The permanent damage of Brexit

The negotiations between the UK government and the European Union have finally begun this summer. The UK will probably leave the EU at the end of the first quarter of 2019, although it is also probable that a transition period will be part of the agreement between the UK and the EU. Despite the fact that it will take more than a year before Brexit actually takes place, the British economy is already starting to feel the impact. GDP growth in the first two quarters of 2017 was a meagre 0.2% (q-o-q) and 0.3%, respectively (Figure 1).

Household purchasing power is affected negatively, as the strong depreciation of the British pound is pushing consumer prices up, while nominal wages grow at a slower pace. Since the referendum in June 2016 the pound has fallen by more than 15% vis-à-vis the euro, although there has been some recovery due to the suggestion of an upcoming rate hike by the Bank of England in September. In addition to a loss of purchasing power, corporate profits have deteriorated, as the purchase of intermediate inputs from abroad has become more expensive. Combined with the large uncertainty surrounding the negotiations on the Brexit deal, this has a pervasive effect on UK business investments. Underlining the worries of many corporates active in the UK, on 6 September more than 100 firms signed a letter and sent it to the Brexit negotiators to speed up the progress. In their opinion, the risk of ‘no deal’ remains real, and so businesses have to prepare for the worst, with inevitable consequences for jobs and growth.

The big question, of course, is what the permanent negative effects on the British economy will be once Brexit has actually materialised. There are several channels through which Brexit can hit the British and European economies.[1]

Trade and foreign investment

A first important channel is trade, as the EU is the UK’s most important trading partner (Figure 2). The introduction of tariffs on goods and non-tariff barriers on goods and services, such as customs controls, raises trade costs on UK exports for the EU and vice versa. Higher import inflation due to these increased trade costs also results in a lower real disposable income of households, which will squeeze their purchasing power. In addition, the UK purchases about half of its imported intermediate products from the EU.[2] Imports of intermediates would become more expensive due to trade barriers, which means that British companies would face a deterioration of competitiveness, higher export prices and a lower global market share.

An exit from the EU also means that the UK is at risk of losing its position as a gateway to Europe, which will come at the expense of foreign direct investment. Currently, many firms are already putting investment plans on hold, while others will even decide to cease business activities in the UK. A recent survey of 1,200 major European companies, of which 80% are active in the UK, shows that half of these companies are planning to invest less in the UK after Brexit. In addition, 28% indicate that they plan to move a large part of their capacity and 15% say that they intend to stop all activity in the UK.

Moreover, the UK runs the risk of losing its ‘financial services passport’ for UK financial institutions. These passport rights ensure that European and non-European financial institutions located in the UK can serve the entire European Single Market from one location. If the UK loses these rights, London will most likely have to give up its current position as the financial centre of Europe, which would not only have implications for foreign direct investment but would also have negative implications for all kinds of economic activity related to financial intermediation, such as legal advice and accountancy. It is still questionable whether the UK will retain these passport rights after Brexit. Even Switzerland, which is integrated in the EU internal market to a large extent, does not have these financial service passport rights.

Although the strong depreciation of the pound gives some relief to British exporters, only 40% of exchange rate fluctuations usually feed into export prices.[3] Thus, the deteriorating effect of imported cost-push inflation on relative export prices outweighs the effects of the depreciation of the pound.

[1] See Irwin (2015) for an overview.

[2] García-Herrero and Xu (2016)

[3] (IMF, 2015).

Productivity

Lower foreign direct investment will have negative implications for growth of the capital stock, which will hold back productivity growth directly. However, labour productivity developments in the UK can be affected by Brexit via other channels as well. Lower foreign direct investment in Research & Development could have negative implications for domestic innovative capacity. Moreover, it is well known that international knowledge developed abroad has a larger impact on domestic productivity if a country is more open to either foreign trade[4] or foreign direct investments[5]. The uncertainty surrounding the post-Brexit world has a major impact on the scientific community, which depends on long-term funding, cross-border mobility and international collaboration. Stricter migration policies and a deterioration of the UK business climate could result in an exodus of high-skilled immigrants as well, or at least a lower net inflow of migrants. Results from a survey conducted by among 2000 EU immigrants working in the UK show that 8% of the respondents are planning to leave and 35% are considering leaving. Especially younger, higher-paid and better qualified people are considering an exit from the UK, which increases the risk of a brain drain. Furthermore, openness to foreign trade fosters market competition, which stimulates firms to reduce their X-inefficiencies and increase efforts to innovate.[6]

Mitigating factors

The British government does have policy options that may mitigate the negative effects of Brexit on the British investment climate. A reduction of corporate taxes could generate positive effects on private investment and could prevent companies from relocating their activities. The downside is that this reduction has to be compensated for somehow by raising taxes on other fronts, such as income tax. Without compensation, public debt ratios would rise even further than the worrisome levels seen since the Great Recession of 2008. Second, deregulation could benefit firms. Then again, the OECD (2016) states that regulation of both network industries and the labour market has already been the least restrictive among OECD countries, which limits the scope for improvement.

Another benefit for the UK is a reduced contribution to the EU budget. The UK contributes roughly 8bn pounds on an annual basis and this is the largest net payment to the EU budget after Germany. In the case of a hard Brexit, the government will have GBP 8bn net budgetary savings. However, if the UK wants to keep access to the EU internal market, it will most likely have to keep contributing to the EU budget as well. Norway, for instance, is a member of the European Economic Area but still contributes marginally less than the UK (83% of the UK contribution). Moreover, the UK also has to pay a financial settlement, the ‘Brexit bill’, which could be as large as 60bn euro.

Another potential benefit for the UK from exiting the EU is that it can make separate trade agreements with countries outside the EU, such as the US and China. It is, however, quite uncertain whether the UK will be able to adopt the FTAs that the EU currently has with third parties or whether the country will have to build a completely new trade framework. In the latter case, the UK will have to enter into lengthy and tough negotiations. This also implies that before the instalment of new FTAs, trade costs with these ‘third countries’ will rise. UK trade with third countries that have a FTA with the EU represents 14% of UK exports.[7] Besides, it is questionable whether the UK will be able to get a better trading deal with the US and China than an entire trading block like the EU. The US has recently imposed a tariff of 219% on British aircraft maker Bombardier. In addition, the US and, amongst others, Brazil and New Zealand have filed a formal complaint at the WTO against a deal between the UK and EU to divide the agricultural quotas post-Brexit. When the WTO would validate this objection the UK will be forced to open up the market for many agricultural products to foreign competition. These two examples show that the US will not hesitate to tighten trade screws in order to protect national interests, even at the expense of close allies. More importantly, it illustrates that the UK will come off worst in a dispute with bigger trading partners, as it misses the critical mass to retaliate.

Three exit scenarios plus ‘Bremain’

Broadly speaking, there are three scenarios conceivable for the future trade relationship between the EU and the UK, when outside the EU.

1. ‘Soft’ Brexit: The UK remains fully part of the European Single Market and trade costs will only result from non-tariff barriers, since the UK does leave the Customs Union.
2. Bilateral Free Trade Agreement (FTA): the tariffs on products are expected to remain zero, but the increase in non-tariff barriers will be larger than in the soft scenario. Services will no longer be able to move freely.
3. ‘Hard’ Brexit: negotiations between the EU and the UK break down in this scenario and the UK leaves the EU without any trade agreement. The WTO agreements will form the basis of the hard Brexit scenario. It is assumed that the UK will be able to copy the EU’s WTO schemes for tariffs and quotas.

We compare these scenarios against the alternative of ‘Bremain’: If the weakness in the British economy continues and the purchasing power of British households is further eroded, the British population may still rethink its decision to leave the EU. Via a second referendum or new elections a Brexit could be averted. We use this ‘Bremain’ scenario as our benchmark scenario, as it lends itself better to compare the damage of the Brexit scenarios. It is important to stress that a Bremain is not our official RaboResearch baseline scenario. In the Rabobank baseline, we assume that the UK will leave the EU, but will sign a trade deal with the EU. However, to assess the economic damage of a Brexit it is preferred to compare outcomes with a Bremain scenario.

Some British politicians, including Prime Minister Theresa May, have suggested the option of a transition period in which the UK’s EU membership would be more or less extended (particularly in her recent speech in Florence). Because it is still uncertain whether Brexit will come with such a period, and if so, what the trading conditions and the length would be, we did not include this in the scenarios.

[4] Coe and Helpman (1995) and Lee (2005).

[5] Branstetter (2006).

[6] Both Edwards (1998) and Alcalá and Ciccone (2004) find that international trade has a robust positive effect on productivity.

[7] Baldwin (2016).

In this study, we use an improved tariff version of the macro-econometric model NiGEM in combination with a unique productivity model for the UK. In the appendix, we elaborate on the adopted methodology. The infographic above shows three assumptions in our scenario analyses. A full overview of all assumptions and technicalities can be found in Erken et al. (2017). Below, we will discuss the most important results of our scenario analyses.

Economic growth

In all three Brexit scenarios, the UK ends up in a two-year recession right after Brexit has materialised in 2019. The magnitude of the recession varies considerably in the scenarios, with a GDP decline over two years of 2.4% in a hard Brexit scenario, 1.1% in the FTA scenario and 0.3% in a soft Brexit scenario. Although recovery sets in after the initial shock, growth remains below potential growth over a long period of time. In the hard Brexit and FTA scenarios there is still a substantial output gap even in 2030.

Ultimately, a hard Brexit will cost the UK 18% of growth in 2030, compared to a situation where the UK would continue its EU membership. In absolute terms, this comes down to £400bn until 2030, which is equal to £11,500 per British worker. A FTA and soft Brexit will cause less harm but will still cost the UK economy roughly 12.5% and 10% of GDP growth, respectively. This is equal to £9,500 (FTA) and £7,500 (soft Brexit) per British labourer.

Annual potential output is affected by Brexit as well (Table 1). In the hard Brexit scenario, potential output in 2030 amounts to 1.3%, compared to a potential growth of 2.1% in our Bremain scenario. The FTA and soft Brexit scenarios both show a potential growth of 1.6%. In all three Brexit scenarios, the factor holding back potential growth the most is lower productivity growth (Figure 5). In the Bremain scenario labour productivity in 2030 is £56 per hour, whereas in our hard Brexit this is roughly ten pounds lower (£46 per hour).

The slowdown in productivity is especially caused by lower so-called total factor productivity (TFP).[8] Compared to the Bremain scenario, TFP drops by more than a factor 2 from 1.1% to 0.5% in the hard Brexit scenario (Table 1). The slowdown in TFP is caused by a slowdown in growth of domestic R&D capital, less openness of the economy which is an impediment to benefitting from knowledge spillovers from abroad and at the same time lower competitive pressure domestically. Finally, TFP in all three Brexit scenarios slows due to all kinds of labour market metrics. In the FTA and hard Brexit scenarios, the amount of hours worked by people decreases less than in our Bremain scenario, as people try to compensate for a loss of wealth by working more hours. The downside of working more hours is that it holds back productivity gains as well. This explains why the contribution of structural labour input is higher in our most pessimistic scenarios (i.e. FTA and hard Brexit). Finally, the contribution of growth of the capital stock per unit of labour is lower in the Brexit scenario, due to lower foreign direct investment.

[8] TFP by itself is nothing more than a residual in the standard growth accounting framework, but at the same time it is the purest measure of technological progress, given that it captures the portion of economic growth that cannot be explained directly by an increase in labour inputs (due to demographic changes) or capital inputs (due to investment).

Trade and prices

Trade volumes deviate substantially in our three Brexit scenarios, with hard Brexit export volumes about 30% lower than in our Bremain scenario and 15% and 10% lower in our FTA and soft Brexit scenarios, respectively. Import volumes are 27% (hard), 23% (FTA) and 16% (soft) lower compared to our Bremain scenario. The slowdown in trade in all three scenarios is the result of higher trade barriers between the EU and the UK in the post-Brexit era. Due to imposed tariff and non-tariff barriers between the EU and the UK, export and import prices in the UK rise steeply. Export and import prices in the hard Brexit scenario are 25% higher than in our Bremain scenario. Export prices in FTA and soft Brexit are roughly 20% higher, whereas import prices are 14% higher.

The fact that trade prices in both FTA and soft Brexit are roughly equal immediately shows that non-tariff barriers are far more important in determining the prices of future trade with Europe than direct tariffs. The consequence of the higher import prices is that it generates cost-push inflation, which will prop up inflation and weigh on domestic consumption and GDP. Moreover, higher inflation will result in nominal wage increases, which will boost unit total costs of manufacturing firms operating in the UK. This is detrimental to firm competitiveness, which will result in lower export market shares of British firms.

Labour market

In our scenarios the labour damage will be limited in the UK, due to very flexible labour market institutions. Hence, there is no indication that a Brexit in any form will result in higher structural unemployment. Cyclical unemployment will rise in our scenarios, with a hard Brexit causing a jump from 4.6% in 2018 to 6.2% in 2020, whereas in our Bremain scenario, unemployment is stable, hovering just above 4% (Figure 7). Unemployment rates decline quite rapidly in all three scenarios. As stated, the UK labour market is quite flexible, which means deviations from structural unemployment are not persistent. Furthermore, labour-augmented technological change is growing at a slower pace in all three of our Brexit scenarios, which implies that technology will shred less jobs compared to our Bremain scenario. Finally, real wages grow less rapidly than in our Bremain scenario (and even decline slightly in the hard Brexit scenario), which is beneficial to employment growth, but weighs on private consumption (Figure 8).

The Dutch economy has a strong trade relation with the UK. After Germany, the UK is the Netherlands’ second largest trading partner in the EU. Around 10% of total Dutch exports are shipped to the UK and therefore, we expect larger negative effects of Brexit on the Netherlands than for the EU average. Figure 9 shows the average damage in the case of a hard Brexit, where growth in the Netherlands will slow from 1.5% to 0.2% in 2020. In the FTA and soft Brexit scenarios, the Netherlands will see a slowdown to 0.5% and 0.7% in 2020, respectively. The negative effects are not only the result of less direct trade with the UK, but are also the result of higher import inflation which weighs on private consumption and investment in the Netherlands.

According to our calculations, the cumulative losses in the long run will be somewhere between 3.5% and 4.25% in a hard Brexit scenario until 2030, which comes down to somewhere between €25bn and €35bn, which equals €3250 to €4000 per Dutch worker. The damage to the Dutch economy in our hard Brexit scenario is almost twice as high as the effects found by CPB (2016), which reports cumulative GDP losses of roughly 2% in their most severe Brexit scenario. The deviation in results stems from the more severe economic impact on the British economy in our scenario compared to effects found by CPB (2016). In the FTA and soft Brexit scenarios, we find cumulative GDP losses in the range of 3% and 3.5%. The impact on the euro area will be less severe than for the Dutch economy. We expect a cumulative impact on euro area GDP growth of of roughly -2% in 2024 in all three Brexit scenarios (Figure 10).

In this study, we evaluate the effects of a Brexit in three different scenarios: 1) a hard Brexit scenario in which negotiations between the UK and the EU fail and do not lead to a new trade agreement, 2) a free-trade agreement equivalent with the agreement that for instance Switzerland has with the EU, and 3) a soft Brexit scenario where the UK remains part of the European internal market, but exits the Customs Union. Our results show that the economic costs of a Brexit are expected to range between GBP 400bn (hard Brexit) and GBP 260bn (soft Brexit). This translates to a whopping £11,500 - £7,500 per British worker until 2030.

We deviate strongly from previous studies in our approach and assumptions and find much higher costs associated with the Brexit. This can be attributed to differences in methodology. First, we use an improved tariff version of macro-econometric model NiGEM, which enables us to better assess the negative impact of cost-push inflation resulting from imposed trade barriers between the UK and the EU. Second, we estimate a unique productivity model for the UK, which allows us to adequately gauge the UK-specific effects on productivity caused by Brexit. In this sense, we follow-up on criticism by Dhingra et al. (2016), who state that the HM Treasury has been too careful in their assumptions with respect to trade, FDI and productivity.

To our knowledge, there are four studies that use a general equilibrium model, such as NiGEM, to assess the effects of Brexit and take into account dynamic productivity effects as well: the OECD (2016), the CPB (2016), HR Treasury (2016) and NIESR (2016). The impact on British GDP found in these studies is illustrated in Table 2. Broadly speaking, the impact of a soft Brexit on GDP is expected to be somewhere around -3%, a FTA would generate GDP losses of -5% and a hard Brexit would result in GDP damage between -7.5% and -9.5%. These effects are in line with effects found by Van Reenen (2016). CPB (2016) similarly assesses the impact on the Dutch economy, which in the case of a hard Brexit would face losses of 2% GDP (vis-à-vis the Bremain benchmark in 2030) and 1.5% in the case of a FTA. The EU27 is expected to see less permanent damage: -1.5% of GDP in the case of a hard Brexit and -1.1% of GDP in the case of a FTA regime between the UK and the EU.

We find much larger negative effects than most existing studies. Consequently, this could imply that UK’s decision to leave the EU has been taken based on a too positive representation of negative effects. Our deviation from the existing literature can be attributed to differences in methodology which is described more specifically below.

Endogenous trade effects

CPB (2016) critisises the use of NiGEM for assessing Brexit effects, as it is not capable of dealing with trade policy shocks, unless short-term effects and other non-trade effects are analysed. As such, the UK can only be shocked by lowering export and import volumes directly, while it is impossible to take into account import inflation as a result of higher trade barriers or changes in bilateral trade volumes. To obviate this problem, we use an integral approach that includes the majority of these short-term and non-trade effects. Furthermore, we use an adjusted tariff version of NiGEM, which has been released by NIESR this year. We adjust this model to be able to include changes in trade flows between the EU and the UK. This model has the major advantage that the introduction of tariffs is embedded in the model and as such, import inflation is properly taken into account, which consequently affects real wages, real disposable income and lowers private consumption. At the same time, relative competitiveness is hurt by rising nominal wages in response to higher inflation, which raises unit costs of production, lowers UK competitiveness and the UK’s export market size.

Endogenous productivity

The CPB (2016) accounts for endogenous shocks in trade policy like tariffs and (import) inflation with their CGE model WorldScan. Nevertheless, we think their model specification underestimates the dynamic productivity effects from a Brexit. The CPB (2016) creates an exogenous link between trade volumes to productivity and uses a crude elasticity of 0.1. HM Treasury (2016) adopts a similar elasticity for trade and productivity but includes the impact of lower FDI on productivity. The impact of FDI on productivity is estimated using an industry-specific fixed effects model for the UK. NIESR (2016) calibrates productivity losses from declines in trade in their optimistic WTO scenario. The shock is based on effects assumed by the study of HM Treasury. NIESR calibrates the shock by adjusting labour-augmenting technology, which is the variable that we also adjust in this study.

The OECD (2016) does consider many determinants that might be affected by Brexit and at the same time are important for productivity, such as openness of the economy, anti-competitive product market regulations, business R&D and decline in management quality. But the OECD (2016) uses elasticities taken from panel data estimates.[9] The drawback of this approach is that country-specific effects might differ substantially from the average pooled effect. To illustrate this drawback, our UK-specific estimates show that the impact of R&D capital for the UK is much larger (elasticity of 0.6) than the impact found (elasticity between 0.1 and 0.14) in dynamic panel estimates for 20 OECD countries by Erken, Donselaar and Thurik (2016). Obviously, the higher return on domestic R&D activity in the UK compared to the OECD average might reflect a better dynamic innovation system, better quality of knowledge institutes and universities, a better regulatory framework, higher dynamic spillovers of human capital etc.

We obviate the problems listed above by using a UK-specific productivity model that uses half a century of macro data. The various determinants of labour productivity are thereby integrally estimated. This might explain why we find much stronger effects than documented in previous studies that analyse the determinants of labour productivity in a more partial and limited fashion. In addition, our parameter estimate for R&D capital is much larger as discussed above which translates to stronger effects. Due to the quality of knowledge infrastructures, the highly skilled labour force, top knowledge institutes and universities, and an excellent business climate for knowledge-intensive firms we deem it to be realistic that a pound invested in R&D in the UK is more productive in the EU on average.

Other effects

In our study, we have not only taken into account more channels through which British productivity can be affected, we have also taken into account more channels through which a Brexit will have direct impact on the British economy. For example, we have incorporated a decline in the growth of the labour force due to declining migration flows from the EU to the UK and an outflow of EU migrants currently living in the UK. Opposed to studies by HM Treasury, NIESR and CPB, the OECD also incorporates the implications of a change in migration flows into their analysis to a certain extent. Furthermore, we include a potential financial settlement demanded by the EU from the UK into our analysis while the other studies do not incorporate a potential Brexit bill. In addition, we model an increase in trade costs between the UK and the rest of the world, because we assume that the UK will leave the European Customs Union which means that the UK loses its access to existing FTAs of the EU with third countries. Only HM Treasury corrects for a potential increase in trade costs between the UK and third countries.

Mitigating factors

The OECD includes an important mitigating factor in their central optimistic scenario. They propose that the UK will relax regulations which will positively affect productivity. However, the UK already has a favourable business climate which means that there is little room for improvement. Moreover, under the current circumstances, the UK could already have adjusted regulation accordingly.

Furthermore, we expect that the UK can only partially compensate for the loss of existing trade agreements by replacing them with new ones. This expectation is based on the fact that on average it requires a lot of time and diplomatic resources to close a new FTA. Nevertheless, when the UK would succeed in swiftly closing new trade agreements this could somewhat mitigate the negative impact of Brexit.

We also include important mitigating factors in our analysis that are not included in the existing literature. For example, we model the impact of lower corporate taxes which softens the negative effects of labour productivity and investment.

[9] Égert and Gal (2016)

In this study, we use a two-step approach to assess the economic impact in our scenarios. We combine calculations using NiGEM together with calculations using a UK productivity model developed by RaboResearch.

NiGEM

Using the expanded tariff model of NiGEM for scenario analyses has three main benefits. First, the model allows us to assess the impact of several key variables in the short to medium term, such as exchange rate fluctuations, trade flows, foreign direct investment and the labour market. Second, NiGEM ensures that the global trade flows are viewed within a closed accounting setting. Thus, trade flows between countries add up to global trade and possible trade or economic shocks, such as a Brexit, are accounted for via the global world trade matrix. This also means that we can assess what the impact of Brexit has on other countries, e.g. the Netherlands, for which the UK is an important trading partner. Third, NiGEM is an error correction model (ECM), which ensures that short-term deviations of GDP from a country’s growth potential are made up eventually.

Endogenous productivity

NiGEM has its merits for conducting scenario analyses, but a major impediment is that long-term effects via an important channel of productivity are disregarded, being labour-augmented technological change. This variable is more or less exogenous in NiGEM. This impediment applies to many macro-econometric models, which explains why HM Treasury (2016), OECD (2016) and CPB (2016) adopt exogenously-imposed TFP effects. We are also forced to use this workaround to assess dynamic productivity effects in the tariff model of NiGEM. However, we do assess these productivity effects endogenously, for which we have developed a dynamic productivity model. This model specifically applies to the UK, based on almost half a century of macro data. It is highly important to properly take stock of productivity effects, as labour productivity has been the key pillar of increasing wealth in the UK over almost half a century and has especially been driven by labour productivity growth (Figure A.1).

In our productivity model, we are able to explain 75% of the variance in total factor productivity growth over the period 1969-2016. Factors that have been included are: domestic R&D capital, technological catching-up interacted with openness of the economy, human capital, the impact of the business cycle, hours worked per person employed, labour participation, openness, the corporate tax level and entrepreneurship. It is important to properly take stock of productivity effects, as labour productivity has been the key pillar of increasing wealth in the UK over almost half a century and has especially been driven by labour productivity growth and will be the most important factor going forward.

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