The departure of the UK from the EU at 23h GMT today will be a defining moment for Europe. For the first time ever, the 70-year process of European integration that has helped to underpin an unprecedented period of peace and prosperity in Europe is going into reverse in a meaningful way. In a rapidly changing world in which the disruptive forces that gave rise to Trump and Brexit remain strong, the way ahead will be bumpy. With Brexit, the EU share of global GDP falls from 22.1% to 18.8%. The loss of the UK‘s soft power and its extensive diplomatic ties adds to that.
Below, we discuss:
| the economic and fiscal consequences of Brexit for the EU and the UK, |
| the outlook for future political co-operation, and |
| the likelihood that the UK may – or may not – decide to draw closer again to the European mainstream in the future. |
EU27: towards a club of clubs
Following last year’s political chaos in the UK, the risk that any other country will want to follow the UK seems low for the next few years. Many anti-establishment populists across EU countries have mellowed their erstwhile EU-scepticism. In this sense, the EU27 and the euro look fairly safe for the time being.
Facing up to the Brexit trade-offs and agreeing on an exit deal has been more painful for the UK than for the EU27. By and large, the big EU27 stuck to its initial negotiating position, forcing the UK to choose from the options on offer. The EU27 sees Brexit as a major and regrettable setback. However, the EU27 is pleased that it conducted the divorce negotiations without serious internal discord.
As long as the EU27 maintains a common position, it can use the conditions under which it grants access to its huge internal market as powerful bargaining chips in negotiations with others. Taking its cue from the US and China, we expect the EU to wield this tool more decisively than before, and not just in the upcoming talks about post-Brexit relations with the UK. Of course, a better use of its power cannot fully offset the fact that Brexit reduces the global weight of the EU.
While external challenges are forcing EU members to work together more closely, serious internal divisions exacerbated by the rise of anti-establishment parties are preventing progress in many areas. Even without the UK, finding a consensus will not become much easier. In the absence of a major crisis that could concentrate minds, as it did during the euro crisis when the EU devised new rules and institutions such as the European Stability Mechanism in a rush, changes in EU27 and Eurozone governance will be gradual and haphazard.
Noisy muddling through remains the hallmark of the EU. Half-baked compromises struck at late-night sessions in Brussels may not be edifying. But relative to all other ways of managing differences between close neighbours over time, the EU compromise machine still works quite well. For EU members, the need to regularly discuss and resolve a wide-ranging array of issues with each other imposes a healthy discipline. Countries tempted to misbehave too badly know that they would pay a price soon on other issues of mutual interest. Even the governments of Hungary and Poland are being forced by the EU to rein in their half-authoritarian temptations.
Over time, we expect the EU27 to slowly evolve even more into a club of clubs. The Single Market, democracy, the rule of law and respect for human rights will be the common basis that is mandatory for all members of the club. On that solid basis, integration on select issues will proceed mostly among coalitions of the willing. The euro is the key example for this. As a club of clubs, the post-Brexit EU may look ever more like the kind of EU many Britons had wanted it to be: a common market with little need to participate very much in other aspects of integration. Foreign policy and military cooperation could be key areas for deeper cooperation between many but not all EU members.
Economic consequences of Brexit
The UK has thrived during its time as an EU member. Having transformed itself from the sick man of Europe of the 1970s into one of the most vibrant and well-regulated economies of the advanced world, the post-Brexit UK will maintain many of the features that have made it a good place to invest and create jobs. We estimate that a lesser inflow of qualified migrants from the EU27 and reduced access to its biggest export market can cut UK trend growth from 2.0-2.1% to a still respectable 1.6-1.7% in the future.
The extent of the damage will depend on the future framework for cross-border exchanges between the UK and the EU. Backed by a strong Conservative majority in parliament, UK Prime Minister Boris Johnson seems unlikely to renege on his promise to not extend the economic transition period beyond 2020. Amid considerable noise in the run-up to the EU summit on 10-11 December, we expect the UK and the EU to conclude no more than a bare-bones deal for frictionless commerce for many goods and for close co-operation in some other areas by the end of the year. For many services, we may get no more than temporary stopgaps akin to the provisions prepared in 2019 to contain the immediate fallout from a potential no-deal hard Brexit.
Subsequent negotiations should eventually lead to a more settled future economic relationship. Judging by the UK‘s insistence on its right to diverge from EU rules, standards and regulations, that relationship may not be closer than that between the EU and the much more distant Canada. Such a semi-hard Brexit would imply serious and costly impediments to EU-UK commerce. However, the damage will only be felt over time as long as temporary fudges prevent an end-2020 cliff edge.
Of course, the UK could offset the damage through pro-growth structural reforms at home. The scope for that seems limited, though. The UK could easily have implemented almost all such reforms, such as those needed to fix the housing market, as an EU member already. Prime Minister Boris Johnson will likely score political points by abolishing some specific and highly visible EU regulations. Expect some attention-grabbing photo opportunities in this respect. However, we do not expect the UK to turn itself into a Singapore on Thames. The fiscal deficit and long-term spending commitments linked to healthcare and an ageing population are too high to sustain a low-tax dream. Also, UK voters are unlikely to endorse a massive deregulation and/or a wholesale switch from EU to US food hygiene standards. In addition, the UK would pay a heavy price for it as an extensive divergence from the European mainstream would further reduce its access to the EU Single Market.
The economic impact of Brexit on the EU27 will be minor. Exports to the UK account for c3% of EU27 GDP whereas the UK earns 12% of its GDP by selling goods and services to the EU27. The EU will face less privileged access to one of its major markets, which will also be less dynamic on trend. The damage will be roughly offset by some diversion of trade, investment and skilled migrants away from the UK to the EU27.
Fiscal consequences
In the UK, the costs of Brexit will likely be obscured for the next few years by a major public spending spree coupled with some tax cuts. The fiscal stimulus may reach 0.6-0.8% of GDP this year and a further 0.2-0.3% in 2021. In this sense, the initial result will be more public debt rather than subdued economic growth. Over time, less dynamic trend growth will exacerbate the future fiscal challenges for the UK.
In the EU27, the fiscal consequences of Brexit will be minor. Brussels will miss the UK’s net contribution to its budget of €10.6bn in 2018. But that is less than 0.08% of EU27 GDP. The UK will continue to honour its legacy financial obligations according to the divorce agreement, for an estimated total of c£33bn. The EU27 will thus feel the fiscal loss only gradually over time. However, the departure of the UK will complicate the negotiations over the EU’s next seven-year financial framework 2021-2027, to be discussed at a special EU summit on 20 February. In the end, we would not be surprised if Germany picks up close to half the bill over time if other net contributors also share part of the burden and the net recipients accept some conditions in return within the usual package deals to tackle EU problems.
Political co-operation
Geography, history as well as close economic and cultural ties suggest that the post-Brexit UK will remain closer to the EU than to any other region of the world. In dealing with, say, Russia, China and Trumpian bouts of “America first” as well as other threats to global trade, the UK has little to gain from playing its own games instead of trying to co-ordinate with its mostly similarly-minded neighbours. Size matters. With Brexit settled, London may even find it politically easier occasionally to agree a common approach with its key EU neighbours. The Conservative government will not have to watch out for anti-EU hecklers from its own ranks as much as before.
The real difference will be that, in genuine European affairs such as the future of the Balkans, Ukraine, Turkey and the further evolution of the EU itself, London will no longer have a say. Instead of shaping its neighbourhood, the UK will simply have to adjust to whatever happens on the other side of the Channel.
Back to the EU in the future? Probably not
For two reasons, we consider it highly unlikely that the UK will try to rejoin the EU in the foreseeable future. First, settling the divorce from the EU was such a bruising experience for the country and both of its dominant political parties in 2019 that they will shy away from the issue of EU membership for a long time. Second, most UK citizens will likely experience Brexit year 2020 as a year of relief after the 2019 upheaval rather than a year of trouble. The fiscal stimulus will see to it that the costs of Brexit will not become obvious yet. And once they do so, many voters may not attribute either these costs or the future need for austerity to pay for the current spending spree with Brexit.
Of course, an initial semi-hard Brexit with a bare-bones deal on future economic relations between the UK and the EU, and some subsequent arms-length arrangements for individual sectors, need not be the last word. We would not be surprised if, after a future swing in the political pendulum in the UK, London may be willing to upgrade its economic relations with the EU again by negotiating new cross-Channel deals. This may take quite a while, though. For the time being, we all have to get used to a UK that – in economic more than in political term – is drifting somewhat apart from the rest of Europe.
Holger Schmieding
+44 7771 920377
Kallum Pickering
+44 20 3465 2672
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