June 30, 2016
The post-Brexit options are mercifully few
If you look at the media coverage of the post-Brexit mess you may easily be confused. There are still many who peddle the idea of another referendum, or other ways of undoing the vote. There are suggestions that the Scottish Parliament might veto the whole thing. But the point is that the referendum is now creating irreversible facts. EU leaders met without Britain for the first time, and reaffirmed their negotiating line: not even informal talks before Article 50 is triggered by the next government; and no cherry picking, as Donald Tusk put it: the EEA is an option the EU will not refuse, but it is a rather inflexible option because in exchange for single-market access it leaves the four freedoms as they are, including the freedom of movement of people. If the next government prioritises its ability to control immigration, there will have to be a special agreement that is visibly short of full single market access. The single passport for financial services will definitely be gone under such an arrangement - or maybe phased out. There is a straight trade-off between the City of London's single passport and control of immigration. The UK can't have both. Or, as Donald Tusk said, there would be no single-market access à la carte. We agree. This is going to be either the EEA, or a trade deal - or maybe both in succession. EEA membership could be a stop-gap measure to give Britain and the EU time for an orderly implementation of the new regime, which cannot be done within two years.
One important development yesterday has been the recovery in financial markets, which will also impact the debate. It is as though Brexit is almost a non-event for the UK. Here is a Reuters screen for the main European stock indices. The FTSE 100 index is the purple line at the top, now back to where it was pre-referendum. The blue and green indices in the middle are Germany, France and the Netherlands. The red and yellow indices at the bottom are Italy and Spain, respectively. They are still down 9%. This confirms our view that Brexit is very much a near-cataclysmic event for the eurozone, but not for Britain.
Those who express the hope for another referendum are betting on, and presumably hoping for, economic chaos that would change people's hearts and minds. That could have been an option if markets had collapsed. But that did not happen. The economy will take a hit over the short term simply because people are holding back investment decisions until there is more clarity. The housing market has slowed down - which is a good thing. And so is the measured devaluation of Sterling. It will help rebalance the British economy. We believe that the impact of a well-managed Brexit is neutral or marginally positive for the UK.
So, why are commentators - especially economic commentators - so horrified that they start to overuse adjectives in their prose? We have never read so many criticisms of a popular vote - it's not something you would normally do even if you disagree. One reason is perhaps a realisation that the ludicrous post-Brexit predictions will now be tested against reality. We suppose one reason the pro-Remain campaigners used Project Fear was the expectation that they would never have to live to see their propositions tested, so confident they were in their victory.
The other is a realisation that politicians will not employ macroeconomic arguments in the foreseeable future. The 1990s and the last decade were the heydays of the profession. The financial crisis ended the public's uncritical belief in economic forecasts and explanations. The failure of the hysterical Brexit forecasts will do the rest. We don't think that politicians will be using economic arguments for a long time after this.
One area where we urge caution, however, is the UK's ability to hang on to all the business activities of the City of London. One issue under debate is the clearing business, after Francois Hollande's intervention. We think this business will eventually have to go even if Britain stays in the EEA. The ECJ did not allow the ECB to discriminate between EU countries, but it is not clear whether this ruling will apply to the EEA as well. And, even if it does, given Britain's absence in future financial regulation decisions, there is a slippery slope that will make it harder for the City to cling on to everything. Clearing is a lucrative business, but it will have to go eventually. The pressure from inside the eurozone is simply too large. More optimistic views such as this one naturally assume that Brexit can somehow be reversed, which we think is so unlikely as to not be worth considering.
We also noted a story in Frankfurter Allgemeine that pressure is growing on Deutsche Börse to not make London their sole headquarters. That view was previously expressed by the German financial regulator Bafin. Now the prime minister of the state of Hesse is also adding to the pressure to keep Frankfurt as the headquarters. The company is now seriously considering a dual-headquarter solution that would give them more flexibility. But there is also pressure on Deutsche Börse's shareholders to not sabotage the deal, which would provide closer integration between the London and the continental markets. This is another example of facts of Brexit being created on the ground.
This is also why we don't think it is going to be a realistic option for the next British government to play cat-and-mouse games on Article 50. The European Council is in the stronger negotiating position. The longer the uncertainty lasts, the worse the impact will be on the British economy. And the longer it lasts, the more control of the situation the politicians will be losing. It is our expectation that the new prime minister will launch Art 50 shortly after being elected, and after having settled for an ultimate option. And, once Art 50 is triggered, Brexit will happen. If there is a second referendum, the questions can only be: do you agree to these terms, or would you like to exit cold-Turkey - which is what would happen if no deal is agreed. That, however, would have very significant economic consequences.