Brexit and the economy

The UK’s decision to leave the European Union will affect the UK economy for decades to come. In the short term, it led to the pound falling sharply, but didn’t affect the immediate growth performance of the economy. In the longer term, the country’s new trade arrangements with the EU and the rest of the world will be crucial in determining Brexit’s economic impact.

Short-term effects of Leave vote

If a Martian economist compared the performance of the UK economy before and after 23 June 2016, they would not really notice any difference. Contrary to most economists’ expectations growth continued in line with the trend of previous years, supported by strong growth in consumer spending. But that is not to say the vote had no effect. The pound fell sharply and remains around 10% below its pre-vote value.

The value of the UK £ fell following the EU Referendum

A weaker pound may boost UK exports (at least in the short-term) but it has also pushed up inflation via higher import prices, squeezing household incomes. In addition, the pound’s decline means UK assets – its wealth – are worth less now than they used to be, compared with other countries. This matters because we buy a lot of things from abroad: imports are equivalent to 30% of UK GDP. If our incomes don’t rise to compensate for the lower value of the pound, we become poorer.

Exchange rates can and do fluctuate for all sorts of reasons. In this case the fall in the pound is clearly a result of the referendum outcome, presumably due to the belief that Brexit will harm the UK economy. If this view changes, say if the UK agrees many advantageous trade deals, the pound may recover lost ground.

Long-term effects of Brexit

Brexit won’t be the only factor to affect the economy by any means. There is, for instance, the critical question of whether the economy breaks out of its decade-long productivity stagnation. Nevertheless, when all is said and done, how will Brexit have affected the UK economy?

Both sides of the referendum debate broadly agree that it’s in the UK’s best interests to have an economy open to trade and investment. Economists agree. Theory and literature show a link between the degree of openness to foreign trade and investment and long-term growth rates (see margin). In other words, more barriers to trade and investment lead to lower growth.

New trade arrangements

We obviously don’t know the scale and scope of the UK’s new trade and investment relationships in a post-Brexit world but we can make some
broad observations.

The EU is currently the UK’s largest trading and investment partner by far: 44% of all UK goods and services exports go to the EU; 53% of UK imports come from the EU; and 45% of the foreign direct investment stock in the UK is from the EU.

It is likely that following Brexit it will be more difficult for UK companies to trade with the EU and for EU companies to trade with the UK. The degree to which this is the case will depend on the type of trade relationship that is negotiated.

The UK’s future trading arrangements with non-EU countries will also be important in determining Brexit’s long-term economic impact. After leaving the EU, the UK will be able to negotiate its own trade agreements with non-EU countries (if it leaves the EU Customs Union, which seems very likely). The UK will also likely have to renegotiate the trade deals the EU currently has in place with other countries (11% of UK exports go to these countries).

What does it all mean?

A large majority of economists think it unlikely that possible new trade deals with non-EU countries will be able to make up for higher trade barriers with the EU given its importance to the UK.

As a result, they believe the final post-Brexit settlement will leave the UK economy less open, lowering the UK’s long-term growth rates compared
to a scenario in which the UK had stayed in the EU.

Other factors will also play a role in determining Brexit’s impact. The UK, if outside the Single Market, will have more control of its regulations (potentially making them more business-friendly) and immigration policy
as well.

Much is still uncertain about the UK’s post-Brexit trading arrangements. How these new relationships shape and change the future of UK trade and investment will be crucial in determining its long-term economic impact.

This article is part of Key Issues 2017 – a series of briefings on the topics that will take centre stage in UK and international politics in the new Parliament. More Key Issues posts will be published on this blog throughout June, subscribe via the homepage to get instant alerts. You can read more Commons Library Brexit research and analysis at www.parliament.uk/brexit

Picture Credit: “Brexit” by Airpix. Creative Commons 2.0 Generic (CC-BY-2.0)

How greater openness to trade and investment can benefit an economy

More investment – increases amount of capital in the economy (machinery, computers, etc.) leading to higher labour productivity growth

New technologies – foreign investment is often associated with technological innovation and better work practices, which may then be adopted by domestic firms

Competition – more foreign companies in domestic market can lead to increased innovation and efficiency

Specialisation – easier access to large trading markets allows domestic firms to specialise and expand, improving productivity