Brexit: the economic impact

Much is at stake for the UK economy in case of a Brexit, because new trade barriers would become relevant depending on the institutional trading arrangement after a Brexit. The UK could partially lose access to the EU internal market which would affect particularly the freedom to provide services and the right for establishment in the EU. These considerations are highly relevant as the EU is still the UK’s dominant trade partner and also because the UK has a particular strength as an exporter of financial and business services. Leaving the EU would also imply that the UK would no longer be able to benefit from future EU trade agreements and further progress in the Single Market. Moreover, higher EU trade barriers, transaction costs and customs delays could induce UK companies to relocate production to the EU – and EU companies could cut UK firms out of their international value chains. Furthermore, the loss of free access to the EU market could lead to relocations by multinational companies to the detriment of the UK which currently benefits from its function as a bridgehead to the continent. Finally, the dominant position of the City of London in euro denominated financial transactions could be endangered.

Possible strategic misconceptions

Regarding the negotiation of the institutional relationship with the EU and of many trade agreements with third countries, there is a risk of certain misconceptions:

• While the negotiation position of the UK might seem strong due to its merchandise trade deficit with the EU and due to the expectation that the EU would want to keep good political relations, this optimism might be misleading: The UK would be in a defensive demandeur position, it would rely much more on market access to the EU than vice versa. And the EU might be inclined to avoid a precedent that encourages other EU members to follow the UK in leaving the EU.
• There will be no free lunch for the UK in choosing from different options of future institutional integration with the EU. The more the politically motivated strive for sovereignty prevails regarding regulatory issues, the higher will be the price for the UK in terms of lost market access to the EU.
• Some argue that the UK can liberalise its trade policy vis à vis third countries to the benefit of UK consumers and can at the same time secure attractive market access conditions in these countries for the UK firms. However, this might appear over-optimistic, because the UK can offer only a significantly smaller market than the EU and it would be in a defensive demandeur position. Moreover there will be a dilemma for the UK: In order to reap the welfare benefits of free trade, the UK would have to unilaterally reduce its trade barriers rather sooner than later. Yet, if it does so, it loses important bargaining chips that are required to obtain significant market access in the give and take of bilateral trade negotiations.

Economic cost-benefit analysis

This paper provides an overview of the main existing studies that attempt to quantify the economic effects of a Brexit for the UK (see Annex). The range of estimates on the potential economic consequences of a Brexit is amazingly wide – from +12 percent of GDP to potentially around –20 percent. This can be explained by significantly different methods, different assumptions, and different aspects included. Apart from considering the above-mentioned risks from reduced economic integration, it is also important to include the economic advantages of a Brexit. They can consist for example of a lower (or zero) net contributions to the EU budget, lower tariffs vis à vis third countries, and of a lower regulatory burden. It is striking that no study covers all relevant aspects in sufficient detail. Obviously, only studies that include positive and negative effects of a Brexit (or of the EU membership) provide a sufficiently sound basis for tentative summarising conclusions. Studies that do so, tend to find that the disadvantages from a Brexit are likely to outweigh the economic advantages. However, several other surveys of the available studies point to only moderate net costs of a Brexit in the lower single digit area in relation to GDP.

We challenge this mainstream conclusion and see a significant probability that the potential economic damage of a Brexit could be considerably larger. We base our arguments on the fact that the conventional methods applied in the mainstream studies fail to cover all relevant channels by which economic integration raises welfare. We extensively document various additional static and dynamic trade channels as well as several non-trade channels of economic integration. Based on this brief survey, we refer to sound empirical academic research that clearly proves the relevance of these channels for welfare and growth. Unfortunately, this evidence only concerns the individual channels and there is currently no agreed estimation method available to integrate all these specific effects in an encompassing manner.

However, several studies that enter this less solid ground are presented. All of these attempts can be criticised to some extent, but the overall evidence strongly suggest that a Brexit could have significantly worse economic impacts than the mainstream conclusions indicate. Accordingly, it cannot be precluded that the economic damage of a Brexit could be around 10 percent of GDP or even higher in the long run. This would be particularly true in case the political strive in the UK for regaining sovereignty prevails and, as a result, the future institutional relationship between the UK and the EU would lead to a significant loss of economic integration.

On top of this, a large uncertainty in case of a Brexit (and possible rating downgrades) could damage the general investment climate in the UK. This uncertainty concerns not only the possibly substantial negative economic impacts but also the uncertain future institutional arrangements with important trading partners. Overall, a Brexit would indeed resemble a potentially dangerous leap in the dark.