Soft or Hard Brexit?

Britons’ shock vote to leave the European Union is a political earthquake that is likely to deeply damage Britain, Europe, and the West as a whole. It threatens the break-up of the United Kingdom, the peace process in Northern Ireland, and the further disintegration of the EU. It shakes the liberal international order, which is already under attack by nationalists, populists, protectionists, Islamic State terrorists, and a newly aggressive Russia. Brexit’s economic aftershocks are likely to be severe, especially in Britain but also potentially in the eurozone.

Britain now faces many years of political instability, financial turbulence, and economic uncertainty. The new Prime Minister Theresa May must somehow seek to implement the Leave vote won on the basis of xenophobic demagoguery, pie-in-the-sky promises, and outright lies—while contending with a slim majority in parliament, a deeply divided country, Brexiteers in her own party intent on a hard break with the EU, businesses desperate for minimal disruption, the prospect of a second referendum on Scottish independence, and a precarious peace in Northern Ireland predicated on an open border with the Republic. Meanwhile, with a current-account deficit of some 7% of GDP, the British economy is reliant on flighty foreigners to keep financing it. And in the face of massive uncertainty about future trading relationships, domestic regulations, and demand, many businesses are putting investment decisions on hold.

Paul Krugman argues that while all this uncertainty may have a negative near-term impact, the economy ought to bounce back when the fog lifts. That, however, would only be true if the Brexit negotiations delivered unexpectedly positive results. In fact, the end result is likely to be tougher immigration restrictions, worse access to EU and global markets, lower foreign investment, and a more corporatist and protectionist EU on Britain’s doorstep. It will depress investment and economic growth in the short term and it is likely to crimp productivity growth and living standards longer term.

Brexit itself is unlikely to do much harm to the global economy. Britain accounts for only a small share of the world economy: around 3.5% at market prices and 2.3% adjusted for differences in purchasing power. For financial markets, Brexit may even be positive, since it seems to have delayed the next rise in US interest rates. Unfortunately, Brexit is a dangerous negative shock for the feeble and fragile eurozone. Economies such as Ireland and the Netherlands are heavily exposed to Britain through trade. Heightened risk aversion and collapsing share prices seem to have brought Italy’s banking crisis to a head. Above all, Brexit exacerbates fears about continued EU disintegration, giving businesses yet another reason to postpone investments.

For now, the UK economy is on the brink of recession. Surveys suggest business confidence has plunged to its lowest since the 2009 post- Lehman slump. Many companies are postponing or cancelling investment and employment decisions. Foreign investors are pulling out of deals. Many open-ended commercial property funds are preventing investors from withdrawing their money. Housing prices are set to fall, denting Britons’ principal form of wealth. All of this is likely to lead consumers to curb their spending too.

Optimists hope that a weaker pound will cushion the blow; by 27 July, sterling had fallen by 9% on a trade-weighted basis since the Brexit vote on 23 June. They point out that when the pound was ejected from the European Monetary System’s exchange-rate mechanism in 1992, a strong economic recovery ensued. Yet back then the plunging pound was accompanied by large interest-rate cuts against a backdrop of strong global demand. Now the interest rates are already near zero and global demand remains weak. A more plausible scenario is that developments will mirror those in the years after sterling’s collapse in 2008–9: a weaker pound will spark inflation, cutting real wages and hence spending, while doing little to boost exports. After all, few companies are likely to invest in increasing export capacity at a time of weak demand and uncertain trade terms.

Monetary policy may provide some relief. The Bank of England looks set to trim interest rates in August. But since they are 0.5%, they cannot fall much further—and slightly negative interest rates have proved counterproductive elsewhere. With UK Treasury bond yields already at record lows, reviving quantitative easing (QE) is unlikely to provide much stimulus either.

The downturn will blow a big hole in public finances, as tax revenues dip and social spending automatically rises. While further fiscal stimulus is feasible, the Conservative government seems unlikely to embark on it, especially since the pre-Brexit budget deficit was already around 4% of GDP. At some point, a poorer Britain will need to cut public spending and raise taxes, compounding the misery.

This crippling uncertainty is likely to be prolonged. Prime Minister May does not plan to trigger the formal Article 50 process of exiting the EU until next year. Tough negotiations will then ensue about the terms of Britain’s departure. These are meant to last two years, although they can be extended by unanimous agreement of the remaining 27 EU member states. There is no direct precedent for Brexit, but when Greenland gained its autonomy from Denmark in the early 1980s and left the EU, the negotiations took three years even though the only bone of contention was fish. Extricating Britain—the EU’s secondlargest economy—from the Union will be much more complex.

Trickier still, Britain must negotiate a new trading relationship with the EU, with which it does nearly half of its trade. This could take many more years. Canada’s free-trade agreement with the EU is often held up as a model; this took five years to negotiate and two years later the resulting deal has still not been ratified. The UK-EU agreement would require the consent of all 27 remaining EU governments, each with their own economic demands and political constraints. Moreover, if the Canada deal is a precedent, this would also need to be ratified by all national parliaments as well as some regional ones.

Economically, the least-damaging option would be for Britain to join the European Economic Area (EEA), along with Norway, Iceland, and Liechtenstein. The UK would retain almost full access to the $16 trillion EU single market (with opt-outs from costly and unpopular EU agriculture and fisheries policies), while gaining the right to strike its own trade deals with non-EU countries. But since EEA membership entails leaving the EU’s customs union, it would involve the return of costly customs controls and other burdensome trade barriers such as rules-of-origin requirements.

Politically, though, the EEA option seems like a non-starter. It would entail accepting single- market rules and associated EU legislation in areas such as consumer, environmental, and social protection, without having a say in setting them. It would require continued contributions to the EU budget, without receiving any spending in return. And it would involve continued freedom of movement for both EU and UK citizens—an economic boon and a precious freedom, but a political bugbear. Since the Leave campaign centered on “taking back control,” spending EU budget contributions domestically, and curbing immigration, an EEA deal that gave the UK no say, while requiring it to pay, obey, and okay continued immigration would be deeply difficult to sell. At best, then, EEA membership might be a transitional arrangement that would fulfill the referendum mandate to leave the EU while giving Britain and the EU time to negotiate a new trade agreement.

The fallback option to such a “soft Brexit” is to trade with the EU on the basis of World Trade Organization (WTO) rules, as the United States, China, and India do. Such a “hard Brexit” would be much more disruptive. It would entail tariffs on UK goods exports to the EU—as much as 10% in the case of cars—as well as non-tariff barriers. It would offer little access to EU markets in services, in which Britain specializes. UK-based financial institutions and other services providers would lose their “passport” to export freely into the rest of the EU. While financial firms might seek continued access to EU markets on the basis that Britain had “equivalent” financial regulations, it would be up to the EU to make that (political) judgement.

Without full access to the EU single market, foreign investment—and the good jobs tied to it—would surely be lower. Two-way trade barriers also entail less competition and less pressure on companies to innovate and become more productive. While the UK would be free to restrict EU migration, this would have an economic price. Financial institutions in the City of London, tech start-ups, the National Health Service, care homes for the elderly, hotels, restaurants, farms, food-processing plants, and many other businesses rely on EU migrants, who also pay more in taxes than they take out in public services and welfare benefits. Their willingness to move around the country and do jobs that Britons spurn is a key element of the country’s much-vaunted labor-market flexibility.

While the WTO option would require less negotiation than a preferential trade deal with the EU, it would still be tricky and time- consuming. Britain needs to apply for independent WTO membership and then agree a schedule of tariffs and other commitments with other WTO members. Eventually, Britain might end up with a Canadian-style free-trade agreement with the EU, which is basically WTO-plus.

Brexiteers—including David Davis, the new secretary of state for exiting the EU—claim that Britain will be able to cherry pick what it likes about the EU and discard the rest: enjoy free trade while keeping out EU citizens. They point out that the EU exports more to Britain than viceversa and argue that German car companies and French wine producers will insist on continued free trade. But the US also runs a trade deficit with the EU and this does not give it the whip hand in the Transatlantic Trade and Investment Partnership (TTIP) negotiations. Besides, exports to the EU (13% of GDP) matter more to Britain than exports to the UK (3% of GDP) do to the EU. And for every EU firm keen to maintain full access to the UK market, there are others keen to steal a competitive advantage against UK-based firms. These include car plants in France and Belgium and financial centers in Frankfurt, Paris, Amsterdam, Dublin, Luxembourg, and elsewhere. Above all, EU governments have a political incentive to drive a hard bargain, to dent the appeal of anti-EU parties such as France’s National Front, and deter other countries from leaving.

Whatever happens, a post-Brexit Britain is set to end up with worse access to EU markets. Brexiteers argue that the UK can more than make up for any lost exports to the EU with increased sales to faster-growing economies such as the United States, China, India, and Australia. But in the near term, Britain will lose the benefits of the trade deals with fifty-plus countries that the EU has negotiated on its behalf. Since the government has hardly any trade negotiators, it will struggle to strike new deals any time soon. And while any future UK trade negotiations won’t be hamstrung by protectionist interests elsewhere in the EU, as a much smaller economy with largely open markets and a government desperate to do deals, Britain will also have much less leverage.

The UK might secure a “bad” trade deal with China, which offers Chinese companies everything they want while demanding little in return. But it will struggle to secure a “good” trade deal that offers substantially better access to those markets for UK firms, especially in services. And given the protectionist tone of the US presidential election, there is likely to be little appetite in the next Congress for new trade deals. Britain’s best hope would be a revival of free-trade negotiations at the WTO, but despite a few recent successes that seems unlikely any time soon.

Brexiteers also argue that Britain could boost growth by slashing regulation. But according to the OECD, Britain’s labor markets are already the least-regulated in the EU and its product markets the second-least regulated, so any potential gains are likely to be slim. Besides, there is no political appetite for such deregulation. On the contrary, Prime Minister May has signaled greater state intervention, notably in industrial policy, while the government is already committed to raise the minimum wage substantially by 2020.

In the short term, then, Britain is heading for a Brexit bust. Longer term, it is likely to suffer weaker growth. While Britain’s economy has many longstanding weaknesses such as poor skills, inadequate infrastructure, and dysfunctional land-use regulations, it has had three huge strengths: a flexible labor market, an open economy, and unrivalled legal and political stability. The Brexit vote jeopardizes all three. The biggest fear is about how far Brexit might exacerbate the disintegration of an economically weak, politically divided, and increasingly insecure EU. Were the EU to collapse, the economic consequences would be devastating.