Faculty Forum - Featured Post Posted on Tuesday, July 12, 2016

The Economic Impact of the Brexit Vote

The unexpected victory of the “Leave” camp in the British referendum of June 23 on whether to remain within the European Union has raised a host of economic questions for the U.K. and the E.U. One may distinguish short term (the next few months), and longer-term consequences of the Brexit.

Short term consequences:

The immediate economic consequences are revealing themselves through financial markets. In the most liquid market, that for foreign exchange, the pound sterling has dropped by more than 10 percent from its previous high, in relation to the E.U.ro or a trade-weighted basket of currencies, and by 14 percent relative to the dollar. The value of real estate investment funds, which have been a prime vehicle for the flow of foreign capital into London’s red-hot property market, have fallen sharply. In order to stem withdrawals, three big asset management firms have halted trading in real estate investment funds in the week last 24 hours, and a number of mutual funds have blocked their clients’ withdrawal of funds.

Private investment requires some certainty over the stability of the political, legal, and economic environment. In anticipation (or fear) of the vote on Brexit, business investment in the U.K. fell 0.5% in the first three months of 2016, as compared to the last quarter of 2015, and will probably show an even sharper drop in the second quarter. Prospectively, given that vote to leave has ratcheted up the level of uncertainty, further drops in investment are to be expected.  Despite the pledge of the Central Bank of England to do whatever it takes to maintain liquidity in the financial system, it seems highly likely that Britain will enter a recession within the year.

Longer run effects:

The medium and longer run effects of the Brexit are speculative at best, particularly since there are various types of relationships between geographically close non-E.U. countries and the E.U., and it is unclear what will eventually emerge. If Britain and the E.U. were to adopt an arrangement like that of Norway, to retain access to the E.U. common market, Britain would still have to contribute to the E.U.’s budget, though somewhat less than their current contributions, and be bound by the Schengen agreement on the free movement of citizens within the E.U.

Eighty percent of U.K. exports are either direct to the European Union, or with countries that have negotiated free or liberalized trade with the E.U. More than half of this total is with the E.U. countries directly. Trade with the E.U. is free of tariffs, and free of the costs of customs administration. If Britain were subject to tariffs or administrative duties on these flows, it would raise their cost relative to the same goods or services provided by E.U. members.

British exports and imports have grown enormously under the E.U. common market. Since 1990, the ratio of gross exports (and gross imports) to national income has increased dramatically. For example, Britain imports almost all of its fruits and vegetables from other E.U. countries. Some of this exchange may represent trade diversion, i.e. exchange that would have occurred with non E.U. countries, but most of it represents the enhancement of total trade flows enabled by access to the largest common market in the world – more than 500 million persons.

While we usually think of trade in terms of goods, just as services have become increasingly important in national output, the share of services in British exports have also grown. British exportation of financial services has particularly benefited from a provision of the E.U. arrangement known as the “European passport”, which allows for the provision of financial services – lending, payments, electronic fund transfers, investments, insurance – to be provided in any E.U. country, so long as the business has been certified by the official agency in the country of origin. Given the importance of financial services to London and the British economy, the European passport is an important source of benefits to the U.K.

By one estimate, if Britain actually does exit the E.U. there could be as much as a 25% reduction in U.K. exports to member states.

The longer term benefits of belonging to the E.U. have in general been quite positive for the U.K.  A number of studies have found that economic growth has been substantially higher (5% – 20%)  in E.U. countries than in comparable non-member countries. The British treasury found that membership in the E.U. augmented commercial exchanges between the U.K. and member countries by 68-85%, relative to membership in the World Trade Association.

The E.U. has been particularly beneficial for investment flows. Harmonization of rules and regulations has favored foreign investment, even before actual membership.  This source of investment funds is particularly important for the U.K., for which, according to a study by the OECD (Organization for Economic Cooperation and Development), foreign ownership of assets is equal to 530% of national output. Moreover, in the long run increased investment flows contribute to productivity increases, via stimulation of competition, transfer of technology, and dynamic learning processes.

Despite the long-run benefits of membership in the E.U. in terms of productivity and economic growth, it is notable that most of the studies showing very favorable effects are based on earlier periods, when the E.U. seemed to be delivering on its promise of greater prosperity for all members. Things look very different in mid-2016, after almost a decade of slow growth, particularly in the southern rim countries. All countries in the union, with the exception of Germany and the Netherlands, have suffered from the world-wide financial and economic crisis that began in 2008. In the post-recession period, economic performance in the E.U. has lagged behind  that of the United States and Canada. British trade flows, as well as those of most other E.U. countries are down from their peaks. Until the weaker members of the E.U. are able to regain their pre crisis economic vigor, we may expect additional challenges to the E.U.’s legitimacy.

Political Economy, Regional Policy, and the Brexit vote:

If the E.U. has been so good for its members, why such fervent opposition in many regions of the U.K.?

One reason is the perception of unfavorable fiscal flows between the U.K. and the E.U., i.e. that the U.K. is a net loser in terms of funds sent to the E.U. versus funds received. In fact, the gross amount of the British contribution is about 0.15 percent of national income, only a bit more than Norway, while the net amount, taking account of what Britain receives, is about half that amount. Since contributions are based on national income, it is to be expected that in any type of economic union, even one as weak as the E.U., richer members will contribute more than poorer members. Compared to interstate disparities in net fiscal contributions in the U.S., for example, the differences between the U.K. and poorer member countries seem relatively small.

Of course, if the argument is accepted that all that Britain gets from the E.U. is a set of constraining rules, (a la Boris Johnson) rather than the vast economic benefits discussed above, then the fiscal flow argument, even if fundamentally false or irrelevant, takes on a more political saliency.

The discussion to this point has been of the average or economy-wide benefits of British membership in the E.U., and the losses that are likely to ensue should a Brexit actually take place. However, as we have learned most forcefully during the 2016 U.S. presidential campaign, it is not averages that matter so much as the distribution of effects, by education, income, and particularly, region of a country.

The U.K. suffers from a growing imbalance between the economically dynamic London region and the rest of the country. London’s financial sector has benefited enormously from the European financial “passport,” as has the greater London economy from the free movement of labor, both skilled and unskilled, from the rest of Europe to the U.K..  These benefits translate directly into gains to the owners of land and property.

Rather than sharing these vast increments to wealth with the poorer regions of the country, regional disparities have been exacerbated by the austerity response of Britain’s conservative government to the financial crisis of 2008. Grants to persons have been reduced, and unrestricted grants to local governments have been cut, according to national statistics, by 40%. Infrastructure investment, particularly in air travel, remains concentrated in the greater London area. Though the E.U. itself targets substantial fiscal resources precisely to the poorer regions of the U.K., its own governmental fiscal policies have overwhelmed these cross-national subsidies.

While nostalgia for the past, distrust of foreigners, and increases in inequality have all played a role in the Brexit vote, I would submit that in latching onto immigration and the distant bureaucracy of the E.U. as the source of their discontent, citizens of the poorer regions of the U.K. have chosen to focus on  the wrong set of villains. A more egalitarian governmental response to growing regional disparities would go a long way toward rectifying the collapse in regional solidarity revealed by the Brexit vote.

This article is part of a series of Roosevelt House Faculty Associates’ commentary on the Brexit vote. Click here to read the full series.

Howard Chernick is Professor of Economics at Hunter College and the Graduate Center of the City University of New York. He is a research affiliate of the Institute for Research on Poverty at the Univ. of Wisconsin, a board member of Citizens for Tax Justice, and a past member of the board of the National Tax Association. Research interests include fiscal federalism, urban public finance, anti-poverty policy, and tobacco taxation. In addition to cities in the United States, including his hometown of NYC, Professor Chernick has studied the finances of cities around the world, including Montreal, Stockholm, and Kolkota, India.