EU Is Likely To Choose 'Hard Brexit' As Perceived Lesser Of Two Evils

Summary

Even though the markets are ignoring it, we may be just two years away from a potentially vicious divorce between the EU and the UK, destabilizing 20% of world's economy.

Current market complacency in part caused by past experience, such as the Greece bailout, the 2008 financial bailout, or the debt ceiling, which suggests that a compromise is always reached.

Complacency is misguided, because the market is ignoring the likelihood that EU officials will view a "Hard Brexit" as being less damaging than making leaving the EU look desirable.

As I write this, the official triggering of article 50, which officially starts the procedures of divorce of the UK from the EU is only days old. As was the case with the shocking vote to leave the EU last summer, the markets are barely acknowledging the event, even though it may be the biggest reversal of the post-WW2 World order to date. The Dow is up by more than 15% since that historical world-changing vote. I was in Europe when that vote took place, in addition to the rest of the craziness such as the terrorist attacks in Nice and Istanbul, or the attempted coup in Turkey, most of which seems to have now been forgotten as we currently got busy with the Trump saga. I spent five weeks on the old continent as those events took place, working hard on ignoring the news as much as I could, in order to actually enjoy my vacation. I was surprised when I came back and found that despite all the events that took place in Europe that summer, the markets were up compared with when I left. After that, I am not at all surprised now at the lack of market reaction to the current news of the beginning of divorce proceedings. I will not be surprised as the market will continue to ignore the coming calamity. It will be ignored until it will be upon us. The question then is when it will be upon us and what should we expect?

Negotiation timeline is two years.

By far the most important issue on the table will be on trade. About 40-45% of British exports go to the rest of the EU, and it also imports about 50-55% of its goods from the EU.

Source: HM Revenue & Customs.

In January, UK exports to the rest of the EU amounted to 12.8 billion pounds, or $16 billion. Imports from the EU totaled 19.5 billion pounds, or $24.4 billion. The EU clearly stands more to lose in absolute dollar terms if there will be no agreement on trade by 2019, which is when the UK will cease to be an EU member. In terms of the potential loss as a percentage of GDP however, the UK will be by far the more disadvantaged one.

In terms of who is economically more vulnerable to the potential losses as a result of a likely disruption of trade, I would say that the EU is actually the one we should be more worried about. While the potential resulting loss of jobs, economic growth and government revenue would be relatively bearable for a country like Germany, given it already has a budget surplus, unemployment rate of about 4% and a very significant trade surplus, countries like Italy, Portugal, Greece and Spain can hardly afford any more hits to their economies. Even France, which we do not usually talk about as a problem country within the Euro zone is looking increasingly vulnerable to any more economic shocks. With an unemployment rate stubbornly stuck in the 10% range, a budget deficit which has not been under 3% of GDP as demanded by EU treaty since 2008, a debt/GDP ratio that is approaching 100% and subdued economic growth, it can hardly absorb more pain.

It is unfortunate that people are not paying closer attention to the overall situation in Europe. After the 2008 global crisis we got stuck with the narrative that we have two Euro-zones. One which is doing just fine, mainly in the Northern part, and another which is struggling, which led to the PIGS acronym. Few people bothered to occasionally check whether the narrative still remains true. As I pointed out already, France is really struggling since 2008. Other countries such as Finland for instance have been having a very hard time getting any economic growth since 2008. According to World Bank data, since 2007, Finland's economy has grown by a yearly average of .13%, while its debt/GDP increased from 34% in 2007, to 63% during the corresponding period.

Source: World Bank.

France, Finland, Austria, Belgium and others are all struggling to keep from increasingly looking like "PIGS" since the 2008 crisis. It is a trend that is largely ignored in favor of the very well entrenched narrative of the North-South Euro-zone divide. It is this lack of appreciation of the actual situation, which is in part responsible for the general complacency in regards to this huge geopolitical and globally-significant economic event. The general consensus is that it is mainly the UK, with an economy that is only 20% of the size of the remaining 27 EU members, which will suffer. The EU is seen as the giant that is five times the size of Britain, therefore it is thought to be able to absorb five times the pain, which could not be further from the truth.

If there is no comprehensive trade deal by the beginning of 2019, trade between the EU and the UK could potentially collapse as there will be no legal framework available to conduct the transactions. Just to put into perspective the magnitude of the economic damage that would result from such an outcome, we have the Russian sanctions, combined with the oil price collapse as a point of reference.

Source: EC.

In 2014 EU exports to Russia amounted to 103 billion Euros. In 2015 it declined to 73 billion Euros. An Austrian study suggests that it may have resulted in the loss of 400,000 jobs in 2015 alone. In other words, about 13,000 jobs were lost for every billion dollars lost in exports to Russia. EU exports to the UK are two and a half times larger and the magnitude of decline could also be more significant if there will be no legal agreements meant to regulate EU-UK trade. We could potentially be looking at millions of jobs lost on both sides of the English Channel, leading to a deep continent-wide recession.

Aside from trade, there are a number of other factors which may deeply affect the economy of the continent if it remains un-resolved. For instance, there are the roughly 3 million EU citizens living and working in the UK. A large percentage of the those are from the former communist Eastern members, and they send home billions of dollars in remittances every year. That money in effect becomes a very important second income for about a million or so EU households in the poorer East. The abrupt end of the flow of those remittances to the region would in many ways have the same effect as the loss of a million jobs in that region, which would send Eastern Europe into an economic tailspin. This is especially so given that the region has also been a net beneficiary of EU funds, which will be diminished by billions of Euros after 2019, given that the UK was the second-largest net contributor. The former communist East has been a bright-spot in the EU since the 2013 recovery began. Growth rates have been twice that of the EU average, creating a great deal of demand for goods and services from the struggling Euro-zone.

Given the potential for European and global economic calamity which will likely be triggered by a failure to agree to a deal within the two year allotted period, one would think that surely a deal will be struck. That is what we came to be used to whenever there is a potentially disastrous outcome to policy. We were told that the global financial system could collapse in 2008, and a huge bailout was made available to prevent it. We were told that the Euro-zone could collapse if Greece defaults, so a bailout was made available. We were told the US will default if the debt ceiling is not raised, and we got a debt ceiling increase every time it was needed. Going by this track record, a Brexit deal is a sure thing.

Problem is that unlike any of those above-mentioned precedents, in this particular case, there are parts of the EU establishment which view a disastrous Brexit as a good thing. They in effect think that if they can make Britain's decision to leave look like a terrible thing, it will automatically convince others to reject the idea. They seem to believe that any resulting pain the EU will suffer will be worth it. I happen to disagree with that notion. I think the best way to make the EU attractive is to convince people that it is a good thing for themselves and for future generations of Europeans. Causing yet another economic shock to an already battered economy will in no way make people think that the EU is a good thing. What they are trying to do has been tried not long ago in Europe, on the other side of the Iron Curtain. I can testify from my own experience that persuasion through fear can only keep a system or institution in place for so long, before people get sick of it and revolt.

The focus of EU negotiators seems to be to make sure that they will make things for the UK worse than things would have been if it would have remained in the UK, in order to make EU membership look more appealing as opposed to leaving the EU. For instance the chief negotiator on behalf of the EU parliament, Guy Verhofstadt more or less made a direct reference to this position as being the desired course of action.

"It is important for Verhofstadt that the U.K.'s deal with the EU be worse than full membership since EU membership must still look like an attractive prospect"

Source: Newsweek.

I personally knew that this will be the main focus of the EU in the negotiations the moment that I learned of the appointment of Guy Verhofstadt as chief negotiator on behalf of the European Parliament. In addition to the European Commission, and the 27 national governments, the European Parliament must also approve of any Brexit deal, which in effect gives Guy Verhofstadt a veto. The fact that a well-known EU fanatic was given the power to pursue a course of hostility towards an EU member which dared to fall out of line says a lot about EU intentions. This should give all those who automatically believe that we will see a Brexit compromise between the EU and the UK at least some reasons to call their own assumptions into question.

Odds of a relatively harmonious divorce between the UK and the EU are relatively low in my view. Unlike all those times when we saw those with power and influence come together in times of crisis, such as on the 2008 bailout or on Greece, in this particular case there is a great deal of difference in that there are two competing interests. On one hand, it would be in the interest of the UK, the EU and the world to see an amicable divorce. On the other hand, one side, namely the EU clearly sees a hard Brexit as the lesser of two evils, given that they feel that they cannot afford to make it look like leaving the EU is an attractive option. I therefore think that we need to keep a keen eye on this story and be fully prepared for a hard Brexit and everything that it will involve.

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