Want To Save Britain's Economy? Vote To Stay In Europe.

As each day passes the EU referendum draws ever closer, a referendum whose outcome will undoubtedly have huge impacts on both the economic and political landscape of the whole country for years to come. A huge part of the debate that’s raging is over the political repercussions of either outcome, much of which focusses on our political sovereignty and by extension the central issue of ‘regaining control’ of our borders. I’m not going to address the potential political outcomes (the endless rhetoric clouding politicians’ true intentions makes this nigh-on impossible anyway) but instead I will focus on the economic aspect of this debate. In doing this I will seek to answer one key question: which option should the people of the United Kingdom take to ensure economic prosperity going forward?

There is no precedent to the situation the UK finds itself in, therefore nobody can state empirically exactly what the outcomes of each choice are. The complexity of prediction is further hampered by the range of trade deals the UK has if it does choose to leave, but that’s not to say we can’t build models to predict at the very least the net effect of the outcomes – whether they are positive or negative. Economically, we can split the potential impacts of a ‘Brexit’ into the short and medium-to-long term, with different potential issues presenting themselves in different time frames.

Author’s Own Calculations using data sourced from ONS

Short term issues are already presenting themselves. The referendum is still a month off but the mere possibility that the UK could leave the EU is already having tangible economic repercussions. We saw a negative trend in GDP growth in the first quarter of this year, with growth falling 0.2% compared to final quarter of 2015, and UK industry has fallen into recession after two successive periods of negative growth in Q4 (the fourth quarter) of 2015 and the Q1 in 2016. Though it would be both naïve and plain wrong of me to attribute this growth slowdown completely to uncertainty, it is at least partly responsible. If seen in the results for the second quarter of the year, it does pose a question – if we’re seeing this kind of trend in an economy which is merely discussing the possibility of abandoning the status-quo, then what results will we see if the UK does actually vote to leave? Further slowdowns in growth, coupled with a very real possibility of contraction of the economy are the most obvious guesses.

The uncertainty goes further. We’re already starting to see markets pricing the risk to the economy, the most obvious of which is in the CDS spreads (Credit Default Swaps – essentially the cost of insuring UK debt against a default). The spread allows the cost to be compared to other economies and the Eurozone to see how the market is pricing the individual risk of default). In the 6 months to April 2014, costs have nearly trebled, nearly reaching the Eurozone level as a whole and overtaking both the US and Japanese cost. What does this mean? The markets see the country as a risky prospect, the problem with that is that businesses don’t invest in a risky economy.

Kierzenjowski et. Al (OECD)

The long term effects are perhaps more of a significant worry, however. One such effect is the predicted impact on Foreign Direct Investment (FDI) – investment by foreign investors in UK businesses or other entities. The scale of FDI in this country is huge, with FDI stock estimated to be over £1 trillion and roughly half coming from within the EU. Part of the appeal for non-EU investors is the UK’s access to the single market – access which we may or may not have if we choose to leave. EU membership has had a huge effect on the level of FDI – the Centre for Economic Performance estimates that membership has increased FDI by around 28%. 

But why does it matter? What impact will this have on our everyday lives? For a start, studies have found that (for varying reasons) FDI has (among others) the benefit of enhancing productivity . This would suggest a positive correlation between GDP and FDI levels and empirically we find that to be the case, especially in an economy with such a large service sector.

Based on a conservative model, if the UK were to leave the EU, we would expect to see a 3.4% reduction in real incomes, a loss even greater than the anticipated drop in trade and a figure which translates to £2200 per household – not small change.

Another issue I want to just briefly address is the supposed reduction in the contribution to the EU budget. The net contribution to the EU budget, once total public sector receipts have been applied, was £8.5billion in 2015- but it is a fallacy to think we will no longer have to contribute to any organisation should we leave the EU. There are thought to be four options for trade agreements – the Norwegian Model (joining the European Economic Area), the Swiss Model in which they negotiate individual treaties to take part in any initiatives, re-joining the Free Trade Association (FTA) or trading through the World Trade Organisation.

I don’t have time to describe exactly what each one entails- it’s safe to say each comes with its own disadvantages- but I’m going to briefly describe how their contributions compare to ours. Norway are part of the European Economic Area; essentially this is just jargon for saying they are part of the single market but not full paid-up EU members. Compared to the UK, the net contributions are only 17% lower and come with disadvantages in the form of having no influence over EU decision making and potentially facing higher costs in trade.

The Swiss Model is significantly ‘cheaper’ than the Norwegian model- it’s estimated that the contribution to the EU budget is 60% lower than the UK’s contribution per capita. However there’s no guarantee of market access that the EU provides, and again, the UK is shut out of influencing key EU decisions.

Rejoining the European Free Trade (FTA) agreement is the third option and, though there is no obligation to contribute to the EU budget, increased non-tariff barriers between the UK and the EU are likely to arise, as well as greater restrictions on the free movement of people (it’s worth remembering that migration has been found to have a positive net effect on the economy).

The final option is to be governed by the World Trade Organisation. This would increase the cost of exporting for UK firms relative to the EU, there would be no right of access to EU markets and the same issue with free movement of people that was present in the FTA would also apply here.

The conclusion of all this? There are trade alternatives that the UK could choose to pursue but each one has its flaws. For some, this is the insignificant reduction of contributions to the EU budget, for others it’s the increased difficulty and cost of trading within Europe. There’s no straightforward alternative.

I said that I wasn’t going to talk about the political side of this argument but I feel I must say something brief in conclusion. Economically speaking, this decision appears to be a no-brainer – the net effect of being in the EU on the UK economy is positive. However, this debate is a wider discussion than just the economic consequences and I understand that the political landscape and ‘ever-closer union’ that the EU appears to be striving for is a potential cause for concern and there are countless other issues that will influence the way people vote. All this means that I think the decision over whether to leave the EU will come down to one key battle – nigh-on ensured Economic prosperity, or political sovereignty. Which will you choose?