Just how bad will Brexit be, and can it be undone?

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By Simon Wren-Lewis. Published in the blog Mainly Macro on June 25, 2016.

Mediamacro love their focus on ‘the markets’, and this leads to talk that makes Brexit sound like a major financial crisis. It almost certainly is not that.

Impact on the UK economy

At the heart of Brexit is an act of self-harm to the UK’s trading industry (including, and perhaps especially, trade in services). But this is something that will evolve over the medium term as we gradually lose the benefits of the single market. It essentially means it will become more difficult for UK firms to sell stuff to the EU. Calculating the size of this effect is an exercise in trade economics not macroeconomics (see here for example). So it is not ‘intellectual arrogance’ to do this kind of analysis even if you think macro models have been a failure over the last 40 years.
This decline in trade leads to a loss in productivity which makes UK citizens poorer over the medium term. It also means that the real value of sterling has to fall to make up for the fall in net exports (any decline in imports that result from leaving the single market will be less than the fall in exports). Other things being equal, this fall in sterling will happen immediately, as indeed it already has. This will make people poorer immediately, because imported goods cost more. But here the macroeconomics gets complicated. The hit to trade from leaving the single market will evolve gradually, but the fall in sterling is immediate. (The reason is something economists call UIP.) That means that trading firms might get a short term competitiveness boost, even though this will evaporate in the medium term. This may or may not be enough to compensate for the short term impact of rising prices on consumption spending.
Unfortunately that is not all that happens in the short term. Uncertainty about future arrangements will hold back investment, and it may also add to the depreciation in sterling. For this and other reasons the short term impact on aggregate demand is likely to be negative, although measuring its size is difficult. We then need to think about whether the MPC will raise or cut interest rates. The National Institute’s analysis is very readable on all this.
Mediamacro will focus on the short term. But the short term involves complex macroeconomics, so the size of the hit from Brexit is as uncertain as macro always is. I have always thought the medium term hit to UK incomes was both more serious and less uncertain.
Impact on the global economy
I was surprised at the extent of the negative global response to Brexit. After all, the direct impact of the UK’s misfortune on the world economy will be pretty small. I think it reflects something I wroteyesterday: Brexit is perhaps the first major casualty of the political populism that has followed the financial crisis and austerity. The worry is that it may not be the last.
Political impact on UK
That a country can shoot its own economic foot is surprising but, as I explained above, not catastrophic. What worries me far more is the politics of it all. 75% of 18-24 year old voters wanted to remain in the EU. They are justifiably angry that the opportunities that the EU offered them have been taken away by the same generation that has increased their tuition fees and made house ownership an impossible dream. They, like many others, see their identity as being at the centre of Europe, not part of its political periphery. Scotland will not want to be ruled by an even more right wing government and be outside the EU. On the other side a large section of those who voted Leave did so on the basis of simple lies, and promises on which the campaign’s leaders cannot deliver, like much reduced immigration and more money for the NHS. This group are going to get more angry when this becomes apparent, and UKIP will only get stronger as a result.
Can it be undone?
Although Boris Johnson might have initially wished that this referendum would secure him the Conservative Party leadership and negotiations leading to a second referendum, I cannot see the rest of the EU playing ball. It is also very difficult to see how the Conservative party and its MPs would allow him to do this without mass defections to UKIP.
But a second referendum would not be necessary if, as a result of Cameron’s resignation, the UK fought a general election where the winning side explicitly campaigned not to invoke Article 50. This general election would become the second referendum.
For this to happen three rather difficult but not impossible things have to happen. The first is that the Labour leadership need to stop talking about ‘respecting the will of the people’ and focus on how the Leave side are already owning up to their lies and false promises. The second, and perhaps most difficult, is that Labour need to form a united front on the basis of a Remain ticket, involving the LibDems, Greens and SNP. This is the only way the Conservatives and most of the tabloid press will be defeated. Third, the new Conservative leader has to be forced to hold a general election before Article 50 is invoked.
Difficult, but not impossible. What is impossible is to try and remove Corbyn on the basis that he helped lose the referendum, for reasons I have explained before. In terms of those who should be blamed for the referendum result (Cameron, Osborne, Johnson, the tabloids, the BBC ….), Corbyn’s role is marginal at best.

Could you persuade Corbyn, Farron and Sturgeon to form an anti-Tory, pro-Remain alliance? Right now, as the horror of the Leave vote and a Johnson led Tory government become apparent, I think many party members could be convinced to do so, and that might put enough pressure on their leaders. It is, as far as I can see at the moment, the only way that Brexit, a right wing government led by our own version of Donald Trump, and perhaps the break up of the UK can be avoided.

Postscript 26/06/16

On ‘can it be undone’, Jolyon Maugham has a good piece in the Independent. He suspects Corbyn will not go with the strategy I outline above, and unless the current coup is somehow successful that is hardly helpful in this respect. (Whatever the outcome, any Labour leadership would have to be convinced that it is not worth trying to appease the ‘Labour heartlands’ by accepting the referendum result.)

My reading of his article is that he thinks a second referendum route has more chance. But that would seem to require new concessions from the EU, and my own judgement (for what it is worth) is that this will just not happen.

However the EU can still be helpful. The calls we saw from many (but notably not from Merkel) for a quick implementation of Article 50 are not. I also think they are misconceived from the EU’s own perspective, which is to discourage calls for similar referenda in other countries. The best discouragement is to focus on the current chaos in the UK, and to hope that the UK eventually comes to its senses and overturns by some means the referendum result.

Whichever route is taken, a big problem is pretext. How do you justify asking the electorate to overturn their earlier verdict? It may be true that many now wish to change their mind, but no one likes the feeling that they are being told they made the wrong choice. A deteriorating economy will help, but I still think you need something more concrete. Suggestions welcome.

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