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Britain’s vote to leave the European Union was more decisive than anticipated with almost 8 per cent more voting to exit than to remain. While this is a clear margin against continued membership of the EU, there is very little clarity about what comes next.  

The first round of uncertainty was transmitted by financial markets jolted into a “risk-off” mode with sharp falls in stock markets and bond yields and with the pound falling across the board and most dramatically against safe-haven currencies.

While the range of contemplated directions has expanded to include the “Bregret” possibilities of a repeat referendum or a refusal of the UK Parliament to pass the legislation required to withdraw from the EU, the more likely scenarios are those that follow through on at least some form of Brexit. There are Brexit-lite possibilities and there are more alarmist scenarios that include Brexit fuelling a wave of populist insularity that leads to the breaking up of the EU and the end of the era of globalisation.  

Whatever directions eventuate, the intervening uncertainties come on top of the unconvincing struggle for momentum post-GFC and associated experimental monetary policy; the refugee crisis and the questions over the sustainability of China’s rebalancing act.   Renewed volatility on global markets and falls in business confidence, investment and consumer sentiment over the remainder of 2016 and well into 2017 seem very sure bets. 

Leaving and replacing the EU

If excessive bureaucracy was a factor behind the vote to leave, there will be no immediate pay-off with extensive demands for bureaucratic effort over the next few years.

Article 50 of the EU Treaty stipulates that the UK must formally notify the European Council of its decision to leave. This does not need to occur immediately and Prime Minister Cameron has stated that notification would be up to his successor (not likely to be in place until September or October).  Once notified, the EU would formally commence talks on a range of issues between the UK and other EU members.  If no deal is reached or there is no agreement to extend the negotiations, membership would terminate two years after notification.  In the meantime, the UK would continue to abide by EU treaties and laws.

Depending on the path taken, the UK could also need to commence negotiations over the range of bilateral and multilateral agreements that could be required to replace those it currently participates in courtesy of its membership of the EU.

The UK could also need to work out a practical way to deal with the myriad of EU laws and regulations currently enmeshed into the UK political and economic system. A ‘one by one’ approach involving Parliamentary consideration of each item on an individual basis would appear infeasible.  At the other extreme, an omnibus bill converting all EU laws and regulations into UK law is unlikely to gain support.

Practical solutions and clear progress on these issues will be fundamental to rebuilding business confidence and providing the certainty needed to underwrite business decision-making.

Brexit lite

These practical considerations could tilt the odds in favour of a Brexit-lite approach under which Britain could negotiate arrangements with the EU that respecified rather than redefined the relationship. This sort of outcome appears to be contemplated by Brexit campaigner Boris Johnson when he said in the wake of the vote:

I cannot stress too much that Britain is part of Europe, and always will be. There will still be intense and intensifying European cooperation and partnership in a huge number of fields: the arts, the sciences, the universities, and on improving the environment. EU citizens living in this country will have their rights fully protected, and the same goes for British citizens living in the EU. 

British people will still be able to go and work in the EU; to live; to travel; to study; to buy homes and to settle down. As the German equivalent of the CBI – the BDI – has very sensibly reminded us, there will continue to be free trade, and access to the single market. Britain is and always will be a great European power, offering top-table opinions and giving leadership on everything from foreign policy to defence to counter-terrorism and intelligence-sharing – all the things we need to do together to make our world safer. 

There is a number of forms that such a re-specification could take. Britain could become a member of the European Free Trade Association (EFTA) and participate in Europe as a non-EU member.  Other members of the ETFA are Iceland, Liechtenstein, Norway and Switzerland.  Switzerland has a somewhat more removed relationship with the EU than the other EFTA members.  The EFTA has an extensive network of FTAs with non-European countries.

An alternative approach to respecification could be achieved by Britain negotiating an expansive Free Trade Agreements with the EU along the lines of the recent EU-Canada FTA. In addition to traditional market access issues, the EU-Canada FTA includes areas such as trade and investment facilitation, competition, mutual recognition of professional qualifications, financial services, e-commerce, sharing science and technology and which also facilitates a regulatory co-operation framework.

The EU’s Dilemma

The UK is the second largest European economy and the fifth largest globally. If considerations were purely economic and there was no possibility of further withdrawals, there would be a strong case for the EU to put aside any sense of abandonment and do all it could to secure a Brexit-lite solution that provided the greatest possible degree of reintegration of the UK.  The EU could also seek ways to preserve in part the important roles the UK plays in the EU as counterweight to German dominance and as a key supporter of liberalism and smaller government. 

However, the EU will also have to deal with the possibility of additional withdrawals and will be wary that navigating a position that is attractive to Britain could also serve as an enticement for other potential exits. How well it manages this dilemma will be a key influence on the eventual outcome of Brexit.  

The British Economy

Brexit poses very significant challenges for the UK’s economy. Already the rating agencies have downgraded its credit standing.  The pound has fallen steeply and there is a strong expectation of a need for central bank easing over the next couple of months. 

Fewer opportunities for British businesses in Europe will create pressures to reorient, restructure and downsize. Half of Britain’s exports go to (or at least via) Europe.  It is the EU’s leading provider of financial services with approximately 25 per cent of the EU total and 40 per cent of its financial services exports.  Global companies that use the UK as a EU base are already said to be considering reducing their UK presence in favour of Continental (or Irish) options.

As these impacts start to play out and until the plethora of uncertainties – large and small – are clarified, business decision in the UK making will be disrupted.

In the longer-term new regulatory arrangements and new agreements governing international trade, and investment will provide new foundations and it is feasible that they could serve the UK as well as or even better than is currently provided by its EU membership. This new foundation could also provide opportunities for non-European countries to gain greater access to the attractive UK market than was possible while it was in the EU.   If the new relationships with non-European countries combined with a continuation of strong ties with EU members, the ongoing impacts need not be negative.  In this scenario the costs would be more or less limited to the short and medium-term disruptions.

On the other hand, another plausible outcome is that Britain could find itself with less access to the EU and with less attractive alternative trade arrangements and fewer international opportunities. In this situation it suffers both the disruption and an ongoing exposure to a diminished opportunity set. 

British Politics

For the more favourable longer-term scenario to play out, the EU will need to be receptive to a Brexit-lite approach and the UK will need to recommit to free-trade and internationalisation. For the UK, doing so will require taking a direction that is very different to that envisaged by many Brexit supporters.  

The fundamental difficulty that both the UK and the EU will need to confront is the climate of alienation from economic liberalism and globalisation that is evident across most developed countries.

The past quarter century may have lifted hundreds of millions of people in emerging economies out of rural poverty and incorporated them into the global economy but this has echoed across OECD countries in the form of real wage stagnation for many and growing internal inequality.  

Among the counting areas that voted to leave the EU, those with lower proportions of people with a university degree were overrepresented as were areas with a high reliance on exports. At the risk of oversimplifying, it is no coincidence that voters who are less skilled and more exposed to trade and for whom the impacts of the economic upheavals of the past couple of decades have been unfavourable voted against continued membership of the EU.

The authority of the UK’s existing political leadership has been thoroughly undermined by Brexit and a potentially dangerous vacuum has formed. There is an immediate challenge for a new leadership with a new approach to winning the hearts and minds of those who feel they are not benefiting from the more globalised world order.  It is no comfort that the alternative of populist insularity is likely to carry few if any benefits for the people who voted to leave the EU.