Economind Explains Brexit: Why did Britain cross the road?

This is going to be a long article. Regardless, if you want to cover something as huge and momentous as Brexit, I feel strongly that to get further into the topic, a few things must be laid out bare and simple. The first section will help you in identifying the type of information you will receive here (what you can expect from me) as well as from the general media. Feel free to skip it though and jump right into part 2 of the discussion.

1. What you ought to know about this article and many others:

First, I do not support Brexit (as written in the foreword posted on Economind’s facebook page). But, I also do not think that the cost incurred by Brexit will be as tremendous and extreme as many claim it will be. I think the long-run is too far ahead into the future for us to make any accurate predictions of, and economics says there is still a possibility that it yields a net positive effect.

Second is my belief about democracy as a ruling system. Democracy is not perfect or even great, but it is the best among many worse alternatives (as Charles Wheelan, the author of Naked Economics, noted). For this reason, there is no such thing as a purely democratic nation. There will be flaws in democracy even if it has proven to be a potent force propelling global economic growth up till now. Furthermore, democracy imposes two major problems on the economy, the inside lag of policies’ effects (take time to deliberate and get things done) and collective irrationality.

The former is the delay in the intended effects of policies, and sometimes, certain policies (that are time-sensitive) suffer from this sort of problem. For instance, stimulus package that is late and is applied when the economy has already recovered might instead cause the inflation of economic bubbles. The latter (collective irrationality) is the notion that individual rationality (individuals acting in accord to their own interests) can turn into a collective irrationality (a surge of devastating force that limps the country, politically, socially and economically). Consider the case of soldiers during war. Those who abandon the front-line make a good decision for themselves, but the more soldiers who do so, the more inclined the rest follow, and the highly likely the war will be lost. As a result, allowing people to exercise their democratic power, hence, is not always a wise decision, especially when self-interest and resentment are strong (exactly the case of Brexit).

Third, just like any good science, economics is a discipline that relies entirely on data/information, on building models (that best describes certain events/things we are interested in), on being able to include as many significant variables as possible while controlling for bias and inefficiency (thus, not eroding the value of the model). Consequently, any economic analysis or conclusion will definitely demand a large chunk of relevant information. In the case of Brexit: What is the investors’ sentiment towards the market? Will there be a social division? What was British trade pattern before the vote? How will the EU react/retaliate? Who will the next British prime minister? Is he/she an astute politician and does he/she have good economists around? Depending on the answers to all these questions, the model’s forecast can change slightly or drastically. I am not aware of the answers to those questions (nor the model), and I am lazy to search for them. Notwithstanding, the economic insights I am offering is not biased and certainly not a result of personal sentiment. What I am about to write is a rough/general analysis that anyone who is familiar with economics can provide you. How? Why? Read the fourth point.

Fourth, you have to understand the difference between positive and normative economics. Positive economics focuses primarily on facts, on empirical findings acknowledged by the majority in the community of economists. Normative economics, on the other hand, seeks to answer such questions as: “What we ought to do?” and “What do you think is the outcome?” and the likes. To put this into perspective, think about two economists sitting in a bar. They are highly likely to intensely argue over what they should do to cut down unemployment rate (normative), but both are also highly likely (90% of the time) to agree that raising minimum wage is a bad measure (positive). What you have read in the media so far (besides the figures and data they flaunt in front of you) are all normative economics. Thus, there is always room to make mistakes and wiggle.

To sum up:

  1. I believe Britain should remain in the EU. And, I am not a strong supporter of democratic process as means to solve every problem, or to devise every single policy, or to make every single decision;

  2. Due to the limited information I have, the discussion will be mostly centered around positive economics. I will provide a rough sketch of the picture. I cannot avoid shoving in my personal opinions here and there, but when I do, feel free to say: “You are wrong sir!”

2. Why Brexit? Why did Britain cross the road?

Without further ado, we will now begin looking at the other end of the story and try to understand the result of the recent British referendum, basically its people’s decision to leave the EU.

And, to get into the heart of the matter, it is necessary that we understand what an economic integration really is and what it entails.

When a group of nations form a regional economic bloc, it loses a bit of its individual freedom. You can call it national sovereignty, but I prefer to use the term “economic liberty”. As the level of integration rises, they also become more socially, economically, and politically intertwined. Among its members, anyone’s decision can influence the outcome of the rest of the economic bloc. Anyone’s decision can harm the rest of the member states. Hence, the more integrated they become, the more synchronized they need to be. Imagine one country in economic boom while the rest is in recession. An expansionary fiscal policy implemented by the EU to help the busting nations will inflate economic bubble in the booming nation, dragging it down into a recession. For this particular reason, to achieve greater synergy, the more integrated they are, the less economic liberty each member can exercise.

While enduring the cost, in more than one way, countries find great returns in being a part of a bigger family. Political reasons like geopolitics, international credibility, bi-lateral and multi-lateral negotiation power, greater resistance against international crime (due to multi-lateral cooperation like Europol), and so forth are indeed factored in. Social reasons like higher sense of cooperation among citizens of member countries and even biological reasons like greater gene pool are parts of the goodies. There are also many economic reasons such as access to larger market, more intra-regional trade, greater economies of scale, high labour and capital mobility, more loanable fund, overall financial security, more knowledge spillover, less prone to global economic shock, etc.

Yet, “unity in diversity” is not something of which we have a full grasp at the current state. The deprivation of substantial degree of economic liberty from each member nation in addition to the different levels of economic development of members can cause resentment towards one another. Accusing the economically strong of abusing its power (or accusing the majority of members of ganging up to exert pressure on the minority) is not uncommon. This is especially the case in the EU. Plus, the lack of transparency escalated the problem.

Basically, the EU is a stronghold composed of numerous institutions, committees, departments, branches, etc. To most of us, the myriads of functions of the EU are confusing. The same goes for many Britons and other Europeans. My good friend, One-Dollar Economist, just made it known to me that google search on “What is EU?” skyrocketed after Brexit. This is a good example of the fact that people simply do not know much about the EU. To many Britons, the EU (with its ambiguity coupled with its highly bureaucratic, centrally-oriented nature) gives off an aura of an undemocratic organization. They are not completely wrong. In the EU, power is seen as highly centralized, and the many regulations imposed on each member country are without much of their say in the matter. This certainly did not help convince the people otherwise.

The loss of economic liberty, while having to abide by EU’s stringent regional policies and regulations, creates an atmosphere of mistrust and bitterness. This is exactly the case in many other parts of Britain aside from London, considering how the EU’s policies and regulations have been restraining them from conducting their businesses at full potential (hurting many industries in the process).

I believe, if not THE reason, this is at least one of the major causes behind Brexit. It comes at a cost. As mentioned in the previous post, the dismal predictions range from loss of privilege (travel, work, etc) to currency depreciation, capital flight (as EU is no longer accessible from Britain), scuba diving property and securities market, shortage of labour in certain sectors, loss of regional market access, and the list goes on.

However, there is hope.

3. What is on the other side of the road?

Economics says that all is not lost. If carefully manoeuvred, not only can Britain gets out of this sticky situation, but we can even expect to see some positive outcomes and possibly a growth rate that it would not be able to accomplish had it chosen the “stay” option (woah, we are making a bold statement here by assuming that political and social issues can resolve themselves in the long run)

The primary objective it has achieved is the reclamation of its “economic liberty”. I do not know if “achieve” is even the right word to use here. Nevertheless, it can now fully exercise its monetary and fiscal policies to best benefit its national interest. It can now determine its own level of budget (either run a surplus or deficit) in the face of economic challenges. It can deliberate the appropriate level of money supply and interest rate to be better suited to its own economic conditions. It is no long subjected to the binding rules imposed by the EU that sometimes did disrupt the internal economy of Britain and slow down growth. This ability to exercise its own policies is important because it allows Britain to better buffer internal shock or any domestic economic frictions that have long-run implications.

Another crucial economic aspect that Britain has regained is “trade efficiency”. Of course, the EU might not be very generous in terms of trade deal with Britain in the future (especially, considering 45% of British export is to the EU members), but the feeling is mutual. The EU, likewise, relies on Britain for its growth. The EU without Britain is a less powerful and coherent EU. (Warning: normative economics coming) The best way out that will allow both parties to still be able to reap benefits from trade is for Britain to do it Norwegian style by being a part of the EEA (European Economic Area). I am not too sure about the how regulated it is though. Anyhow, taking into consideration the mutual benefits desirable for both sides, I do not see Britain that worse off in terms of intra-regional trade unless the EU wish to punish Britain to discourage such behavior in the future from other member states. However, the UK can always retaliate. Again, both sides depend on each other for economic prosperity. The optimal agreement is a free-trade or low tariff trade deal, and that is to be anticipated.

Trade efficiency actually extends beyond what we just discussed. Before Brexit, Britain was a part of the common market where common trade barriers (put up by the EU) increased the price of many imported goods into Britain from outside of the EU. In other words, instead of trading with more efficient partners outside, Britain was forced to trade more with those within the circle simply because of the internal free-trade zone. In 2 years, this is no longer the case. Being able to trade at lower or no barriers with other continents will unlock Britain’s true economic potential. Imported products will be cheaper and competition will get more fierce and ubiquitous (as protection gets lifted) forcing many British industries to value efficiency and innovation to survive and thrive. Consumers will hugely benefit from this.

Furthermore, many more firms in Britain will be able to tap into the more efficient global market and gain access to cheaper inputs (there indeed exist industries in Britain who are crippled by the high input cost due to the trade barrier imposed by the EU). This allows them to operate at full capacity, increasing employment, and pushing down price. It can help cancel out, at least partly, the setback in the labour market due to the lower labour mobility as a result of Brexit.

Of course, the strength of pound matters a great deal. Trade gain due to lower trade barrier can be offset by weaker pound (while it is true that weak currency boosts trade balance, it also increases price of imported consumer goods and production inputs at the same time). On that front, we have to wait and see the performance of the market. I believe that it will gain back its foothold, though not anytime soon.

A major improvement is probably the loosening up of the many economic restraints placed by the EU. The thing about policies and regulations is that they are designed by a group of people who, despite being highly intellectual, do not have all the information to always devise clever and successful policies and regulations. The people at the front-line of the market know best when to do what at where. They are the ones dealing with daily business talks and facing outcomes of the market. Economists usually support bottom-up approach because we believe that people left to their own accord can perform better. Rules of law and regulations are still much in need, but at a minimal level enough to guarantee safe business environment, observance of laws, and rights to ownership of properties and profits (and others like minimizing industrial pollution, welfare support, etc). However, any level of regulation that exceeds the necessary amount is more detrimental than beneficial.

The EU, having to coordinate 27 member states, is like a single mother/father having to look after 27 children. Extortionate number of rules and regulations are inevitable because they are tools to ensure proper cooperation and synchronized growth.

Those many regulations make businesses expensive, especially for new businesses. Starting a business in Britain, with all the regulations you have to abide by, is like stepping into a legal minefield (not my original phrase). This hinders one of the most significant factors that determine GDP, “Investment”. SMEs is where it hits the hardest. Freeing up Britain’s economy can reverse the process. Plus, without its annual (monetary) contribution to the EU, Britain can also save more to lower tax rate that further boosts investment.

Of course, not being apart of the common EU’s market is a problem as it can greatly reduce labour and capital mobility. Businesses might lose the golden passports that allow them to sell their products at lower cost outside of Britain. Regardless, with fewer unnecessary regulations, it is now easier to start and do business locally. Labour mobility decreases, but at the same time, it compels more British talents to seek domestic jobs (less braindrain problem). With more SMEs on the rise and stronger British industries due to trade efficiency and less regulation, a new and vibrant British economy is not out of reach.

What should be a concern is the fact that Brexit is irreversible. A slight misstep can go a long way. However, even with this in mind, and as much as I am personally against Brexit, its merits should not be overlooked. Every gloomy economic cloud has a silver lining. The economy is flexible and alive. The economy is us, the people, not some invisible hand poking the market. The situation is dire if people make it so because the market follows animal spirit, the bull and the bear. Confidence is just as important as any other economic variables in determining growth. I believe that economics can offer a way out, though it requires dexterity of the new British prime minister in calming down the public and assuring them stability. As long as Britain is not divided (Heck, London just asked for independence), a stronger and more vibrant economy is not impossible. Do not judge yet. In the next several years, think back of this article, and well, you might be surprised (either because this article sucks at prediction or it gets lots of things right).

Only time will tell.