Hammond’s ‘whatever it takes’ strategy for a hard Brexit

On Friday, I wrote why, unlike Bank of England Governor Mark Carney, I believe the economic threat of Brexit to the British economy is now higher. The gist of my remarks was that an actual trigger of Article 50 under hard Brexit circumstances is when we should expect any economic impact from diminished consumption and investment. Some brief comments below

Now, after I wrote this post, I had a back and forth with a prolific British economics commentator that I think helps explain the issue. He wrote me that the risks of a hard Brexit were always clear. And so he asked what my reasoning was regarding any difference now than before. I agree with his assessment about a hard Brexit, so let me clarify about the risk assessment before I talk about that.

Hard Brexit basically means no single market access, the Andrea Leadsom position on EU departure for the UK. Remember that back in July,when campaigning against Leadsom for UK Prime Minister, Theresa May was trying to have her cake and eat it too. I saw this positioning as difficult given the EU position on the single market. Here’s how I described her view in July of last year:

“With May, we will not get an invocation of Article 50 until at the earliest the end of the year, with the UK seeking immigration controls, likely from within the single market. I outlined May’s views in full last week here. This positioning is going to be problematic as the EU have already signalled to the Swiss that immigration controls on EU citizens is not compatible with the single market. And this is a warning to the UK regarding immigration, a key issue in the EU referendum.”

On the other hand, Andrea Leadsom, was talking about a hard Brexit right from the start. Here’s how I described her view in that July post:

“Leadsom’s EU views were less known by the general public because she had a lower profile pre-referendum. However, I had listened to her before the vote and know that she has no intention of keeping the UK in the single market. Moreover, she has since signalled that – because she doesn’t want single market access and wants to control immigration – she would invoke Article 50 soon after she becomes Prime Minister. The only question under Leadsom, therefore, would be financial services and the City of London’s role in Europe. Clearly, the UK would take a hit here as the EU would try to be as vindictive as possible in order to create some level of pain for leaving the EU as a way of discouraging other departures. But the EU’s lack of leverage, given Leadsom’s positioning, makes the EU’s role harder.”

Notice that this is very nearly identical to the position Theresa May has been forced into. The reality is just as my British friend said to me – a hard Brexit was always virtually certain. And as he also told me: If people are surprised, they simply weren’t paying attention.

The new Conservative government led by Theresa May has reluctantly come to this conclusion, just as Theresa May is set to release a statement on Brexit. Her Chancellor Philip Hammond has foreshadowed her speech by telling German daily “Die Welt” what the EU should expect. Here is the immigration part of how that exchange went:

Welt am Sonntag: Chancellor, will we be able to travel freely to post-Brexit Britain?

Philip Hammond: Assuming you hold a German passport  you can travel to the U.K. to do business and to travel, of course. The question is about the freedom to travel for work, the freedom to settle and the freedom to establish a business.

Welt am Sonntag: So we won’t be able to take up a job in Great Britain anymore in, say, 2020?

Hammond: We haven’t taken a firm position on exactly what nature our immigration controls will take. But we are aware that the message from the referendum is that we must control our immigration policy. So there will be a decision that the British government make about how we manage immigration from outside the U.K. We would take the decision in the interest of the U.K, but that does not mean that we would close our doors to European migrants coming to work in the U.K. We have over three million European migrants working in our economy and we have full employment. So clearly we need people to come and work in our economy to keep it functioning. Therefore, we will operate in a rational and sensible economically driven way. But we must have overall control. At the moment, we don’t have any control, not any more than Germany does.

Translation: The UK government will not agree to free movement of labor simply because immigration to Britain from within the EU was a major reason people voted to leave the EU in the Brexit referendum. The upshot of what Hammond is saying is two-fold. First, if we try to limit immigration from Poland or other eastern European countries, which are the countries where British voters have qualms, then we have to give equal treatment to other EU countries like Germany. Second, the UK government is using this as a threat – meaning you better not try and be vindictive toward us because we have leverage.

There was a second part of this interview that merits exposure because it goes to why I think Article 50 invocation is where the economic risk lies. Economists were telling us in June and July that the UK economy was headed for disaster because of Brexit. I called that motivated reasoning because it was driven by emotional trauma and not by logical conclusions. The reality then was that currency, fiscal and monetary offsets were going to prevent worst case scenarios. The currency plunged to near my predicted low of 1.20 to the US dollar and initially the 10-year gilt yield plunged to well below 1%. Mark Carney and Philip Hammond even told us they stood ready to inject stimulus if and when necessary. The result: the UK was the fastest growing economy in the G-7 in 2016.

But Article 50 is a different story. A hard Brexit – always the likely outcome – in an environment of likely acrimony between Britain and the EU, will crystallize any of the doubts people had about investment and consumption. If there is a hit to consumption and investment, it will be after Article 50 is invoked. And so the risk to the economy — now that we know a hard Brexit is coming –is greater.

Here’s how Hammond wants to deal with that risk:

Welt am Sonntag: The impression on the European continent is also that your government sees the future business model of the U.K. as being the tax haven of Europe. The government wants to introduce the lowest corporate tax rate among all industrialized countries.

Hammond: We are now objectively a European-style economy. We are on the U.S. end of the European spectrum, but we do have an open-market economy with a social model that is recognizably the European social model that is recognizably in the mainstream of European norms, not U.S. norms. And most of us who had voted Remain would like the U.K. to remain a recognizably European-style economy with European-style taxation systems, European-style regulation systems etcetera. I personally hope we will be able to remain in the mainstream of European economic and social thinking. But if we are forced to be something different, then we will have to become something different.

Welt am Sonntag: We don’t understand: Who or what would force you?

Hammond: Economic circumstances. If we have no access to the European market, if we are closed off, if Britain were to leave the European Union without an agreement on market access, then we could suffer from economic damage at least in the short-term. In this case, we could be forced to change our economic model and we will have to change our model to regain competitiveness. And you can be sure we will do whatever we have to do. The British people are not going to lie down and say, too bad, we’ve been wounded. We will change our model, and we will come back, and we will be competitively engaged.

I think we should call this a ‘Whatever it takes’ strategy. What Hammond is saying – and threatening the EU with, by the way – is that the UK will potentially incur considerable economic damage as a result of Brexit on unfavourable terms. The UK government is therefore willing to do whatever it takes to reform their economic model to deal with those adverse conditions. To me, this makes sense. The UK government has to explore all options available to them if they are to govern the economy responsibly.

But this is where we are: on the cusp of an acrimonious break of the UK from the EU with no special carve outs on the table. The potential for a scorched-earth battle to make the process as onerous as possible is definitely high. After all, if Britain’s exit path is easy, what signal would that send to the Italians? This scenario is bearish for the pound Sterling and bullish for Gilts until it is clear what economic trajectory the UK economy takes.

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