Britain’s Brexit Vote Opens Way for a Regulatory Rethink

In June, as the world well knows now, the people of Britain voted to leave the European Union. At least some of the popular animus towards the vote was a revulsion of regulatory harmonization. People were fed up with the European Commission’s one-size-fits-all approach towards matters as diverse as weights and measures, bank capital asset requirements, and even the curvature of bananas. Thus, Britain leaving the EU provides not just a chance to rethink the country’s relationship with Europe and the rest of the world, but how we approach global regulation.

Global regulation isn’t going away. As World Trade Organization (WTO) Director Pascal Lamy recently told Institutional Investor regarding two big multilateral trades deals that are currently floundering, “[The Trans-Pacific Partnership] was the last of the classical agreements addressing protectionism, whereas [the Transatlantic Trade and Investment Partnership] would be the first trade agreement addressing the problems not of protection but of ‘precaution’—the standards on safety, quality, traceability and the environment.” In other words, future trade deals won’t be about breaking down tariffs—they’ll be about “harmonizing” regulations.

Trade agreements have been going this way for some time. The North American Free Trade Agreement (NAFTA), agreed in the early 1990s, contains provisions on labour and environmental standards. American trade agreements since then have followed this model, imposed more and stricter regulatory standards on partner nations. Indeed, some recent US agreements, such as the one with Panama that came into force in 2012, have been called “Trade Promotion Agreements,” rather than “Free Trade Agreements,” in recognition of this change in emphasis.

The Trans-Pacific Partnership goes a further, even dropping the word ‘trade’ from its title. The US Trade Representative describes the draft agreement thusly: “[T]he Trans-Pacific Partnership reflects the United States’ economic priorities and values. The TPP not only seeks to provide new and meaningful market access for American goods and services exports, but also set high-standard rules for trade, and address vital 21st-century issues within the global economy.” [Emphases added]

The trend is clearly towards global harmonization of rules and standards. In a sense, this is understandable. Tariff barriers around the world have been falling ever since the General Agreement on Tariffs and Trade, the predecessor to the WTO, was signed in 1948. Today’s main obstacle to increasing trade lies in the form of non-tariff barriers, mostly national-level regulations designed to protect local industries.

These can range from food “safety” standards grounded in cultural bias to customs border inspections designed to slow imports. A famous example was France’s response to affordable video cassette recorders from Japan. The French government required that all VCR imports had to pass through one customs house in Bayeux that was so small it had but one inspector who worked less than five hours a day. The Japanese had little ground for complaint, as Japan has its own onerous inspection rules—such as one that requires customs inspectors to draw a picture of the imported object.

Regulatory harmonization reduces some of this problem. If all goods are produced according to the same standards, there is no need for burdensome customs inspections. This was the guiding principle behind the abolition of border trade controls within the European Union’s customs union. A VCR constructed in Budapest is treated the same as one produced in Bayonne.

Extending the principle to be included in trade agreements might make some sense upon first look. But such harmonization is often bad news for people in the developing world, as it can result in protectionism by other means.

Poorer countries have what a comparative advantage in trade, based on their lower costs of production. If those costs are increased as a result of stricter regulation demanded by their developed country trading partners, their advantage will be reduced and they will export less.

This is why American trade unions lobby for strict labour regulations in trade agreements. They view lower labour costs in developing countries as “unfair” competition for the companies where their members work. Jobs will be lost at home without these standards, they claim. They are right, up to a point.

The principle of comparative advantage—first developed by English economist David Ricardo in 1817—suggests that countries should give up on industries, even where they are better at them than their competitors, if they have an even bigger advantage in other areas. For example, Courtney Walsh may have been an excellent car mechanic, but it made more sense for him to concentrate on cricket and pay someone to fix his vehicle. Regulatory harmonization erodes comparative advantages by imposing uniform rules on countries facing different circumstances, and leads to a misallocation of resources.

It’s also potentially very bad news for people in the developed world. Not only do they not gain the advantage from trade they could get in terms of more affordable imports, but harmonization itself magnifies risks that already exist. A good example is the move towards harmonization of financial services regulation following the financial crisis.

An agreement amongst global rulemakers to regulate financial services the same way means that if the regulations are faulty, the world could face a global crisis. We saw this at play during the euro crisis. The Basel II capital standards assigned very low risk to sovereign debt, which provided an incentive for banks to hold national debt as a way to meet their capital reserve requirements. As it turned out, debt from countries like Greece and Spain proved to be very risky, leading to a loss in confidence in European banks and the need for continent-wide bailouts. While the Basel Accords have been updated recently, banking regulators are often still “fighting the last war,” and their rules may become hostage to fortune.

Last but not least, there’s a risk of regulatory cartelization. You have to be in the harmonized club or you don’t get access to the club’s markets. That is what happened with the European Union. Former Czech President Vaclav Klaus lamented that his country spent so much time liberalizing after the fall of the Berlin Wall only to have to reimpose so many of the same restrictions on business when it joined the European Union. Moreover, being in such a club results in an ever-increasing cycle of more regulation as national governments do not have to worry about other member nations developing better policy. Again, this is what happened with the European Union.

This is why Brexit could prove so important. The British people’s implicit rejection of harmonization as a prime objective of trade policy could lead to a new focus on regulatory competition.

Most people agree that competition is a good thing. Even President Obama sings its praises, having signed an executive order last April directing his administration to take steps to increase competition. In markets, competition imposes discipline that can deliver great rewards for innovation, quality, customer service, and value for money—and punish those who fail to deliver those things. The world beats a path to your door when you design a better mousetrap, while those who cling to the old way get left behind. Even a great company like Eastman-Kodak, once a proud member of the Dow Jones Industrial Index, can disappear as a result of misjudging competitive forces.

In the world of international regulation, competition works like this: Two countries recognize each other’s regulatory regimes as equivalent in aims and objectives, and allow goods and services regulated in one country to be marketed in the other. This process can quickly reveal deficiencies in one country’s rules, point to better regulatory practices, and create pressure for reform.

Regulatory competition is inherent in the United States’ federal system of government. Different state regulators demand different rules for goods and services produced in their states, but for the most part these pose no obstacle to interstate commerce. Such “competitive federalism” allows states to serve as laboratories, conducting experiments to see which regulatory systems work best. For example, in some states, labour unions may collect dues from non-members, while in other states “right to work” laws bar collection of forced dues. More states recently have adopted “right to work,” as it provides significant economic benefits.

Similarly, as anyone familiar with the US banking system knows, some small local banks call themselves incongruously “national banks.” That is because they are chartered by the federal government rather than their state under rules from the 1860s, revived in the 1990s, that allow for the formation of banks under national, rather than state, rules. These rules are often stricter than state rules—they have higher capital requirements, for example—but provide a way for banks to operate across state lines without having to navigate a patchwork of varying state rules. Yet, as national banks gained a competitive advantage, state banks responded by introducing such innovations as payment by check.

On an international level, regulatory competition already exists in the form of Mutual Recognition Agreements (MRAs). These agreements allow the free flow across borders of goods manufactured according to different regulatory standards. An example is the MRA between Germany and its EU partners that allows the sale in Germany of beer not brewed in accordance with the country’s centuries-old Beer Purity Law, the Reinheitsgebot. As it happens, Germans quite like those laws, so foreign beers have not diluted the market noticeably, but the MRA means German brewers can produce beers for export not subject to the law, allowing them to cater to different consumer tastes across Europe.

Mutual recognition is also at the heart of EU financial regulations for the “passporting” of financial firms into EU markets. Passporting is policed by the European Securities and Markets Authority (ESMA), which can also grant passporting rights to non-EU firms on the basis of “regulatory equivalence”—a recognition that other jurisdictions provide a similar level of quality assurance. In July 2016, ESMA recommended extending passporting rights to firms from the United States, Australia, Canada, Guernsey, Hong Kong, Japan, Jersey, Switzerland, and of course the Cayman Islands. Therefore, it is highly unlikely that passporting will be refused to the UK’s financial services industry after the nation leaves the EU.

As the UK sets to embark on a hectic round of trade negotiations to offset any problems that may result from its exit from the EU’s customs union, MRAs and regulatory equivalence could prove to be Trade Minister Liam Fox’s secret weapon. They will significantly cut down the time needed to conclude trade deals, by circumventing the extensive wrangling over the details of harmonization that takes up most of the time in trade negotiations these days. Prime Minister Theresa May’s government should follow that route.

With the UK having similar regulatory aims as most other developed nations, equivalence should be easy to demonstrate. The trade deals the UK negotiates over the next few years could demonstrate that whatever happens with the TPP and TTIP, regulatory competition is the way forward for world trade.

Originally posted at Cayman Financial Review