After Brexit, the final shape of Britain’s economic and political relationship with the European Union and the rest of the world may take years to fully emerge. Right now, the most useful response would be for the UK government to signal the direction of its negotiations with the European Union.
By the late afternoon of June 23, the day of the United Kingdom’s EU referendum, the betting markets had priced an 84 percent probability of a “Remain” vote; in the preceding week, equities and the sterling had rallied strongly on expectations that Remain would win. The unexpected vote to leave the European Union triggered a bout of financial market, political, and economic uncertainty. The immediate effects were seen in risk assets, including, most graphically, the biggest-ever one-day decline, of 8.0 percent, in the value of the British pound against the US dollar on June 24.
The final shape of Britain’s economic and political relationship with the European Union and the rest of the world may take years to fully emerge. However, uncertainty is likely to moderate as the shape of the government’s ambitions for the European Union take form. The next main landmark is the election of a new leader of the Conservative Party, and the new prime minister, on September 9. In a surprise move, the front-runner and leading Brexit campaigner, Boris Johnson, dropped out of the leadership race on June 30; the new prime minister is Teresa May, the former home secretary and a low-key supporter of Remain during the campaign.
There are numerous possible permutations of outcomes for the United Kingdom. It is possible that the United Kingdom will not leave the European Union at all. The referendum vote was only advisory, 70 percent of MPs favor Remain, and some Leave voters seem to be suffering from buyers’ remorse. Against this backdrop, the United Kingdom could conceivably hold a second referendum or a general election that might result in the United Kingdom deciding to remain in the European Union.
It is possible that the United Kingdom will not leave the European Union at all. The referendum vote was only advisory, 70 percent of MPs favor Remain, and some Leave voters seem to be suffering from buyers’ remorse.
But at the time of writing, in the aftermath of the vote, the most likely outcome seems to be that the new prime minister will invoke Article 50 of the Lisbon Treaty, which starts the process of withdrawal, and that the United Kingdom will leave the union.
A central issue in negotiations will be the United Kingdom’s ability to retain access to the European Single Market while limiting the right of EU citizens to work in the United Kingdom. UK business wants to access the Single Market and overwhelmingly favors free movement of people, yet David Cameron told European leaders that it was concerns about immigration and free movement of people that caused UK voters to vote Leave.1
The United Kingdom may try to square the circle by negotiating for somewhat reduced access to the Single Market and tighter constraints on EU migration. So far, the European Union sounds unyielding on its insistence on free movement of people, one of the four key principles of the union. Indeed, Angela Merkel warned the United Kingdom that it would not be able to “cherry-pick” the parts of the European Union it likes, such as the Single Market, without accepting its core principles.2
If the European Union maintains this line and the United Kingdom insists on taking control of EU migration, the United Kingdom might find itself in a more distant economic relationship with the European Union, perhaps operating under the rules of the World Trade Organization without trade deals with the European Union, as countries such as Australia do. Under such a scenario, exports from the United Kingdom to the European Union—and vice versa—might be subject to customs controls and tariffs. Crucially, the access of the United Kingdom’s highly successful financial service sector to the lucrative Single Market could be severely constrained. While such a regime would create a new barrier to trade, especially in services, and would have pronounced sectoral effects, many successful exporters to the European Union, including China, do cope with it.
As a shock, Brexit has some elements in common with the 2008 financial crisis. But while that was an economic shock that threatened the solvency of the banking system and triggered a credit crunch, Brexit is a political shock.
As a shock, Brexit has some elements in common with the 2008 financial crisis. But while that was an economic shock that threatened the solvency of the banking system and triggered a credit crunch, Brexit is a political shock. Its impact on the economy is more indirect, at least in the short term, and manifests via financial markets and the knock-on effects on business and consumer confidence.
A declining financial-market risk appetite tends to weaken the corporate sector’s risk appetite. Companies react by battening down hatches, paring investment, and sharpening their focus on cost control. Foreign investors could also take fright and hold back on investing in the United Kingdom. Since the United Kingdom needs overseas capital to cover its yawning current account deficit, such a buyers’ strike would further weaken the pound.
To generate a full-blown recession, consumers, who account for two-thirds of GDP, would need to stop consuming, as they did in 2009–10. The transmission mechanism would come through rising uncertainty and a squeeze on spending power from high inflation and weak earnings. But for now, this does not seem to be the most likely outcome.
There are two lessons from economic history about the effect of external shocks. One is that the impact reduces over time; economies are resilient, and activity, in time, bounces back. The second is that shocks that threaten growth prompt a countervailing policy response. Authorities don’t sit on their hands and do nothing.
Today, the most useful response would be for the government to signal the direction for the United Kingdom in its negotiations with the European Union. In markets and business, as in life, intent matters. The usual policy levers could also be pulled. The Bank of England may well undertake more quantitative easing, stepping up the volume and the range of assets purchased to boost liquidity and asset prices as well as drive down long-term interest rates. Agreed, inflation may head higher as a weaker pound pushes up import prices. But as a one-off phenomenon in an economy facing great uncertainty, such temporary inflation would not justify interest rate rises. Fiscal policy may need to play a role, too. The chancellor previously suggested that Brexit would lead to an austerity budget in order to balance the books. That would dent growth and might well be politically unviable in the face of opposition from many MPs. In today’s exceptional circumstances, the government could put deficit reduction on the back burner and use public spending and tax cuts to bolster growth. Such an approach has particular appeal to those who believe that monetary policy is a spent force. Thus it seems that the United Kingdom faces slower growth with Brexit, but it should be able to skate around recession.
Last Thursday’s vote is as much a shock for the European Union as the United Kingdom. The sharp decline in Continental European equity markets on hearing the news testifies to concerns about the knock-on effects. A British exit would represent the greatest political setback to the European Union in its 65-year history. This comes at a time when the European Union is coping with a migration crisis and is trying to strengthen the euro area against future shocks. After a period of rapid economic and political integration in the ’90s and ’00s, Europe is seeing slower, more divergent growth and a loss of political momentum. Figure 1 shows some of the possible Brexit effects on the union.
More extreme, anti-establishment political parties such as the Freedom Party in Austria, the Five Star Movement in Italy, the Front National in France, and the Freedom Party in the Netherlands are gaining ground. The immediate concern is the risk of a domino effect as Eurosceptic parties elsewhere in the European Union demand their own referenda. Recent research conducted by Deloitte and the German employers’ organization BDI found that 66 percent of German businesses believe a British exit would lead to further such votes in the European Union.3
A complicating factor for any UK negotiations with the European Union is a series of national elections, most crucially in the Netherlands (March 2017), France (April–May 2017), and Germany (August–October 2017; dates to be confirmed later). It is possible that Europe’s de facto leaders, Angela Merkel and Francois Hollande, will leave office in 2017.
In terms of the fundamentals, based on international measures of competitiveness, the United Kingdom looks in decent shape.
The United Kingdom’s departure from the European Union also raises questions about the future direction of the trade bloc. Without the United Kingdom, the European Union loses a significant supporter of free-trade and free-market policies. Analysis by the think tank Open Europe suggests that the United Kingdom’s exit will tilt the balance of power in the European Union under qualified majority voting significantly toward a more protectionist, less free-market, approach.4
Faced with the risk of further secessions across Europe and seeking to avoid political drift, EU leaders may seek to “double down” on ever-closer union. Press reports have suggested that European leaders have already been drawing up plans for a future union without the United Kingdom, developing a so-called “Plan B” focused on closer security and defense cooperation.5
Yet the integration that the European Union sees as necessary to strengthen the European project could run into resistance from national electorates. The Pew Research Center recently reported a decline in support for the European Union across 10 major member states. The research also found that those European voters who favored the transfer of power from nations to the European Union were outnumbered two to one by those who wanted to see powers returned from the European Union to national governments.6
At times of great uncertainty, marginal new information, both important and trivial, is subject to great scrutiny. Dramatic but unrepresentative or erratic events are sometimes given more significance than they deserve. Fundamentals can get drowned in a torrent of speculation and news flow. In terms of the fundamentals, based on international measures of competitiveness, the United Kingdom looks in decent shape. The World Bank, the World Economic Forum, and the Heritage Foundation rank the United Kingdom in the top tier of their league tables of competitiveness, up there with countries such as the Netherlands, Denmark, and Australia (figure 2). This ranking speaks of a flexibility and resilience that will be vital to the United Kingdom as it navigates what lies ahead.