Drawbridge Economics: The Brexit Reality Check Is Coming
A
 leading neoconservative, Irving Kristol once defined neocons as 
“liberals who have been mugged by reality.” Similarly, I fear that those
 today who speak of the United Kingdom’s exit from the European Union as
 a chance for Britain to become a global trader again will be mugged by 
economic reality. Given the recent performance of the British economy, 
where prices are rising and wages are stagnating, that mugging may 
already be under way.
Globalization has mugged far larger countries when they mistook 
economic integration for shackles, and tried to make it on their own 
down lonely pathways of trade. Brazil and much of the rest of South 
America stepped back from globalization, including by limiting trade and
 investment with the United States. These nations deprived themselves of
 stable growth. India infamously tore up its trade relations with the 
West for decades in pursuit of autonomy and self-sufficiency, attaining 
neither. China only leapt forward when it opened up, albeit partially.
The United Kingdom was perhaps especially prone to mistaking useful 
economic ties for chains, because it had a longstanding ambivalence 
about its EU membership. One codified aspect of the European project has
 always been the idea of an “ever closer union,” which was never an easy
 sell for an island nation. The best anybody was going to do was the 
United Kingdom being sort of in, sort of out—and so it was, for as long 
as it remained inside the single market, but outside the Schengen area 
and the single currency, with a bespoke rebate to boot. It probably 
ceased to be sustainable after a majority of the member states bound 
their fortunes more tightly together in the euro area. And it certainly 
ceased to be sustainable after many in Britain, and particularly 
England, began to take the same sort of root-of-all-evil view of 
Brussels that many Americans have taken of Washington.
The sad result of the referendum is that the United Kingdom has lost 
its comfortably ambivalent status within the European Union; even 
Remainers who hope Britain may yet reconsider or rejoin the European 
Union should not presume the country will get back any of the same 
opt-outs and rebates as before, unless it is willing to spend years 
rebuilding lost trust. And leaving that state of political ambivalence 
has a very simple economic implication: The UK economy is suffering “a 
negative supply shock.”
With Brexit, the UK 
economy will not be able to purchase things for the same amount of money
 as it used to—a shock that will ruin its competitiveness with its 
largest trading partner.
A negative supply shock means you are reducing the productive 
capacity of your economy, or the ability of your economy to purchase 
things for the same amount of money as you used to. Now, we can debate 
about how big the harm is, which industries get hit, what happens in the
 end after the United Kingdom adjusts, but there is no serious disputing
 that a shock of this sort will be the result of withdrawal. Why? 
Because withdrawal from the European Union will put up trade barriers.
Shocking truth
In pure economic theory, the United Kingdom could do away with all of
 its tariffs, not only those with the European Union, but with the 
entire world, and leave the UK consumer much better off. One, decidedly 
fringe, libertarian faction of Brexiteers fondly entertains this as a 
vision of the future. It is a delusion. Unilaterally opening all UK 
markets to the whole world would, in reality, impose substantial 
dislocation and disruption on thousands of businesses and millions of 
workers. In any event, no government—and certainly no nationalist, 
Brexit government—is going to stand idly by while domestic industries 
are hammered by foreign competition at home, especially when there are 
no reciprocal opportunities for exports opening up. Additional trade 
barriers are inescapable, and trade barriers are, fundamentally, bad for
 your economy.
There is no disputing that this is a negative supply shock, 
and—furthermore—it is a negative shock that will ruin Britain’s 
competitiveness, very specifically, with its largest trading partner. 
The heightened barriers could apply on up to half of British global 
commerce. The market access that will be lost cannot and will not be 
replaced, even in a generation, due to the “gravity” of trade flows. It 
is one of the few things in economics we can talk about with the same 
sort of confidence as natural scientists—as a fact of life. In physics, 
the more massive and nearer a body is, the greater the gravitational 
pull it exerts. In commerce, gravity means that you trade far more with 
countries you are contiguous with or which are nearby, than you do with 
countries that are far away. This pattern of trade is not only logical—a
 consequence of the costs and delays inherent in long-distance trade, 
and of the networks and habits that develop through history—but is also 
borne out by all studies of trade patterns.
No matter how much there has been a special relationship, be it with 
the United States or the Commonwealth, no matter how much the United 
Kingdom may want to be a global exporter, the fact is that the United 
Kingdom has more than twice as much trade and investment with the 
European Union than it does with the United States, let alone with 
anyone else in the rest of the world. The United Kingdom has exported 
more to Ireland than China in nine of the past ten years, despite 
China’s economy being nearly 40 times the size of Ireland’s. None of the
 other major emerging markets, Brazil, India, or Russia, are in the top 
20 markets for UK exports. So even if we were to negotiate several new 
global trade deals with rising economies, it would not offset the shock 
of leaving the European Union, and could not do anything at all in the 
short term.
In theory, a UK-US trade deal has slightly more potential. There is 
no question that Donald Trump has the authority to move the United 
Kingdom to the head of the queue if he chooses to. And it would not 
entirely surprise me if he did, because American culture has some 
affinity with watching Downton Abbey and Dunkirk, and Britons are 
thought of as rich white people by Trump voters. But if he did, would 
Congress ratify his deal? After all, it is hardly in the US strategic 
interest to annoy the European Union, the largest economic bloc in the 
world, especially when the United States is already alienating Canada 
and Mexico by aggressively reopening the North American Free Trade 
Agreement (NAFTA).
Besides, even if a Trump-backed Anglophone trade deal could be 
approved, to what end? The Trump administration approach towards NAFTA, 
and all the trade officials’ statements make clear that his real 
priority is to tilt bilateral trade balances in the United States' 
favor. Even if he did give the United Kingdom a trade deal, it would be a
 bullying deal which made it certain that the United Kingdom would end 
up buying more in the way of extra US imports than it would be able to 
sell in additional exports. The overall negative supply shock would 
remain, and Britain’s ability to succeed in trade would not be improved.
 New trade deals are not going to make up for the disruption to trade 
with the continent.
The news gets worse for the UK economy when we consider the impact of
 Brexit on cross-border investment. Because the United Kingdom had this 
special status as a less-regulated, low tax, English-speaking, rule of 
law sort of a place, that was nonetheless still in the European Union, 
it used to attract investment as a welcoming platform from which to 
trade with the wider European Union. All the more so as many 
non-European business people liked living in London. Now this investment
 is going to drain away, not to zero, but it will gradually decrease. 
Toyota, Nissan, and Ford, for example, all have disproportionate amounts
 of their European car production in the United Kingdom. All have 
indicated that they will not expand those plants, for example, when the 
United Kingdom loses full market access, and their production will 
likely decline.
Counting costs
It bears repeating that there is a distinction between a limited and 
thus feasible trade deal for the United Kingdom with the European Union,
 and full membership in the European single market. A simple trade deal 
would normally start by reducing the rate of tariffs charged on some 
goods and perhaps a few services. The single market, however, covers all
 those things that are not simply the price of goods off the boat. It is
 whether your vehicle meets safety standards, whether your chemicals or 
food additives have been recognized, whether you fit standard sizes of 
various objects, whether your accountants are accredited, or whether 
your university degree is recognized in other countries.
Since the United 
Kingdom is primarily an exporter of higher-end products and especially 
of business, financial, media, and education services, there can be no 
escaping the need for agreed rules and standards.
These regulations cut both ways. They are partially inefficient 
restraints on business, protecting incumbent companies and guilds from 
competition. At the same time they are also partially economically 
beneficial, because they set the ground rules that facilitate a large 
and integrated market. In any given industry, the European standards 
will display more or less of these two attributes. But since the United 
Kingdom is primarily an exporter of higher-end products and especially 
of business, financial, media, and education services, there can be no 
escaping the need for agreed rules and standards. So it loses a lot by 
being—as [British prime minister] Theresa May has proposed it should 
be—outside of the single market, even if it manages to get a trade deal.
Of course, one can say, “Ah, but Brexit is about the long term. The 
UK economy will adjust, and over the long term, we will be better off.” 
But how? Beyond fanciful hopes of gravity-defying trade deals beyond 
Europe, the case for being bullish here comes down to sparing the United
 Kingdom from the supposed growth-sapping “costs of Europe.” Five such 
costs get talked about. There is overregulation of EU labor markets. 
There is heavy-handed regulation from Brussels in other things. There 
are big bills for European-style welfare states. There is demographic 
decline. And there are problems associated with euro membership.
Now, on that list, four of those five do not apply to the United 
Kingdom, even if it stayed a member of the European Union. The United 
Kingdom has looser labor market regulations than anyone else in the 
European Union, and—even while complying with those strictures that 
Europe does require—its labor markets remain flexible by world 
standards. The European Union has not prevented the United Kingdom from 
having a smaller welfare state than comparably wealthy states in western
 Europe. Demographically, the United Kingdom has actually been a 
beneficiary of membership of the expanded European Union, because people
 from Poland, France, Portugal, and Romania have come and helped balance
 out the ageing of British society. And the United Kingdom was, of 
course, never a member of the single currency.
The economic cost of remaining really boils down to excessive 
regulation in certain areas of business life. Even there, leaving 
represents a mixed blessing because at the same time as escaping some of
 these regulations, it is unrealistic for British business to escape 
them all if it continues to export into the European standards-based 
market. Yet, by leaving, you give up the ability to push back against 
any of these regulations in the future because you will no longer be a 
member of the discussion that sets those standards.
Leave the rhetoric aside, look at the reality. This is not a very 
good deal in economic terms. Now, again, you can always say, “Well, this
 is about sovereignty, we want to do it.” But you should be aware that 
there is no economic upside to Brexit.
Reality check
Assuming Brexit goes ahead as May plans, the United Kingdom is simply
 going to have to cope with this negative supply shock. In order to 
adjust, the British economy will have to endure some mix of higher 
inflation, lower purchasing power, declining terms of trade, and a 
weaker pound for several years. This painful adjustment process has in 
fact already begun, as was seen when the Bank of England felt it 
necessary to raise interest rates in November, despite there being 
little reason to do so in terms of domestic conditions. Mark Carney, the
 Bank’s governor, made clear that the impact of Brexit brought 
productivity and currency concerns to the fore.
More fundamentally, the UK economy will have to absorb this shock at a
 time when it is already suffering from a staggering decline in 
productivity growth relative to other western economies. This other 
reality inherently makes any Chancellor’s Budget arithmetic much more 
difficult (see Diane Coyle (link is external)).
 Even more importantly, near-zero productivity growth means near-zero 
real wage growth. There is no reason to expect that workers will be 
protected from the pain of inflation.
Furthermore, the United Kingdom has accumulated through both the boom
 and the bust a set of large imbalances. It has ongoing budget deficits,
 large trade deficits, an over-concentration of activity in the 
financial sector, and then—in geographical terms—an over-concentration 
in the southeast as well. Over the last few years, even after the Brexit
 vote, there has been a further growth of consumer borrowing while 
corporate investment has gone negative and trade has gone the wrong way.
 Overall, the British economy already had a painful adjustment coming, 
and now that process will be compounded since the United Kingdom has 
resolved to pull itself out of economies of scale and curtail easy 
access to its biggest markets.
Do the mental exercise. If this were Britain in the post-war Bretton 
Woods period, or during its time in the European Exchange Rate Mechanism
 circa 1992, and we were seeing this same mix of unbalanced 
macroeconomic indicators, we would predict a crash in the pound. The peg
 would be doomed. Thankfully, the United Kingdom today does not have a 
fixed exchange rate. But if you do that exercise, it reminds us of just 
how unsustainable the current British economic path is. The pound has to
 decline further. Like Britain as a whole, it has further to go in being
 mugged by reality.
Stable prices and exchange rates are going to have to give. No one 
should fantasize that a depreciation will lead to prosperity, however, 
any more than repeated devaluations delivered sustained growth to the 
United Kingdom (or to Italy) in the 1960s and 1970s. At a time when 
benefits for the poor are frozen and—in the last few months—wage growth 
has ground to a halt, even relatively modest inflation is going to hurt.
 And the most obvious direct cost of imposing tariffs on imports from 
the European Union, of declining terms of trade, is a sharp decline in 
British consumers’ purchasing power.
A surprising recent economic phenomenon makes the challenge from 
globalization to a Britain outside the European Union even greater. We 
have seen the occurrence in recent years of currencies declining in 
advanced economies, while the trade gap fails to change appreciably. 
Usually a falling currency is thought to be a direct mechanism of 
adjustment for a country that is suffering from declining terms of 
trade. So, in the case of the United Kingdom, after the pound falls, 
Brits used to find they could afford fewer German cars or Italian 
holidays and cut back on those products for cheaper domestic 
substitutes, while at the same time British exporters found their wares 
were cheaper in euros or dollars, and thus sold more.
But that textbook adjustment is not working today. In fact, it hasn’t
 worked in Britain for some years. There was a similar pattern at the 
start of the crisis where the trade-weighted pound also declined 
sharply—by roughly 25 percent over the course of 2009—but the trade gap 
failed to close very much at all. One factor is that the United Kingdom 
is towards the upper end in global supply chains. That means whether it 
is cars or financial services of certain kinds, production requires a 
bunch of imported inputs, whether of people or car parts, before the end
 product can be exported. The net gain you get from currency 
depreciation is limited. A similar logic is at work in Japan, where the 
decline in the value of the yen in recent years has not had as big an 
impact on the trade balance as economists initially expected.
A second point is that the crisis meted out a structural hit, 
targeted on Britain’s bloated financial services industry—reducing it 
from about 15 percent of UK GDP at its height, to somewhere in the 
region of 10 to 12 percent. That is a large and sudden shrinkage in a 
major economy, reflecting the wider economics of the crisis and more 
particular failings of the City. The damage to the British financial 
sector is now set to be multiplied by the shift of some of those 
financial services to Ireland, Germany, the United States or wherever, 
once the single market is exited (see Nicolas Véron (link is external)).
 These are real lasting setbacks to British service exports for which 
exchange rates alone cannot compensate—at best, a persistently weaker 
pound will, over time, lead to a reallocation of workers and investment 
to industries that compete internationally on price rather than quality.
 That sounds like a step backwards.
Whatever the reason why depreciation has ceased to work to improve 
trade balances as it used to, it leaves the United Kingdom an unbalanced
 economy facing a self-inflicted supply shock with one fewer means of 
adjustment to the new reality.
Defying gravity
Amid the daunting reality of international commerce outside the 
European Union and low productivity growth, it is plain that Brexit is 
only going to succeed economically for the British people if the country
 were to somehow leap beyond the reach of economic gravity, and replace 
much of its trade with the European Union with new markets. There is no 
obvious precedent, however, for any large nation successfully defying 
gravity, and reordering its trade on a whim, let alone doing it so 
quickly.
At best, a long and painful process of adjustment is required to 
reorient to new markets, new industries, and new relationships. In the 
decades after 1989, the old East European countries did achieve this—but
 these iron curtain countries had the option of competing as low-wage 
economies during the generation-long adjustment period, much to the 
annoyance of Brexiteers. There is no reason to believe that Britain, a 
country where wages already disappoint domestically but remain high by 
world standards, will be able to pull off the same trick.
More importantly, while Eastern Europe could forge a new economic 
accord with the West, there is absolutely no reason at all to believe 
that the rest of the world will alter its patterns of trade and 
investment in reaction to the efforts and aspirations of a Britain that 
has, for whatever reason, resolved to go it alone.
Believing such a shift will happen requires a faith that recalls 
Margaret Thatcher’s proclamations of TINA, that desired change must come
 simply because There Is No Alternative. Her disinflationary policies 
did not ultimately succeed in transforming the UK economy: Inflation and
 trade deficits bounced back with the economy in the late 1980s. Despite
 Thatcher’s insistence on TINA, it transpired that the British economy 
did not readily adjust to bullying.
But for its devotees, Brexit is likewise bound to succeed today 
because it must. What else, however, does one have to believe to sustain
 that faith? Brexit would have to cast some very special spell on all 
British businesses, to offset the damage done by rising trade barriers, 
and the flight of investment and workers from abroad. Thatcher would 
surely be appalled, and protest that such magical thinking involved 
standing TINA on her head. For all the social harm unleashed by the Iron
 Lady and TINA, at least the original Thatcherites could point to some 
plausible mechanisms for imposing new discipline—like hard money and 
fiscal austerity, as well as the resulting strong pound, which would 
force painful shake-outs on workers and old industries. The Brexiteers’ 
TINA is, instead, somehow meant to force transformation on an economy 
beset by rising inflation, and in industries that are increasingly 
sheltered behind trade barriers, starting with tariffs re-imposed on EU 
goods.
Brexit is not going to make Britain into a wonderful capitalist 
exemplar, let alone a global trader, like Hong Kong was in the 1970s. 
Brexit is going to make today’s Britain more like Britain was in the 
1970s. Ultimately, it will produce lasting economic harm to British 
citizens, because market economics works and global integration has 
benefits. The costs of some overregulation imposed by Brussels in some 
industries are nothing to compare with the self-imposed costs of a 
trading nation running away from globalization. That’s reality.
Follow @AdamPosen (link is external) on Twitter.

 


 