Policy Update 068

The Uncertain Consequences of Brexit

President, CEPR / Professor, Graduate Institute, Geneva

On June 23 2016, Britain voted to leave the European Union (EU). The question was simple: "Should the United Kingdom (UK) remain a member of the EU or leave the EU?" with the possible responses being "Leave" or "Remain." The implications, however, are extremely messy since voters were not asked about what should come after Brexit.

The Vote

The Leave voters were on average older, less educated, and less employed than the Remain voters. For example, 73% of 18 to 24 year-olds voted Remain while 60% of over 65 voted Leave. A majority of Britons with jobs voted Remain while a majority of those who were retired or without jobs voted Leave.

The vote was not along party lines. About 40% of Leave voters were from the Conservative Party while about 20% were from the Labour Party (the rest were from the far-right UK Independence Party, or unaffiliated.)

Most striking of all, many of the Leave voters had no idea of the economic consequences of their vote. According to an exit poll conducted on the day of the vote, 69% of Leave voters thought the decision "might make us a bit better or worse off as a country, but there probably isn't much in it either way."

The Brexit process

To exit the EU, the UK has to trigger a provision of the EU Treaties known as Article 50. This launches a two-year process that ends with the UK outside the EU with or without a formal agreement. The period can only be extended by unanimous agreement.

Technically, there are two parts of the Brexit negotiations: a "divorce," and a "remarriage." The divorce settles rather technocratic issues such as how much the UK has to pay for the future and past spending commitments it agreed to when it was a member, and the status of EU citizens who are long-tie residents in the EU and vice versa. For this, the two years will probably suffice; the trickiest part being the amount to be paid (the Financial Times estimated it to be up to 20 billion euros.)

The hard part is the remarriage, i.e. the new economic relationship between the UK and the EU. Here there are three options. Only the first, so-called "Hard Brexit," or the WTO-option, would be quick to negotiation. This would involve the UK exports of goods and services being treated as those of any other WTO member. The exact implication of this would vary by sector and product since EU restrictions on imported goods and services vary, but a rough estimate is that it would be like a rise in the cost of exporting to the EU by 6% due to tariff, red-tape and regulatory barriers that would be imposed.

The second option would be a "deep" free trade agreement of the type that Japan has with, say, Thailand, or the EU has with Canada. This would provide tariff-free trade in goods, but exporters and importers would still face many technical and frictional barriers that arise with the imposition of border controls. (Note that there have been no physical checks between the UK and EU for exported goods and services since 1992, but these would be reimposed.) The UK service sector, especially financial services, would suffer severely under this option.

The third, or "Soft Brexit" option would involve the UK staying inside the deep economic cooperation arrangement known as the Single Market (similar to what Norway is in now.) This would minimize the economic disruption but it would also commit Britain to a deep economic relationship with the EU without having a political voice inside the EU.

A study by professors at the London School of Economics estimated that the Hard Brexit option would lower UK incomes by about 2.6% while the Soft Brexit option would lower them by only 1.3%.

Looking forward

In my view, the current government is split between "ideologues" and "pragmatists" camps. The ideologues want the Hard Brexit option since they cherish a 19th century conception of sovereignty and are unconcerned by the economic disruption it would imply (or deny that it would be costly.) The pragmatists respect the referendum results but want to minimize the damage.

To date, Prime Minister May has kept the two camps together by keeping her "remarriage" plans secret—ostensibly to avoid constraining Britain's negotiating tactics. This intentional obfuscation allows her to suggest that the UK can negotiate a remarriage that gives both the ideologue and the pragmatists most of what they want.

Unfortunately, the EU side cannot agree to this for a variety of reasons. First, it would just not be possible for the 27 EU members to agree unanimously on any special deal within two years (the EU routinely takes several years to agree anything that requires unanimity.) Second, the EU 27 will not want to create an attractive halfway house between being in and out of the EU since this would encourage the anti-EU fringe parties that exist in many of the EU27 nations. Lastly, discussion of a halfway-house agreement would trigger a disruptive discussion inside the EU. The Single Market, which is a complex, delicately balanced deal negotiated over three decades, would be threatened by such discussions. Thus to avoid threatening the Single market—which is important to all EU27 members—the EU will, in my view, force the UK to choose between being in the Single Market with its "four freedoms" (free movement of goods, services, capital and people,) or being outside with access that is no better than what Canadian firm enjoy.

It seems quite clear that the remarriage talks will take years, so some transitional trade arrangement will necessary, but for the same reasons, the EU27 are likely to only accept a continuation of the status quo during the transition and that mean the UK will have to accept all four freedoms including the free mobility of people.

January 5, 2017

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