Waiting for Brexit – The UK in a Changing Europe

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This blog summarizes our new working paper reviewing the findings of academic research on the impact of the Brexit vote on the UK economy ahead of actual EU exit.

Although the UK voted to leave the EU in June 2016, its economic relationship with the EU did not change until January 2021, when the Trade and cooperation agreement (TCA) entered into force. But Brexit further affected economic behavior ahead of 2021, as it changed expectations about future economic policy.

The Leave vote made it more likely that barriers to trade, investment and migration between the UK and EU would increase in the future. It has also heightened uncertainty regarding changes in UK and EU economic policy, creating a higher risk environment for policymakers.

How has this change in expectations affected economic results? Research shows that the exit vote had a huge negative effect on the economy even before the UK left the EU. Based on the available evidence, our judgment is that the UK economy was around two to three per cent smaller at the end of 2019 than it would have been if the UK had voted for stay in the EU. This drop is equivalent to a loss of GDP of between £650 and £1,000 per person per year.

What evidence supports this judgment? The economic consequences of the Brexit vote first materialized in the financial markets: on the night of the referendum, the pound suffered the largest single-day drop in one of the world’s four main currencies since the introduction floating exchange rates in the early 1970s. And this decline proved persistent. Since the referendum, sterling has fluctuated around 10% below its pre-referendum value.

The fall in the value of the pound has impoverished UK households by increasing the cost of imports, leading to higher inflation and lower real wage growth, as shown in the figure below. The Brexit vote is valued having raised consumer prices by 2.9%, raising the cost of living for the average household by £870 a year.

Figure 1: UK real wage inflation and growth, monthly 2015-18. Source: Office of National Statistics. Inflation: Annual CPI inflation (D7G7 series). Real Wage Growth: EARN01 Average 3-month year-over-year percentage change in Total Earnings, seasonally adjusted (A3WW series).
Notes: The vertical line indicates the date of the Brexit referendum (June 2016).

The weaker pound also raised the cost of imports of intermediate goods by businesses. This cost increase has hurt workers in reduce real wage growth in the most exposed regions and industries.

At the same time, the data shows that the fall in the pound sterling has not generated any gain in long-term price competitiveness for British exporters, which could Explain why this has not led to an increase in export volumes.

UK GDP growth was not immediately affected by the referendum, but it slowed compared to other countries in 2017 and 2018, as shown in the following figure. The UK fell from the highest growth rate in the G7 in 2015 to the lowest two years later. It is never easy to determine the causes of variations in overall growth, but the two at company level and aggregate evidence suggests that voting to leave the EU led to weaker growth, with consumption and investment cuts both playing a role.

For example, using data on firm-level exposure to Brexit uncertainty, researchers found that the Leave vote reduced total investment by 11% and value added by 2-5% in the three years following the referendum. Companies facing greater Brexit-related uncertainty also reported devoting more management time and financial resources to Brexit preparations.

Figure 2: UK and G7 GDP, quarterly 2013-19. Source: OECD. National currency, chained volume, seasonally adjusted, expenditure approach (LNBQRSA series).
Notes: Quarterly GDP normalized to 100 in the 2nd quarter of 2016. Rest of the G7 Simple average of normalized GDP in Canada, France, Germany, Italy, Japan and the United States. The vertical line indicates the date of the Brexit referendum (2016-Q2).

Taken together, the accumulated evidence on import prices, inflation, real wages, GDP and investment paints a rich picture of the channels through which the Brexit vote hurt the UK economy. And, so far at least, there is no evidence to support the argument that Brexit has generated sufficient economic benefits to outweigh these costs.

Finally, how has Brexit affected UK trade? In the long term, Brexit is expected drastically reduce the EU’s share of UK trade. But despite the evidence that solidify and product level of trade were affected by the threat of rising trade costs, the EU’s share of UK imports and exports remained roughly stable between 2016 and the onset of the Covid-19 pandemic , as shown in the figure below.

The lack of overall trade diversion out of the EU before the introduction of the ACT is surprising and implies that many of the anticipated effects of Brexit on trade have yet to materialise. Therefore, it is too early to draw conclusions on the long-term economic impact of Brexit.

Indeed, data for 2021 shows that the TCA has already started to reduce UK-EU trade, particularly UK imports from the EU, showing that the adjustment to Brexit is far from over. We expect Brexit to provide fertile ground for economic research for years to come.

Figure 3: EU share of UK trade, 2012-20. Source: Office of National Statistics. Goods: UK trade: May 2021. Services: UK total trade: all countries, not seasonally adjusted, July 2021.
Notes: Trade in goods excludes precious metals.

Through Swati DhingraAssociate Professor of Economics at the London School of Economics, and Thomas SampsonAssociate Professor of Economics at the London School of Economics.

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