On June 23, 2016, 51.9% of the voting citizens of the U.K. voted to leave the European Union. This post will go over the economic context of the UK in and out of the EU, and will lay out my thinking as to why Brexit is a bad idea. This post is not intended to be political, and any opinions you read are my own and should not be treated as official advice.
The U.K. economy has been interwoven into the E.U. economy since 1993, and in 2016, accounted for 16% of its GDP, second only to Germany. For comparison, the E.U. GDP was 14.8 trillion Euros, and at an exchange rate of about 1.12 USD/EU from the beginning of 2017, equates to $16.576 trillion, roughly 75% of the US GDP of that year (http://ec.europa.eu/eurostat/web/products-eurostat-news/-/DDN-20170410-1). The U.K.’s unemployment sits at 4.3%, around the same as the US, and their economic growth was 1.8% in 2016, roughly the same as the US again. You can debate whether this number is good or bad, but it tracks the western-economy-wide gradual recovery from the Globl Financial Crisis of 2007-2009, that being, economy grows slowly, jobs added slowly but reliably, persistently low wages and consequently inflation.
Given that the UK has been tracking the global economic recovery so well up until Brexit, why would they want to leave? The nationalistic wave of political economics that swept up much of the world in 2016 and 2017 is one answer, but there is a better explanation having to do with economic forces. Let’s talk about a few, Supply and Demand, and International frameworks.
As with most things economic, the first rule to know is supply and demand. In our discussion over Brexit, since Land is a fixed means of production, this rule applies to Labor and Capital. The European Union’s single market eliminated tariffs and restrictions between member states on the flows of Labor, Capital, and Goods and Services. Workers from poorer countries, mainly in Eastern Europe, had the ability to work in richer countries, such as Germany and the UK. It is in this way that lesser jobs in those richer countries were taken by foreign labor, and higher skilled jobs were left in all countries for people who had the expertise to handle them. Sounds familiar, no? Next time you hear about how illegal immigrants from South of the US border are taking American jobs, think of this.
At face value, this seems like a net negative. Foreign labor comes in to take the work of domestic labor? Reread the above paragraphs and you’ll be surprised to know that the UK has an unemployment rate of less than 4.5%. Economists in the US consider ‘full unemployment’ to be about 5%, to account for seasonal layoffs and hiring and the general business cycle. With unemployment so low, even with foreign labor working lower skilled jobs, where is the negative?
The negative, friends, is what happens when that foreign labor leaves. Brexit means leaving the EU, and leaving the EU means leaving the single market. Foreign labor will have a tougher time entering the UK to do low skilled work, and who else would do that work? Would you want to wait tables or clean bathrooms when your country offered you nearly free education and incentives to do much higher paying work, like finance or medicine? We’ll come back to Labor in a minute.
The second barrier that Brexit will cross is that of International Frameworks. While the UK is a member of the EU’s internal single market, it is not a member of the monetary union. The Monetary Union is the single unit of exchange between all participating countries, or simply put, the Euro. Having every participating country use one functional currency allows goods and services to be quantified the same way among each country, but more importantly, it simplifies Purchasing Power Parity. PPP is the relationship between different currencies and exchange rates, and dictates essentially that the difference in purchasing power between two different currencies is limited to their exchange rate, all else equal. Meaning, if the Euro was trading against the Dollar at 1:1.5, then one Dollar would buy you one good, and one Euro would buy you 1.5 of that same good, so more Dollars are required to purchase the same amount of goods.
The UK does not participate in this monetary union, so they would normally have to rely on the Pound Sterling, the UK’s currency, to maintain parity without much volatility in order to proceed with trade in a predictable manner. The single market largely made up that gap by making labor and capital flows ubiquitous among all member states, meaning the UK had a market to both acquire means of production, and sell their finished products, without much hassle. The Pound was able to float alongside the Euro and currency fluctuations wouldn’t make that much of a difference.
The problems begin when the UK decides to leave that single market, and when they do, the tariffs the EU imposes on non-member states would retroactively apply to the UK. Their currency fluctuations would matter a whole lot more, as a weaker Pound would mean UK consumers wouldn’t be able to buy as much foreign goods, and a stronger Pound would mean UK businesses wouldn’t be able to sell as many of their products.
The two issues of Labor and Currency combine in a very bad way when the wrong policies are sought after. Less labor supplied for low skilled work, such as farming or basic manufacturing, means that supplies of food and basic materials would drop. This would push up prices of those goods, leading to rising inflation. Couple that with UK businesses being able to sell less of the goods they produce to foreign countries (because of the new tariff rules from leaving the single market) and there will be less domestic economic growth. Lower Economic growth and rising inflation is called Stagflation, and if you want an example of how bad it can be, look at the 1970’s oil crisis. The best way to fight stagflation (a rapid appreciation of the currency) is to rapidly raise interest rates and ‘beat inflation back down’ to a more manageable level. Unfortunately, this would raise borrowing costs of businesses to an unsustainable level (because remember, a stronger currency to make up for the increased prices means domestic businesses grow slower and sell less) and may cause a deep recession.
To wrap up, take a look at this article from the Wall Street Journal (Bank of England Raises Interest Rates for First Time in a Decade- The Wall Street Journal.
Bank of England Raises Interest Rates for First Time in a Decade https://www.wsj.com/articles/bank-of-england-raises-interest-rates-for-first-time-in-a-decade-1509624422). The Bank of England raised their interest rate for the first time in a decade. From a US standpoint this is a good thing, because when the Federal Reserve raises rates, it usually means the economy can sustain the hike. But the UK raised their rates because the Pound fell, pushing inflation higher. The article says that the UK economy only grew at a rate of 1.5% over the last year, significantly less than even the lower US growth estimate, but it also said that inflation had topped 3% and showed no signs of slowing down. Raising interest rates simply to combat inflation means the underlying economy cannot sustain those higher rates on a fundamental level, and will suffer because of them.
In summary, we’ve gone over some context to the UK’s economic position and some possible effects of them leaving the EU. All this is, of course, secondary to what the people voted for, and elected officials must see the will of the people done in a democracy such as theirs. However, I encourage you to do your own research as to the effects of policy decisions, and to not underestimate the effects of politics on an otherwise healthy economy.