The case for hard Brexit

For all the talk of Brexit meaning Brexit what has become abundantly clear over the past few months is that most politicians and political commentators haven't got a clue what Brexit means or should mean, and nowhere is this confusion more apparent than in the Labour Party. At the heart of this confusion is the single market. Time and again we hear politicians from both the Leave and Remain camps declaring that while we might leave the EU, we will still need to be part of some aspects of the single market. On this they are all completely wrong to the point of delusion.

The problem is not that they want to cherry-pick which parts of the single market they want to keep, and thereby appear to trying to have their cake and eat it. The problem is that (a) they clearly do not fully understand what "access to the single market" (as they term it) means or entails, and (b) they have still failed to realise that all aspects of the single market, not just the freedom of movement of people, represent an existential threat to the very concepts of nationhood, sovereignty and democracy in the UK and in the rest of Europe. As a result it is not just small parts of the single market architecture that we need to reject, like the free movement of people, it is ALL of it.

Today Theresa May finally seemed to get some of this. Speaking from the same venue, Lancaster House,  where Margaret Thatcher once extolled the virtues of the single market, the current prime minister finally admitted that Brexit is incompatible with single market membership. Of course the big irony in this whole debate is that the single market in its current incarnation is primarily a child of unbridled Thatcherism. It is economic neo-liberalism in its purest form. In which case one would think that the Labour Party should be the party above all others that opposites it tooth and claw while the Tories should be the most vociferous advocates. It's a strange old world. No wonder the public are confused.

As we are forever being told, the single market is constructed around four fundamental freedoms: the freedom of movement of goods, the freedom of movement of labour, the freedom of movement of capital, and the freedom of movement of services. This is my reasoning on why we need to reject all four of them.

The freedom of movement of goods

On the face of it this is the one aspect that everyone agrees that we should keep. After all we are all in favour of free trade aren't we? Well yes, maybe, up to a point (although in a future post I may proffer a more contentious view). But we can protect most free trade using World Trade Organisation (WTO) agreements, and as most global tariff barriers now average less than 2%, any further reductions will have diminishingly small economic gains. Unfortunately this aspect of the single market goes much further than just free trade. It also seeks to create a "level playing field" within the EU by prohibiting any form of state aid and outlawing any government action or policy that could be construed as having distorted the market. Now while this may appeal to the neoliberal free marketeers, it should fill anyone with a social conscience with profound horror.

This freedom, in concert with EU competition law, effective curtails many socially progressive state interventions, ranging from taxation policy (such as minimum pricing of alcohol) to industrial strategy such as support for key industries like steel or nuclear power. If we accept the freedom of movement of goods, then we will be compelled to accept the rest of EU competition law and thereby be prevented from running our own economy in a way that allows us to protect it against external shocks and predatory pricing from outside the EU. If we can't set minimum prices for socially damaging substances like alcohol, then we can't set minimum prices for anything else such as labour. So you can kiss goodbye to the national minimum wage. If we can't support key industries in a recession then you can kiss goodbye to Keynesian economics. In short you can kiss goodbye to any form of economic choice at the ballot box. That is one reason why support for social democratic parties has fallen across Europe. It has fallen because those parties can no longer offer the policies that they once could. Instead they are forced to offer a sanitised version of centre-left neo-liberal economic orthodoxy and so democracy effectively dies.

The freedom of movement of labour

The negative effects of this part of the single market have become obvious. More than any other it has led to mass migration across the continent and widening inequality in all member states. The result has been catastrophic depopulation in the east and high structural unemployment in the west. Yet it didn't need to be this way.

Before most of the eastern former communist states joined the EU they were granted interim status where they were able to trade freely with the EU but had no freedom of movement of people, much as many Brexiteers want for the UK now. The result was that firms inside the EU, including a number of major German car manufacturers, moved some of their production out of the EU and into these states attracted by the lower wages and supply of labour. The jobs moved to where the labour was. Then, when these states gained full membership of the EU it all changed. The jobs stopped moving east and the people were forced to move west instead. Why? Because it was cheaper and more profitable for the corporate sector for people to move to where the jobs were rather than the opposite happening. The result has been one of the greatest economic migrations Europe has seen since the Irish potato famine of the 1840s, and both have been driven by the same laissez-faire liberal economic free-trade ideology.

This highlights one of the key objections to the freedom of movement of labour: it transfers the economic cost of matching jobs to people from the firm to the worker. In effect the costs are socialised and the gains are privatised. There is nothing remotely socially progressive about that. In fact it smacks of moral hazard as was illustrated in extremis by the financial sector pre and post 2007 where the benefits of an unequal system are privatised and the costs socialised. The result for member governments is also potentially calamitous. Their potential liabilities in terms of future welfare and education payments will become unlimited due to immigration while their income could become squeezed by tax avoidance from an increasingly mobile upper-middle class. The result would be either economic insolvency at a national level or a collapse in public services, and before either of these happens we would see a rise in income inequality and unemployment as migrant workers drive down wage rates ever further.

Then there is the effect on tax revenues. Those that support freedom of movement claim it benefits the UK economy, that it leads to increased taxes and that immigrants make fewer demands on public services than the average UK citizen. What they fail to note is that many migrants are temporary and so are exempt from UK tax, and those that stay often send money back to their country of origin. According to the World Bank (pdf) this could be over $11.5bn. This has the double whammy effect of both reducing jobs and GDP per capita in the UK and worsening our current account deficit.

So freedom of movement of labour represents a complete volte-face in terms of economic rationale. It treats workers as little more than a commodity that exists to serve the economic machine rather than treating the economy as a system designed to optimise the happiness of the individual. When coupled with other measures that effectively remove any form of democratic choice for the individual, then it really is the stuff of a some nightmare dystopian future that has so far only really existed in the pages of a few sci-fi novels.

Even more worryingly given that most in the Labour Party appear to support it, it is not even remotely socialist. For a start you cannot have full employment if you have open borders because the faster you create jobs the more migrants will flood in. It is like trying to bail out a rowing boat with a hole in the bottom. And if social democracy is about anything it is about aiming for full employment. On top of that freedom of movement of labour increases inequality. It allows rich countries to strip poor countries of their best talent to the disadvantage of the least well of in both countries. So much for international solidarity.

The freedom of movement of capital

The ability to move capital freely between member states may at first glance seem relatively harmless, but actually it has had a major detrimental impact on the ability of states to balance their budgets. The recent controversy over Apple's tax dealings with Ireland illustrate how multinationals can exploit the freedom of movement of capital to avoid tax. And it is not just Apple. Google's Dutch double-Irish sandwich tax avoidance scheme also plays heavily on this freedom, not to mention that of GSK and many others.

It is of course not just corporate tax avoidance that benefits from the freedom of movement of capital. Tax avoidance by individuals does as well. In my last post I argued for the taxation of UK ex-pats, partly as a way of tackling tax avoidance by the rich. Yet as long as we are in the EU, and more importantly, obliged to respect the freedom of movement of capital such measures will be impossible. In short freedom of movement of capital is at the heart of most tax avoidance, and so as long as we cling to it we will be unable to tackle the scourge of tax avoidance and governments will find it ever harder to raise the taxes they need to fund the services we all want.

And then there is the issue of financial speculation. For years there have been calls for something akin to a Tobin tax to be levied on financial transactions in order to suppress both the size and the volatility of the financial markets in order to improve market stability. Yet such a tax, particularly if imposed on currency trades, would again violate the principle of the freedom of movement of capital.

The freedom of movement of services

Of all the four freedoms this is perhaps the most rarely used, overvalued and misunderstood. The principal argument in favour of it is that because the UK has a large service sector that accounts for up to 80% of its economy, and also because a large part of that is the financial sector that accounts for a large part of our invisible exports, then we desperately need to retain access to the single market in order to protect jobs in London and to generate wealth and taxes. At the heart of this freedom is the concept of the financial passport. This allows any financial institution to operate in any other EU member state once it has been given regulatory approval in another EU state. The problem is that this just doesn't work.

This financial passporting is the system that allowed unregulated Icelandic and Irish banks (among others) to operate within the UK before 2007 and then collapse. It also allowed UK banks to import much of the financial crisis in 2007 from the US and the Eurozone. Do we really want a repeat of that?

The fact is the freedom of movement of financial services is a red herring. After 2007 the City was complaining about excessive future EU regulation. Now it says it needs to be part of the EU. These two positions are contradictory. The reality is it is easy for a UK financial company to open an office inside to EU for regulatory reasons and the cost is negligible. Moreover the financial benefits of exported financial services are puny. Financial services may account for about 13% of the economy, but exported financial services are a mere fraction of that. It really isn't worth the hassle.

Summary

What I have shown is that none of the four freedoms of the single market brings any real benefit. The freedom of movement of services exposes our economy to high risk lending and other dubious financial practices. The freedom of movement of capital prevents governments taxing the rich and large corporations, and will ultimately lead to a collapse in national tax receipts. The freedom of movement of people leads to social disintegration and alienation, inequality and unemployment, and will ultimately lead to a collapse of national finances. The freedom of movement of goods leads to a loss of democratic choice and sovereignty.

What I think all this illustrates is how the EU has lost its direction and its soul. The EU could have been a force for social good. It could have protected workers rights while promoting equality across the continent through the redistribution of income and resources such as through a common industrial policy. Instead of exporting jobs to China and importing labour from Poland we should have been exporting jobs to Eastern Europe thereby re-industrialising the continent and not de-industrialising it.  The result would have been an EU that was richer and more equal. Instead it has become consumed by a neoliberal monster that ultimately has had the opposite effect. That monster is the single market.

The EU, and particularly the single market, has become little more than a protection racket. As we are now seeing as we try to leave, the EU not only bullies those countries that have chosen to join, like Greece, it also bullies those outside. The message it is sending out, even to non-members, is play by our rules or we will trash your economy. This is another reason why it must be stopped.

Time to tax ex-pats

Apparently, John McDonnell, the shadow chancellor, wants Sir Richard Branson to be stripped of his knighthood. Why? Because, he claims, Branson is a tax exile living (for most of the time) on his private island in the Caribbean (well the British Virgin Islands to be exact).

According to McDonnell:

"The whole purpose of the honours system is undermined when the rich and the powerful can collect their gongs without giving anything back. It's even worse when tax exiles are given honours."

Now John McDonnell may have a point, but is his solution the right one? Is the right solution to strip Branson of his "gong"? Or is the better solution to make him pay more tax in the UK?

According to McDonnell the problem is the honours system but I would argue that the real culprit is the tax system. What we are dealing with here is tax avoidance, even if Sir Richard Branson claims his choice of residence is driven by the scenic location and not the potential tax advantage.

Sir Richard Branson is, however, not the only alleged tax-avoiding knight to be domiciled outside the UK. Sir Philip Green has attracted controversy recently, and it is probably only a matter of time before a neighbour of his in Monaco, Lewis Hamilton, receives his own gong as well. So why does this matter? Well, because this issue highlights one of the key issues in tackling tax avoidance: residence.

In previous posts I have discussed how different types of corporate tax avoidance schemes work such as transfer pricing and the abuse of debt interest relief. Other possible techniques involve the abuse of royalty payments, but more on that some other time. Unfortunately it is not just corporations that are guilty. The super-rich, celebrities, sports stars and entertainers are all complicit. And so too are millions of middle income professionals living and working in places like Dubai, or retiring to sunnier climes with lower tax rates. In 2010 it was estimated that 3.97 million Brits were living abroad. Today the figure is probably even higher. Most are earning much more than the average wage in this country and many are earning that money virtually tax free. As I pointed out when discussing Brexit, tax avoidance within the EU is a major factor in undermining the finances of sovereign member states, but so too in tax avoidance from outside the EU.

At the heart of the problem is the tax system itself and its rules. Most countries only tax people who are resident in that country. Additionally they may tax their citizens living abroad, but only on income earned in their native country. The exception is the USA. Only it of all the industrialised countries taxes its citizens wherever they live.

What is now becoming abundantly clear is that taxing individuals on the basis of either their country of residence or the place/location/country of their income does not work. In a globalised world with freedom of movement of labour and capital it is impossible to definitively allocate a person's earnings to a single territory. The result is that it is relatively easy for the rich (and not so rich) to avoid tax to the detriment of their fellow citizens whose employment is less mobile. The only way to solve this problem is to tax people based on the thing that they cannot change or disguise easily: their nationality. So why don't we?

Well part of the reason is historical, but another reason is the EU, and in particular the single market. Single market rules currently prevent us from taxing our citizens living in the rest of the EU, but as we are about to leave the EU there is now no legal reason why we couldn't follow the example of the USA. If we did we could also apply the same rule to UK citizens living in overseas crown dependencies like the British Virgin Islands, the Isle of Man and the Channel Islands. 

So how would this work? Well tax should be payable in two stages. The first obligation should be based on residence (as now) with all individuals being obliged to pay tax first on income derived in their country of residence to the government of their country of residence. However, the second stage would be based on nationality with the payee paying additional tax to their country of origin (i.e. the UK) equal to the difference between what they would be expected to pay if they resided in the UK and all their income was generated in the UK, and the tax on their total global income that they do pay. 

So, for those who are already living in countries that do tax their income on the basis of residence, standard double taxation rules should apply with the UK citizen paying the difference to the UK Treasury between what they pay abroad and what they would pay on their entire global income if they had remained in the UK and all their earning had been generated in the UK. For completeness we should of course continue to tax overseas nationals on their earnings in the UK based on residence. 

In short, the only changes would be that British citizens living abroad would be obliged to pay tax as if they lived in the UK while British citizens living in the UK would be taxed in the UK on their worldwide earnings. 

Taxing UK citizens in this way would have a number of positive advantages. Firstly, it would be easier to enforce. Secondly, there would be no tax advantage for UK nationals to move their country of residence away from the UK. That would make it easier for governments to adjust the tax rates without losing tax through avoidance schemes. Thirdly, it would reduce emigration of highly skilled professionals such as doctors. Fourthly, it would reduce demand for tax havens, and finally it would increase tax revenues. In fact it could raise over £100bn in extra revenues; enough to fund the entire NHS. And then if UK citizens did still decide to go and live on their own private Caribbean island, we could at least be more certain that the decision was more likely to be motivated by a love of the scenery and not by a love of their bank balance.

MMT vs the bond market

Why do governments borrow from the bond market? Is there a better way for governments to finance their deficits than this? If so, what economic factors should determine where governments need to look for finance? These are questions that I have been asking myself over the past few months and years, but I seem to be in a minority. Certainly most mainstream economists don't seem to be that bothered, but I think they should be because it is becoming pretty obvious that the old ways don't work any more.

This week the Bank of England cut interestrates to 0.25% and embarked on a new wad of quantitative easing (QE) in a bid to head off recession. Now I pointed out a few years ago that lowering interest rates to near zero will have practically no effect on stimulating extra demand for credit and so will not create new demand via increased consumer spending in the real economy either. Only a fiscal stimulus will do that but this government has set itself against doing anything that remotely resembles Keynesian interventionism. But as I pointed out last time, even governments that are supposed to believe in Keynesian economics have consistently failed to apply sufficiently large fiscal stimuli during major recessions.

Yes they increase welfare spending, but only because unemployment has increased and that has forced their hand. Meanwhile, they compensate by cutting spending in other areas to try and minimise total borrowing. These cuts often further increase unemployment and lower GDP. This leads to the austerity that we have been familiar with over the last eight years, and while welfare spending has still increased, it has often been undertaken grudgingly and parsimoniously. Consequently, while government spending increases, it does not increase fast enough to reverse the effects of the recession. The result is the recession is longer and deeper than it needed to be and chancellors like George Osborne continuously miss their deficit targets.

So while the government may claim that their actions are Keynesian because they are increasing spending and borrowing in the recession, their actions cannot in any way be considered to be within the spirit of Keynesianism because they make no attempt to restore the economy to full employment or maximum output. But this failure to adhere to Keynesian orthodoxy is not totally ideological. As I pointed out previously, the last Labour government was almost as obsessed with deficit reduction post-2008 as the Tories have been. What drives this fiscal trepidation is fear and loathing about debt. In the aftermath of the 2007 crash the worry was all about debt to GDP ratios and sovereign default. We were bombarded with threats to our credit rating from the very credit agencies that partially created the financial crisis in the first place. We were told that if we borrowed too much we would end up like Greece. But all this was bogus economic scaremongering for two reasons.

Firstly, unlike Greece we had control of our own currency, and secondly all our debt was denominated in our own currency. No developed country has ever defaulted on its sovereign debt when that debt has been denominated in its own currency. But there is another more important point that needs to be appreciated when it comes to sovereign debt. Who you borrow from matters just as much as, if not more than, how much you borrow.

To see this consider these two examples. Greece currently has a debt to gdp ratio of 180%. As a result most economists consider Greece to be essentially bankrupt and incapable of paying back what it owns. Most expect it to default sooner or later. Japan on the other hand has an even higher debt to gdp ratio of 230% but no-one expects Japan to go bust. Why?

The answer is because Greece owes virtually all its debt to foreign creditors (ECB, IMF, German and French banks) in a currency that it cannot print, cannot control, and cannot devalue. Even if Greece left the euro its new currency would devalue and its economy shrink relative to its economic competitors, but its debt would not. So its debt to gdp ratio would skyrocket even further.

Japan's debt on the other hand is owned mainly by its own citizens and domestic banks and corporations and is also denominated in its own currency. The Japanese government can never fail to repay its debts because it can always raise taxes on the people it owes money to in order to pay them the money it owes them. As a result it can never run out of money and the money it pays out in interest and maturity repayments never leaves the Japanese economy. The only risk to the Japanese government is loss of confidence by the public in the government and a rush to liquidate the bonds they hold, but this can be avoided in two ways. Either the government can impose fixed maturity dates on the bonds or savings, or it can borrow from itself in the form of its central bank (like QE). This latter mechanism is the essence of what is known as modern monetary theory or MMT, which I will discuss further in a future post, and what this and previous posts are intended to provide the justification for.

What this shows is that when it comes to national debt, borrowing from within your own currency area is more sustainable than borrowing from outside it. In short, countries that borrow internally instead of externally from the bond market can never go bust. This is one major reason why countries should shun the bond market, but there are other good reasons as well.

Every time a government borrows from overseas it is adding to the current account deficit. The UK gilts created are in effect exchanged for foreign currency which can then be used to purchase additional goods from overseas. This happens without an equal amount of production having taken place inside the UK and then exported. Alternatively, the foreign currency is first converted to sterling in order to buy the gilts, thereby leading to a strengthening of sterling on the currency markets. Neither of these effects is desirable.

So what is clear is that conventional methods of government borrowing come with a significant sting in the tail, and yet as QE has shown, these stings are often unnecessary and could be avoided. So why does most of the mainstream economic community not appear to get this? Why don't they recognise that there might be better ways for governments to finance their deficits and to run the economy?

Well one reason that they continue to use the bond market is perhaps because that is what they have always done. In the times before fiat currency and free flows of capital governments needed to physically borrow other people's money in order to spend it. Money creation was not possible. But I think there is a deeper problem. Economists don't think like physicists. A physicist will always tackle a problem by simplifying it to its core. This means first considering a closed system problem and then looking at system leakage as a perturbation to that initial system. Economics on the other hand seems obsessed with open systems, globalisation and free trade.

What I think MMT could do is allow a government to more effectively internalise its economy and protect its currency. It could enable it to borrow unlimited funds (from its own central bank) in a recession in order to enact a proper Keynesian response to a financial crisis. This in turn could be used to fund investment, job creation or helicopter money which would be far more effective than cutting interest rates to zero or providing QE for banks. The result could be much greater macroeconomic control and shorter and shallower recessions.