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Triangulating Brexit

BRUSSELS – More than 100 days after the United Kingdom voted narrowly to leave the European Union, it remains far from clear what arrangement will regulate cross-Channel trade after Brexit. Political discussions tend to revolve around three key issues: immigration controls, access to the single market, and passporting rights for financial services. Which balance should European leaders strike?

Many in Britain know exactly what they want: to impose controls on the movement of workers from the rest of the EU, thereby protecting the domestic labor market, but without losing access to the single market or passporting rights, which allow British firms to sell their financial services on the continent. That was, after all, the kind of deal many leaders of the “Leave” campaign promised before the June referendum.

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But the Brexiteers’ promise remains wishful thinking. As German Finance Minister Wolfgang Schäuble has pointed out, access to the single market is inextricably linked to the free movement of people. Indeed, he has even offered to send Boris Johnson, the UK’s foreign secretary, a copy of the Treaty of Lisbon, where that link is established.

This may sound legalistic, and it certainly reflects political motivations. But basic economic principles imply that free movement is, indeed, at least as important as free trade.

Trade usually benefits both sides. It is thus clear that it is in the common interest of the UK and the EU to minimize the losses from the introduction of new barriers through Brexit. From the point of view of European welfare, it is the size of the trade barriers that matters, not which side is a net exporter or importer. Low barriers typically have low costs, unless very large volumes of trade are affected. But as barriers become higher, the negative impact on welfare grows disproportionately.

The good news for the UK is that it probably wouldn’t face substantially higher trade barriers even if it did leave the single market. After all, the EU has, in general, a liberal trade regime, with low external tariffs. That is why so many studies do not consider the economic benefits of tariff-free transatlantic trade as the primary reason for pursuing it.

Even if the UK faced some additional barriers – such as new customs requirements and certificates of origin – their impact would most likely be relatively small. The case of Switzerland – which is even more integrated into EU production chains than the UK – shows that efficient customs administrations on both sides are enough to keep such barriers to a minimum. In any case, exports of goods to the EU generate only about 6% of the UK’s GDP.

Yet another reason why the introduction of some low trade barriers is unlikely to produce large losses is that the differences in the cost of producing goods in one market or the other are small. Producing a car in Britain, for example, costs about the same as producing one in Germany.

Barriers to the free movement of labor are a different story. Productivity and income per worker in the UK remains significantly higher than in, say, Poland. A worker would get about €25 ($27.70) for an hour of work in the UK, but only €8.50 in Poland. In other words, not allowing a Polish worker to work in the UK would imply large economic costs for Europe. Moreover, if British Prime Minister Theresa May follows through on her stated goal of reducing annual net immigration to less than 100,000, the UK would have to implement drastic – potentially costly – measures to close off the UK labor market.

This means that the barriers that EU negotiators are in a position to impose – which largely affect trade in goods – are likely to have a much smaller impact than the UK-imposed barriers, such as quotas on EU workers. But there is one more issue that negotiators must consider: financial services.

While overall trade in services is unlikely to suffer enormously from Brexit – the internal market for services never worked all that well, anyway – finance constitutes a special case, largely because of the passporting arrangements for banks.

Economists are often ambivalent about the benefits of financial integration, not least because large flows of bank credit can have a serious impact on macroeconomic stability. Whereas securitization, for example, can help to reduce risk and increase the availability of credit for risky borrowers under the right framework, the 2008 global financial crisis starkly demonstrated that it can imply huge costs if it goes too far.

But steps can be taken to maximize the benefits of cross-Channel provision of financial services after Brexit. The key is to base decisions not on sustaining the City of London’s role as Europe’s financial hub, but on ensuring that the services provided strengthen Europe’s capital markets. That would require an emphasis on equity over debt instruments, and on market-based financing over bank credit.

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From an economic standpoint, the priorities that should guide Brexit negotiations are clear. Negotiators must focus on minimizing new barriers to the free movement of labor; indeed, this should be an even higher priority than maintaining the free movement of goods. And British financial services should be welcomed in the EU, but only if they help it to move away from its bank-centric system and complete the capital market union.

But politics continues to distort discussions, driving leaders to draw red lines on free movement and adopt mercantilist stances on financial services. It will take some statesmanship on both sides to shift attention to the common good.