit the UK wants – a debate politicians should have been having for the past two years.

Assessing the official Brexit simulations

The release of three sets of Brexit impact studies this week showed quite clearly that there is no such thing as a Brexit dividend. To use Boris Johnson's famous metaphor, the choice is between having a cake and eating it - we can't do both. Like the slow motion car crash that I have long used to describe the whole Brexit process, the car is about to hit the tree.

There can be no doubt that the quality of the analysis underpinning each of  the studies is first rate and although the teams involved were able to devote considerably more resources to their analysis than I was, their numbers are not too dissimilar to my own.

Starting first with the analysis produced by the National Institute, their simulations suggest that the Withdrawal Agreement which is to be put before parliament in two weeks' time will cost 4% of GDP compared to the case where the UK remains in the EU, largely due to a reduction in trade with the EU, with services particularly affected. As they put it, "this is roughly equivalent to losing the annual output of Wales or the output of the financial services industry in London." To put it in terms of the cost to individuals, this reduces income per head by around 3% which is the equivalent of £1000 per person. 

The government's own simulations also represented a considerable intellectual tour de force. They were based in four scenarios: (i) The Chequers Plan set out in the summer (and rejected by the EU); (ii) a Free Trade Agreement; (iii) EEA membership and (iv) no-deal. Unlike NIESR it did not consider the agreement reached last week – the FTA is probably the closest we are likely to get. It was also useful that the modelling strategy separated trade costs from the impact of changing migration assumptions. In terms of results, the discredited Chequers Plan implies the lowest output losses relative to the baseline of remaining in the EU, with output losses between 0.6% and 2.1% of the baseline (depending on assumptions used for the extent to which non-tariff barriers are raised – see below). EEA membership implies a loss around 1.4% of baseline GDP whilst an FTA or no-deal could lead to losses of 6.7% and 9.3% respectively on the assumption of no new net migration (in line with the government's plan).

These numbers focus only on the longer-term costs (15 years). But the worst case outcomes imply huge short-term disruptions and it may be the case that there are even bigger losses in the near-term which are partially offset in the longer term. In other words, if there are big short-term output losses this will matter more to people's perception of the Brexit costs than the long-term outcomes. 

The BoE’s analysis focuses on the near-term losses up to five years ahead and models a number of possible outcomes ranging from a disorderly Brexit, a disruptive Brexit; a less close relationship with the EU and a close relationship. In the latter two cases, the impact relative to baseline is minimal. But in the disorderly Brexit scenario, the term premium on UK government bond yields rises by 100bps and sterling collapses by another 25%, in addition to the 9% since June 2016. In this case the inflation rate spikes up to 7.5% whilst output falls by between 7¾% and 10½% which drives the unemployment rate up to 6.5% (see table below).

Indeed, the BoE's simulations dominated the headlines this morning. What was less remarked upon was why the BoE predicted such a large short-term decline in output. It transpires that the worst case scenarios point to a big rise in interest rates to combat a surge in exchange rate-induced inflation (Bank Rate rises to 5.5%). This apparently counter-intuitive result is all to do with the structure of the models used by the BoE. The main simulation tool is a so-called Dynamic Stochastic General Equilibrium (DSGE) model. One of these days I will look at them in more detail but suffice to say they assume that Brexit represents a supply shock that results in a slowdown in potential GDP growth and thus to a narrowing of the output gap. This in turn leads to a rise in inflation expectations at the same time as measured price inflation is picking up, and the model assumes that the BoE will respond by tightening policy, which of course exacerbates the effect of the initial Brexit shock on output.

It is a moot point as to whether the BoE will really respond in such a way. My guess is that it will not and will act in a similar fashion to summer 2016 by assuming that inflation is a one-off exogenous shock that will eventually fade. After all, households will not react kindly to a big income squeeze if interest rates are being raised and I maintain that the BoE will be forced to ease monetary policy rather than tighten it.

Perhaps what all this analysis suggests is that we have to be aware of the different types of models and in-built reaction functions when interpreting the simulation results. Although all the modellers have been explicit about the assumptions and models used, it is difficult enough for specialists to figure out exactly what is going on. Thus the average person on the street has no chance. It is therefore easy for charlatans like Jacob Rees-Mogg to dismiss the carefully constructed analysis as part of Project Fear.

It may indeed be true that the worst case outcomes do not materialise. But for his ilk to dismiss the costs associated with a no-deal Brexit is irresponsible. It is certainly unworthy of JRM to dismiss Mark Carney as "a second tier Canadian politician", particularly when he himself has never held a frontline political position and struggles to count to 48. The sky may not fall in next March, in which case it will be the result of a degree of preparedness on the part of responsible adults such as Carney. But if it does, we know where to come looking to apportion the blame.

Persuading BOB

Theresa May's open letter to the electorate in support of her Brexit deal has been roundly criticised on social media. I can certainly see why: It was riddled with more than a few distortions and untruths.

But we need to see this appeal for what it really is: An appeal to those members of the public bored of Brexit (or BOBs) to put pressure on MPs to make it sound like she has achieved the best possible deal. In one sense, of course, she has. The EU was never going to give the Brexit brigade what they wanted, which was essentially membership of the EU without paying any of the costs. Given that starting point, the PM can justifiably say that she has concluded a deal that minimises the risks to the UK economy, which is what we have wanted all along. The question is whether she has paid too high a price.

I suspect the answer is yes. The UK is locked into various aspects of the EU that Brexiteers wanted to get away from. It is still largely beholden to the product standards of the single market and therefore to the rulings of the ECJ. Britain cannot unilaterally leave the backstop customs arrangement which prevents the imposition of a hard border with Ireland. And worst of all, there was little to nothing in the agreement that covered the non-tariff barriers that govern services trade. Financial services, for example, continue to be given short shrift with last week's political agreement suggesting that future arrangements would be based on some form of equivalency. Just as a reminder, the current equivalency arrangements effectively allow the EU to pull the plug on third country institutions with 30 days’ notice.

But for all the shortcomings of the deal, what is particularly irritating is the tone of the PM's letter. It reminded me very much of the speeches May gave in 2016 and 2017, in which her inner school mistress was evident, telling us that she was doing all sorts of terrible things for our own good.

"From my first day in the job, I knew I had a clear mission before me - a duty to fulfil on your behalf: to honour the result of the referendum and secure a brighter future for our country by negotiating a good Brexit deal with the EU." Never mind the fact that 48% did not vote for this. And no acknowledgement that things have changed in the interim. The electorate was only asked whether it wanted to leave the EU - not about the terms on which it will do so - and there is a mounting sense that a plurality of voters believes the June 2016 option to have been the wrong choice.

"We will take back control of our borders, by putting an end to the free movement of people once and for all." An end to free movement cuts both ways, of course. It means Brits will find it harder to work and travel within the EU (and it will in any case continue during the transition phase). "Instead of an immigration system based on where a person comes from, we will build one based on the skills and talents a person has to offer." Having last week accused those EU citizens taking jobs in the UK as queue jumpers, the PM again fails to acknowledge that the majority of those entering the UK are non-EU citizens.

The next sentence was just a downright lie: "We will take back control of our money, by putting an end to vast annual payments to the EU. Instead, we will be able to spend British taxpayers' money on our own priorities, like the extra £394 million per week that we are investing in our long-term plan for the NHS." The extra money committed to the NHS came from a windfall gain that the OBR found in UK public revenues that has been blown in one fell swoop - it has nothing to do with EU budget commitments. If we are going to pillory the Leave campaign for making the kind of misleading statements they made in 2016, we should also give the prime minister both barrels for the same kind of lie.

"And we will take back control of our laws, by ending the jurisdiction of the European Court of Justice in the UK. In future, our laws will be made, interpreted and enforced by our own courts and legislatures." As noted above, they will not. The UK will be bound to the ECJ for a long time to come.

"Outside the EU, we will be able to sign new trade deals with other countries and open up new markets in the fastest-growing economies around the world." Really? What if the UK is still bound into the customs union? Legally it is not permissible to conduct trade deals with third countries so long as the UK remains inside. "With Brexit settled, we will be able to focus our energies on the many other important issues facing us here at home." Brexit settled? Don’t make me laugh.

The letter ends with a call for national unity suggesting that 29 March "must mark the point when we put aside the labels of 'Leave' and 'Remain' for good and we come together again as one people. To do that, we need to get on with Brexit now by getting behind this deal." Why should we? The PM is selling out the half of voters who oppose Brexit and despite the untruths contained in the letter, it comes nowhere close to giving people the kind of Brexit they thought they were voting for.

Up to now, I have suggested that the withdrawal compromise cobbled together by the UK and EU27 was the least worst option. But having read the dishonest way in which the PM is selling it, I am tempted to change my mind. This is snake oil of the worst kind - a tissue of lies all the way through, and frankly deserves to be rejected by parliament on these grounds alone.

As a final twist, I noted that May ended her letter with the comment that "I will be campaigning with my heart and soul to win [the parliamentary] vote and to deliver this Brexit deal, for the good of our United Kingdom and all of our people." I recall that David Cameron also promised to campaign with all his heart and soul to remain in the EU back in 2013. And look what happened to him.

Tactical genius or reckless gambler?

Many moons ago I did wonder whether Theresa May’s plans were an elaborate attempt to strangle Brexit or whether she had become a convert to the Brexit cause. I subsequently concluded that she was determined to deliver Brexit, irrespective of the cost to the economy. Over the last week, I have found myself revisiting the question once again. The PM has basically presented a plan which will put the UK at a significant disadvantage vis-à-vis the EU compared to its current position, with the only alternative being no deal. The “my way or the highway option” is really no option at all, which makes me wonder whether May is a strategic genius trying to manoeuvre the idea of a second referendum back onto the agenda or whether she really means it.

If MPs thought that these really are the only two choices on the table, they clearly have to accept the draft Withdrawal Agreement because the option of a no-deal Brexit is unthinkable. We have been told by Brexit supporters that because the economy remained afloat following the June 2016 referendum, despite suggestions to the contrary, that all will be well on 30 March 2019 even in the event of no deal. I do not share this optimism. The fact that the UK will no longer be a member of EU institutions such as the European Aviation Safety Agency, for example, means that aircraft parts or indeed whole aircraft made in the UK would not have legal clearance to fly in international airspace. Imagine for a minute what that means: Something like 750,000 people who travelled in and out of British airports on March 29 would be unable to do so on March 30. Around 6,660 tonnes of freight will also be grounded. Public frustrations that well up around holiday periods when flights are delayed will have nothing on this.

And that is just air travel. What about the ports? Some simple calculations suggest that 297 lorries arrive at the Port of Dover each hour. Let us assume that half of them travel from the UK to continental Europe and that WTO customs checks require them to be processed at a rate of one per minute. In other words, 60 per hour cross the Channel towards France rather than the current flow of 148. Assuming that each lorry is 15 metres long, within six hours the traffic jam will extend back 8km and it will take 9 hours for lorries joining the queue to get onboard a ferry. After 24 hours the tailback will extend for 32 km and it will take 36 hours to escape. After 3½ days the tailback will extend all the way to London (115km) and it will take more than five days to get across the Channel. Naturally, this is a stylised example but it serves to highlight that, given the extent to which the UK depends on free movement with the EU, even small obstacles can quickly gum up the works.

It is for this reason that economists fear a no-deal Brexit will have big effects on the economy. In practice we can only ever guess at the magnitudes, but some of the analysis I have conducted using a gravity model of trade suggests that losing easy access to the EU single market will incur a one-off reduction of 8% in exports and 5% for imports, implying a reduction of 1.5% in GDP relative to the case where access is maintained. Running the numbers through a structural macro model to assess the feedback effects on the domestic economy produces a loss of output equivalent to anywhere between 3% and 8% of baseline after a five-year period (chart). It might be possible to limit the decline in output to 3% of GDP if the BoE steps in with a huge liquidity injection. But if there is little to no additional monetary support in the event of a no-deal Brexit, as the BoE has recently hinted, I fear that the worst case outcome could materialise. Indeed, the threat to raise interest rates to counter an exchange rate-induced inflationary spike in the no-deal case strikes me as a hollow threat when the rest of the economy is likely to be in such dire straits.

To return to the political calculus, any MP who votes for a no-deal Brexit would have to be crazy given the economic risks. Equally, however, it is clear that the Withdrawal Agreement is such a sub-optimal piece of legislation that I can understand why MPs would want to vote it down. But a second referendum would also be such a hugely divisive tactic (as I pointed out here) that it is difficult to see how this resolves anything in the near-term. Consequently, I still favour an extension of the Article 50 period.  It has the advantage of postponing many of the hard choices (although not indefinitely) and would permit the government to continue testing public opinion.

Of course Theresa May does not publicly favour this option – as she said yesterday, “the British people want this settled.” But she has said many things over the course of the last two years from which she has been forced to backtrack. The Brexit debate is far from over. Like kabuki theatre, it just goes on and on.

Imagine they held a coup and nobody came

Four days ago, amidst much media ballyhoo, the European Research Group began a campaign to launch a motion of no-confidence in Prime Minister Theresa May. All they had to do was get 48 Conservative MPs to sign up and, hey presto, the easiest election call in history. At the time of writing, they hadn't managed to do it. The powerful right-wing backbenchers that the prime minister has spent the last two years trying to appease continue to look like the disenchanted malcontents that they really are. All mouth and no trousers, as they say.

They may get the requisite 48 signatures one of these days. But the fact that it is taking them so long to do so weakens their case to be speaking for a large element of the Conservative Party. And the longer this drags on, the weaker they look. In some ways, their fate is beginning to look like that of Islamic State, which was a formidable terrorist organisation that occupied territory held by sovereign governments before being gradually pushed out by the well-organised forces ranged against them. IS are still dangerous but they are a shadow of their former selves. Without wishing to accuse the ERG of terrorism, they have infiltrated large parts of the Conservative Party and have occupied the political agenda by winning the 2016 referendum. However, as the inconvenient economic facts close in on them, they are fighting a losing battle to stay relevant. They are losing ground, and they know it. Even Theresa May is not scared of them anymore. The ERG has lost its power to intimidate and the PM is prepared to battle on her terms. 

The ERG is losing because it has never accepted the reality of Brexit. Over recent weeks prominent Leave-supporting MPs have made some ridiculous statements which have undermined their credibility and do make you wonder whether they are looking at the issues in the same way as other rational people. Take, for example, former Brexit Secretary Dominic Raab’s comment that “I hadn’t understood the full extent of this but … we’re particularly reliant on the Dover-Calais crossing.” This is the port through which a lorry passes every 12 seconds of the day and through which 17% of UK merchandise trade flows. Or take Nadine Dorries’ comment that Theresa May’s deal with the EU gives us “No voice; no votes; no MEPs; no Commissioner.” Seriously? And just to prove that the inability to face up to reality knows no party bounds, when faced with a quote by EU President Juncker that the UK will not get a deal that is as advantageous as EU membership, Jeremy Corbyn responded “Well that was his view. We have a different one.” 

Brexiteers may have won the 2016 referendum but they never knew how to deliver Brexit. It is not as if they have not had plenty of opportunities: Two Brexit Secretaries and a Foreign Secretary, all with influence over the relationship with the EU and all have walked out. They will undoubtedly continue to intervene from the backbenches but they have four months to pull a non-existent rabbit from an invisible hat and nobody believes they can do it. 

This does not mean that the Withdrawal Agreement will necessarily pass through parliament. Too many people oppose it for different reasons. I am thus increasingly of the view that extending the Article 50 deadline is the best option and sure enough, Michel Barnier yesterday proposed extending Britain’s transition period out of the EU until end-2022. Naturally it will cost more – another €10bn is the figure being put about, which is broadly the same as the UK’s current net contribution. So that's OK then: Pay the same and have no say over the rules. 

What is particularly irritating is that it was so blindingly obvious that this was going to happen, yet politicians blindly led us to the edge of the cliff despite being told they were on the wrong track. We told you that the EU would extract a quid pro quo as the UK left. We told you that the UK would lose any say over the rules whilst still paying into the budget. And we warned you that it was virtually impossible to take back control in a globalised world. For those MPs who still think they can negotiate the impossible deal, I have a bridge to sell you.