Potential problems

Last weekend’s news that Nissan will not after all build its X-Trail model in Sunderland, having indicated in 2016 that it would do so, highlighted once again that there are costs associated with Brexit: Trade-offs about which politicians have not been clear. To be fair, Nissan’s decision was not all Brexit-related and is partly due to the fact that demand for diesel cars in Europe is falling. But Brexit undoubtedly weighed at the margin. After all, Nissan set up shop in the UK in the 1980s to export to the European market but now that economic ties to the rest of the continent are threatened with disruption, the case for being here is weaker.

Nissan continued to make all the right noises about its commitment to its existing UK workforce but let’s not be fooled. It has R&D facilities in Belgium and Spain, and production facilities in Spain – as well as a joint venture with Renault which gives it access to production capacity in France. Nissan has options which may not necessarily include the UK, and given excess global auto production capacity, companies are always looking for reasons to slim down. But for the moment it will continue producing in Sunderland so long as border disruptions do not become too excessive. However, this hides a wider truth about Brexit which is often lost in the hysteria – as Tom Kibasi, director of the Institute for Public Policy Research, reminded us in an excellent article in The Guardian.

Although we cannot rule out Armageddon scenarios in the event of a no-deal Brexit on 29 March, the likelihood is that both sides will take pragmatic decisions to ensure business continuity. As Kibasi points out, “in a no-deal Brexit, the EU will not place the UK under some medieval siege; there won’t be trucks filled with rotting food in Calais or shortages of medicines in pharmacies.” But the longer-term effects will hurt. Just as happened in 2016, the economy is unlikely to immediately fall off a cliff but a sharp fall in sterling – generally expected in a no-deal scenario – will produce a spike in inflation and squeeze real incomes. To put it into context, real wages – which were rising at a decent pace of 2%-plus in 2015 – have flatlined since Q2 2016. As Kibasi put it, “living standards that have barely improved for more than a decade would get noticeably worse.” 

Companies will also rethink their location decisions, as Sony and Panasonic have already done by shifting their European headquarters out of the UK. This may not matter so much if equivalent jobs can be created in other sectors, but the evidence suggests that such actions risk sending cluster effects into reverse which will have a bigger knock-on effect on employment. In effect, we will suffer a “boiled frog Brexit.” Drop a frog into a pan of boiling water and it will realise it is being boiled alive and hop out of the pan. But put it in a pan of cold water and turn the heat up slowly, and you can boil the frog without it being aware of its fate.

To assess this in economic terms, consider trends in potential GDP - the economy's underlying speed limit - and how Brexit could impact on it. The evidence suggests that growth potential has slowed anyway – the BoE estimated in this week’s Inflation Report that growth has fallen to around 1.5%, which is a full percentage point slower than twenty years ago (chart 1). In order to understand the underlying forces we can think of growth potential as being driven by three main factors: capital, labour and technical progress (or total factor productivity, TFP).

The good news is that the contributions from labour and capital have held up reasonably well. On my calculations based on European Commission data, they together contribute around one percentage point to growth potential which is not significantly different to twenty years ago (see chart 2). The real problem is the slowdown in TFP which has recorded its worst performance in a century (chart 3). Numerous possible explanations have been advanced for this slowdown. One view, promoted by Robert Gordon [1], is that the number and scope of technical innovations in the period 1870 to 1970 was exceptional in its applicability to a wide range of areas and there is no reason why this pace should be expected to continue. Another is that there has been a slowdown in the rate at which technology is diffused through the economy. Analysis conducted by the ECB [2] in 2017 suggests that there has been a widening gap across the OECD between productivity growth in so-called global frontier firms on the cutting edge of the technological revolution, and non-frontier firms which make up the bulk of the corporate sector.

What does any of this have to do with Brexit? On the one hand an ageing population, in which baby-boomers are retiring in droves, relies on immigration to expand the labour force. During the 1990s the working age population expanded at a rate of 0.3% per year. In the eight years prior to the financial crisis, this accelerated to 0.8% per annum, but over the last five years has slowed back to 0.3%. If we do not get any offsetting pickup in productivity growth, migration curbs will likely act as a drag on growth potential. Moreover, by reducing the attractiveness of the UK as a business location, the UK may not attract the technological leaders required to disseminate cutting edge technology and working practices into the UK capital stock, which will hold back any recovery in TFP.

Not all of the slowdown in potential growth is attributable to Brexit. Indeed, it is largely the result of pre-existing secular trends, but it threatens to make a bad situation worse. We may not notice this immediately but as we have learned over the last 10 years, a slower speed limit makes us all feel as though we are not doing as well as we once were.

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[1] Gordon, R., ‘The Rise and Fall of American Growth: The U.S. Standard of Living since the Civil War,’ Princeton University Press, 2016

[2] ‘The slowdown in euro area productivity in a global context’, ECB Economic Bulletin, Issue 3/2017

America first

Last month, The Economist published a couple of articles highlighting the extent of the extraterritorial reach of US policy and its implications. There has long been a supposition that the wave of bank fines issued by US regulators since the financial crisis has fallen disproportionately hard on foreign institutions, and The Economist cites evidence suggesting that over three-quarters of the $25bn it has levied in fines have been aimed at European banks. The evidence also seems to suggest that anti-corruption fines fall hardest on non-US companies, with eight of the top 10 fines levied under the Foreign Corrupt Practices Act falling on non-US companies.

The Deepwater Horizon disaster in 2010 added to suspicions that the playing field may not altogether be level. BP was fined more than $20bn for "gross negligence and willful misconduct”, in addition to $45bn of outlays in compensation and clean-up costs. Meanwhile, Houston-based Transocean, the company that owned and operated the oil rig which exploded, was hit with a fine of $1.4bn and Halliburton – the company responsible for doing the cement work which was the primary contributor to the well blow-out – escaped with a fine of $1.1bn.

As The Economist points out it is hard to prove that “America treads more lightly at home than abroad.” US firms generally have a pretty clean track record. But a very insightful piece into the murky takeover of French company Alstom by GE suggests that there are some dark forces at work. Alstom was already the subject of an investigation by the US Department of Justice into allegations of corruption when a senior Alstom official was arrested by the US on bribery charges. He entered into a plea bargain on the understanding that his jail term would be significantly reduced, but in the event served five years in detention. Shortly after the guilty plea, Alstom began to explore the possibility of a deal with GE. The Economist suggests that the DOJ’s investigations “distorted Alstom’s sale process, giving an edge to a potential American purchaser.” But “in order to be legitimate, a legal process must be transparent and independent – and be seen to be so. In this case, the legal process and the commercial one become uncomfortably intertwined.”

All of this goes to the heart of one of the biggest economic concerns underpinning the current shift towards economic nationalism – the idea that countries are increasingly prepared to use their leverage to secure their own interests rather than uphold the rule of law. The US is better placed than most to flex its muscle given the dollar’s position as the global reserve currency. Under the Obama Administration, which increasingly started imposing secondary sanctions, the US began a policy of issuing sanctions against any non-US individual or business which did not adhere sufficiently to US sanction regulations. Since dollar transactions ultimately almost always have to be conducted via US banks, the US authorities are in a position to obtain information on virtually all global dollar transactions and can use their leverage over access to the dollar payments system to extend their judicial reach.

I first became aware of this at a seminar three years ago which discussed business opportunities in Iran following the end of sanctions. Despite the optimism that Iran was once again being welcomed back into the international fold, many of the bankers present warned that they were very uncertain as to their position in the event they were required to provide dollar funding for Iranian projects. Although sanctions against Iran had formally ended, the US authorities even then were less willing to provide the green light. The election of Donald Trump suggested that all parties were wise to be circumspect given subsequent efforts to renew the sanctions.

Such apparently capricious policymaking raises a question of what this might do to the status of the US dollar as the world’s reserve currency? The choice of reserve currency is determined by three main considerations:

1. Size. Large economies generate a lot of foreign exchange transactions which puts a lot of currency into circulation; 
2. An advanced financial system which offers liquidity and a range of ancillary services;
3. Stability. The currency needs to act as a store of value. Political stability is another prerequisite.

The dollar continues to fulfil all these requirements. But increasingly, the likes of the euro zone and China have to weigh up whether the advantages of using the dollar are sufficient to outweigh the associated political costs. There is also a question mark on the US side. The Triffin paradox, which was first outlined in the 1960s, highlights that in order to meet global demand, the issuer of the reserve currency must be prepared to run a current account deficit. But as the current account deficit increases, so the external value of the reserve currency declines, thus reducing the willingness of creditors to hold it. In a world in which President Trump appears unwilling to sanction a rising external deficit, logically the flow of dollars into the rest of the world might be expected to slow.

Just because the dollar remains the dominant reserve currency today does not mean that it always will be. Prior to 1918, the US dollar accounted for a negligibly small share of global foreign debt with the UK accounting for 90% (chart). Within the space of five years, however, the dollar increased its share of global reserves to almost 40%. The US gained at the UK’s expense due to having a bigger economy, less indebtedness and a quantum leap in sophistication of financial markets following the foundation of the Fed in 1913. Between 1918 and 1945 there was not one single global reserve currency: The US and UK shared the burden.Who can say that we will not move towards a multipolar world in future?

I am not suggesting that we are yet at anything like the watershed moment of a century ago. But history suggests that changing trade patterns and a shift in the balance of economic power may be setting up the dollar for a reduction in status as other currencies take up some of the slack. Wielding the big stick, as President Trump is doing today, might hasten the search for alternatives.

Enough is enough

Brexit has become such a dominant element of my professional life over the last six years that I thought I had become inured to the craziness as politicians bend over backwards to fulfil “the will of the people” following a non-legally binding referendum that threatens to crash the economy. But the events of the past few days have tried my patience like never before. We are increasingly in a 1984-style Orwellian world in which politicians operate in a world of doublespeak. Take today’s parliamentary votes in which MPs passed two motions, one of which called for redefining the nature of the Northern Irish backstop designed to avoid a hard Irish border whilst the other made it clear that parliament is not in favour of leaving the EU without a deal.

MPs fell over themselves to suggest that somehow we had moved forward. How? By accepting two contradictory motions, one of which suggests the UK is prepared to go to the wire on the backstop proposal and the other which says the complete opposite?  Such is the predicament facing the Conservatives that Theresa May is prepared to ride roughshod over the national interest in a desperate attempt to keep her party together. And everyone can see it. Obviously the EU has no interest in renegotiating the deal – the need for an Irish border exists to ensure that if the UK does indeed crash out of the EU and falls back on WTO rules, they can be enforced. Moreover the EU has made it clear that the UK can remain within the customs union if it is prepared to accept the terms. But this is not enough for a group of MPs who, in the words of Boris Johnson, want to have their cake and eat it.

If Orwell had not written 1984, someone else would have had to invent Emmanuel Goldstein’s The Theory and Practice of Oligarchical Collectivism, the first chapter of which is entitled Ignorance is Strength.

Ignorance abounds: Following the warnings by Airbus CEO Tom Enders that the company may be forced to reconsider its position in the UK in the event of a hard Brexit, we were treated to this spectacular rebuttal from Conservative MP Mark Francois who remarked that his father “was a D Day veteran. He never submitted to bullying by any German and neither will his son." Yes, you did read that right: an elected member of the British parliament, born in 1965 and whose military experience came no closer than serving in the Territorial Army, refers to a war that ended twenty years before he was born to attack the business interests of a multinational company. Is this really where we are? Has Brexit at all costs simply become a cause celebre for nationalists to realise their fantasy of a pre-EU Britain that never really existed? In the words of comedian Chris Addison, “it’s a peculiar anomaly that Brexiters can clearly recall World War 2 yet have no apparent memory of The Troubles in  Northern Ireland.” Shame on you, Mark Gino Francois.

The extent to which the Conservative Party has tied itself in knots over the EU question was laid bare by a recent BBC programme Inside Europe, the first episode of which followed the trail which has led us to our current predicament. It illustrated the extent to which the British Conservatives have failed to engage with the EU. But perhaps more damningly, it highlighted the ham-fisted efforts of former PM David Cameron, who was elected on a promise “to stop banging on about Europe”, to deal with the EU and how he failed to stand up to the right-wing of his party at pretty much every turn. We were reminded of how the UK vetoed the EU’s efforts in December 2011 to rewrite treaties which would place limits on fiscal deficits and debt, and impose automatic penalties for countries which breach them, as it attempted to place a firebreak in the way of the raging Greek debt crisis.

As it happens, the EU did not cover itself in glory. The measures were badly designed and focused on imposing fiscal discipline at a time when it was least needed. In the preceding the 17 years Germany had only complied with the debt brake rules twice and France not at all. But the EU was still not willing to grant the UK any concessions which would exempt the UK financial services industry from any treaty changes, thus prompting Cameron’s veto. I wrote at the time that it “could set the UK on a collision course with other EU members. It is to be hoped that such an outcome does not arise.” I had no idea it would lead us down the path towards  the 2016 showdown but it is no surprise that the EU was not overly keen to help Cameron when he attempted to wring concessions which would  allow him to claim some progress ahead of his self-imposed (and foolish) decision to call a referendum on membership.

One of the issues that struck me most forcibly was that many Conservative politicians were fixated on the need for a referendum as early as 2012 in a bid to lance the boil of Euroscepticism. Whilst the Westminster bubble may have focused on the fact that UKIP was drawing support away from the Conservatives, the issue of the EU simply was not as uppermost in the minds of voters as the programme led us to suppose. I thus could not help feeling that there was a certain amount of history being rewritten.

Every time British MPs engage in a bout of navel-gazing such as we have seen tonight, we call enough is enough. Yet still it goes on. But Brexit is simply a problem for the Conservative Party that cannot agree on what form it should take. If I were an EU negotiator, I would tell the UK government that they have a choice – accept the deal as it is or leave without one. They have no interest in giving in to the Conservative hard-liners who have demonstrated unwillingness to compromise. It is now up to British politicians to face them down, and stand up for what they were elected for: The interests of the people who put them there – all of them, and not just the 52%.

The business end of Brexit

The warnings by business leaders over the past three years that Brexit would be bad for the British economy have gone largely unheeded. One of the most frequently cited examples is that of Sunderland, in the north of England, which voted 61.3% in favour of Leave despite the threat this posed to the region's largest employer, Nissan. Even today TV camera crews can found on the streets of Sunderland filming the views of locals who continue to insist that Nissan will not leave the town. Yet two years ago Nissan executive, Colin Lawther, appearing before a parliamentary committee indicated the difficulties for companies like Nissan in dealing with a hard Brexit. The plant receives 5 million parts a day, 85% of which are imported, but the plant holds only enough parts for half a day’s production due to the costs of storing them. Just-in-time inventory management, facilitated by free movement of goods, is crucial to the plant’s success.

As long ago as September, BMW announced that it would bring forward its annual maintenance shutdown to late March in order to deal with any potential problems. Since the turn of the year we have seen a number of other companies announcing Brexit contingency measures. A couple of weeks ago Honda announced that it would shut its factory in Swindon for 6 days in April to ensure it could adjust to "all possible outcomes caused by logistics and border issues." Jaguar Land Rover has also decided to shut down its four main factories for an extra week at the start of April on top of a previously planned maintenance pause because of “potential Brexit disruption.” Not convinced yet?

Earlier this week, Airbus CEO Tom Enders warned that the company might be forced to quit the UK in the event of a hard Brexit. In Enders’ words, “please don’t listen to the Brexiteers’ madness, which asserts that because we have huge plants here we will not move and we will always be here. They are wrong.” Indeed, Enders gets to the nub of a problem which has been a running sore in the Brexit debate with some politicians having demonstrated extraordinary arrogance with regard to business. Last summer, when asked about corporate concerns over a hard Brexit at an event for EU diplomats in London Boris Johnson is reported to have replied: "F*** business." A couple of weeks ago he was at it again: When presented with the not-unreasonable claim that Jaguar Land Rover boss Ralf Speth might know more about the car industry than he does, Johnson replied “I’m not certain he does.”

A few months ago, Owen Paterson MP also dismissed claims by car manufacturers that Brexit would have consequences for their business. In his words: “If we really do leave the Customs Union, Jaguar Land Rover will have access to cheaper parts and components all around the world and the European suppliers will be forced to compete or they will lose Jaguar Land Rover’s business.” This is peak Bluffocracy and is reminiscent of armchair fans who claim that they would make better football managers than the present incumbent. Clearly there is something seriously wrong with our political culture when MPs can make such claims in public and not suffer the ridicule they deserve.

But it is one thing to ignore the warnings of business: It is another thing entirely for politicians not to take any decisions at all which hugely complicates the difficulties in the business decision-making process, particularly when there are very long lead times involved. This lack of certainty acts as a brake on corporate activity, and business investment declined in volume terms in each of the three quarters of 2018 for which we have data. In the nine quarters since the EU referendum, UK business investment volume has increased by just 0.6% compared with 5.7% in the nine quarters leading up to it. CBI survey data indicates that investment intentions in plant and equipment have been lower over the past six months than at any time since 2009. This is not indicative of a business community that has any faith in the government’s Brexit assurances.

Business is no longer taking government on trust. The Guardian reports today that firms are planning a mass exodus in the event of a no-deal Brexit. In the financial services industry, banks have long been preparing for the worst case outcome. Since the passporting legislation, which allows banks to be regulated in one EU country but conduct business throughout the EU, cannot be guaranteed beyond 29 March this has prompted them to put in place contingency plans to transfer staff to other EU locations to maintain business continuity.  Although the numbers involved so far are relatively small, probably of the order of 7000, firms are also transferring assets out of London as balance sheets are run down. And this is only to keep business running in April – the shift will be far larger in future. 

The experience of Nordea bank acts as a cautionary tale. Nordea was involved in a tax dispute with the Swedish government and threatened to shift its headquarters from Stockholm to either Copenhagen or Helsinki. When the Swedish government refused to back down, Nordea management persuaded shareholders to sanction a move to the Finnish capital which was not only one in the eye for Sweden but allowed the bank to base itself inside the euro zone’s banking union. The moral of the story is that businesses do not issue threats they are not prepared to carry out.

Of course, the biggest irony over the last week was the announcement that that Brexit supporter James Dyson is to move his company’s HQ to Singapore. There may indeed be good business reasons for the move but it is a PR own goal of mammoth proportions. It does not sound as though Dyson has great faith in the UK’s role at the heart of a new global trading hub. Still, it is consistent with the actions of the likes of Jacob Rees-Mogg whose investment fund decided last summer to set up a fund in Dublin, as asset managers worry about being cut off from European investors. A case of “do as I say, not what I do.”

Plan B looks like Plan A revisited

Anyone hoping for anything new from Theresa May’s statement to parliament today would have been sadly disappointed. The law required the prime minister only to give a neutral motion – one which does not require parliament to take a decision one way or the other – and that is what we got. However, the PM effectively admitted that her efforts to reach out across parliamentary lines have failed. Other political leaders are simply not prepared to draw the same kind of red lines as May who remains in a clear minority as one who believes the Withdrawal Agreement is the only game in town.

Worse still, the prime minister continued to rule out an extension of Article 50 and a no-deal Brexit, thereby failing to put in place a safety net that other MPs might be prepared to buy into. She also ruled out the prospect of a second referendum, arguing that there is unlikely to be sufficient support for it in the House of Commons. She may be right. As I noted in my last post, constitutional experts at UCL argue that it will take a minimum of 22 weeks to get a referendum done from start to finish – and that is without dealing with the aftermath. It is more likely to run over a much longer time period and the government recently released material to MPs suggesting it could take a year. This would require a much longer Article 50 extension than the government is currently prepared to accept.

There is a strong possibility that at next week’s vote, May will simply try and present the same deal as last week but with some tweaks that give the impression the Irish backstop deal will be time-limited. This may allow it to pass through parliament but will count for nothing unless the EU agrees, particularly since the Irish government has resisted UK efforts to do a bilateral deal on the border problem. Putting the same deal to a vote next week is akin to Einstein’s definition of insanity – doing the same thing over and over again in expectation of different results. But we need to look at this debate in the same terms as the main protagonists – trying to apply economic rationality is not the right way to go about it.

Both the Conservative and Labour leaders are clearly using this issue to play for party political ends. May’s problem is that if she crosses red lines on issues such as remaining in the customs union or extending Article 50, she will lose the support of yet more MPs whilst further alienating the Conservative party membership which clearly favours Brexit. She is clearly doing everything she can to avoid going down in history as the leader who split the Conservative Party. Opposition leader Jeremy Corbyn is playing a similar game. Although his party members oppose Brexit, Corbyn has refused to engage in negotiations which enable the government to deliver Brexit on its terms which in turn will reduce the chances that Labour can win a general election. His tactic is to force the Conservatives to “own” Brexit in the expectation that it will blow up in their face. As a political manoeuvre, the actions of both sides make sense. But since there is a real risk of a no-deal Brexit if one or both sides miscalculate, this strikes most observers as unnecessarily risky.

Another worrying trend is the sense that the electorate is becoming so disenchanted by the process that it would rather the government took a decision one way or the other rather than engage in continued debate. I was particularly struck by the debate on the BBC's Question Time programme last week when the biggest cheer of the night was reserved for an audience member who called for politicians to enact the result of the referendum result and leave the EU. To the extent that politicians tap into the public mood, they may feel emboldened by this sort of sentiment to push for a hard Brexit in the knowledge that their electoral prospects are unlikely to be harmed by acceding to the “will of the people.” Nonetheless, Anand Menon, Professor of European Politics and Foreign Affairs at King's College London, who was also on the Question Time panel, made it clear that a no-deal Brexit implies trade-offs that too many politicians have not been sufficiently honest about.

Indeed, it is almost six years to the day since David Cameron’s speech at Bloomberg’s European headquarters in London, which he gave on 23 January 2013, in which he stated “It is time to settle this European question in British politics.” Obviously, we have done nothing of the sort and in retrospect, it is clear that we have arrived at our current position because of a series of unintended consequences flowing from that speech. It was obvious at the time that Cameron never thought he would be in a position to take a decision on a referendum, as it was expected that his Conservative Party would only be able to govern in tandem with the LibDems. This assumption turned out to be wrong and Cameron compounded the error by adhering to his election manifesto pledge to hold the referendum.

It has also become obvious in retrospect that the idea of allowing an outbreak of direct democracy in a system based on representative democracy was a mistake. Direct democracy requires a far greater degree of engagement than representative democracy, which effectively outsources decision-making to the government. Since it is not a system which people in Britain are used to, it became an emotional battleground rather than a subject of rational debate. Theresa May’s government further compounded the problem by taking a non-legally binding vote and transcribing it into law.

This trail of unintended consequences makes it clear that the hoped-for outbreak of rationality, which many expect will save us from the cliff-edge Brexit, may fail to materialise. Sound advice would thus be to hope for the best but prepare for the worst.