Brexit as Europe’s Lehman moment

I want to get to the Fed decision later today. But, before that, let me update you on Brexit under the rubric “Brexit as Europe’s Lehman moment”. I am thinking of it this way because many policy makers want to avoid the political and economic fallout of a no-deal Brexit, but are unable to climb down from the present policy path to do so. So, a no-deal Brexit very well could happen.

The French

Let’s start with Emmanuel Macron here. The French President wants to take over the role as standard bearer for liberal democracy from Angela Merkel. And this is particularly important for Macron given the potency of his domestic political rival Marine Le Pen, the French nationalist. As such, the French have been particularly implacable, fearing the impact of Brexit on the European election in May.

In fact, Macron may be the key obstacle to a long Brexit extension because he fears the Brexit debate would poison the progression of his vision for Europe. Macron is worried that the continuing Brexit debate will give oxygen to the agendas of nationalist in Italy and in Eastern Germany. Even in the Netherlands just yesterday, we have just seen the ruling coalition lose votes in the Senate to the eurosceptic nationalist factions.

Thierry Baudet’s Forum for Democracy party, which also backs a “Nexit” from the European Union, came from nowhere to win most votes in the provincial elections, with 93 percent of ballots counted, the NOS broadcaster said.

So, Macron, as much as he wants a smooth and easy Brexit and continued bilateral defense cooperation with the UK, is ready to cut the cord. He is willing to risk the ‘Lehman’ moment because he feels boxed into a corner by circumstances.

Theresa May

It’s hard to know what Theresa May is trying to achieve. But her stewardship of the whole Brexit process has been disastrous. Last night’s address to the nation was very much in that vein. Here’s the Telegraph on her speech:

Theresa May has been warned by furious MPs that her “incendiary and irresponsible” address to nation may have cost her the support needed to pass her deal.

As the Prime Minister heads to Brussels this morning to seek an extension of Article 50 from European leaders, she is facing a growing revolt in Westminster over her decision to blame MPs for the Brexit impasse.

On Wednesday night, Mrs May attempted to shore up public support for her deal via an address from Downing Street in which she claimed MPs had done “everything possible to avoid making a choice”.

Her speech has been interpreted as ‘Parliament versus the people’ and has drawn a furious response from a number of moderate MPs, whose support could prove the difference between her deal passing or falling.

To make matters worse, Theresa May essentially claimed last night that voters backed her plan because “you the public have had enough.” This is preposterous and delusional. As polling just yesterday indicates:

As the European Union mulls whether to grant the extension, a snap poll by YouGov indicates 61 per cent of the population would vote to remain in the EU rather than for Theresa May’s deal (39 per cent) if a referendum offering those options were called.

However, if people were asked in a public vote whether they would prefer to remain in the EU or leave with no deal in place, remain would still win, though by the smaller margin of 57-43 per cent.

May simply is unwilling to climb down. She wants MPs to vote for her deal because they feel it is favourable to no deal. So, she is forced to limit choices, to get her deal through, even though Parliament has specifically rejected the no-deal outcome.

Outcome decision tree

We’ll have to see what happens in Brussels today. But, as it stands, May will ask for a short delay to the Article 50 timetable. And that request will only be granted under the proviso that she get British MPs to back her deal first, in order to give Britain a chance to make the legal accommodations necessary for leaving the EU. Parliament is unlikely to agree to her deal on the 3rd go round, having rejected it by huge triple digit majorities. So I expect this to fail.

When her deal fails, since a short extension has been ruled out, there will be limited time to decide whether to grant the UK a long extension or to allow Britain to simply leave with no deal in place. There is the possibility that Macron or others reject a long extension simply because Brexit has sucked all the air out of the room in the EU, dominating the political agenda for months now. They want this drama to end, and may be willing to pull the ripcord to get it over.

All of this would force the British Parliament to decide whether to revoke Article 50 altogether or simply allow the UK to crash out.

Consequences

I think the consequences of no deal would be severe, perhaps more severe for the EU in the short-term than the UK. First, those countries with the largest ties to the UK would see their trade flows disrupted. This includes Ireland, the Netherlands, Germany and France. And since Europe’s structurally weak domestic economy has recently been exposed, this shock would likely be enough to cause a recession. The stability and growth pact ensures that the fiscal response to a recession would be limited and delayed.

The big threat in recession is the European banking sector, which remains weak and lacks a common deposit guarantee mechanism. In a worst case scenario, bank fragility could lead to fears of sovereign liability and default as well as bank runs. This is particularly true in Italy and regarding Deutsche Bank. The result would be a fracturing of the eurozone, with individual actors flouting the rules to shore up their economies and banking systems.  The UK, with its own fiscal and monetary sovereignty, would be better placed to react to the trauma of a clean break.

But, a no-deal outcome would create a problem regarding the Irish border as well as reignite Scottish nationalist sentiment. The real risk is that the UK fractures as a result of Brexit. I have no doubt Nicola Sturgeon would compel a second Scottish independence referendum if we see a no-deal Brexit. And in Northern Ireland, the need for no border between north and south could create a de facto border in the Irish Sea between Northern Ireland and the rest of the UK. That would play into the hands of a United Ireland campaign.

This is the train we are on now. I have been optimistic that we would eventually find a solution, but clear this meant a delay or revocation of Article 50. That has been my base case. But now, unless someone climbs down, we may well find out that our train’s end station is a no-deal Brexit cliff that ends in catastrophe for Europe, politically and economically. If you had to blame anyone for this shambles, it would be Theresa May, who may go down surpassing Neville Chamberlain as Britain’s worst Prime Minister in history.