Brexit: What’s Next
Professors Linda Lim and Kyle Handley shed light on the likely fallout from Great Britain leaving the European Union.
Voters in the UK, in a historic decision, chose to leave the European Union. The move has immediate and long-term economic and political consequences.
Michigan Ross Professors Linda Lim and Kyle Handley explain what this could mean for the U.S., European, and world economies.
- How this affects EU unity depends on how the UK exit fares. If things go badly in the next few weeks or months, there will be little inclination among others to attempt a “Leave.” Even before then, this may provide impetus for the rest of the EU to work together more determinedly to "show the Brits" they can do well without them. So it could be a spur to unity rather than to disintegration. But as the vote showed, you can never tell!
- Overall, trade will diminish because of (a) lower growth due to lower investment in both UK and EU (b) more barriers to two-way trade (and investment).
- As for the U.S., the dollar (like the yen) will strengthen as capital takes a "flight to safety." The corollary of a plunging pound and euro is a strong U.S. dollar. This has a couple of implications. First, inflation will be even lower in the U.S. because import prices fall, making the Fed even more disinclined to raise interest rates. Second, manufacturing will be hurt because U.S. factories will find it harder to compete against cheaper imports from Europe, and U.S. exports will also find it hard to sell in those markets.
- Will this spark a recession? Probably not in the U.S., so long as consumer demand holds up. But growth will be slower here and the UK and EU could tip into recession. It's not good for the world economy as a whole (note that Asian markets fell even more than the EU or U.S.). If everyone else goes into recession, the U.S. could as well,, but at this point that’s probably still unlikely. This economy is very resilient.
Uncertainty about business conditions, especially the risk of adverse shocks, can lead managers to behave more cautiously with respect to new investments in capital, research, foreign direct investment, or export market entry. Simply put, managers may take a “wait and see” approach and the reluctance to invest until uncertainty is resolved can put a damper on economic activity.
With respect to Brexit, the potential downsides to international business loom large.
- In the worst case, trade tariffs between the UK and member countries would revert from zero percent to the common customs tariff of about 5 percent on average. This is the most-favored-nation rate applicable to all WTO members that are not part of a free trade agreement with the EU.
- But many tariffs are much higher than 5 percent. About half of agricultural tariffs are above 10 percent and about one-third of non-agricultural tariffs are higher than 5 percent. If negotiations between the EU and UK break down, these higher tariffs could ultimately prevail.
- If and when a new deal is struck, bilateral trade between the UK and the rest of the EU could take place with positive tariffs for the first time in decades. Moreover, the UK could renegotiate its commitments to the WTO independently from the agreements made on its behalf by the EU over the last 40 years. This would affect the U.S. and other non-EU countries as well.
- Many firms will need to reallocate their business operations to different countries depending on the outcome of subsequent negotiation. For example, automobiles produced at General Motors’ Vauxhall facilities in the UK may no longer receive duty free access to the rest of the EU.
What effect does this type of uncertainty over trade policy and international business conditions have on the economy? What we know comes from evidence and applications when trade and policy uncertainty was reduced. Brexit is the opposite – a situation where policy uncertainty has increased.
- Exiting the EU throws permanence of stability provided to businesses by EU rulemaking and institutions into reverse. Even if the entire apparatus is replicated by a full set of new agreements between the UK and the EU member states, the intervening years are likely to be fraught with uncertainty that has real effects on economic activity.
- My research with Nuno Limao of the University of Maryland shows that the reduction in trade policy uncertainty when Portugal joined the EU in 1986 accounts for large fraction of entry in EU markets and subsequent export growth.
- Similar effects have been found when the U.S. granted permanent normal trade relations to China in 2002 and stopped threatening to increase tariffs substantially on an annual basis. Likewise, reducing the worst-case ceiling tariffs that all WTO members negotiate multilaterally promotes trade and market entry. An increase in the worst-case tariff from current EU preferential rates of zero is detrimental to trade and investment.
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