Brexit: Consequences for a Broken Britain

08.14.16
The Guardian
Longform /14 Aug 2016
08.14.16

Brexit: Consequences for a Broken Britain

On June 23rd, 2016, Britain voted in a non-binding referendum to leave the European Union (EU). The result sent shockwaves through Europe and the world. The British pound fell to its lowest level since 1985. Prime Minister David Cameron, who was pro-EU and had daringly called the referendum to end the ‘leave or stay’ debate, announced his resignation the following day. Xenophobic attacks aimed against Polish immigrants roiled the country in the days following the vote. But beyond these immediate consequences, Britain faces an ocean of uncertainty and possible economic hurt over the next decade.

While no one knows the exact consequences Britain will have to deal with post-Brexit, many different scenarios exist that almost all spell a negative outcome. Firstly, British policy makers will have to adjust to changing economic conditions surrounding foreign direct investment, research, and education. Secondly, Scotland, a region whose people voted overwhelmingly to remain in the EU, could choose to secede from the UK and rejoin the EU as an independent nation. Thirdly, British politicians will face many different possibilities in regards to their immigration policies post-Brexit. Fourthly, foreign multinationals headquartered in London may not find the business environment of ‘the City’ as attractive anymore and relocate British jobs to EU countries, especially in the financial services sector. Lastly, British negotiators could settle on five different economic packages with the EU, whose consequences are explored in detail.

Background to Brexit: The Brexit referendum addressed a nearly three-decade old debate over EU membership in the UK. Britain joined the European Economic Community (ECC), or ‘Common Market’ in 1973. Since then, questions over immigration and fiscal policy have fueled the debate. ‘Vote Leave’ was the official group that led the ‘Leave’ campaign. Leave advocates argued that an opaque European political elite didn’t have the right to force Britain’s national parliament to surrender its legislating power.

In addition, the Leave camp contended that Brexit would allow for tighter border control and reduce pressure on public services. For example, Nigel Farage, leader of the UK Independence Party (UKIP), touted that independence from the EU would save the National Health Service (NHS) an estimated £350 million every week. Media reporters later proved that the Leave camp had fabricated the number. ‘Leave’ campaigners also promised that Brexit would save the UK billions of pounds in EU membership fees and free Britain from an inefficient, bloated bureaucracy in Brussels. The economic and political package 10 Downing Street will negotiate with the EU will test the validity of these claims. Britain has yet to invoke Article 50 of the Lisbon Treaty, which initiates the exit process. After this, Theresa May, the new British Prime Minister, and her cabinet will have two years to negotiate a new deal with the EU.

Consequence on Foreign Direct Investment: Contrary to the many assertions from the leaders of the Leave campaign, the UK is a less important trade partner for the EU than the EU is for the UK. Only ten percent of EU exports go to the UK, while half of the UK’s exports go to the EU. Likewise, the largest source of foreign direct investment (FDI) for the UK comes from the EU. Foreign direct investment is the ownership of a share of a company in one country by an entity based in another country. In 2013, the EU accounted for 46 percent of the UK’s FDI. Considering the recent rhetoric of many European leaders who denounce Britain’s ‘cherry-picking’ between EU immigration and economic advantages, British politicians will likely not come home from Brussels with a deal that facilitates FDI in the UK. Therefore, the amount of FDI in the future will probably decrease. Instead, other metropolises inside the EU, such as Rome, Berlin, Copenhagen or Oslo may become more attractive to FDI originating from both EU and non-EU countries.

(Nicola Sturgeon/Facebook)

(Nicola Sturgeon/Facebook)

The decrease in FDI from EU companies who are currently heavily invested in the UK may cause higher unemployment for unskilled workers. This sizable FDI could change depending on the trade deal achieved with the EU post-Brexit. For instance, EU states boast a sixty two percent share of the retail and wholesale markets, a seventy-three percent share of the mining and quarrying industries, a ninety percent share of the utilities market, and a seventy-five percent share of the transportation market. German, Dutch and French companies account for the majority of this FDI. Since these industries mostly hire low-skilled workers, this will likely result in higher unemployment for blue collar workers living in the UK.

Many unknowns remain for any observer to accurately predict Brexit’s impact on unemployment in the UK. May’s cabinet might elect a fiscal policy that resembles Ireland’s by drastically cutting taxes to compete with EU countries. Liberated from exhaustive EU legislation on industries that pollute the environment like the mining and transportation industries, for example, the UK could become a serious competitor to EU member states. While such policies would likely compromise the UK’s environment, they would certainly attract FDI from both EU and non-EU companies. Perhaps indicative of this course of action was Prime Minister May’s recent decision to shut down the Department on Energy and Climate Change, a key government agency that led efforts to curb global warming, and to transfer its mission to the Department for Business, Energy & Industrial Strategy. Green Party member of Parliament (MP) Caroline Lucas deemed the decision “deeply worrying.” This action may indicate that the new Conservative cabinet will not hesitate to favor business interests over the environment.

Scottish Secession: Scottish Prime Minister Nicola Sturgeon announced that a referendum on Scottish independence was “highly likely” following Brexit. Scottish voters cast their ballots overwhelmingly against Brexit, with 62 percent of Scots voting Remain. In addition, Scotland already held a referendum on its independence from the UK in 2014. The results were close, with 52 percent of voters choosing to remain in the UK. However, uncertainty over EEC membership was not in question then, and possible pro-EU sentiment now may tip the scales in favor of the Scottish independence camp in a future referendum. Sturgeon qualified Brexit as “democratically unacceptable” for Scotland, and has promised a second referendum within the next five years. Once out of the United Kingdom, Scottish diplomats could freely negotiate accession into the EU or the EEA.

Scottish secession would devastate the British economy. In 2012, Scotland contributed £106.3bn worth of goods and services in “Gross Value Added” (GVA) to the UK economy. GVA is a statistic used to measure a region’s output within a confederation of states. In comparison, the UK’s total GVA for 2012 was £1,383bn. Therefore, the UK would lose 9.4 percent of its GVA overnight. Such a loss would contribute to a significant rise in unemployment as Scottish-UK trade would decrease.

Consequences on Research, Development and Education: Depending on the trade deal, British researchers could receive less funding from the EU. With decreased EU funding for scientific research and development (R&D), the UK’s leading technology industries will likely suffer. British universities and research centers have received more funding from the European Research Council (ERC) than any other EU university since the UK’s admission to the EEC. This funding previously allowed UK universities to pay for 10 percent of their projects and undertake cutting-edge research. The EU’s recent FP7 program, which has injected unprecedented funds into the European higher education system, listed ten UK universities among its top twenty investment recipients, including the top three schools.

Similarly, the Horizon 2020 program, the successor of FP7, will provide €80 billion euros in funding to these same universities spanning 2016-2020. Diminished funding for research will also affect the UK companies downstream who rely on scientific advances for their business, such as the automotive, aerospace, chemical and pharmaceutical industries.

Decreased competitiveness of UK universities might also attract less foreign students, who are responsible for a large annual injection of money into the British economy.

Decreased competitiveness of UK universities might also attract less foreign students, who are responsible for a large annual injection of money into the British economy. Political barriers could also diminish the number of foreign students studying in the UK. More than 26,000 publicly-funded European students studied at UK schools under the Erasmus program in 2013. Erasmus is an EU program that funds top students to study at foreign universities to encourage linguistic and cultural exchange. Similarly, tighter immigration controls could prevent privately-funded students from attending top UK schools.

Outcome for Immigration: Today, hundreds of thousands of immigrants currently live in the UK. In total, foreign-born immigrants comprise 12.7 percent of the British population, with 7.9 million foreign-born immigrants living in the UK today. A majority of immigrants from the EEA are young, skilled and employed, and statistically fare better than their native counterparts in the British job market. These foreigners’ residency status will depend on the immigration package negotiated between the UK and the EU.

Contrary to the mainstream media’s fear-mongering reports to the opposite, immigrants actually contribute positively to British society. Dustmann and Frattini, two economists from the University of Central London, found that immigrants provide their know-how when skill shortages arise and help sustain economic growth by replacing an aging native population. Similarly, while immigration to the UK depresses wages below the 20th percentile of income, the wages of native workers with higher than average earnings increases. In addition, 79 percent of immigrants from the EEA between the ages of 18-35 held a job, while only 70 percent of the British population in the same age segment were employed. Therefore, immigrants are net contributors to the UK’s economy. If the new cabinet chooses to follow statistics over popular misconceptions, British advisors will choose a Norwegian-style or Swiss-style model, where Britain would have to open its borders to immigrants as part of the free movement of labor clause.

Otherwise, British arbitrators could choose to apply the UK’s current points-based immigration system for non-EEA immigration to immigrants from the EU. This points-based tier system for non-EEA permanent immigrants separates candidates into five tiers depending on their skill, history and perceived contribution to British society. Applicants earn points for the quality of their resume and of their interview. Immigrants need to meet a certain threshold of points for their application to succeed. The Tier 1 category is for “high-value immigrants” who typically fit the profile of entrepreneurs, investors and people with “exceptional talent.” Tier 2 includes applicants who are “skilled workers” who have a job offer in the UK. Tier 3 is for “low-skilled workers” who can fill a temporary labor shortage. The UK has never granted any visas for Tier 3 applicants. Tier 4 is for non-EEA students who have a spot to study at a UK university. Tier 5 is for temporary workers looking to work in the UK during British holidays and for youth travelling to the UK on approved cultural exchange programs. Therefore, British legislators would have much more say over immigration policy under the five tier system and could freely refuse entry to EU refugees. However, UK policy makers would also have to significantly raise quotas for Tiers 1 and 2 if their objective is to keep their country competitive, since many immigrants from the EEA who would have previously elected to work in the UK might not find the country as attractive after Brexit. In addition, British lawmakers will have to raise quotas to replace skilled native workers who are expected to migrate to pursue better job opportunities abroad after economic conditions worsen post-Brexit.

Britain may become a less attractive business environment for conglomerates after Brexit.

Impact on business environment: Britain may become a less attractive business environment for conglomerates after Brexit. More than half of the European headquarters of non-EU firms are based in the UK, with the UK counting more HQs than France, Germany, Switzerland and the Netherlands combined. Once out of the EU, Britain may find it harder to compete with EU member states who benefit from tax exemptions and benefits. For example, the Parent-Subsidiary Directive (PSD) is an EU program that grants up to 25 percent tax exemptions to foreign companies headquartered in member states. Under the PSD, legislators had engineered the UK tax system to exempt holding companies based in the UK from taxation on their profits from foreign branches. This intentional loophole created thousands of jobs in management positions in the UK as holding companies based their headquarters in London. However, UK bureaucrats will need to update the tax code to reflect Brexit. This will likely result in relocation of holding companies to EU states and cause higher unemployment among skilled workers living in the UK.

Consequences for financial services industry: Whatever trade policies British politicians negotiate with the EU, the UK’s financial services sector will almost surely suffer. Since the 1950s, banks and hedge funds have flocked to London to establish their headquarters as their gateway to European financial markets. In 2015, the UK had a 49 percent international market share for interest rate derivatives, a 41 percent share of the twenty trillion dollar foreign exchange market, and an 18 percent share of hedge fund assets. These market share figures are only closely rivalled by those of the United States. Outside Britain, the cities of Glasgow, Leeds and Edinburgh also boast consequential financial centers. A Swiss-style set of bilateral agreements or an FTA would require that the UK apply for access to the European financial sector. The European Central Bank (ECB) would ask that the UK comply with EU regulation on certain sectors of financial trading, which Britain already did as part of EEC, while leaving out other finance specialties. For instance, the EU would allow British bankers to fully participate in the European wholesale banking industry, as it does with Swiss traders, without tariffs or regulation. Wholesale banking is the most important financial services sector and comprises 42 percent of the British financial sector. However, the FTA or bilateral treaty would probably use the EU’s Solvency II program to review the UK insurance regulation sector case by case. This would impose additional regulation that would hamper the UK insurance market’s growth. Finally, EU legislators would block British bankers’ access to the highly profitable yet volatile securities sector to protect their capital-intensive markets from extreme fluctuations in interest rates.

The British government will have to create new jobs for the highly skilled workers whom Brexit will put out of work. The finance sector accounts for nearly 3.9 percent of UK jobs, or 1.2 million jobs, and for 7.9 percent of the UK’s Gross Domestic Product (GDP). Although banks would face significant moving costs, large conglomerates may at least transfer some of their services to Eurozone financial centers, where the ECB would grant them access to more advantageous Common Market rules for euro trading. The most conservative economists predict that the UK will lose 120,000 jobs from relocation within five years, while the most pessimistic estimate that 450,000 jobs will disappear. This rise in unemployment could have devastating consequences for the British economy. On the other side of the English Channel, Paris, Frankfurt, Amsterdam and Dublin stand as the most likely EU metropolises to capture the UK’s lost business.

The best economic deal British negotiators could reach is a Norwegian-style European Economic Area (EEA) agreement with the EU.

Norwegian-style EEA agreement: The best economic deal British negotiators could reach is a Norwegian-style European Economic Area (EEA) agreement with the EU. Norway is part of the EEA, which is a community of countries that allows for the free movement of capital, services, goods and persons within the European Common Market. Like Norway, Britain would also become a member of the European Free Trade Association (EFTA) and have tariff-free access to the EU’s Common Market. However, the EFTA still incorporates roughly 5,000 of the 23,000 EU laws currently in force, meaning Britain would have to comply with around 21 percent of EU laws (EEA Lex). The free movement of people clause in the EEA would also entail the free movement of workers between Britain and Europe. Britain would also become part of the Schengen Area, an area that includes twenty six European countries that have all abrogated their border controls and operate with a common visa policy (see Appendix A) (EEA Lex). Although this plan would benefit Britain the most economically, it wouldn’t address the UK’s current political schism over immigration.

Turkish-style Customs Union: British negotiators could also achieve a Turkish-style Customs Union with the EU. The European Union-Turkey Customs Union is an agreement that provides for the free travel of goods between Turkey and the EU without any tariffs or customs restrictions. However, the EU would still impose a tax on agricultural products and services. Like Turkey, Britain would also have to impose a common external tariff on products coming from outside the EU. British diplomats would then accept the EU’s import quotas and customs duties on foreign imports and forfeit their voting power over the determination of this common external tariff. Britain would also essentially give up any say over its foreign relations. Indeed, British delegates would have to accept any treaty between the EU and non-EU countries and could only enter into a treaty with a non-EU party with the explicit consent of the majority of the EU. UK politicians would have to convince their citizens that they should willfully strip themselves of any negotiating power. This would make little sense considering the questions over national sovereignty brought up by Brexit.

Free-Trade Agreement Deal: Another solution UK politicians have at their disposal is a Free Trade Agreement (FTA) approach. A FTA is similar to a customs union in that it reduces trade barriers. However, unlike a Customs Union, FTAs do not mandate signatories to impose an external tariff on non-members. Britain would agree to a bilateral FTA with the EU that would likely not include tariff barriers, since the UK would probably conform to customs requirements set by the EU in exchange for better terms. Although negotiators on both sides would determine the FTA’s exact impact on Britain, the FTA would almost surely intensify trade between Britain and the EU and become a net benefit for Britain. This is because either party would have a comparative advantage in certain industries and therefore prioritize production in that area to manufacture more at lower costs. However, with reduced clout in the international arena, British negotiators could experience difficulty fleshing out trade deals with non-EU countries that would offer the UK conditions as advantageous as those it enjoyed while it was still part of the ECC. Brexit’s impact on total British trade thus remains hard to quantify. Despite this uncertainty over Britain’s aggregate wealth, most economists conclude that this FTA wouldn’t distribute this wealth fairly across the UK. Indeed, income inequality could increase as certain aging industrial regions around Manchester, Newcastle and Sunderland could lose much needed business while more service-oriented regions such as London could come out less affected by Brexit. In the long run, more of the same resentment that pushed the majority of older, disillusioned workers to vote for Brexit could resurface and taint UK politics.

Nigel Farage: One of the chief proponents of the Brexit vote. (Gage Skidmore)

Nigel Farage: One of the chief proponents of the Brexit vote. (Gage Skidmore)

Swiss-style bilateral accords: A fourth approach Brexit bureaucrats could take is to negotiate a Swiss-style set of bilateral accords. In this scenario, Brussels would grant a British company’s access to the Single Market for certain products. Bilateral treaties would determine British-EU policy over subjects as diverse as the economy, immigration, trade, business, and scientific research. However, European leaders would almost certainly voice their ire over perceived British cherry-picking on immigration policy and stall the talks. A poll conducted in 2013 by Ipsos found that 67 percent of citizens in the UK consider immigration “a problem,” while only 29 percent regarded it as “an opportunity.” Given this prevailing attitude towards immigration in Britain, and considering the importance of the debate on immigration in the months leading to the referendum, British policy makers would almost surely refuse a treaty providing for the free movement of people. But Angela Merkel, Germany’s Chancellor and one of the most prominent voices in the Brexit discourse, has said that “whoever wants to leave this family can’t expect to do away with all of its responsibilities while keeping the privileges.” If UK diplomats still push for a treaty limiting immigration from the EU, they cannot seriously expect European leaders to fulfill their requests on other treaties. Swiss citizens, in contrast, voted to open their borders to the Schengen agreement in 2005 as part of the Bilateral II treaty. In exchange, EU delegates agreed to virtually all of the stipulations of their Swiss counterparts on economic issues. Economists have found many parallels between these bilateral treaties and the EEA, and have compared Switzerland to a quasi-EEA member. Unsurprisingly, the Swiss economy has benefited tremendously from these bilateral accords. Roughly 80 percent of Swiss exports are to EU member states, and daily bilateral trade is of the order of CHF 1 billion. British negotiators could look to gain much more if they can reach bilateral treaties that don’t seem like cherry-picking to other EU leaders. Overall, bilateral treaties seem likely as the most feasible for both sides of the negotiating table.

Most Favored Nation Status: A final solution for British politicians is to work towards a Most Favored Nation (MFN) agreement with the EU. An MFN is a promise from one country that it will provide equal trade advantages to another country. Members of the World Trade Organization (WTO) agree to grant each other MFN status, and since both the UK and the EU are WTO members, an MFN agreement is the de facto solution. These advantages can range from low tariffs on goods to high import quotas on agricultural products, for example. However, British manufacturers would face the EU’s external tariff on any good they export across the English Channel. In regards to immigration, British officials could decide to define their immigration quotas around the five tier system. An MFN agreement would not exist in harmony with Britain’s historically liberal approach to trade and business. Therefore, UK delegates would probably not leave Britain’s relationship with the EU at an MFN.

Obstacles to ratification: Even if British policy makers do work out a treaty with EU representatives, several obstacles could remain in the path of ratification. First, the British Parliament could choose not to enact the deal. Since the UK is a parliamentary democracy, Parliament holds the power over ratification. MPs could argue that the Prime Minister does not have the right under the British constitution to invoke Article 50 of the Lisbon Treaty. Instead, Parliament would have to give its approval first, and with 76 percent of MPs favoring the ‘Remain’ camp, Brexit may never actually materialize.

A second possibility is that the Scottish Parliament could veto Brexit. The 1998 Scotland Act, passed by both the Scottish and the British parliaments, stipulated that the Scottish Parliament would have to “act in a manner compatible with EU law.” Sir David Edward, a British constitutional expert, recently argued that the Scottish Parliament could declare the referendum unconstitutional by invoking the Scotland Act, since Brexit would also remove Scotland from the EU. Given that an overwhelming 62 percent of Scots voted against Brexit, Scottish MPs could very well veto Article 50 of the Lisbon Treaty without misrepresenting their constituencies, unlike British MPs who would have to overrule the popular vote to avoid Brexit.

Lastly, Theresa May may simply choose not to enact Article 50 for political reasons if she doesn’t expect a favorable outcome. This is because all twenty-seven parliaments of the EU member states would have to ratify any EU-UK deal. After Article 50 of the Lisbon Treaty is invoked, Britain has two years to negotiate a new deal, during which the EU would still treat the UK as a member state. At the end of those two years, however, if no deal is yet signed, the EU constitution specifies that Britain would automatically take the status of a MFN in relation to the EU. This condition means that a majority of the MPs of any member state could veto a deal proposal if it deems that the deal would grant conditions too advantageous to a certain British industry. The two year buffer period would expire, after which the UK would default to MFN status and face an external tariff on its exports to the EU. If Theresa May foresees such resistance from a particular EU member state’s parliament, she could understandably choose not to trigger Brexit. Of course, this course of action would directly undermine the foundations of British democracy and damage Prime Minister May’s credibility.

Economists and politicians all around the globe are still uncertain as to Brexit’s exact consequences, although the prevailing sentiment is that Brexit will have a negative impact on Britain. The future package negotiated by British and EU politicians will determine the extent of this economic and political damage. This deal will affect many sectors, such as Britain’s FDI, immigration policy, financial services industry, business environment or research initiatives, to varying degrees. On one side of the spectrum, British diplomats may choose to apply for EEA membership, which would grant British companies the right to export their goods and services to the EU’s Common Market free of tariffs, but would also force Britain to accept EU immigration policy. On the other side of the spectrum, the new cabinet may decide to let Britain default to a MFN status, which would impose an external tariff on British goods exported across the English Channel but would also let Britain enforce its own quotas on immigration from the EU. The future of Brexit now hinges on the willingness of British negotiators to swap sovereignty for advantageous economic contracts. Regardless of the specifics of this treaty, however, Brexit will forever change the political and economic landscape of the UK, mostly for the worse.

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