Friday, July 28, 2017
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With a weaker currency, the country will benefit from an increase in export competitiveness. Other factors will also cushion the blow of Brexit.

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The Not-So-High Costs of Brexit

BRUSSELS – The United Kingdom’s vote to “Brexit” the European Union is on course to become the year’s biggest non-event. Beyond a weaker pound and lower UK interest rates, the referendum has not had much of a lasting impact. Financial markets wobbled for a few weeks after the referendum, but have since recovered. Consumer spending remains unmoved. More surprising, investment has remained consistent, despite uncertainty about Britain’s future trade relations with the EU. Have the costs of Brexit been overblown?

Not exactly. In fact, the UK may well end up losing the predicted 2-3% of GDP from Brexit. But it is the exit from the single market, not the initial vote to leave, that will bring those losses, and that may happen over a long period. If the exit turns out to be a ten-year process, the losses would be borne gradually over that period, costing the UK about 0.2-0.3% of GDP per year, on average.

This could be very good news for the UK. With a weaker currency, the country will benefit from an increase in export competitiveness that could offset those incremental losses and the transient investment weakness that is likely to arise.

Other factors will also cushion the blow of Brexit. Over the last two decades, the UK has transformed its economy to foster unprecedented specialization in services. In the mid-1990s, goods exports were three times as important as services exports, and the majority of British exports went to the EU. Nowadays, the UK exports mostly services – and mostly to non-EU markets.

UK exports share of GDP

As a result, the internal market for goods is far less important for the UK today than it is for other EU countries. The value-added contained in British goods exports to the EU accounts for only about 5% of GDP – several times less than for, say, Germany. Meanwhile, Britain’s non-EU exports account for about 7% of GDP.

The shift in UK goods exports away from the EU reflects a change in the sources of economic growth, with Asia, in particular, gaining primacy. To some extent, other EU member states have also shifted their goods exports away from Europe, but the effect has been most pronounced in the UK.

The fact that the UK now relies more heavily on access to world markets than on access to the EU’s internal market surely contributed to the Brexit vote, as it minimized the sacrifice that the UK would have to make to regain control over hot-button issues like immigration. The belief that the UK could secure superior access to world markets on its own than as part of the EU also helped.

This is where the Brexit bet becomes riskier. To be sure, approving trade deals will be much easier for the UK than it is for the EU, which requires agreement from 30 parliaments (including some regional ones). The political challenges that have impeded the approval of a relatively low-profile free-trade agreement with Canada exemplify this challenge. But the UK will also have less leverage in negotiations than the EU does, especially in dealing with large emerging economies.

Similarly, the UK does not have to fear huge changes in its ability to export services to the EU, which currently accounts for about 40% of the UK total, because the EU’s internal services market already is far from open. But there is one exception: financial services. And it is a big one.

As it stands, financial services account for about one-third of Britain’s total services exports and two-thirds of the overall services surplus that the UK needs to pay for its deficit on goods. The industry’s success is the result, at least partly, of the UK’s EU membership.

The specialization of the UK economy and its external accounts toward financial services (and services in general) began when capital movements were liberalized under the internal market program of the 1990s. It was accelerated with the introduction of the common currency, which, combined with the elimination of obstacles to cross-border capital flows and a global credit boom, fostered the concentration of many types of wholesale financial services in the City of London.

The financial sector has a natural tendency to form clusters, and London – where English is spoken, the legal system is efficient, labor markets are flexible, and the regulatory regime is relatively streamlined – offered substantial advantages. Add to that the EU’s “passporting” system, which enables London-based banks to sell their services directly throughout the EU, and the growth of the city’s financial-services sector makes perfect sense – as does the fact that citizens of London voted overwhelmingly against Brexit.

Yet the reality is that most of the advantages that have made London into a financial-services hub will remain even after Brexit. And the loss of passporting might be offset by the creation of subsidiaries or “bridgeheads” within the EU, such as Dublin, Frankfurt, or Paris. London’s financial-services industry could therefore survive Brexit, though it is unlikely that it will maintain its previous vigor.

Indeed, no matter what terms the UK negotiates with the EU, it will probably have to change its growth model, probably through a modest revival of manufacturing, among other things. Given decades of decline in British manufacturing, this would be easier said than done. But, if the country doesn’t manage such a rebalancing, the long-term cost of Brexit might turn out to be substantially higher than current estimates.

The expansion of the financial-services industry – which creates few, but very highly paid, jobs – has contributed to rising income inequality, which has been more pronounced in the UK than elsewhere in the EU. And inequality helped fuel the widespread frustration with globalization and the so-called “establishment elites” that carried the Brexit campaign to victory.

In this sense, one of the major economic benefits of the UK’s EU membership led the British to reject the project. The question is whether the economic changes that Brexit will necessitate will produce the benefits for British workers that the “Leave” campaign promised. The answer remains far from clear.


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barry eichengreen

The early returns on Brexit are in, and contrary to what some have been claiming, they’re not good.

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Brexit and the Pound in Your Pocket

BERKELEY – The early returns on Brexit are in, and, contrary to what some have been claiming, they’re not good. In July, following the referendum, consumer confidence collapsed at its most rapid rate since 1990. Surveys of manufacturing and construction dropped precipitously. While August’s data were better, it is too soon to say whether the improvement was just a “dead cat bounce.”

In this topsy-turvy post-referendum world, the one piece of good news is sterling’s fall on the foreign exchange market. A lower exchange rate will make British exports more competitive. Faced with higher import prices, consumers will shift their spending toward domestic goods. This, too, will give a boost to the British economy.

The question is how big a boost. Skeptics caution that Britain relies heavily on exports of financial services, which are not especially price-sensitive, and that the scope for growth of merchandise exports is limited by the subdued global demand.

Britain has been here before, so this is a question on which history can shed light. In 1931, when the UK abandoned the gold standard, sterling plummeted by 30%. Like now, the country relied heavily on exports of services – not just banking services but also shipping and insurance. And the external environment was even more unfavorable than it is now.

Yet, despite these headwinds, the merchandise trade deficit fell by a quarter between 1931 and 1932. By 1933, the services balance was strengthening as well. At this point, the economy was on the road to recovery.

Three circumstances made this possible. First, excess capacity enabled companies to ramp up production. Second, Britain was able quickly to put in place a set of favorable trade deals, negotiated with Commonwealth countries at the Ottawa Conference in 1932. Third, political uncertainty fell sharply, as the Labour government, widely blamed for the 1931 crisis, was replaced by a Conservative-dominated cabinet with broad popular support.

Clearly, none of these conditions is present today. Excess capacity in traded-goods sectors is low. In today’s more complicated legal environment, it will take years to negotiate trade deals with the EU and then other partners. Political uncertainty is high, and there is no prospect of a general election to resolve it anytime soon. Investors have every reason to adopt a wait-and-see attitude.

In 1949, Britain found itself in the same position, with a trade deficit vis-à-vis the United States and weak investor confidence. In September of that year, sterling was again devalued, as it had been 18 years before, by 30%.

Because pressure for higher wages was subdued, British exports became more competitive. The trade deficit with the dollar area, made up of the US and other countries that used its currency to settle international payments, contracted sharply. The current account of the balance of payments swung from deficit in 1949 to surplus in 1950, and GDP rose strongly.

Again, three things made this possible. First, there was robust demand in the US, which was recovering from its 1948-1949 recession. Second, the outbreak of the Korean War in 1950 created demand for exports of all kinds. Third, with the creation of the European Payments Union, the UK and its European partners agreed to dismantle controls on trade with one another.

Here, too, the current situation could not be more different. US growth is far from robust, and EU countries have made clear that they are in no hurry to negotiate a trade deal with the UK.

A third precedent is the 1967 devaluation of sterling, again after an interval of 18 years. The balance-of-payments crisis of 1966-7 reflected the tendency of British wages to grow faster than productivity, the consequent trade deficits, and foreign investors’ reluctance to finance a position they saw as unsustainable. This time, however, it took two years for the external accounts to improve. With unemployment already low, that much time was needed to reallocate resources from nontraded- to traded-goods sectors.

In the interim, foreign investors remained reluctant to finance Britain’s deficits. Seeing the difficulty of the adjustment, they worried that sterling would collapse. The UK, unable to attract short-term capital inflows, was forced to borrow from the International Monetary Fund.

This history suggests that exchange rates matter for competitiveness, and that sterling’s depreciation should help by enhancing the competitiveness of British exports. But policymakers shouldn’t expect too much. The external environment is unfavorable. It will take time to reallocate resources toward the production of traded goods. And a new set of trade deals will not be concluded overnight.

Meanwhile, British leaders must resolve the lingering political and policy uncertainty. They must use not just monetary policy, but also fiscal tools, to support spending and strengthen the incentive to invest. Until now, they have shown little awareness of the urgency.


Living With Brexit

Read Comments (2)
  1. Comment Commented


    History and Geography demands peace n prosperity in Europe.
    Europe's longest and best interlude 1945-2015 ends with Brexit.
    Eschewing Europe, Britain's Economics surpassed Europe's Next 5 put together at the end The 19th century. The Anglosphere now has The Pacific option, greater than The Atlantic option. Unless ClubMed understands that it's Majority within European Union CAN become irrelevant - with The Anglosphere growing without ClubMed - the path that Brexit has unleashed has only One Final Destination. But in their Megalomania, The Majority have always overplayed their hands. NATO Economics is The Truth - NOT THE EUROPEAN UNION.
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  2. Comment Commented

    Much of the analysis of the Brexit result continues, as here, to focus exclusively on its economic dimension. But there is a political dimension that is, I think, more important to the future of Britain and the EU.

    Certainly the economic implications are important -- but they will eventually arrive at an equilibrium (favorable to the people of Britain or not). In the meantime though, the political fractures in the current EU foundation will not go away -- and will, I suspect, play more of a role in determining the union's future than economics. For a good example of the sort of fracture I'm referring to, see this short report from today's Guardian:

    The EU, while Britain is still a member, should I think call a "constitutional convention" to address its structural problems. If progress can be made on those problems (like the one represented in the Guardian article --a big if), the current member states (including Britain) might decide to jointly abandon "EU 1.0" in order to join an "EU 2.0" that is built on a sounder political foundation.

    The other possible outcome of such a convention, of course, might be the prompt demise of the whole idea of a European Union. But even there, a case can be made that a prompt abandonment of a failed experiment would be better than a long, lingering one. Read more