Settling the Brexit Bill

This issue has dominated the Brexit news cycle, resonating strongly with the Pro-Leave UK press. Economically the sums are not that significant (~3% of GDP compared to UK’s debt of 88% of GDP – material but not catastrophic) especially when compared to the loss of membership of the Single Market, but it seems to evoke highly charged emotions on both sides.

From the EU side, it is simply settling the financial obligations that the UK had signed up to. They talk in terms of paying the bill in a restaurant after having eaten there. The Brexiteers in the UK, such as John Redwood and IDS, are adamant that the UK owes nothing. If an agreement is not reached, it could derail the entire negotiation and distract attention from far more important matters such as trade and Ireland.

Legal situation

My impression is that the argument that the UK does not owe money is legally plausible but completely misleading. For example, UK debt is issued under UK law therefore the UK has the legal right to not pay any of it. That does not make it a good idea.

A good rule of thumb for international treaties is that they cannot be enforced via the courts. There is no effective international court that has sufficient authority. The EU may well have grounds to take the case to the Hague; this is beyond my expertise but I think a highly unlikely place we end up.

In practice, international treaties are upheld via mutual consent and the desire to maintain international reputation and credibility. Enforcement for unreasonable behaviour is via repercussions in other areas.

Moral situation

How much of the Euro 60bn does the UK reasonably owe?

The argument that the UK morally owes nothing rests upon the argument given by Barney Reynolds, head of financial institutions at Shearman & Sterling
“It is essentially more analogous to a corporation, where the member states are akin to shareholders. The UK is departing and handing back its shares.”

Let’s run with this analogy. If the shares have a positive value then this is of course simple. You are giving back shares with a positive value for nothing, which is very generous. What if the shares have negative value? This is where the analogy becomes stretched as it is not possible for shares to have negative value. OK let’s say the shares have a very low value to start with, say £1, but it turns out after some time that they had a large negative value, because of say a large unfunded pension liability. Maybe this analogy is rather good after all!

It could be argued that Philip Green did nothing illegal in walking away from the BHS pension liabilities. However, MPs apoplectic with rage and a strong public reaction showed he had a clear moral obligation to pay with repercussions for non-payment in other areas (such as losing his knighthood). It reminds us of the outrage of Juncker which should not be assumed faked or bluster. When he says “the EU is not a golf club” he is expressing genuine horror.

The EU balance sheet

I think the above analogy is excellent but leads me to the conclusion we need to see the details of what the UK owes. Ignoring if the items are legally-binding for now and simply looking at the net value of the balance sheet so we can make a judgement call on what the UK could pay or receive. I will ignore contingent liabilities for now.

One material assumption is to include the rebate or not – is the UK’s share 12 or 15%?
I will assume the UK share is 12% (including rebate) – this makes the numbers smaller but seems reasonable to argue.

I found these excellent summaries for a full explanation of the line items if you really like the details.

Start with items that are clear cut and large (all figures in euro)

  1. Pensions – 7.7bn

John Redwood argues the UK should not pay because he does not like European civil servants. This argument seems ridiculous to me so I will include. Walking away from this seems identical to the BHS case.

  1. Commitments versus Payments – 29.2bn.
    This is the kind of item that causes confusion and emotional reaction and it shouldn’t.
    There are different ways of accounting for spending, which help visualise things in different ways. One is to only record items when you pay the cash. The other is to record items as you have “accrued” the benefit or cost.

The UK chooses to only account for its obligations to the EU after it has actually paid the cash. The EU keeps that version of the accounts but it also records the accrual method. This is known as the reste a liquide (RAL).

In the restaurant analogy, you can choose your accounting method to recognise your liability to the restaurant once you have ordered the meal, or you can choose to record it once you have paid the cash. There is no conflict between the methods. When you leave the restaurant however, you still need to pay the bill either way!

Politically given the popular confusion over accounting this item will be easy to misrepresent to the UK electorate but the EU will see any attempt to avoid payment as outrageous.

I think the next items are more debatable

  1. Future commitments to the EU – 22.7bn

These are items which are in the budget but since they are in the future they are not yet in the accounts. The EU is arguing that since the UK agreed to the budget, it should pay them. This seems genuinely debatable. It is politically difficult because if the UK refuses to pay, then to maintain the budget, either other large EU countries have to increase their contribution or the payments recipients countries such as those in Eastern Europe must fall. These same eastern European countries are being relied on by the UK as allies in the negotiations – refusing to pay money which they think you have promised to pay them is not a good start.

  1. Future payments from the EU to the UK – 17.7bn

Similar to Item 3 so similar logic applies.
If we add them up

  1. Theoretical Total – 41.9bn
    Simple answer would be that the UK pays all of its obligations (59.6bn) and receives all it is due (17.7 bn) for a net payment of 41.9bn. If the UK attempts to walk away from these commitments, then the EU will see this in the same way that Mexicans view Trump’s wall. We cannot stop you building a new hard border between our countries but would prefer you did not as it will cause mutual harm. But you must be joking expecting us to pay for it as well.

Negotiating stance

The progress of negotiations may be hard to assess from the outside. Sometimes parties seem a long way apart and then come to an agreement very quickly as they were just performing a ritual dance.

So far, this issue started informally as rumours of a 40bn bill from the EU. The UK Brexiteers made a lot of noise, taking the brinksmanship position of stating they owe nothing. Michel Barnier then responded with a bill of around 60bn. The UK has continued to argue strongly that it may refuse to pay anything with Merkel and Tusk further hardening their positions, adding more to their calculations.

If you are an optimist, you may think that this is normal deal making. Everyone asks for things they do not expect and eventually they meet in the middle and move on. I find this form of negotiation tiresome but very common. Given my career in liquid markets, I have always liked dealing at a clear price in a transparent market , distressed debt or property markets are very different.

Perhaps a compromise position will eventually be reached but I am concerned that we are heading in the wrong direction. The intervention by the arch-Brexiteers, such as John Redwood, looks to be similar to the approach of Varoufakis in the Greek debt negotiations. To insult and vilify the Germans, refuse to negotiate at all, claim the moral high ground and whip up your supporters into a self-righteous anger. This makes any subsequent compromise much harder to find.

PS – after writing this post I have just seen this headline.

This fits my model perfectly. The EU started at the number they believed should be quickly agreed to. The UK changes the nature of the negotiation into one where we start at extremes and move to the middle. The more extreme the UK gets the more the EU moves its starting point away. So now if the UK and the EU “meet in the middle” we can end up back where we started.

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