Brexonomics

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Summary

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.

The bigger issues come with the City of London and its role in global finance, and in particular in relation to transactions in euros.

The real consequences may come though in the non-economic realm, and as a product of the unintended consequences of leaving the EU.

So in conclusion, I think the risks to the UK leaving the EU are subtantially hidden - and potentially could cost the country its existence.

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 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.

Source: Financial Times

So let's first deal with the economics, and then pass on to what I think are the much more important ( - a union of countries that has the same trade policies with 3rd party countries) and essentially then joining the same thing. Why? Because it would be very difficult for the EU to deny membership of the UK in the European Economic Area (or EEA), which is as has been said elsewhere (see Patrick Minford's website here which evaluates the trade consequences). The EEA is the area in which 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. In other words, it is likely that the UK would (rejoin) the EFTA bloc and so be able to trade with other EU countries without any restrictions. Essentially the UK could then set whatever tariffs or quotas it wanted on 3rd party countries. Now even if the UK did not rejoin EFTA, it would still likely have an option to remain in the EU customs union.

A closer look at some of the countries that lie outside the EU reveals that there are significant differences, though. 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. In other words, if, as the EU has recently made clear (see here), the EU could 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.

The bigger issues come with the City of London and its 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.

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.

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 described 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 in conclusion, I think the risks to the UK leaving the EU are substantially 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.

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