Two weeks after British citizens voted to leave the European Union, the government has shown little urgency about implementing the “Brexit.” Recent economic research suggests that delaying the trade agreement that will guide this process may create additional costs for the British economy.
Economists call this the “real options effect” of economic policy uncertainty. For non-economists, this means that investment in both tangible and intangible assets will be affected one way or the other.
In the case of Brexit, a combination of trade and regulatory policy uncertainty means potential setbacks for companies in the United Kingdom. Some major companies with U.K. headquarters for their E.U. operations are already debating moving their ventures elsewhere, according to news reports. The list includes not only British firms like Vodafone, easyJet and HSBC, but also major foreign multinationals with a U.K. base, including Samsung, Bank of America and Ford.
Businesses don’t like uncertainty
Suppose a U.K. firm is contemplating a new project to expand a U.K. manufacturing facility or provide new finance, banking or information technology services. Green-lighting the project means additional investment — as well as new jobs.
The decision to exercise a company’s “option” on such projects involves whether to begin it today, and incur an irreversible investment — or wait. The company must estimate the size of the future market and the firm’s costs of servicing that market. But because of the uncertainty created by the Brexit vote, companies can’t make that estimate.
At one extreme, the future market for this new project could be very small, limited mostly to the U.K.’s own consumers. At the other extreme, the U.K. company might still have access to the other E.U. countries’ 450 million consumers as well. Obviously the second scenario is more attractive. But with Brexit, is it now realistic?
With the future payoff from investing in a U.K. project now uncertain, companies will no doubt put many of these decisions on hold.
Here are three key trade and regulatory elements the U.K. must negotiate, post-Brexit
1. Import taxes. U.K. firms that manufacture cars, pharmaceuticals, steel or other tangible goods really need zero import tax — or a free-trade agreement — with E.U. countries. Without it, E.U. import taxes would tack on a cost disadvantage averaging more than 5 percent of the value of export sales to Europe. This would leave U.K. firms competing with partners without negotiated special deals, like the United States, and at a disadvantage to firms from countries with E.U. free-trade agreements, including Norway, Switzerland, Turkey, South Korea and Mexico. Because roughly half of U.K. exports go to the E.U., the losses could be considerable.
2. Labor mobility. Will U.K. workers be able to work easily elsewhere in Europe? To access European consumers, firms increasingly need to send their sales force out to expositions and their information technology specialists and engineers out to troubleshoot. Aside from the deals that the E.U. has struck with Norway and Switzerland, few trade agreements comprehensively cover services or the free movement of people. But services — particularly financial services currently headquartered in the City of London — are important to U.K. exports. With anything less than full agreement on services, the market for U.K. exporters will be smaller.
3. U.K. vs E.U. standards. Will future U.K. regulations be compatible with E.U. regulations? Regulators in Brussels set the standards to determine access to the E.U. market. Will the results of U.K.-based clinical trials for pharmaceuticals, medical devices and biotech products routinely transfer for sales to E.U. countries? Will U.K.-produced autos or food — recall the U.K.’s BSE (mad cow disease) scares — automatically be deemed safe enough? Will professional qualifications for U.K.-trained lawyers, architects, engineers or health professionals automatically be extended?
Take a look at Portugal, 30 years ago
Given the uniqueness of Brexit, there are no prior empirical studies to help estimate the size of the real options effect of this uncertainty on U.K. trade or investment. However, a good starting point is new research examining an important example of an “opposite” scenario that arose 30 years ago.
Economists Kyle Handley and Nuno Limão recently examined the impact of Portugal’s 1986 accession to the European Community (E.C.). In 1986, Portuguese firms were forced to react to quite the opposite policy shock: reduced uncertainty. In this case, policy uncertainty was reduced because the 1986 trade agreement meant the E.C. could not revoke import tax exemptions it had been granting to Portuguese companies on a provisional basis. The 1986 elimination of uncertainty led to sizable increases in Portuguese firm investment, entry into exporting and increased exports. These increases occurred even in places where applied tariff policy did not change upon entering the E.C.
Translated into Brexit terms in 2016, the mere threat that tariffs, labor mobility or regulations may come into play means the U.K. economy is likely to suffer. Until these Brexit uncertainties are resolved, U.K. companies are likely to scale back investment and employment, reduce exports to the continent and even potentially exit from exporting to the E.U. altogether. They are likely to set up shop elsewhere to service the E.U.
And there’s an added complexity that makes it difficult to extrapolate from the Handley-Limão results from Portugal in 1986. The U.K.’s economic dealings with the rest of Europe are much more intertwined, covering trade in services, the mobility of workers and regulatory issues. Does this mean policy uncertainty is higher for U.K. firms today than it was for Portuguese firms in 1986?
While the evidence that economic policy uncertainty has tangible negative effects on international trade is new, unfortunately, its effects are also not limited to trade flows.
Consumers also don’t like uncertainty
Perhaps even more convincing is the growing body of macroeconomic research — much of it conducted by economist Nicholas Bloom with co-authors — that concludes that firms and consumers overall are less responsive to economic incentives in the face of high levels of uncertainty. This reflects research on how levels of policy uncertainty in many major high-income economies have risen over time, including in the period since the onset of the Great Recession in 2008-2009.
Thus the Brexit uncertainty — which may continue until the U.K. formally strikes a new regulatory and trade deal with the E.U. — means that even U.K. monetary and fiscal policy will be less than 100 percent effective, just when such policies might be most needed to ward off what could turn out to be a severe recession.
If Brexit is inevitable, what is the holdup?
The outward movement toward the E.U. of U.K. goods, services and even people can be on no better terms than it is today. This fact alone creates a paradoxical incentive for U.K. policymakers — even those that pushed for the “leave” vote — to try to delay the arrival of the new trade and regulatory relationship. The U.K. economy will face new costs as soon as these post-Brexit relationships go into effect.
Unfortunately, economic research suggests that the delay tactic itself introduces a second and separate cost to the U.K. economy: policy uncertainty. And these costs are there even if, after all of the politics play out, there turn out to be few actual changes to trade policy or regulations affecting U.K. companies.
Chad P. Bown is a senior fellow at the Peterson Institute for International Economics in Washington, D.C.