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.

Source: Bloomberg.com

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.

Brexit Blues and the Economic Aftermath: "Hard", "Soft" or "Squidgy?

The Brexit referendum was a shocking experience for many of us ex-pat Brits.  But democracy has to be respected, and the UK should move as quickly as possible to start negotiations to leave the European Union (EU), regardless of what the political elite in the UK thinks.  As EU leaders have stated, the more uncertainty about the exit conditions, the more economic damage is likely to be done to both the EU and the UK. And I have said in comments on FT posts, such as the one by Gideon Rachman (see here), the idea that politicians should act against the will of the people is just unimaginable and would lead to further constitutional problems in the UK.

So in this Econoblog posting I am taking my cue from a recent article in the NYT (here) about how Brexit might not happen, to first discuss how Brexit might not happen, and then deal with various options as to how it could happen.

Option 1: Simply don't do it.
As I have stated already, I really don't think this is an option.  Why not?  Because even the EU acknowledges that a rejection means that the citizens of the UK on balance, do not want to be part of the Union.  That is why it is incredibly important that Cameron's successor is willing to trigger Article 50 of the Treaty of Lisbon, and start negotiations to leave.

Option 2: Scottish veto
Once again, this was a referendum of a country, not of specific regions.  So the UK as a whole has decided to leave the EU.  The fact that the protocol for any changes to Scotland's status needs to be approved by the Scottish Parliament are irrelevant for the proposal as a whole. If Scotland had a right to remain in the EU, then it should have been made clear in the referendum itself.  So this was not about whether individual countries voted to remain or not, as Scotland is not currently a member of the EU: the UK is, and Scotland happens to be part of the UK.  The EU leadership stated a such last week when Nicola Sturgeon, the leader of the Scottish National Party (SNP) visited Brussels.

Option 3: A do-over
OK, so over 3 million people have signed a petition, wanting to leave - but so what?  David Cameron stated very clearly before the referendum that a vote to leave would be "an irreversible process" - how much clearer could he have been?  So these fanciful notions of a do-over are just that: fanciful notions. And that is not only because there is no real reason to re-do the referendum (there were no major irregularites), and even if it was re-done, I doubt that the result would substantially change.

Option 4: An exit in name only
There are those on the "leave" side who have this fanciful notion that the UK can accept some of the EU's single market, and just leave others on the table. For example Boris Johnson stated recently that: "British people will still be able to go and work in the EU; to live; to travel; to study; to buy homes and to settle down. As the German equivalent of the CBI – the BDI – has very sensibly reminded us, there will continue to be free trade, and access to the single market.".  This has prompted the EU Council President, Donald Tusk to state categorically that “there will be no single market à la carte”, and a sentence was added to the communique from the meeting stating that “access to the single market requires acceptance of all four freedoms”, a reference to EU principles on the free movement of the factors of production, namely capital, labour, services and goods.  So option 4 is now essentially off the table as well.

So in my view, Article 50 will be triggered, and this will then require negotiations to immediately commence.  But here are my views on how the UK and the EU should approach these negotiations, from an economic standpoint.

First, the UK should immediately reach out to the European Free Trade Association (EFTA) bloc, namely Switzerland, Iceland, Norway and Liechtenstein, and start negotiations to join this trading bloc.  Now of course all of these countries have negotiated bilateral agreements with the EU, but at least it would give the UK some backing from other countries that might consider it an advantage to have a country like the UK as part of an FTA. Norway already has reservations about this option (see here), but there is no harm in the UK putting its application forward for membership as soon as possible, as this would allow some trade to flow through countries like Norway or Switzerland, both of which already have access to the EU's single market.

Second, and this is where things get complicated, the UK needs to pick a Conservative Prime Minister who was on the "remain" side in the last referendum, and for this reason alone I favour Theresa May (who was on the "remain" side) over Andrea Leadson (who was on the "leave" side). If you think about it, if you are an elite club, and one of your members wants to leave, who do you prefer to negotiate with, and who are you most likely to give concessions to?  Exactly, the individual who understands the advantages of membership, but who is in an unfortunate bind where she has to extract her country from the club.  Theresa May is much more likely to make sympathetic noises about perhaps cooperating on future EU defense missions or perhaps assisting the EU some budget contribution in exchange for some concession from the EU. From the EU, the dynamic is made much more complicated as other EU member states are now talking about having referenda to leave the EU, so the EU has an incentive to be as tough as possible without being punitive towards the UK.  The kind of negative rhetoric that has been thrown around by the "leave" side will not help to secure the UK the best deal.

Third, we need to distinguish between "soft" and "hard" Brexit (see here, for more on this) and what I call a "squidgy" Brexit.  "Hard" Brexit supporters are arguing for what is known as the "Canada Lite" model, as Canada has a free trade deal negotiated with the EU, but no automatic access to the single market for every good, and of course no free flow of labour between the two - this agreement tends to be supported by those who were part of the "leave" campaign .  On the other hand "soft" Brexit supporters are arguing for what is known as the "Norway plus" model, which would include the deal that Norway has, and therefore would include budget contributions together with the free flow of labour between the EU and Norway ( - this is what most "remain" supporters are in favour of).  Let's look at each of these separately in terms of the economics:

a.  "Hard" Brexit.  This would essentially entail being the same as any country outside the EU, with no special access to the EU, but there again the ability to completely control the flow of labor across all borders into and out of the UK.  The economic argument that this would be bad is based on the fact that the UK is already part of the single market and so this would involve erecting new tariffs and quotas on UK exports being sold into the EU and vice versa.  This would obviously raise prices in the UK and lower the amount of goods being exported, except if the pound ( - the UK's currency), depreciates by at least the amount of the tariffs that would then be in place.  So far the UK pound has depreciated by more than the 6% average of tariffs that the UK would face, so our goods and services are already more than 6% cheaper than before, so more than offsetting the negative impact of the tariffs.  Quotas are more difficult though as this is a quantity restriction - obviously here there will be some negative impact.  The impact on UK inflation could potentially be quite serious though, as imports will be more expensive, and there is the possibility that the UK might retaliate and start to levy tariffs and quotas on imports coming into the UK, making them even more expensive.  In terms of wages, many of the EU immigrants to the UK are likely to leave, which will push wages up in the UK in certain sectors leading to more expensive goods and services and some "cost-push" inflation.

b.  "Squidgy" Brexit.  This would essentially allow the UK to sign an FTA with the EU, with maybe some added clauses such as are found in NAFTA ( - free movement for qualified professionals).  The latter idea would appease the financial sector, while at the same time satisfying the spirit of the "leave" campaign's demands for less EU migration.

b.  "Soft" Brexit.  This would essentially require a new agreement with the EU, and that's what makes it "soft" in the sense that it is not a complete break with the EU.  But the question is, what kind of agreement can be made?  If the UK insists on not submitting to all the 4 freedoms, then we revert to a squidgy outcome, as the main type of agreement that existing members of the EEA have with the EU requires all 4 freedoms mentioned above to be respected.  So it remains to be seen if an "a la carte" agreement can be signed, or whether an EEA type of agreement which honors the referendum result is the outcome.  This is why who is doing the negotiating is important, and there might be something unique to address the UK situation which is possible, but it cannot be too generous otherwise it will encourage more referenda, and if it doesn't live up to expectations.

Which outcome is most likely?  If Theresa May is the PM negotiating, I would expect that a "soft" Brexit may be possible - and here I agree with Wolfgang Münchau in the FT (see here), that an EEA-minus the free flow of labour should not be expected as one of the deals offered - with membership of EFTA and EEA a possible outcome.  If Andrea Leadson becomes PM, then I would suspect that a "hard" Brexit becomes much more likely, and this will either entail the UK being a member of EFTA alone or with it's own FTA with the EU (a "squidgy" result), or outside the EU entirely (a "hard" outcome).

So in summary, there are several variables in play going forward - first, whether the UK will be accepted into EFTA if it applies, second, who is going to be doing the negotiating, both on the UK and the EU side, and third, whether what kind of "soft" Brexit deals might be considered.