What are the macroeconomic impacts of Brexit?

Hello Readers, welcome back to another edition of rsira-economics.com. Last time you might remember me discussing a number of key economic concepts that are vital to economists and the understanding of the world in which we live in. This week, I will be going back to discussing current economics news and I will be focusing on perhaps the most controversial issue looming over our minds at the moment. Brexit. With the announcement by Theresa May to trigger article 50 and the recent call for a general election on the 8th June, so much has happened since my last Brexit post, further demonstrating how economics is such a fast moving subject which is all around us. It is important that we actually understand some of the implications of Brexit and where Britain stands economically, particularly on the macro side. In this post I hope to summarize the situation so far, and discuss the macroeconomic impacts on the UK of leaving the EU and the single market which is likely if the Conservative government stays in power, as they have announced that they will be going for a hard Brexit, or as May’s government prefers to talk of a “clean” Brexit.

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Let us first consider some of the short-term impacts that Brexit has had on the UK economy so far:

  1. Demand-Side Shocks

Before the referendum last June, many economists produced gloomy forecasts, which have since been proved wrong. Consumer confidence has not suffered, and by and large, things have gone on as before. However we must remember that the UK has not actually left the EU yet – the real change may only happen once it does. Business confidence, however, has been affected and current uncertainty, ahead of talks between the UK and the rest of the EU, over what form Brexit will take is an issue for many firms when it comes to investment planning. Many firms have made the decision to defer investment projects until the situation becomes clearer and others such as HSBC have made decisions to relocate jobs to Europe to ensure any connections with Europe are not severed.

If when Brexit does actually happen, and people start to become concerned (lower animal spirits) about the future of the UK, leading to a potential fall in demand for goods and services, there is not much room for the Chancellor to stimulate aggregate demand since the base rate of interest is already close to 0. Although some central banks have experimented with negative interest rates in order to stimulate the economy in the past few years, this is not something that has been widely discussed in the UK and is itself a topic for another post.

  1. A weakening exchange rate and Inflation

The pound fell dramatically after the Brexit vote last year, and since then has been trading around 15% lower compared to the dollar and 12% lower compared to the euro than it was before the referendum. The fall in the pound has helped British exporters but it has made foreign holidays more expensive for British tourists, as well as made imports more expensive. Since Britain is a net importer, this is particularly damaging and Britain could suffer from imported inflation. The UK’s fall against the dollar was of particular concern as oil is priced in US dollars and thus the cost of importing oil has risen, leading to issues with production and transport costs. JP Morgan Asset Management is projecting that CPI inflation will rise to 3 or 4 % by the end of 2017, beyond the bank of England’s target 2.0.

 

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It has also increased import costs for manufacturers, which is a key factor for sectors such as the car industry, where vehicles which may be completed in the UK often have imported component parts.

The prolonged weakness of the Sterling could lead to speculative selling of the currency and although unlikely, a collapse in its value. Such a crisis could lead to the Bank of England having to raise interest rates sharply to try and encourage investors to hold the currency, however rising interest rates could restrict demand and inflict more damage to GDP.

 

The long-term effects on the UK:

Currently, the UK is a member of the European Union meaning that there are no tariffs for trading with other EU members, although in return countries have to allow for the free movement of people, within the European Union. However, Theresa May has said that we can no longer be a part of the EU single market as the primary reason for voting for Brexit was to control immigration. It is very unlikely that from the negotiations so far that Britain could have access to the single market and its own immigration rules as this would be unfair to other countries who would also demand similar rules or even worse have their own ‘Brexit’. Without the single market, it would mean that trade restrictions, taxes, and tariffs would have to be implemented on Britain’s exports.

In economic theory, trade restrictions are damaging as tariffs raise prices and reduce consumer surplus. The average tariff on non-agricultural goods exported to the EU was 2.3% and since 44% of all UK exports goes to the EU, there is scope for some serious damage, as the price of UK goods when sold in the EU would be raised relative to the price of goods produced within the EU. Furthermore, tariffs on some products that the UK exports most successfully are higher, for example, cars at 10%.

On the flipside, such trade destruction could be offset by the UK diversifying its trade partners with non-EU member countries, since at the moment the single market encourages the UK to stay in this confined network. However, 44% is close to half of UK exports and this alone brings in billions for the country meaning it is a huge risk to take.

Others argue that the EU membership fee could be spent elsewhere such as on the NHS, although this is such a small percentage of the amount the EU generates for the UK economy.

  1. Growth and Security

David Tinsley of UBS projects that long-run UK GDP could be around 3% lower in a scenario where UK access to the EU market is severely restricted. This would put Britain further behind other countries such as Germany and America. It has also been suggested that without the EU, Britain would be vulnerable and not as safe as it would be with the power and scale of the EU. Further, many people for Brexit suggested that Britain could make its own rules if it was no longer part of the EU, however, some of these rules have been established for years and disrupting the system could only make things worse.

 

  1. Loss of Foreign Direct Investment (FDI)

In 2015 the UK was the third largest recipient of FDI primarily because the UK acted as a ‘gateway to the EU’ in the sense that goods produced here can be exported to the EU free of tariffs and with relatively low transport costs. There are of course other factors making the UK attractive such as a flexible labour market but losing access to the EU single market is likely to lead to a reduction in FDI. George Osborn, in his last act, cuts corporation tax to 15% to attempt to maintain the UK’s attractiveness as a hub for business.

 

  1. Reduced Inwards Migration

This was perhaps the ultimate driving force behind Brexit since the large-scale inwards migration mainly from Eastern European countries where wages are lower and living standards relatively poorer, gave the British people the impression that it was time to “take their country back”. Migration actually adds to the labour resources of the UK economy thus increasing its productive capacity, an important determinant in long run economic growth. Economists for Brexit have argued that we could move to a points based immigration system instead, only allowing those with high skill levels to gain admittance to the UK. Although this would ensure that we do not rule out immigration altogether, what about all the low skilled labour which is largely being provided by this inward migration from Eastern Europe. Furthermore, British workers have on numerous occasions been proved to be less productive when placed in the same low-skilled jobs and farmers, restaurants and factories would face huge inefficiencies if this channel of workers was blocked off.

 

Conclusion

Whilst economists are unable to say with certainty what the true impacts of Brexit will be, it is clear that Brexit has and will continue to cause uncertainty and disruption which is damaging to the UK economy. In the months after the referendum, a poll from the Observer stated that 88% of economists felt that Brexit would damage the prospects for the UK economic growth over the next five years.

Although Theresa May has said that Brexit means Brexit and that article 50 has been triggered, if Liberal Democrats were to win the general election, they could actually call for a second referendum, meaning the UK could still remain in the EU and part of the single market. The President of the European Parliament has said Britain would be welcomed back with open arms if voters changed their minds about Brexit on 8 June. This directly contradicts Theresa May’s claim that ‘there is no turning back’ after Article 50. Liberal Democrat Leader Tim Farron said: “This shows it’s not too late to prevent a divisive, hard Brexit. “On 8th June, together we can change the direction of this country. “The Liberal Democrats will be the real voice of opposition to this Conservative Brexit government.”

 

Sources Used:

http://www.bbc.co.uk/news/business-36956418

Economics Today Volume 24.

http://www.libdems.org.uk/brexit-can-be-overturned-this-is-your-chance

https://www.forbes.com/sites/francescoppola/2017/04/30/the-uk-government-is-completely-deluded-about-brexit/#68e9e6f54f04

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