Plus ça change ...

Whilst the focus on this sceptred isle has been very much on the shenanigans of Brexit, the rest of the continent is focused on its own troubles. The most prominent issue, which has captured newspaper headlines across the continent, is the wave of public unrest in France where the gilets jaunes have been demonstrating against higher fuel taxes in particular and the rising cost of living in general. 

This reflects concerns expressed around the world that “the system” is not working for the average voter and that more of the same just won’t do. This in turn reflects a complex series of issues which have come together all at the same time to create a Gordian Knot of such complexity that no politician can reasonably be expected to resolve them. Environmental challenges, technological change and a shift in the geopolitical tectonic plates are big enough challenges on their own. Trying to deal with their implications at a time when we are still recovering from the biggest recession in 80 years magnifies their impact.

Looking more closely at the French government’s plan to raise fuel taxes, the French electorate appears to be as concerned as anyone about the problem of global warming and climate change, if opinion polling data are any guide. It is not unreasonable, therefore, for the government to conclude that consumers will appreciate that they have to pay more if they wish to continue emitting greenhouse gases in the process of burning fossil fuel. But they are not having it: Having been squeezed for so long, French voters just see this as another attack on their living standards.

Indeed, this demonstrates the problem of getting consumers to buy into the social changes which will inevitably have to come, and highlights the challenges for policy makers who have to wean the electorate away from certain types of behaviour. This requires an adjustment that people are not prepared to make – at least not now. However, history shows that although democratic societies frequently resist big changes at first, only to subsequently accept they are inevitable, this often occurs only after considerable social unrest, as anyone who lived through the Thatcher era in the UK will attest.

But there is another issue at work in France. Outside observers (such as me) look at the current French situation and realise we have been here before. The reform agenda set out by prime minister Alain Juppé in 1995 met with huge resistance and the general strike it provoked only ended when the retirement reform plan, which amongst other things eliminated the rights of railway workers to retire aged 55, was dropped. These strikes, which were the biggest public demonstrations since 1968, were repeated in 2010 when the government was again forced to modify its plans to reform public pensions. Given this experience, the initial reaction of the Macron government is understandable: Do what previous governments have done and suspend the tax changes in a bid to cool public unrest.

However, Macron has now gone much further than this. He appeared on TV on Monday promising to take the concerns of rural and suburban France more seriously, offering higher payments to pensioners and a rise in the minimum wage, all of which amount to additional outlays around €10bn. Having originally planned a budget deficit of 2.8% of GDP in 2019 – which is higher than the much-contested Italian plan – the budget minister now admits that in the absence of offsetting measures, the deficit will rise to 3.4%.

There are a couple of problems with this strategy. On the one hand, the French government has now done what many of its predecessors have done by kicking the can further down the road rather than engaging in the structural reform that Macron knows is required. This will only invite further protests when the government has to revisit the problems again, but the challenges in future will not get any easier. In addition, it gives cover to Italy’s position and will stiffen its resolve not to back down in the face of the European Commission’s fiscal concerns. Given that the EC has already started excessive deficit procedures against Italy, how does it intend to deal with France?

Against that, we could argue that European countries are once again rediscovering the joys of fiscal policy after years of wearing the hair shirt. But whilst across the euro zone as a whole the cyclically-adjusted budget deficit has averaged 1.3% of GDP over the period 2012-2017 (chart) and Germany has averaged a surplus of 0.5%, France has run a cyclically-adjusted deficit of 3.1% (versus just 1% in Italy). France is certainly less well placed than other EMU countries to provide a fiscal stimulus. 

Another casualty of this policy approach will be Macron’s attempt to move Europe forward. Admittedly his fine words last year were exactly what Europe needed to hear as he attempted to prevent the EU from ossifying as the messy compromise into which it had evolved. But his words did not get a particularly good hearing on the other side of the Rhine. Given the German fixation with keeping deficits down, it is unlikely that his stock in Berlin will have risen.

Whilst there is nothing wrong with judiciously using fiscal policy to nudge the economy forward when circumstances demand, the French – and the Italians – are increasing their fiscal deficits to buy off the electorate. And it may even work for a while - after all it is voters' money. But hard choices sometimes have to be made. I have long argued that the UK has overdone the degree of austerity and I understand why Macron made his choices. But I cannot help feeling that somewhere down the line this might be a policy that backfires.

A void where the government used to be

Just when you think you have seen it all in the Brexit debate, we always find something interesting around the corner. Brexit Secretary Stephen Barclay said yesterday: "The vote is going ahead and that's because it's a good deal and it's the only deal." This morning, Downing Street was telling us that the “meaningful vote” that parliament had been promised on the terms of the Brexit deal was definitely going ahead. This afternoon, the prime minister informed us: “We will … defer the vote scheduled for tomorrow.”

Obviously, the fact that there was a snowball-in-hell’s chance of the deal being ratified would have put the prime minister in an impossible position and called what is left of her authority into question. On only three occasions in the last 100 years has a government been defeated by more than 100 votes and it is pretty easy to construct a scenario in which the Withdrawal Agreement would have been rejected by a majority of around 125. Recall that the 139 vote defeat suffered by Tony Blair’s government in 2003 on the question of involvement in the Iraq War arguably marked the beginning of the end for the prime minister as his authority began to leach away. Theresa May is in a far weaker position and it is questionable whether she would survive such a crushing blow. May’s future, however, is a subject for another day. At issue is where does the UK go from here? 

The PM has made it clear that she intends to meet with other EU leaders to discuss the concerns surrounding the backstop which threatens to leave the UK permanently tied to the EU. However, it is difficult to imagine any circumstances in which the EU will make any concessions. The Commission’s view is likely to be something along the lines of “we gave you a reasonable deal which you can take or leave as you see fit. In any case, you haven’t voted on it yet. Come back and see us when you have.” So May could be forced to put the Withdrawal Agreement to a parliamentary vote, and of course it will be heavily rejected. In this case the prime minister goes to Brussels to repeat her request and the EU27 merely repeats the first part of its answer.

Under these circumstances, the UK would have no option but to request an extension to the Article 50 process. The question is how the UK would then use the extra time made available? Probably the first option it would pursue is a Norway Plus arrangement in which the UK joins EFTA and applies to join the EEA (an option only available to EFTA or EU members). Whilst this would minimise the economic costs, the UK would still be subject to the four freedoms of goods, services, capital and labour. In essence it would be a rule-taker. Indeed, as I noted six years ago in response to the FT’s year-ahead 2013 questionnaire “Anyone with notions that we can negotiate a Swiss or Norwegian-style existence on the fringes of the EU is dreaming. Such an existence would still mean that we are subject to large parts of EU legislation but without any power to change it – something which the euro sceptics would like even less than the system they have now.”

What is worrying is that many politicians still don’t understand this point and they have had six whole years to think about it and a whole lot of information put in front of them to demonstrate it. Maybe, just maybe, they will eventually get it in which case the UK would be mad to pursue such a course of action. I suspect that the other alternatives involve either a general election or – and whisper it quietly – a second EU referendum. An election does not do anything to resolve the Brexit question and should be viewed as a side effect of the current political impasse rather than an attempt to resolve it. With regard to a second referendum, I agree with the PM when she says “if you want a second referendum to overturn the result of the first, be honest that this risks dividing the country again” (as I hope I made clear here). But if politicians cannot agree what form of Brexit they want, they may have no choice but to put the question back to the people.

The reason we might end up in this position is primarily due to the fact the government failed to manage the process. The referendum result was never legally binding but May did all she could to make it sound like it was. She was far too late to face down the Brexit ultras who promised unicorns and cakes and indeed pandered to their prejudices (remember “citizens of nowhere” and “queue jumpers”). Perhaps most damningly, the referendum was treated as a winner-take-all outcome in which the near-half of voters who opposed Brexit were completely marginalised. For those who express sympathy with the PM for the near-impossibility of her task, remember that she made it far harder for herself than it needed to be.

I would not like to predict the outcome of a second referendum (I wouldn’t even like to predict the question on the ballot paper). But if it is a choice of “Remain” or “Accept the current deal” the likelihood is that the UK might not even leave the EU (some polling data here, for what it is worth). Further support for this option comes from today’s ECJ ruling that the UK can unilaterally rescind its Article 50 notification, for it suggests that the EU is giving the UK room for manoeuvre if it changes its mind on Brexit.

Nothing that has happened today has helped markets, with sterling falling to its lowest since April 2017. Although markets fear that today’s events have raised the likelihood that the UK will leave the EU without a deal, I don’t buy it. Nonetheless, there is major uncertainty regarding the nature of the UK’s future relationship with the EU which has put sterling under great pressure and 3-month GBP option volatility is on a par with what we saw around the time of the 2016 referendum (chart). Like nature, markets abhor a vacuum and today’s decision to withdraw the parliamentary vote has exposed a major void where the government used to be.

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.