2016 As a Special Year for the UK and the U.S.

The UK experienced a rather surprising victory by the supporters of Brexit—i.e., those in favor of the UK leaving the European Union. The British referendum result of a majority in favor of Brexit was indeed a surprise to most observers, however, not really to this author who had expressed his skeptical view on the expected British referendum outcome in a piece for AICGS at the end of March 2016. If Brexit should actually be implemented, this would mean a considerable change for the EU, which would lose 13 percent of its Gross Domestic Product (as EU28) and 13 percent of its population; at the same time the UK would suffer a major long-term real income decline. Donald Trump, during the U.S. presidential election campaign, publicly welcomed the Brexit decision since this would bring political autonomy back to the UK. The perception here, obviously, is that any EU country joining the EU is losing political autonomy which, however, is an inadequate view. If the UK could effectively obtain better trade liberalization deals as an EU28 member country—for example, one may think of the EU-Korea deal or the half-finished EU-Japan trade deal which may be concluded in 2018—then there could in fact be an indirect power gain for all EU member countries within the current institutional framework under which the European Commission negotiates trade deals for all EU member countries. Prime Minister David Cameron’s government had not prepared any plans for the eventuality that the majority of voters would not follow Cameron’s recommendation that the UK should remain in the EU. What is strange, however, in the case of the EU referendum, is that the Cameron government did not include key economic findings of the Treasury’s study on British EU membership advantages and the cost of Brexit, respectively. As discussed in Brexit aus Versehen (an English version of this book, provisionally titled “An Accidental Brexit” is forthcoming in spring 2017) if the relevant information, namely that Brexit would bring a 10 percent real income loss, would have been included in the 16-page government brochure that was sent out to all households in the UK that explained “Why the Government believes that voting to remain in the European Union is the best decision for the UK,”[1] the referendum outcome would have been 52 percent in favor of Remain.[2] This can be calculated on the basis of UK popularity functions that explain relative government popularity by such economic variables as unemployment rate, inflation rate, and the growth rate of disposable real income.[3] The Cameron government allowed the overwhelming majority of voters to cast their vote under a veil of ignorance regarding the economic consequences of a UK exit from the EU, a phenomenon which is historically unique. On the other hand, the Cameron government proved itself capable when the situation of the referendum on Scottish independence—i.e., the preservation of the United Kingdom—arose in 2014.  It supplied all Scottish households with the relevant economic information by providing two economically convincing info brochures to all households in Scotland, which contained meaningful insights on the expected consequences of a vote for Scottish independence according to experts, in a timely manner. Against this background, the 2016 referendum therefore appears as damaging to democratic quality standards and thus unfair to British voters and EU partner countries alike.

However Britons would like to vote in a referendum—and however they want to decide—one must expect that a referendum, here announced by Cameron as early as 2013, in an OECD country would fulfill the minimum standards regarding information. In the UK in 2016 that was clearly not the case and from that perspective one cannot say with certainty how the UK’s referendum would have turned out in the event of a normal situation vis-à-vis information. Should the government of Theresa May want to refuse a second—but well prepared from an information point of view—referendum, then it could be said that the government has no interest in getting an unbiased and well-informed decision from the population; and furthermore, after almost 45 years of UK membership, intends to implement a separation from twenty-seven partner countries on the basis of the inadequate and uncertain first referendum. From a political and integration perspective, that is not a rational process, particularly given the knowledge of British voters, with just 49 percent correctly answering questions on EU institutions in a Bertelsmann survey. With that result, the UK voters were 4 percent behind their counterparts in Poland, a country that joined the EU thirty-one years after the UK. The results for Germany, Italy, and France were 81 percent, 80 percent, and 74 percent, respectively. The second most asked question on Google in the UK on the day after the Brexit referendum was: What is the EU? While prior to the Scottish referendum of 2014 the Cameron government conveyed key economic insights to households (i.e., that devolution would mean a loss of GBP1400 per capita in Scotland), before the Brexit vote the government did not widely publicize the Treasury’s finding that a 10 percent output loss was to be expected as a long-run Brexit effect. Thus there is a new, very convincing, argument for a second referendum.

There is no doubt that a sound information policy both should and could have been implemented for the referendum (in any event, a narrow pro-EU victory would certainly have resulted in a discussion over the required EU reforms). The determination that a professional information policy was required also applies in the hypothetical case that, taking the EU referendum into consideration, a lower elasticity existed between the influence of the economic growth and government popularity as was found in the classic study by Frey/Schneider which related to national elections in the UK. The British government will definitely have to explain the aforementioned issues—a lack of coordination, a visible indifference to an extremely poor information policy, and the unprecedented information breakdown by the government itself—to Parliament and the British and European public in general. Certainly, one would have also had, in the event of a narrow margin of victory for the Remain side, reason to carefully consider an EU reform agenda. However, the many conclusions on the referendum result to date, which have not taken the massive information blunder of government into account, need to be qualified. What is more, it is surprising how little the EU, and the national governments in Berlin, Paris, and other countries, carried out critical monitoring, i.e., engaged in a supervision process, in the run up to and indeed during the referendum. The huge information deficiencies and procedural irregularities stressed here would have been apparent to any critical monitor prior to the referendum. As astounding level of flippancy with regard to government work in EU member countries is apparent, which can only be a cause of concern for citizens. Here, too, can one reasonably expect and indeed demand more professionalism in the work of government. Going forward, political responsibility is an absolute must—and the in part superficiality of the internet needs to be opposed where necessary.

Moreover, the flawed, negligent information policy of the Cameron government can be a ground for the EU27 to offer the UK, in regard to conditions for future access to the single market, a diplomatic minimal solution which is not much better than the WTO conditions. As an EU member, the UK has rights and responsibilities in the community, with a political duty to appropriately inform its own citizens; in the second national EU referendum, the Cameron government, due to organizational failures of the government itself, did not fulfil this duty. Therefore, there is every indication of the need for a critical British and European debate on the information failure of Cameron’s government in relation to the Brexit referendum of 2016, and every responsible and rational politician must now reassess the need for a second referendum on the question of EU membership in light of the arguments and facts that are now known. A second referendum and a wider debate on referenda in the EU are called for.

The U.S. president-elect, Donald Trump, who achieved a slightly surprising majority in terms of the Electoral College (although Hillary Clinton’s lead in the popular vote is more than two million, meaning Trump will be the second minority president within two decades) is expected to maintain strong cooperation with the UK. Trump’s support for Brexit will mean a novel situation for Europe, namely that the U.S., for the first time since 1919, is not supporting European integration, but rather seems to support disintegration dynamics. The conservative government in London is seeking a strong politico-economic alliance with the U.S., particularly under the new Trump administration. This holds despite the fact that Trump has announced that the regional trade liberalization of the U.S. with eleven partner countries in the Pacific Area, dubbed the Trans-Pacific Partnership, will not be implemented, because Trump thinks that this regional trade agreement could contribute to the further international relocation of U.S. industry in the future. This protectionist sentiment is in contrast to the British liberal trade policy stance, but Prime Minister May’s government will not have many alternatives other than to seek a close collaboration with the U.S.

With Theresa May assuming her new position as Prime Minister of the UK on July 13, 2016, the future of the ruling Conservative government in London could be secured. However, May is facing serious problems with the Brexit project, and as of December 2016 it is still unclear whether she would be able to send a letter—required under Article 50 of the EU constitution—to the European Commission and the EU partner countries that would express the firm intention of the UK to leave the EU. The European Commission has indicated that it wants to conclude the negotiations with the UK regarding future access to the EU single market by autumn 2018, which would be early enough to get a vote from the European Parliament and EU member countries by early 2019—this is a European Parliament election year and it is inconceivable to hold such elections during the summer of 2019 with the UK still being an EU member country (assuming that the UK government seriously wants to leave the EU).

New Big Deficits in the UK and the U.S. after 2016

Philip Hammond, the British Minister of Finance in the May government, has declared that the British cumulated government deficits will climb by about GBP 122 billion (i.e., €144 billion or about $160 billion) relative to the budget plans of spring 2016. The government debt-to-GDP ratio of the UK would increase from 84 percent in 2015 to about 90 percent by 2018 and one should not expect—so explained by Hammond—that the earlier plans to achieve a balanced budget by 2020 could be achieved if reduced output growth should be realized in 2017/2018 as is expected by government. For 2017, the downward revision on the side of government was 1.4 percent output growth instead of the previous assumption of 2.2 percent, while for 2018 the expected UK growth rate of output is 1.7 percent rather than 2.1 percent. The May government also wants to reduce the corporate tax rate from 20 percent to 17 percent. In the August 6, 2016, edition of The Economist it was shown that there is a positive correlation between a country’s UK export share (i.e., the ratio of exports to the UK relative to total exports) and the percentage of people indicating in a MORI-IPSOS survey, carried out in fifteen countries, that they find BREXIT to be a bad development. Belgium, Sweden, Germany, and Spain each have a fairly high share of people—between 40 and 55 percent—who find Brexit a bad idea. Outside the EU, in Japan and Canada more than 25 percent view Brexit negatively, while the percentage in India and the U.S. is below 5 percent. The G20 meeting in Hangzhou has shown that Brexit is also is considered by most G20 countries to be a rather doubtful political project. With the statement of the constitutional committee of the House of Lords of September 13 arguing that to invoke Article 50 of the EU, and thus declare that the UK wants to leave the European Union, government needs a positive vote from Parliament, new questions have been raised as to whether Brexit will become reality. The UK is facing new political infighting resulting from a deeply flawed referendum that is undermining political stability in the whole of Europe—not least since right-wing populist parties on the European Continent feel encouraged by the Brexit vote. At the bottom line, inconsistent British politics and policy is undermining the stability of the Western world.

The foreseeable strategy of the May ministry, to achieve a new impulse for growth via numerous new free trade agreements, may, on closer inspection of the partner countries being mentioned, bring less than one might expect—as the analysis of one ex-employee of the Bank of England and other considerations show. While the exit-minister David Davis explained in spring 2016 (in a speech at the Institute of Chartered Engineers in London) that he would suggest free trade agreements with China, the U.S., Canada, and Hong Kong in the first instance and in a second stage with Australia, Brazil, India, and South Korea, one may argue that China will be a difficult negotiation partner and embracing broadly free trade with China would immediately condemn certain sectors, including the steel industry. Canada and Australia are rather small countries and thus cannot deliver major impulses for more growth in the UK. A free trade agreement with India, in turn, is difficult since India’s government will certainly require visa liberalization which is not exactly what the UK will want if one considers the strong anti-immigration sentiment of many voters in early 2016.

Nevertheless, the Brexit decision represents a call on the EU to vigorously undertake new institutional reforms—i.e., steps toward a better functioning Neo-EU. Less regulation, more transparency, and a better implementation of democratic principles are pressing matters to be addressed in the medium term, in the longer term a political union in the euro zone, which would represent 5-6% percent of GDP in terms of expenditure for Brussels. Through the transfer of above all infrastructure projects and spending, defense expenditure, and the introduction of an EU unemployment insurance for the first six months; plus interest expenditure on Eurobonds, where member countries of the EU and euro zone, respectively, can only raise credit for infrastructure expenditure and would also be subject to a constitutionally-guaranteed debt brake. National borrowing should, via constitutional debt brakes, be restricted to about half the Brussels structural net borrowing: 0.25 percent of GDP, which with 0.5 percent of GDP as an upper-limit on the cyclically neutral deficit ratio on the supranational level results in a long-term debt ratio in the euro zone of 50 percent (assuming that the trend rate of economic growth amounts to 1.5 percent). The political competition in the elections to the European Parliament in such a new EU would intensify and the voting shares of small, radical parties would decrease significantly, Europe would be more stable. Germany and France, in particular, are encouraged to undertake national reforms and EU initiatives.

It is interesting to note that the Trump transition team, preparing the Trump administration, has emphasized that the U.S. corporate tax rate should be reduced to 20 percent—reaching the low British level—and later should even be pushed down to 15 percent. Wolfgang Schäuble, the German Minister of Finance, has already voiced his critical opinion of the British tax plan as this program element of the May government is designed to keep foreign investors in the UK even after Brexit becomes reality. Moreover, Germany and indeed other EU countries anticipate considerable pressure to also reduce corporate income tax rates if the UK (and the U.S.) should do so, but this would not find broad political support in most continental EU countries since the income growth rates of capital owners would continue to increase much faster than those of workers and employees. Also, it is doubtful to tax capital income at lower rates than wage income. For the UK, an aggressive corporate tax policy will have the effect that the EU27 countries will become even more determined not to offer the UK favorable conditions in the field of access to the EU single market.

The New Economic Policy Approach of the Trump Administration

The Trump administration is likely to push for a corporate income tax rate of only 15 percent in the medium term. Tax reductions along with big infrastructure projects of government is likely to stimulate U.S. economic expansion, but at the same time it will increase the long-term debt-GDP ratio of the U.S. This holds even if many infrastructure projects could be financed within a public-private partnership approach in which private investors finance most of the investment project and then operate the project for two or three decades on the basis of collecting user fees; only then are the assets transferred to government which then is left facing maintenance costs. PPP approaches in infrastructure projects have been financed this way in several EU countries and in Canada, by contrast the U.S. does not have much experience in this field. Anticipating lower tax rates and higher government expenditures under a Trump administration, financial market participants in the U.S. drove up interest rates by almost 1 percentage point within five weeks of Trump’s victory. If one assumes that the inflation rate will rise by only half a percentage point or less, the implication is that there will be a rise of real interest rates (nominal interest rate minus inflation rate) and this will dampen private investment to some extent. More importantly, the increase of the interest rate and anticipated output expansion stimulates net capital inflows into the U.S. and this will bring about a real appreciation of the U.S. dollar. This, in turn, will dampen export growth while the import volume—stimulated by lower USD import prices—will increase. A worsening U.S. current account deficit will thus dampen output expansion and job growth in the medium term. This effect will be reinforced by the expansion of the non-tradables sector in the context of the infrastructure programs—in particular, the construction sector will expand. If the Trump administration should really impose higher import tariffs on exports of Mexico and China, this will not improve the U.S. current account situation much since the associated real appreciation of the exchange rate will stimulate imports from all countries and dampen U.S. exports.

The Trump announcement to increase U.S. oil and gas production will be a modest counter-effect in the medium term as U.S. imports of oil and gas can be expected to decline. While oil and gas prices might stay higher for some time to come, the world market prices can be expected to decline in the long run as global investment in renewable energy is strongly increasing—driven by the declining relative prices of both solar panels and wind power generators where both stand for static and dynamic economies of scale. An increased economic U.S. expansion in 2017/2018 is likely to be followed by declining output growth later. The UK and Germany will particularly benefit from U.S. economic expansion as their transatlantic exports are rather high. Moreover, U.S. subsidiaries play a major role in UK GDP—the share of these subsidiaries in value-added in the UK is about 7 percent, in Germany the respective share is about 2.5 percent. The UK, facing Brexit, is running the risk of losing foreign investors from the U.S. and other countries if the fear should spread that the UK will lose full access to the EU27 single market with its 440 million customers. As regards the UK negotiations with the EU in early 2016, the concessions obtained by the UK will not be implemented if Brexit should be realized, namely that the UK will participate in an enhanced EU single market program that was expected to generate an extra 4 percent output growth for the UK in the long run. The UK government will, however, implement restrictions on immigrants—including from EU countries—in the field of claiming social benefits; a delay period of up to a five years will be applied and Germany and other EU countries are likely to follow suit here. This, however, effectively undermines labor mobility in the EU which is already rather modest compared to the U.S. or Canada.

Brexit: A Disorderly Referendum and a Dishonest Immigration Debate

The Brexit referendum has not met the standard Western criteria in relation to government information which should be provided to voters and households, respectively—and the resulting majority in favor of Leave is opposite to the result an orderly referendum would have produced. It is indeed a disappointment for the western world and indeed many other countries across the globe to witness a historical degradation of referendum standards in the United Kingdom. That populist sentiments have contributed to the Brexit movement also is clear, however, one strange aspect is that David Cameron, i.e., the prime minister himself, has been a hidden cause of the growth of populism in the United Kingdom. By assuming a leading UK role in terms of a critical stance vis-à-vis the EU, Cameron’s credibility in the referendum—i.e., calling for a Remain vote—has been undermined and as a result was rather weak. Moreover, with Cameron’s Minister of Justice, Michael Gove—another leading voice of the Leave campaign—refusing in a TV interview prior to the referendum to name any economist who would be in favor of Brexit and Gove’s subsequent answer that people are fed up with hearing the views of experts, one may state the following: His type of populism is dangerous and will be costly to society. Rational political choice requires to take into account the insights of experts and scientists, respectively. Modern Western societies and the products we produce and consume or use are highly complex and nobody would like to fly in an airplane or go on a high-speed train which has not been designed and built by experts. One may also argue that the collapse of the socialist systems in Eastern Europe was partly the result of a lack of analytical expertise in the field of economics in the Soviet Union and Eastern Europe’s socialist countries. The Transatlantic Banking Crisis of 2008/09 has shown that Western capitalist systems could also face the risk of self-destruction and it was indeed the coordinated policy response of several Western OECD countries in combination with the involvement of leading economic experts, including those from central banks and academia, that has helped to avoid a dangerous financial and real social meltdown in the U.S., the UK, and some other countries. The banking crisis itself has led in the U.S. and the UK to very high deficit-GDP ratios in 2009 and 2010 as the interplay of strong recessions, the high cost of bank recapitalizations, and the need to finance expansionary fiscal policy through high budget deficits created a strong rise of debt-GDP ratios within a few years. It was already clear in 2009 that neither the UK nor the U.S. could regain economic stability if the double digit deficits in the U.S. and the UK could not be reduced rather quickly. As can be shown for the case of the UK, the need to reduce the high deficit-GDP ratio of government indirectly contributed to the strange and distorted British discussion on EU immigration.

As regards the immigration debate in the UK, in the run-up to the referendum Cameron has emphasized since 2013 that the UK was suffering from too much immigration, including too much immigration from other EU member countries. This is a strange conjecture since the OECD[4] has shown that the immigrants’ employment ratio is higher than the British average and that the UK has even enjoyed net benefits in fiscal terms. Prime Minister Cameron also never mentioned that immigrant entrepreneurship plays a considerable role in the UK. Both Cameron governments have, however, cut fiscal transfers to local government within five years of the banking crisis by 3.5 percentage points of GDP, which is an enormous budget cut for local communities and resulted in huge deficits for the National Health Service. These, in turn, have been forced to cut local public services so that the impression of an under-provision of local public services has been created—and many people, following the anti-immigration rhetoric of both Cameron and May (who was the Minister of the Interior in charge of immigration issues in the last Cameron government), wrongly attributed these under-provision problems to the immigrants from the EU. The annual growth of the population through EU immigration was, however, only 0.2 percent so that this perception is totally wrong: The perfidious strategy of Mr. Cameron and of Mrs. May in the field of EU immigration shaped, however, the referendum debate. According to the IMF, the United Kingdom was not even among the top five destination countries for migrants from Eastern Europe.[5] That Cameron made calls for the fourth pillar of the EU single market to be abolished, i.e., to end the free movement of labor, was both strange and unfair: Not once did Cameron take the trouble of presenting an objective description of the facts relating to immigration. As regards the U.S., it is also strange how much anti-immigration rhetoric was part of the Trump campaign. From an EU perspective, and also with respect to peaceful international relations, tolerance and functional integration of immigrants is crucial.

 

Prof. Dr. Paul J.J. Welfens is Jean Monnet Professor for European Economic Integration; chair for Macroeconomics; president of the European Institute for International Economic Relations (EIIW) at the University of Wuppertal; Alfred Grosser Professorship 2007/08, Sciences Po, Paris; Research Fellow, IZA, Bonn; and a Non-Resident Fellow at AICGS/Johns Hopkins University, Washington DC.

[1] HM Government, Why the Government believes that voting to remain in the European Union is the best decision for the UK (2016), available at https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/515068/why-the-government-believes-that-voting-to-remain-in-the-european-union-is-the-best-decision-for-the-uk.pdf

[2] P.J.J. WELFENS, Brexit aus Versehen. Europäsiche Union zwischen Desintegration und neuer EU, (Wiesbaden: Springer Gabler, 2016) and “Cameron’s information disaster in the referendum of 2016: an exit from Brexit?” International Economics and Economic Policy, Vol. 13, Issue 4 (2016): pp. 539-548 (free download until mid-January 2017: http://link.springer.com/article/10.1007/s10368-016-0361-3)

[3] B. Frey and F. Schneider,  “A Politico-Economic Model of the United Kingdom,” Economic Journal, Vol. 88 (1978): pp. 243-253.

[4] OECD, “The Economic Consequences of Brexit: A Taxing Decision,” OECD Economic Policy Paper, No. 16 (Paris: OECD Publishing, 2016).

[5] R. Atoyan, et al., “Emigration and its Impact on Eastern Europe,” IMF Staff Discussion Note, SDN/16/07 (Washington, DC: IMF, 2016).