Former Cabinet Secretary Lord O’Donnell: UK and Scotland post-Brexit. Where next?

Over four months ago the UK voted to leave the EU. I wonder what David Hume would have made of our EU referendum? Would he have called for us to base our votes on the facts as “A wise man apportions his belief to the evidence”. Or might he have sided with Michael Gove’s attack on” experts” arguing “when men are most sure and arrogant, they are commonly the most mistaken.”

Perhaps he would have predicted the result on the basis that “Reason is and ought only to be the slave of the passions”. More fundamentally I believe he would have felt that such decisions should be driven by “public utility” or the “true interests of mankind”.

He might also have been interested in how people developed their beliefs about the evidence. The recent study by the Reuters Institute follows an earlier study by Loughborough University in finding that the number of pro – leave articles vastly outnumbered the number arguing for remain. The study also showed that “campaigners” were quoted far more often than “experts”.

While I cannot claim to know Hume’s views, I am delighted to be here to share my own perspectives on our current situation. During the course of this lecture I want to explore what this will mean for the future of the UK and Scotland and the impact of Brexit on our economy and our political landscape.

The emerging shape of the post BREXIT UK

We now know that the UK government wants to trigger Article 50 before March 2017 but little of substance has emerged from either the EU or the UK regarding Article 50 negotiations and the shape of future arrangements. Declarations from either side that portend a “hard Brexit” need to be taken with a pinch of salt. This is because both parties have the incentive to signal their toughness. Partly in the hope that this may persuade the other side to relent.

And partly because they need to send a signal to internal constituents: Theresa May to the pro-Brexit camp that she does not intend to remain by stealth; the Commission because it wants to discourage other members from jumping on the leave bandwagon, or at least watering down key elements of the EU’s functioning.

The High Court’s decision last week means that Parliament will need to be consulted and have a vote prior to triggering Article 50. The government has appealed and that should be heard before Christmas but I have yet to meet any constitutional lawyer who thinks the government will win. That means the PM needs to act quickly to put a bill before Parliament. The nature of such a bill will, I am sure, be the matter of much debate inside Downing Street. It is already clear that members of both Houses are likely to seek to amend such a bill to enable both Houses to be more involved in the broad direction of the negotiations.

The government will say that they can’t play poker with their hand face up and their opponents will say they just want to know what their objectives are and broadly how do they intend to meet them. The Lords behaviour over tax credits suggests the government will not find this easy. I would also expect an amendment which asks for the final deal to be brought back for consideration by Parliament.

I think the Prime Minister could take a lot of heat out of this situation, without losing negotiating room for manoeuvre, by stating clearly that she wants to be part of a single European market, the brainchild of Margaret Thatcher, and a huge step towards free trade. But Britain is no longer prepared to pay the price of ceding control over its borders to Brussels to achieve this, at a time of huge migration turbulence. It’s simply not in our interest to do so.

That’s why we’re leaving the union. But all of Europe is facing a migration crisis and this will be a massive issue during the numerous elections in 2017, including in France and Germany. Could we not work together to meet our public’s concerns on this issue?

Unless we can make progress on modifying free movement we will end up with limited market access that will damage both the UK and EU economies. What is becoming clear is that the UK will not be adopting a Norwegian model with full access to the single market. We will not accept full freedom of movement and  will extricate ourselves from the oversight of the European Court of Justice, (although please don’t ask me exactly what that means in practice).

We have not said we will no longer pay anything to Brussels which I take as a sensible negotiating position as we might need to buy access to either some aspects of the single market or a say in future decisions on rules and regulations. In short we will attempt to obtain a unique EU- UK deal, including transitional arrangements, a formidable task.

Of course there is a crying need for us to know what the EU27 are looking for in this process. They will all be driven by what is most in their country’s economic interest but this will be weighed against their political objectives. For some countries they will want to show their own nationalist movements that leaving has large costs.

Some political leaders will worry that the UK’s exit might prompt other countries to leave the fold. This would be particularly bad news if the leavers are all the net contributors to the EU budget: remember they already have to fill the funding gap left by the UK’s departure. But all this is conjecture as we do not even know who will be the key leaders in France, Germany and Italy, to name just three key interlocutors, in late 2017 and 2018.

What we do know is that we have a very different UK cabinet in place since July, with the FCO, Dexu and DIT all run by prominent leave campaigners. As a former Cabinet Secretary I can only wish my successor the best of luck as he tries to ensure the doctrine of collective responsibility is maintained throughout the difficult negotiations over the years to come.

The fact that it has already had to suspend collect responsibility over the Heathrow decision does not augur well but presenting a united front to the EU 27 is vital.

Impact of BREXIT on key economic challenges

As something of an economic determinist I will start with the economics. Does BREXIT make any difference to the greatest economic problems we face? Of course this depends on what you think are the main problems.

Personally I put climate change at the top of my list, while Lord Lawson, my former boss, would say that it is not an issue or at least not one we need to worry about now. So for him, a proponent of leaving, the fact that we will no longer be bound by EU renewables targets is a positive. For me, it is very bad news: the UK has its own Climate Change Act which might keep us on a path to cleaner energy but both sides of this debate would agree that one country acting alone will make little difference.

Our voice at The EU Council and at Paris helped produce strong statements, which may still be turned into actions, like the Mission Innovation programme, which will make a difference. Without us around the EU table, the pace of tackling climate change is likely to fall.

The second great challenge we face is ageing: or to use a more uplifting phrase from, The One Hundred Year Life, by Lynda Gratton and Andrew Scott, we are staying younger for longer. The costs of dealing with an ageing population, many of whom have not saved enough, will fall on future taxpayers. At the moment the costs are being kept down as we have access to the global labour supply and many carers and health practitioners choose to come here to work.

This situation will get worse as restrictions are placed on free movement of labour with the intention of reducing net migration.

The third great challenge is productivity. Since the global financial crisis we have seen a slowdown in productivity growth. In the decades leading up to the crisis labour productivity grew on average at around 2-3%, but it has barely changed at all since 2008. We know that recoveries from financial crises are particularly slow but we do not know how long this slowdown will persist. Restrictions on skilled labour and in particular on the time that students and recent graduates can spend in the country will reduce productivity. The question is how much?

Similarly the same restrictions plus limits on access to EU research funds put at risk the innovations that drive growth. Again the size of this effect is unclear but no one disputes the sign.

In Scotland these arguments should have strong resonance. You have a number of great Universities producing world class research welcoming experts from around the world. And you have exported great minds, like Edinburgh’s own Alexander Graham Bell, who have innovated in their new countries.

Another great advantage of our open borders has been the stabilising impact of migration on our economy. As demand and hence wages rise, we suck in workers while when the reverse happens the inward flows diminish and some return home. (You can see this happening between States in the USA.) Without this process much more of the work of stabilising the economy would have to be done by fiscal and monetary policy, which has its own problems.

Now it is of course possible that the design of our new border controls will mitigate the impact of these effects. But the referendum vote has already sent out a clear signal to the rest of the world that we want to reduce the number of migrants coming to the UK.

In addition, as Jonathan Portes has pointed out in the latest National Institute Review, controls on EU migration will inevitably impose larger regulatory burdens on business and a rise in illegal working. Other countries, like Canada are already responding to the opportunities this creates for them.

If we implement restrictions for EU migrants like those now in place for non-EU migrants, the effects will be concentrated on those sectors and professions in which immigrants are concentrated. At the low skill end that means low tech manufacturing, construction, private households and cleaning. At the upper end of skills it means finance and higher education.

Since UK born workers are far from perfect substitutes for new migrants, and UK born workers have higher reservation wages, it is likely that there will be labour shortages in sectors of the economy most exposed to skill shortages. The CEP study suggests this will hit hardest in food manufacturing, domestic personnel and parts of the public sector.

Since we are determined to restrict free movement of labour, we will not have full access to the single market on existing terms. We will not know for a very long time what precise terms we will be able to negotiate but hardly anyone expects them to be as good as they are now. The sectors most at risk are those that gain most from the single market: financial services and areas like cars and food where tariffs and non-tariff barriers are high. This will differentially impact various parts of the U.K: London is most at risk on financial services, but Edinburgh will also feel the draught.

Overall the majority of economic analysts predict that a hard BREXIT will have damaging consequences in the short and long run. The respected Fraser of Allender Institute suggests the long run impact on Scotland could be GDP that is between 2 and 5% lower. Interestingly they believe the impact on Scotland will be smaller than for the UK as a whole.

For the UK as a whole, the work of Swati Dhingra and associates at the LSE’s Centre for Economic Performance suggests a decline of over 5% in GDP per capita as a result of lower foreign investment and increased trade costs.

Impact of BREXIT on politics: Scotland

For Scotland the uncertainty generated by BREXIT could not have come at a worse time. The low level of oil and gas prices is bad enough. In addition Scotland has, unusually, been underperforming the UK throughout 2016. Of course the Scottish government has an increasing set of levers to use to offset this underperformance.

They will be responsible for raising 40% of their revenue once the VAT changes are in place, and about half of the Scottish budget will be funded by revenue raised in Scotland as opposed to the block grant. It will be interesting to see if the government introduces measures which might raise Scotland’s growth rate relative to the UK.

Such measures are not easy to find and are unlikely to take effect immediately. This creates a very difficult economic backdrop against which to call a second independence referendum.

Clearly a substantial majority of Scots voted to remain in the EU. Some commentators thought a vote to leave would be followed by another referendum in Scotland on whether to leave the union with the U.K. The thinking was that Scots would prefer a union with the whole of Europe rather than one with the U.K.

Nicola Sturgeon has adopted a more nuanced approach, with her 5 tests. I remember working with Ed Balls and Gordon Brown on their 5 tests to assess our readiness to join the euro. Hers span the political and economic spheres and are almost certain to be failed.

Tony Blair probably thought Gordon’s tests were designed in much the same way but at HMT we approached the subject as objectively as possible. If one were to think about the economic tests for whether BREXIT benefits Scotland as objectively as possible what would those tests look like?

  1. How does BREXIT affect the great challenges mentioned earlier: does it help with climate change, the demographic challenge and the need to raise productivity?
  2. Does BREXIT reduce inequality in Scotland?
  3. Does BREXIT enhance Scotland’s voice on global issues?
  4. Does BREXIT enhance Scotland’s freedom to enhance the wellbeing of its inhabitants? And a fifth test which Scottish Nationalists will presumably want to study:
  5. Does BREXIT enhance the case for Scottish independence?

 

Scottish voters clearly took the view that BREXIT was not a good idea. But now it will be necessary to develop the answers to the first four tests, given the emerging information about what kind of BREXIT we will have, in order to answer the fifth test.

This is a complex piece of work which will involve looking at how any new freedoms can be exploited to enhance Scotland’s economy. Of course while BREXIT might enhance the case for independence this does not mean that independence within or out with the EU is preferable to union with a U.K. out with the EU. To answer this question I would go back to the six tests presented by my former colleague Professor Andrew Goudie in Scotland’s Future (2013).

What is clear is that Nicola Sturgeon has a difficult hand to play in the BREXIT negotiations. Some in her party may take the view that the worse the deal the Prime Minister gets, the greater the case for independence. There are also those in the SNP who feel that they need a second referendum quickly in case support ebbs away as it has in Quebec. As a frequent visitor to Canada I think this analogy is wrong: in Quebec it is the older age group who favour independence and they are literally dying out.

I have enormous respect for your First Minister: I believe she is one of the most able politicians I have met. It would be a cruel irony if she were to share David Cameron’s fate and end up being remembered for calling a referendum expecting to win only to set back their own cause irreparably.

Impact of BREXIT on politics: UK

UK Parliament: The High Court’s decision means that Parliament will need to be consulted and have a vote prior to triggering Article 50. What is clear is that members of both houses are likely to amend any bill that comes before them to enable both Houses to be more involved in the broad direction of the negotiations and possibly in vetting any final deal. How this might happen in practice has to be decided but it is clear the Select Committees could have a role to play here. They have proved a robust way of holding the executive to account, particularly since the election of their chairs has made them more independent of the executive.

Precisely how they will choose to operate during a period of live negotiations is not yet clear. The government really cannot be expected to reveal its detailed negotiating stance publicly: that would be counter- productive. But Ministers will come under pressure, quite rightly, to explain their strategy.

Devolved Parliaments: The PM has met with all the heads of the devolved administrations and explained how she hopes to handle the negotiations. Of course the PM has to find the best deal for the UK as a whole, and that may well involve trade-offs. This is where each devolved nation will need to explain carefully their case so that the UK negotiators can get the best overall deal. This is another reason to welcome the work envisaged by your First Minister as ideally it will help both the UK and Scotland get the best deal from the EU27.

Negotiations with the EU

Turning now to the detail of our negotiations with the EU, we have heard much talk about a “hard Brexit”. Let me start by clarifying an important point here. “Hard Brexit” is sometimes characterised as “a return to trading on WTO rules”. This isn’t quite correct: trade between the UK and EU is already subject to WTO rules in the sense that these rules (notably Article XXIV of the GATT and Article V of the GATS) set conditions that free trade agreements, such as the EU’s single market, are required to follow. This has some important implications which I will explain later.

From a UK perspective, the key negotiating objective seems to be to retain single market access for goods and services while repatriating some degree of power over immigration and the making of laws. Uncertainty on the extent of access carries the potential to dampen investment since it increases the option value to investors of waiting until such uncertainty is resolved. The only way the government can manage this uncertainty is either by committing to achieving market access conditions equivalent to those currently prevailing, or by agreeing to compensate investors for any adverse effects – in effect, by “buying out” the option value of waiting.

The recent announcement by Nissan that it will invest in manufacturing new vehicles illustrate the policy predicament facing the government.

  • If it is done on the understanding that the government is committed to single market access, this could weaken the government’s negotiating hand on other matters. It is important to emphasise that the government cannot negotiate duty free access for a handful of sectors – whether these are motor vehicles or financial services. This is because such selective liberalisation between two trading partners is forbidden by WTO rules. GATT Article XXIV and GATS Article V require comprehensive liberalisation via a free trade agreement that would have to be notified to the WTO. Any commitment to achieving duty free access for motor vehicles, or free trade in financial services, implies a commitment to comprehensive free trade with the EU.
  • If Nissan’s investment is on the basis that the government will offset the cost of any reductions in market access to the EU, there are broader implications. If, as seems likely, the offsetting would be done by financial means, the UK will need to be careful not to contravene WTO rules on subsidies. In brief, financing schemes need to be as non-specific as possible to particular firms or industries, if they are to be immune to legal challenge. This suggests the UK would need to consider “horizontal schemes” i.e. ones that cut across different sectors, based on objective economic criteria (such as skills creation). There might be sensible economic grounds for such schemes, but it is uncertain how far they will meet the specific concerns of producers such as Nissan, and if they square with promised exchequer savings from Brexit In any event, it is not clear that the trade-offs between market access and other issues, such as free movement of labour and the repatriation of judicial powers are as clear cut as they are presented. This is because the four different pillars of the single market (goods, services, capital and labour) are not easily separable.
  • Take services trade and cross-border investment. Free movement has been a significant factor in reducing restrictions on both because it reduces the costs associated with cross-border supply chains, and facilitates the movement of service suppliers. This is particularly true in the professional and financial services sectors. Reduced mobility will impose costs on these sectors regardless of whatever else is achieved in free trade negotiations in goods and services.
  • We can see this, for example, if we compare the services commitments recorded in the Canada-EU FTA (CETA) to what the EU has achieved internally. The EU’s internal commitments go well beyond what is available through CETA, principally because of cross-cutting commitments such as those on free movement. Indeed if we want to look at an agreement to build on, it would be better to start with the EU- South Korea deal but this is still less attractive than our current arrangements.
  • On laws and rule making, there is a strong linkage between these and trade through the impact of non-tariff measures. It may be the case that getting rid of inefficient EU regulation may enhance the UK’s efficiency. But is all regulation inefficient? Economic models, like Professor Minford’s, imply that they all are because they assume perfect competition and no market failures. Such models are, to borrow from David Hume, little more than sophistry and illusion, and should be consigned to the flames. In the real world, markets fail conspicuously, and therefore at least some regulation will be efficient. Moreover, UK producers exporting to the EU will need to comply with EU regulation in order to do so. This could be done by negotiating equivalence or mutual recognition provisions at arms-length, but that appears to be a poor substitute for being present at the table when the regulations are designed in the first place.

Non- EU Trade deals

One of the advantages of exiting the EU’s customs union is that it would allow the UK the latitude to set its own tariffs vis a vis the rest of the world at levels below the bound MFN rates it has inherited from the EU. That could boost internal efficiency and hence growth. But the politics of such unilateral reform, especially in the aftermath of Brexit, do not appear promising.

It would also be possible for the UK to negotiate reciprocal free trade agreements with other trading partners. The UK would have the advantage of not being burdened with the sort of cumbersome decision-making process the EU needs to follow in securing agreement across 28 members (even if it does not choose to resort to the unprecedented approach it followed with CETA, in which the Commission in effect re-delegated its competencies to national parliaments to approve, as opposed to ratify, the text that had been negotiated.).

The disadvantage is that with a smaller market and an already liberal trade policy environment that it has, in part, inherited from the EU, it will probably need to make treaty commitments on matters of policy and regulation that go well beyond trade. This could include, for example, health services and policy. In the case of the Australia-US FTA for example, Australia’s monopsony-based system of procuring pharmaceuticals was subject to negotiation.

I firmly believe that the UK will be able to negotiate reasonably good trade deals with non- EU countries. There will be some areas, like services in general, where we may well get more extensive deals than have been achieved by the EU. In other areas we may do worse, because our negotiating power is not as strong given the more limited size of our market

It is certainly true that the UK government is a little short of experienced trade negotiators but in the time between now and our formal departure from the EU we can build up that capacity so we are ready to strike deals as quickly as possible thereafter.

Managing the transitional period

As we look ahead, one of my worries is that the UK government will be totally dominated by BREXIT issues and will not undertake the reforms needed to enhance our overall economic performance. For example in the public sector we are beginning to realise that behavioural approaches have the capacity to enhance the way government helps individuals achieve better outcomes, in health, education and many other spheres. Hume would understand that human decision making is often far removed from the rational calculus as defined in neo- classical economics.

The U.K. leads the way in these innovations but the rest of the world is catching on fast. Bringing together a better understanding of human decision making with the scope for digital solutions can transform public services. Similarly governments should be using the opportunity of incredibly low long term real interest rates to borrow for worthwhile infrastructure projects.

Some believe that growth can be enhanced by removing regulations imposed by the EU. I am very sceptical about this. The truth is Parliament tends to be heavily influenced by the various pressure groups and these invariably call for more regulation. It is a myth that the Civil Service likes regulations. Indeed one of the great attractions of behavioural approaches is that they can operate in place of regulations. Of course there are pressures on regulators that punch them to be over zealous sometimes: Parliament, and particularly Select Committees, have looked very severely on regulators who are seen to have been too lax. The pressure to deregulate has tended to come from the executive in the form of various bonfires of regulations. So while there may be some scope to drop certain EU regulations that adversely affected the UK I doubt that the net effect will be very large.

Indeed the sensible decision to keep all existing EU regulations shows that any future changes will be at the margin. And of course we may need to adopt future EU regulations despite not having been involved in framing them, in order to retain access to EU markets. (The irony of having a bill called the Great Repeal bill that actually imposes all previous regulations into UK law seems not yet to have been appreciated.)

As regards macro policy, it is clear that the Bank has been forced to stimulate the economy by keeping interest rates unsustainably low and using QE to such an extent that it has severely distorted asset allocations. The Chancellor will need to use his first Autumn Statement to think how he can help correct this imbalance. One possibility is to introduce regulatory changes to encourage pension funds to diversify away from bonds into equities and, in particular, into real assets like infrastructure. He also needs to think about the right fiscal rules in a world of virtually zero long rates.

Let me be clear, I am not advocating extra current public expenditure: the deficit is still too large. We should take a ruthless look at all those areas where the state gives money to relatively rich people, the winter fuel allowance being the prime example. We could also usefully get rid of the plethora of special tax reliefs which make our tax system so complex , and help rich people and companies reduce their tax bills, and use the proceeds to lower rates or to enhance capital spending.

Believe me the Treasury has a host of such plans: all we need is a Chancellor willing to take the political gamble to implement them. Now might just be the time as we desperately need to show that our “independence” can be used to good effect.

Conclusions

Much discussion on Brexit supposes that the world otherwise by and large remains constant. This may not be a wise assumption. The EU, post Article 50, will be deprived of one of its most consistent liberalising voices, and may well face the temptation to turn inwards. A Trump presidency in the US could usher in turbulent times in international trade, with a significant risk of trade-wars breaking out on a beggar-thy-neighbour basis. The old adage that free trade agreements and economic partnerships are like gangs – they may be ugly but it’s better to be in one if others are and the neighbourhood is unsafe – may come back to haunt the UK.

The BREXIT negotiations will dominate the political and economic agenda for the next few years at least. It is incumbent on all the involved parties to undertake the analysis necessary to allow the UK government to get the best possible deal.

The Scottish independence referendum and the BREXIT one have in common that the people were asked to choose between the status quo and a different world that was only vaguely mapped out. The post BREXIT problems illustrate how harmful this can be. And it is just this feeling that what is being delivered is not what ” the people” voted for that is producing arguments from both wings: the BREXITEERS saying the people’s will has not been followed and some remainers making the case for a second referendum when the alternative to staying could be clearly spelt out. The fundamental lesson is that before having a referendum it is important that the alternative to the status quo should be spelt out more clearly.

Of course some will argue that the leavers managed to win the vote by enticing both anti- and pro- globalisation voters so clarity would not have helped them win. But it’s how you manage the world post-victory that will affect the lives and wellbeing of all the electorate. In a democracy that surely should be our number one concern.