GEORGE KEREVAN thinks the unthinkable. What would happen if UK voters opted to leave the European Union, as presently constituted?
First, a caveat. On balance, this correspondent would vote Yes to stay in the EU. But I am increasingly alarmed by the bullying attitude Berlin and a compliant Commission in Brussels have taken to the small debtor nations of the Eurozone.
As a result of Berlin’s insane, 1930s-style commitment to austerity, the European economy is being pushed into secular deflation. The UK is being sucked into this economic black hole, as a consequence of our trading links. An EU addicted to mad economic policies cannot long endure.
But leave that aside for the moment. For the purposes of this thought experiment, let’s assume (by whatever set of political circumstances) that there has been an In-Out referendum and the Brits have opted to quit the EU. What next?
The Dutch ING bank has just published a gory analysis predicting the outcome of a Brexit would be catastrophic for the UK economy. But ING analysts are prone to such dramatic forecasts. In early 2013, they published a similar bromide regarding an independent Scotland.
The ING folk ignore the long-term growth prospects, and concentrate on the two years running up to a referendum. Result: they think the likely market uncertainties will cut growth by around half a percentage point a year. How much are they getting paid to produce this stuff?
Of course uncertainties prior to any major vote on the UK’s political and trade links with mainland Europe will spook the markets. If the impact is only half a point of GDP, I’ll eat my hat. Anyway, the market rebound following a Yes vote will make up any losses.
But all that is beside the point. The real issue is the long-run implications of Brexit, not the instant froth – some of which will be down to ING’s customers shorting UK assets.
First, what will happen to interest rates and sterling? ING thinks the Bank of England would hold down rates for longer than currently anticipated, in the aftermath of a Brexit, or at least raise them more cautiously.
Possibly. However, I would have thought that the Bank would be more inclined to raise rates if it thought Brexit would lead to a flight of capital. Any rise in rates will, of course, strengthen sterling, everything else being equal.
Because ING is betting on rates being kept down, it thinks a Brexit will see sterling sink to around 90 pence to the euro, a level last seen in 2011. Against the dollar, ING thinks, sterling could fall below $1.40. All this is absolute sticking of fingers into the air, of course. If anyone at ING can forecast the sterling rate this accurately, we should all be buying the bank’s shares.
Certainly the dollar is likely to be a safe haven for some time to come. Strong US growth means the American economy can withstand prospective interest rate hikes.
If the Eurozone tries to raise rates in the middle of a deflationary bout, with the Mediterranean zone deep in public debt, it won’t be long before the common currency collapses. In these circumstances, I reckon sterling could gain strength in the medium term, not lose it. Even if the pound slid on a Brexit, that is hardly bad news for exporters fighting to retain market share in deflationary Europe.
What will happen to inward investment? Some 20 per cent of UK business investment comes from foreign companies. That’s double the average for most advanced industrial economies and results from the fact that multinationals use Britain as a stable base for operations the rest of the EU. Would this investment skip the UK and go to the mainland instead?
If US and Asian investors put their money into a Europe sans the UK, they will find the value of those investments plummeting in value because they will be denominated in euros. And the euro is plummeting against both the pound and the dollar as we speak – it just scored an 11-year low against the almighty greenback. Just you wait till the Fed starts to raise rates.
Of course, the low euro might cause a surge in European global exports, encouraging a fresh wave of foreign investment (to the detriment of the UK).
More likely, secular deflation will cause the European consumer market to stagnate, offsetting any export gains from a cheaper euro. Indeed, with Eurobond yields sinking into negative territory by the barrow-load, I’d expect investment cash to pour into London from the mainland.
In assessing the impact of a Brexit on inward investment, the key point is where does most of the existing flow come from? The US is the largest source of FDI projects for the UK (with 501 projects in 2013), followed by Japan (116). They came to the UK as much for reasons of low taxation and ease of doing business, as anything else.
The two next biggest sources of UK inward investment are France and Germany. Certainly, this cash could stay at home in future. But a lot of it was money going into the UK energy industry – three of the Big Six UK utilities are Franco-German owned and a fourth is Spanish. Can’t see them relocating the plant to the mainland, can you?
So where does this lead in the way of UK growth prospects after Brexit? The biggest pessimists are the banks. But they are parti pris, fearing the loss of the City’s pre-eminent role in the European financial system if the French and Germans more to erect financial trade barriers in the wake of a Brexit.
Witness the recent siren song from Garry Cohn, president of Goldman Sachs: “I think that having a great financial capital of the world staying in the UK and having the UK be part of Europe is the best thing for all of us.”
Goldman Sachs is one of over 250 foreign banks based in London. The inference is that if they didn’t have access to trade across the EU, they would move to Paris or Frankfurt.
It is news to me that the EU (sans the UK) is in any position to renege on international commitments to free trade in financial services. In Europe, the EU is already committed to giving Efta countries equal treatment in the financial services market.
The current EU-US trade talks are designed to create an Atlantic free market in banking. So quite why Mr Cohn thinks half the City will decamp to socialist France or corporatist Germany, on a Brexit, is obscure. The penchant for basing international banking in London has much to do with light regulation, ease of communications, personal security, and the time zone. A Brexit changes none of those things.
What about scholarly analysis of the impact of a Brexit on growth? Last year the Centre for Economic Performance at the LSE published a technical paper which attempted to assess (ostensibly in as neutral a manner as possible) the welfare impact of the UK quitting the EU.
This paper suggested the losses due to reduced trade could be substantial. “Even under very optimistic assumptions”, it concluded, “the sum of the static and dynamic trade losses would be almost 2.2 per cent of GDP. More pessimistic calculations would lead to a long-term loss of almost a tenth of national income.”
Frankly, the suggestion that the UK would lose a tenth of its GDP if there was a Brexit vote is on a par with the daft suggestions in the Scottish independence referendum that Scotland would be exiled from every international agency, its economy would implode and that all the money would flee overnight to London.
The weakness in the CPE/LSE paper is that it is classic comparative statics – change one thing and pretend everything else stays the same. The CEP analysts are assuming a Brexit UK loses free access to European markets.
But there is no way UK exporters can be denied current access to European markets if Britain adheres to Efta. Equally, the Eurozone economies in their current weakened state would be silly to start erecting trade barriers with the UK – collectively they have much more to lose.
None of the above should be read as an endorsement of a Brexit. For the record, though, I do not believe the current EU model works – politically or economically. We need to negotiate a reformed Europe, keeping the best bits – democracy, free trade, free travel, collective defence and a commitment to work together. But we also need to evolve a Europe where the big nations cannot bully the smaller, and where the Brussels bureaucracy is more accountable.
If the UK debate on EU membership leads to that, it will be worthwhile. What will impede such a positive debate is couching discussion regarding EU membership in the same daft, apocalyptic terms that dogged the Scottish referendum debate. ING please note.