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November 22, 2016

Towards a transitional deal

There was a period of confusion about Brexit, but some of the outlines are now becoming apparent. The Brexit will be hard because immigration controls leave no choice. The UK will exit the single market and the customs union (and no, the two are not logically linked - you can theoretically be in one or the other, but this won't be on offer). To mitigate the frictional costs that would arise from such a harsh transition, the UK will accept a transitional period, the length and nature of which have yet to be discussed. We would assume that a five-year period, or something along those lines, would give everybody enough time to prepare. And, politically, it would allow the final stage of Brexit to happen before the end of the next parliament, while the formal Brexit moment should happen in 2019, before the end of this parliament.

There is a lot of political and economic logic in this sequence of events, and Theresa May has now officially mentioned that a transitional agreement is being considered to avoid what she called a "cliff edge" Brexit in two years. That would mitigate the frictional costs - which in our view constitutes the main economic risk of a hasty Brexit.

The UK has a few cards up its sleeve in the negotiations. Wolfgang Schäuble yesterday reiterated his fears of a UK corporate tax cuts. He said, curiously but wrongly, that the UK cannot do this while still a member of the EU. As Schäuble knows well, the EU has no jurisdiction over corporate tax rates.  A more pertinent argument he made, according to FAZ, is the G20 commitment of avoiding predatory tax practices.

If the EU were to force the UK into a hard Brexit with the imposition of tariffs, then of course the UK will do whatever it can to stop companies from relocating. And that could include tax breaks, state aid of the kind that would be deemed illegal in the EU, and possibly even compensation for tariffs. What we see in the repeated warnings by Schäuble is a real concern that post-Brexit Britain and the US could start a new round of global tax competition, which the Germans consider extremely dangerous politically.

And, finally, we note a tendency of judges to give opinions on either running or even non-existing cases. In doing so, the legal profession is turning itself into a political player, as a result of which we should no longer be surprised by a hostile media reaction. This time, the president of the ECJ, Koen Lenaerts, pronounced that there are many ways an Article 50 process could end before the court, according to the FT. That is trivially true in the sense that everything in the treaty can go to the ECJ. Lenaerts was careful not to go into specifics, but we are wondering why the president of the ECJ accepted to be interviewed and even drawn into such a subject. This comes after the deputy of Britain's Supreme Court commented on the pending appeal by the British government. One gets the impression that the judiciary is up to something rather strange.

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November 22, 2016

Estonia's new PM

Less than two weeks after the Estonian government coalition failed, Estonia has a new PM, Jüri Ratas of the left-liberal Centre party. He leads a coalition with the Social Democrats and the conservative Pro Patria and Res Publica, both of which were part of the previous coalition with the centre-right Reform Party, which had been in power for 11 years. At his confirmation debate in parliament he identified the population crisis, the stagnant economy, inequality, and security as his government's priorities. As the Centre party is favoured by voters from the Russian minority in Estonia, Ratas is characterised as pro-Russian in the foreign press. There were questions in the parliament about his stance on Ukraine, to which he responded by saying the Centre party had been a leading critic of Russia's annexation of Crimea. The foreign ministry will remain in the hands of the Social Democrats, as in the previous coalition, and will go to Sven Mikser, a former defence minister and currently chairman of the parliament's foreign affairs committee. 

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November 22, 2016

Merkel's depressing plan for a fourth term

If you look at Angela Merkel's renewed candidacy from the perspective of the eurozone, it is an utter disaster. The CDU's economic manifesto has not a word about the eurozone and its governance. Even worse, its only hard commitment is for Germany to not incur any net debt during the next term. All spending and taxation commitments are subjected to this overall goal. We are not surprised by this, only reaffirmed in our view that Germany's introduction of a constitutional debt brake has essentially ended all pretences of eurozone economic co-ordination. If Germany fixes the balance of its state sector at a permanent level of zero, the country is destined to run excessive surpluses indefinitely for as long it is in a monetary union with weaker countries.

The spending commitments of the manifesto are vague, except that they are linked to extra revenues exceeding the baseline scenario. One third of those is to be spent on tax cuts for lower- and middle-income earners, one third on infrastructure, and one third on security. Frankfurter Allgemeine noted in its coverage that German tax experts are forecasting cumulative tax surpluses of €162bn between 2016 and 2021, of which €68bn would accrue at the federal level. Within infrastructure investment the emphasis will be on digitalisation, including a commitment towards country-wide high-speed internet. But, as FAZ also noted, not a word is lost in the CDU's election manifesto on the eurozone.

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November 22, 2016

Why Italy cannot stay in the eurozone

There was quite a bit of a reaction in the Italian press to Wolfgang Münchau's column on what would happen if Matteo Renzi lost the referendum. It characterises Italy's membership of the eurozone as fundamentally unsustainable, a statement that never ceases to shock the Italian establishment. The consensus view, especially among Italian economists, is that the country could muddle through in the past and will muddle through in the future. If Renzi loses, he may step down and be replaced by another political or technical premier, charged with the task of reforming the electoral law with the primary goal to prevent a first-past-the-post victory of the Five Star Movement. For as long as Italy is run by coalitions, so the argument goes, there can be no euro exit. In any case, there cannot be a referendum on it since the Italian constitution does not allow this.

We know the arguments very well. But that does not change the logical conclusion that, if something is unsustainable, it will either end or be made sustainable. So let us dissect the three elements of the argument in more detail:

  1. Italy's position is unsustainable;
  2. Italy's position cannot be rendered sustainable in time;
  3. Italy will eventually leave the eurozone.

The unsustainability is a consequence of low structural growth, high sovereign debt, weak institutions, and weak banks. If Italy had been in the ERM, instead of the euro during the period that the euro has existed, we are sure that the lira would have devalued at least once. What keeps Italy away from the abyss at the moment is the ECB's bond-purchasing programme. But it will not last indefinitely. The critical moment will come not when these purchases end, but once markets become convinced that the tapering process is about to start. At that point it would be reasonable to expect an increase in Italian bond yields.

Regarding the second point, we would argue that it is too late to influence Italy's fate in the euro through structural reforms. We recall arguing back in 2003 that Romano Prodi's government was the last chance for a policy of structural reforms that would have helped Italy converge to the eurozone average (or rather towards Germany, given that Germany is fundamentally non-convergent). Adjustment through the real economy is painful, and we don't even think it possible in this case.

There is no way we can forecast when the fateful moment of a euro exit will arrive. That will depend on a confluence of factors - such as politics and the onset of panic among investors. The markets may even stay calm in the face of a 'No' vote, especially if the ECB leaves its QE programme unchanged. But eventually something will happen that will inflame the situation. It could be a strong 'No' victory. Or the 2018 elections. Or a massive fiscal overshoot. Or an escalation of the refugee crisis. Or something completely unforeseen. We have no idea when and how this will happen. The referendum is just a possible known event.

Also do not dismiss the possibility that the referendum might result in a 'Yes' vote. The polls are unpredictable in all directions. Turnout was the key in the Brexit, Trump, and Fillon votes, and it would not surprise us if turnout became the decisive factor once more.

Where we part company with the optimists is in their judgement that one can muddle through a fundamental macro imbalance indefinitely. Economic history teaches us that you can't. Fixing the electoral system may buy some time, but is not going to solve the problem - and, in Italy, gerrymandering has on more than one occasion backfired in the past.

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