Commentary | 30 June 2016

Economic risks of Brexit are big but unclear

Originally published in the Nikkei Asian Review.

Originally published in the Nikkei Asian Review.

Executive Summary

Global financial markets will soon recover their composure after the Brexit decision, but the damage to Britain will endure. Before the vote George Osborne, the U.K. finance minister, quoted Treasury forecasts of "an immediate and profound shock," with a worst case "severe shock" scenario in which growth in gross domestic product would fall by 6% over two years, with unemployment rising by 500,000.

Osborne saw the outlook over the next 15 years as equally parlous, saying: "If we take as a central assumption that the U.K. would seek a negotiated bilateral agreement [with the EU], like Canada has, the costs to Britain are clear. Based on the Treasury's estimates, our GDP would be 6.2% lower, families would be 4,300 pounds ($5,762) worse off and our tax receipts would face an annual 36 billion pounds black hole."

Of course he was talking before the vote, arguing the case for staying in the EU on the basis of the Treasury's worst case scenario for short-term impact and its mid-case scenario for the longer term. That said, the predictions are not a politician's arm-waving fantasy: they are model-based, and their Treasury source lends credence. This would be a huge hit: on these assumptions, Britain's GDP would be 6.2% lower in 2031 than it would be if the U.K. remained in the EU -- a permanent loss equivalent to more than two years' growth. Can Britain's future really be this dire?

This pessimism makes more sense if we recognize that Britain actually has a very attractive deal with its EU membership. Of course, membership of a common market has pluses and minuses. There are some goods that Britain could buy from low-cost non-EU suppliers, but instead buys from more expensive EU sources because the outsider's price is inflated by EU tariffs and product rules. This is, however, far outweighed by the advantage of having seamless trade linkages with a large nearby market. Half of Britain's exports go to Europe, passing through the well-lubricated procedures within the common market, protected from outsider competition by the administrative complexities facing non-EU rival suppliers.

Britain has also been able to piggyback on the 60 trade agreements that the EU has negotiated (with even more currently under negotiation). Britain will be excluded from these, and when it comes to negotiate equivalent agreements in its own right, it will find itself, in the words of U.S. President Barack Obama, "at the back of the queue."

With its advantage of a universal language, political stability and a strong legal system, Britain was not only the first choice of foreign investors wanting to get access to the European market, but was the global gateway for European companies trading with the rest of the world. British industry was able to reap economies of scale and scope by being part of a larger production chain. The British automobile industry, moribund before membership of the EU, revived in a different but highly productive form when it had the opportunity to work jointly with continental manufacturers and non-EU manufacturers using the U.K. as their European base.

Seamless integration

This seamless integration with European rules and procedures is nowhere more important than in the financial sector. Thanks to expertise, language and law advantages, together with EU "passporting" procedures that allow U.K.-based companies to operate in all 28 member countries, London is effectively the wholesale banker to the whole of Europe. As a result, finance accounts for 8% of British GDP and London buzzes with the dynamism of big-spending financiers. This sector will not collapse, but some part of it will have to cross the Channel to retain access.

While having this advantage, Britain has not had to give up its own currency -- with the loss of monetary independence that would be entailed if it had been in the eurozone. British monetary policy had the freedom to react to the 2008 financial crisis without being shackled to the one-size-fits-all policies of the European Central Bank, with its diverse membership. The pound depreciated after the 2008 global financial crisis, which must have been helpful in supporting domestic economic activity. Britain negotiated further favors: it obtained a specific exemption from having to contribute to the cost of rescuing troubled banks in the rest of the EU, thus avoiding the inevitable burdens faced by the EU in completing the unfinished rescue of Greece (and perhaps others).

While Britain had to open its borders to EU immigration, this simultaneously opened the opportunity for easy access to the pleasures and job opportunities available in the rest of the continent: there are roughly as many Britons enjoying life elsewhere in Europe as there are EU migrants in Britain. The competition in job markets from hard-working and strongly motivated immigrants is unpalatable to some who see their jobs threatened, but for the economy as a whole this sort of immigration is a clear benefit.

As a further favor, the U.K. negotiated special exemptions that allow it to restrict social security payments for recent immigrants. This is tough on new arrivals, but a safeguard for the budget. Britain is not a signatory of the Schengen Agreement, so retains the border controls that passports provide.

The clear vote by a majority of younger people in favor of remaining in Europe is a measure of how the upcoming generation values access to jobs elsewhere in the EU.

Immigration was certainly a vexed issue, but to see this as an EU problem ignores the fact that around half of Britain's immigrants come from non-EU countries. Prime Minister David Cameron's promise to dramatically reduce immigration was incompatible with continuing membership of the EU, but it seems just as unachievable with Britain outside the EU.

There are many risible stories about the EU's regulatory requirements for uniformly-shaped bananas and cucumbers, and no doubt the Brussels bureaucrats have over-reached at times. But an increasingly complex world that demands higher standards of safety and performance will inevitably be one with greater regulation. Globalization reinforces this, with a need for supranational regulation.

Departing from the EU will not lighten the regulatory burden much, if at all. According to the Organization for Economic Cooperation and Development, Britain already ranks as the second-lightest regulator of product markets (lower than the U.S.). British exporters will still need to meet European biosecurity, product-safety and rules-of-origin requirements.

In any case, many of the most efficiency-sapping regulations are home made (such as urban planning rules and building regulations). Post-EU Britain could go its own way on issues such as the environment, but again there are powerful pressures to conform (not least from the domestic public). In short, Britain has largely succeeded in avoiding the worst excesses of the Brussels bureaucrats.

Is there an economic upside?

Does the potential loss of this long list of advantages that Britain has derived from EU membership justify Osborne's gloomy pre-vote prognosis? Now the vote is over and the die is cast, he is trying to sound positive about the future. The opportunities to retain these EU-related advantages are, however, tightly constrained.

Since seamless integration into the common market is such an advantage, why not retain it through membership of the European Economic Area (as Norway has done) or by separate negotiation (as Switzerland has done). EEA members retain full access to the EU single market, including in financial services, in return for a contribution to the EU budget, but are exempt from many other aspects of EU regulation in areas such as defense, home affairs and justice. Switzerland has a network of separate agreements with the EU that amount to a similar outcome.

Both these countries, however, are required by Brussels to allow free immigration from EU countries. (and are signatories of the Schengen Agreement). With these precedents, the EU is not going to agree to a high degree of trade access for Britain without the same open immigration obligations. Since immigration was the key motivator for Brexit, it is hard to see any prospect of retaining de facto common market status. Nothing better than the Canadian model (which was the basis of Treasury's grim central forecast) is likely to be on offer.

Surely there are some offsetting advantages in Brexit? Possibly. If it gives up access to the single market, Britain will not have to contribute to the EU budget. This would provide a saving, but payments between London and Brussels are a two-way flow, with the net contribution about 0.3% of Britain's GDP. This is not small change, but nor is it much compensation for the forecast reduction in GDP growth.

Are there big efficiency gains from ending the country's involvement with the EU's notoriously uneconomic Common Agricultural Policy? The problem is that many British farmers rely on these subsidies for their continuing viability (Britain gets back about half of its CAP contributions to Brussels in the form of subsidies to its farmers). It would be hard to wean the farmers off this assistance, so domestic subsidies are sure to replace the CAP subsidies in the short run. In the longer term, it would take a rural revolution to reap the potential gains from ending the CAP.

Forecasting such a complex change is fraught, and Osborne had good reasons for making Brexit look painful. The Treasury forecasts for Brexit did contain less pessimistic scenarios: the least bad envisaged a short-term fall in GDP of 3.6% over two years, and a reduction in growth of 3.4% over 15 years. Economists for Brexit, a group that includes some prominent U.K. economists, says GDP could rise significantly if Britain significantly reduces regulation and declares free trade with the world. The problem, of course, is that no British government is likely to take such a radical step.

More than half of Britain's voters took no notice of the economic debate. Confused by conflicting forecasts and contemptuous of so-called experts and their models they voted against immigration and against what they saw as the establishment. In this, they may be right. Economies are enormously resilient, and the Treasury scenarios on which Osborne based his warnings are a series of possible descriptions of Britain's future, not privileged glimpses of an inevitable outcome. The long term is in any case unfathomable -- no one looking at Italy or Germany in 1945, or at Ireland or India in 1979, would have forecast the extraordinary growth these countries achieved over the following 35 years. One thing, however, is indisputable: the downside risk to Britain and its former European partners has been hugely increased by the events of June 23.

Stephen Grenville is a nonresident fellow at the Lowy Institute for International Policy in Sydney and a former deputy governor of the Reserve Bank of Australia.