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January 17, 2017

In denial

We have been noticing in our daily perusal of the British and the continental press a tendency for denial - by the continentals in particular - of all the bad things that are happening in the world. The Germans, in particular, still seem to believe that Brexit is a passing fad - that it won't happen once the British wake up and see reason. The journalist who interviewed Philip Hammond asked a question about whether Brexit can be frustrated - a question we would never hear in the UK. We noted a story in Tagesschau last night, approvingly quoting various German politicians who claim that the hard Brexit sought by the UK was just a bluff. The article quoted Jo Leinen MEP, a German Social Democrat, as saying that the threat of Brexit serves to scare the other Europeans. Sven Giegold MEP, a member of the German Green Party, said the UK was dependent on the single market more than the other way round (which is true but fails to recognise huge disparities among member states - Germany, for example, has much to lose).

What this tells us is that, as this stage, the UK is better prepared for the negotiations than the EU-27, who have not yet even begun to work through the implication of a hard Brexit for their economies, and in particular for financial stability.

Theresa May will today provide more clarity about the shape Brexit will take. The FT got ahold of extracts of the speech she will give today, in which she will rule out any form of membership or even an association agreement with the EU, or anything that would leave the UK "half-in, half-out". The UK would not seek to adopt any existing model. 

We should always note in these discussions that these stated goals only affect the final Brexit arrangement, which is not necessarily what will happen when Brexit first becomes effective - presumably in July 2019. A transitional period would certainly imply a half-in, half-out arrangement. We find it hard to imagine a transitional deal that is not based on a customs union membership. It wouldn't be much of a transition otherwise. The FT quoted Michel Barnier as saying that the EU would be willing to agree a special relationship with the City, presumably as some people are beginning to think through the impact of a hard Brexit on the financial stability of the eurozone.

A broad tendency for denial is the underlying sentiment in the German press also towards Donald Trump. Germany was flabbergasted when he won, and they are now flabbergasted that he may do a few of the things he threatened to do. The normally sharp Berthold Kohler is so appalled by Trump's comments on Nato because he is now beginning to realise that Trump may well mean what he says. Trump cannot even remember the name of the person who called him from Brussels (it was Donald Tusk, not Jean-Claude Juncker as he suggested) - a sign that Trump could not care less about the EU. Kohler seemed genuinely shocked.

Perhaps the most glaring example of denial is the statement by Pierre Moscovici that a US administration hoping to dismantle the EU "is simply not possible". If that were true, it would be new to us. It may not be a good thing, but it is clearly possible. We don't think Trump wants to dismantle the EU, but to weaken it. This is already happening.

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January 17, 2017

Northern Ireland's snap elections and Brexit

The collapse of the government in Northern Ireland could have implications for the whole Brexit process, although it wasn't caused by Brexit. Sinn Fein withdrew from power-sharing with the Democratic Unionist Party (DUP) over allegations that the unionist leader Arlene Foster had misspent more than £490m of public funds in a renewable energy scheme. Sinn Fein’s Martin McGuinness resigned as deputy first minister last week, without replacement, as a result of which Foster was forced to stand down under the power-sharing agreement. The two parties have been at odds for some time now. The DUP is pro-Brexit, while Sinn Féin wanted the UK to remain in the EU. The two parties shared power in the Northern Ireland executive under the terms of the Good Friday Agreement of 1998.

Fintan O'Toole writes that the election campaign could well be about Brexit. Northern Ireland is not, despite the DUP's insistence, just another part of the UK. And these elections might well show this. The three main opposition parties: the Ulster Unionists, the SDLP, and the Alliance; all oppose Brexit. With these elections they will get a chance to show that there is a real alternative to the compromised DUP, that used opaque party funds to finance pro-Brexit campaign material in a newspaper for London metro commuters.

Northern Ireland is expected to be particularly affected by Brexit, not only because checkpoints and borders with the Republic of Ireland that would have to be brought back. The region stands to lose EU funds and subsidies for peace projects. In the referendum Northern Ireland voted 56% for Remain. Colum Eastwood, leader of main nationalist opposition group, the Social Democratic and Labour Party, told the Independent that the hard Brexit option pursued by Theresa May threatens the Good Friday agreement. 

The regional parliament will now be dissolved, with an election scheduled for 2 March to elect a new government. Theresa May will still hold a meeting with the dissolved government to discuss Brexit.

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January 17, 2017

Watch out for the border tax adjustment

One of the big policy issues to watch out for in the US, also from a European perspective, is the debate about the border tax adjustment (BTA). While this is not a VAT formally - it does not affect consumption taxes, but corporate taxes - it acts like VAT economically, in the sense that it would shift taxation to where production is occurring. Technically it means that goods purchased abroad by a US corporation would no longer be counted as costs. Under the plans by the Republican congress, the tax could bring in revenues of some $1.2tr over a decade. The border tax would make imports more expensive, but this would be mostly compensated for by a rise in the dollar, which should theoretically go up proportionately. And the measure would subsidise exports, as domestic costs would remain tax-deductible. If the US were to adopt a European-style VAT system the macroeconomic effects would be similar, but with less distortion as VAT would be levied at every part of the process. The world economy has benefitted a great deal from the fact that the US has no system of this kind in place whatsoever.

There was always quite a bit of speculation on where Donald Trump stands. He has now distanced himself, sort of, from the BTA because he fears a further rise in the dollar, as he told the Wall Street Journal. He prefers simple import tariffs.

Sebastian Dullien explains that a BTA is probably not legal under WTO rules, which only allows explicit VAT-type taxes. A unilateral US tax could have a severe negative impact on the global trading system. The WTO could act, but only after the law has been passed. That would be followed by a complex arbitration procedure, but the powers of the WTO are limited. If the WTO rules the plans to be legal, then other countries will follow. The BTA allows countries to simulate the economic effects of an import tariff without the need to impose an actual tariff. 

Gavyn Davies notes that the issue is hugely important. The BTA is effectively a 20% import tariff, combined with an additional 20% export subsidy - a huge shift in the terms of trade. Davies notes an argument by Martin Feldstein, who supports the BTA, according to which a rise in the dollar would offset most of the discriminatory effect. One estimate, by Citigroup, is that a 20% BTA would raise the dollar by 15% over a period of three years. Davies makes the point that the real issue is how others will react to it. If others do the same, the benefits for the US would be correspondingly reduced - and everybody would be worse off as a result.

"The border tax may well get heavily watered down during its passage through Congress, and would certainly be phased in over a long period. But the potentially large long term effects of this reform – on equity sectors, the dollar, and foreign economies – are not yet factored into financial asset prices. This could be one of the big stories of President Trump’s first year in office."

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