A way out of the Brexit morass?
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Brexit-bound Britain will participate in this month’s European Parliament (EP) election, unless UK prime minister, Theresa May, and opposition leader, Jeremy Corbyn, manage to push the thrice-rejected EU withdrawal agreement through the House of Commons …

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Economic repercussions of a political convulsion

Submitted by on 29 Sep 2016 – 09:00

The historic plebiscite has tipped many into disillusionment and despair. While the poor, the jobless and the pensioners would face the severity of the Brexit storm, Philippe Legrain, British political economist, journalist and founder of OPEN think tank, says its ripple effects will be felt in every aspect of Britain’s trading relationship with the EU. Making a thorough scrutiny of Britain’s political, economic and trade options, he pinpoints the major economic lessons of Britain’s Leave vote

The Brexit vote is a political earthquake whose economic aftershocks are likely to be severe.

Britain faces years of political instability, financial turbulence and economic uncertainty that will depress investment and growth. It is likely to end up with a more closed labour market, worse access to European and global markets, lower foreign investment and a more corporatist and protectionist EU on its doorstep – crimping productivity, growth and living standards.

For the feeble and fragile eurozone, Brexit is also a dangerous shock. Economies such as Ireland and the Netherlands are highly exposed through trade. Heightened risk aversion and collapsing share prices seem to have brought Italy’s banking crisis to a head. Above all, Brexit exacerbates fears about continued European Union disintegration, giving businesses another reason to postpone investments.

Britain’s economy is already on the brink of recession. Business confidence has plunged to its lowest since the 2009 slump. With massive uncertainty about future trade, regulations and demand, many companies are postponing or cancelling investment and employment decisions. Foreign investors are pulling out of deals. Open-ended commercial-property funds are preventing investors from withdrawing their money. Housing prices look set to fall, denting Britons’ principal form of wealth. All this is likely to deter consumers from spending. And with a current-account deficit of 7% of GDP, Britain’s economy is reliant on flighty foreigners to keep financing it.

A cheaper pound – down 9% in trade-weighted terms since the Brexit vote by the end of July – is unlikely to help much. As after sterling’s collapse in 2008-9, it may lift inflation, cutting real wages and hence spending, while doing little to boost exports. Few companies will invest in increasing export capacity with global demand weak and trade terms uncertain.

Monetary policy can’t help much either. Official interest rates have fallen to a record low of 0.25%; negative interest rates have proved counterproductive elsewhere. With UK Treasury bond yields at record lows, reviving quantitative easing (QE) probably wouldn’t provide much stimulus.

The downturn will also widen the budget deficit, already 4% of GDP. While fiscal stimulus is feasible, the Conservative government seems unlikely to embark on it. Eventually a poorer Britain will need to cut public spending and raise taxes, compounding the misery.

This uncertainty is likely to be prolonged. Extricating Britain, the EU’s second-largest economy, from the Union will be extremely complex. Britain must also negotiate a new trading relationship with the EU, with which it does nearly half of its trade. That could take many more years.

Economically, the least-damaging option would be to join the European Economic Area (EEA), with Norway, Iceland and Liechtenstein. Britain would retain almost full access to the £11 trillion EU single market (with opt-outs from EU agriculture and fisheries policies), while gaining the right to strike its own trade deals with non-EU countries. But EEA membership would still involve the return of customs controls and other barriers such as rules-of-origin requirements.

Politically, though, the EEA option seems a non-starter. It would involve accepting single-market rules and associated EU legislation in areas such as consumer, environmental and social protection, without a say in setting them. It would require continued contributions to the EU budget, without receiving spending in return. And it would entail continued freedom of movement for EU citizens – an economic boon, but a political bugbear. At best, then, EEA membership might be a transitional arrangement.

The fallback option is to trade with the EU on the basis of World Trade Organisation (WTO) rules, as the United States and China do. Such a “hard Brexit” would be much more disruptive. It would entail tariffs on UK goods exports to the EU – as much as 10% in the case of cars – as well as non-tariff barriers. It would offer little access to EU markets in services, in which Britain specialises. UK-based financial institutions would lose their “passport” to export freely to the EU. While financial firms might seek continued access on the basis that Britain had “equivalent” financial regulations, which (political) judgement would be up to the EU.

Without full access to the single market, foreign investment – and the good jobs tied to it – would be lower. Trade barriers also entail less competition, and so less pressure on companies to innovate and become more productive. And while the UK could restrict EU migration, this would have an economic price. Many businesses and organisations rely on hard-working EU migrants, who pay more in taxes than they take out in public services and benefits. Their willingness to move around and do jobs that Britons spurn is a key element of the country’s much-vaunted labour-market flexibility.

The WTO option would still be tricky and time-consuming. Britain needs to apply for independent WTO membership and agree a schedule of commitments with the 163 other WTO members. Eventually, Britain might negotiate a Canadian-style free-trade agreement with the EU, which is basically WTO-plus.

Brexiteers are deluded in claiming that Britain will be able to cherry pick what it likes about the EU: enjoy free trade while keeping out EU citizens. Exports to the EU (13% of GDP) matter more to Britain than exports to the UK (3% of GDP) do to the EU, so the EU will have the whip hand. And for every EU firm keen to maintain access to the UK market, there are others – notably financial centres in Frankfurt, Paris, Amsterdam, Dublin, Luxembourg and elsewhere – keen to steal a competitive advantage. EU governments also have a political incentive to drive a hard bargain, to dent the appeal of anti-EU parties such as France’s National Front and deter other countries from leaving. Any deal would require the consent of all 27 remaining EU governments, each with their own economic demands and political constraints.

Whatever happens, a post-Brexit Britain is set to end up with worse access to EU markets. Brexiteers argue that the UK can make up for lost exports to the EU with increased sales to faster-growing economies such as the US, China, India and Australia. But in the near term, Britain will lose the benefits of the trade deals with 50-plus countries that the EU has negotiated on its behalf. Since the government has hardly any trade negotiators, it will struggle to strike new deals quickly. And while any future UK trade negotiations won’t be hamstrung by protectionist interests elsewhere in the EU, as a much smaller economy with largely open markets and a government desperate to do deals, Britain will also have much less leverage. And given the protectionist tone of the US presidential election, a trade deal with the US is unlikely any time soon.

Brexiteers also argue that Britain could boost growth by slashing regulation. But its labour markets are already the least-regulated in the EU and its product markets the second-least, so any potential gains are likely to be slim. Besides, there is no political appetite for such deregulation. On the contrary, Prime Minister Theresa May has signalled greater state intervention, while the government is committed to raise the minimum wage substantially.

Britain is heading for a Brexit bust and beyond that weaker growth. Hardest hit will be the poor, the jobless and pensioners – often Leave voters – who depend on taxpayer largesse. It is tragic.