When the money tap went dry…
Across Europe, and particularly in the 18-member Eurozone, the economic news is sobering. It’s now clear that the credit crunch in emerging markets which has played out over most of this year, plus the slowdown in China, are having negative consequences in Europe. Yet, despite the ongoing trauma of Brexit, the UK is cruising along relatively smoothly – for now.
A number of critical events are about to coincide. Firstly, the ECB will cease printing money by means of quantitative easing (QE) in December. The principal measure of the money supply across Europe, M3, was growing by around 5 percent per year when the ECB was buying up to €80 billion of bonds a month in 2013. That rate slowed to 2.1 percent in Q3 this year and will prospectively fall to zero in Q1 2019.
QE was instigated by ECB President Mario Draghi who took over the reins on 1st November 2011. At the beginning of 2012, at the height of the European Sovereign Debt Crisis, he pledged that the ECB would do everything it takes to save the Euro. First came a programme of soft loans to Eurozone banks (the so-called LRTO); then came a massive programme of government and then corporate bond-buying following the example set by America’s Federal Reserve in the aftermath of the financial crisis of 2008.
The ECB’s programme of QE was always opposed by the Germans who tend to have an instinctive animus against inflationary economic policy. This derives from the Germans’ historic memory of the cataclysmic episode of hyper-inflation which took place in the Weimar Republic over 1921-23. At root, there is a cultural dichotomy here. Northern (Protestant) European countries believe in sound money; while Southern (Catholic) countries favour monetary stimulus as a policy tool. As a result, QE was always supposed to be a temporary measure, indeed a compromise. In late 2019 Signor Draghi’s term of office as President of the ECB will expire and the powers that be are already looking for his successor. This will pitch German monetary conservatives against the rest.
Then there is a second shock about to arrive, namely Brexit, scheduled for 29th March 2019. As I write it seems very unlikely that the May-Barnier Withdrawal Agreement will be approved by the House of Commons when it comes to the vote on 11th December (see below). The Europeans have already said that there is no room for any form of renegotiation. Therefore, a no-deal Brexit is looking more than 50 percent probable.
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While that would be a huge shock for the UK economy as supply chains freeze (at least for a few weeks until manufacturers work out how to trade with the EU under WTO rules), it would also be a massive shock to the EU economy. Remember that something like 20 percent of all German cars produced are shipped directly to the UK. Threats to shut down air links (Ryanair’s Mr O’Leary seems, happily, to have fallen silent of late), and of closing cross-channel ports in Europe would prove a double-edged sword. The European Commission’s Eurozone growth forecast for 2019 of 2.1 percent now looks highly implausible.
Thirdly, the spat between Brussel and Rome over the Italian government is about to bubble over into a major crisis. The North-South rift over economic policy is now rivalled by the West-East culture war. This is manifesting itself with increasing acrimony over the handling of the refugee crisis. Right across the EU, movements which are hostile to immigration are gaining electoral ground, picking up votes from the unemployed young, blue collar workers and skilled tradesmen. European citizens are shifting to the right – much to the chagrin of liberal Europhiles like Emmanuel Macron. The Guardian recently published a report which suggested that one in four European voters has voted for a populist party in the last year or so – compared with just 7 percent in 1998.
As populism advances, both of left and right varieties (the Italian government is a coalition of both types) so animosity towards the EU elite intensifies.
The German IHS Markit manufacturing index fell to 50.2 in November. The Germans have not been as short of confidence about their future since the end-game of the European sovereign debt crisis in 2013. Orders for German exports have fallen to a six-year low.
Destatis, Germany’s version of the UK’s Office for National Statistics, confirmed on 23th November that Germany’s economy contracted by 0.2 percent in Q3 2018. It partially blamed disruption in the all-powerful German automotive industry as a result of new vehicle test standards at a time when Volkswagen Group (ETR:VOW) lurches from one scandal to another. The German manufacturing sector has been hit by falling sales in China, Italy and Turkey. That trend is likely to continue in 2019.
Italia: la figlia che piange
Italy’s economic growth sputtered to a halt in Q3. The ECB’s Chief Economist, Peter Praet, warned that the country is moving towards financial crisis. Italian government 10-year bonds are yielding 3.2 percent this morning – while equivalent German Bunds are yielding 0.34 percent. Italy’s banks are becoming unable to refinance their outstanding bond issues in the current market with the result that they are curtailing lending at a moment when the economy is already pitching downwards. Mortgage rates have been rising markedly – and this is having an immediate impact on disposable incomes.
There is unlikely to be any reprieve for Italian lenders at the next ECB annual meeting in December. Rome is blaming the ECB for pushing its bond yields higher. Economist Lorenzo Bini-Smaghi (an ex-ECB board member) claims that Italy is already in recession. Real GDP per capita in Italy is no higher than it was 20 years ago.
La France: la vie en grise
French manufacturing data in November was sobering. France has been beset by mass protests and demonstrations of various kinds – all opposed to President Macron’s economic policies which, despite his socialist pedigree, appear to benefit only the rich. His liberal metropolitan liberal credentials have been reinforced by some of his social initiatives but he is increasingly perceived as a globalist – both within and outside France. The opinion polls suggest that he is now the most unpopular French president ever.
Ireland: Irish eyes unsmiling
In late November the EU bailout team of inspectors turned up in Dublin with their clipboards and officious manners. They told their hosts that they were in danger of overheating. They warned that a Brexit shock could upset the country’s fragile banking system.
In 2010, readers will recall, Ireland was obliged to accept a bailout of €85 billion from the troika (the EU, the ECB and the IMF). That was supplemented with bilateral loans from Denmark, Sweden and the UK. The Irish economy fell by 11 percent and haemorrhaged 300,000 jobs. While the economy has recovered since then, much of the uplift is on the back of a few multinational corporations (principally Apple (NASDAQ:AAPL)) domiciling themselves in Ireland on account of its favourable corporation tax regime. This had the effect of inflating the country’s growth rate (and thus the Eurozone’s overall) artificially.
About 10 percent of Irish mortgagees are still in negative equity – though few people are likely to lose their homes as a result of Ireland’s liberal foreclosure rules (unlike in Spain). Overall, Ireland’s banks have a ratio of 9.2 percent of non-performing loans.
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Ireland is heavily exposed to any negative fallout from Brexit. Ireland sends 15 percent of its exports to the UK and the UK accounts for 25 percent of Irish imports. However, Brexit, in my view, is not the single biggest threat to the Irish economy. Rather, that is manifested by President Macron’s plans to harmonise business taxes across the Eurozone.
Currently, Ireland offers multinationals like Apple the so called Double Irish tax break. This loophole allows Apple et al to vest their intellectual property rights into an offshore jurisdiction (Panama – whatever) and then license that technology to a company based in Ireland. (Starbucks does something similar in the Netherlands). Such entities are subject to offshore taxation but the US government regards them as Irish companies. Soon, our Irish friends will have the European Commission and the US Internal Revenue Service after them at the same time.
Monsieur Macron’s big idea
A “true” currency union – like that which obtains across the 50 states of the USA – is supported by the tacit promise of fiscal transfers between relatively rich states (California) to relatively poor ones (Missouri). The Germans, despite having benefitted most from the single currency, have never been keen on that idea. Recently the French Finance Minister, Bruno Le Maire, has said that the Euro is dangerously vulnerable to a downturn without new institutions – but the Germans are not listening.
In his early days in office President Macron had a grand plan to transform the architecture of the Eurozone. The Germans were never quite so keen: Frau Merkel seemed to withdraw from European affairs the German elections of September 2017 until the coalition of March this year. Since then she has been in retreat – and is now officially on her way out.
In June this year in Meseberg (Saxony-Anhalt) the French and the Germans agreed “to explore” the creation of a Eurozone budget presided over by a European Finance Minister, and to continue with the next phase of the banking union (whereby all retail bank deposits are underwritten by Eurozone governments). The future Eurozone budget would be funded by a common tax which would be approved by an elected assembly in which each country would be represented in proportion to its fiscal contribution.
Net transfers from one state to another would be used to stabilise Eurozone economies during downturns. So that, if governments were required to cut spending in times of austerity (Greece comes to mind) these transfers would be used to mitigate the social impact of such cuts. For citizens to benefit from this pan-European social insurance system, their national governments would be obliged to subject their budgets to supervision by the European Finance Minister.
This scheme would effectively replace the Stability and Growth Pact (SGP – enacted in July 1998 and reformed in 2005) which determined that national budget deficits of Eurozone states may not exceed three percent of GDP. It also stated that total national debt should not exceed 60 percent of GDP: a provision that was never observed.
Five months after the Meseberg declaration, however, the EU published on 19th November what amounted to little more than a footnote to the existing EU budget. There was no mention of any cross-border social insurance. No new pan-European institutions are in the offing.
President Macron has said that his social insurance scheme would have to amount to “a few percent” of Eurozone GDP to have a meaningful impact. By comparison, the US Federal budget is worth around 20 percent of US GDP and Germany’s federal budget accounts for 11 percent of its GDP. One reason for the German’s reluctance to commit to this scheme is that they envisage major problems in the next EU budget cycle given the loss of British contributions after Brexit. The French president must be hoping that the next German Chancellor will be more amenable – but that is by no means guaranteed.
On Wednesday (28th November) German finance minister Olof Scholz demanded that France’s permanent seat on the United Nations Security Council should be ceded to the post-Brexit EU-27. The French response was, shall we say, unenthusiastic.
The Germans did just enough in 2012 to save the Euro from an existential crisis. But they have done nothing at all to address the fundamental issue: that Germany (plus the Netherlands) generates huge recurring trade surpluses whereas most of the other Eurozone members run perpetual trade deficits. Instead they imposed a regime of internal devaluations on the deficit nations of the south.
During the European Sovereign Debt Crisis (2010-12) the debt-to-GDP ratios of all Eurozone states were much lower than they are now. Spain’s is up from 36 percent to 98 percent; Portugal’s from 69 percent to 125 percent; France’s from 65 percent to 99 percent; and Italy’s from 103 percent to 133 percent. But there would be deep resistance to any new round of austerity – so future spending cuts are politically impossible. Furthermore, there will be little scope next time for alleviative monetary policy. The ECB interbank rate is already minus 0.4 percent – how much lower can it go?
Any future Eurozone recession would inevitably result in sovereign defaults – Italy in the vanguard. Add to that the prospect of a no-deal Brexit. If the French close the port of Calais then how will the Germans deliver the 750,000 cars they sell in Britain each year? The Daily Telegraph’s Ambrose Evans-Pritchard is now talking about MAD – mutually assured depression[i].
Economists should know better
As I have been writing this both the Treasury and the Bank of England have come up for air with forecasts which predict dire economic outcomes for (a) Brexit in general, and (b) a no-deal Brexit in particular. These have been regurgitated persistently by the BBC.
I’m not going to dissect these studies here. Suffice to say that the OBR cannot even accurately project next year’s growth figure – so how can the Treasury possibly claim to know the size of our GDP in 15 years’ time? Especially when they assume that the make-up of our exports in future will remain much as it is today. (UK exports to Europe as a percentage of GDP have been falling long-term – see my piece last week).
As for the BoE’s catastrophe movie – featuring an immediate eight percent crash in GDP – we have heard all of this before – it was recycled from a similar study last year but sexed-up for our febrile time. Very soon, I shall share exactly the sequence of events that would play out in the event of a Crash Brexit on 29th March 2019. It’s scary – but the downside is largely a function of the confidence with which people expect to swim from one side of the river to the other.
On Thursday evening (29th November) I learnt that a UK fund investing in UK energy projects has reached a momentous decision. In the light of Mr Carney’s talking down the pound, they have determined that their entire £250 million 2019 plant and equipment budget be sourced from British manufacturers to avoid potential FX risk…Surely Mr Carney deserves a gong for that alone.
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Albion perfide: Should we swallow the poison?
Having held back on definitive judgment of the May-Barnier deal, I have had the opportunity to make a forensic analysis. It is much worse than even I thought.
The EU exports £95 billion more goods to the UK than it imports, facilitated by the zero tariff regime within the Customs Union/Single Market. It was a priority for the EU to maintain this. And this is exactly what the May-Barnier deal gives them: continuity throughout the transition period and then further to any putative deal (which the Political Declaration states will “build on the single customs territory provided for in the Withdrawal Agreement”). The deal binds us to existing and future EU law on state aid and competition.
If no trade deal has been agreed by the end of the (extendable) transition period, trading arrangements will default to the backstop (which sets in stone the Customs Union with zero-tariff trade via a Single Customs Territory), until such time as the EU agrees with the UK to modify such a regime – or agrees that it can be abandoned. Except that there is zero incentive for the EU to do so. So we would most likely remain trapped.
Even if the UK were to escape the cage of the Customs Union it could sign as many free trade agreements with non-EU countries as it likes but it would be prohibited from bringing into force tariffs that are lower than prevailing EU tariffs. Disingenuously, the PM and her supporters claim that we will be able to conclude free trade agreements (FTAs) as if this is a triumph. But she fails to mention that any such FTAs will remain vacuous until such time as the EU agrees otherwise.
Even worse, the deal is designed such that the EU can steal as much services business from us as they can. The EU buys £28 billion more services from the UK than it sells to the UK. The May-Barnier deal appears to allow the status quo to continue across the transition period. However, at the end of the transition period (extended or not), free trade in services will terminate unless the EU and the UK have agreed a new arrangement on goods.
There is not even a backstop arrangement with services as there is with goods. This creates massive uncertainty across the services sector throughout the transition period, the most likely outcome being that service providers will decide to relocate service provision to EU countries (mostly France, I’ll wager) in order to preserve continuity. This is little more than a land grab for our services sector.
The EU wants the UK to continue to make a major contribution to European security – in fact to join Monsieur Macron’s European Army. Of course, the UK is far and away the major military power in Europe – with France in second place. But continuity of security finds its way into the legally binding Withdrawal Agreement – with the divorce bill of £39 billion as a condition of implementation.
Everything that is really important to the UK such as preservation of the services sector, expansion of international trade in goods not to mention the future of the fishing industry and Gibraltar is relegated to the non-binding Political Declaration with no guarantees and no certainty.
Worse, we cannot even extricate ourselves from this mess without the EU’s consent. Any negotiating leverage we might have had such as continued security cooperation or a payment to ease the divorce (whether justified or not) has been given away in the Withdrawal Agreement. The longer we are tied to the potentially open-ended backstop, the greater the erosion of our services sector with no gain on trade in goods. This is a treaty one would expect to see imposed on a small nation conclusively defeated in war.
MPs who vote in favour of this despicable deal in the House of Commons on 11th December will be largely acting out of desperation, so keen are they to end the Brexit nightmare (as they see it – though it will continue) they will vote for anything. Labour will oppose it in the delicious conceit that they could come back from Brussels with a “better” deal. In so doing, they will bring about the no-deal outcome that they supposedly most fear. Actually, they want chaos, as they know that that is their only chance of seizing power.
Mrs May is a fine human being: but she has led the nation into a trap. It is a pity that she allowed herself to be captured by the Remainer deep state after the election (a catastrophe that was of her own making). Before that, she had shown great promise. But she has not just been bloody-minded, but economical with the truth. First, she changed the Lancaster House agenda without admitting it publicly. Then she concocted the Chequers mess which was discreetly jettisoned behind the scenes – also without consultation.
In my view the whole Brexit debate is no longer about what is good for our economy – Remain or Leave? It is about whether the process of European integration is reversible or not. Just as the American Civil War (1861-65) was not in fact about slavery at all but about whether states had the right to secede from the Union. It is when economics becomes secondary to higher-order goals that things can turn very nasty.
It is now very likely that a disorderly Brexit will be the spark that sets the Eurozone tinderbox aflame in the first half of 2019. Mariners of a nervous disposition may prefer to get below deck.
[i] See: If we reject Barnier’s Brexit we could hurl all Europe into existential crisis, Daily Telegraph, 15th November 2018.