Wednesday, February 8, 2017

A Realistic or Panglossian Brexit? What lies beyond Article 50.

Source: Chicago Showbiz
Pangloss was a character in Voltaire's Candide ( - which was made into a wonderful opera incidentally, by the late Leonard Bernstein), who suffered from unbridled optimism. Obviously with Brexit the Panglossian "best of all possible worlds" (or as a note on a memo that was recently leaked to the UK press said "to have your cake and eat it") is unlikely to come to pass in the difficult negotiations ahead - but to me that is hardly a surprise, as I will explain in this econoblog.  

We now have some clarity on what is going to happen regarding the UK's exit from the EU (otherwise known as Brexit). UK PM Theresa May has determined that the type of Brexit that occur has to be of the "harder" variety, and she made a speech to this effect, and you can read the full version of the speech here.  Also, after the challenge made in the UK High Court (roughly equivalent to the US Supreme Court), the UK Houses of Parliament has had to vote on a bill to take the UK out of the EU, and although many of the MPs themselves wanted to remain, there was a "whip" to ensure that the vote (498 to 114) to start the Brexit process formally by allowing the PM to trigger Article 50 (which then is the official notification to the rest of the EU that the UK is on a 2 year timetable to leave).
Source: Getty Images

Some commentators, such as Martin Wolf of the FT (see here) had already gone on record to say that he thought the only feasible outcome is now a so-called "hard" Brexit. Martin Wolf stressed that the linear (or quadratic) programming problem that satisfies all the political and economic constraints for a deal is essentially an empty set. So Martin Wolf sees this as leading to the hard option, with no soft "squidginess" allowed.  I think that indeed "ceteris paribus", this is certainly the direction of the negotiations, but that the mostly likely outcome will be more nuanced than this.

My reasoning is as follows  "Ceteris" does not have to be "paribus", so although we ulimately need some practicality imposed on all this, clearly EU immigration is the big sticking point that leads to what most economic commentators believe is an "empty set". But I think as the weeks and months have passed since the referendum the general public is now beginning to get it's mind around the tradeoffs involved with the practical steps needed to achieve Brexit, and understands that leaving the single market is the only way forward, but even PM May has already suggested some "squidginess" here, in referring rather mysteriously to what she called "customs agreements".

OK, so let's back up a moment and remind ourselves of the distinction between a customs union and a single market.  A "single market" means you have the "4 freedoms" - free flow of goods and services, workers and capital - in other words free flow of all goods and factors of production.  A "customs union" is different - it is a free trade agreement where the participants agree to a common external tariff (CET). And then of course you have a free trade agreement (FTA) where each country can set it's external tariff separately.  So for example there are countries in Europe that are members of the single market, but not of the customs union ( - Norway and Iceland for example), and countries that are members of the customs union but not of the single market ( - Turkey, Andorra and the Isle of Man).

So how do PM May's "customs agreements" fit into this framework?  I had actually never heard the expression before PM May's talk, so what might it mean?  Remember that PM May has stated that she would like a free trade agreement (FTA) with the EU, which then suggests no CET, so my interpretation of a "customs agreement" is that for trade in certain sectors, the UK would agree to use the EU's CET.  In other words this opens up a "sector by sector" negotiation.  But are these two concepts (FTA and a CET in certain sectors) compatible?

My answer to this question depends on who you are.  I think to the UK, these two concepts are completely compatible, as they just see trade in goods and services continuing as before, except with certain sectors having to have tariffs the same as the EU's tariff levels to ensure that no "trade deflection" occurs ( - companies trading through the UK because for example it has a lower external tariff than other countries).  But to the EU this is not compatible, as the customs union is just not the same as an FTA to the EU, because with FTAs there has to be a geographical distance there (or internal value added thresholds) to permit different external tariff rates.  So for example the EU now is moving towards an FTA with Canada in both goods and services, but this is in a limited number of goods and services (given how small the Canadian economy is compared to the EU's) and so differential external tariffs are not likely to cause a company to set up in Canada in order to export to the EU, or vice versa.  The same cannot be said of the UK though as it is much closer to the rest of the EU, and there is a lot more trade in goods and services between the two entities.  So I think that an FTA with the UK will not be that attractive to the EU, but they will go along with the "customs agreements".  Incidentally a useful map of all the trade agreements that the EU has with the rest of the world is shown below.
Source: HM Government - Alternatives to membership: possible models for the United Kingdom outside the European Union (Annex A) p.45, 2016.
So, the Brexit is likely to be hard, but I think that free trade will only exist with the EU in certain sectors where "customs agreement" have been negotiated.  So, this leads me to further think that the "Swiss model" is still the best model for negotiation between the EU and the UK. And here, by Swiss model I mean the structure of the negotiations, not the exact template that the Swiss have right now, as clearly the free movement of people is not something that will happen.

The Swiss model contains many of the advantages that the UK desires in its post-Brexit relationship with the EU – a bespoke series of bilateral agreements that would minimize the economic damage from Brexit, while allowing the UK and the EU the latitude to tailor these agreements to ensure that the underlying cause of the Brexit vote is honored if not entirely in substance, certainly in spirit, while also pursuing common economic and political interests.  While the "full" Swiss model will take a long time to come to fruition, in my assessment it certainly trumps the other alternatives.  

So what would a Swiss model look like if applied to the UK?  This is difficult to say, as the Swiss agreements are numerous and extensive in their coverage (see for a good summary).  Clearly there are certain bilateral agreements that the Swiss already have on the books which could be simply transferred in template directly to the UK ( - for example research, media, education, civil aviation and pensions), but there are areas of mutual interest where the UK and the EU would have to create new bespoke agreements (areas such as trade in goods, trade in financial services, FDI, and migration), and this will pose significant challenges for both sides. 

For example in migration, mutual interest might be served by instituting a NAFTA-style agreement on movement of qualified labour.  In NAFTA, a degree from a North American institution of higher education together with a job offer gets you a NAFTA visa which allows educated workers from Mexico, the US and Canada to work anywhere within the NAFTA zone.  A similar clause has also been put into the Canada-EU comprehensive economic and trade agreement (CETA), so there is precedent for this already.  Implementing a similar agreement for a bilateral agreement between the UK and the EU would allow free flow of educated workers, while still permitting the UK to institute its own rules on inward migration for unskilled workers. 

On trade, sectoral customs unions (or "customs agreements") would be negotiated for example for automobiles and other vehicles, for pharmaceuticals and for certain agricultural products.  A similar approach could be taken with financial services, with certain types of financial services (such as foreign exchange transactions, banking services and marine insurance) wrapped up in a bilateral agreement.  

The Swiss model is a compromise model, but it is a flexible model that can cater to the requirements of both the EU and the UK, and probably the biggest advantage of this model is that new areas can be added over time, so that the 2 year deadline becomes irrelevant, as the relationship is ongoing and integration becomes dynamic, rather than the static level of integration that is the hallmark of a conventional FTA.  It hopefully offers the best deal (where it exists) for each sector and common interest, so contains elements of both “hard” and “soft” Brexit strategies.  Obviously the biggest hurdles to achieving this model are the set-up costs. These will undoubtedly be significant, and some areas and sectors may end up being excluded at first, so there may also be significant “transition” costs to the eventual new arrangements for some sectors and common interests.

Tuesday, January 24, 2017

Happy New Year for 2017!

(Source: ThinkStock photos)
Happy New Year for 2017 to all my econoblog readers.  And first, one of my resolutions in 2017 will be to "blog" more, as I do enjoy it, and hopefully you all get something out of it too!  I will be honest, and say that 2016 was a hard year for some reason - more teaching than expected, deaths in the family and other issues meant that blogging was not the priority.

Hopefully that can change in 2017. And 2017 will clearly be a pivotal year for the US, as a new administration takes the reins with likely a very different course to be charted, and with likely quite different results.  As an entrepreneur, President-elect Donald Trump has largely kept his views on fiscal and monetary policy to himself, and even in the election he mostly focused on what he would do to change trade policy, which for a country like the US, with only around a 15% dependency on foreign trade, is not going to have that much of an effect.  Of course changes in trade policy will have an effect on the US's other NAFTA partners, the T-TIP and the TPP, the former likely negatively affecting Mexico and Canada, and the latter 2 now dead on arrival.  The TPP is the only new transcontinental trade agreement that could be saved, but it would not be as influential without the US being part of the agreement - on the other hand T-TIP is clearly dead.  In a way it is just as well that Canada recently signed the new CETA deal (see here), which will allow Canada to partially offset any negative impact arising from any renegotiation of what President-elect Trump has called "one of the worst trade deals the US has ever signed".  This in addition to the so-called "Thucydides Trap", where a rising power (China) begins to challenge the hegemony of the existing power (the US) would point to trade war with China, which some commentators (such as Paul Krugman (see here)) think will soon occur.  But more on this "Thucydides Trap" in a future blog.
NYE 2016 in Dubai

But what are the other effects of the tariffs that President-elect Trump has threatened (and presumably will have to go ahead with if he really stands any chance of a second term in the White House)? As any student of international economics will tell you, the first implication is that domestic prices will rise for those goods that are protected from international competition.  So these rising prices will lead to a boost in US inflation, which although not substantial, will have other effects.

To understand US domestic price pressures, we must also include the prospects for oil in our discussion here. Oil prices have been on an upward trajectory lately, and are headed for $60 per barrel based on increased demand for oil with the lower prices as well as more robust demand as we head into the final expansionary growth phase of the international business cycle. There is also a reinforcement effect going on here as well, as higher oil prices means more fracking, which means increased output and wages in the US, which further adds to price pressures.  So it is likely that US inflation pressures will finally start to build.
So unless President Trump turns out to be a complete economic disaster, which is unlikely, then US economic growth will continue to pick up, US inflation will start to accelerate and unemployment will head for 4% and "full employment".  This will lead to perhaps more Fed hikes in 2017 than some economists are expecting, and a continuation towards a normalization of monetary policy in the years ahead.

Sectors that will benefit from this are the financial and construction sectors in the US.  There are considerable uncertainties surrounding the healthcare and biotech sectors though, The financial sector will continue to do well as US banks are in much better shape than their counterparts elsewhere and will also benefit from higher interest rates, and the latter because the millennials will finally start to inherit wealth and get sufficient pay raises to afford their own properties.  More on this in a future blog I am preparing.

Let's now turn our attention to Europe.  The main problems here are i) the political and economic fallout from Brexit; ii) the continuing migration problem; and iii) continued weakness of the financial sector.  On the first problem, I have another blog coming out tomorrow on this topic, so I won't steal my own thunder, but essentially this will create uncertainty and therefore some economic and financial wobbles this year in the markets.  The interactions between the UK and EU negotiating teams on Brexit will inevitably leak and cause considerable volatility, particularly in the UK. I do not foresee other member states following the UK though, as the deal they will likely strike will be tailored specifically to the UK, and the EU will make sure that it is not attractive to other member states, to facilitate cohesion after Brexit.  On the second issue, the migrant problem: this will cause some political problems in Germany, but will also provide significant labor needed to ensure that German labor supply expansion supports economic growth, but the political backlash in both France and Germany may cause more business friendly governments to be elected in those key member states, which are the engines behind the EU, so this might actually not be a bad thing for economic growth (although it might not be so good for political cohesion).  And the third issue, that of the EU financial sector will start to be resolved in 2017 as a more concerned ECB and the EU Banking Authorities take action to ensure the capital adequacy of the European banks.
Source: IMF IFS and authors calculations

So what does all this mean for European growth and stockmarket prospects in 2017.  The chart above gives us some clues.  The chart shows that even with the 3.5% annualized rate of growth reported in the 3rd quarter in the US, the rate of growth for the US will still be below that of the EU.  But Trump's election has changed this equation completely, with the US likely to leapfrog over the EU in the 2017.  That points to outperformance for the US over the EU stockmarkets in 2017, although there still could be some bright spots in the EU, notably once again the banking sector and also the energy sector, depending on where the price of oil goes.
Source: Yahoo Finance

Let's now turn to Japan.  Despite the effots of the Abe government, the Japanese economy still in dangerously close to turning deflationary again, as can be clearly seen from the chart on GDP growth.  This is on top of the exceptional fiscal and monetary stimulus that has already been delivered under Abenomics.  The stockmarket performance of the Japanese Nikkei reflects the reflationary policies adopted since 2012, but the Nikkei is still not performing as well as the US and German stockmarkets.  This can be clearly seen in the stockmarket chart above, which sets the end of 1990 as the base year to show longer term stockmarket returns.

This stockmarket chart is informative as it indicates that in fact on returns basis the DAX (German stockmarket) has given a slightly better return than the S&P500 since 1991, which is not what I would expect, especially when taken in nominal terms. Nevertheless, the return from the stockmarket over these 26 years has been remarkable, with a 7 fold increase in stockmarket value, and this doesn't even include the total return (return including dividends).  Investment in Japan (represented by the Nikkei) has clearly not given a good return (in fact it is still negative), and this reflects Japan's "lost 2 decades" of economic growth and deflation.

So what of other economies and stockmarkets?  My own view is that China is now a riskier bet (given the prospect of a trade war with the US), and so should be avoided.  India, on the other hand, still has good prospects, although the Modi reforms appear to have stalled, which may put the brakes on the good economic growth performance (currently higher than China's) that the country has recently experienced.

For other regions, Australia and New Zealand have performed very well recently, but now appear to be running into some inflationary concerns, and Africa also still has considerable unlocked potential, but does not appear to have gotten past it's political problems quite yet.

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