Brexit Blues and the Economic Aftermath: "Hard", "Soft" or "Squidgy?

The Brexit referendum was a shocking experience for many of us ex-pat Brits.  But democracy has to be respected, and the UK should move as quickly as possible to start negotiations to leave the European Union (EU), regardless of what the political elite in the UK thinks.  As EU leaders have stated, the more uncertainty about the exit conditions, the more economic damage is likely to be done to both the EU and the UK. And I have said in comments on FT posts, such as the one by Gideon Rachman (see here), the idea that politicians should act against the will of the people is just unimaginable and would lead to further constitutional problems in the UK.

So in this Econoblog posting I am taking my cue from a recent article in the NYT (here) about how Brexit might not happen, to first discuss how Brexit might not happen, and then deal with various options as to how it could happen.

Option 1: Simply don't do it.
As I have stated already, I really don't think this is an option.  Why not?  Because even the EU acknowledges that a rejection means that the citizens of the UK on balance, do not want to be part of the Union.  That is why it is incredibly important that Cameron's successor is willing to trigger Article 50 of the Treaty of Lisbon, and start negotiations to leave.

Option 2: Scottish veto
Once again, this was a referendum of a country, not of specific regions.  So the UK as a whole has decided to leave the EU.  The fact that the protocol for any changes to Scotland's status needs to be approved by the Scottish Parliament are irrelevant for the proposal as a whole. If Scotland had a right to remain in the EU, then it should have been made clear in the referendum itself.  So this was not about whether individual countries voted to remain or not, as Scotland is not currently a member of the EU: the UK is, and Scotland happens to be part of the UK.  The EU leadership stated a such last week when Nicola Sturgeon, the leader of the Scottish National Party (SNP) visited Brussels.

Option 3: A do-over
OK, so over 3 million people have signed a petition, wanting to leave - but so what?  David Cameron stated very clearly before the referendum that a vote to leave would be "an irreversible process" - how much clearer could he have been?  So these fanciful notions of a do-over are just that: fanciful notions. And that is not only because there is no real reason to re-do the referendum (there were no major irregularites), and even if it was re-done, I doubt that the result would substantially change.

Option 4: An exit in name only
There are those on the "leave" side who have this fanciful notion that the UK can accept some of the EU's single market, and just leave others on the table. For example Boris Johnson stated recently that: "British people will still be able to go and work in the EU; to live; to travel; to study; to buy homes and to settle down. As the German equivalent of the CBI – the BDI – has very sensibly reminded us, there will continue to be free trade, and access to the single market.".  This has prompted the EU Council President, Donald Tusk to state categorically that “there will be no single market à la carte”, and a sentence was added to the communique from the meeting stating that “access to the single market requires acceptance of all four freedoms”, a reference to EU principles on the free movement of the factors of production, namely capital, labour, services and goods.  So option 4 is now essentially off the table as well.

So in my view, Article 50 will be triggered, and this will then require negotiations to immediately commence.  But here are my views on how the UK and the EU should approach these negotiations, from an economic standpoint.

First, the UK should immediately reach out to the European Free Trade Association (EFTA) bloc, namely Switzerland, Iceland, Norway and Liechtenstein, and start negotiations to join this trading bloc.  Now of course all of these countries have negotiated bilateral agreements with the EU, but at least it would give the UK some backing from other countries that might consider it an advantage to have a country like the UK as part of an FTA. Norway already has reservations about this option (see here), but there is no harm in the UK putting its application forward for membership as soon as possible, as this would allow some trade to flow through countries like Norway or Switzerland, both of which already have access to the EU's single market.

Second, and this is where things get complicated, the UK needs to pick a Conservative Prime Minister who was on the "remain" side in the last referendum, and for this reason alone I favour Theresa May (who was on the "remain" side) over Andrea Leadson (who was on the "leave" side). If you think about it, if you are an elite club, and one of your members wants to leave, who do you prefer to negotiate with, and who are you most likely to give concessions to?  Exactly, the individual who understands the advantages of membership, but who is in an unfortunate bind where she has to extract her country from the club.  Theresa May is much more likely to make sympathetic noises about perhaps cooperating on future EU defense missions or perhaps assisting the EU some budget contribution in exchange for some concession from the EU. From the EU, the dynamic is made much more complicated as other EU member states are now talking about having referenda to leave the EU, so the EU has an incentive to be as tough as possible without being punitive towards the UK.  The kind of negative rhetoric that has been thrown around by the "leave" side will not help to secure the UK the best deal.

Third, we need to distinguish between "soft" and "hard" Brexit (see here, for more on this) and what I call a "squidgy" Brexit.  "Hard" Brexit supporters are arguing for what is known as the "Canada Lite" model, as Canada has a free trade deal negotiated with the EU, but no automatic access to the single market for every good, and of course no free flow of labour between the two - this agreement tends to be supported by those who were part of the "leave" campaign .  On the other hand "soft" Brexit supporters are arguing for what is known as the "Norway plus" model, which would include the deal that Norway has, and therefore would include budget contributions together with the free flow of labour between the EU and Norway ( - this is what most "remain" supporters are in favour of).  Let's look at each of these separately in terms of the economics:

a.  "Hard" Brexit.  This would essentially entail being the same as any country outside the EU, with no special access to the EU, but there again the ability to completely control the flow of labor across all borders into and out of the UK.  The economic argument that this would be bad is based on the fact that the UK is already part of the single market and so this would involve erecting new tariffs and quotas on UK exports being sold into the EU and vice versa.  This would obviously raise prices in the UK and lower the amount of goods being exported, except if the pound ( - the UK's currency), depreciates by at least the amount of the tariffs that would then be in place.  So far the UK pound has depreciated by more than the 6% average of tariffs that the UK would face, so our goods and services are already more than 6% cheaper than before, so more than offsetting the negative impact of the tariffs.  Quotas are more difficult though as this is a quantity restriction - obviously here there will be some negative impact.  The impact on UK inflation could potentially be quite serious though, as imports will be more expensive, and there is the possibility that the UK might retaliate and start to levy tariffs and quotas on imports coming into the UK, making them even more expensive.  In terms of wages, many of the EU immigrants to the UK are likely to leave, which will push wages up in the UK in certain sectors leading to more expensive goods and services and some "cost-push" inflation.

b.  "Squidgy" Brexit.  This would essentially allow the UK to sign an FTA with the EU, with maybe some added clauses such as are found in NAFTA ( - free movement for qualified professionals).  The latter idea would appease the financial sector, while at the same time satisfying the spirit of the "leave" campaign's demands for less EU migration.

b.  "Soft" Brexit.  This would essentially require a new agreement with the EU, and that's what makes it "soft" in the sense that it is not a complete break with the EU.  But the question is, what kind of agreement can be made?  If the UK insists on not submitting to all the 4 freedoms, then we revert to a squidgy outcome, as the main type of agreement that existing members of the EEA have with the EU requires all 4 freedoms mentioned above to be respected.  So it remains to be seen if an "a la carte" agreement can be signed, or whether an EEA type of agreement which honors the referendum result is the outcome.  This is why who is doing the negotiating is important, and there might be something unique to address the UK situation which is possible, but it cannot be too generous otherwise it will encourage more referenda, and if it doesn't live up to expectations.

Which outcome is most likely?  If Theresa May is the PM negotiating, I would expect that a "soft" Brexit may be possible - and here I agree with Wolfgang Münchau in the FT (see here), that an EEA-minus the free flow of labour should not be expected as one of the deals offered - with membership of EFTA and EEA a possible outcome.  If Andrea Leadson becomes PM, then I would suspect that a "hard" Brexit becomes much more likely, and this will either entail the UK being a member of EFTA alone or with it's own FTA with the EU (a "squidgy" result), or outside the EU entirely (a "hard" outcome).

So in summary, there are several variables in play going forward - first, whether the UK will be accepted into EFTA if it applies, second, who is going to be doing the negotiating, both on the UK and the EU side, and third, whether what kind of "soft" Brexit deals might be considered.  

Brexonomics

Source: Paolo Ferrarini

Now we are only a few days away from the Brexit vote, and I have been meaning to blog about this, in terms of the economics and the unintended consequences (which I believe are actually much more serious).

For those not born or brought up in the UK, it is hard to see what the fuss is about, but if you are from the UK you will know that ever since the UK joined the European Union (EU) in 1973 there has been a running argument about whether being in the EU was a good thing or not.  To many, the EU has little democratic underpinnings, and yet makes laws and rulings that trump those coming from the member states of the EU.  This is undoubtedly a heated topic, but nevertheless there are certain elements of the equation that are pretty clear.

To be honest, as Simon Schama has written in the FT here, the economic case is pretty strong for remaining in the EU, but the economics are really not what is at stake here, despite those that have been trying to make it so.  But more of that later.

Source: Financial Times

EU-UK kissing chain

Nigel Farage in front of controversial poster from the UKIP party

So let's first deal with the economics, and then pass on to what I think are the much more important.

Trade

First, the UK is part of the EU's common market  ( - a union of countries that has the same trade policies with 3rd party countries).  So in leaving the EU, the UK would also be leaving the customs union.  As the figure above shows, it is possible to stay in the EU customs union, either by asking to be in it (as Monaco, San Marino, Andorra and Turkey have done) or by (re-)joining the European Free Trade Area (or EFTA), which has an agreement with the EU as part of what is called the European Economic Area (EEA).  In my assessment it would be very difficult for the EU to deny membership of the UK in the European Economic Area (or EEA) if the UK joins EFTA.  After all, the UK was a founding member of EFTA in 1960, so there is no reason why they could not rejoin.  This has been the basis of various other estimates of the trade losses from leaving the EU (see Patrick Minford's website here which evaluates these trade consequences).  

The Agreement on the EEA provides for the free movement of persons, goods, services and capital within a single market. The EEA was established on 1 January 1994 upon entry into force of the EEA Agreement and it essentially joins the EU with the European Free Trade Agreement (EFTA) bloc.  If the UK rejoined EFTA, essentially it could then set whatever tariffs or quotas it wanted on 3rd party countries, but on closer examination the EU might not make it so attractive to the UK.  

Of the countries remaining in the EFTA we have (as the figure above shows) Norway, Turkey, Switzerland and Iceland. Now Iceland was thinking of joining the EU, but just last year decided to drop it's application (see here).  Of the other countries in EFTA there are significant differences though in their involvement in the EEA. Norway is part of the Single Market but it has no power over Single Market regulations - it still has to pay the EU for the privilege of being a member and accept full labor mobility. Switzerland has partial access to the Single Market, but not in financial services. The Swiss voted to restrict EU immigration, but found that this was forbidden under their bilateral agreements with the EU. For Turkey, they permit only the free movement of goods.  

One of the problems here is that if, as the EU has recently stated (see here), the EU would have an incentive to be as tough on the UK as possible during the negotiations, so that it sets an example for other member states who also might be looking to leave.  

So in summary, on the trade side, there is a clear course of action to minimize the impact on the UK, but the devil will be in the details.

The City and Financial Flows

The bigger issues come with the City of London and it's role in global finance, and in particular in relation to transactions in euros.  The majority of large financial transactions in euros are currently done in London, because London is the global centre of the foreign exchange market.  So the question becomes how much business London would lose by the UK not being part of the EU.  I think some would be lost to Frankfurt and other financial centres in the EU, but some of it would definitely remain in London, given London's stature as a global financial centre. 

Other financial outflows would occur because of foreign companies investing in the UK because it is an English speaking base in the EU. US, Canadian, Australian, and South African companies all use the UK as their EU base, because of the language advantage and the fact that it is in the EU.  That would change, and I can see that the UK would lose some investment (FDI) to countries like Ireland and polyglot countries like the Netherlands and Belgium.  

If a Brexit occurs, there will also be the possibility of a slump in the currency, as financial capital will tend to move out of the UK, putting downward pressure on the currency.  But this will likely only be short term, as London will still remain the largest foreign exchange market global centre.

Other factors

The real consequences may come though in the non-economic realm, and as a product of the unintended consequences of leaving the EU.  As is well known in the UK, and as descrbed here in the New York Times, the smaller countries that make up the UK, notably Scotland, Wales and Northern Ireland, by a big majority all want to stay in the EU.  The trouble is that England, which represents roughly 85% of all UK voters, wants to leave,  So I think that independence movements will have a lot more impetus in Scotland and Wales if the UK votes to leave.  That could, in effect, break up the UK as an unintended consequence, which is patently a lot more serious than the economic effects I have outlined above.  Now some would say "so what, if they want to go, let them go", but in my opinion this would be a high price to pay.

You might ask why Scotland, Wales and Northern Ireland like the EU so much?  Well much of this has to do with EU policies relating to funding of public infrastructure projects (called Structural funds) or funding for agriculture (also known as the Common Agricultural Policy or the CAP).  In those countries they can see the tangible benefits of EU membership.  One of the problems is that in England it is much harder to see.

But there are other unintended economic effects as well. First, UK property prices would likely be affected.  One of the attractive features to foreigners of owning UK property is that so many people want to live in the London area that prices there have skyrocketed.  If Brexit occurs this might make the UK less attractive to foreigners, so London prices could fall.  If this happened inevitably there would be a wealth effect (people feel poorer because their assets have just gone down in value) attached to this, so that consumer spending could then fall.  Second, if Brexit occurs and the UK does limit its inward migration, then this could potentially have an effect on unskilled wages in the UK - it could in other words push unit labour costs up significantly, leading to higher inflation than.is currently the case.

Now another unintended consequence could be on the EU itself.  If the UK leaves, how will that affect other countries where there is a substantial portion of the population that is not favorably disposed towards the EU?  It would also cast some of the recent decisions regarding things like the migration crisis and the Greek crisis in somewhat of a different light, if a member state managed to successfully leave the EU and then prospered.  These are unknowns, and as such it is difficult to assess exactly what the consequences would be.  What is certain is that some of the complacency that the EU would and should always move forward with more and more ambitious integration projects needs more thought, as clearly there is a growing backlash within Europe.  The EU needs to basically show its worth to its citizens with the projects and problems it currently has before starting on new projects - a period of consolidation is in order.


So without making hysterical predictions about depressions and sharp downturns, I think there would be a net negative economic impact of leaving, but only over a number of years.  The magnitude of the impact would depend on the global economic growth dynamic, but undoubtedly this could have a meaningful impact if global growth continues to be sluggish.  But given that both sides negotiate in good faith, then I fail to see that leaving would be the unmitigated economic disaster that some in the remain camp portray, but it would still be a negative impact.

So in conclusion, I think the risks to the UK leaving the EU are subtantially hidden - and potentially could cost the country its existence.  Also of course nothing is certain, and some of the threats now being made by European leaders may not come to pass if the UK does leave, but nevertheless there is a large veil of uncertainty hanging over the eventual outcome if the UK chooses to leave this week.  

I hope that the UK electorate will think long and hard before voting to leave, but if they do vote to leave, then I hope that the EU negotiates in good faith, allows the UK to rejoin EFTA, and that the country remains united as the UK.