There is no such thing as a costless Brexit

A guest blog by Alexandra Dumitru, an economist at RaboResearch

“All forms of Brexit are a hard Brexit for customs” I was recently told by a customs- expert. The study by RaboResearch, Rabobank’s knowledge centre, on the impact of Brexit published in the May edition of the National Institute Economic Review drew more or less the same conclusion from an economic point of view: leaving the EU has significant direct and structural economic costs for the UK. Our estimates were on the pessimistic side of the spectrum. The magnitude of the estimated impact on UK output varied widely with the type of future trade relationship between the EU and the UK and a transition period could soften the blow considerably. From that perspective it is not reassuring that with ten months left before ‘Brexit day’ the UK is still divided over the Brexit objectives.

Leaving the EU bears an economic cost

In October 2017 RaboResearch investigated the outcome of three possible Brexit outcomes: 1) a ‘Soft’ Brexit defined by UK’s participation in the European Single Market and departure from the Customs Unions, whereby trade costs would only result from non-tariff barriers; 2) a Bilateral Free Trade Agreement (FTA) in which tariffs on products would remain zero, the increase in non-tariff barriers would be larger than in the soft scenario and services would no longer move freely and 3) a ‘Hard’ Brexit scenario in which negotiations would collapse and the UK would leave the EU without any trade agreement and, thus, would have to fall back on WTO agreements. ‘Bremain’ served as a reference for the purpose of estimating the costs of leaving the EU. The scenarios did not include a transition period. Such a set-up isolated the costs of leaving the EU, but we stress that this is not the base case of RaboResearch for the Brexit outcome.

The most striking outcome of the analysis was that irrespective of the outcome of the Brexit negotiations the UK economy may slide into a two year recession after leaving the EU in March 2019. Moreover, economic growth would remain below previous potential growth for longer and the damage would be structural too. Potential economic growth in 2030 would fall from 2.1% in the Bremain scenario to 1.6% under a ‘soft Brexit’ or an FTA and to 1.3% under a ‘hard Brexit’. The magnitude of the direct economic impact varied greatly amongst the various scenarios. In the two years of recession GDP would decline by an accumulated 2.4% in a hard Brexit scenario, 1.1% in the FTA scenario and 0.3% in a soft Brexit scenario. By 2030, a hard Brexit would have cost the UK 18% of GDP, compared to a situation where the UK would continue its EU membership. An FTA and soft Brexit would cause less harm but still cost the UK economy roughly 12.5% and 10% of GDP, respectively. The RaboResearch base case is currently a transition period until December 2020 followed by a comprehensive FTA. The transition period would soften Brexit’s impact and the economy would avoid a recession. Still, in anticipation of the new trade relationship, economic activity would slow down towards 2020 and pick up slowly in subsequent years. 

Why so pessimistic?

Compared to other studies that analysed the impact of Brexit, RaboResearch estimated a higher Brexit impact for all outcomes investigated. The reason for this ‘pessimistic’ estimates stems from the methodology employed. First, RaboResearch was the first study to use the adjusted tariff version of NiGEM, released by NIESR in 2017. This model has the major advantage that the introduction of tariffs is embedded in the model. As such, import inflation is taken into account and consequently affects real wages, real disposable income and private consumption. Moreover, relative competitiveness is hurt by cost-push inflation as intermediate goods become relatively more expensive, raising production costs and export prices and thereby lowering UK competitiveness. These factors are very relevant for the UK economy which imports roughly half of its intermediate products from the EU. Second, RaboResearch estimates a new productivity model for the UK. Consequently, the study can adequately assess the impact of Brexit on productivity, while previous research assumed total factor productivity to be exogenous. Endogenising productivity is very relevant for a country whose income increase in the past half a century was significantly driven by labour productivity growth. Especially since Brexit will affect many factors that drive productivity such as the openness of the economy. Last but not least, RaboResearch looked at other Brexit transmission channels to the economy. For example, it was the first study to include a Brexit withdrawal settlement bill.

Brexit is not getting any easier

Brexit negotiations have progressed significantly since October 2017 when RaboResearch carried out this study. For one, the EU and the UK have reached an agreement over a transition period until December 2020. However, the shape of the future trade deal is still unclear and PM May has come so far by postponing contentious issues such as a hard Irish border. And since “nothing is agreed until everything is agreed” such issues could still derail Brexit negotiations. Consequently, a “hard Brexit” is still a possible outcome. In fact, recent polarisation in UK politics and within Prime Minister May’s own cabinet around the possibility of a customs union with the EU may have only increased the odds of such an outcome.

Further reading on NIESR’s own research on this topic: Modelling the long run economic impact of  Leaving the European Union, by Ebell, Hurst, Warren