Why it's advantage EU ahead of Brexit negotiations

This article was first published by the Peterson Institute for International Economics.

After the United Kingdom’s vote to leave the European Union on June 23, financial indicators in London fell dramatically, costing the UK its AAA credit rating. Then the indicators stabilized amid signs that the actual divorce might not happen soon. More recently, they have resumed their slide. In early July, several UK commercial real estate property funds were forced to block the investors’ right to withdraw their money. The British pound renewed its decline to new 30-year lows and UK domestic stocks again dropped. The reasons for the latest reversal are clear. Both the Conservative and Labour Parties are in disarray, and the EU and the UK have hardened their negotiating positions, making it more likely that the UK will end up severing most if not all economic ties with the EU.

To combat these conditions, the Conservative government has signaled several dramatic policy U-turns, including the end of austerity by abandoning Prime Minister David Cameron’s commitment to achieving a budget surplus by 2020. The Bank of England has more or less committed itself to easing British monetary policy further in the coming months. Of more lasting significance, perhaps, George Osborne, chancellor of the exchequer, has announced a new 5-point economic plan for post-Brexit Britain in which he foresees UK corporate income tax rates reduced below 15 percent (very close to Ireland’s 12.5 percent “tax haven” rates). The plan also calls for public investment in (mostly rail) infrastructure in Northern England—mostly through the Bank of England’s reduction in banks’ countercyclical capital buffer to zero for lending to the UK. The aim is to support credit creation for the domestic economy, safeguard the UK’s fiscal credibility, and double-down on securing new investments into the UK from China. Of course, many of the details of future UK economic policy will be in the hands of the next prime minister and flow from future Brexit negotiations with the UK, but Osborne’s announcement raises several concerns.

The first concern is that although public infrastructure investments may be good economic policy compatible with fiscal credibility, cutting UK corporate tax rates even further than had been announced in the Conservative government’s long-term budget planning will likely draw the ire of the EU’s 27 other members, poisoning the negotiating climate further once London invokes Article 50 and lays out its terms for Brexit.

Even if lowering UK corporate tax rates and UK bank capital charges makes sense in the short term, the unmistakable impression left by these actions is that pursuing an offshore tax and regulatory haven has become the centerpiece of the government’s post-Brexit strategy. As for Chinese investors, why should they invest in the UK right now at anything other than rock-bottom prices? They have a clear incentive to wait before committing new money to UK assets, safe in the knowledge that procrastination might push UK asset prices even lower. Significant Chinese investments into euro area crisis economies like Greece and Portugal have in recent years followed such a pattern.

A main reason for the return to pessimism over the post-Brexit economy lies in the confrontation with what is now the EU-27. The first meeting of the leaders of the EU-27 laid down a hard line. However regretful and business-like is its tone, it would be a serious mistake not to view its stance as an iron fist in a velvet glove.

First, there will be no negotiations before Britain launches the formal Article 50 procedure to leave the EU, setting in motion the two-year window of opportunity to negotiate the departure of the UK from the EU. Article 50 is written in a way that benefits the EU at the expense of the departing country. It thus operates like a doomsday clock strengthening the EU’s negotiating position as the clock ticks. If the UK and the EU-27 countries do not agree unanimously to extend the 24-month period, EU treaties and rules stop applying to the withdrawing country. Such a sudden stop would throw into limbo the legal status of 40 years of EU rules and regulations governing a host of activities across the UK economy. Westminster could simply convert all the “Brussels regulations” into UK law with the promise to review them over time, but such a step would be politically difficult and do little to lift the uncertainty that has dampened investment and depressed economic growth. For its part, the EU has no interest in extending the deadline by starting negotiations before Article 50 is invoked, just as the UK government has no interest in invoking Article 50 before settling on a negotiating position.

What EU leaders clearly want is for negotiations to follow a fixed chronology, starting with Article 50 and perhaps eventually undertaking negotiations in which the UK would be treated as an outside “third country” seeking a relationship with Brussels and the EU members. No time line for such talks exists. They could stretch out for many years, imposing long-lasting uncertainty on UK society and darkening prospects for a new forward-looking economic agreement between the EU and UK. The additional economic uncertainty would likely become a kind of feedback loop strangling the British economy, strengthening the negotiating hand of the EU.

EU leaders have also made it clear that there is no scope for partial access to the internal market in return for partial access to free movement of labor. Switzerland is heading toward a possible second referendum on its attempt to reduce EU immigration later this year, at the risk of canceling its economic agreements with the EU if Swiss voters again vote to restrict free movement of labor. Norway and Switzerland have thus learned that they must live by all “four freedoms”—freedom of movement of goods, services, capital, and people—or none at all.

Finally, one should not underestimate the impact of the EU Treaty requirement of the European Parliament to give its consent to any new EU agreement with the UK, even though the parliament is not directly involved in the Article 50 negotiations for the UK to leave. It seems safe to assume that parliament members will take a harder line than many EU member states against the UK on many issues. Nigel Farage, recently resigned as head of the United Kingdom Independence Party, may thus come to rue his gloating post-referendum appearance before his European parliamentary colleagues. “Isn’t it funny?” he told the parliamentarians. “When I came here 17 years ago and I said that I wanted to lead a campaign to get Britain to leave the European Union, you all laughed at me. Well, I have to say, you’re not laughing now, are you?” Yet the lawmakers may have the last laugh in driving a hard bargain with Britain over Brexit.

Key EU leaders, such as German chancellor Angela Merkel, seem willing to accept the UK government delay of some months before the launching of formal Article 50 negotiations, or at least until a new prime minister has been selected. European demands seem unlikely to change before the 27 leaders meet again in Bratislava in September. It will not, however, help that the proposed slashing of corporate tax rates to Irish levels will be seen in much of the EU as attempts at beggar-thy-neighbor policies.

Another factor hardening European attitudes is that they do not want to encourage copy-cat referenda in their own countries, following Cameron’s political recklessness in scheduling such a vote for his own domestic political reasons—to try to outflank his right wing. Only if populist parties win power in national parliamentary or presidential elections (e.g., in France) would such a referendum be called. Some countries allow signatures to be collected demanding referenda on specific policy issues against the will of the incumbent government. But such citizen-initiated measures are generally only advisory in scope and exclude international treaties like the EU Treaty and membership. A Frexit referendum in France, for instance, would be possible only if Marine le Pen of the National Front wins the presidency and the party also wins a parliamentary majority (together with other anti-EU parties). The political bar for new referenda on EU membership in the next couple of years thus remains high.

Europe is headed for a tough negotiation in which Britain has few good cards to play.

Copyright for this work is held by the Peterson Institute for International Economics.