Among Uncertainties After Brexit Vote, Low Growth Is Sure

British voters elected to leave the European Union, which in turn ushered in new leadership for the United Kingdom. But few are sure of the next step, and British leaders are wise to proceed cautiously before invoking Article 50 of the EU treaty and starting the process of negotiating a separation agreement. If agreement is not reached in two years, membership ends unless both parties approve an extension. British voters seek freedom from regulations and immigration requirements, but “The greater freedom UK negotiates will lessen access to the common market,” warns economist David Dapice. Consultants list options, but the bottom line is that the European Union has little reason to open its market to those who reject outright its standards and rules. About 44 percent of British exports head to the EU. Many costs and gains of Brexit– including new trade rules, foreign investment, inflation levels and status for British banks – won’t become apparent until negotiations begin and policy is set. That could take years, and in the meantime, uncertainty ensures lackluster growth. – YaleGlobal

Among Uncertainties After Brexit Vote, Low Growth Is Sure

Britain moves slowly on EU exit – every new freedom negotiated will decrease access to the common market
David Dapice
Thursday, August 18, 2016

Britain great no more? Supporters of keeping Britain in the European Union suffer defeat, top; new Prime Minister Theresa May has the unenviable task of discussing separation with EU leaders like German’s Angela Merkel

MEDFORD: As the dust settles after the emotional British breakup decision, the cost of leaving European Union turns out to be far higher than the benefits it was expected to confer. The hope that Britain will gain greater freedom from the EU bureaucracy while retaining lucrative access to the pan-European market has turned out to be a chimera. The greater freedom UK negotiates will lessen access to the common market. Revisiting the question might allow the electorate to revoke its decision, but voters may not go along.

The negative consequence of Brexit is already evident in falling growth rate. The Economist Intelligence Unit in January expected the United Kingdom’s annual growth of GDP to average 1.9 percent a year from 2017 to 2019. The Economist Intelligence Unit now expects zero growth, falling investment and rising debt/GDP levels. The United Kingdom, representing only about 3.5 percent of global GDP, will have limited bargaining power in trade negotiations compared to the 20 percent or so that the EU, including the UK, had in 2015. Many UK banks and financial services are likely to be constrained, their status reduced, as they no longer have the same access to the vast European market. Tighter migration controls – a major point of the Brexit vote – will further reduce the quality of the labor force without clever parsing of applications.

In addition to low growth prospects, many northern English cities will lose EU infrastructure funding and struggle to attract either private investors or national support from a strapped government. The United Kingdom itself may well split, with Scotland leaning towards leaving and Northern Ireland facing difficult decisions. This would further shrink the size of the remaining portion of the UK and remove valuable North Sea resources, even while diminishing and expensive to extract at current oil prices, and military bases. Clarifying new arrangements with the EU may take a decade, and uncertainty during that period will depress investment.

Former Prime Minister David Cameron had tried to open a warm bilateral relationship with China, but the likely cancellation of nuclear projects, while economically justified, will also put a chill on relations with Beijing and affect economic ties with France, China’s co-partner for the project.

Global Counsel, a consulting group, has outlined several possible “solutions” to negotiating a new set of arrangements. One model, Norway, is not an EU member, but has access to the single market – at the cost of agreeing to the external tariff, regulations and internal immigration rules without ability to influence those rules. Norway also contributes to the EU budget – politically difficult for the UK. Switzerland negotiates a series of accords on specific sectors with the EU – but would the EU go out of its way to offer favorable terms to the UK? A free trade arrangement is possible, but again the UK must accept the EU standards and regulations to secure preferred access. About half of UK imports from the EU is in intermediate goods, where, say, a Dutch component is used in a UK product that’s sold to another EU member. Preserving this flexibility is crucial to maintaining UK industry in its present form. If the negotiations took the form of a Customs Union, the coverage would be negotiated at the sector level. Depending on the sectors and the terms, the outcome could be reasonable or quite unfavorable. Finally, the UK could just rely on the WTO and “most favored nation” treatment, but then must face the common EU external tariff. That would necessitate substantial structural adjustment during an extended period of uncertainty.

In general, the dilemma is that by negotiating more freedom, the UK obtains less access to the EU market. The question remains whether freedom is worth the lack of access, when 44 percent of UK exports of goods and services go to the rest of the EU, excluding Scotland. The Brexit vote seemed to demand more freedom without contemplating the tradeoffs. The concern is not just the trade in goods in play – foreign direct investment may well contract if EU access takes a big hit. Financial services, an outsized part of the UK economy, at 8 percent, could suffer badly. UK influence over the continent’s immigration policy or regulations will decline, though the British can expect to still adhere to EU rules and policies to secure liberal trade access. The international heft of the UK in negotiating new trade deals outside of the EU or in other matters is likely to suffer as it becomes a more isolated and smaller player. The budget, it was argued, was a major reason to leave and the UK does pay more out than it gets.   

The budget numbers, however, are not large in net terms. In 2015, the UK paid about £13 billion to the EU – and would have owed nearly £18 billion but for a deduction negotiated by Margaret Thatcher in 1984 – but received about £6 billion in various subsidies and transfers. So the net “hit” was less than £7 billion in an economy with a GDP of £1900 billion. The lost growth projected for 2017-2019 will be five times as much each year, and the lower taxes from that lower output suggest that budget gains will evaporate. Taxes over GDP in the UK average 35 percent, so a drop of £36 billion a year in lost GDP growth will mean £12.6 billion a year in lost revenue, far more than the net EU cost.

Likewise, industrial policy may be freed up, but with lower revenues, more demands from displaced workers, and WTO rules to comply with, the gains here may also be meager. It’s hard to spin the outcome in any positive way that offsets the real costs of Brexit, if only through the prolonged period of uncertainty, lower growth, depressed investment and shrinking international attractiveness. A large part of the services exports comes from the net contribution of the financial sector – fully 3 percent of GDP. This helps offset the growing deficit in the goods trade. If this financial export contribution declines along with FDI inflows, including less in the purchase of real estate, the pound will take a considerable hit, driving up inflation through higher prices of imported goods. While a weak pound should curtail imports and help exports, this might take a large shift in exchange rates to work well, and then only after a lag.

Prime Minister Theresa May’s government has the unenviable task of carrying out the voters’ wishes. A dysfunctional Labor Party will offer few ideas. Younger and more educated workers will be angry and consider leaving. Older ones may realize a mistake was made, but blame others. Amid so many bad choices, political leaders will quarrel about how to proceed.

Any sober assessment cannot escape the conclusion that the Brexit vote was certainly an economic mistake and likely a political one as well. Revisiting the question would allow the electorate to either confirm or revoke its recent decision. If this is off the table, then the government must work for years to get the best deal it can – and that’s likely to be worse than being a full member of the European Union.  

David Dapice is the economist of the Vietnam Program at Harvard University’s Kennedy School of Government.

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