What are the economic consequences of Brexit?

David Cameron has fired the starting gun for a June referendum on Britain’s membership of the EU — a vote with profound implications for the economies of the UK and continental Europe.

In the first part of a special series, the Financial Times investigates the economic scenarios for the UK if voters on June 23 opt for “Brexit”, drawing a line under Britain’s four decades in the bloc.

In a poll of more than 100 economists for the Financial Times at the start of 2016, more than three-quarters thought Brexit would adversely affect the UK’s medium-term economic prospects, nine times more than the 8 per cent who thought Britain’s economy would benefit.

Many in the Leave campaign counter that economists tend to favour Britain remaining as an EU member because they are naturally in favour of deeper trading relationships with other countries.

The UK’s membership of the bloc has, in truth, both created and diverted trade. Most economists accept the evidence that trade creation has far exceeded trade diversion and brought increased competition, innovation and specialisation in its wake. But economics cannot predict what will happen if Britain leaves the EU.

Economists are generally wary of transitions, fearing that heightened uncertainty over Britain’s relationships with other countries will damage confidence and investment, at least for a few years if Britain were to leave the EU.

They are also more likely than many politicians to play down the importance of sovereignty, maintaining there will be a trade-off between sovereignty and the best decision-making authority.

The consequences of Brexit would vary depending on the terms of departure — which would have to be negotiated after a vote — as well as on the prevailing economic climate.

Here, the FT looks at the case for three very different economic futures for a UK outside the EU: a Booming Britain, a Troubled Transition and a Disastrous Decision. The first envisages a vibrant economy unconstrained by Brussels red tape; the second foreshadows a period of turmoil and financial instability before the UK finds its way; the third portends an economy that suffers long-term damage.

Booming Britain

The scenario
Brexit is an orderly process that avoids short-term turmoil and brings greater prosperity to British people in the medium term.

The assumptions
For Britain to prosper more outside the EU than it did as a member, some of the following four conditions have to be met.

To reduce the regulatory burden loathed by many businesses, the UK has to repeal or amend swaths of EU regulation. To restore control over its borders, which many supporters of Brexit crave, the UK must have an immigration policy that no longer discriminates in favour of EU citizens. To cut down on the cost of membership, it must save all or part of the £13bn a year in net budgetary transfers to the EU (offset by about £7bn the EU sends Britain).

£13bn: Britain’s net budgetary transfers to the EU

Finally, to prevent disruption to the trade flows on which the British economy has come to depend, the country must negotiate agreements with the EU and with non-EU countries including the US, India, China, Japan and Australia. This would be a matter of urgency: in 2014 just over half Britain’s trade was with the EU, while sales to and from 60 other countries are governed by agreements struck with the bloc.

What proponents say
Patrick Minford of Cardiff Business School argues that: “In the long term, Brexit will herald a major growth-boosting period, as the UK breaks free of the over-mighty EU with its protectionist mindset and establishes free trade and intelligent regulation aimed at UK economic interests.

In a similar vein, Leave EU, one of the two main groups campaigning for Brexit, talks of freeing Britain from the EU influence that “prevents the UK from taking full advantage of a surging global economy [and] capitalising on its unrivalled influence throughout the rest of the world”.

Ruth Lea, adviser to Arbuthnot Securities, argues that being outside the EU’s single market need not be a serious concern. “Trade with World Trade Organisation rules is not disastrous,” Ms Lea says, referring to the rules that underpin global commerce. “A lot of EU trade is done on these rules.”

The challenge
Most economists question the underlying assumptions in this scenario.

“The package of stopping free movement, but remaining in the single market and being free to liberalise the [EU’s] external tariff, seems to be pie in the sky”, says Professor Nick Crafts of Warwick University.

Thepackage of stopping free movement, but remaining in the single market and being free to liberalise the [EU’s] external tariff seems to be pie in thesky

- Professor Nick Crafts of Warwick University

If Britain were to remain a full part of the single market, it would have to accept EU regulations, including the free movement of people, without any influence in setting them. It would still have to pay for access to that market, as does Norway. It could not deregulate more than it can already today.

If the country were to adopt a looser trading arrangement, it would have more control, but would struggle to negotiate the same access for goods and services.

Raoul Ruparel of Open Europe, a think-tank influential in Number 10 Downing Street, questions the premise that Britain stands to make big gains from striking deals with countries outside the EU. “Lots of countries get free-trade agreements,” he says. “The question is whether they are quality or not.” For example, a recent Swiss free-trade agreement with China opens up all of the Swiss market to China immediately, while maintaining tariffs on exports of Swiss watches to China in perpetuity.

Jonathan Portes of the National Institute of Economic and Social Research, a research organisation, adds that regulations could be a heavier burden for business outside the EU than in. At present, the rules that inflict most damage on the British economy are planning laws, a wholly domestic affair.

FT verdict
Today’s campaigns to leave the EU make for a striking contrast with the groups that opposed the common market in Britain’s 1975 referendum. In the 1970s the bloc’s opponents were fundamentally protectionist. In 2016, their rallying cry is freer trade outside the EU.

But assertions that Britain will be better able to foster trade with third countries once it has left the EU are not yet very credible. Nor is it likely that the country can maintain the same access to the European single market while cutting down on regulation and budgetary transfers.

Troubled transition

The scenario
Leaving the EU is risky and will give the British economy a nasty jolt but, once a new relationship is forged, life will be neither better nor worse outside the EU.

The assumptions
Ultimately, the main assumption is that membership of the EU is not one of the most important issues in British economic prosperity. Though trade matters and ties with the EU would deteriorate, that would be offset by better relationships with other nations. The other main forces behind economic growth — investment, skills, competition, innovation and entrepreneurship — would remain intact.

But breaking away from the bloc would inject deep uncertainty into the UK economy until new relationships with Brussels and non-EU countries were established, creating an unstable period of low investment with the risk of a run on the pound. Foreign investors could stop lending to Britain in the short term, choosing to wait and see at a time of upheaval.

What proponents say
A sizeable minority of economists maintain that Britain could continue outside of the EU with relatively little disruption. Proponents of this school of thought point to European economies, such as Norway and Switzerland, which have prospered despite never being members of the EU.

Such economists accept that if the UK were to maintain deep and wide trade relations with the EU after leaving the bloc, it would have to continue with many of the laws and regulations that are currently part of EU law.

Bridget Rosewell, Senior Adviser at Volterra Partners, says: “I don’t think that Brexit makes any real underlying difference, and indeed the advantages and disadvantages of membership of the EU are finely balanced.”

But some who argue that Brexit changes little in the long run still worry about the transition out of the EU — a concern they share with a wider number of economists. Ms Rosewell adds that “uncertainty and political disruption could make a difference”.

'There would be a bureaucratic crisis. The hope would be not to do too much damage' - Jonathan Portes, NIESR

Jonathan Portes, who was a former senior government official before joining NIESR, says that leaving “would be a bloody nightmare — especially for my former colleagues in the civil service. There would be a bureaucratic crisis. The hope would be not to do too much damage”.

Of greater concern in financial markets is the possibility of a sudden outflow of money from the UK, which could make the country’s current account deficit of 5 per cent of national income difficult to finance.

“Given the clear economic risks [in the event of a vote to leave the EU], markets would likely demand a considerably higher risk premium on the huge capital inflows required to finance that deficit,” says Neville Hill of Credit Suisse. “That would mean a sharp fall in sterling and the price of UK assets.”

The challenge
Many economists reject the idea that Brexit would create purely transitional problems. Instead, they argue that investment would fall in the wake of a bumpy exit from the EU, leading to persistently lower growth. Productivity could be affected too. Raoul Ruparel of Open Europe says that, “with less foreign direct investment, we would lose some potential and technical benefits”.

Isee no reason there should be an uncomfortable relationship with Brussels and an almighty run on the pound. But it would take maturity on bothsides

- Ruth Lea, a Brexit supporter

Even temporary problems could take years to resolve. Charlie Bean, former deputy governor of the Bank of England, says that if Britain did decide to leave, “the continuing uncertainty surrounding the terms of access of UK companies to the EU market mean that this dampening effect on investment could be expected to last for several years”.

Ruth Lea, a Brexit supporter, advises the government to minimise the risk of adverse market reaction to exit from the EU, a potential peril highlighted by the overwhelming majority of economists.

“If we do vote for Brexit, this is the time we need to start making friendly overtures to the rest of the EU,” she says. “I see no reason there should be an uncomfortable relationship with Brussels and an almighty run on the pound. But it would take maturity on both sides.”

FT verdict
The contention that trade is only one element in the long-run performance of economies is well-founded. But such an argument can easily be exaggerated, since trade is clearly an important element of prosperity. A difficult transition out of the EU would jeopardise Britain’s living standards.

The scenario
Britain’s economy suffers after Brexit. The negotiations to leave the EU are fraught with difficulty and the trading relationship with Europe is worse than before, without offsetting benefits elsewhere. Britain’s economy once again begins to fall behind the country’s European partners.

The assumptions
After acrimonious negotiations, which drain confidence from the British economy, Britain secures a looser trading relationship with the EU. Free movement of people is curtailed, but the price is weaker access to the EU market for goods and particularly services. Britain finds it difficult to sign beneficial trade deals with other countries, receives less inward foreign direct investment, has fewer immigrants and does not improve the regulation of the economy.

What proponents say
Most supporters of the EU do not expect Britain to secure as favourable a trading relationship outside the EU as it enjoys at present if it insists on curbing free movement of people, one of the EU’s four principal freedoms, together with the free movement of goods, services and capital.

90% of UK’s trade with Europe is in goods

“A free-trade agreement is not the same as being in the single market,” says Rebecca Driver of Analytically Driven, a consultancy. “You end up having to comply with rules of origin regulations, which can be 200 pages long for a product and are particularly detrimental to small and medium-sized companies.”

Ms Driver also worries that Brexit supporters exaggerate the ease of signing new trade deals with other countries. “Think how the US is going to prioritise trade deals,” she says. “UK or EU? With a limited number of negotiators, which market are they going to choose?”

Raoul Ruparel of Open Europe expresses concern about the “strong negative effect” of a clampdown on immigration from the EU, which could reduce an already limited supply of skilled labour.

Michael Saunders, an economist at Citigroup, anticipates a series of three big shocks: “Worse export performance due to inferior EU access for business and financial services; lower potential growth and lower consumer spending from reduced migration inflows; and weaker investment growth, reflecting the above factors plus extra uncertainty.” This would hit the government budget, requiring higher taxes or lower public spending amid higher costs of financing the deficit, he adds.

The challenge
Brexit supporters argue that the pro-EU camp always exaggerates the costs of opting out of EU initiatives, highlighting that many warned incorrectly of the consequences of not joining the euro in the late 1990s and early 2000s. Despite confident predictions that the City of London in particular would suffer because of the failure to enter the single currency, the financial centre has thrived.

Thinkhow the US is going to prioritise trade deals. UK or EU? With a limited number of negotiators, which market are they going tochoose?

- Rebecca Driver of Analytically Driven

The Leave campaigns say that, because of its importance as a destination for EU products, Britain could relatively easily strike a free-trade deal with the bloc. Such agreements typically govern goods rather than service, but 90 per cent of trade with Europe is in goods.

Moreover, they add, once it is outside the EU, the country would be more agile in striking new trade deals with third countries. While Michael Froman, President Barack Obama’s trade adviser, has warned Britain that the US is “not particularly in the market” for free-trade agreements with individual countries, the Vote Leave campaign maintains that trade relations with the US “will not change” if Britain left the EU.

Ryan Bourne, head of policy at the Institute of Economic Affairs, adds that Britain will prosper outside the EU so long as “domestic policy remains sensible, economically liberal and mutually beneficial free trade is agreed”.

The issue of whether a post-Brexit UK would have a heavier burden of regulation rather than being freed from the EU’s bureaucratic yoke remains deeply contentious. Brexit supporters acknowledge that the UK’s regulations are often wider ranging and more restrictive than the EU rules on which they are based — a habit known as gold plating. But Mr Bourne says that the real issue is the question “where sovereignty should reside”.

FT verdict
With clear and easily specified economic risks in the short and medium- term, Brexit does not easily pass any cost-benefit analysis. But supporters of the EU should be wary of making overconfident claims, since trade is only one driver of growth and prosperity.