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July 29, 2016

How Brexit might happen

This is probably the most detailed informed analysis we have yet read on the Brexit process. Charles Grant unscrambles the various negotiations that lie ahead and comes up with a list of six:

  1. Article 50 talks - the separation agreement;
  2. the FTA with the EU;
  3. an interim agreement;
  4. accession to full membership of the WTO;
  5. third-country FTAs;
  6. agreement on foreign and security policy. 

The last is of a different category than the first five - and we think it is possible to fold the negotiations on an interim agreement into the Article 50 process - for the simple reason that they logically have to be completed at the same time. Another advantage of folding the two is that an article 50 procedure does not require national ratification: QMV in the council, plus a vote in the European Parliament, will suffice.

Grant makes a couple of points we have not yet considered - that the EU27 wants the Art 50 process completed by June 2019 - the date of the next European elections. That would make sense. In any case, the entire two-year process needs to end well before the 2020 general elections in the UK. That leaves only a narrow window. Brexit by July 1 2019 would seem a sensible choice.

Secondly, he notes that the reason third countries cannot start FTA negotiations in parallel with the Art 50 procedure is that the former depends on the outcome of the latter. Trade negotiators will need to know the degree of the UK's market access and to which extent EU laws and regulations apply in the UK.

In terms of the deal that will be on offer, Grant offers a realistic set of expectations, with which we broadly agree - except on one point. Where we agree is that the UK will negotiate a Canada-style FTA with the EU, but this cannot be done within two years. In such an agreement, some limited trade-offs between the degree of market access and acceptance of free movement of labour are indeed possible - but the single passport is indeed gone. 

Where we disagree with Grant is the assessment of the interim agreement. We don't think there can be bespoke deal as part of which the UK gradually extricates itself from EU laws, and starts to impose restrictions on the freedom of movement. While such a bespoke deal would be in the best interest of the UK government, we don't see a majority among EU member states for a soft transition - it would also create facts for the FTA. The only interim agreement the EU will offer is a plain vanilla EEA - with no rights on the restrictions of free movement. If that is not acceptable to the Brexiteers inside Theresa May's government, they will have to consider the hard Brexit option - something we would indeed not rule out.

The upside is that, from a position of a hard Brexit, an FTA can be agreed faster for the simple reason that countries like Germany have an interest to lock in their trade surpluses with the UK. It is true that Britain is much smaller than the EU, which could thus stomach the loss of a trading partner easier. But this argument ignores the political dynamics. Companies like BMW and Siemens are already exerting much pressure on the German government in favour of a soft trade deal. The long timetable for the Canada deal served as a useful Remain campaign scare story. Three things are different now: at the point of departure the UK already fulfils all EU regulations; the UK has a large trade deficit with important EU member states; and the ratification procedure can be short-circuited, since trade is a competence of the EU, not member states. We would agree with the timetable of Philip Hammond that this could be wrapped up in four years - after Brexit.

In our own analysis, the UK government faces two realistic interim choices: a hard Brexit or a time-limited EEA. The hard Brexit entails big economic risks, but has the important advantage that the entire procedure would conclude earlier, and thus reduce the uncertainty. This is important also from a political perspective. The risk with the EEA is that once the UK is inside, it might not be possible to agree an FTA with the EU, since the EU will have less of an incentive to speed up the negotiations. An EEA deal could produce a never-ending political nightmare for May and her government. 

One could imagine an EEA with a strict ex-ante time limit, and no renewal, but if there is no agreed deal within the period, the hard Brexit option will be back on the table. The period of uncertainty will be longer, and the government may have spent much of its political capital. We think that Conservative Party strategists will therefore seriously consider the hard Brexit option especially if they believe that the economic shock of a hard Brexit would be over by 2020.

With a hat tip to Danny Blanchflower, here is a chart on the latest economic sentiment indicators, which shows that the UK economy may be falling off the cliff right now. If this translates into hard data, we think that May will have an incentive to make up her mind quickly. But for the reasons mentioned above, a hard recession does not necessarily imply a soft transition agreement.

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July 29, 2016

The economics profession is doubling down

As this is our last briefing before the holiday, we would like to return to an important theme of 2016 - what the response should be to the rise in economic populism. We think this article by Tony Yates (hat tip @Simontilford) encapsulates the problem almost perfectly, in an unintended way: it is hard to find a better example of the profession's arrogance. Yates' discourse presumes the presence of a right and rational choice - and that those who disagree with the position are illiterate. In particular, Yates talks about "perceived grievances", and notes that Brexit was "voted for by the older, less educated, less skilled".

Like many macroeconomists, he confuses politics and policies. He assumes that people care about aggregates and averages, rather than about their own position. When your real income falls, as it has done for almost 40% of the UK population in the last ten years, then this is not a perceived grievance but a real one that translates into votes. These people may be, on average, less educated, but they are not necessarily irrational. In many EU countries, for example, young people find it impossible to find steady forms of employment on ordinary work contracts. It is completely incomprehensible to us why they should support the kinds of policies that the political establishment has been pursuing. Yates castigates policies to address these grievances as a "sop response". That may be so to the extent that some of these policies may be symbolic and superficial. But for sure we need to address the problems. 

We have before discussed the surprise expressed by some economists that no one is listening to them any more. There is a reason for this. The profession, which is very inward-looking, has failed to address its shortcomings after the financial crisis. And if this article is any way representative of the post-Brexit response of the economics establishment, it is doubling down. The profession is shocked by the Brexit vote partly because the forecasts about the long-term impact of Brexit will eventually be tested against reality. It was meant as a scare story only. And it will reduce the profession's reputation among non-economists further.

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