Why a Hard Brexit Is Likely

Before we get into the politics, let us deal with the economics, for it will be central to the form of Brexit the UK pursues. The way in which currency markets have been processing UK politicians’ statements about Brexit has been surprising.

Sterling fell around 10 percent immediately after the vote to leave the EU. This was not particularly large by historical standards: sterling fell by more than a quarter against the dollar after the UK left the exchange rate mechanism in 1992 and during the financial crisis in later 2008. Any reputable economic analyst will tell you that higher trade barriers with the UK’s largest trade partner will lead to significant productivity losses in the long run – and the muted exchange rate reaction was not in keeping with the vote.

It appears that, in the vote’s immediate aftermath, currency markets were not convinced that the UK would leave the single market as well as the EU. In her first two months of office, the new Prime Minister Theresa May slapped down her three leading Brexiter ministers, David Davis, Liam Fox, and Boris Johnson, whenever they made statements saying we were going to leave single market (although careful observers would have noted that Number 10 was also making promises that were incompatible with single market membership). Two weeks before Theresa May’s conference speech, David Davis said that “if a requirement of membership [of the single market] is giving up control of our borders, I think that makes it very improbable” that the UK would remain in it. Theresa May’s spokeswoman told reporters that Davis was merely “setting out his opinion.” But May herself has said that the British people “do not want free movement to continue as it has in the past,” and Number 10 said that a new immigration system should “ensure that the right to decide who comes to the country resides with the government.” Still, Theresa May and the Finance Minister Philip Hammond were careful to say that nothing had been ruled out.

The creative ambiguity ended on October 2nd with Theresa May’s speech to the Conservative party’s annual conference, in which she said that the UK would not accept the jurisdiction of the ECJ and that free movement would end. This finally convinced the markets that Britain will leave the single market, and the unified and clearly coordinated response of France and Germany to her speech confirmed it. Merkel said again that the four freedoms come as a package. Hollande said that the EU must be “stubborn” in defending the single market.

The result has been a further slide. The pound is now 16 percent down on its pre-referendum level against the dollar. This means that assets held in the UK would be worth less and the currency should move further, as investors withdraw capital and put it in higher-yielding assets in other countries.

However, we should not simply assume that the sharp fall in the value of sterling will lead to a recession – and prove that “Project Fear,” as the Remain campaign’s economic arguments were dubbed, was Project Fact. The way the economy looks likely to adjust to the Leave camp’s victory will probably be more subtle, and will make life difficult for those who hope for a close economic relationship between the EU and the UK.

Initial post-referendum data pointed towards a recession, as consumer and business confidence plummeted in July. But the August and September purchasing managers’ indices—surveys of companies’ output, sales, orders, and employment levels, which offer speedy (but incomplete) evidence of economic activity—bounced back. The Bank of England further lowered interest rates and restarted quantitative easing. Hammond plans to boost infrastructure spending in order to deliver a “short-term demand stimulus” in his budget statement in November. The fall in the value of sterling will make British exports more price competitive, which will partly offset higher prices for consumers as food, fuel, and clothing prices rise. So the near-term reaction to the vote will probably be an economic slowdown while Brexit is negotiated, largely caused by declining investment, with macroeconomic policy and the exchange rate providing some stimulus to help the economy cope with the divorce.

That is not to say that Brexit will not be costly in the long run. But the pain will be more chronic than acute, in the form of a slower rate of growth both before and after barriers to trade, investment, and migration have risen after the UK leaves the EU. With luck, barriers could rise gradually, if the UK and EU can agree on a way for a trade agreement to come into force on the date of Brexit, scheduled for April 2019, or if transitional arrangements can be put in place before a trade agreement is signed. But, if there is no recession, it means that Remainers’ arguments on the economics will be more easily dismissed by the government and the pro-Brexit media. And Brexiters will deploy other arguments to explain the slower rate of growth—an ageing population and a generalized slowdown in the rate of productivity growth across the OECD—or they will say that the British economy is growing faster than country X or country Y, so what is all the fuss about?

Many Remainers argue that the electorate did not vote for a particular form of Brexit. The Remain camp is starting to get organized, with Philip Hammond fighting to maintain a close economic relationship with the EU from within government, and with Labour and pro-EU Tories teaming up to fight for a vote in Parliament on the government’s Brexit strategy.

But even if such a vote were held, it is unlikely that the Remain faction would win. This is because voters did reject two fundamental principles of the single market. First, they voted to end the free movement of low-skilled labor. Second, persuaded by Vote Leave’s “take back control” message, they voted to end the supremacy of EU over British law, and the jurisdiction of the European Court of Justice. Labour is torn between its middle-class Remainer and working-class Leaver voters, and many of its Members of Parliament feel that they cannot campaign for free movement to continue. Labour will instead seek domestic political advantage by claiming the government has failed to allow Britain to end free movement of workers and stay in the EU’s markets for goods, services, and capital. As for the Tories, according to Chris Hanretty, a political scientist at the University of East Anglia, 70 percent of Conservative MPs represent constituencies that voted for Brexit. Even those that feel uncomfortable being on the opposite side of the business community will have qualms about defying the electorate’s wishes. A trade agreement between the EU and the UK, not single market membership, is the only plausible political outcome.

This will be costly. Oxford Economics, a consultancy, reckons replacing single market membership with a trade agreement would cost the UK between 0.75 and 3 percent of GDP, depending on how comprehensive the trade deal is and how open Britain remains to immigration. These are big numbers in economic policy terms – the only supply-side policy that might achieve an equivalent boost to national income would be radical planning reform. Still, Brexit is not an event but a process of disintegration. As long as there is no sudden crisis, Brexit voters will believe that its absence justifies their decision.

Such an outcome would be especially costly for the City of London. The UK has a comparative advantage in high-value added services, which rely on the single market principles of non-discrimination and freedom of establishment, enshrined in EU law and enforced by ECJ judgments, to sell across the EU. For their part, Poland and the other newer member-states have a comparative advantage as a site for manufacturing, largely “offshored” from Germany, and in low-value added services. Free movement is the only way that most of such services—in construction, retail, and so forth—can be traded, as construction workers and baristas cannot provide their services remotely. Poland will be unwilling to allow UK services companies to take market share while its citizens are denied equivalent opportunities in Britain. Neither will France and Germany, who must show that Brexit is costly in order to discipline continental Euroskeptics. Merkel shows little sign so far of succumbing to the interests of Germany’s manufacturers, who do not want higher trade barriers – but who have not been particularly vocal in defense of the UK so far.

Given the vote, UK trade with the EU will probably be governed by a bilateral trade agreement, but there are good reasons to be pessimistic that it will be nearly as comprehensive as the single market. The EU’s institutions provide a political process for updating regulations as markets evolve or market failures are identified, and these regulations minimize the barriers to trade between the member-states. Bilateral trade agreements, on the other hand, are more static, as they mostly deal with traditional barriers to trade, such as tariffs and quotas, and less with regulations or other “behind-the-border” discriminatory measures. New institutions could be created within a trade agreement to allow regulatory co-operation to continue: colleges of regulators in different economic sectors could agree that UK regulations were equivalent to those of the EU. This is what happens—to a much more limited degree than in the EU—in the NAFTA agreement and in the Canada-EU trade agreement, if it is ratified. And the regulatory preferences of the UK and the EU-27 are not as different as many Brexiters argue.

But it would be far from straightforward. Any “living” free trade agreement would require political institutions designed to negotiate compromises between the EU and the UK to ensure that regulations were equivalent, and the EU would insist that it had the final say. For the EU to give UK firms access to the single market on the basis of equivalence would be a much bigger concession than the UK giving similar access to EU firms to the much smaller UK market. The UK would therefore have to offer something in addition: the EU determining whether the UK’s rules were equivalent, as well as a financial contribution to the EU or free movement of people. Disagreements about financial regulation, transactions taxes, bankers’ pay and incentives, and the City’s role as a bridgehead for non-European banks to access EU markets would become more fraught. And there are differences in opinion on chemicals, GMOs, data sharing, and more.

A new free trade agreement with UK-EU institutions to enforce regulatory equivalence looks remarkably like the Swiss deal with the EU, in which joint committees ensure that Swiss legislation accords with EU law. The Swiss deal only provides goods access, with services largely excluded. And for that the Swiss have been forced to accept the free movement of people.

The EU is unlikely to offer Britain better access to its services markets—and equivalent goods access—than Switzerland without free movement or budget contributions. And without acute economic pain that is clearly attributable to Brexit, Britain’s politicians will find it impossible to defy the electorate’s demand to “take back control,” whatever the chronic damage to the economy.