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).

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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 http://www.europarl.europa.eu/meetdocs/2009_2014/documents/deea/dv/2203_07/2203_07en.pdf) 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.