06 June 2016

Insoluble Contradictions of the Leavers’ Policies: A Scenario for Timeline to Reality

The Gove/Johnson statement on migration has set in concrete the insoluble and basic contradictions inherent in the Leavers’ policies if Brexit. These contradictions may well push the UK economy over a `tipping point’ – with dramatic economic and financial consequences for Britons' daily lives.

This analysis is not a scenario of econometric projections, but simply the logical results that flow from the application of existing, settled EU and UK law – at least for Britain’s largest exporter: financial services. Officials are duty-bound to enforce these laws – until they are changed by the legislative authorities. For the UK after a referendum decision by the people to “take control”, it seems politically implausible for “unelected bureaucrats” at the Bank of England to `give total control back to the EU’ via secondary legislation. This might be a practical, very short-term solution to the problems, but it would not even remove the risk that much of the UK’s financial services industry’s non-UK activities would relocate to remain within the EU – probably by the time of legal Brexit.

The alternative - Project Future - is clear: re-engage fully with our EU partners so that our emergence as the second most powerful state in the EU will enable us genuinely to influence the world around us to our advantage – the definition of true sovereignty. To achieve this, the British public must make a hard-headed assessment of the foreseeable effect of Brexit: the hard logic of Reality versus a romantic Fantasy. 

What are the contradictions? The migration policy proposal has opened a window for a surge in EU citizens wishing to establish themselves as “already lawfully resident in the UK” because “there will be no change” for them – to quote Gove/Johnson. Any such surge would make a mockery of the Leavers’ campaign promises. But abruptly slamming the window shut in mid-discussion will aggrieve many EU citizens and, crucially, their home government just at the very moment when the UK may be asking for unanimous agreement by all 27 to a trade deal.

Such a blatant repudiation of free movement would probably remove any chance of an EEA-style deal that would give unfettered access to the EU’s Single Market. Making a virtue out of necessity, the Leavers are now advocating that Britain’s trade relationship with the EU should be based simply on World Trade Organisation rules.

The Leavers fail to understand the danger that relying on WTO rules will damage services – especially financial services. They argue that the economic response to Brexit will be a “Nike swoosh” – an initial downward move followed by a major uptick in the decades ahead. But their argument will founder because the entirely-foreseeable re-location of financial services to the euro area may instead tip the UK into a vicious downward spiral instead of a Swoosh. This risk is a natural consequence of the sheer scale of that industry’s contribution to foreign exchange earnings and tax revenues. Moreover, these dangers coincide with our massive balance of payments deficits - each year, a new “record since 1948”.

Possible scenario for a `quick exit’ timeline to Reality:

• Soon: the UK serves the Article 50 notice to quit the EU
• Summer `16: the rest of the EU prepares its position on the Article 50 “arrangements for withdrawal”; the ECB prepares the rules to oblige euro-denominated activity to be settled in the euro area after legal Brexit.
• Winter ’16: The financial services industry also reads the regulatory writing on the wall and accelerates preparations to leave by legal Brexit.
• Mid ’17: UK realises it has no negotiating leverage; accepts the proposed “arrangements” and Brexits.
• Summer ’17: As identified by HM Treasury, major gaps open up in the UK’s financial regulatory system as EU `Regulations’ cease to be binding in the UK. UK-based firms lose their `passport’ for business in the EU; in this regulatory limbo, UK rules can never be judged `equivalent’; firms find themselves classed as 'unregulated financial sector entities' and non-UK counterparties face higher capital charges to deal with them.
• 2018:

o   The £21 billion of financial services earnings with the EU have migrated to the euro-area; a significant portion of the £50 billion of earnings from the rest of the world has migrated; UK goods exports hit the EU’s Common Customs Tariff wall (up to 10%) as well as bearing the cost of non-tariff barriers – perhaps 15%. According to an LSE report, exports slump by perhaps 30%/£70 billion. The UK’s current account deficit looks set to rise from the 2015 record of 5.2% of GDP/£96 billion to over £150 billion – 8% of GDP - and beginning to approach the levels that  tipped southern Europe into catastrophic capital outflows in 2009/12.

o   HM Treasury estimated that under the WTO-rules scenario, the budget deficit would rise sharply from the currently forecast levels due to the operation of the automatic stabilisers. Result: the 2018 deficit may be little different from last year’ £76 billion. As a significant portion of the City’s £65 billion of tax revenues (latest data 2012/13) moves to the euro area, the UK’s budget deficit looks set to hit £100 billion again.

• At some stage after 24 June (and especially after serving the Article 50 Notice), the bond/currency vigilantes conclude this combination of foreseeable outcomes of the contradictions inherent in Project Fantasy is impossible. They exert their undoubted, genuine sovereignty and put a `sudden stop’ to capital inflows to the UK. The economic catastrophe begins to unfold.

 

Full paper available for consultancy clients here

© Graham Bishop