The Daily Update - Brexit and Bruegel

It is now close to ten weeks since the vote for Brexit. Interestingly, the economy is holding up better than the doomsday scenarios projected, in the short-term at least. The August manufacturing PMI showed one of the strongest monthly gains in 25 years rising 5.1 points to a reading of 53.5; this suggests UK manufacturing has benefited from the fall in sterling since the vote on June 23. The recent house price data has also proven robust so far rising 5.6% yoy in August, although we note the more bearish will point to a weakening in mortgage approvals. All this has given sterling a bit of a reprieve but it is still trading over 10% weaker against the US dollar and over 9.5% weaker against the euro. Whether this better than expected growth scenario is sustainable is still up for debate as the impact on investment is still an unknown. But with a strong legal framework and a skilled workforce investment may be more resilient than is feared, particularly as the UK Treasury seems to favour cutting taxes: Apple’s €13bn EU fine for tax avoidance suggests Europe is moving in the opposite direction.

What form ‘Brexit means Brexit’ will eventually takes remains unclear. The negotiation is going to be complicated with the potential for fireworks along the way on concerns about Britain wanting to ‘cherry pick’ terms and issues such as the UK cutting corporate tax. In March 2016 George Osborne legislated to lower corporation tax to 17% by 2020 and then post the referendum said is should be further lowered, and the new Chancellor Philip Hammond is expected to clarify the strategy towards the end of the year.

The Bruegel Institute, a highly regarded economic think tank, released a report on 29 August, written by Jean Pisani Ferry et al. in which they suggest that none of the existing arrangements are likely to work for the UK and recommend thinking along the lines of a continental partnership: ‘a new proposal for the EU-UK relationship that is considerably less deep than EU membership but rather closer than a simple free-trade agreement.’ This could provide a possible basis for relationships with other countries giving Europe a supranational euro core area and an outer circle with a structured intergovernmental partnership. They argue ‘Without a common vision of their shared future over the longer term, the UK and the EU risk being dragged into unprincipled bargaining and, albeit in slow motion, weakening their positions in the wider world.’

Given the geographical proximity and that Britain has already been part of the EU since 1973 there is already a high degree of interconnection and communality of interests. The Bruegel paper argues that Europe is a supranational political project but the UK has clearly rejected this vision and one of the principal elements: the freedom of movement. They see the best way forward is to create a framework for close cooperation but also one that has some limits on labour mobility under the creation of a ‘Continental Partnership’ (CP). It aims to keep functional integration in the sense of a deeply integrated market with an absence of tariffs, common rules and standards, common enforcement and competition in conjunction with common budget contributions. They also envisage ‘close cooperation on foreign policy, security and possibly, defence matters.’ This falls short of the economic-political constitution under the Treaty of Rome with the four freedoms; in this case allowing only limited ‘temporary labour mobility’ rather than completely free movement. They suggest a workable structure as one where there is a CP council to input, negotiate and discuss draft regulation and policies but lawmaking would still run through the EU channels: in effect ‘a political – not legal – commitment by EU member states to take into account the positions and deliberations in the CP council.’

Under this arrangement the UK could still access the market and limit immigration but would pay the price of less political influence and contributing to the budget in return for market access. For the EU this relationship could create a more effective model using the community method and at the same time increasing political stability and legitimacy. It could could be used for membership beyond the UK; for example, it could be applied to Turkey in the future where the Bruegel paper notes ‘Arguably, one of the reasons why some EU member states would never accept Turkey joining the EU is free movement.’

In the aftermath of Brexit this sort of arrangement may at first seem inconceivable but the situation is a bit of a prisoner’s dilemma in that both parties stand to lose by taking a hard-line approach.