The Economic Impact of Brexit on UK and EU Trade

The world of hope — the world of ever-closer union among countries which for centuries would kill each other by the million — unexpectedly came to a shattering end on June 23, 2016. The United Kingdom voted, in a referendum, to leave the European Union.

Over 33 million people, equivalent to over 70% of eligible voters, turned out for the referendum. The margin of victory was slim — 51.9% voted in favor of leaving and 48.1% voted in favor or remaining. Voter’s opinions were split geographically. Wales and rural England wanted to leave, while London, Scotland, and Northern Ireland were decisive about wanting to remain. Furthermore, exit polls suggested the leave vote was overwhelmingly carried out by the older generation and less educated voters.

How did Brexit happen? In 2015, then Prime Minister David Cameron put the referendum on the table as a strategy to unite the country under his agenda. Cameron was confident that UK citizens would vote to remain in the EU. Up until the day of the election, prediction markets and pollsters such as FiveThirtyEight placed the probability of Brexit happening at around 30%. But Cameron and others underestimated the support of rural England, and the results of the referendum shocked the world.

The political ramifications were immense. Immediately after the election, Cameron announced he would resign and be replaced by Theresa May. Not only was the position of Prime Minister replaced, but also Philip Hammond became Chancellor of the Exchequer, Boris Johnson was appointed Secretary of State for Foreign and Commonwealth Affairs, and David Davis became Secretary of State for Exiting the European Union.

The economic aftermath of the referendum was far worse. Share prices of the five largest British banks fell by an average of 21% the morning after the election. The pound sterling tumbled to the lowest level against the US dollar since 1985; in fact, the drop from $1.50 to $1.37 was the biggest move for the pound sterling in history. All of the big three credit rating agencies — Standards & Poor’s, Fitch Group, Moody’s — downgraded the UK’s credit rating.

The main reasons why people voted to leave the EU dealt with the economy. Europe had been stagnant for the past decade, causing migrant workers to emigrate to the UK for work and displace cheap British labor. The free movement of labor in the EU seemed at odds with protecting British jobs and British identity. Along with growing income inequality and xenophobia from the terrorism threat in Europe, many parts of the British population blamed the EU as the source of their problems. While evidence suggested that the Leave campaign, led by UK Independence Party leader Nigel Farage, bent the facts, ultimately the decision to leave was more emotional and thus the Leave campaign didn’t need a logical argument.

Withdrawal from the EU is governed by Article 50 of the Treaty of the European Union. UK Prime Minister Theresa May formally triggered Article 50 on March 29, 2017, beginning a two-year negotiation process with the European Council about the terms of the withdrawal. Discussions about the withdrawal negotiations often include the terms “hard Brexit” and “soft Brexit.” Hard Brexit means the UK would continue to trade with the EU under the World Trade Organization’s rules but there would be no obligation to accept the free movement of people under the European Single Market. Soft Brexit, on the other hand, means that trade would be governed by the European Economic Area such that the UK would retain membership of the European Single Market, allowing for the free movement of people, capital, goods, and services.

Many believed that a hard Brexit would be the most likely outcome for the UK leaving the EU. To strengthen her hand in a hard Brexit negotiation, Theresa May called for an early general election on June 8, 2017 in hopes of gaining a larger majority of Conservatives in parliament. However, the snap election backfired for May, resulting in a hung parliament with the Conservative Party losing their parliamentary majority.

The results of the election mean more uncertainty about Brexit when negotiations start on June 19, 2017. One study estimates that the Brexit bill would cost €100 billion to cover all outstanding UK liabilities to the EU. If the UK and EU are unable to reach an agreement, then the Brexit “cliff-edge” happens — the UK immediately loses all benefits from the EU and defaults to the harshest Brexit scenario possible. The UK could get an extension for the negotiations, but that would require all 27 EU member states to unanimously approve the extension. This is highly unlikely to happen since the EU has an incentive to make the negotiations as difficult as possible to dissuade other countries from leaving the EU.

Nonetheless, the important takeaway from the UK withdrawal negotiations is that much of the contention is primarily surrounded on economic issues. The most important economic policy area regarding the UK and EU is free trade.

Trade

The end of World War II was marked by an era of globalization. Global trade had grown faster than global output. Between 1980 and 2007, global trade tripled while economic output only doubled. Since 2007, the rate of growth in trade has declined but is still outpacing world GDP growth.

There are several causes to increased trade over the last few decades. First, the invention of containerization by Malcolm McLean caused transport costs to fall several orders of magnitude, enabling the efficient shipment of goods between ports across the world. Second, tariffs have fallen steadily due to the emergence of supranational trade partnerships such as the World Trade Organization. And third, governments have worked together to reduce non-tariff barriers to trade such as different national regulations and quotas that make it difficult for exporters to penetrate foreign markets.

The benefit of free trade rests on the economic principle of comparative advantage. Countries specialize in producing their most cost-efficient goods. Then countries trade their goods among each other such that each country can consume more than it can produce for a lower overall cost. Note that comparative advantage is not the same thing as absolute advantage. Country A could be less efficient than Country B and producing goods X and Y, but both countries would benefit if each specialized in producing one good and traded with one another.

Europe, by itself, has become a regional trading hub. Over 60% of EU member states’ trade is conducted among themselves. As an EU member, UK companies can sell their goods freely to customers anywhere else in the EU without those customers having to pay additional taxes to import those goods. British consumers and companies can also import from EU member states without tariffs. In addition, the EU has agreements allowing free trade with countries such as Norway, Switzerland, South Africa, and South Korea.

Much of the Brexit debate has revolved around the implications of Brexit on British trade. Currently, the UK has a trade surplus of £19.8 billion with the EU. 44% of all UK exports and 53% of all UK imports are with the EU. Seven of the top ten trading partners of the UK are EU member states. Out of all industries, the manufacturing and service sectors are the most reliant on trade. Moreover, official trade statistics do not take into account the “Rotterdam effect,” or UK exports sold to the EU that eventually get shipped to non-EU countries.

Impact on British Trade

Most experts believe that Brexit would hurt British trade. Because the UK’s economy is deeply integrated with the rest of the EU, the effects of higher trade barriers could be substantial. According to one study, for every 1% reduction in UK exports to the EU, there would be a 0.5% loss in the British GDP. Another report by the Institute for Fiscal Studies claimed that reduced trade activity and the resulting economic stagnation would cost the UK around £70 billion, more than the £8 billion savings in EU membership fees. New trade deals would not be expected to make up the difference. Even with a weaker pound, increased costs of production would outweigh more competitive prices of finished goods.

The UK agriculture industry would be impacted the most by Brexit because the largest portion of the EU budget is dedicated to subsidies for farmers. In recent years, 60–65% of the UK’s agricultural exports and 70% of its agricultural imports were with the EU. These numbers indicate the UK’s strong integration into the EU’s agricultural markets. With Brexit, farmers would lose subsidies from the EU, increasing the cost of food production and price level in the UK. On top of that, average real wages are lower now than they were a decade ago.

The financial and professional services industry — banks, accountants, corporate lawyers, and investments — would also be greatly impacted by Brexit. London is the largest financial center in Europe. Roughly one-third of the industry’s business involves handling transactions for clients in Europe. After Brexit, much of that business could be illegal unless banks satisfy the proclivities of regulators in the 27 EU member states. Banks are already planning to move jobs to cities elsewhere in the EU to ensure that they would be able to execute all trades. Goldman Sachs, for instance, recently confirmed that it planned to move hundreds of jobs out of London to offices in Frankfurt and Paris.

The EU has negotiated 759 treaties and international agreements with 168 countries. These agreements range from customs procedures and agricultural quotas to the landing rights of planes to even trade on sheep meat and goat meat with Iceland. The UK would also need to set up new regulatory agencies and decide on which EU regulations, on issues such as environmental, health, and safety standards, it wants to keep.

The UK could choose to renegotiate trade deals with all these countries once it leaves the EU, but this would be a very time-consuming and costly process. Past experience shows that free trade agreements take between five to ten years to negotiate and may need to be ratified by national, and even regional, parliaments. Some countries would be willing to replicate the EU’s free trade agreements but some would not. As such, it is unlikely that a comprehensive new agreement would be in place on the day the UK officially leaves the EU, leaving Britain’s exporters facing higher barriers to trade and uncertainty over future market access.

Moreover, since the UK’s GDP is less than 20% of the EU’s GDP, it would have substantially less bargaining power in trade negotiations than the EU does. This is especially true towards countries whose domestic policies favor protectionism, such as the US, China, and India. For many countries that currently do not have a free trade agreement with the EU or are in the process of negotiating one, a trade deal with the UK would not be as important as a free trade agreement with the EU, given the difference in market size.

Alternative Trade Agreements

Of course, the UK can avoid negotiating trade agreements country-by-country by simply joining a trade union. There are several options for managing its trade relationships: European Economic Area, EU Customs Union, Swiss-style, Free Trade Agreement, or simply trade under the World Trade Organization’s rules.

If the UK remains the European Economic Area under a soft Brexit, then British firms would have unimpeded access to the Single Market. The UK’s trade relations with the EU would become similar to those between the EU and Norway. There would be no tariffs on trade in this scenario. But the UK would have no power over EU trade policy and would need to follow EU regulation without having a say on the regulations. Without being a member of the EU Customs Union, the UK would also face some non-tariff trade barriers that do not apply to EU members, such as rules-of-origin requirements and anti-dumping duties. A study in 2015 found that Norway’s productivity growth has been harmed by not being fully integrated into the EU.

An alternative to the European Economic Area would be the EU Customs Union. The EU Customs Union eliminates internal tariffs, but unlike the European Economic Area, it requires member states to agree beforehand to common tariffs with countries outside the EU. The UK would have no input on these tariffs. Currently Turkey is a member of the EU Customs Union but does not benefit from free trade agreements that reduce tariffs between the EU and outside countries. In other words, Turkey is still subject to the higher tariffs agreed beforehand on exports to non-EU countries. Typically joining the EU Customs Union is a precursor to full EU membership, so this trade relationship would be unlikely for the UK.

Swiss-style trade agreements would be modeled after those between Switzerland and the EU. Switzerland has a series of bilateral trade agreements on a sector-by-sector basis with the EU. Only about 20 of those agreements are important, but not all important sectors are covered. For instance, Switzerland has free trade for goods but no comprehensive agreement for free trade of services. Moreover, Switzerland has no agreement on the trade of financial services with the EU, which is a huge industry for the UK that would be affected by Brexit. Another issue is the constant renegotiation of trade agreements as EU legislations are newly created or revised.

The UK could also negotiate a Free Trade Agreement with the EU to make tariffs on most goods zero. Unlike the EU Customs Union, the UK could determine its own trade policies with other non-EU countries. But the deeper the trade agreement is, the more EU regulations and standards the UK would have to abide by. The UK would still be subject to anti-dumping and rules-of-origin measures that would make it more difficult for British companies to fully integrate with EU supply chains. It is also unlikely for there to be a Free Trade Agreement unless the UK agrees to the free movement of people, in which the Leave campaign has been focusing on stricter immigration controls.

Lastly, the default scenario is to simply revert to the rules of the World Trade Organization (WTO). This is also the outcome of a hard Brexit. The UK would not have to comply with EU regulations but instead would be subject to the EU’s Common External Tariff and other substantial non-tariff barriers to trade. For instance, EU tariffs range from 5% for car components to 10% for cars to 15% for food imports.

In the World Trade Organization case, one study estimates that the EU’s GDP would be 0.8% lower than what it could be in 2030. The UK’s exports to the EU would be vulnerable to tariffs and other barriers to commerce such as health and safety rules. These WTO tariffs range from 4.1% for liquefied natural gas to 9.8% for cars to 12.8% for wheat products to 32% for wine. The Center for European Reform estimates that the total cost of those tariffs would be huge, ranging from 2.2% of UK’s GDP (£40 billion) to 9% (£164 billion). Moreover, Damian Chalmers, professor of EU law at the London School of Economics, argues the biggest threat to UK exports would not be from WTO tariffs but other EU member states imposing new regulations and non-tariff barriers to keep UK services out.

Regulation

Much of the EU’s power comes from being able to enact regulations that govern trade among member states. Governments regulate markets because they are not always perfectly competitive or that they generate negative externalities such as pollution or congestion. When done correctly, regulations bear the social cost of activities on those who engage in them. But when badly designed, regulations impose unnecessary and damaging costs on companies and ultimately consumers.

After Brexit, a major outstanding issue is which EU regulations the UK would choose to keep. Between 2000 and 2013, the EU enacted 52,000 pieces of legislation. At the same time, Norway, a member of the European Economic Area but not the EU, adopted just 9% of those legislations, which were only the most significant EU laws. Although trade with the EU is still subject to EU regulations, the UK would have greater flexibility with regulations on domestic goods and services and non-EU trade after Brexit.

Eurosceptics believe that the EU is a bureaucratic red-tape whose draconian regulations hinder the UK’s economic growth. The impact of the 100 most costly EU regulations for UK business has been estimated at £33 billion annually. With Brexit, there may be some gains from less onerous regulations in sectors such as technology which would increase productivity. But any of those benefits that arise would be offset by increased costs of British exports and the reduction of foreign direct investment. Ironically enough, the UK also has one of the most stringent regulations for financial services, environment, and labor of all EU countries, so the benefits of getting rid of EU regulations could merely be overstated.

Impact on EU Trade

Unlike the UK, the trade impact from Brexit on the EU economy is likely to be negative but small. The UK is a large trading partner for the EU, with total trade amounting to about 5% of the EU’s GDP. EU exporters would lose free access to the UK market if the UK decides on a hard Brexit to leave the European Single Market. Additionally, the negative impact of Brexit on the UK economy would reduce UK demand for EU goods and services.

The four EU member states most affected by Brexit are Ireland, Netherlands, Belgium, and Germany. These countries export significantly more to the UK than they import from the UK, and Brexit would significantly increase the cost of trade between the UK and these countries. For Ireland, the re-introduction of the customs border would impose new costs and lost time to cross-border transactions. The Netherlands is the UK’s second largest trading partner in terms of both volume and proportion of imports and exports. The UK is the most popular destination for Dutch investors, and the Netherlands is the second most popular destination for British investors. For Belgium, a large portion of its imports and exports are dependent on the UK. And lastly, Germany is the largest trading nation in the EU in terms of volume; Brexit would remove much of the benefits of the European Single Market for the Germany economy, especially for the automotive industry. However, due to the size of its economy, Germany could compensate for this decline in trade by exporting to other countries.

EU sectors that would experience the biggest impact from Brexit are motor vehicles and parts, electronics equipment, and processed foods. Motor vehicles, in particular, are the most traded commodities between the EU and the UK. The UK is a large auto manufacturer and relies on the EU’s supply chain of raw materials. Brexit would hurt EU exports of raw materials such as steel from the German Ruhr valley.

Conclusion

The European Union is at its weakest moment in history. Before Brexit, it was widely believed the process of European integration — both deepening and widening — could not be reversed. Brexit sent a wake-up call to the world that, in fact, the opposite is true. Populism is a more powerful political and economic force than what most people would have imagined. Middle-class workers remain frustrated by the slow pace of recovery since the financial crisis. That said, it is imperative that we look beyond the emotional appeal of populism and consider the empirical facts behind economic policies.

Meanwhile, British citizens remain deeply divided over its membership in the EU. Many Eurosceptics believe Brexit would liberate the UK from the bureaucratic inefficiencies of the EU and reinvigorate the British economy. The data, however, overwhelming shows that the UK benefits far more from free trade within the European Single Market than other alternative trade agreements. In addition, the terms of the Brexit withdrawal agreement itself would also likely have a huge negative effect on the British economy.

Jean Monnet, one of the founder fathers of the European Union, once said before his death that “there is no future for the people of Europe other than in union.” Yet 38 years later, there remains great uncertainty about the future of the EU. As Brexit negotiations begin next week, only time will tell before we know the true economic impact of a soft or hard Brexit on UK and EU trade.