The UK has voted to leave the EU, but not in favour of any specific alternative to EU membership. This poses a challenge for UK policy makers and the new Prime Minister. What should the UK’s relations with the EU be, following Brexit? The UK should join the EEA and remain part of the single market, write Swati Dhingra and Thomas Sampson.
It is naïve to expect economic considerations will be the only factor that determines what relationship the UK eventually seeks with the EU, or what deal the EU is willing to grant the UK. If the UK government’s objective were to obtain the highest possible standard of living for UK citizens it would never invoke Article 50 of the Treaty of Lisbon and start the Brexit process. But if Brexit must happen, it is useful to understand which option would do least harm to the UK economically. This option can then serve as a benchmark for evaluating the trade-offs required to obtain political objectives such as limits on immigration and ‘taking back control’.
The UK’s Options
There are many models available for the UK: join the European Economic Association and remain part of the Single Market like Norway; negotiate bilateral deals providing partial access to the Single Market like Switzerland; sign a free trade agreement with the EU like Canada, or; trade with the EU under World Trade Organisation (WTO) rules as the United States currently does. Research on the economic consequences of Brexit clearly shows that the costs would be lowest under the first option – joining the EEA and remaining part of the Single Market.
Economic Reasons for Choosing the EEA
To explain why the EEA is the least bad option we can consider the consequences of Brexit along four dimensions: trade, investment, immigration and regulation. Trade makes countries better off by allowing them to specialise according to their comparative advantage, providing access to new and cheaper imported goods and increasing competition between producers. Leaving the EU will hurt the UK economy by increasing trade barriers between the UK and the EU, but joining the EEA would lead to lower trade barriers than any of the alternative options.
As a member of the EEA, the UK would remain part of the European Single Market meaning there would be no tariffs or other new border measures on UK-EU trade. In addition, the UK would continue to adopt all the EU’s economic regulation keeping non-tariff barriers between the UK and the EU at a lower level than if the UK leaves the Single Market and starts to diverge from EU regulatory standards. After joining the EEA the UK would no longer be part of the EU Customs Union meaning it would face some new non-tariff barriers on its trade with the EU, such as rules of origin and the threat of anti-dumping duties. However, it would also be free to seek its own trade deals with the rest of the world.
Analysing the trade effects of Brexit, Dhingra et al. (2016a) find the EEA option is equivalent to a 1.3% fall in the UK’s income per capita, while the WTO option is twice as costly leading to a 2.6% decline. Importantly these estimates also net out post-Brexit changes in how much the UK pays into the EU budget. As an EEA member the UK would continue to contribute to the EU budget, but based on how much Norway pays, its contributions would be around 17% lower. Dhingra et al’s analysis shows that the costs of Brexit come mainly from higher non-tariff barriers not from changes in tariffs. This illustrates why a traditional free trade agreement that focuses only on reducing tariffs is not a good alternative to EU membership.
Foreign direct investment (FDI) directly raises output and employment, but also has indirect benefits through the transfer of new technologies and managerial know-how. Bruno et al.(2016) estimate EU membership increases FDI inflows by around one-quarter compared to either having a free trade agreement with the EU or trading with the EU under WTO rules. The UK is the third largest recipient of FDI in the world. One of the reasons the UK is an attractive destination for FDI is that firms which invest in the UK have free access to all other EU markets, so they can use the UK as an export platform for exporting to the EU.
Higher tariff or non-tariff barriers between the UK and the EU would reduce the advantages of investing in the UK. EEA membership is the best alternative from the perspective of FDI because it would lead to smaller increases in trade barriers than any other option. Particularly important are ‘passporting rights’ which allow financial institutions operating and regulated in the UK to do business throughout the Single Market. Passporting rights have played an important role in allowing the UK to dominate the European market for financial services. All EEA members have passporting rights, but no country outside the EEA does (Dhingra et al 2016b).
Turning to immigration, EEA membership requires agreeing to free movement of labour with other EU and EEA countries. While immigration from the EU is politically unpopular in the UK, research has failed to find any robust evidence that immigration has hurt the UK economy (Dhingra et al 2016c). In fact, there may be benefits from obtaining access to a wider pool of skills. Limiting immigration into the UK would also mean accepting new restrictions on emigration from the UK to the EU, which would reduce the opportunities for UK citizens to live and work in other EU countries. Finally, it is important to remember that EU immigrants are net contributors to the UK government’s budget (Dustmann and Frattini 2014). Consequently, reducing immigration would increase the UK’s fiscal deficit.
Since EEA members are part of the Single Market, they must adopt the EU’s economic regulations. But EEA members that are not also part of the EU do not have a vote on what the regulations are. Therefore, leaving the EU to join the EEA would reduce the UK’s control over economic regulation. By contrast, trading with the EU under a free trade agreement or WTO rules would give the UK greater control over economic regulation.
However, there are two reasons why EEA membership is still the better economic option. First, EU and EEA members have ample scope to tailor their implementation of EU regulations to reflect their national interests. OECD measures of product and labour market flexibility show the UK has similar levels of flexibility to the US and Canada, while most other EU members have more rigid economies. Consequently, the potential benefits from regulatory changes in the UK are likely to be small. Second, common regulatory standards across members of the Single Market are what keeps non-tariff barriers low which increases the gains from trade. Overall, the costs of reduced control over economic regulation are lower than the benefits of regulatory harmonisation.
Economically, none of the options facing the UK are preferable to staying in the EU. But joining the EEA and remaining part of the Single Market is the best available option as it would minimise the disruption to the status quo and keep the UK closely integrated with the rest of Europe.
Given the importance the new UK government, and at least part of the UK public, attach to imposing controls on immigration from the EU, the EEA option may not be politically viable. But this only highlights that the government’s political objectives have economic costs. The question the UK must address as it debates the aftermath of Brexit is whether these costs are a price worth paying.
Note: This blog first appeared at LSE Business Review Blog, and is draws on work published in the VoxEU ebook Brexit Beckons: Thinking ahead of leading economists, and Life after BREXIT: What are the UK’s options outside the European Union?, Brexit Analysis 01 of LSE’s Centre for Economic Performance (CEP).
Swati Dhingra is an Assistant Professor at the Department of Economics at LSE. Before joining LSE, Swati completed a PhD at the University of Wisconsin-Madison and was a fellow at Princeton University. Her research interests are international economics, globalisation and industrial policy. Her work has been published in top economic journals including The American Economic Review. She is Associate Editor of the Journal of International Economics, and was awarded the FIW Young Economist Award and the Chair Jacquemin Award by the European Trade Study Group for her work on firms and globalisation. Swati is a member of the Globalisation group at the LSE’s Centre for Economic Performance, and has made regular contributions to work on economic policy.
Thomas Sampson is an Assistant Professor in the Department of Economics at LSE. He holds a PhD in Economics from Harvard University and an MSc in Econometrics and Mathematical Economics (with distinction) from LSE. He has worked as a consultant to the World Bank, a fellow of the Bank of Papua New Guinea and other organisations. He has published papers in a number of leading academic journals. His research interests are in international trade, growth and development.
The bottom line is we do not need a trade deal with the eu, we can trade with them anyway and as we have a negative trade balance they would be the losers if they even consider being childish about it.
In terms of the original post I think many economists are missing something.
David Cameron gave us a referendum. If the main issue was economics (and you have been careful not to say that I know), then there was no point in having the referendum. To hold a referendum and say “you can choose A or B, I think you should choose A and all the experts say you should choose A. If you choose B it will be very bad” is a very strange thing to do. Implicit in the offer of a referendum is that option B is worth considering, otherwise why offer it as a choice? So it was the Remain side discounting the expert advice as otherwise the offer of the referendum would have been absurd.
Again lots of comments (not here I know)about Brexiters not having a plan, not put-on together a clear offer. But the logic of those complaints is that we were offered a referendum in which we could not vote for one option as it was not logistically possible for the “out” side to meet the criteria of a single clear agreed proposition. Hence we were having a referendum who’s only purpose was to show our hand and so reduced our bargaining position.
Now you economists don’t just do hard maths and build macro-economic models. You also do game theory and how people make choices. so I look forward than analysis of the referendum as a strategy in a game analysing the two choices available and how the two choices were framed and the consequences of each choice.
Thank you ‘Dipper’, I think you have been fairness itself.
What, I wonder, might ‘game theory’ have to say about the value of, “Brexit means Brexit” over: ‘We asked for advice, and we have it. We must now give it every consideration.’?
-I see less of any need for an eventual climb-down.
-And…less need for the ‘outers’ to accept a ‘Norway’ scenario.
The referendum was indeed a strategic fiasco.
I would like to have seen more of the kind of analysis given here before we all had to vote, but now, only post-vote, attention focuses.
The national media failed to spark this sort of thinking in time.
If it were to do so now, and engage the public at large’s attention (to something which after all will affect all our lives) then, as one wishful thought, perhaps we might even recover a total re-think, a re-referendum with the opposite result, and still be able to remain in the EU.
Or, what other possibilities exist for us? Could we perhaps work towards a federation of Northern European states? (Let France go with the South and have Italy, Spain and Greece etc, whilst we could join with economies and cultures more fitting to ourselves ????) I wish this would have been the kind of thinking we had had before the referendum, rather than the relatively crude and paranoid immigration scare stuff.
This analysis seems to start at the wrong end – macro numbers, averages, per capita. How about starting with an individual, or number of individuals, and working out the consequences on them. Here’s a few suggestions:
– a 30-year old in Grimethorpe who would like to get a job at ATOS, but instead ATOS is advertising specifically in Rumania and Poland for workers (see the Times a couple of Saturdays ago)
– a steel worker in Wales.
– a young economics graduate who would like to become an academic but finds all the posts are going to academics from overseas.
– a young person contemplating becoming a lorry driver, but wondering whether the investment in training and licenses is worth it when so many drivers are being employed on cheap rates from Latvia. (https://www.theguardian.com/commentisfree/2016/aug/02/industrial-failure-uk-lorry-trade-truck-driver-squalor-low-pay-no-unions)
If your analysis cannot shed light on how the various options work out for these folks then I’m not sure how much use it is (other than for impressing other economists with the rigour of your analysis).
“Higher tariff or non-tariff barriers between the UK and the EU would reduce the advantages of investing in the UK”
Well it would also reduce the advantage of investing in the EU, this being a reciprocal arrangement
And given the UK is a net importer, then presumably it would make it more advantageous to invest in the UK for those items being bought by citizens of the UK?
In anything approaching ‘aftermath’:The first thing to do is to stop having the UKIP conversation.
The EU, in correct terms, represents; Free Movement of labour etc. and a refugee crisis. Neither of which can be usefully discussed as ‘immigration’.
‘Brexit’ – whatever that is, looked at in relation to economics throws-up one inevitability:UK Plc. shall enter the ranks of SMEs.
The role of scapegoat – so ably assigned to the EU by our Political establishment, has now found a body that has elected itself to the role;by a margin of 4%.
No matter how dire the form of our separation from the EU takes, our Political establishment has a long record of requiring the poor to foot all bills.
And as the demographics of those who voted to leave emerge, to show how strongly the well-heeled affected the referendum outcome. The result will be sold to us all as having been the poor choosing to sacrifice themselves and their progeny on the altar of Party-Political advantage.
Unless, of course, we force Brexit into the bin of history…
Both eu and non-eu Immigration has a net negative impact on fiscal balances – Migration Watch (2014) and Rowthorn (2014)
Further evidence how ‘experts’ manipulate data in order to impress upon ‘non-experts’ their opinion.
The people have spoken.
Is strongly believe that the ONLY thing denying a strong, viable partnership with Europe is the EU political Unions itself.
Undeniably, the policy of FREE MOVEMENT of people was clearly tested Post Recession when economists failed to foresee the vast amount of economic migrants coming in their 100s of thousands from failed economies in Europe to stronger economies such as the UK. This had a profound impact on British people – their public services, employment opportunities and housing. But, most unforgiveable, we saw BRITISH politicians not giving a VOICE to the concerns and detriment to those they were meant to be fighting for. Thus, Neglect over decades were finally harnessed in the form of BREXIT.
Many would argue that these same British people have a LOVE of Europe, but not for the EU political Union. Thus, it is hoped that the EU dies a death that gives HOPE, Discovery and Prosperity for Europe in a new partnership… stemming from new leadership at the helm of the EU – without FREE Movement. Free Movement can be seen as one Country’s failed economic woes being FORCED onto other countries. THIS CANNOT BE ACCPETABLE!! The EU has to be a PROBLEM SOLVER – An INSPIRATION – not just to its political counterparts, but to the PEOPLE it MUST have a Duty of Care towards.
What should BREXIT look like? Without FREE Movement!! It MUST, and will, Forge a continued trading partnership with EU countries such as Germany – who sells its cars and other products to the UK. It will be difficult to see Germany STOP such trading agreements with the UK.
The UK also has a GREAT opportunity to LEAD – forging ahead with partnership-building and trade agreements that Forces the EU political union to its knees – and towards an improved ethical stance that is NOT self-serving!!
“But, most unforgiveable, we saw BRITISH politicians not giving a VOICE to the concerns and detriment to those they were meant to be fighting for. Thus, Neglect over decades were finally harnessed in the form of BREXIT.”
And so…threw us all back into the arms of these same neglectful Politicos. Accompanied by the cry:Beat-me, beat-me, show you care, and beat-me.
Brexit not so much wishes for the fall of the EU, but is wholly and utterly reliant upon the fall of the EU. For, unless and until such a thing comes about, every trade deal – across Europe and around the globe, can only be signed in-line with the existing (or pending) agreements any likely trade-partner has with the EU.
Having lost an arm to the voracious (and otherwise neglectful) Political establishment of ‘our’ UK, Brexit will now force-feed that same beast with it’s first-born.
An increased Politicization of the EU held out hope for us all – no wonder the UK establishment has grabbed onto Brexit with both hands.
British politicians can be voted out, unlike the EU Commission.
Mmmm…We got rid of Cameron?
Oh, and; “Members of the House of Lords who were once MPs ”
[Too many to count…]