Sovereignty and Power

I have been pondering in what sense does Brexit affect UK sovereignty. In simple terms, the UK’s sovereignty is unchanged. The UK has the right to leave the EU, therefore it has independent authority whether it chooses to use it or not.

What is Sovereignty?

Wikipedia defines Sovereignty as the “power of a governing body over itself, without any interference from outside sources or bodies.” This suggests that we need to consider degrees of power, and this takes us rapidly beyond the simple terms above.

In one regard, the definition above suggests leaving the EU would clearly increase the UK’s sovereignty. Currently there is a lot of interference from EU bodies that a Hard Brexit would remove.

Sovereignty – to give it away or to exercise it?

Another way to think about degrees of power is to consider effectiveness i.e. the power to do or get things you want. While a country might claim theoretical power to do anything it wants to, in practice all countries enter in binding agreements with other countries which put constraints on some behaviour in return for other benefits. For example, a trade treaty creates easier trade once you agree to certain standards, or joining NATO because you care about your economy and your security. In this way, you exercise your sovereignty, giving up some of your autonomy in exchange for a benefit you value more highly. To use an analogy to the individual: you lose autonomy by having a job (you have a boss and you have to go to work) but you gain power to do what you want by having money.

Relative power

Relative power therefore, is an important determinant of the effective sovereignty of a country.
If you are very powerful compared to another country, then a treaty you enter into will likely be better suited to your preferences than to theirs. Whilst superpowers and small states are both sovereign, in practice the superpower gets to set the terms a lot more often.

Smaller states can change this is by clubbing together: finding like-minded states, forming coalitions, standing up to larger powers by, in effect, acting like a large power themselves. If your internal values and goals are similar, then the loss of independence is more than made up for by the increase in power you gain. Thus, the EU is a greater global power than any of its constituent countries. The US, when thought of as constituent states, is similar. Under this approach, you could even suggest “sovereignty” has been increased by pooling it, rather than diminished.

And finally back to Brexit….

The question for the UK is whether it had more effective sovereignty by pooling its sovereignty within the EU or by going it alone. This is a way to think about why people voted the way they did.

  1. Is the UK pooling its sovereignty with countries with which it shares values?
  2. If the UK left would it be a significant global power?

For people older than me, my guess is that they do not feel an affinity with continental Europe let alone its values, and at same time retain clear memories of when Britain was a significant global power.

For people younger than me, there is a much greater affinity for European culture and values, and a very limited sense that the UK is an important independent state if it were alone on the global stage.

Thus, one group sees a freedom from EU control, and with that an ability for the UK to use its power without restraint. The other sees a separation from modern liberal values, towards political extremism and a rapid decline in economic and political power.

Brexit – where are we heading?

I outlined my thoughts on the progress in Brexit discussions back in August (https://appliedmacro.com/2017/08/16/brexit-means-no-brexit/), at a time when the UK government was attempting to give energy to the talks, already appearing to stall. May’s speech this week, again an attempt to break the deadlock, largely confirmed these opinions i.e. we still have no proposal on either Ireland or financial obligations and we prefer not to talk about them. The Conservatives are united around holding out for an impossible deal, Labour has united around agreeing not to talk about Brexit.

Concessions?

The UK media, on the other hand, seems to create a false impression that progress is being made, for example with talk of “concessions”. It is indeed a concession for the UK to ask for a 2-year transition, but not, as often misleadingly reported, a concession of the UK to the EU. It is a concession between different squabbling wings of the UK government, with the hardliners eventually agreeing to it. The UK media also present this transition deal as certain to happen i.e. the views of the EU are presumed to be irrelevant. These “concessions” are better thought of as the continuing struggle for the UK government to work out its opening negotiating position. This further support my views in the previous post that we have made very little progress.

Where next?

I have spent some time thinking about what the outcome of these negotiations will be. I see 3 broad possibilities:

  1. Hard Brexit
    The UK leaves Single Market and Customs union without a clear replacement, relying upon rebuilding global trade. (it could be with or without a transition period).
    In this way, the UK joins N Korea in prioritising sovereignty over economics.
  2. Soft Brexit
    The UK stays inside Single market, accepting the EU’s rules. This is pretty much the same as being inside the EU, except the UK gives up participation in the EU government. I thought this sounded a bit like being a colony, closer to what the Leave campaign said the current situation is. Maybe like America before the War of Independence.
  3. Bespoke deal
    Ideally a “have cake and eat it” deal but could also be more reasonable. Some form of customised new relationship for mutual benefit, where the UK retains good trade links, but is able to stop free movement of people.

Let’s think about the UK’s view on these possible outcomes:

  1. Loved by Brexiteers. Obviously, I think it is madness.
  2. No-one wants this outcome. Clearly worse than staying in.
  3. This is the mainstream view that Leavers and Remainers will find common ground.

And the EU view:

  1. It would be the UK’s choice. Looks insane but if they want it, the EU cannot stop them.
  2. Ideal. No economic shocks and would get rid of the troublesome UK.
  3. This is the interesting one – see below…

Does the EU even want a bespoke deal?

The evidence so far suggests the answer is a clear no. Statements from the major EU politicians have been entirely consistent i.e. for free market access to EU markets, you need to abide by EU rules (freedom of movement and oversight by the ECJ)

But in negotiations words are cheap, so let’s look at the EU’s behaviour. If the EU wanted a bespoke deal, it would share in the UK’s anxiety to get moving on talks now, as any delay adds to the risk that a complicated deal will not be made. However, they seem not to be in a hurry at all, happy to have negotiations sit where they are. It also implies that even if the UK makes an agreement on the EU’s
three red lines, they will be sorely disappointed by what the EU puts on the table next.


Which is better? No Deal or a Bad Deal?

May initially declared that the UK would prefer “No Deal”. But after the general election result,
it’s clear that only the hard line Brexiteers really believe that. At least in the UK….

I think it might be the case for the EU however. A bespoke deal is a nightmare for them. It would threaten the integrity of the Single Market, the political concept of the EU and be a loss of sovereignty. Why would the EU agree to have regulation done in partnership with the UK? Surely, they will just do their own regulation and if the UK wants to freely access the EU market, then the UK can agree to subordinate its regulation to the EU.


Transition

This brings us back to transition periods. In my previous post, I described how the EU and the UK think differently about transition. For the EU, it is a bridge between the current situation and a known destination. For the UK, it is a lifeboat while you work out where you want to go.

I previously suggested this made a transition period highly unlikely, but I had not considered another option, a transition with virtually nothing changing. This seems highly likely to me as it would suit both sides. The UK will legally have left the EU, with no option to change its mind, thus pleasing the hardcore Brexiteers. For the EU, the UK would then have even less negotiating leverage. The UK can either stay as an EU satellite state or leave as it chooses.

Conclusion

The UK desperately wants a bespoke deal. Ideally a favourable one but anything that is better than the economic disaster of Hard Brexit and the political disaster of Soft Brexit. Desirability bias makes the UK think a good deal is likely. But the EU is not cooperating, which leads me to believe that it has no interest in any such deal. I think that the EU may offer the UK a choice between Hard Brexit or abiding by all the rules without a seat at the table.

Brexit means No Brexit!

I returned from holiday eagerly anticipating the papers setting out the UK’s position on Brexit.
As far as I can make out, the UK’s primary idea is that the UK firmly leaves the EU…. and also, that it does not!


Customs Union.

The UK will leave the Customs Union in March 2019. Today’s proposals relate what happens after.

The UK government proposes to then enter “a new customs union based upon a shared external tariff and without customs processes and duties between the UK and the EU.”

Hmmm. That sounds remarkably like not leaving?

Well it is not identical to not leaving. The UK also says it would be “time limited” (i.e. a transition), importantly during which they would be able to negotiate new trade deals.

The government also mentions that this is a “innovative and untested approach”, hardly a confident endorsement.

Transition

Leaving aside how reasonable this proposal is, the key conceptual error is misunderstanding what the UK and the EU mean by a transition.

  • For the EU, a transition is a well-constructed bridge between where we are now and an agreed future destination. Therefore, what really matters is to agree the destination.
  • The UK seems to see a transitional deal as a lifeboat. It is the resting place after we leave the EU where we decide where we are heading to.

This leaves the discussions in a precarious position. The EU has no interest in discussing the features of a bridge to nowhere.


Where are we heading?

This is the part I do not understand and I am sure the EU will not understand either. I cannot even write down the UK proposal in a way that makes internal sense, let alone decide whether it would be acceptable or reasonable.

I would instead highlight a dangerous misconception coming from the UK negotiators, often cited in the UK press, that “tariff-free trade” is the same thing as “frictionless trade”.

This perpetuates the myth that the major barriers to trade are tariffs. The major barriers to trade are regulation. The big problem with the US exporting chlorine-bleached chicken to the EU is not a tariff, it is that the process is illegal in the EU.

If the UK leaves the EU and does not abide by EU regulations, then having a zero tariff is irrelevant. The UK’s current plan to create a lower regulation environment for UK produced goods, and similarly when making trade deals with the rest of the world, to import goods which do not meet EU standards.

In this respect, the main policing of the Customs Union is not by the UK, it is by the EU to protect themselves. We may freely take all EU goods, but the EU will likely not take ours.

On the items, the EU wants to make progress on….


N Ireland (previous post – Brexit and Ireland)

So far, we do not have much of a plan. The importance of the DUP since the election, means that there will not be a border drawn between N Ireland and the rest of the UK.

Apparently, the fact there is currently no smuggling issue between the North and Republic of Ireland, means that there will likely not be one after the UK leaves the Single Market and Customs Union.

The idea seems to be that we will have a hard border, but this will not require an actual border.

Again don’t ask me to explain that one.

Brexit Bill (previous post – Settling the Brexit Bill)

The EU has asked the UK to come up with a proposed number and methodology for its calculation.
They are still waiting.

EU Nationals status

The EU proposal is that everyone retains the automatic right to stay where they are.

The UK idea is that EU residents can apply for some kind of second-class citizen status.

Conclusion

So far, the only UK request that makes much sense to me has been to ask for more time.

Of course, a simpler way of doing this would have been to have delayed triggering Article 50 until we had some idea what we wanted.

Brexit – Deal or No Deal?

Before the election

Before the general election, whether we reached a deal with the EU or not, did not seem to matter much. We seemed determined to head for a Hard Brexit, which looked similar to No Deal.

With the UK outside the Single Market and Customs Union, we would face a massive negative economic shock and potentially a resulting financial crisis. I did not discount the idea that we might not leave the EU or get a Soft Brexit, but did not see a path to get there. (https://appliedmacro.com/2017/05/04/what-game-are-brexiteers-playing/)

This all changed with the election…..

The election result

After the election, there is no longer a mandate, either for Hard Brexit or for exiting without a deal. I loved the article in the FT last week which laid out 6 options (https://www.ft.com/content/7be243f2-51ae-11e7-a1f2-db19572361bb) It is very funny and I highly recommend a read. I will leave the comedy to Robert Shrimsley, and think about what paths are likely now.

What is striking about any possible path is that none have a mandate or parliamentary majority.
Let’s start by separating them into:

  1. Deal
  2. No Deal

What does a Deal look like?

A deal will have to cover an extremely broad range of areas:

  • Rights of UK citizens in the EU and EU citizens in the UK
  • Settling the accounts (“Brexit Bill”)
  • What to do with Northern Ireland
  • Single Market
  • Customs Union
  • Trade agreement
  • Services agreement
  • Role of ECJ
  • Regulation
  • Tax
  • Etc ……
    the mind boggles at how complex this is.

It is very hard for me to see the current UK government managing to cobble together a common negotiating position on all of these in its tenuous state, never mind go through all the details with the EU.

Where next?

Although the tide of public opinion seems to have turned against her mindless slogans, Theresa May seems likely to go on, for as long as possible, using silly phrases like “Brexit means Brexit” and “Strong and Stable” and “Red, White and Blue Brexit”. Her problem is that any attempt to lay out a strategy with sufficient clarity that the EU can understand it, is likely to bring down her government.

There is no parliamentary majority FOR any Brexit option, but I think there is a parliamentary majority AGAINST all of them.

The fall of the government would lead to another election. In this, I am not too optimistic that the main parties will lay out clear and distinct sets of ideas on Brexit. May previously tried this and completely failed. The “success” of Corbyn was perhaps to be so incoherent on Brexit that no one understood it well enough to object to it.

So again, how can a government without a clear UK negotiating position make a deal?

Maybe they just can’t.


What does no Deal look like?

Which means we get left with No Deal.

This has two clear and distinct paths:

i) Stay in the EU

ii) Leave without a Deal

Now I really do not know which is more likely.

A new Referendum posing this much clearer question?
My money would be that the vote will go against whatever the government in power proposes.
If May wants to Remain then we will Leave, if she wants Hard Brexit we will stay.

Brexit has gone from being an odds-on fiasco to utter chaos.
I am not sure yet if this is better or worse.

UK Election Results and Brexit

I am writing this while we do not know the full results and have yet to hear Theresa May speak, so I expect much of what I write will quickly be irrelevant or overtaken by events.
But this is so important and interesting, it is worth recording some ideas.

Most likely outcome seems to be:
Minority Conservative government led by May with informal backing of DUP

This is the very likely outcome in the short term, because the other options look so terrible:

  1. DUP fail to back Conservatives
    Why would they not take this excellent opportunity to be central to government and push their agenda?
  2. May resigns
    Her main character trait seems to be her stubbornness, and it’s not clear why she would have an unprompted crisis of confidence now.
  3. Tory MPs force her resignation
    This is possible but the Brexit timeline makes this difficult and dangerous. The current rules of the Conservative party mean that any new leadership election takes months and how that would intersect with a new General Election is unclear to me. Either the whole process will take many months or the Conservatives are heading into an election with no clear leader appointed.
    The 2-year countdown to Brexit has already begun, this would make a disorderly exit highly likely.


If this minority government is formed what would it do?

The top priority of the DUP will be the Irish portion of the Brexit negotiation. I wrote at length about this here (https://appliedmacro.com/2017/05/02/brexit-and-ireland/). The only option which seems to make sense for an Ulster Unionist is for the UK to stay at least within the Customs Union and possibly within the Single Market. Hard Brexit involves Hard borders.

The next priority for the DUP will be on domestic Northern Ireland issues. The vote has been strongly polarised, with the DUP with 10 seats and Sinn Fein with 7 seats. If the DUP are successful in promoting their Unionist agenda for N Ireland, then this will bolster the Sinn Fein argument that the power sharing government in the Good Friday Agreement is not working, and a further breakdown in politics is likely.

For the Conservative Party, especially any aspiring Tory Prime Ministers, it may seem attractive to let May spend the next 2 years negotiating Brexit while they snipe at the side-lines. Then they can blame her for the deal, whatever it is. They can then say that she betrayed Brexit, was incompetent and if they had been in charge it would have been great.

But this path will likely be contested from day one. For true Brexiteers, acceding to the demands of the DUP, will not be acceptable and they will rebel. So I doubt this softer Brexit route will be a stable one.

Would another election solve anything?

Probably not.

All the parties are formed from coalitions of views and these intra-party divisions are becoming more critical. Look at the inability of the Republican party in the US to agree on anything, despite having control of both Houses and the Presidency. The electorate is similarly unstable. Such volatile opinion polling in an election campaign can often indicate something highly unusual is about to happen.

The ideal election would have been one in which the two main parties laid out clear, coherent, and different plans for Brexit. Then for one of them to win a clear majority, and to lead the country on that mandate.

But with such a conflicted electorate (https://appliedmacro.com/2017/05/24/uk-election-brexit-views/), Labour chose an incoherent policy so as not to offend anyone. The Conservatives, after running on a Hard Brexit platform, might be tempted to try the same although it is not clear this was the flaw in the campaign. The Brexiteers have perhaps done too good a job convincing people Brexit has already happened with the triggering of Article 50, as it became a shockingly minor issue in the campaign.

The UK is in danger of remaining in political chaos. It would have made more sense to have sought this mandate BEFORE triggering Article 50. But May has copied Cameron in choosing to play politics, more like a game of Russian Roulette.

Market implication

I have been extremely negative on the UK for a long time, in particular on the currency and I see nothing now to change my mind. May’s Brexit negotiating position never made any sense to me (https://appliedmacro.com/2017/05/04/what-game-are-brexiteers-playing/) and it remains unclear.  Her position, to stay stubbornly unreasonable, and then the EU will be forced to give in. A different character might be chastened by this election and move to a more centrist negotiating position, but that does not seem to be in her dogmatic manner.
After this election , a veneer of bravado may remain over what seems an ever more chaotic position but this may be a catalyst for more rapid problems in financial markets.

UK Election – Brexit Views

UK Election – Brexit views

I have found the shift in public sentiment on Brexit to be very striking. A recent YouGov poll shows how people who want the UK to remain in the EU are a minority, even amongst those who voted to Remain.

When I listen to interviews with the voting public, I am left confused.
Many appear to talk as though fears of the impact of Brexit have been disproved (i.e. Brexit has happened already), but then others talk about making a good deal (i.e. Brexit has not happened yet). It is not clear to me if this represents a form of widespread cognitive dissonance, or if the media is splicing together pieces of interviews from different people. It is also possible that it is the media that is confused.

This table gives my brief description of the camps.

uks

 

What are Re-Leavers thinking?

I can follow the argument that Re-Leavers do not want to reopen the debate, and prefer we leave than to try to change the decision. But I am left confused as to what they think is going on.

One hypothesis I have is that Re-Leavers are under the misapprehension that Brexit has already happened. My metaphor for Brexit is jumping off the ledge of a building.

Stage 1 Decide to jump

Stage 2 Jump and experience sensation of falling

Stage 3 Hit the ground

In this metaphor, we are currently at Stage 1 in Brexit.

Stage 1 It is not too late to step back from the ledge.

Stage 2 This may feel exhilarating, a sense of freedom and elation.

Stage 3 Depends on your view of the economics.

From the Leave campaign, it suggests we were on the ground floor of a prison and can now run and be free in the glorious countryside around us. My view is that we are on an upper floor and it is not yet clear how much damage we will sustain. At least some pain, likely a few broken bones, but hopefully not a critical injury.

I will do an economic analysis of Brexit and its implications for asset markets in another post.


How will Hard Remainers vote in the Election?

I found this FT graphic of the same YouGov poll enlightening. It shows why the Remain group are not having any impact and why Labour are struggling to put together any kind of coherent message.

  • Hard Remainers are not uniting behind any party.
    The Lib Dems are trying to court them but only a small fraction of Remainers are going to vote Lib Dem. In fact, the majority of Lib Dem voters are now in favour of Leaving.
  • Labour support is split evenly between the 3 tribes.
    This is why they have not formed any coherent message on Brexit at all. They are trying to appeal to all 3 Tribes, which of course turns into unintelligible policy pronouncements.
  • Conservative voters are overwhelmingly in favour of Leaving.
    This makes the policy message for Theresa May extremely easy.

Who loses more from Brexit? The UK or EU?

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.