We’re Headed for a Brexit Crashout

We’re on a path to the worst sort of Brexit: no plan, no transition period, and a U.K. financial crisis for which we’re totally unprepared.

Worried by gyrating stock markets? Spooked by the ten year anniversary of Lehman’s collapse? Time to stop fixating on emerging economies like Turkey, or Trump’s trade wars hurting global growth, and turn your focus to the U.K. — which is even now, after last week’s summit, on a path to the worst sort of Brexit, a disorderly “no deal” in which the U.K. leaves the European Union with no agreement at all on March 29. That means no plan and no disruption-reducing transition period — which in turn means chaos at U.K. and E.U. ports, food and medication shortages, and, if we’re unlucky, an eventual U.K. financial crisis for which we’re extremely unprepared. And there isn’t a scenario that has a decent chance of changing that trajectory.

Brexit was always going to be a messy divorce, but there are better and worse settlements. Best would be an agreement with a transition period, which would hit the pause button on the U.K.’s departure from the E.U., while allowing it to negotiate new treaties with other countries like the U.S. and South Korea. This would amount to a two-stage exit, allowing the U.K more time to untangle itself from the E.U. and both sides more runway to adapt to a U.K outside the so-called Single Market of borderless trade.

But with five months before the Brexit deadline, the “best-case” version of Brexit seems far away indeed, and none of the recent attempts to salvage it have succeeded. In September, the E.U. let U.K. Prime Minister Theresa May pitch her so-called Chequers plan to the national leaders at an informal session at Salzburg, but the plan — named for the site where her ministers agreed to it in July — was dead on arrival, because it crossed clearly and repeatedly stated E.U. red lines.

A mid-October European Council meeting, where heads of member states convene, was then set as a make-or-break moment for Brexit. A flurry of negotiations before the summit came to naught; May rejected draft terms the E.U. negotiators thought had been settled. She gave a short speech before a Wednesday dinner but had no ideas on how to resolve the most stubborn sticking point, how to handle the Irish border.

And then the Council decided not to proceed with a possible November special session, penciled in earlier in case the U.K. and E.U. were on the road to an agreement. They’re not.

The European side tried to put the best face possible on the breakdown in talks, pointing to the goodwill on both sides. Later reports suggest the mood among officials was sober, as they are helpless to solve the fact that there is no consensus in May’s ruling coalition or across parties in Parliament on what sort of Brexit the U.K. should have. And the one change in position that May voiced in her talk — that the U.K. might consider a longer transition period — demonstrated how hard it will be to settle the open questions: May came home to a firestorm of criticism as every faction of the Tories and her coalition partner, the Democratic Unionist Party (DUP) called for her head, and important Labour MPs also savaged the proposal. With no meeting in November, unless something radical changes, the U.K. is now committed to the default option: a Brexit with no deal whatsoever — and no desperately needed transition period.

What are the impediments? Theresa May claimed in Parliament this week that 95 percent of the Final Withdrawal Agreement has been completed. Items like a financial settlement (the so-called “Brexit bill”), the rights of E.U. and U.K. citizens, and even the once-heated issue of Gibraltar have been sorted out. But just as it’s possible to drown in six inches of water, the intractable 5 percent is enough to produce an impasse.

One sticking point is the fate of what the Irish call the British border in Ireland, and the U.K calls “Irish border.” Since the Good Friday Agreement, which explicitly referred to the U.K. and Ireland’s partnership within the E.U., this border has been entirely open. Numerous businesses operate across the border, with thousands of people transiting daily for work; cows, sheep, and pigs cross multiple times between farms and processing plants, all under the E.U. regulatory framework.

In what may have been a mistake, the E.U. let the U.K. miss a December 2017 deadline for settling the question of the Irish border by committing the Brits to a “backstop” of what is colloquially called a “sea border.” In greatly simplified terms, that means border checks take place in ports. Many observers had assumed May would eventually swallow that option, since the high-tech alternative border-control solutions the U.K. had been promisingwere vaporware. However, the backstop effectively put Northern Ireland under E.U., rather than U.K, rules for trade-related matters. The hard Brexit wing of the Tories, and especially their coalition partners in the Northern Irish DUP, see that as ceding control of the region to the E.U. and an unacceptable loss of U.K. sovereignty. May repudiated the backstop, closing off any path forward on a border agreement. No border agreement, no transition period: Crashout Brexit, here we come.

Another sticking point concerns the “future relationship” between the E.U. and the U.K., which the thin text of Article 50 — the piece of the E.U. treaty that gives member states guidelines on withdrawing from the union — says the Withdrawal Agreement must acknowledge. After Salzburg, the E.U. suggested settling on extremely fuzzy language, but many U.K. MPs insist that U.K. and E.U. need to settle on a general framework, both to reduce economic uncertainty and to reach an understanding when the U.K. arguably has more bargaining leverage.

The problem here is the same fundamental problem across the board: The U.K. has been unwilling to accept that a divorce is a divorce. The E.U. has patiently and repeatedly pointed out that any U.K. agreement needs to fall within the parameters that the E.U. has with other countries outside the E.U. The government has refused to hear the E.U.’s message and has insisted that it must have a “bespoke,” “special,” and close relationship due to its obvious importance. In fact, the U.K.’s red lines mean the only arrangement possible is like the one the E.U. recently concluded with Canada, as in a not-special free trade agreement that took seven years to negotiate and another year to achieve provisional approval.

Now, in theory, the U.K. could back out of Brexit. The E.U. has said it would welcome that, even though it would have to get unanimous approval of all members. And it might not even take E.U. consent to abandon Brexit. A case before the European Court of Justice contends that the U.K. could just rescind its notice.

But despite the large weekend demonstrations for a new “people’s vote,” there isn’t enough time to complete a referendum before the Brexit drop-dead date. Any corners-cutting would be contested in court by the hard-core Brexit faction. Admittedly, chief negotiator Michel Barnier has said the E.U. would delay the Brexit date in the event of a referendum, but this would be procedurally messy, since it isn’t contemplated in Article 50. Even if the U.K. won a deferral, that extension would likely come out of the eighteen-month transition period, since its end date was set to prevent the U.K. from messing up E.U. budget cycles.

What about turfing out the Tories via a new general election? Even moderate Tories loathe the idea of Labour in power, particularly one led by the unabashed socialist Jeremy Corbyn. And Corbyn also supports Brexit, and his six-point plan has elements that are just as unacceptable to the E.U. as Chequers.

Perhaps the biggest problem, however, is the shambolic U.K. approach to Brexit. There seems fundamentally to be a lack of comprehension across U.K. elites on basic issues of what it means to be in the Single Market. That is: you need to accept the E.U.’s rules, and its full regulatory apparatus, which includes the jurisdiction of the much-maligned European Court of Justice. It’s as if the E.U. is dealing with someone who is buying a house and wants a renovation, and keeps proposing knocking out load-bearing walls, and keeps insisting on layouts that remove those walls even after being told why that can’t work.

Theresa May sent the Article 50 notice without the foggiest idea of where she wanted to go, let alone how to get there. The U.K. negotiators have refused to come to grips with the fact that the E.U. is governed by treaties that it cannot waive to accommodate any single member. The U.K. pattern during the Brexit talks, of delivering napkin-doodle-level proposals late in the game and then taking affront at predictable E.U. rejections, squandered precious time. May welshed on a settled deal point, the Irish backstop, and has more recently threatened to put another supposedly concluded item, the so-called exit tab, back in play. You can’t negotiate with counterparties who keep reneging.

So what are we left with? For starters, a crashout has high odds of precipitating a sterling crisis. The pound would plunge in value, greatly increasing the cost of imports. In response, the Bank of England would try, unsuccessfully, to defend the pound by increasing interest rates. Meanwhile, individual firms or banks could wrong-foot their sterling bets, default on obligations and hurt other firms too, precipitating a banking crisis, which, given the interconnectedness of the big end of banking and the fragile condition of too many European banks, is not likely to be contained.

In contrast with the financial crisis, the U.K. and to a lesser degree the E.U. and the rest of the world would also suffer real economy dislocations — starting at 11 p.m. on March 29, 2019: Gridlocked major ports as E.U.-bound goods face a hard border, shortages of food and medicines, and restricted civilian air travel as the U.K. falls out of E.U. aviation agreements (the U.K. thinks it has a fix; the E.U. version would curtail flights). There has never been an instance of anything like the real economy dislocation you would see with a Brexit on top of the disruptive impact of the pound falling. The pound now is absolutely not pricing in a crashout. The closest thing to the effects of a disorderly Brexit would be the sudden declaration of war.

Americans are predisposed to think that there’s always a solution; the Brits have great confidence in their ability to muddle through. But sometimes the choice is between bad and worse, and, in this case, “worse” would be very bad indeed.

~Yves Smith publishes the finance and economics website Naked Capitalism.

Source: We’re Headed for a Brexit Crashout

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