16 June 2016
Brexit: It’s the economy, stupid!
An economic case for Remain
by Frank O’Nomics
Information on the potential costs or benefits of Brexit has hit overload and most people just seem to want to get beyond the 23rd June referendum. There are so many different claims and assertions that we struggle to know what to believe. It is not that we think people are lying necessarily, just that they are being selective, using data which supports their side of the debate.
In an effort to reach a conclusion ahead of the vote, I have tried to boil the issue down to one of economics. You may argue that Brexit is about many other things as well, with issues of sovereignty and immigration figuring large, but if by economics we really mean targeting the outcome that produces the best overall social welfare, with the narrowest variance across the UK population, then hopefully that will cover most of the areas people really care about. Taking this approach it seems to me that we can come up with credible estimates for the short-term costs of Brexit, which are likely to be large and numerous, but it is much harder to calculate the extent of the benefits and just how quickly they will kick-in. In other words we are being asked to accept a few years of severely reduced economic growth in return for a better long-term future whose timing and magnitude we have to take for granted. I suspect that this is a bet that few will be prepared to take.
For many of us there is a great deal wrong with the European Union. Having an effective common monetary policy is hard to rationalise without a common fiscal policy, and this points to increasing federalism over time. Given that a common currency sits at the heart of this, and that we continue to opt out of the Euro, it seems hard for us to continue to be part of the EU, particularly if we cannot contemplate a loss of sovereignty. However, running counter to all of this are the historical economic benefits that we have received while the UK has been an EU member.
Comparing UK GDP per capita with the average of Germany, France and Italy over time, shows that, while in the post-war period before our entry in 1973 the UK data sits well below that our of European neighbours, from the early 1980’s (excluding the problem years of 1990-1994) the UK has enjoyed a level of prosperity well above the average of the others. In looking at the economy as a whole since the single market began in 1993, OECD data shows UK GDP up 62% in real terms, compared with France, up 42%, Germany, up 31%, and Italy, up just 15%. Outside the EU, Switzerland has grown by 48%. Clearly some will argue that we could have done just as well, or even better, by negotiating trade agreements across the globe, but there seems little evidence to support this. If then we take it as read that we have done reasonably well by being part of the EU, we should look closely at the consequences of leaving.
The effects of Brexit that we can rationally quantify are those which will develop over the next couple of years; some of them may be temporary: others are potentially long-lasting. First comes the impact on sterling, which could depreciate by as much as 20% very quickly. Secondly, and related to the decline in the currency, it is likely that short and long–term interest rates would rise; short-term rates would be impacted by the inflationary impact of a weaker currency (although initially they would perhaps be artificially restrained by the Bank of England on fears of an economic slowdown) and long-term rates by the increased yield that investors would demand for lending money to the UK government (due to the increased uncertainty). Thirdly, there are significant transition costs for both the manufacturing and services, and especially the financial services, sectors of our economy.
If we go the free trade route we open ourselves up to competition from imports from across the globe, while our exports would be potentially subject to tariffs, at least until trade agreements were made (and these could take a long time). The financial sector, which is a big contributor to UK growth, could be a big loser if barriers are raised which encouraged a shift in financial transactions to the likes of Frankfurt and Paris. This transition phase for trade and finance is very likely to result in an increase in unemployment, and all the social and economic costs which go with that. In the longer-term, lower net migration may not help reduce unemployment but could instead create supply side problems by decreasing the size of the workforce. Note that employers are already reporting a growing skills shortage.
What does all of this add up to? The OECD sees a “large negative shock” from Brexit which could leave our GDP over 3% below what it would otherwise be by 2020, and over 5% lower by 2030 (note that the EU itself would take a hit of around 1% by 2020 if we left). Such a fall in GDP would mean that either taxes would have to rise to cover the shortfall in government revenues, or spending would have to be cut – most probably both. For those who worry about health, education, and even defence, the key to generating more cash for these areas is increased economic prosperity, and the immediate impact of Brexit would be quite the reverse. A more moderate assessment comes from Open Europe, who estimate that the long-run negative impact of Brexit would be 0.5%-1.5% of GDP, but this assumes that a “reasonable trade agreement is struck between the UK and the EU”. Such an agreement could take some time, as could any negotiations outside Europe to offset the costs of leaving. The German Finance Minister, Wolfgang Schauble, has said that a deal similar to Norway or Switzerland would be “unworkable” for the UK.
The positives of leaving are difficult to calculate and will have an indeterminate timing.
Many economists have, of course, produced data to demonstrate the benefits of Brexit, but few show any of these appearing in the first couple of years. One of these few is Patrick Minford of the Cardiff Business School, who argues that the EU is a Customs Union that protects its manufactured goods and agriculture, keeping their prices above those in the rest of the world. He suggests that this, together with the fact that we buy more from the rest of the EU than we sell to them, costs us about 4% of GDP. This number can be increased when the costs of regulation are taken into account, but for us to instantly benefit from free trade and freedom from regulation would seem to be unlikely. Much of the regulatory burden would remain and new trade agreements outside of the UK would involve a lot of time and uncertainty which, in a difficult economic environment, would be very hard to weather. The economists arguing for Brexit are somewhat isolated, with the OECD, IMF, UK Treasury, LSE, PwC, IFS, NIESR and others all producing compelling models which demonstrate the case for remain.
We are left then looking at a situation where we can reasonably estimate the prospects for UK growth if we remain in the EU, and come up with a range of estimates of the short (or possibly not so short) term costs of leaving. What is very hard to ascertain is the long-term benefits of leaving and, returning to the concept of social welfare, the variance of outcomes is much wider. With this in mind even those of us who are highly critical of the EU may take some persuading that now is the time to be contemplating an exit.
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