Category: Politics

A much-repeated claim throughout the Brexit campaign was that the EU needs a trade more than UK because the EU has a large trade surplus with us. It formed a remarkably effective argument as it implies that an unfavourable outcome can only happen if the EU is “irrational” (David Davis’ term)

This claim is, of course, nonsense.
The EU is a far larger economy than the UK (~ 5 times) so if we accept that there is a cost to putting up trade barriers, then the cost is far larger as a share of the economy for the UK than for the EU.

This has been explained clearly many times in other blogs such as https://musealoudblog.wordpress.com/2017/04/03/brexit-they-need-us-more-than-we-need-them/ http://www.niesr.ac.uk/blog/after-brexit-how-important-would-uk-trade-be-eu#.WQiNUBPyvuo.

Economic Model for trade

What I find intriguing is why this argument is so appealing.
It is a common mistake to use intuitive models and analogies from microeconomics and apply them to macroeconomic issues even when they do not make much sense. Take the word “competition” used in international trade, it evokes emotional memories of sport in which there are winners and losers. The one with the surplus is the winner, and the loser has the deficit.

This model gave rise to Mercantilism school of economics and is one of the earliest around, a hundred years before Adam Smith, and notably articulated by Thomas Mun of the Honourable East India Company. From the perspective of a single business, the concept makes sense replacing the term “surplus” for “profit”. Why would a company trade if it was not making a profit? Why would a country trade if it was not making a surplus?

This idea was replaced by Ricardo’s demonstration, in 1817, of the mutual benefits of free trade. In essence, if two countries focus on producing the goods they have natural advantages in, the resulting free trade will make them both richer. Remarkably it’s one of the very few areas economists generally agree about.

However, the more old-fashioned Mercantilist ideas of winners and losers are still very much alive outside academia. Previously primarily on the left and the anti-globalisation movement, but now with the recent rise of the populist right with Trump’s “economic nationalism” and Brexit.

Distribution of gains/losses

If we leave behind the assumption that surplus/deficit defines who will lose most and accept that there is a net loss to be allocated, we still need a model of how this might be allocated. The simplest model, and I think most often used in blogs, is that the cost is allocated according to each country’s gross exports and this is perfectly sensible. Economics reveals another way to think about it. While Ricardo showed that there is a net gain from trade, it was JS Mill who formed the theory of how it would be distributed. What matters is the relative elasticity of demand.

Car Industry example

Let’s take the car industry as an example, commonly cited by Brexiteers.
The UK exports 760k cars to the EU and imports 1.86 million.

If we take a simple ratio, we would expect the EU to face more than double the costs in absolute terms, which is less than the ratio of the economy sizes. Does that model true up with reality?

It is often forgotten than people in the UK like buying EU cars (especially German ones) and would not immediately substitute into buying ones produced in the UK. Due to efficiencies of scale, the UK produces a far narrower range of models than it imports. The 760k cars the EU imports from the UK are largely substitutable for similar models built in Spain. i.e. there is a substitution difference between the UK’s imports and exports of cars. In economics speak, this represents a significant difference in elasticity of demand which by Mills theory suggest UK will take a larger brunt of the costs from the imposition of trade barriers than the simpler model suggests.

Supply Chain

Another factor to consider is how disruptive barriers would be to production and supply chain.
If the UK is outside the customs union, then the current complex supply chains for all goods could be heavily disrupted. This is not just the supply chain for goods we export, it is the supply chain for goods we consume domestically as well.
I do not have numbers for this (if anyone can point me to some that would be very helpful) – so I will work from general principles.

A simple model would be to imagine 11 countries and that each good they produce crosses a border to another country and back just once, and the country it goes to is random. Of these 11 countries 1 is the UK and the other 10 are various EU states.

Of every 10 goods produced by the UK, 10 of them cross a border into an EU state.
Of every 10 goods produced by EU states, 9 of them go to other EU states and only 1 goes to the UK.
So the UK’s supply chains are 10 times more disrupted than the EU’s.

Even without actual numbers, I find this model a helpful example. The UK is at risk of disrupting its entire economy without a deal on free movement of goods. The EU would also lose but to a far lesser extent. My experience of the financial crisis tells me that the plumbing of modern economies is far more interwoven and complex than people understand and untangling it has far larger risks than people assume.

Game theory

Game theory can be a great way to look at negotiating strategy.
Even when we do not have full information on the individual decision process and perceived payoffs of the participants, we can attempt to reverse engineer what they might be and then think about likely outcomes.

First important point is to recognise about the Brexit negotiation is that it is a negative-sum game. Brexit has large economic costs so thinking about how they are allocated will be contentious. Negotiations on dividing profits are generally less problematic than allocating losses due to the endowment effect. It will be hard for either side to go back to the electorates with any form of loss, so a complete failure of the negotiations is definitely more likely than markets are currently pricing.

Second, there is no clarity or agreement on how large these costs are. It is entirely possible that the Brexiteers genuinely believe that there are net gains to the UK from leaving the EU. Disagreement on the payoff between outcomes can lead to mutual incomprehension and poor decisions. It has been argued that WW1 could have been avoided if the participants had had more time to work out how destructive it would be. However, the Schlieffen Plan put Europe on a rapid and rigid path to war.
If the tight timetable of Brexit does not give the participants enough time to understand how bad some outcomes are, they may not avoid them. I think that markets are not correctly pricing how destructive these bad outcomes are.

What is UK negotiating position?

The UK approach so far has been to take what they would describe as a “firm” negotiating stance. The EU might describe it as unreasonable. This could be because the plan is

1. Start at an extreme and expect to compromise towards the middle
2. Believe your starting point is reasonable and the EU will be forced to agree to it
3. The outcome of no deal is a good one and only an extremely favourable deal with the EU is preferable.

My fear is that the UK government is at 2.) or 3.) and not 1.) as it is consistent with their rhetoric. Another reason to believe that 1.) is not their view is that they are actively whipping up anti-EU feelings, representing their negotiating stance as a moral one against an immoral enemy.

Even if the plan is to start extreme with both sides moving to a compromise, it is unclear they are going about it the right way. The theory behind this approach is laid out in “Influence” by Robert Cialdini. Humans have a desire for reciprocity, if you start out by asking for more than you want and then make concessions, the other side will find themselves compelled to concede as well.
This is such an effective method that it becomes the norm in a variety of bargaining situations: whether you are buying a house in London, a teapot in Morocco or getting a Bill through Parliament.

There is one instance where it is counter-productive. “If the first set of demands is so extreme as to be seen as unreasonable, the tactic backfires” as we are “not seen to be negotiating in good faith”. As described in the last post, the EU does not see the UK’s approach as reasonable and so will be unlikely to move to a position closer to the UK’s desires.

If we look at 2.), I think that no-deal is preferable to the EU than the deal the UK is offering. Allowing the UK to leave and retain all the benefits of membership would fatally undermine the very existence of the EU and the Single Market. A no-deal result is a poor economic outcome but a lower magnitude than for the UK so I do not see outcome 2.) as viable.

Option 3.) is a bad strategy to me given that I think no-deal is a disaster for the UK. But that is a large topic and needs to be explained properly in later posts.

Comparison to Greece

The dangerous precedent I see for this negotiation is what happened with Greece in 2015. Syriza and Varoufakis acted as though compromising with the EU was a bad idea so that if they were completely intransigent, the EU would back down. When the EU did not back down, they refused the deal and called a referendum. The Greek government won this on July 5th , in which they gain support to not accept the EU bail-out terms. Then on 13th July, Greece accepted a deal with worse terms all round. Somehow, they represented this as a victory in which they had stood up to and beaten the EU.

We have clear precedent on how the EU will behave in tough negotiations. The danger is that the UK misunderstands both the game they are playing and the nature of their opponent.

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. https://www.ft.com/content/2d0ba6ac-04c3-11e7-aa5b-6bb07f5c8e12

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.

http://www.cer.org.uk/sites/default/files/pb_barker_brexit_bill_3feb17.pdf

http://bruegel.org/wp-content/uploads/2017/03/WP_2017_03.pdf

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.

2. 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

3. 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.

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

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

5. 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. http://www.independent.co.uk/news/uk/politics/brexit-latest-news-divorce-bill-100bn-eu27-demands-contributions-a7714436.html

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.

The EU has called for “imaginative and flexible solutions” for the question of dealing with Northern Ireland post-Brexit. This issue has had a surprisingly low-profile so far. I think it is more important than wrangling over pension obligations but also more intractable, whereas the implicit assumption seems to be that it will be quick and easy. It is also worth noting this is one of the stated three items the EU wants to resolve before any trade negotiations can begin (the Brexit Bill, EU-Citizens rights, and NI).

Framework assumptions

I want to lay out a simple framework in which to think of possible structures.
It is easier only to consider 2 of the principal pillars of the current structure which would change

1. Goods
   Within the Customs Union, free movement of goods across borders without tariff or checks
2. People
   People can move across the border if they are an EU citizen.

The current structure

1. Goods
   Everyone is part of the EU and so goods can move freely.
2. People
   More complicated as UK and Ireland are not part of the Schengen area but have had a Common Travel Area (CTA) between each other since 1922, such that different checks for different journeys are in place.

Journey	Documentation Required
Between the Republic and Northern Ireland	Nothing
Between EU and UK or Ireland (both)	Passport
Between the Republic or N Ireland and GB	Photo ID (not necessarily a passport)

If UK were to leave EU with no special agreement on Ireland, then the default situation would be.

Default – UK leaves EU

1. Goods
   Free movement from Rest of EU to Republic of Ireland.
   Border checks between UK and the EU – so border checks between Republic and N Ireland

2. People
   No right of travel or residence between EU and UK
   Hard border with checks for people between Republic and North.

Problem
An imposition of a hard border is likely to reignite old conflict, the Good Friday Agreement having removed military checkpoints along certain parts of the border.

Idea 1 – UK leaves EU but Common Travel Area remains

“Special status for Irish citizens and a common travel area allowing free movement for Irish citizens pre-dates our membership of the EU by decades, and there’s no reason why it can’t continue in the same way after we leave the EU.”

Pre-referendum, Theresa Villiers Secretary of State for N Ireland suggested that there would be no future problem in case of Brexit as we would maintain the CTA and not have any border checks.
She was, in fact, a prominent Leave campaigner who signed a letter to Theresa May demanding a withdrawal from Single Market and Customs Union.

Problem
The justification seems to be that the CTA has existed for nearly a century and there has never been a material problem of trafficking of people or goods from the South to the North.
The problem here is the assumption that behaviour does not change when the incentives do.
Given we are all in the EU, goods and people do not move to Britain via the Republic and Northern Ireland – they move direct. If the direct route is closed, but the backdoor is open then I would suggest the route would become very popular. Note the argument applies for goods and people.

Note that this is a problem for the EU as well as the UK. if the UK allowed goods from China in with a lower tariff than the EU then there would be an incentive to bring them into NI to be rerouted to the EU.

Idea 2 – Open border between the Republic and Northern Ireland – Hard border around GB

To me, this looks like a transitionary stage to a united Ireland. I struggle to see that an area with a hard border is part of the same country, in particular when it has no border at all with another country. The EU seems to be cognizant of this too, recently clarifying if the North joined the South then they would automatically join the EU. Perhaps too this is what the UK government has in mind with the term ”Brexit” i.e. a Britain Exit” – Britain exits but the UK does not.

Problem
To have democratic validity, this would require a referendum in favour in both the North and the South. Even so, quite a few Ulster Unionists would passionately object to this whatever any referendum said. Also, it seems an ironic policy choice for the Conservative and Unionist Party.

An aside on geography

For those of you who do not know the complicated naming structure of this area, this chart may help.
Northern Ireland is in the UK but not GB.
For UK citizens, the passport says “The United Kingdom of Great Britain and Northern Ireland”.
Also note that in the Republic of Ireland they do not use British Isles as they do not see themselves as living in the “British Isles”.

Idea 3 –Hard border between the Republic of Ireland and the Rest of the EU.

Problem
To me, this looks like Ireland joining the UK in Brexit.
Nice solution for the UK perhaps but not very politically palatable for the Republic of Ireland. For the Irish Republicans, the de facto unification of Ireland would likely be far outweighed by the new relationship with Britain.

Idea 4 – UK does not leave the Customs Union and also retains the CTA.

This removes all the issues about goods and no hard border between North and South.
Would require passport checks and controls between N Ireland and the rest of the UK .
Small difference to situation today so the diagram would look very similar to the start.

Problem
The UK government has declared it wants to leave the Customs Union and this forms a core part of Brexit strategy and negotiating position. To the bulk of Brexit supporters, the Irish problems are far less important.

Idea 5 – UK does not leave the Customs Union and allows free movement of people.

Problem
Sounds very much like not leaving the EU at all. The diagram would be identical to the current position.

I am out of ideas.
I hope other people have more “imaginative” ideas than me.
If not a lot of people are going to have to be very “flexible” to choose one of the options above.
It seems unlikely to have a quick solution before we move onto discussing trade agreements.