That EU Vote - 1. Economics

We're less than three weeks away from the EU referendum so I need to start consolidating my thoughts. As background, I've already discussed the baleful influence of newspapers on the language of domestic debate, the historic roots of the EU's democratic deficit, and the wider context of migration. The current consensus is that economics is losing out as the salient issue to immigration, though the Remainers seem convinced that financial self-interest will flush-out enough "shys" to get them over the line on the 23rd. The other issue in the top-three is sovereignty, though we are no closer to defining what that means. Some see it as an expression of English self-determination, while others see it as the rhetorical reflex of a global resentment towards the neoliberal order. The question of whether sovereignty is substantial strikes me as the most important, but it's the one that the public debate has barely touched on as yet. I'm going to tackle these three topics in separate posts, in ascending order of significance. First, economics.
 

All economic forecasts have a margin for error. This applies even more to post-Brexit predictions because we cannot know in advance how much the costs of political disengagement would be offset by compromises to maintain access to the single market, a point conceded by pro-remain economists if not by politicians. In other words, the forecasts are not only conditional on economic variables but on political ones too. The suggestion that the EU would demand punitive divorce terms to discourage emulation by others looks like scaremongering. The Greek crisis proved that the EU core was sanguine about a Grexit and that the Greeks were unwilling to risk a departure despite their pain. Of course, this was the Eurozone and a shattered economy, where the risks of exit were greater, but I think it shows that the EU core aren't fussed by deserters or the semi-detached. Variable geometry has been the EU reality for over twenty years. Pissing off the UK as a warning to Sweden seems improbable.

The British media have promoted the idea that Brexit would lead to a comprehensive reset of relations, for good or ill, but it would be in the interests of all parties to simply carry on as usual while negotiations proceeded, so deliberate disruption is unlikely. For example, the Common Agricultural Policy could not be immediately rescinded in the UK without creating chaos across not only farms but food supply-chains. Likewise, the idea that VAT would disappear in an emergency budget is for the birds, while we can be confident that visas would not be reintroduced for the 2016 holiday season, let alone the knockout stage of the Euros. This will be a long drawn out process. Of course, this delay would entail longer-term uncertainty and might thereby depress inward investment in the interim, but it could also prompt domestic investment in anticipation of future market protections or deregulation. The most likely scenario is a flurry of market-calming announcements and lengthy talks.

 

Where we might expect existing agreements to swiftly fall apart is where we currently enjoy trading asymmetries to our advantage. In other words, where we've penetrated foreign markets with high-volume goods that would be vulnerable to tariffs and where we don't have equivalent imports from those markets against which we could threaten retaliation. I'm struggling to think of any (for example, we export lots of cars to the rest of the EU, but we import more). The relative decline of the UK export sector since the 1970s has been about a qualitative improvement as much as a quantitative reduction. We increasingly export high-value or non-substitutable goods, from specialist engineering and pharmaceuticals to luxury products, which tend to be relatively price inelastic. We know this because recent devaluations, such as after 2008, have been ineffective in increasing export volumes.

It's easy to over-estimate the role of trade and the contribution of exports to the national economy. The sort of fluctuations in trade envisaged by various pessimistic Brexit scenarios are trivial in comparison to the secular decline of the oil and gas sector, while in the short-term we have more to fear from our worsening balance of payments and weak productivity growth. Global trade flows have been stagnant since 2008 and many economists believe there has been a structural decline in world trade since 2000. This is attributed to production consolidation in developing economies (i.e. less fragmentation of supply-chains across countries), onshoring in developed economies due to advances in automation, and the increasing importance of data (i.e. designs being moved across the globe for local fabrication plus the growth of digital products). In other words, globalisation (as hitherto understood) may have peaked.

We're probably looking in the wrong place if we imagine that the costs of Brexit would mainly appear in the form of trade disruption. In contrast, foreign direct investment would certainly be vulnerable, but it's worth remembering that less and less of FDI is capital invested in traditional factories and plant. Many of the companies recently attracted to the UK (and specifically London) are service providers, such as Amazon and Google, whose business model depends on regulatory arbitrage. Being outside the EU may not prove as costly to them as it might to a Nissan, while the other attractions of the UK, from language to low corporation tax, may well be of greater value (it's worth noting that George Osborne's business policy has been to provide extra-European capital with a favourable route into Europe, which is unlikely to change in the event of Brexit). Part of the problem of the trade debate in the context of the EU referendum is that it is premised on a twentieth century industrial paradigm (or even a nineteenth century one).

 

The warning that Brexit would lead to a shift in financial business from London to Frankfurt isn't convincing. The City was the pre-eminent centre for European financial services long before we joined the EEC, and it remains the leading market for euro (and other foreign exchange) trades despite not being in the Eurozone. While London has timezone and language advantages, it also benefits from a legal system that protects property rights against state expropriation and a political system that accepts the City's privileges. It's not just the football or schools that attract foreign oligarchs. It's possible that this may change over time as other financial centres, particularly in the Far East, attract more business from developing economies, but this will be the result of wider secular trends not anti-London legislation in Brussels. The current "fears" of the City reflect short-term uncertainty, not a long-term conviction that the industry faces decline.
 

The economic case against Brexit is essentially founded on the short-term costs of disruptive change, in particular a decline in investment due to uncertainty, and the expectation that long-term the UK would lose some of the trading advantages it currently enjoys without compensatory gains elsewhere. Behind this lies an assumption that there would be little fundamental change in the structure of the UK economy, even allowing for a declining share of the EU in UK exports. This is reasonable - i.e. a straight extrapolation of current circumstances - but it also assumes political timidity or at least inertia. While the prospect of an interventionist government set on a dramatic reordering of the economy (i.e. true "rebalancing") is currently remote, it isn't beyond the bounds of possibility. Though the chief political beneficiaries of Brexit are expected to be Tories drunk on their own rhetoric, the desire to "do our own thing" might ultimately benefit the Labour Party more.

 

On balance, Brexit would be a negative for the economy but it might prove less dramatic than advertised in the short-term due to the interest of all parties in avoiding disruption (for that reason, the argument that it would jump-start the move to full fiscal union within the Eurozone strikes me as fanciful). That said, a run on the pound and a balance of payments crisis are real possibilities, and the odds are that correcting these would further imbalance the economy in the medium-term. Global sentiment will either turn against the UK or the EU and could remain that way for some years. Over the longer term, the impact of Brexit may well be diluted by secular changes in the composition of the UK economy and global trade. If we assume that the UK maintains most of its integration in the EU single market out of self-interest, then the economic ramifications of Brexit may be minor in comparison to the political.