Brexit referendum - UK votes 'leave'

Brexit referendum - UK votes 'leave'

Brexit picture

Referendum result

In an historic referendum vote, the UK has voted to leave the EU – with 51.9% voting to leave, against 48.9% who voted to remain. The ‘leave’ vote will trigger Article 50 of the Treaty on European Union (The Lisbon Treaty), which states that negotiations should be fully completed within two years of the formal notification to the European Council of the intent to withdraw.

The date for formal notification is uncertain given the resignation of the Prime Minister, David Cameron. Notification will depend upon the appointment of Mr Cameron’s  successor, which is likely to be made in October*.

Theresa May*The UK has now appointed a new Prime Minister, Theresa May (appointed on July 11th, 2016), who formally takes office on Wednesday, July 13th.


The Bank of England Governor, Mr Mark Carney, stated on Friday (June 24th) that he was ‘..well prepared for this..’ ‘..with extensive contingency planning..’. He went on to say that the Bank ‘.. will not hesitate to take additional measures as required as those markets adjust and the UK economy moves forward..’..and is ready to provide more than £250bn of additional funds, and provide substantial liquidity in foreign currency, if needed.

Despite the short-term turmoil in the financial markets, the fundamentals of the UK economy, prior to Brexit, were sound and it remains to be seen what the next few weeks and months will bring – especially in terms of political stability.

How ‘messy’ the divorce will be will depend on the approach of both parties – the EU and the UK.  Indeed, the US may have something to say on this, given that as smooth a transition as possible is also in the interests of America. Despite the rhetoric, it is clearly in the interests of all parties to come to an agreement, but until the UK government takes the initiative, and constructs a plan for withdrawal, including setting out its negotiating position, the uncertainty is likely to continue.

Donald Tusk imageA statement by European Council President, Donald Tusk, said ‘.. We are prepared for this negative scenario. There will be no legal vacuum..’.


UK Economy – a shapshot

GDP graph

EU, US and UK unemployment

Unemployment image

More on Unemployment

CPI image

More on Inflation

Deficit image

More on Public finances

current account %

More on Trade

Brexit – the economic battle lines

Earlier report – analysing post-Brexit options

On the surface the economic case for the UK remaining in the EU seemed an open-and-shut one. As well as a host of highly supportive national reports, including those from Her Majesty’s Treasury (HMT), the Institute for Fiscal Studies (IFS), and the National Institute for Economic and Social Research (NIESR), analysis by the leading international organisations, including the OECD and IMF, conclude that the economic risks to the UK of leaving outweigh any benefits. Add to this the 600 economists who, in a recent poll (by Ipsos-Mori) declared their opposition to Brexit, it would seem that the economic battle has been won. There is a broad consensus that Brexit would create a sizeable negative short term shock, followed by a lengthy period of low growth, will fall-out adversely affecting the value of sterling, inflation, productivity and jobs.

However, dig a little deeper and things become less clear. What assumptions have been made by the forecasters, and what data have been put into the econometric models? How have they factored-in changes that the EU might make in the future that may be against the UK’s economic interests (but are not effectively resisted by the government of the day?).

Of all the recent official reports, the one from the IFS – which covers the effect of Brexit on trade, productivity, growth, and public finances – is recognised a being the most influential given it historical independence from government.

The IFS and Treasury view

So what can we agree on? As the IFS states, the main benefits of membership of the EU can be summarised as:

  1. Tariff-free access to other member’s markets, which reduces the costs of trade, and creates trade between members
  2. No customs check or controls on the movement of goods between EU members
  3. A single market with common regulation creating a level playing field
  4. Further access to 55 other markets through numerous EU-Free Trade Agreements (FTAs)
  5. Common external tariffs on non-member imports

Add to this the indisputable fact that UK trade as a share of national income – trade openness – has risen to over 60% in the past decade, compared to under 30% in the years before the UK joined the EU, the case against Brexit would seem overwhelming.

Trading scenarios if the UK leaves the EU

All reports looked at similar trading scenarios should the UK vote to leave on June 23rd, including:

The European Economic Area (EEA) scenario

This scenario involves the UK leaving the EU, but continuing as a member of the wider European Economic Area (EEA). The EEA includes the existing 28 EU countries, together with the European Free Trade Area (EFTA) states of Iceland, Liechtenstein, Norway and Switzerland. EFTA was founded in 1960 as a counterbalance to the more politically driven European Economic Community (EEC) as it then was, and included Austria, Denmark, Norway, Portugal, Sweden, Switzerland and the United Kingdom. In 1973, the United Kingdom and Denmark left EFTA to join the EC (as it had then become) and were followed by Portugal in 1986 and by Austria, Finland and Sweden in 1995. In recent years, EFTA’s has successfully concluded free trade agreements with North America and Asia. Supporters of this option have argued that the UK could, fairly quickly, become a 5th member of EFTA.

However, in this scenario there would still be free and uncontrolled movement of labour, and a budget contribution to the EU, while at the same time EFTA-only members have no influence on EU trade rules. It also means that there is no free trade in agricultural goods and in terms of fishing tariffs. There seems a consensus among analysts that this EU-lite option would put the UK at a significant disadvantage in terms of influencing the direction of the EU going forward.

The EU-UK Free Trade Agreement (FTA) scenario

This option would involve the UK negotiating a completely new free trade agreement with the EU, similar perhaps to that enjoyed by Canada. Clearly this would involve a lengthy negotiation period, perhaps with the EU dragging its feet somewhat in the wake of a ‘leave’ vote.

The WTO scenario

The WTO scenario means that a country’s trade is subject only to the rules of the WTO club. If the UK left the EU and adopted this approach it would be subject to the Most Favoured Nation (MFN) rules of the WTO. The main principle of this WTO rule is that countries should not be discriminated against. This means that, in the absence of specific FTAs, WTO members enjoy the same treatment, in terms of trade, as the most favoured country. Hence, if one member grants another member a special favour, then this favour should be conferred on all other members. Adopting this policy would mean that the UK would not have free access to the EU, and of course cannot influence EU trade rules.

The Unilateral free trade scenario

This is a variant of the WTO scenario, where the UK faces the tariff levels agreed through the WTO, but reduces its tariff levels without any reciprocal reduction by trading partners. This is widely thought to be the least likely option following Brexit, although New Zealand and Singapore have adopted this approach. The models used by key forecasters place this option at the bottom of the pile in terms of benefits to the UK.

However, the Economists for Brexit group – including Roger Bootle, founder of consultancy Capital Economics and Ryan Bourne, head of public policy at the Institute of Economic Affairs – who base their forecasts on the Liverpool Model, developed by professor Patrick Minford (now of Cardiff Business School) – would prefer the unilateral free trade route.

The economic effects of leaving

For those using the popular gravity-based forecasting models, there is a clear consensus that the main economic effect of leaving comes from changes to the costs of trade (a key element of the gravity model), to FDI flows, to migration and to regulation. None of these forecasts leave any doubt that Brexit would create a negative economic shock in the short term.


The uncertainty shock is likely to be amplified by the uncertainty surrounding the policy framework that would be put in place while the UK triggers Article 50 of the Treaty on European Union (The Lisbon Treaty) – the Article that governs how members can negotiate a withdrawal from the EU. It could be argued that this uncertainty is, in part, a direct result of the current UK government not having a Plan B in place – which would clearly reduce uncertainty. Supporters of ‘remain’ (Stronger In) including the UK government, clearly do not see it in their own interest to publish details of Plan B (if they exist). This puts the ‘remain’ camp at a considerable advantage because, in not releasing a Plan B, the level of uncertainty increases and therefore strengthens their hand! A well-formed Plan B would be the equivalent of turkeys voting for Christmas. The uncertainty is also derived from the fact that no country has ever exited the EU, with countries tending to be attracted to it rather than away from it.

Increasing costs of trade

The IFS takes the view that, in the longer term, the costs of trade will increase and this will feed into lower output and GDP. The precise effect of this depends, of course, on whether the UK joins the EEA, unilaterally engages in free trade, adopts the WTO rules, or develops a hybrid policy arrangement.

With unilateral free trade, where the UK simply reduces its tariffs to zero, the most likely effect is a reduction in the size of the agricultural and industrial sectors relative to the service sector, as the UK’s lack of a comparative advantage in agriculture in particular will be exposed in a free trade environment.  While this may well create advantages in the very long run, the IFS argues that there will be considerable economic costs associated with the period of transition, as well as considerable political constraints.

The IFS goes on to suggest that reduced trade will negatively affect GDP in two ways – firstly, a direct impact from a reduction in trade openness, with both imports and exports falling as a proportion of GDP, and secondly the knock-on effect on innovation, economies of scale, specialisation and productivity. This would make it difficult for the UK to achieve its key macroeconomic objectives, including price stability, sustainable growth and sound public finances.

Reduced FDI

In terms of FDI, the IFS concludes that it is most probable that flows will fall. This will reduce productivity (given that productivity relies on the level of capital investment) which will further reduce GDP. Lower FDI will have both demand and supply-side implications.

Lower regulation

Given that the EU sets regulation in many areas, including the environment, health and safety, employment and financial services, exit from the EU may lead to a reduction in the level of regulation, the IFS considers this to provide a minor benefit, given that the UK is a relatively unregulated economy compared with international standards, with the OECD suggesting that this is especially true in energy, transport and communications industries.


In terms of the economic effects of changes to migration as a result of Brexit, the IFS is at its most cautious, concluding that this is the single area exhibiting most uncertainty. Despite this, its view is that, depending on what policies are pursued, any change to the current patterns of migration will have a negative effect on GDP per capita. Migration is, of course, an area exploited by the ‘leave’ campaign, whose general assessment is that controlled migration is the more rational approach as it would enable the UK’s public services to ‘catch-up’ with changes in the pattern of demand and need. A controlled approach will, they argue, enable the UK to encourage migrants into industries and occupations where there is a specific labour requirement.

GDP per capita

According to Treasury estimates, GDP per capita will fall as a result of Brexit. The annual loss of GDP per household under the alternative scenarios after 15 years are:

EEA – £2,600
WTO RULES – £5,200

Lost jobs

If all of the above is proven to be accurate, then clearly jobs will be lost in terms of employment directly related to trade, and indirectly, which the Treasury estimates to be over 3m.

Public finances

Finally, the IFS considers the overall impact on the public finances, which will depend on two distinct effects – each of which is uncertain to some degree.

Firstly, the positive mechanical effect, which means that leaving the EU would strengthen the public finances as a result of a fall in net contributions of the order of £8 billion a year. (Gross contribution of £18.8 b, less the rebate and the return back of funds from the EU budget.) However, a second and stronger negative effect, the national income effect, suggests that the fall in GDP as a result of Brexit will weaken public finances. The Stronger In campaign, headed by David Cameron, have picked up on this claiming that spending cuts to public services are the most likely result of falling government revenues.

Why do the economic forecasters come to similar conclusions?

The fact that economists specialising in trade theory come to the same conclusion is that, ultimately, they share the same forecasting model – the gravity model. This was first presented in 1962 by Jan Tinbergen, who proposed that the size of bilateral trade flows between any two countries can be approximated by employing the ‘gravity equation’, which is derived from Newton’s theory of gravitation.

Brexit image

While planets are attracted to each other in proportion to their sizes and proximity, so too are countries. Relative size is determined by current GDP, and economic proximity is determined by trade costs – the more economically ‘distant’ the greater the trade costs.  So relative economic size attracts countries to trade with each other while greater distances weaken the attractiveness. Initially, the gravity model was seen as an empirical one, without any particular grounding in trade theory, but the widespread adoption of the gravity model to explain patterns of trade has been seen by economists as a significant development on previous theoretical models. These include the Ricardian model, that explain trade patterns in terms of differences in the distribution of technology, and the Heckscher-Ohlin model that relies on differences in factor endowments among countries as the basis for trade. In these pre-gravity models the size of an economy was not considered significant.

The stability of the gravity equation and its ability to explain bilateral trade flows led to the development of theories that could incorporate the model.  The gravity model is now seen at the workhorse of trade theory, and especially in terms of forecasting the impact of changes in trade policy on trade costs.

More on: gravity theory

The view from the LSE

The view of the LSE (Economists for Brexit – A critique) is as much a criticism of economic models that are not based on the gravity equation as an analysis of why the UK should not leave the EU. They are particularly scathing of the Liverpool Model, which has shaped Professor Minford’s view. In response to Minford’s claim that the UK’s GDP will improve by 4% after Brexit, they question his assumption that prices of imported manufactured and agricultural goods would fall by 10% under a unilateral free trade arrangement. The 10% number, they argue, does not come from looking at the actual level of tariffs – around 3% – but from looking at the estimated differences in producer price levels between the UK and other countries (using 14 year-old data), and suggests that these higher prices are entirely the result of EU trade barriers. As the LSE points out, price differences are, of course, the result of a variety of demand and supply-side factors, of which tariffs are one.


Despite the widespread consensus among the forecasters, it really is naïve to expect econometric modelling to be that precise when applied to a one-off and unique event. Forecasts regarding Brexit are based on a sample of one – which has not even happened yet! This is not to say that the forecasters will get it wrong, only that no-one will be that surprised if they do. Accurately forecasting the impact of a change from a known economic environment (the UK as a member of the EU) to an unknown one (the UK outside the EU), when there are no similar examples or reliable data, is by no means without its dangers.

It is possible that a new approach will emerge in the immediate days following Brexit or during the ‘out’ negotiations – including a hybrid version of the scenarios considered – that up to now has not be included in the current modelling framework.

It is also not known precisely how the EU will evolve in the future. Uncertainty regarding the evolution of the EU is a central plank of the Leave campaign. Even the most ardent supporters of the EU would accept that it is far from perfect, and has clearly evolved from a simple free-trade single market, to a politically driven Union which is largely undemocratic, yet increasingly powerful.

There is a view that forecasters are making the assumption that the UK government, in a newly formulated Brexit policy programme, will come up with harmful policies or hopeless trade agreements. If we reverse these assumptions, and assume that the UK government would quickly disengage with the EU, and proactively construct the most beneficial trading strategy and implement the most effective policy framework to ensure that the UK gains from free trade, while the EU at some unspecified point in time decides to implement ‘stupid’ policies, what then of the forecasts? Of course, those favouring the ‘remain’ campaign would argue that they can stay and fight the UK’s corner. The problem with much of this is that the EU does seem to have lost some of its vision along with the ability to deal with increasing problems (real or perceived) associated with economic integration and ever closer political relationships – the migrant issue being one of them.

What about the direction of the global economy in terms of services, and especially financial services? What of the future of the digital economy and eCommerce? Research suggests that, apart from the US, web users are highly inward looking, generating a strong ‘home-bias’ in favour of local suppliers and providers. While the internet should reduce ‘economic distance’ between countries, the home-bias effect may well counteract this. Can the EU cope with the new realities of a digital world? Should the UK cut loose from its orbit around the EU and connect more closely to the US, which dominates the digital economy, and where there may be much less ‘economic distance’ between the UK and US? What of China, and its presence in the global digital economy? Would leaving the EU enable the UK to have a closer relationship with China at the global and local levels? Of course, those in favour of remaining in the EU argue that such a relationship can be forged within the EU, but Euro-sceptics are yet to be convinced.

What will happen if the UK votes to stay – will the rest of the EU be unwilling to listen to the UK in any future negotiation knowing that the prospect of another in-out referendum is unlikely – will the UK be pushed ‘quickly down the pecking order’? Unfortunately, econometric forecasting may find it difficult to deal with such hypotheticals.

If the UK does decide to leave on June 23rd it may be more to do with the UK citizen’s apparent loss of faith in the political establishment of the EU than an expectation that the economic grass is greener outside. The old adage about elections – that ‘’s the economy, stupid..’ – may, in this case, simply not be true.