[Having just reviewed what I imagined to be the outcome in the event of Leave in the week before the Brexit referendum, I thought I’d drop it online for posterity. This is an abridged version (nothing added, only the scenarios that did not emerge and irrelevant details removed) from that written during the week between the devastating murder of MP Jo Cox and the referendum in 2016. With hindsight, the strength of public finances and the economy is clearly wrong and remains a puzzle to resolve; the business cycle more generally has held up–something to ponder in the period ahead; the prediction of a new PM in Bojo was also (thankfully) wrong; while I completely failed to foresee the recalcitrance of Labour to push back meaningfully against Brexit alongside a few other details… but still, our current predicament was in broad brush terms there to foresee. As to Article 50 extension, which i thought would not be granted, it now seems more a question of whether the UK asks rather if the EU grants, but let’s wait and see. I give myself 6/10, perhaps optimistically.]
June, 2016, LONDON
THE TRAGIC murder the the United Kingdom MP Jo Cox—Member of Parliament for Batley and Spen, a small consistency in West Yorkshire—has prompted welcome introspection across the political spectrum about the divisive and confrontational style of the EU referendum campaign. Whether this horrific crime will have any impact on the outcome of the referendum remains to be seen—and will no doubt be debated for years to come. And whether the tone of British politics subsequently changes for the better will take time to reveal. But still the referendum goes ahead—representing the most significant political event in the United Kingdom (and perhaps the European Union) for a generation.
… In recent weeks a string of opinion polls put Leave in the lead. Markets have since woken to the possibility of the unthinkable—the exit of a major country from the European Union. Here we speculate on the contours of global politics after the vote. How will things unfold if Remain wins? And what if the unthinkable happens: what will happen if the UK Leaves the European Union?
Two Leave Scenarios: Happy and Unhappy Divorce
First, happy divorce. Amicable divorce is difficult to foresee. But it would look something as follows. Within the UK, it is agreed PM Cameron delivered his manifesto commitment to hold a referendum and should complete his term and negotiate exit from the EU. In Brussels, it is recognized the costs of a protracted breakup negotiation for the economy and regional relations would be large, so a relatively smooth renegotiation of the UK’s relationship should occur—including continued reciprocal access to goods and service trade. While the process could take longer than 2 years, mutually beneficial agreements to avoid disruption during the transition would reassure private investors. Such a “business as usual” solution would keep disruption and uncertainty to a minimum, freeing up the private sector to undertake productive investment; the impact on the European and Global economy from the UK divorce would be relatively pain-free.
Second, unhappy divorce. We can be sure that initial noises from all sides in the aftermath of a Brexit vote will be conciliatory and kind. Separation from the EU will be unlikely smooth, however.
UK politics. A huge march on Downing Street by those in favor of remaining in the European Union—including by those, such as EU nationals, without a vote in the referendum—will be an attempt to reopen the vote. But PM Cameron will likely have to resign—his tenure entirely overshadowed by the historic withdrawal from the EU. The resulting Tory leadership contest will shift the party to the right under PM Johnson. Fearful of the economic backlash, Westminster MPs—who are in largest part in favor of Remain—could refuse to back legislation needed to withdraw the UK from the single market and deliver on the referendum outcome. Meanwhile, the negative impact on the public finances of the economic slowdown would raise concerns about growing deficits and public sector debt—and the prospect of more austerity.
Domestic politics could delay triggering Article 50 of the Lisbon Treaty—which contemplates withdrawal from the EU. A new General Election will be necessary to add legitimacy to the government—whose mandate will be dominated by the need to renegotiate EU membership and revisit the public finances. The question of what the “correct” limit for net migration into the UK should be will be become a political football. UK political parties will be asked by the electorate to set out their positions on how the accumulated influence of EU laws in UK legislation should be revisited—opening up large areas of the social compact. Such minutiae will ultimately take decades to resolve. Meanwhile, given that EU law is incorporated directly into the devolved statutes in Scotland, Wales, and Northern Ireland, the division of regional competencies within the UK will be reopened. Scotland will quickly look for another independence vote—and will likely vote to leave the UK. The free movement of people across the border in Ireland will also be in question, given the scope for migration from Europe through this route. At a time of reemerging sectarian influence, the peace process in Northern Ireland could be called into doubt. Overall, as well as relations with the EU, many aspects of domestic political order will be open to scrutiny.
EU politics. It is typically argued that since the UK runs a trade deficit with the Euroarea (exports to EUR being about GBP40 billion per year; imports nearly GBP65 billion) it is in the interests of the European Union to deliver a swift renegotiation of the UK’s trading relationship. But this overlooks the legitimate concern that smooth EU exit will facilitate additional future withdrawals—at potentially huge cost for the European core. The main pre-occupation will therefore be to prevent others contemplating leaving the club. This could be done positively through measures to solidify the Eurozone—for example, by meaningful fiscal transfers and risk sharing. But such measures remain politically unpalatable. Most likely, therefore, renegotiation with the UK will become protracted and contentious. While Article 50 of the Lisbon Treaty allows for the unanimous extension of the 2 year renegotiation period, agreement will be unlikely. The UK will fall back on WTO trade arrangements once the 2 year period expires. Negotiations could drag on for a decade or more. The possibility of retaliation against trade in services with the UK or restrictions on the movement of UK citizens cannot be ruled out—especially if the UK migration limits begin to bind. A string of important parliamentary or presidential elections (Spain next week , the United States in November; France and Germany in 2017; Italy and Russia in 2018) makes the constellation of political power and influence difficult to predict.
The resulting negative macroeconomic impulse in the UK and Europe of Brexit—as investment decisions are postponed—will be folded onto the already difficult ongoing global adjustment—in particular, the slowdown and adjustment across the EM world. More precisely, the compression of the UK current account deficit—and associated GBP depreciation—and wider Eurozone current account surplus will add to global deflation pressures. Pressure will grow on Germany to use fiscal policy counter-cyclically. And if China’s current account surplus continues to widen… additional pressure will be exerted on asset prices to equilibrate global saving-investment balances. Renewed USD appreciation and commodity price deflation could follow; major central banks will seek new tools to head off deflation.
Finally, some additional complications for the EU are likely to emerge if the UK leaves. First, Schengen and free movement of people. The previously sacrosanct notion that the free movement of people should accompany the free movement of goods and capital in the European Union will be increasingly questioned. A challenge to free movement of labor could accompany the next political cycle in Europe. Second, the EU budget. If the UK leaves the EU, other member states will have to fill a roughly EUR7 billion hole in the EU budget. Interestingly, due to a special ¾ reduction for Germany, Austria, Netherlands and Sweden in financing the UK’s rebate, the largest cost from Brexit will fall on these four countries (roughly EUR4½ billion of the EUR7 billion shortfall being met by these four, EUR3 billion falling to Germany alone.) With the cost of EU budget transfers already unpalatable, the EU budget formula will likely be open to renegotiation for the next multiannual financing framework (beginning 2021) with an outcome likely be negative for the balance of payments across Eastern Europe. Third, as noted above, momentum amongst anti-establishment parties will likely deliver another EU referendum in the near future.
In summary, the result of the EU referendum is unlikely to bring an end to the challenges facing Europe and the UK. Of most concern, it is difficult to build a benign baseline. For now, the best outcome would be a decisive victory for remain. However, regardless of the outcome of this historic vote, until there is some meaningful leadership from the core, the future of Europe will continue to be in doubt.