The UK after Brexit

This Blogpost in Short:

• High levels of uncertainty mean lower investments in the UK and thus a fall in GDP
• Fewer EU exports lead to a GDP decrease in the rest of Europe too, though on a much smaller scale
• The depreciation of the pound leads to more expensive imports in the UK, a decrease in real wages, lower demand and hence a furter British GDP decline

Since 24 June it has been clear that the UK wants to leave the EU. The initiator of the referendum, David Cameron, resigned and made way for new British prime minister Theresa May. Back in the spring of 2015, we commissioned a study to examine what long-term effects a Brexit would have on economic growth in Europe. The results applied to the year 2030. But what does this decision mean for economic development over the coming months?

Uncertainty on the rise

One direct consequence of the Brexit referendum is the high level of uncertainty surrounding future political and economic development across Europe. Will the UK retain access to the Single Market? Will duties be imposed on trade between the EU and the UK? And what will happen to the free movement of persons? Furthermore, it remains to be seen when the UK will leave the EU and how long it will take to establish the new contractual provisions governing the relationship between the EU and the UK.

Economic impact on the UK

This uncertainty has negative economic consequences, especially in the UK (see Fig. 1):

• Uncertainty has a negative impact on investment activities because it is not clear whether an increase of production capacities is actually worthwhile. Domestic companies will therefore reduce their investment in the UK.
• Foreign investors will also lower their investment in the UK for the same reason. The UK’s potential departure from the EU’s Single Market makes the country unattractive as a location for foreign companies to establish or maintain production facilities. This raises the specter of companies withdrawing from the UK. The withdrawal of foreign direct investment (FDI) goes hand in hand with job cuts.
• There is increasing fear among citizens that they will lose their jobs or see their salaries cut. Both have a negative impact on consumer spending. In addition, it is expected that people will increasingly look to save money as they gear up for economically tougher times.

If the level of investment and consumer demand in the UK decreases, companies will reduce their production. This leads to a decline in gross domestic product (GDP).

Economic impact for Europe

This growing uncertainty also has a negative impact on investment, and therefore on economic growth, throughout the rest of Europe. However, this is less pronounced than in the UK as the other European member states remain in the Single Market. Furthermore, European countries can expect to see foreign direct investment being transferred from the UK to Europe, where it will create new jobs.

However, in addition to this, European countries will have to contend with a decline in their export levels, which will weaken their own economic growth (see Fig. 2):

• On the one hand, the lower levels of foreign direct investment in the UK mean that foreign investors need less UK Sterling to finance their investments. The slowdown in demand for the British pound leads to its depreciation, while the euro appreciates. This appreciation of the euro makes European products more expensive in the UK and reduces European exports.
• On the other hand, the slowdown in economic growth in the UK leads to a decrease in the demand for products from Europe among British consumers. This further reduces exports from Europe.

For other European countries, this reduction in exports weakens their economic growth.

₤-depreciation not beneficial to UK in short term

The depreciation of the British pound makes British products cheaper for the rest of the world and can therefore increase British exports. However, this does not benefit the country in the short term. For the last 25 years, the UK has had a current account deficit (see Fig. 3). In short, this means that the country receives less money than it spends in its economic exchanges with the rest of the world.

This foreign trade situation has two main economic consequences (see Fig. 4):

• The depreciation of the British pound increases the price of British imports. This means that the overall price level in the UK rises. Rising prices worsen the country’s international competitiveness, resulting in a decline in exports. This has a negative impact on GDP and employment.
• Rising prices lower the purchasing power of a given amount of money. For employees, rising prices mean a reduction of their real wage. The decreasing purchasing power for wage earners means that consumer demand declines. This also leads to reductions in production and employment, and therefore to a reduction in GDP.

This means that in the short term, the depreciation of the British currency therefore also leads to a weakening of economic growth in the UK.

Conclusion

Uncertainty surrounding the political consequences of the Brexit decision leads directly to a reduction in investment in the UK – both from domestic and foreign investors. The associated decline in the demand for the British currency leads to a depreciation of the British pound and an increase in rate of inflation in the UK. The higher level of inflation lowers exports and consumer demand, both of which weaken production, employment and economic growth in the UK.

In 2016, the GDP decreases in the UK will still be relatively low. According to the calculations by Baker et al, the Brexit decision will mean that British GDP in 2016 will be around 0.2 percent below the level that it would have been without the decision to leave the EU. In 2017, this difference will rise to around one percent; in 2018, it will be as high as around 2.4 percent.

A decline in growth is also to be expected in the other EU member states. However, this will be considerably less than in the UK. For example, the German Institute for Economic Research (DIW Berlin) expects that the growth rate of German GDP in 2017 will be approximately 0.5 percent lower as a result of the Brexit decision. According to ifo Institute (Munich), German growth losses will be even smaller: less than 0.1 percentage point in 2016 and only up to 0.2 percentage point in 2017.

The same conclusion we drew in our study on the long-term consequences applies to the short-term consequences: a Brexit will cause economic damage in all countries, but especially in the United Kingdom.