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Brexit: What Next?

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Brexit: What Next?

Professor Nick Crafts talks to the Financial Correspondent of the German newspaper 'Neue Zürcher Zeitung' about the implications of UK's EU referendum.
2 July 2016

 'Referendum on United Kingdom Membership of the European Union is Irrelevant to Reforms' An interview with Nicholas Crafts by Gerald Hosp.

Professor Crafts, the pound has fallen sharply, the government in London is not functioning, the opposition is in crisis. It is unclear what the United Kingdom wants by the EU. Are you surprised by the chaos?

It is to be expected. Whatever one thinks about the medium- and long-term implications of Brexit, in the short term there will be a significant downside. There are many different versions of Brexit so there is bound to be uncertainty initially and this will be reflected in lower investment and probably a recession.

With a lower external value of the pound exports are expected to rise?

Yes, provided the competitiveness gain is not offset by wage adjustments. The current account balance could be improved and this would be welcome. However, the devaluation reduces real incomes of British citizens through higher import prices.

However, the long-term effects could be less pessimistic. Would you rather compare the proposed referendum decision on United Kingdom membership of the European Union with the Glorious Revolution in the 17th century or the Suez Crisis in the 1950s?

I'm afraid this is no Glorious Revolution. Whether it's a Suez crisis depends to a great extent on the nature of Brexit and how well politicians cope with it. In all likelihood, we can expect a medium-term decline in economic activity of at least 2.5% to 3%. The key point is that exit increases the cost of international trade and leads to lower trade volumes. The key question is how big this impact will be and that depends on the detail of future trading arrangements. A lower trade volume leads to less investment and lower productivity but probably does not reduce the long-run trend rate of growth.

Most economists predict Brexit will harm the economy. Why does the majority of the population not heed the economists?

First, economists talked about macroeconomic rather than regional implications and benefits of EU membership have been unequally distributed across the country. Increased trade with the EU may well have accelerated the decline of the manufacturing sector, which is mainly located in the North of England which voted strongly for Brexit. Increased market access to the EU has encouraged a drift of economic activity towards the south which has benefited more. Second, there is the problem of immigration. Most economists say that migration from the EU has been beneficial both for public finances and economic growth overall but with some adverse effects on the wages of low-skilled workers. In a context of post-crisis wage stagnation, migrants are convenient scapegoats. Thirdly, the cost of contributions to the EU budget is easy to understand and is a ’fact’, the (much greater) benefits of more trade have to be inferred through economic analysis and can be dismissed as the fantasy of deluded experts.

The UK describes itself as a proud trading nation. Was the Brexit vote more a rejection of globalization or an opening towards new markets outside Europe?

The proponents of Leave were deeply split on these issues. The voters who supported them were more in the former camp. Some economists proposed that Brexit should not entail limits on immigration and should lead to freer trade with other countries but many supporters of leaving are basically protectionists and workers who think they have lost out from globalization, although a more important reason is technological change which will not be prevented by Brexit. In fact, Brexit threatens some of the remaining manufacturing employment through higher trade costs and lower foreign direct investment. Most obviously this applies to the car industry.

Will Brexit promote closer trade relations with Commonwealth countries?

The UK could complete trade agreements with countries with which the EU has not yet done so. British rather than EU interests would be paramount in such negotiations. At the same time, the UK has less bargaining power than the EU and this may make the terms less favourable. In addition, negotiations in services are notoriously difficult and this is very important for the United Kingdom.

In the 1960s and 1970s, the United Kingdom was the ‘sick man of Europe’. Was this problem cured by joining the EEC?

We had a serious problem at that time. This is indisputable. Accession was helpful in addressing some of the difficulties that we faced especially insofar as it increased competitive pressure on British producers and improved productivity. Greater competition reduced inefficiency and undermined trade union power.

You emphasize in your work, that accession to the EEC promoted competition. But were the reforms of Prime Minister Margaret Thatcher more important?

This is a false antithesis; EEC accession was part of the Thatcher reforms. The Thatcher government was originally a strong supporter of the single market. Thatcher later turned against the idea of the EU because of deeper political integration. It is important, however, to recognize that the problems of the 1970s have largely been resolved and Brexit would not turn the clock back to the 1960s

Will Brexit not give added impetus to further reform of the UK economy?

In an optimistic scenario, Brexit is seen by some as a stimulus for supply-side reforms leading to higher productivity. However, the obstacles to adopting these policies lie in Westminster not Brussels so Brexit is basically irrelevant. I doubt that the new leadership of the Conservative Party will change this situation much. For example better policies with regard to education, innovation, infrastructure and the structure of taxation would be welcome but these are under UK control in any case as is control of the most damaging form of regulation, namely, land-use planning. In the worst scenario, the UK might become significantly more protectionist, for example, through subsidizing declining industries once free of EU state-aids controls.

Even inside the EU, the labour market is only lightly regulated?

That's true. We have a comparatively low unemployment without inflationary pressure. The biggest problem in the labor market is currently low regional mobility, which in turn can be attributed to the problems of spatial planning and the housing market.

Should the UK give up its austerity plan for the time being?

This might well be appropriate given the threat of a Brexit recession. Because monetary policy has its limits, there probably will be a looser fiscal policy. There is some scope for this because the ratio of public debt to gross domestic product is not dangerously high. In the medium term it could mean, however, that harsher austerity measures are required to restore fiscal sustainability.

Will monetary policy also be more expansionary than was previously expected?

Yes. The Bank of England will find several reasons in the short term not to raise interest rates or even reduce them, even though inflation will increase due to higher import prices. I also think that we may even go through a period of financial repression when interest-rate policies are subordinated to the government’s fiscal needs as happened in the early post-war period.

What relationship will there be with the EU?

I don’t know. It depends partly on who will be the Prime Minister. It is possible but most unlikely that Brexit does not happen. I think an absolute minimum that is required from the political side, is control over immigration. This will mean that the UK does not have full access to the internal market, which will increase trade costs appreciably.

What will happen to the Euro Zone?

I tend to think that there will be eventual stabilization of the euro zone and this will entail deepened political integration. I am not sure anymore. In the 1930s the gold standard collapsed. In 2011, a Martian might have assumed that the euro zone would follow suit given that similar pressures had built. However, a collapse of the euro zone has been avoided and this underlines that many European politicians are determined to do whatever it takes to preserve the euro.

This is an English transadaption of an interview which was published in 'Neue Zürcher Zeitung' on 2.7.2016. The original article may be seen here