The Economic Effects of a Brexit on the UK

The results of a plethora of studies on the likely economic impact of a Brexit on the UK are rather confusing. In this article, IW economists Jürgen Matthes and Berthold Busch challenge the mainstream view and argue that the risks of a Brexit are likely to be underestimated.

The results of the UK referendum in favour of a Brexit have left the British public in dire need of reliable insights about the economic impact of this historical cesura. The Brexiteers allege that a Brexit will benefit the UK while Remain campaigners have warned about considerable economic damage. In fact, the economic studies that lay on the table reflect this wide range of outcomes. We cut through the fog of assertions and seek to get to the reality of the situation facing the UK after a Brexit. To this end, we provide an overview and basic evaluation of important existing studies that attempt to quantify the long-term economic effects of a Brexit for the UK.

As a starting point, the major pros and cons of a Brexit have to be laid out in qualitative terms. The main advantages consist of lower (or zero) net contributions to the EU budget, lower tariffs vis-à-vis third countries, and of lower bureaucratic burdens which result from the obligatory takeover of EU regulations. The main disadvantages of a Brexit result from the loss of economic integration with the EU which will result in new trade barriers for UK firms. This is highly relevant, because the EU is the UK’s dominant trade partner. Particularly, the potential loss of access to the Internal Market in services will be relevant as the UK has specialised in financial and business services.

The degree to which these effects become relevant obviously depend on the new institutional relationship with the EU to be negotiated by the UK. In this respect, a distinct trade-off is relevant. The more the UK strives to regain regulatory sovereignty (which was the driving force of the Leave campaign), the more severe will be the loss of economic integration with the EU. Access to the Single Market can only be upheld, if UK regulations do not significantly deviate from EU regulations. The post-Brexit trade relationship will also depend on the relative negotiating power of UK. In this regard, the UK is in a defensive position as the country is much more reliant on access to the EU market than vice versa. Moreover, the EU will prevent the UK from cherry-picking in order to prevent a positive precedent which would encourage other EU countries to follow suit. These considerations suggest that a significant loss of economic integration with the EU cannot be precluded.

Mainstream results from forward looking studies and caveats

The main category of existing studies are based on economic models and are thus theoretical and forward looking. Several results stand out:

• Forward looking studies that include both costs and benefits of a Brexit tend to find that the disadvantages from lower economic integration outweigh the economic advantages.
• Most of the more reliable studies estimate the net economic costs to remain moderate in the lower single digit range (between 1 to mostly below 5 percent of economic output or income in the longer term).

This suggests that the economic effects of a Brexit seem manageable.

However, we raise serious doubts about this mainstream conclusion. In fact, important shortcomings of the forward looking methods employed to estimate the economic effects of a Brexit could conceal significantly higher risks. The pertinent forward looking studies are unable to cover all relevant channels by which economic integration raises welfare. Figures 1 and 2 provide an overview of the effects which are hardly covered: static and dynamic trade effects on welfare and growth as well as additional positive non-trade effects of economic integration. Wide-ranging and substantial theoretic deliberations exist about these additional welfare effects. Moreover, most of these specific welfare and growth effects are robustly supported by sound empirical research, as our study thoroughly highlights. However, the available empirical evidence is more general and less focussed on European integration or the case of a Brexit.

Results from backward looking studies

Currently, there is no universally accepted forward looking method of estimation available to integrate all of these specific effects in a comprehensive way. However, going beyond the pertinent forward looking studies implies entering less solid ground in economic terms. Several backward looking studies, which use existing data, are presented that attempt to quantify these additional welfare effects of EU integration or a Brexit in a more comprehensive but only implicit way. All of these attempts can be criticised to some extent, but the overall evidence suggests that a Brexit could cause a significantly worse economic impact in a more pessimistic scenario than the mainstream conclusions indicate.

Sound evidence exists that theoretical forward looking trade models tend to underestimate the trade effects of economic integration. In fact, ex post studies tend to find significantly larger trade effects of trade agreements than ex ante models, such as CGE models.1 Recent methodological developments tend to increase this divergence. A new strand of the literature argues that traditional gravity models – the workhorse for ex post analysis of trade agreements – also tend to underestimate trade outcomes.2 Based on a more modern gravity approach,3 Baier et al. estimate that membership of the EU (and of its institutional predecessors) has raised trade between members by 100 to 125% over a 15-year period alone.

Based on these general insights, we survey several studies that attempt to quantify additional welfare, income and growth effects of economic integration in a more encompassing way.

Using recent forecasts for the negative effects of a Brexit on bilateral trade between the UK and the EU, the induced income decline can be quantified in a tentative way. Based on a general trade-income-relationship calculated by recent thorough studies, two Brexit papers estimate that UK incomes could possibly decline by around 10% or more in a more pessimistic scenario regarding the future institutional relationship between the UK and the EU.4 An important shortcoming of these attempts lies in the fact that the trade-income relationship could not be tailored specifically to the UK.

Several thorough studies employ regression analyses of ex post data to implicitly but comprehensively capture the variety of economic integration effects depicted above (Henrekson et al., 1997; Badinger, 2005; Crespo Cuaresma et al., 2008).5 A regression uses a statistical method that identifies how closely a target variable (in this case GDP) is aligned with the explanatory variables, such as education, investment, or EU membership. Even though the results differ in their details, these studies identify sizeable effects of EU membership on the level of GDP in the long term – mostly in the range of 20 percent or more. Depending on the future integration scenario between the UK and the EU, not all but possibly a considerable share of these benefits would vanish. However, some uncertainties remain, as the results are in part not completely robust and as growth regressions are notoriously difficult to make watertight.

Campos et al.6 (2014, 2015) apply a relatively new Synthetic Counterfactual Method (SCM) which was developed by Abadie and Gardeazabal.7 Mimicking the approach of clinical studies, the authors construct an artificial synthetic control group by selecting countries with similar economic performance to the UK during a longer time before EU accession in 1973 (pre-treatment period). The effect of EU membership (treatment) can be deduced from the difference between the economic outcome for the UK and that for the control group. Campos et al.8 estimate that in the long run (between EU accession of the UK up to 2008), real GDP per capita in the UK is nearly 24% higher than in the synthetic control group. However, this result is not very robust. Focussing on the findings of various robustness checks on productivity increases over a ten-year horizon, the respective results lie in the higher single digit range (up to 10%). This is still a substantial result, particularly when taking into consideration that benefits might increase further over time.

Conclusion

Our approach and main conclusions on the potential long-term effects of a Brexit suggest that a Brexit would resemble a potentially dangerous leap in the dark in terms of economic consequences.

The large uncertainty about possibly substantial negative impacts of a Brexit can in itself be damaging to the UK in the short term, as far as the general business and investment climate is concerned. Furthermore, the perceived negative economic impact of a Brexit could be priced in by financial markets, causing a certain degree of financial turmoil during an adjustment period after the official announcement of a Brexit. The uncertainty could also be more protracted. In fact, rating agencies point to the risk of rating downgrades. Moreover, the negotiation of new agreements with the EU and particularly with third countries could take years and leave the UK business in a fragile institutional environment. Overall, the economic impact of this short-term uncertainty could be significant as a recent study of PwC9 shows.

See the article on europeanfinancialreview.com