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Brexit: Through the LENS OF AN eCONOMIST

4th September, 2019

It is hard to find any newspaper today without some mention of Britain’s Exit from the European Union (Brexit) within it. Brexit has completely divided the British public (read more on YouGov here) and many news outlets have written of the consistent confusion surrounding one of the biggest events in recent British history.

This post looks at Brexit through a number of key economic lenses, identifying how each relates to a potential Brexit. 

TRADE

One of the most obviously impacted economic areas is trade. If you study/studied Economics at school, you might be aware of some trade models such as Adam Smith’s model of absolute advantage, as well as Ricardo’s extension to comparative advantage. Both models (pictured) invoke some use of the idea of productivity, and countries then trading with each other based on their differences in productivity. This means that each may specialise more in one good that they are better at producing. The impact of Brexit on our trading power depends on what goods you look at, because we consume goods from all over the world.  

Goods that we buy from Europe may go up in price if tariffs are imposed - these goods include spinach, chillies and peppers, tomatoes, and cucumbers (read more here). However, the EU unilaterally imposes some tariffs on non-EU goods, which the UK might have the power to lower under its ‘WTO Schedule’. Each country negotiates their rules of international trade at the World Trade Organisation (WTO), and each of these tariffs makes a country seem comparatively less productive, as their goods become more expensive. The UK government also set out its plans for tariffs earlier this year, should a no deal Brexit occur.

FINANCIAL MARKETS

As we saw in the financial crisis of 2008, financial markets can impact the economy in a big way. The crash started with banks losing confidence in one another after a few of them had made some risky investments. Once some banks started to show signs of failure, confidence that was previously there fell away and investors tried to pull their money out of the financial system. The fall in confidence affected the real economy in a big way, affecting the funding that firms and households could access. After the crash, unemployment hit a high of 8.5% after staying at around 5% in the years between 2000 and 2008.

Considering the impact of Brexit on financial market confidence is therefore an important endeavour if we want to estimate how much the financial system might worsen any economic outcome of Brexit (this is called procyclicality - read more here).

The FTSE 100 is a share index of the largest 100 companies listed on the London Stock Exchange. News outlets and market analysts follow its size very closely in order to estimate and forecast market changes. Since the Brexit vote in 2016, UK stocks have seen their share prices fall relative to stocks elsewhere in the world (read more here). This disruption is also set to continue in 2020, with the exit being described as ‘torturous’ for hanging over markets.

These confidence woes are also reflected in the pound’s exchange rate - which is invested in as an asset in itself but is also used to purchase UK shares by foreign investors. The pound is increasingly buying less and less in foreign currencies, with one pound now translating into only €1.10 and $1.22 (five years ago it would buy you €1.25 and $1.66). This affects the price of Britain’s imported goods, and also British people’s ability to travel abroad, both having a significant impact on quality of life.  

BANK OF ENGLAND

The Bank of England is responsible for the UK’s monetary policy and also oversees regulation of the UK’s financial sector. It offers forecasts and guidance, and also publishes research papers, which you may wish to read here. Crucially, the Bank has published a range of GDP outcomes in a no deal scenario - with GDP being expected to dip by up to 7.5% due to a combination of assumptions;

  • The EU applies its Common Customs Tariff to goods imported from the UK and the UK reciprocates with equivalent tariffs 
  • The EU requires its products be certified for sale in the EU  
  • Trade deals may not be implemented 
  • The EU does not take action to address the risks of disruption to financial derivative markets  
  • Expectations affect both consumer and business spending  
  • Knock on effects to the general economic outlook: lending is expected to fall given the challenges banks face in derivatives markets, but also due to general economic uncertainty  
  • Spillovers from the fire sale of some assets (UK property and bonds) meaning borrowing costs rise  
  • The UK loses existing trade agreements that it has with non EU countries 
  • The UK’s border infrastructure is unable to process imports efficiently  
  • Investors demand more return for holding sterling assets (meaning that the pound weakens) 
  • It is also assumed that there will be some fiscal and monetary response from the government and the Bank of England  

The impact of these assumptions on the economy is explained in the full length version of the Bank of England’s November 2018 publication. It also sets out how it makes forecasts for Britain’s economic future and how that in turn impacts what the Bank expects it will have to do to maintain stability - for example, changing the base interest rate or the CCyB (Countercyclical capital buffer). Measurements of the depths of economic impact include: the exchange rate, the unemployment rate, and the inflation rate.  

BEHAVIOURAL ECONOMICS

Behavioural economics and questions over the strength human rationality are becoming increasingly relevant in academic discussions. A search of the terms ‘financial crisis’ and ‘hubris’ for example yields 45,200 results on Google Scholar. Behavioural economics is also helping to inform how Brexit forecasts are being made, for example with reference to financial markets and general economic uncertainty. 

A recent Nobel prize winner, Richard Thaler, suggested that incorporating psychological assumptions into analyses of economic decision making could explain the narrow vote to leave the EU. He claims that the decision was influenced by gut choices in many cases, as opposed to rational decision making.

Thaler is also well known for his work on nudge theory, which explains how small state interventions can encourage individuals to make different decisions. This might be helpful in the context of setting policy post Brexit, in order to mitigate any adverse effects of it (for example, policymakers could try to encourage spending and investment).

IMMIGRATION POLICY

According to The Economist, areas that saw increases of over 200% in foreign-born population between 2001 and 2014 saw a majority of voters back leave in 94% of cases. The Economist concluded that ‘high numbers of migrants don’t bother Britons; high rates of change do’ (read more here).

The economics of immigration can be simply viewed as a cost benefit analysis. The benefits that migrants may bring come in the form of culture, but also in the form of monetary benefit. Some immigrants will pay more in taxation than they take in the form of public services or benefits, while others do not. Immigrants will also affect the multiplier. For example, if they send money back to their country of origin, this represents a leakage. However, their spending in the UK would contribute to income circulation in the economy.

Research shows the European migrants living in the UK in fact contribute £2,300 more to the public purse each year than the average adult, meaning that each extra immigrant on average means more money for the National Health Service (NHS), for schools, for the police force, and to reduce the level of public debt.

This suggests that were Britain to deter immigration from the EU, it might find itself weaker fiscally. However, this depends on how stringent the UK’s immigration rules become, and whether they are useful in identifying higher taxpayers (for example, some migrants may have the potential to earn more in the future even if they currently do not earn much).  

Economics is an important discipline for trying to understand the implications of Brexit - indeed, normally economic analysis is applied to every piece of legislation that goes through Parliament. However, as highlighted above, economics is not black and white like mathematics and science - its models can provide some insight, but cannot definitively stipulate what is the right and wrong way forward.