Casting Off The EU Millstone

Introduction

It should have been no surprise that Boris Johnson is now Prime Minister. It should also be no surprise he will implement Brexit on 31 October, the last date agreed between Mrs May’s government and the EU. Johnson was elected by Conservative constituency members to do just that. His cabinet appointees are fully supportive, including ex-Remainers (that’s politics!) and he has appointed an aggressive rottweiler, Dominic Cummings, as his Brexit enforcer. Already, his influence over Brexit strategy can be detected. There are no compromises to be had, a point which slower minds in the commentariat find difficult to comprehend and accept.

It is likely there will be an agreement on the way forward after Brexit, which could involve a transition period, but nothing like that agreed with Mrs May. If, as seems unlikely, the EU digs its heels in, the UK will walk away. That is the message being given by the new administration.

The establishment media are still wrong-footed on Brexit. The BBC, and others, have been too idle to analyse properly, taking their information from biased pro-remain sources and politicians who are out of the loop. They are still doing it. Disinformation is substituted for truth.

The EU, disinformed by Remainers including a chorus of past ministers and prime ministers, has relied on the divisions within Parliament to put Britain into a political and economic stasis. Their repeated utterances (there will be no new negotiation, the withdrawal agreement stands etc.) reflect the continuation of the EU’s established position. That is likely to change, because the EU will find it is forced to accept the dangers to its own position.

There is a crucial difference between the new cabinet and its predecessor. In Johnson, as well as ministers such as Rees-Mogg, Raab, Javid and Gove there appears to be an understanding of and commitment to free markets, unlike anything we have seen since Margaret Thatcher. Obviously, the strength of that commitment is yet to be tested.

The new reality and the dismissal of the old socialising compromisers should swing Parliament behind the instructions given to it by the electorate in the Brexit referendum. An advertising campaign to prepare everyone for Brexit without a deal starts now. The strategy is not to go to Brussels (UK-US is being negotiated first) but only when Brussels comes to its senses will a dialog commence. Facing a lost cause, Remainers are likely to melt like midsummer hailstones, and the euro-nuts, like Dominic Grieve, will sink into obscurity.

The electoral consequences are appalling for the Labour Party. By changing from its conditional support for implementing the Brexit referendum to demanding a second one with the intention of overturning the first, they have almost guaranteed that in a general election they will face a wipe-out. This is important, because it means that they have no incentive to table a vote of no confidence in Johnson’s government. They have already gambled and lost.

Because of Labour’s bad call it looks like Boris’s government will get its way and is here to stay, not only through Brexit, but beyond. The EU will have to get used to it. The Europeans have lost control over the negotiations and seem unlikely to get more than a pittance of the £39bn settlement agreed with Mrs May. When Boris refers to our friends in Europe, he actually means our adversaries. When he refers to his preference for a deal against no deal, he means a deal only on his government’s terms. Already, trade negotiations are commencing with America, existing EU trade agreements with other significant nations will be simply novated, and the whole of the Commonwealth, including populous India are ready to sign up.

This is the new reality and Dominic Cummings’s task is to ensure all government departments are firmly on message. There is bound to be a little drift from this black and white, but the process of political destruction now moves from London to Brussels. Having made such a fuss of it, the Irish border is a non-issue. The UK has no need to put in a border. With lower UK tariffs, ownership of the problem is fully transferred to the EU and the Irish government.

Assuming the Treasury has already made provisions for it, Boris needs the £39bn promised by Mrs May to the EU to be reallocated to a mixture of the health service, education, law enforcement and tax cuts. Then there’s that infamous £350m per week, which was on the side of the Brexit bus. That was gross of the Thatcher rebate, so the actual figure is closer to £275m per week, and there was an amount within that spent in the UK under the EU’s sole direction. That left £181m in 2016, sent to Brussels for the privilege of EU membership, or £9.4bn per annum. How much of that can be diverted for funding government spending depends on the new government’s tariff policies. There is no doubt that from a purely economic point of view they should be removed in their entirety.

By not paying the planned £39bn divorce settlement and gaining the £9.4bn net annual payments to the EU, Johnson has some wriggle room when it comes to funding his spending plans and tax cuts. Without it, he will have to rely on inflationary financing, and hopefully there are enough wise heads in the cabinet to dissuade him from going down that road. Therefore, if only because of the money, the odds strongly favour a hardball approach on Brexit negotiations instead of compromise.

The EU’s problems are mounting

There is likely to be an important consequence, and that is a Johnson Brexit could trigger a mounting financial and ultimately political crisis in the European Union.

A study last year by Germany’s Halle Institute estimated a no-deal Brexit would cost 12,000 jobs in the UK, and 422,000 jobs in the other 27 EU members, of which 100,000 are in Germany and 50,000 in France. Yesterday, Ireland’s central bank forecast a loss of up to 100,000 jobs in the medium term  in Ireland alone, on a no-deal. Clearly, the EU’s negotiators risk losing the wholehearted support of its two largest post-Brexit paymasters and others. But for Brussels, giving in on Brexit encourages rebellion from disaffected populations in other member states. Rather like the Soviets ruling Eastern Europe in the late eighties, the Brussels establishment finds itself struggling to keep its non-democratic political model intact.

It is increasingly likely Brussels will find events are spinning out of its control. For the UK, this introduces collateral damage, necessitating even more urgent separation from the EU. In a paper published at end-June, Bob Lyddon points out that a Eurozone financial crisis (which is becoming increasingly likely, as argued below) could cause the UK’s contingent liability as an EU member to be as much as €441bn. “This derives from the near-criminal irresponsibility by the UK’s negotiators”.

Whatever the numbers, there can be no doubt that this is an extremely serious issue. Furthermore, in the event of a financial and systemic crisis in the Eurozone, the UK will face its own crisis, if only because of cross-liabilities through the two banking systems. And the cyclical economic downturn that always follows the failure of a period of credit expansion is coming up on the inside rail very rapidly.

The EU economy is left badly unbalanced, with Germany dominating production and exports. Other populous member states, notably in the Club Med and France, are in a financial mess. They have relied on Germany’s production to provide for their unproductive profligacy. Her production output is now contracting.

Germany has been hit by three adverse developments at the same time. There is President Trump’s tariff war against China, which has undermined Germany’s largest growing markets at the eastern end of the Silk Road, and the threat he will deploy similar tactics against Germany. There is EU environmental legislation, which is making Germany’s motor production obsolete and forcing manufacturers to put a time-limit on existing production while investing enormous sums in electric technology. The damage this has done extends down the whole production chain, undermining the Mittelstand.

Then there is the crisis in Germany’s major banks, most publicly seen in Deutsche Bank because of longtail liabilities from its investment banking division. But all German banks, as well as those throughout the EU, face a lethal combination of margin compression from negative interest rates and a legacy of an expensive branch network when customers are migrating to online banking. The slump in German production now provides an additional threat to their loan books.

In the background, there is the turn in the global credit cycle from its expansionary phase into a periodic contraction, usually resulting in a credit crisis. To understand the transition from credit expansion to a tendency for it to contract is to recognise that the expansion of credit as a means of stimulating an economy depends on tricking economic actors into believing prospects are improving. When the evidence mounts that they are not, monetary stimulation fails, and credit begins to contract. Despite the ECB maintaining negative interest rates, despite the ability of highly-rated companies to raise finance at zero or even negative rates, and despite the ECB’s offer to pay companies to borrow (which is what deeper negative rates amount to) economic actors are now aware that it is all deception.

This is why Germany now has all the appearances of being in the early stages of a deepening economic slump, and there is nothing monetary policy can do about it. Brexit will simply add to these problems, not just for manufacturers, but for their bankers as well, as the Halle Institute report implies.

It is increasingly difficult to see how with escalating budget deficits in member governments Brussels can afford to continue with its head-in-the-sand approach to trade negotiations with Britain. The eurocrats naturally retreat into more protectionism when they see the system threatened. But asking Germany, France, the Netherlands, Austria, Finland, Sweden and Denmark for more money when their tax revenues are slumping is unlikely to cut much ice.

The new Johnson team will know some of this. There may be a temptation to make a portion of the £39bn, promised by Mrs May, available to Brussels to alleviate their pain in return for a quick deal. This goes against the new hard attitude of the Johnson government, exemplified by the presence of Dominic Cummings. But we shall see how this one pans out.

The UK economy Post-Brexit

Meanwhile, as economist Patrick Minford recently pointed out, a US-UK trade deal could lower prices of goods in the UK by as much as 20%, being the effect of EU tariff protection against global competition, raising prices above the world price level by that amount.   Minford estimates a UK-US trade deal would lead to an overall gain to UK GDP of between four and eight per cent, a markedly different outcome from the project fear propaganda of the old establishment. And in the event of No Deal with the EU, the UK Treasury will receive up to £13bn in tariffs from EU importers, assuming no reduction in EU imports. Obviously, there will be substitution of EU goods for goods from the US and elsewhere, once trade agreements are in place, so this will be a maximum revenue figure.

The point is No Deal is not the disaster promised by the May establishment and its business lobbyists. It is a disaster for the remaining EU. Exiting the EU offers the Johnson government a good start, a clean sheet. Any compromise with the EU on trade and money detracts from this benefit.

It is an opportunity for Britain to reset the approach to political economy, which is our next topic. For attention-deficit politicians, there are two important factors to understand that are central to formulating post-Brexit policy: the reason why trade imbalances arise, and therefore how trade and economic policies should be constructed, and the destructive effects of inflationary financing.

How trade imbalances arise

It is vital to understand the source of trade imbalances, so that the mistake made by President Trump, which is driving the world into a Smoot-Hawley-style 1930s slump, is not repeated by Britain. The common error is to believe that the exchange rate sets trade surpluses and deficits. It therefore follows, the argument goes, that artificially raising the price of imported goods by imposing tariffs achieves the same effect.

The simplest explanation to understand why this is wrong is to start with a theoretical sound money example before progressing to the current fiat money environment. When gold was money and if unbacked currency and credit were not available, imports could only be paid for in gold or fully-backed gold substitutes. The same is true of exports. An individual borrowing to buy an imported good has to source gold or a fully-backed gold substitute, so the provider of money has to defer consumption, which includes that of imported goods. And unless the people in a nation collectively adjust the amount of gold in circulation, imports will always balance exports.

Compare this with nations trading with each other using unbacked state-issued currencies. These are issued at will by central banks as new money and by commercial banks in the form of bank credit. Therefore, anyone can buy an imported good without having to have the money, so long as a bank advances the credit.

Money and Credit expanded out of thin air replaces the need for imports to be paid for by exports. Now that all countries work their currencies the same way, the trade balance becomes a relative matter. Other things being equal, the country which expands its money and credit the greatest ends up with the largest trade deficit, and the one that expands the least the largest trade surplus.

But national statistics are designed to reflect money spent on consumption (GDP) separating out money spent on capital items. A nation whose population has a savings habit will spend less on imported consumer goods than a nation with a lower tendency to save. This is why Japan’s monetary expansion has not fuelled a trade deficit in consumer goods. In other nations, such as the US and UK, where personal savings are now minimal, credit expansion leads to chronic trade deficits.

The expansion of fiat money to bridge the gap between tax revenue and government spending similarly leads to a rise in imports, because the expansion of money and credit, when they are not saved by the consumers who ultimately benefit, always ends up fuelling consumer imports, often as a second or third order event. This gives rise to the twin deficit phenomenon commonly observed in both the UK and US, where consumer savings are virtually non-existent.

The destruction arising from inflationary financing

The Keynesian policy of stimulating an economy through a temporary budget deficit relied on deceiving economic actors into thinking there was more demand in the economy than existed. Like all confidence tricks, it eventually fails. Governments end up with perpetual budget deficits, which trend larger with every unresolved credit cycle.

Expanding money and credit as a means of funding government spending through the creation of debt has now become central to state finances everywhere, including the UK. The advantage for governments is very few people understand that this form of finance transfers wealth from the producers in an economy to the state. But the government is eating its own seed-corn by impoverishing its tax base, which if continued leads inexorably towards the destruction of its currency.

Any politician who claims to be a free-marketeer is not one unless sound money, devoid of inflationary financing, is embraced. Taking into account the importance of sound money and the reasons trade imbalances arise, a Johnson government that understands these issues will be equipped to fashion economic and monetary policy for the future. It is not enough to merely pay lip service to the necessary objectives, but to grasp the economic theory behind them, so that socialist and neo-Keynesian claptrap can be fully exposed in reasoned debate.

These are two objectives to strive towards, and will necessarily take time, because changes in government policy must steer the electorate along with it. They should be pinned up as mission statements on the notice boards in Downing Street. That being accepted, the following supporting policies must be implemented to re-orientate the ship of state towards economic success:

• Tax policy. Tax cuts should be broadly financed by reductions in government spending, not through increasing the budget deficit in the hope that the economic stimulus will generate higher taxes. Welfare must only support people in genuine need, not those with just a sense of entitlement.
• Government spending. Means must be found to reduce the proportion of government spending in the economy as a whole, to reduce the burden on the productive private sector. A financial and economic crisis requires departmental spending to be slashed, not just future planned increases cut, as was the case under Gordon Brown in 2009.
• Encouragement to save. Taxes should be removed from savings and capital gains. Inheritance tax must be abolished. This is to allow people to accumulate personal wealth and to reduce the need for the state to provide.
• Trade. Trade agreements with other nations should be viewed as a first step towards wholly free trade. By exploiting the comparative advantage of allowing people to buy what they want from providers of goods and services irrespective of location, capital resources will naturally be redeployed towards their more efficient use. This is why understanding that trade imbalances do not arise from currency differentials is so important.
• Monetary policy. Steps must be taken to restrict the Bank of England from manipulating the economy through monetary policy. Targeting inflation and employment must be abandoned, and markets allowed to set interest rates. Credit expansion should be curtailed by ensuring that UK banks and branches of foreign banks operate to stricter capital rules. Goal-seeking stress-testing must end. In the longer-term, banks should lose the protection of limited liability, which has allowed bankers to make rash lending decisions without bearing the ultimate cost.
• Gold. The Treasury must replenish the nation’s gold reserves. The risk of a global currency crisis is increasing by the day, and foreign currency reserves will need to be reallocated at least in line with those of other major nations.

Conclusion

Brexit is an opportunity to reset economic, monetary and trade policies. The implications of getting rid of the EU millstone go far beyond the leaving date of 31 October. Assuming a Johnson government has a good grasp of why free trade benefits the economy and why trade imbalances exist, combined with the courage to steer Britain towards the long-term prosperity offered by free markets, it will derive its future power from a strong economy instead of merely claiming it based on the past.

Alasdair Macleod

HEAD OF RESEARCH• GOLDMONEY

 Twitter: @MacleodFinance

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