Philippe Legrain looks at the options available to the UK as it starts extricating itself from the EU and warns about the economic consequences.
Britain’s shock vote to leave the European Union is a political earthquake that is likely to have severe economic aftershocks. The country 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.
The economy is already on the brink of recession. Business and consumer confidence have plunged. Companies are postponing or cancelling investment and employment decisions. Housing prices look set to fall, denting Britons’ principal form of wealth. 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 is unlikely to help much. It may lift inflation, cutting real wages and hence spending. But few companies will invest in increasing export capacity with global demand weak and trade terms and regulation uncertain. Nor will the Bank of England’s quarter-point interest-rate cut provide much stimulus – and with Treasury bond yields at record lows, neither will reviving quantitative easing (QE). The downturn will also widen the budget deficit, already 4% of GDP. While fiscal stimulus is feasible, it seems unlikely. Eventually a poorer Britain will need to cut public spending and raise taxes, compounding the misery.
This uncertainty is likely to be prolonged. Extricating 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. While this would involve the return of customs controls and rules-of-origin requirements, Britain would retain almost full access to the EU single market (with opt-outs from EU agriculture and fisheries policies) and gain the right to strike its own trade deals with non-EU countries.
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 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 is to trade with the EU on the basis of World Trade Organisation (WTO) rules. This would entail tariffs on UK goods exports – 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 they might seek continued access on the basis that Britain had “equivalent” financial regulations, that (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 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.
The WTO option would still be tricky. 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 thinking 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 anxious to maintain access to the UK market, there are others – notably financial centres – keen to gain 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.
Brexiteers argue that Britain can make up for lost exports to the EU with increased sales to faster-growing economies such as the US, China and India. But in the near term, Britain will lose the benefits of the trade deals with 50-plus countries that the EU has negotiated. Since the government lacks trade negotiators, it will struggle to strike new deals quickly. And while future negotiations will not be hamstrung by protectionist interests 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 turn of American politics, a US trade deal is unlikely soon.
As for slashing regulation, there is no political appetite for this. On the contrary, Theresa May has signalled greater state intervention, while the government is committed to hike the minimum wage.
Britain is heading for a Brexit bust. It cannot expect Germany, France and its other much-maligned EU partners to save it from the consequences of its colossal blunder.
Philippe Legrain is a senior visiting fellow at the London of Economics’ European Institute and the founder of Open Political Economy Network (OPEN), an international think-tank. He was previously economic adviser to European Commission President José Manuel Barroso and special adviser to World Trade Organisation Director-General Mike Moore. His latest book, European Spring: Why Our Economies and Politics are in a Mess – and How to Put Them Right, was among the FT’s Best Books of 2014.
Published in August 2016