Commentary: the economic consequences of leaving the EU.

Armstrong, Angus ; Portes, Jonathan

"The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought."

Rudi Dornbusch

The phony war is over. We enter a crucial final six weeks before the UK's referendum on EU membership. A decision by the British people to vote to leave will alter the course of both British and European history. While this is fundamentally a political choice, economic consequences are rightly central to the debate. In this issue of the Review we bring together some of our colleagues from the ESRC's 'UK in a Changing Europe' programme, from a variety of disciplines, to examine the implications of this decision. We also summarise the National Institute's estimates of the macroeconomic consequences of leaving the EU and compare them to other model based estimates. This exercise is of particular interest since both the well-publicised HM Treasury and OECD analyses use our global macroeconomic model, the National Institute Global Econometric Model (NiGEM). (1)

Referenda are relatively rare in the UK, although they have become more common of late. The last time the UK voted on Europe was a generation ago--or 41 years ago to be exact. But because they are so infrequent, the outcomes are typically long-lasting. Some on the Leave side have contemplated the idea of a further renegotiation and a second vote, but this seems very unlikely. The Prime Minister has made it clear that the government would have an obligation to give effect to the electorate's wishes and, following a vote in Parliament, would give notice to the European Council under Article 50 of the Treaty of the European Union. (2) This starts a two-year process of negotiating the terms of withdrawal, unless extended by unanimous agreement of all other 27 Member States. There is no provision to withdraw an intention to leave under Article 50. (3) Meanwhile, many in the rest of the EU already see Prime Minister Cameron's agreement with Heads of State in February as going as far as feasible or desirable (or indeed farther) in giving the UK a special status.

Influence and immigration

One of the most often aired concerns in the referendum debate is that the UK has little influence over EU institutions and regulations. Our first research article by Menon and Salter examines the degree to which the UK is able to set and influence the EU's agenda. They find that, despite headlines about the UK being 'outvoted', that at least up until the most recent period, the UK has been relatively successful in influencing policy, in both a negative (preventative) and positive (proposing) sense. In many ways the UK has steered the EU in its own preferred direction of market liberalisation combined with national control of social policies. However, the run-up to the referendum may have eroded our credibility and hence our ability to advance this agenda. Paradoxically, then, the UK government's mishandling, over the past few years, of the domestic EU debate and the renegotiation has, if anything, strengthened the case for Leave. If we vote to Remain, re-establishing the UK's centrality to EU debates will be an urgent task.

Perhaps the greatest concern about our EU membership is the inability to control migration. In the second article, Portes points out that negative attitudes to immigration, and in particular free movement within the EU, are by far the strongest predictor of opposition to EU membership. The Prime Minister's initial objective of imposing significant restrictions on free movement was resoundingly rejected in the UK's renegotiation. This means that a vote to Remain will unequivocally be a vote for the status quo. Some who favour leaving the EU argue that ending free movement of labour might allow a more liberal approach to non-EU migration, particularly of skilled workers, with consequent economic benefits; but it also seems plausible that policy might become significantly more restrictive overall, since even a large reduction in EU migration would leave overall net migration well above the government's target.

The Single Market

In the past few weeks the alternative on offer has come into sharper focus. Previously, scenarios ranging from continued membership of the European Economic Area (EEA) to completely independent trade policy on the lines of New Zealand or even Hong Kong were floated. Now, however, the official Leave campaign has narrowed that range considerably. Their vision is of a UK outside the Single Market, but within what they describe as the "free trade zone stretching from Iceland to Turkey that all European nations have access to, regardless of whether they are in or out of the euro or EU". (4) This includes not just members of the EEA and European Free Trade Association (EFTA) but also countries like Bosnia and Turkey.

Let us then suppose that the preferred alternative to the EU is an arrangement that secures, broadly, continued tariff-free access for UK exporters and importers to EU markets, subject to rules of origin, and other regulatory and non-tariff barriers that do not apply to full members, particularly in trade in services. In this light, what do the remaining three research articles collected in this issue tell us about the impact of leaving the EU?

Services account for the overwhelming majority of the UK economy, and a large and growing proportion of our trade. Focusing on the sectors of tourism and higher education, Barnard and Ludlow examine how the process of liberalisation, driven by EU law and policy, has largely worked to the benefit of the UK. Looking forward, many Member States continue to be very cautious about further liberalisation. But leaving the EU, in the absence of an alternative such as EEA membership, would make matters considerably worse. Currently, the Treaties, the Commission and the European Court of Justice mean that there are strong central authorities which broadly share the UK agenda. We would lose our influence within these bodies, and our ability to call on them for recourse. By comparison Free Trade Agreements (FTA) do not cover all services, and there is no region in the world which has such a high level of integration of services across sovereign borders.

For good or (sometimes) ill, the financial sector plays a key role in the UK economy, and is a major contributor to our trade performance and public finances. Despite remaining outside the Eurozone, London continues to be Europe's dominant centre of financial services. It is difficult to see how leaving not just the EU but also the wider EEA would not have important implications for this status. Armstrong argues that some substantial UK institutions would necessarily be excluded from key parts of the European financial infrastructure, including central counterparty clearing houses. This in turn could have major consequences for the decisions of private sector firms on where to locate both their headquarters operations and large parts of their operational business.

[FIGURE 1 OMITTED]

The direct impact of EU membership on the public finances --the 'membership fee'--is often cited as a key argument for leaving the EU. Begg points out that it is easy to present the same basic data as either an unreasonable burden or a comparatively trivial cost to the tax-payer which yields considerably greater benefits. He concludes that, although it is a net contributor to an extent comparable with several other Member States of a similar level of prosperity, the UK does not face an unfair share of the burden of the gross costs of the EU. Nevertheless, it is clear that the direct fiscal impact of leaving would be a saving to the UK budget that would be significant, albeit not huge, in both budgetary and political terms.

There are profound differences between the Single Market and a free trade area. The former is a single set of rules designed to create a level playing field. It removes barriers to competition as well as to the free movement of goods, services, capital and labour. Shifting to a free trade agreement is not, as some would argue, a relatively minor matter. It would be uncharted territory, likely to result in significant changes to the structure of the UK economy, particularly in respect of the tradeable services sectors.

Macroeconomic impact

We turn now to a discussion of the macroeconomic impact of leaving the EU. The Treasury's recent analysis estimated that if EU membership were replaced with a free trade agreement, similar to that currently being negotiated between the EU and Canada, this would reduce UK GDP in 2030 by 6.2 per cent (compared to a base case of remaining in the EU). Other credible analyses, including that by the Centre for Economic Performance at the LSE, also find that leaving the EU would result in a significant decline in UK GDP relative to remaining in the EU. Table 1 summarises the key results.

The OECD's analysis is arguably the most comprehensive; for example, it includes estimates of the impact on migration flows, which is notably absent from the Treasury analysis (Portes, 2016); it also includes some potential benefits from deregulation, although these are small. However, in all cases the key mechanism leading to the decline in GDP is a decline in trade openness, which is assumed to feed through into a decline in investment and labour productivity.

The Institute's analysis (Baker et al.; Ebell and Warren, both in this Review) is also set out in the table. Like the OECD, we look both at the long-term impacts and the short-term adjustment process in an integrated framework. In the short term, increased uncertainty leads to a sharp fall in the exchange rate and an increase in risk premia and hence firms' borrowing costs. This can be thought of as a higher cost of financial intermediation as discussed by Armstrong in this Review. The increase in risk premia act to tighten monetary and financial conditions. But the exchange rate, which falls and possibly overshoots, acts to soften the various blows.

Over the longer term, we model three scenarios, and their impact on trade in both goods and services and foreign direct investment: a 'Norway' scenario (EEA membership), a 'Swiss' scenario (EFTA with various EU bilateral agreements) and an 'Island Nation' scenario where we face WTO tariff conditions. We incorporate several additional, detailed mechanisms into the adjustment process, including changes in tariff rates and the impact on the capital stock.

In the short term, we expect that a vote to leave would result in a significant economic downturn, with unemployment rising by up to 1.7 per cent. However, as uncertainty was resolved, employment and growth would recover. Over the long term, our results are somewhat less pessimistic than those of the Treasury or OECD, with the long-term hit to GDP ranging from about 1.5 to 3.7 per cent.

We do not incorporate changes in migration into this analysis: however, forthcoming research by our colleague Katerina Lisenkova uses an overlapping generations model with detailed treatment of migrants, their labour market characteristics and access to welfare payments. The model takes into account general equilibrium impacts on wages, prices and investment. Initial results suggest that substantial reductions in EU migration will reduce GDP per capita and worsen the overall fiscal position; in other words, changes to migration policy would likely further exacerbate the negative economic impacts.

Finally, we note that a group called 'Economists for Brexit' has produced a model based forecast showing a positive impact on GDP of withdrawing from the EU, assuming that the UK moved to implement a policy of unilateral free trade (Economists for Brexit, 2016). However, their analysis raises a number of concerns. First, they model the impact of reduced regulation as equivalent to a reduction of 2 per cent in national insurance contributions; this number appears to be arbitrary. Second, they model a tariff reduction after leaving the EU as a cut in expenditure tax; but the impacts on domestic producers of such a cut would in fact not just be different to that of reducing tariffs, but of the opposite sign. The resulting impact estimates therefore do not appear credible.

To summarise, there is a degree, albeit not unanimous, of consensus that leaving the EU would depress UK economic activity in both the short term (via uncertainty) and the long term (via trade). However, it is important to emphasise that all these analyses assume that leaving will in fact lead to a significant decline in trade with the EU. This is in turn based, explicitly or implicitly, on the historical experience of countries (like the UK) that joined the EU (or the EEA).

Leave campaigners accept this basic underlying assumption that trade is good for productivity and hence growth. However, they argue that the UK would in fact be able to negotiate arrangements with the remaining EU that would ensure that any reduction in trade was mitigated and that at the same time the UK would succeed in negotiating new free trade arrangements with non-EU countries. The result would be a faster expansion of trade with the fastest-growing parts of the world economy than would otherwise occur.

These assertions are impossible to disprove ex ante. However, future trading arrangements with the EU would require complex and difficult negotiations, while leaders from the US, China and India have stated that they would prefer to deal with the UK within the EU. A fair summary is that the overwhelming weight of economic opinion is that leaving the EU would not have a significant negative trade impact if- and only if- the UK was able to undertake a remarkably successful series of complex and difficult trade policy negotiations after leaving the EU.

Real options

One of the most important result in modern finance theory over the past five decades is that irreversibility matters. Real options pricing theory tells us that when a decision is irreversible, we need to consider the full range of outcomes, not just the expected value. If you cannot change course--or reverse time--the distribution of outcomes, and 'tail risks' in particular, become extremely important. In this instance, the UK has the option to leave the EU. Optimal decision making therefore requires an assessment of the risks involved. As the above discussion suggests, these appear considerable, in particular around future UK trade arrangements.

Moreover, withdrawal from the EU could also have serious UK constitutional consequences, particularly if a decision to withdraw did not represent the wishes of all the constituent nations. Under the Sewel Convention, governments should only make changes to devolved legislatures with the consent of their respective parliaments. Further referenda, and the potential dissolution of the UK, are possible. Since the Northern Irish and Scottish governments do not have the funds to repay their share of UK public debt, this could result in an increase in public debt per capita in England and Wales of up to 14 per cent.

These political and economic risks, combined with the likely relocation of at least some parts of the financial sector, could in turn pose a risk to the UK's ability to fund its 'twin deficits'; the current account deficit is currently in excess of 5 per cent of GDP. (5) The result might be an adjustment process that was quicker and more disorderly than any of the models suggest; this would in turn have a considerably more negative impact on the real economy.

Those in the Leave campaign emphasise that there are also risks to staying in the EU: the status quo is not an option. There is indeed widespread recognition that the economic governance of the EU, and in particular the Eurozone, has proved hopelessly inadequate, and that fundamental change is required. At best, the EU is only at the beginning of that process. The European Banking Union, promoted by the UK as a panacea for the "remorseless logic of monetary unions", is arguably as ambitious as the single currency project. (6) Greater financial, and some fiscal, integration is inevitable for Eurozone countries, with potential consequences for the UK. While the Prime Minister's agreement with EU Heads of State in February secured a number of clear safeguards, the possibility that Eurozone nations caucus and introduce rules unsuitable for non-Eurozone members cannot be eliminated. If we remain, we do at least have the opportunity to shape and influence those changes.

Conclusion

Economists agree that trade, migration and access to large markets are good for economies. EU membership has led to a relatively liberal approach to both and provides full access to the largest single market in the world. If this could be maintained outside the EU and better trade deals negotiated, then the economic impact might indeed be neutral or even a slight positive. But this would require benign political and economic developments in the UK, in the EU, and globally. Moreover, the potential downside risks of a decision to leave, while not susceptible to precise quantification, appear large, and need to be taken into account in assessing the overall costs and benefits. Risks are also attached to remaining in the EU, but appear easier to manage.

NOTES

(1) While NiGEM is produced and maintained by us, the assumptions fed into it, and hence the results, are of course the Treasury's own responsibility.

(2) HM Government (2016) notes that the Prime Minister has made it clear that "if the British people vote to leave, there is only one way to bring that about, namely to trigger Article 50 of the Treaties and begin the process of exit, and the British people would rightly expect that to start straight away".

(3) The Treaty suggests that the only option would be to re-apply for membership, just as for any state aspiring to join the EU. According to University College London's Constitution Unit, "anyone who suggests that unsure voters can vote to 'leave' at the initial referendum safe in the knowledge that they can later change their minds is either playing with fire or manipulating voters disingenuously" (Renwick, 2016).

(4) Gove (2016).

(5) While long-term interest rates remain very low by historical standards, demand for UK government debt securities may be precarious; the bid-cover ratio in the latest gilt auction was only 1.07 times.

(6) HM Treasury (2014).

REFERENCES

Baker, J. et al. (2016), 'The short-term economic impact of leaving the EU', National Institute Economic Review, 236, May.

Dornbusch, R. http://www.pbs.org/wgbh/pages/frontline/shows/ mexico/interviews/dornbusch.html.

Ebell, M. and Warren, J. (2016), The long-term economic impact of leaving the EU', National Institute Economic Review, 236, May.

Economists for Brexit (2016), The Economy After Brexit', http;// static I .squarespace.com/static/570a 10a460b5e93378a26ac5/ t/5722f8f6a3360ce7508c2acd / 146190977995 6/ Economists+for+Brexit+-+The+Economy+after+Brexit.pdf.

OECD (2016), The Economic Consequences of Brexit: A Taxing Decision, Policy Paper No. 16.

Gove, M. (2016), The facts of life say leave: why Britain and Europe will be better off after we vote leave', http://www. voteleavetakecontrol.org.

HM Government (2016), The process for withdrawing from the European Union, CM 9216.

HM Treasury (2014), Extracts from the Chancellor's speech on Europe, https://www.gov.uk/government/speeches/extractsfrom-the-chancellors-speech-on-europe.

--(2016), Analysis of the long term economic impact of EU membership and its alternatives, CM 9250.

Portes, J. (2016), The Treasury's Brexit analysis and immigration', http://www.niesr.ac.uk/blog/treasurys-brexit-analysis-andimmigration.

Renwick, A. (2016), 'What happens if we vote for Brexit?', The Constitutional Unit https://constitution-unit.com/2016/01/19/ what-happens-if-we-vote-for-brexit.

Angus Armstrong and Jonathan Portes, National Institute of Economic and Social Research and Centre for Macroeconomics. E-mail: a.armstrong@niesr.ac.uk; j.portes@niesr.ac.uk. Funding in support of this research was provided by the ESRC's UK in a Changing Europe programme, of which the authors are Senior Fellows.

Table 1. Comparison of recent studies on the impact of leaving the EU
on the United Kingdom

                                OECD               LSE/CEP

                              WTO/FTA            FTA           WTO

Near term                       2020            Static
  GDP (%)                      -3.30            -1.30         -2.60
  Real wages (%)                n.a.             n.a.         n.a.
Longer term                     2030           Dynamic        n.a.
  GDP (%)                       -5.1             -7.9         n.a.
    Range (%)               -2.7 to -7.7     -6.3 to -9.5     n.a.
  Real wages (%)                n.a.             n.a.         n.a.
    Range (%)                   n.a.             n.a.         n.a.
Implied multiplier on
    trade to get
    long-run
  GDP effects                0.27--0.39      0.5 to 0.75      n.a.

Method                         NiGEM          Estimated       n.a.
                                                trade
                                           elasticities (1)

Short-term uncertainty           X
Reduced trade with EU            X                X             X
Productivity losses from
    reduction in trade           X               x(l)           X
Reduction in FDI                 X                              X
Productivity losses from
    reduced FDI                  X                              X
Lower contributions to           X                              X
  EU
Change in migration              X

Productivity gains from
    deregulation                 X
Lower or zero
    contributions to the         X
    EU budget

                                           HM Treasury

                                EEA            FTA            WTO

Near term                                      2020
  GDP (%)                       n.a.           n.a.           n.a.
  Real wages (%)                n.a.           n.a.           n.a.
Longer term                                    2030
  GDP (%)                       -3.8           -6.2           -7.5
    Range (%)               -3.4 to -4.3   -4.6 to -7.8   -5.4 to -9.5
  Real wages (%)                n.a.           n.a.           n.a.
    Range (%)                   n.a.           n.a.           n.a.
Implied multiplier on
    trade to get
    long-run
  GDP effects                   0.42        0.33-0.41      0.32--0.40

Method                                        NiGEM

                              Channels

Short-term uncertainty
Reduced trade with EU            X              X              X
Productivity losses from
    reduction in trade           X              X              X
Reduction in FDI                 X              X              X
Productivity losses from
    reduced FDI                  X              X              X
Lower contributions to           X              X              X
  EU
Change in migration

Productivity gains from
    deregulation
Lower or zero
    contributions to the         X              X              X
    EU budget

                                              NIESR

                                EEA            FTA           WTO

Near term                                     2020
  GDP (%)                       -1.9          -2.1           -2.9
  Real wages (%)                -2.3          -2.6           -4.2
Longer term                                   2030
  GDP (%)                       -1.8          -2.1           -3.2
    Range (%)               -1.5 to-2.1    -1.9 to-2.3   -2.7 to -3.7
  Real wages (%)                -2.7          -3.4           -5.5
    Range (%)               -2.2 to -3.2   -3.1 to-3.8   -4.6 to -6.3
Implied multiplier on
    trade to get
    long-run
  GDP effects                   0.13          0.14           0.13

Method                                        NiGEM

Short-term uncertainty           X              X             X
Reduced trade with EU            X              X             X
Productivity losses from
    reduction in trade
Reduction in FDI                 X              X             X
Productivity losses from
    reduced FDI
Lower contributions to           X              X             X
  EU
Change in migration

Productivity gains from
    deregulation
Lower or zero
    contributions to the                        X             X
    EU budget

Sources: OECD calculations: LSE/CEP study: Dhingra, S., Ottaviano,
G., Sampson, T. and Van Reenen, J. (2016), The Consequences of
Brexit for UK Trade and Living Standards, Centre for Economic
Performance (CEP), London School of Economics and Political Science
(LSE); and Treasury: HM Treasury (2016), HM Treasury Analysis: the
Long-Term Economic Impact ofEU Membership and the Alternatives,
April 2016.

Note: The LZSE/CEP analysis uses econometric estimates of the
relationship between trade and GDP to estimate the impact of a given
reduction in trade on GDP. These estimates would, in principle,
capture any and all impact of trade on GDP, including productivity
gains from increases to openness.