14 minute read

The Economics of Brexit

Britannia Sets Sail    14 minute read

The Economics of Brexit

Pay no heed to either the David Davises or the Donald Tusks: weighing up Brexit’s economic impact is a mammoth task far bigger than any one politician, pundit, or think tank. The crucial role of trade in what is one of the freest economies in the world makes the UK’s departure a distinctly economic phenomenon, yet the headache of building reliable predictions, with so many economic variables to feed into already contested models, is a hundred times more crippling when all the political variables come into it.

One thing is for certain: gloomy forecasts are having far more truck with British citizens than the stocky optimism emanating from the Cabinet:

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The question is how much of this is justified – a fiendishly difficult one to answer even before trying to account for the idea of self-fulling pessimism.

As becomes evident from a look at the questions the British economy must answer now – as a result of the immediate impact of the referendum and the Article 50 trigger – even the short term is riddled with ifs and buts. Further down the line, things will become more and more down to what is decided in the negotiations. The cards in each team’s hands are more or less plain to see. But it’s how they’re played that matters, and it’s that realm of nuanced politics and human risk-taking that will throw up surprises.

The Short Term: Pounding at the Door

The immediate impact of the vote has been widely covered: the bruising fall in the pound, which hit a thirty-year low in October as markets began to realise that Britain is all but certain to give up single market membership.

The crash in the pound quickly reignited the debate over the extent to which it would boost export volumes and push up import prices, and how these two would play off against each other and potentially increase the value of British exports and/or hamper business elsewhere.

The issue is particularly relevant to British industry, whose performance is generally more sensitive to how competitive its prices are – as opposed to its service sector, which trades more on quality and reputation and is thus less elastic. Optimists could seize upon the export-led recoveries that economists like Paul Krugman argue have taken place in other countries in similar pickles. The FT’s Martin Sandbu was quick to attack the idea, arguing that the volatility in the pound would do away with any benefits by creating uncertainties in companies’ calculations.

But Sandbu was writing back in October. The pound’s behaviour since then strongly implies that the devaluation is here to stay. It has ebbed and flowed as almost every batch of monthly economic data seemed to swing from optimistic to pessimistic pictures and vice versa, though never straying too far from the $1.24 mark. The fact that the pound hasn’t punched through a ceiling of $1.26 – even as expectation-defying performance led to the Bank of England to close the book on its pessimistic outlook for now – suggests that the cheaper pound can be counted as a persistent feature of Brexit’s economic impact in the coming months.

Brexit’s Economic Rebalancing?

It is important to note that this trend is not just true of the dollar (which could become less of a reliable benchmark as Trump’s reforming agenda goes from winning to wheezing) but of the euro, too. Despite the UK’s major role in future markets less defined by borders, like finance and state-of-the-art technology, the importance of distance means that the exchange rate with its European neighbours matters hugely. Another flare-up of the eurozone crisis would work to favour British exporters, and though with the European economy possibly on the brink of turning the page on stagnation (and the breathing room afforded to the ECB by the recent ease-off in German inflation), this currency outlook is likely to remain a major part of the Brexit saga through the medium term.

British industry’s performance since October shows tentative signs that the weak pound is indeed pushing it upwards. The CBI has reported a consistent if fluttering rise in industrial orders and manufacturing outlook. The latest data shows export orders at their highest since 2013 and expectations for overall output in the next three months at their highest since 1995. Incidentally, arguments have been made that the market movements that the fall in the pound represented aren’t as harmful as they might seem.

An Expensive Trip

On the other hand, the same CBI data shows a creeping expectation of inflationary pressures. And just last month, the S&P Global Ratings warned that the consumer-driven growth that stockily resisted Mark Carney’s forecasted slowdown is running out of steam. Still, economists’ forecasts for price growth do not spell doom just yet:

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Most forecasts see inflation pushing above the Bank of England’s 2% target as Brexit takes its course. It is difficult to see consumer spending staying buoyant through what will surely be more and more pricey waters, and the trade-off between boosted export volumes and higher input prices could swing against British industry. But even if these forecasts come true, hovering just a few tenths of a percentage point above the target more likely spells an unfavourable balance in the long equation linking import prices to export prices as opposed to any kind of significant downturn.

Cautious Uncertainty

Whilst all bets are off once the Brexit deal crystallises, the justifiable position to take on the next year or two of British economic performance is one of uncertainty. As limp an answer as that may seem, it’s what the markets appear to be pricing in as a response to the tension between the good reasons to think that the economy is doing fine now and the good reasons to think that it won’t be from April 2019.

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It’s for this reason that the Bank of England has twice upgraded its growth forecasts, and that its governor Mark Carney now sees Brexit’s economic impact as no longer the biggest risk to financial stability, with rapid growth in credit card and loan debts now his top concern.

To put it crudely, markets dislike uncertainty more than anything else.

brexit

The shift from turmoil to vigilant growth in UK stocks since the referendum more closely matches the time it took for the ruling Conservative party to overcome its post-referendum infighting. Major speeches from Theresa May spooked the markets to the extent that they do not want the risk of being invested in a ‘hard’ Brexit Britain through 2019. But they rallied them insofar as the firmness in her message and her grip on her cabinet spelled out the likelihood of a united front heading into negotiations, reducing political uncertainty.

Much has been made of political unity (or lack thereof) beyond the Conservative party. Indeed, one of the medium-term risks facing Britain as it breaks away is rather more homegrown.

Pict Your Battles Wisely

A resurgent Scottish independence movement was on the cards from the moment the referendum results came in, with 62% of Scots voting Remain. On most accounts, leader of the Scottish devolved government Nicola Sturgeon appeared to have leveraged a good deal of political capital out of that figure, taking every moment on the airwaves to assert that it gives her a mandate to keep Scotland in the EU – until she took her argument to its natural conclusion and demanded an independence referendum.

8% Scotland’s GDP as a proportion of the UK total

A Scottish departure would be a hit for the UK economy. 8% of its GDP would cut ties, with costs ensuing as capital loses its ease of crossing Hadrian’s Wall, and the costs to the civil service’s time and resources of arranging another break-up just as Brexit is in full swing would squeeze an already overwhelmed Whitehall even further, with worrying ramifications for its ability to secure the best possible trade and exit deal.

But the attempt has seemingly fallen on its face now that Theresa May (though caught in the headlights for a moment) called what has arguably turned out to be a bluff of Sturgeon’s part. Support for Scottish independence is at an all-time high, with 46% of Scots in favour, but Sturgeon’s desire to hold a referendum before Brexit’s completion just doesn’t add up with the details of Scottish attitudes.

Recent polling by NatCen for Social Research found that “62% of Scottish voters think that after Brexit the rules on trade and immigration should be the same in Scotland as they are in the rest of the UK”. Meanwhile, at least half of all Scottish Remain voters are in favour of ending freedom of movement. Only 6% more Scots are willing to allow free movement in return for free trade than the UK average, but 62% believe the rules on trade with the EU should be the same throughout the UK.

The signs that Sturgeon had a weak hand were there when she changed her stance on paper to seeking just membership of the single market rather than full EU membership as part of Scottish independence. But so much of her case for a UK break-up – founded on the idea that the Scottish National Party represents a united front of Europhile separatists – is at odds with how her country really feels about a ‘hard’ Brexit. They’re softer on the idea than she lets on, at least. The SNP will inevitably harry May’s team with pro-single market attacks from its Westminster beachhead, but Sturgeon is unlikely to risk any more damage to her position by putting the cracks in her narrative on show. A break-up of the Union is, for a while yet, an unlikely consequence of Brexit.

Will British Trade Run Aground?

The UK may be heading into negotiations more or less united, but it still takes two to tango. And the uncertainty over how the two sides will face off means that the jitters from potential investors could well turn into a concrete loss of (potential) capital into next year – not to mention how the final deal will impact the British economy.

£16.3bn Total FDI into the UK from the referendum to Dec 2016

The world is still showing confidence in what is still one of the freest economies in the world – incidentally, behind only two other EU countries, Ireland and Estonia, according to the 2017 Index of Economic Freedom. £16.3bn worth of foreign direct investment poured into the UK between the referendum result and the end of last year, for example. But this will all inevitably change if anything short of a full free trade (http://themarketmogul.com/economics-trade-deals/) deal is signed with the EU.

A few new car plants or a few billion from Qatar, for example, may carry the British negotiators into Brussels on high spirits. However, the future of such investments will come down to the quality of the final deal, and the way it is marketed to the business community.

Britain’s government has a big task on its hands both on and off the negotiating table because the final outcome will almost certainly not be a full free trade deal. This is for the simple reason that the EU’s ‘four freedoms’ are off the table: the UK will not stop short of repatriating immigration controls, making a trade-off all but certain. The UK will face some degree of tariffs.

If the EU were to concede on that trade-off, it would lose its raison d’être – or at least the part of it which stops it from crumbling, as many Europeans remain unconvinced of economic benefits of immigration, difficult to quantify (https://fullfact.org/immigration/do-eu-immigrants-contribute-134-every-1-they-receive/) in the first place, leaving trade as the only glue holding together its economic arguments (very little passion is spared for its regulation outside the corridors of Brussels mandarin-dom, it is fair to say).

6.2% The potential cost to UK GDP of a Canada-style deal

Ultimately, although waning, the role of the European market in British trade remains crucial. The UK Treasury, for example, put the cost of a bilateral trade agreement similar to Canada’s at 6.2% of GDP, whilst the LSE’s Centre for Economic Performance argues even that is too cautious. It’s important to contextualise this against the failure of many of the Treasury’s short-term Brexit-related forecasts to come true, though (to the extent that many economists are openly distancing themselves from it).

Setting Up Shop

There are a great many other dimensions to the upcoming battle that could make or break the UK’s chances of surmounting the trade barriers it will face.

Perhaps the biggest card up Theresa May’s sleeve is her freedom to make the UK more attractive to businesses through tax cuts and deregulation. Though she has been wary in public to avoid being seen as pursuing a ‘Singapore-style tax haven’, the costs of doing so in a more moderate and low-profile fashion are low.

Opposition to the Conservative government is too weak to mount any internal challenge to it, for a start. And though the EU has been quick to condemn any such move, red lines in negotiations are there to be tested. Brussels could refuse to budge, for example, and the UK could respond by cutting business rates. Or it could respond to the threat with an improved offer on tariffs. 

The EU’s argument for rejecting the threat based on a guiding economic principle could fall flat if pushed much further. Both Switzerland and Iceland are both within the EEA and EFTA, yet offer much more accommodating tax landscapes. Meanwhile, Ireland is already more of a tax haven than the UK (its government takes just 26.6% of wages in the form of income tax and social security, for example, to Britain’s 31.5%).

The argument could be made that Brussels is in a position to call May’s threat as a bluff, but its vociferous response to the idea is arguably a good measure of just how anxious it is over it. The eurozone’s failure to set up a financial hub to rival London (banks are shifting operations, yes, but this is so far concentrated around the loss of euro clearing operations, which make little sense to lose sleep over keeping) has exposed an awkward doubt in its own ability to attract global business in droves to places like Frankfurt.

A Game of Sticks and Stones

This is just one option. May has more scope to play a game of divide and conquer. The EU’s united front on its ‘four freedoms’ will be difficult to upheave when it comes to an exit deal, but when it comes to a trade agreement she will have the freedom to appeal to different countries with different attitudes towards those pillars of the EU’s project. Frexit looks an unlikely possibility given the state of its presidential race, but Poland and Hungary are already thorns in the European Commission’s side, and Italy could pose yet more divisions after its elections next year.

There is simply too much politics in it to guess what the trade arrangement will look like, making estimates like the Treasury’s and the LSE’s limited in use, at best. Not only can all the cards in each team’s hands be played against different counterparts, and in different orders, but the game is on show for all to see.

The final Brexit deal will not just be about the minutiae of this or that tariff and its likely effect on GDP, but how the agreement as a whole looks to the business world and to consumers, too. Theresa May’s government currently looks like a well-fortified nest from which to harass a great European bear with a lot of cubs to feed, though this could all change. Brexit’s economic impact will come down not just to the negotiating teams but to a war of words between both sides.

The long-term impact of Brexit is gloomy in light of the near-certainty of a loss in trade, but there is room yet for a few surprises.

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