Finance: Research, Policy and Anecdotes

Three days after the Brexit vote – some early thoughts

Also published on All About Finance.

The vote to leave the European Union by a majority of British voters is a historic watershed moment.  It is almost impossible to spell out all the implications that this will have for the UK, the European Union, global cooperation and the global, but especially UK, economy.  We economists have been ridiculed during the campaign for providing a rather negative outlook for a UK outside the EU and while predictions on the growth impact of Brexit to one digit after the comma are certainly hard to believe (rather than stressing that these are predictions of a mean impact across a range of possible growth outcomes), the UK is slowly waking up to the reality that the “experts” might not have been so wrong after all. And it is easy to predict that the high degree of uncertainly, in financial markets, in exchange rates and therefore inflation rate, all driven by the uncertain future relationship between the UK and the EU and its political and economic repercussions, will result in a recession.  And while some of this uncertainty has a self-fulfilling effect on consumer demand, there are important supply-side channels, such as that financial institutions might be less willing to support the real economy, given the high degree of uncertainty. It seems all but certain now that the UK will slip into recession: length and recovery will certainly depend on how quickly certainty can be established on the future of the UK relationship with the EU.  

Beyond the immediate effect of the Brexit vote on the economy, what are the longer-term repercussions? Specifically, what are the repercussions for the financial center London of a possible exit of the UK not just from the EU but also from the Common Market (thus not choosing the Norwegian or Swiss model)? Well, one institution will certainly have to relocate: the European Banking Authority, responsible for ensuring effective and consistent bank regulation and supervision across the European Union (and thus beyond the Eurozone).  As banks in the UK would lose their passporting rights across the EU (which allows a bank authorized, regulated and supervised by one of the bank regulators in the European Economic Area to be active across the EEA), London would become less attractive as location for European and non-European banks.  And there will certainly be a lot of political pressure to relocate much of the euro-related trading away from London to Frankfurt and Paris.  

Will the Brexit lead to substantial regulatory deviation of the UK from the rest of Europe?  This is somewhat doubtful. First, the major regulatory reforms after the Global Financial Crisis have been initiated on the global rather than European level, including the Basel III accord.  Second, UK banks that want to continue to be active across Europe will still have to comply with EU law.  The EU will also pressure the UK to not adopt too light-touch regulation that might result in negative externalities for European host countries of London-headquartered banks.    However, the Brexit will certainly make cross-border regulatory cooperation more difficult, with one major player - the Bank of England – being outside the EU institutional framework.  

Beyond the financial system, Leave campaigners have suggested to get rid of red tape and unnecessary regulation "forced upon" the UK by the Brussels bureaucracy. As pointed out before, some of this red-tape is very much home-made, while being EU member has not prevented the UK from offering one of the most market-friendly business environments in Europe.  Importantly, the devil is in the fine print – many of these regulations are part of national legislation; a decade-long challenge for UK government officials and MPs.   Not to speak of the constitutional repercussions for the devolution of Scotland and Wales, which relied on some of the policy responsibilities being shifted from London to Brussels and which will now have to be renegotiated (and not to forget the possible need to reintroduce border controls in Northern Ireland).  More generally, one can expect a long soul-searching policy debate in the UK about the future role of the state, a topic on which many of the Leave campaigners and their voters certainly do not see eye-to-eye.  Just observe the recent discussion on possible state aid to keep the Tata-owned steel plants in Wales open; state aid is rather restricted under EU law and would certainly also not be consistent with the libertarian approach of some of the Leave campaigners; however, there will be much more political pressure in an “independent” UK to provide such state aid.  

As the UK woke up on Friday morning, there was an intense discussion of a split country among many dimensions: geography, income level and education. One important split was along age groups, with the overwhelming majority of below-25 years having voted for Remain.  Looking at my own (EU passport holding) teenage boys, I can understand the recriminations that British teenagers and young adults will make their parents and grandparents for taking away their opportunities of moving freely around the European continent in the future. 

On a final note, one wonders whether this first major reversal of European integration after 60 years is part of a broader trend that points to the end of a long globalization cycle. Populist movements calling for more nationalist and closed societies  have gained strength across both sides of the North Atlantic. For Europe the question is whether the dam has broken or whether this crisis will be the one not wasted, in terms of fundamental reform!