How’ll Brexit work out? Assume a parachute…

As Adam Silverman points out, Brexit may have won, but they don’t seem to have done so with any idea about what is supposed to happen next. The strategy seems to have been:

  1. Campaign to get out of Europe
  2. Win vote!
  3. Freedom and democracy! All the bad parts will now go away!
  4. Ok, maybe the EU has a few good parts, but we’ll just negotiate to keep those.

This is a bit like telling your boss that you quit your job, but you’d still like to negotiate about keeping the salary and company car, and maybe a few of your more enjoyable work tasks.

I’ve not seen one person articulate a list of what those good and bad parts are, but here’s what the campaign rhetoric would seem to imply:

GOOD

  1. Access to the common market.

BAD

  1. Control of the UK’s borders.
  2. No more paying money in
  3. No more Euro red tape

 

It is taken for granted by Brexiters that the EU would sign on to this deal. They don’t seem to have done any behind-the-scenes negotiating or persuading or sounding out to confirm this. Heck, they haven’t even figured out whether they will invoke article 50 (i.e., the separation mechanism) immediately, or not for a little while, or not for a very long while, or maybe not use all all, except for waving it as some kind of bluff that would let them issue demands (“We’re giving Pilate two days to dismantle the entire apparatus of the Roman Imperialist State…”).

I have watched conservative MP’s parading across my TV set, saying with a completely straight face that of course we’d still have access to the free market because “Germany will still want to sell us cars, obviously.”

Except that isn’t obvious. At all.

Germany can sell us cars with or without the European market, our leaving will just make them a bit more expensive, because we could wind up with import duties, and more complex logistics in selling across market boundaries. WTO rules would probably set duties at a maximum of about 10%, so that would add a bit on to the cost of everything made in Europe. But then there would be extra hidden costs, because, taking the example of cars, Britain would now have its own set of regulations covering everything from how bright headlights must be, to what emissions are allowable, to how mileage is measured (i.e., my company isn’t free to claim a hundred miles per gallon for its cars by rolling them down a hill in neutral gear – rules have to be in place to force an apples-to-apples comparison for consumers).

Imagine that the UK, free from the tyranny of the EU, passed slightly different rules about fire safety standards for fabrics. Fabrics sold in the UK might now have to be manufactured as a whole separate batches than ones from the EU. That would add costs to design and manufacturing, and remove economies of scale. It would mean you couldn’t sell off any leftover Calais couches in Dover, or vice versa. It would require whole new rounds of paperwork and testing, and experts paid to track all the small differences in rules. And those extra cost will be passed along to consumers in higher sales prices.

Bottom line: Germany doesn’t have to let us into the common market to sell us cars (or anything else). Their goods will just get a bit more expensive over here, and ours will get a bit more expensive over there.

But wouldn’t they like to be able to sell stuff cheaper here? Surely that is in their interests?

Indeed they would! In fact, the EU has already agreed to let both Norway and Switzerland into the common market, without their being full members of the EU. So why not the UK too?

Because the EU didn’t let Norway and Switzerland in for free. They both have to pay a price for being given free access to the large European market. Specifically, they have to allow free movement of workers across their borders, pay into the EU pot, and follow EU regulations. In other words, they have to give up every single thing that Brexiteers imagined this vote was supposed to liberate the UK from.

Britain would almost certainly be required to pay that kind of price too – we no longer have the leverage to demand otherwise.

Statistics are a little hard to find, but it seems that of everything the newly reconfigured EU (i.e., minus the UK) exports out of its borders, about 16% of it is sold to the UK. That’s about a sixth of it – roughly the same amount as they export to the USA (who you might note, has not been granted full access to the European market). Now that’s a lot of trade, and the EU really doesn’t want to lose a chunk of it to higher cross-border prices. All else equal, they’d prefer to keep us in the market.

At the same time, though, 45% of the UK’s exports are sold to the EU. Losing some percent out of nearly half of everything we export to the entire world would make that a far more painful loss to us than it would to the EU. When you are negotiating with someone and they want what you have, but you NEED what they have, that’s a recipe for being taken to the cleaners. Especially in cases like this where all sides know exactly what the stakes are, so there’s no real room to get away with bluffing.

And it’s not like the UK is mostly exporting commodities like crude oil that can just as easily be sold to China or the USA. A disagreement over trade doesn’t mean that we can simply reroute our tankers to a different port, and unload our wares for sale there instead. The top 5 types of commodity the UK exports are mechanical appliances,  motor vehicles, pharmaceutical products, electronic equipment, and mineral fuels. Those things generally have to be built and designed for specific needs and markets and regulatory environments in specific places. You can’t take a suspension systems designed for a Skoda, and simply plug it into a Hyundai instead, just because you’re having a tiff with the EU.

So the UK is walking into a high stakes negotiation in which everyone can see that the other side holds most of the aces. But it actually gets worse from there.

Let’s game this out. The EU starts out by offering Norway’s deal: We keep access to the common market, but we are required to pay in money, allow free movement of people across the border, and follow EU regulations.

The UK’s new Brexit Prime Minister says no. Those are the exact things we demand to escape from. We’ll take anything BUT that. It’s our bright red line, put one toe over it, and we walk away.

Now the EU has to look at the various nationalist movements bubbling up in France and the Netherlands and some of its other countries, and realize that there are a whole lot of angry people looking to try to win over their countrymen that leaving is painless, and let’s you keep all the good stuff. If the UK is seen to get a sweetheart deal, then that enables these people to start a rush for the exits. Countries, big and small, would start flooding out of the EU. Why buy the cow if you can get the milk for free, as the old saying goes. If the EU wants to survive (and it does), then it needs to make an example out of the UK, giving us the ugliest possible deal, in order to send a message to its other malcontents who have been conspicuously eyeing the doors.

Bottom line, the EU could not offer the deal that pro-Brexit MP’s seem to imagine is there for the taking. Not even if they wanted to. The UK doesn’t have the leverage to demand any better, and the EU has a gun to their head that prevents them from offering any better.

If you look at what they are saying, the EU politicians clearly know all of this. Analysts on the sidelines can see all of this. The only people who don’t seem to have taken the time to work it out are the ones who have just won a referendum. They’ve fought for, and won, a mandate for a plan that they haven’t bothered to think through, and are now noisily demanding control of the driving seat in the UK Conservative party so they can be the ones to implement it… at some point in the future, maybe, somehow, and please stop hassling them for details. The details aren’t important. Winning is. And Britain, ra ra, and FREEDOM!

There’s an old joke about economists who “assume a can opener”. This appears to be a darker version, in which politicians win a referendums with the line “assume a parachute”.

Brexit wins, why is the market crashing?

We wake up this morning to Brexit winning, the pound dropping like a stone, and UK bank stocks losing a lot of value. One Tory MP appeared on BBC News explaining that these are Remain’s “scare tactics” turning into reality. Norman Tebbit was there to say that no, this little crash is just the result of the Leave side scaring gullible markets into believing that terrible things will happen, even though they won’t really, because France will still want to buy cars off us (his exact example).

With all due respect to Mr. Tebbit, while stock and currency markets are certainly capable of some pretty irrational hijinks, this really isn’t one of them.

The problem was never that Brexit would mean we never sell a single pencil south of the channel again. Nobody ever claimed that the EU was the only thing physically holding the British Isles above the grey North Atlantic waves.

But imagine that you are a successful, let’s say Italian, company. Things are going so well that you want to open up a UK headquarters. That’s great news for the Britain, because it means you’re guying to hire a lot of locals to work in the offices, do local sales, manage the local HR, wipe and vacuum it at night, supply food to the cafeteria, etc. Those people will all get paid, then take their wages to the local supermarket, pay rent, buy houses, pay taxes, etc. So it provides jobs and income for a whole lot of Brits beyond even the ones who are directly hired. As I say, good news.

But when you open an operation like this, there are lots of potentially expensive things you have to worry about. You have to pay your lawyers to make sure that you comply with all the local labour and business practice laws. You have to pay accountants to make sure that you are complying with all the local rules about how you spend and account for your money. This is the kind of boring, tedious, invisible but necessary legwork that goes into running big operations.

If Britain is part of the EU, then those regulations and laws are pretty much the same here as they are in Milan, Rome, Frankfurt, or Madrid. Opening a new regional headquarters in Birmingham or Manchester is easy, then. You don’t even need visas for any workers you move over – they just show up, follow all the normal rules (for the most part), and get on with it.

But if Britain is not in the EU, then it’s going to have its own regulations that will be different from the EU ones. That means that you need to hire a whole new set of local lawyers and accountants, and spend time training your managers on the different rules. It means you need to worry about work visas for employees. And that all costs money. Quite a lot of money. Enough that you might want to take a serious look at putting your headquarters in Ireland or Northern France or somewhere else nearby instead. Which means the jobs and the income all go somewhere else, and Britain loses out.

It’s a similar problem if you are an American or Japanese company deciding where to set up local shop. GB isn’t has an economy the size of California, so it’s got plenty of people with money to sell stuff to. But even without Britain, the EU has an economy the size of almost the entire USA (including California). That’s a much bigger and richer market. So if you are deciding which side of the fence to put your HQ on – which side you want to pick to be easy to operate in, and which side to take on the extra border hassles of working over – all else equal, you’re probably looking for the place with the biggest market potential. Out of the available choices, Sheffield just got a lot less likely.

This is an example of the ways an independent Britain loses out economically (there are others too).

Now you might ask what that has to do with bank stocks and pound sterling crashing. After all, nobody has yet taken a single one of these business decisions, so why be so dramatic? Is this just silliness from crazy investors scared by the Remain campaign’s over-hyped rhetoric?

Well, possibly, but the thing about these trading markets is that the prices they pay for things have a lot of expectations for future success already baked into them. When I buy stock in Lloyd’s bank, it’s not because I necessarily think they are making lots of money now (Amazon sold stock for very high prices when it first opened, despite losing money hand over fist at the time). It’s because I think that they are going to keep on making lots of money into the future, and so they will be able to pay me dividends, or their stock will become even more popular, letting me sell mine for a profit (which is what happened with Amazon – they lost money initially because they were investing so much of it in growing their business – if you bought the stock then, and still own it now, then you are reaping the payoff you invested in). If I suddenly realize that LLoyd’s or RSB’s future looks a lot less rosy than it used to, then all of a sudden the price I’m willing to pay drops, because I’m not expecting to get nearly so much future reward out of them.

That’s exactly why the pound and bank stocks crashed this morning. The people who have staked their own cash in Britain’s future prosperity believe that yesterday’s big decisions means there’s going to be less of that prosperity coming down the road than there used to be, and so they are not putting nearly so much of their cash on the line for it any more.

None of which means that Britain’s economy is over – it will still go on, there are still 60 million customers on this island who buy things, there are still companies here who will sell products and services. Britain will continue to sell car components abroad (though probably fewer of them if we get new border tariffs – which are entirely now possible, depending on the outcome of negotiations that Britain won’t necessarily have a ton of leverage for). But the markets are now suddenly seeing a whole bunch less potential here than they did yesterday. They are now expecting less jobs and less revenue, which means less tax revenue that will support fewer government programs, and so on. In other words, Britain’s prosperity is likely to take a hit.

That’s not scare tactics anymore, it’s our immediate future.