Understand Brexit, before it blows

Understand Brexit, before it blows
  • The EU is playing with matches in a drought
  • Why Britons voted for Brexit
  • EU the loser in Brexit
  • Financial crisis in the making?

Are you mystified by Brexit? Probably less so than the Britons and Europeans stuck in the middle of it.

Nobody can agree on anything about Brexit here in Europe. Not even the basic facts.

One thing everyone agrees on, though, is the potential for a crisis.

To some, a no-deal Brexit would unleash financial and economic chaos. But they argue about whether that chaos would be in Europe or in the UK, or both.

Others argue that Europe is on the verge of a debt crisis anyway. Brexit is a threat to the European political establishment at a particularly inconvenient time. Britain is being made example of to discourage other nations from leaving the EU in the coming European crash.

Either way, understanding Brexit may be the key to unlocking the next downturn in financial markets. And based on our 2008 experience, we know how fast those can spread. Not to mention the October 2018 plunge in stocks as Italy faced off with the EU.

So let’s take a look at Brexit.

The EU is playing with matches in a drought

The story begins with what the EU was supposed to be relative to what it is becoming. When nations joined and voted for the EU, it was sold as a trade and cooperation bloc only. But as one German MEP (Member of the European Parliament) is fond of saying, the British showed up at the EU with hockey sticks to play hockey. But the rest of Europe wants to play football.

The EU today is about Europe becoming a federal state — the United States of Europe. During the Brexit referendum campaign in 2016, those who claimed this were ridiculed. Today, it is a completely mainstream fact.

Since the Brexit referendum, the façade has been dropped. The EU now openly wants to create a banking union, a military and a transfer union. Something it denied in the past.

The EU wants to become one country, for all intents and purposes. One French politician even enthusiastically called it an empire, something Brexiteer politicians were lambasted for warning about.

Here’s why all this is so important. When people argue about Brexit being good or bad, they tend to argue about different time periods.

British people see the direction the EU is moving in, and has moved in relative to what they were promised in the past, and they don’t like it. Brexit, for Brexiteers, is about what the EU will become, and its direction of change. And that implies a loss of sovereignty and the imposition of foreign rule.

Remainers want to remain in the EU as it currently stands. And they claim it won’t become what Brexiteers fear.

Why Britons voted for Brexit

Because the two groups argue about different time periods, they talk past each other.

Now, I don’t know if being ruled by UK politicians is better or worse than being ruled by EU politicians. But I do know that every attempt to unite Europe under one government has failed miserably in the past.

For good reason. The trouble with a United States of Europe is that all the different countries in Europe are deeply different. Especially Britain.

If you try and make one law apply across Europe, people in each country react differently to it. This leads to divergence in economies over time, instead of the convergence that the EU wants. And that’s exactly what’s happened.

The euro has split Europe into a prosperous and growing north, and a struggling south. The same exchange rate and monetary policy is pushing the economies apart, not together.

Applying the same laws to the Italian and German banking systems led to divergent lending practices. Huge debts in Italy and low ones in Germany. That’s why Italian banks keep failing. Because those banking systems are different, the same EU-wide government policy leads to different results.

The same applies to government debt. Apply a low interest rate to German government debt and the government will use the opportunity to pay down that debt. Apply a low interest rate to Italian government debt and the government will borrow more.

Apply the same fiscal rules and the Italians will ignore them while the Germans demand they’re enforced.

The various nations also respond to problems differently. The Germans want austerity to deal with a slowing economy. The Italians want stimulus.

In the past, the EU accounted for deep differences within the EU by allowing Britain and others to opt out of key parts of the EU project. Some nations avoided the euro. Or the Schengen Area. Or the refugee policy.

When Eastern European nations were first welcomed into the EU, only three nations accepted their workers as immigrants. The UK, Sweden and Ireland. Germany, France, Italy and others rejected the Eastern Europeans. And yet, it’s the Britons who are painted as anti-immigration today!

Each of Britain’s opt-outs from EU rules proved highly successful in the past. Always in the face of warnings to the contrary. All the arguments made against Brexit today were made against keeping the pound years ago. And yet, the euro is widely accepted to be a disaster. Even by former chief economists of the ECB and founders of the EU.

Often, the arguments against keeping the pound featured exactly the same protagonists. The same businesses warned they’d leave for the EU. That’s why nobody believes them today.

EU the loser in Brexit

When you think about Brexit, you should also keep in mind what it really means. Brexit is about deciding who makes law in the UK — the EU or the UK government. But Brexit doesn’t say anything about what that law should be. What immigration policy should be, what trade policy should be…

Consider trade policy, for example. The UK government recently floated a plan to cut all tariffs to zero to deal with Brexit. This would make Brexit pro-trade, not anti-trade, as is often claimed. It would just end discrimination in favour of the EU and treat all nations equally.

But what about all the drama playing out in the news? It sounds like Brexit is a complete disaster.

That’s mostly about the need for the UK and the EU to do some sort of deal before the UK leaves in March.

Under a no-deal Brexit, the EU would have to treat Britain as a ‘third country’. To EU enthusiasts, a world without the EU is a world where everything stops working. If you don’t have an agreement with the EU, you can’t interact with Europe at all.

Without new treaties on trade, trade will be thrown into chaos. Without treaties on travel, British tourists will need visas to go on holiday to Spain. Without new treaties on security, there would be no cooperation between policy. Without new treaties on flights, flights between the EU and the UK would be grounded, as well as flights over those airspaces.

All of this is, of course, nonsense. It is in nobody’s interest to prevent cooperation between the EU and the UK. The EU and the UK have been busy setting up waivers, deals, agreements and unilateral action on all of the issues I mentioned. The only way trade will stop is if the EU or the UK actively stop it, and the UK has ruled this out. The same goes for flights, etc.

Quite frankly, the EU has too much to lose. Britain has a trade deficit, not to mention a tourism deficit, with Europe.

The only issue the EU is digging its heels in on is the Irish border with Northern Ireland. Without a deal, the EU says it will close the border. This is especially dramatic because it violates the Good Friday Agreement, which ended sectarian violence in Ireland.

For some reason, the EU fears a land border with a former-EU country. It is especially afraid of American chicken being smuggled into the EU via Northern Ireland. And it’s willing to risk civil unrest in Ireland to stop it.

This is no joke. Here’s how the Daily Express summarised the situation:

But now high-ranking MEPs have hardened their position, insisting the single market must not be compromised even to maintain peace on the island of Ireland.

Elmar Brok, a German MEP with close ties to Angela Merkel, insisted that if Ireland failed to police its own borders the EU would have to take its own protectionist action.

“We would have to set up a customs border with Ireland,” the German said.

He also warned that if Brussels didn’t make the demands then “we will soon have American chlorine chicken in the EU”.

The premise of the standoff is ridiculous. But it’s still a very real standoff. And it creates an impossible situation.

Financial crisis in the making?

If the UK remains in the EU Customs Union but leaves the EU, the border can remain open. But the UK must adopt all EU law on traded goods. And it will no longer get a say on how that law is made, because it left the EU.

If Britain leaves the Customs Union, there must be a border with Ireland — to collect tariffs and stop American chicken. But this violates the Good Friday Agreement. And the UK government’s Irish coalition partner won’t agree to it anyway, leaving the government without a majority.

If you ask me, there’s no reason to set up such a border, even if Britain leaves without a deal. And the UK and Irish governments agree. But the EU is threatening to kick Ireland out of the EU if it doesn’t set up the border…

Here’s what has really changed since the Brexit referendum.

The EU has revealed itself to be exactly what Brexiteers warned.

Nobody argues the EU is a good idea anymore. Only that leaving it is worse.

And most important of all, the UK’s economy is doing well in the face of a looming Brexit, while Europe’s economy is increasingly in trouble.

This means the EU is throwing stones from a glass house when it plays hardball on Brexit. That’s why one of Europe’s three presidents recently said there’s ‘a special place in hell’ for Brexit’s architects.

Brexit has exposed the EU’s nature. The question is whether investors are going to hell too.

If EU politicians really do disrupt trade with Britain, it will plunge Europe further into an economic crisis.

And at that point, the risk of a financial crisis grows too.

This is why you need to have one eye on the other side of the planet over the coming weeks.

Alternatively, if Brexit is thwarted altogether, or works out well, UK markets could perform well.

Take your pick…

Until next time,

Nick Hubble Signature

Nick Hubble,
For The Daily Reckoning Australia