The long-term economic implications of a Brexit might not be as negative as many studies suggest, writes Lorenzo Codogno. The UK government could seek more favourable solutions on trade than the default options of the WTO framework or bilateral renegotiations of all the treaties. Moreover, economic policy has a role to play in mitigating the negative consequences. The long-term economic implications may thus be overstated, but the immediate risks may instead be underestimated. Brexit would act as a catalyst and trigger a typical balance of payment crisis, with a likely deep depreciation of the GBP and potential negative spillovers in the global financial markets.
The devil is in the detail
We are only days away from the UK referendum on its membership in the European Union and the outcome remains highly uncertain. Financial markets are already jittery. But what would be the true economic effects of a Brexit? Many studies have been published over the past few months. Many look very much alike. Many have even shared the same econometric model. Few voices break away from the pack. Almost all show a very negative effect on the British economy over the short and the long run. However, simulations must be managed carefully and there is a need to look at the details and the underlying assumptions of these studies.
HM Treasury as a benchmark
Take for example the “official” estimates of the HM Treasury. They sparked controversy for the unusual position taken by a public institution, although they are representative of many other studies. In the two scenarios of “shock” and “severe shock”, there is a negative impact that reaches 3.6 and 6.0 percentage points of GDP respectively over two years, which would bring the British economy into a recession. This would be coupled with an increase in inflation between 2.3 and 2.7 percentage points and in unemployment between 1.6 and 2.4 percentage points, a collapse in house prices (to which British voters are very sensitive to), an increase in the public deficit and, finally, a depreciation of the GBP between 12 and 15%. Where does all this negativity come from and is it reasonable?
What is “neutral” for trade?
As with most simulations, the HM Treasury made “neutral” hypotheses those that do not require too many subjective judgements and do not assume any policy reactions. Following a Brexit, trade agreements signed by the EU would no longer be valid for the UK. By default, they would be replaced by two possible arrangements: (1) going back to the WTO framework for trade or (2) a renegotiation of all trade agreements on a bilateral basis, which the study realistically assumes would take over 15 years. However, the UK government could do better and thus less negative (although much more arbitrary) assumptions can be made. For example, the UK could join the European Economic Area (EEA), in line with what already happens with Norway. This would allow full access to the European Single Market, although it would have two major drawbacks: (1) the UK would have no say on EU decisions and would simply accept what the other 27 EU countries decide on trade and the Single Market, and (2) the UK would continue to pay a contribution to the EU that is higher than the current “rebated” amount. These are very significant problems, especially from a political point of view, but the EEA solution would limit the potential economic damage. With skilful negotiations and a constructive attitude on the part of the other EU countries, there is a chance to do even better. The UK government, for example, could try to stretch the two-year transition until a complete revision of the European Treaties, which may well take several years. In the renegotiation of the Treaties, the UK together with other EU countries, could try to spell out the conditions for a free trade area (and cooperation in other areas) that would de facto replace the EU. This option would also be politically very difficult, but it would not be impossible and would reduce economic consequences due to uncertainty and limit the potential damage.
Moreover, in the simulations HM Treasury made another important technical assumption: no policy change. In essence, the Bank of England and the British government would do nothing as a result of a Brexit, leaving aside letting the so-called “automatic stabilisers” work (the automatic increase in unemployment benefits when unemployment increases). This assumption could be perceived as extreme, although technically fully justified. At any rate, the Bank of England could inject liquidity and, through massive purchases of securities and transactions with the banks, prevent an increase in the borrowing costs for the economy. Moreover, the government could implement counter-cyclical policies to mitigate the negative impact on growth and jobs. In conclusion, the medium to long-term impact would not be as devastating as many of the existing studies suggest.
Risks are concentrated in the short term and are related to financial markets
The immediate risks may instead be underestimated. A preview of what might happen has already been on offer in financial markets over the past few days, with the recorded sharp fluctuations of the GBP. Brexit can act as a catalyst and bring to light a fundamental problem of the UK economy. In 2015, the trade deficit reached 6.7% of GDP, the current account 5.2%. In the final quarter of last year, the latter reached 7.0%. This, in the presence of a general government net borrowing (EU definition!) that had declined but still stood at 4.4% of GDP in 2015. Until now, substantial foreign investment inflows into the UK (and some repatriation of British investments from the rest of EU) offset the current account deficit. However, guess what would happen if this net inflow suddenly disappears due to the heightened uncertainty of a Brexit? There would be a typical balance of payments crisis, which would require a significant depreciation of the GBP to bring the external accounts back to balance. The 12-15% depreciation assumed by the HM Treasury would be a good reference point. However, financial markets tend to anticipate future developments and therefore this devaluation can take place within a few days or at most a few weeks after the referendum outcome. Needless to say, such a large shock could have significant repercussions globally. A Brexit could potentially quickly change from an economic thriller to a horror comedy.
This article gives the views of the author, and not the position of BrexitVote, nor of the London School of Economics.
Lorenzo Codogno is Visiting Professor in Practice at the European Institute and founder and chief economist of his own consulting vehicle, LC Macro Advisors Ltd. Prior to joining LSE he was chief economist and director general at the Treasury Department of the Italian Ministry of Economy and Finance (May 2006-February 2015) and head of the Italian delegation at the Economic Policy Committee of the EU, which he chaired from Jan 2010 to Dec 2011, thus attending Ecofin/Eurogroup meetings with Ministers. He joined the Ministry from Bank of America where he worked over the previous 11 years and he was managing director, senior economist and co-head of European Economics based in London. Before that he worked at the research department of Unicredit in Milan.