Will the UK economy be hurt by Brexit?

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Almost two weeks after Britain’s shock vote to leave the European Union, there is still uncertainty about what might happen to jobs, trade and investment.

THERE ARE clearly immense ramifications for the UK’s decision to leave the European Union.

And there is also no doubt that these consequences will play out over decades to come.

The reaction in financial markets to the June 23 vote was immediate and brutal, with the pound down to levels last seen in 1985, stock markets sliding sharply, oil price lower and global financial markets severely affected.

The reason appears to be that financial markets, in particular, had self-selection bias: most of the people they knew were saying they would vote to remain and most of what they read confirmed their views. The underlying assumption was that, in the end, a majority would vote to remain, as the benefits of being in the EU were so obvious – to financial market participants.

The referendum results highlighted a split in the UK between the under 25s and the older generation; between metropolitan and rural; between educated and less well educated; between areas of fast economic growth and weak economic growth, and between the better off and the less well off or combinations thereof.

These divisions are not just a UK phenomena, of course. One can see these trends repeated in the US, Poland, Hungary, France Germany and other European countries. It seems anger against globalisation – as the market economy spreads the benefits of progress and rising living standards around the world – is also creating winners and losers. This outcome is leading to dissatisfaction, and some people are feeling left out and not consulted and, perhaps, that they do not matter.

In the long run, no one can say for sure they know what the economic implications of the UK’s exit from the EU will be.

Much of that depends on what sort of deal is struck and how the UK responds to its ‘independence’ to chart its course free from cooperating with 27 other countries in the EU.

For instance, if the UK has a deal similar to Norway, which is allowed access to the EU market but must accept free movement of people and pay an entry fee, perhaps the impact would not be that significant. But if, as it seems, free movement is anathema to many that voted to leave, this deal would be a non-starter.

If, on the other hand, the UK could have a deal similar to the recent one just concluded with Canada, which focussed on trade but had no free movement of people, that might be acceptable to Leavers that wanted to reduce immigration drastically. But that deal still took nearly three years to conclude and will not be as beneficial as the deal the UK had when it was a full member of the EU.

NEGOTIATE

Indeed, it appears that the UK will first have to negotiate its way out of the EU, which could take two years and then negotiate a new trade deal, which could take a further two to five years.

In the longer run what happens will rest on the deal struck with the EU and the success of the UK in forging news ties with the rest of the world to replace its EU links.

There are two useful economic facts to bear in mind when ways of thinking about the benefits of markets and trading, though.

First, we must remember that David Ricardo proved freer trade benefits all participants, even if they lowered barriers unilaterally because competing with the best raises productivity.

Second, the fact that a bigger market offers greater economies of scale, lower average costs and higher profitability as well as lower prices to consumers which leave them with enough spending power left over to buy other goods and services compared is well known.

From a macroeconomic perspective, these outcomes result in increased investment spending and this, in turn, generates higher levels of productivity. In turn, this leads to higher paid jobs, greater levels of employment and so raised living standards. A smaller market and slower growth in the labour force means slower economic growth than in the other case. Moreover, multilateral deals are better than bilateral deals.

The desire to be a global economy may be salutary but the UK is a smaller economy than the EU so has less to offer other markets and will not get deals that are as advantageous. Of course, that is clearly seen as a price worth paying for the freedom of being able to make these deals on its own. In the same vein, the desire to look at regulation from the EU and reshape them to suit the UK is a good aim but whether or not it leads to substantial reductions remains to be seen.

Of course, the EU will also be affected, with the loss of one of its largest economies, the third biggest contributor to the EU Budget and an advocate of free trade and a market economy. But the impact will fall asymmetrically on the UK. This is because whereas the UK exports 44% of its goods to the EU, the EU exports just 7% of its products to the UK.

However, no matter how the exit negotiations play out, we expect a significant negative hit in the short run.

Economic growth was just 0.4 per cent in Q1, and there was little momentum going into Q2. With the uncertainty and volatility created by the vote to leave, a surge in GDP in Q3 and Q4 now seems unlikely. In fact, the reverse seems more likely: that growth slows even further. In other words, the UK economy might struggle to expand by 1 per cent this year.

Beyond that, some other critical factors matter.

Proportionally, the UK is more dependent on exporting to the EU than the EU is of exporting to the UK for the simple reason that the EU economy is much bigger than that of the UKs. Some EU countries, like Germany, trade a lot with the UK others, like Poland, less so.

DEFICIT

The UK has a significant current account deficit to fund, so needs to strike trade deals that allow it to remain an open economy and investment to flow in to support its appetite for goods from abroad.

The UK is overwhelmingly a services economy, nearly 80 per cent, so it wants trade deals that allow access to its services based firms. Since it has lost access to the services market in the EU and the prospect of further reform, it needs to cut other deals.

Manufacturing may face higher tariffs when exporting to the EU in 2 years’ time, even if is a new deal is struck by then which seems unlikely. In such a situation, typical World Trade Organisation (WTO) rules would apply, and those tariffs are higher than the ones the UK has now, which are zero now since it is in the EU bloc.

Higher tariffs could similarly hit agriculture. Also, EU farm subsidies will end in two years, and a plan to replace them needs to be made. Whether the UK government will offer the same support to its farmers as Brussels might be in doubt. Where will the money come from to help the farmers? Not the £350m a week sent to Brussels that was widely touted in the Referendum campaign by the Leave camp as that’s the gross figure, not the net.

However one positive lesson from the last few weeks is the one about democracy.

Leaders have decided to stand down when they have failed and respect the results of the referendum.

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