Five years on, is Brexit finally paying off?

Paul Diggle

Hello and welcome to Macro Bytes, the economics and politics podcast from abrdn. My name is Paul Diggle.

Luke Bartholomew

And I'm Luke Bartholomew.

Paul Diggle

And today on the pod, we are going to revisit the knotty subject of Brexit. We're going to do a bit of a Brexit retrospective in terms of its impact on the UK economy, because it has been five years now since the UK left the EU.

The initial Brexit vote was, of course, in June 2016, but the UK withdrawal agreement came into force at the end of January 2020. The transition period ended in 2021 and while, Luke, I think we both bear some of the battle scars of navigating Brexit as economists and working in finance, I think the long-term macro consequences are fascinating and arguably still up for grabs, still up for debate, especially as the global trading system continues to change.

Luke Bartholomew

Indeed. I think, you know, one of our key points today is going to be, much like the French revolution, it may be too early to tell exactly what the long-term consequences of Brexit are. Because, look, on the one hand, I think it is pretty clear that there was a decent amount of economic pain from the decision to leave the EU, including higher inflation, lower investment, lower growth and more fundamentally, it's pretty hard to write down a standard economic model where increasing trade barriers with your major trade partners boosts growth. It, you know, stunts competition, innovation, investment and the efficient allocation of resources.

But on the other hand, the promise of Brexit was always meant to be that over the long-term, it allowed Britain to set its migration, trade and regulatory policies in a way that might better reflect its preferences and needs, and more nimbly adjust to a changing world.

And there are some tentative signs that that might be happening right now, like around how the UK could handle the EU / US trade war, or in regulation of new emerging sectors of the economy.

Paul Diggle

Indeed. So lots to get into. We're going to talk about some of the impacts on sterling and inflation in the months and years after, the impact on growth, investment and productivity, and talk about how migration flows changed post-Brexit.

And then look ahead, as you say Luke, look to some of these current topical questions of the US trade policy and how Brexit might change the way that the UK navigates those.

But let's start with the initial impact on sterling and inflation, because that was the first most acute economic marked impact of Brexit. On the night of the referendum, 23rd of June 2016, the pound fell by 8% against the dollar. It was the biggest one day move in modern history. By a point later that year the peak to trough move was something like 20%, and that reflected the increase in economic and policy uncertainty. Markets, of course, needed to price in a certain amount of instability, perhaps a weakening in the long-term growth outlook, and a degree of capital flight occurred. Foreign investors pulled money from UK assets to push the pound lower and what we saw was a drop in sterling bigger than, say, Black Wednesday 1992, when the UK fell out of the exchange rate mechanism.

Luke Bartholomew

And just on that comparison with the exchange rate mechanism (ERM), I think it is worth spelling out an important difference between those two episodes, which is, you know, in the exit from the ERM the pound fell because then UK monetary policy could be eased to settings that were much more appropriate to the domestic conditions of the economy, rather than trying to defend a particular exchange rate target.

And so it makes sense in that perspective, why that helped to boost demand and growth. But that wasn't the case following Brexit. There, the fall in sterling was much more about a reassessment of the UK's terms of trade, potential growth, return on UK assets that the market was making. I mean, in a sense, it was sort of like the mechanism that brought about the fall in living standards that the market judged would be the long-term impact of the policy.

Paul Diggle

Yeah. And there was this inflation impact as a result of that move in the pound. Of course a weaker pound makes imports into the UK more expensive and the UK imports a lot of food, fuel, manufactured goods. Inflation heading into the referendum was pretty low – like half a percent in fact – year-on-year in June 2016. But a year later inflation was approaching 3% in the UK.

And while those numbers actually look quite modest in the subsequent context of the of the pandemic, the post-pandemic inflation surge, they were still large enough to cause a degree of real wage erosion, at least relative to that kind of counterfactual path. And they contributed to a period of weaker consumer spending. And indeed, they then required a monetary policy response.

So the Bank of England, of course, initially cut interest rates shortly after the vote to stabilize the economy and also, in the immediate aftermath, it used its balance sheet to shore up UK financial markets. But that then was reversed come 2017, when inflation was increasing, and the Bank of England initiated a modest rate hiking cycle.

Of course, other central banks were also hiking at that point in time. If we cast our minds back, the Fed was hiking as well. The difference was that the UK was dealing with quote ‘bad inflation’ in the sense of, responding to a negative supply side shock – import-driven inflation, whereas the Fed by contrast, was dealing with quote ‘good inflation’ in the last year - affecting the strength of the demand side of the economy.

Luke Bartholomew

And so turning from inflation to growth, and I think, you know, a naive inspection of the data pre and post the Brexit vote does show a pretty stark difference in growth, performance. Before the 2016 referendum UK GDP growth was growing at around 2 to 2.5% year. Since the vote, growth has averaged around 1% a year, and that has lagged behind the US and the eurozone.

And small differences in GDP growth levels compound over time and that's what leads to some of these very big level estimates that are associated with some of the early analysis of the impact of Brexit. But look, it can’t of escaped anyone's notice that quite a lot has happened since 2016 that isn't to do with Brexit but could of influenced those different growth rates. So I think an important question is ‘how do we tease out that Brexit impact?’.

Paul Diggle

Yeah. And what economists did is this thing called a ‘synthetic counterfactual’. That's a couple of big words. But essentially what it means is economists, statisticians, try to build a model of UK GDP using similar comparable economies. So they took the likes of Germany or Canada or Australia or the US, and they try to explain the pre-Brexit referendum path of UK GDP growth, using those economies as sort of explanatory variables. And then by projecting that model forward beyond the Brexit referendum, the withdrawal agreement and so on, you could build a sort of ‘what if’ scenario, a ‘synthetic counterfactual’, of how the UK may have done, economically speaking, in the absence of the Brexit shock. And if you do that kind of economic modelling, what you seem to find is that Brexit, knocked between 2 and 4% off the level of GDP growth in the UK, and may have also had a lasting effect on the trend growth rate itself.

Luke Bartholomew

And I think that kind of counterfactual analysis is exactly the right way to think about ‘causation’ and getting at the idea that we just want to isolate the Brexit impact. We want to answer the question of how Britain would have performed were it not for Brexit. So conceptually, this approach is extremely powerful, but I think there are some caveats that are worth noting on the methodology. And not least, that it is very difficult to construct the right sample of countries to compare Britain's performance against, because many of the countries in that sample have been impacted by different pandemic responses. In the US, there was massive fiscal stimulus. Germany had its own very idiosyncratic energy and shocks to its core basic economic model during that time.  And so those are differences in economic behavior that have nothing to do with Brexit and should make you therefore a bit worried about the precision of the numerical estimates that come from those models trying to abstract through those various different ‘confounders’.

But that said, I think the sign of the likely impact is clear that growth has been weaker, and in particular, business investment has been very weak. I mean, it has stagnated after the 2016 vote. Is now maybe 10 to 20% lower than it otherwise would have been. And foreign direct investment has been especially weak, falling about 30% from 2017 to 2022, which in the same time both the EU and the US saw increases. And the thing with business investment is that not only does it impact present GDP, it makes up weaker, but it also impacts future GDP as well as the capital stock that could deliver that future growth is lower than it otherwise would have been.

Paul Diggle

Yeah. And it's not particularly difficult to motivate why business investment would have been hit. Of course it reflects uncertainty. Businesses do not like uncertainty. There was the regulatory divergence that businesses had to navigate. There was option value in waiting to see how the UK/EU post-Brexit arrangement would pan out. And even when that uncertainty was resolved, when the withdrawal agreement was signed, that doesn't necessarily in and of itself boost business investment because you could in fact have a crystallisation of the quote ‘bad outcome’, you know, regulatory divergence on trade barriers and that can continue to weigh on business investment. And as you say, that all impacts productivity growth as well. Capital deepening is a crucial way in which per capita, per worker, productivity growth increases. And you know, UK productivity growth wasn't exactly ‘stellar’ in the decade or so before the Brexit vote - running at perhaps something like 0.5 to 1% per year per worker. Sluggish, but at least positive. But since Brexit, it seems that UK productivity growth has stagnated, has really been close to zero.

Luke Bartholomew

And it isn't just the per capita or per worker numbers that have been affected by Brexit. It's also the total number of workers. Because perhaps one of the biggest surprises, or perhaps even ironies, compared to expectations before the vote, is that there has been a significant liberalisation of the immigration system and a large increase in migration accordingly, since the UK's exit from the EU.

Paul Diggle

Yeah, indeed, so just to put a few numbers on that. In 2023, UK net migration hit a high of about 900,000 people, and that's about triple the pre-Brexit average - which was running something like 250,000 net migration into the UK per year. So I did a few quick calculations, looked at the four-year average of UK net migration over 2021 – 2024, so that's after the withdrawal agreement and the transition period, and it excludes the big drop in migration that occurred in 2020 during the pandemic - although it is perhaps going to be biased upwards from the post-Covid rebound in movement. But that was 600,000, right. So we've been running at something like 2 to 3 times pre-Brexit net migration into the UK post Brexit. And it's worth asking quite what changed then to lead to that increase, that, as you say Luke, that ironic increase in migration.

 It was partly about the UK ending free movement in January 2021 - replacing it with a points-based immigration system. So EU net migration dropped significantly and that hit sectors such as agriculture, hospitality, healthcare. But what EU migration was replaced by was a large increase in first of all, humanitarian migration. So this was the Hong Kong visa scheme that the UK government put in place, and of course taking a very large number of Ukrainian refugees following the Russian invasion of Ukraine. But I think most impactfully has been the new visa and student visa arrangements. So visas for skilled workers in key industries saw a large increase in arrivals to work in healthcare in IT, in engineering. That was a response partly to post-Brexit labour shortages.  International student visas also increased as well as the UK expanded that graduate route that was partly required to fund the UK's university sector.

Luke Bartholomew

And in terms of the economic impacts of that, it is very likely to have boosted overall total GDP, in part just by expanding the workforce. In fact, one trick that several governments have discovered is that a surefire way to get the OBR, the Office for Budget Responsibility, to deliver more favourable growth forecasts - and so more fiscal space - is for that government to pursue more liberal migration policies. But I suppose what might matter more from a quality-of-life perspective is GDP per capita and the total fiscal impact of certain migrants over their full lifetime. And that will depend on the productivity of the migration flows’ skills - whether they're filling very hard to fill strategic sectors, the age profile, the incentives this creates for capital investment. And I think on that front, the evidence is relatively mixed at this point. So it will take time to see how the long-term impacts of this very different migration policy play out. But absolutely, a crucial part of thinking through the long-term impact of Brexit will be monitoring this channel.

Paul Diggle

And what is also TBC in terms of Brexit's impact on the UK economy is quite how it interacts with the new, more aggressive, more assertive approach that the US is taking to global trade policy.

Luke Bartholomew

I mean, I think it's fair to say that many of the trade deals that the UK struck with the new trade freedom that it had outside of the EU have been a bit underwhelming economically. The early arrangements were largely about rolling over existing EU deals. The Australia deal did go a little bit further and the UK of course joined CPTPP - the Pacific trade deal - but the economic benefits of those trade agreements is pretty small, perhaps as small as a 0.08% boost to GDP over a decade. I mean, that really is a rounding error on a rounding error. And the reason it is so small is because of the limited density of trade with those trade partners. And it's certainly plausible trade could increase with those countries due to the new trade arrangements - and so the benefits get bigger over time - but it is hard to see that being a radical change, because in a sense, that would literally be bucking gravity. There is robust empirical findings that countries trade far more intensely with trade partners that are geographically close. That is the so-called ‘gravity model of trade’. And so the benefits of trade liberalisation are much greater with partners that you trade more - and so partners that are that much closer. I mean, that being said, of course, CPTPP was about more than trade. It was, about the UK's geopolitical posturing - wanting to be inside a trade arrangement in Asia that China wasn't part of, but just on the straight economics, I'm not sure there's a huge amount to write home about there.

Paul Diggle

That said, where that could well be a silver lining in trade terms is if being outside the EU allows the UK to avoid the worst of the increase in tariffs, that are very likely coming from the US, from the new Trump administration. So I think at this point, we can say that it is extremely likely that the US will, at least temporarily, impose tariffs on EU goods. I think certain sectors are very likely to be targeted. In fact, already we know that the US is going to tariff global steel and aluminum, but in time it may target European green technology, cars. We know that Trump is particularly unhappy with EU state subsidies especially in electric vehicles. But other European trade practices, rules, regulations – particularly in the tech sector. VAT, which is a non-tariff barrier, but Trump really effectively compares to a tariff. And if tariffs hit European manufacturers that is potentially going to make the UK a more attractive place to do trade with the US. And by contrast, the UK itself is likely to avoid the worst of US tariffs because it is a more service-based economy - focusing on services exports which do not, for now at least, seem to be the object of Trump's trade ire.

Luke Bartholomew

And that being said, Trump's trade policies and the fact that these are measures against erstwhile allies is just a sign of how much the global trade environment is becoming fragmented, and that is an environment that the UK could find itself feeling rather lonely. In part, what Trump is doing is demonstrating the importance of economic scale when it comes to global trade agreements. He has so much leverage in some of these talks, precisely because of how huge the US market is as an export destination, and outside the EU the UK has that much less scale. It is a much smaller market, and so may find that it has a lot less power in trade agreements, and so ends up with less favourable trading terms.

Paul Diggle

Well another area in which the US policymakers are particularly interested in trying to exert some pressure on European policymakers is around AI regulation. I wonder if this too will in time prove to be another opportunity arising from Brexit? Because the EU seems to be going down a more stringent approach to AI regulation. It's rolling out its AI Act, which is a fairly tough regulatory framework to limit AI deployment, or at least put pretty clear guardrails and compliance rules around it. And certainly, in the telling of Silicon Valley itself, this could stifle AI innovation and harm Europe's ability to sort of build a strategic competitive advantage in this advanced technology.

Luke Bartholomew

I mean, I think the UK definitely does see itself as a potential beneficiary, especially if, firms are turned off by the EU's approach to tech policy. The government is trying to stake out a very different strategy, a more ‘light touch’ approach. So instead of rigid regulations it's focusing on guidelines, industry collaboration, more agile overthought. There is the thought that the UK might find it easier to change policy, just as one government that needs to decide, compared to the EU where there are multiple governments and interest groups. And so regulation around this very fast-moving sector might be more stagnant in the EU. And I think AI firms are looking at the UK as a more business-friendly environment - and there are some early signs of success. OpenAI, Google DeepMind, other AI players are expanding operations in the UK. And just the other week, when Prime Minister, Keir Starmer was discussing this AI strategy, he was asked about the UK's ability to pursue this outside of the EU and noted that it was just as a consequence of Brexit that this strategy could be pursued.

 So look, if AI does turn out to be radically economically transformative and regulation does turn out to be a big deciding factor in how those gains are distributed, then potentially this is an area which could be a material long-term benefit from the UK being outside of the EU.

But look, we often say at the end of the podcast that, we will no doubt come back to this topic in time, and perhaps it'll be five more years before we revisit this one again. I wouldn't be surprised if we rolled out the same French revolution joke at that point, but, until then has always please let me ask you to like, subscribe, wherever you get your podcasts from. And then all that remains is to thank you all for listening. So thanks very much and speak again soon.

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