On March 29th 2017 the UK government declared its intention to leave the EU. In the next two years, the EU 27 and the UK will negotiate terms of Britain’s exit and its future relations with the EU. It is possible to extend this deadline, but both sides have an interest to conclude the negotiations as soon as possible.

What are the economic issues? First and most importantly, the UK and the EU will need to agree on the regime for the trade of goods and services. Second, new rules are needed for migration. Third, the UK needs to be disentangled financially from the EU. This is the debate about the ‘Brexit Bill.’

Red Lines

Both sides start the negotiations with ‘red lines’. For the UK there seem to be three red lines. The UK wants to have full control over immigration and it does not want the rulings of the European Court of Justice to apply to the UK any longer. It also wants full sovereignty over its trade policy. On the EU side, one red line is that EU citizens currently living in the UK will retain their rights. Moreover, there is a lot of talk about the indivisible nature of the internal market’s four basic freedoms, meaning, in particular, that the EU wants to respond to limits on migration by restricting trade in financial services. There are also frequent warnings that there is to be no cherry-picking, although it is unclear what that means. Any deal with the UK will be a bespoke agreement specially tailored to the particular conditions of Brexit. Finally, the view is widespread that the EU 27 cannot allow Brexit to be an economic success because that might encourage others to follow.

Future Trade in Goods and Services

Given that the UK wants national sovereignty over its trade policy, European Internal Market membership and a customs union with common external tariffs are ruled out, so that a free trade agreement for goods and possibly also services seems to be the only possible arrangement. Compared to no agreement, which would imply trade under WTO rules, a free trade agreement would make a big difference. A comprehensive agreement which ensures free trade in goods and services would preserve most of the benefits implied by the single market, even though some additional hurdles like rules of origin would arise. According to estimates based on trade simulation models carried out by researchers at the ifo Institute (Felbermayr et al (2016)) the losses in GDP caused by a switch to WTO rules would amount to roughly three per cent of GDP for the UK and 0,35 per cent for the EU. In absolute terms the losses are of similar magnitude. A comprehensive free trade agreement could reduce these losses by approximately eighty per cent. Clearly, the UK will place emphasis on free trade in services while the EU will focus on trade in goods.

For business the uncertainty surrounding Brexit is a problem that will grow as the exit date in 2019 approaches. At the moment companies on both sides of the channel must face up to the prospect of tariffs applying as of 2019 or regulatory barriers arising that will endanger existing business models. If this risk cannot be dispelled, adjustments need to be made very quickly. The British economy is integrated into Europe-wide supply chains in a wide variety of ways; and it would be costly for both sides to restructure these chains now just to be prepared for the possibility that the negotiations fail to result in an agreement. To avoid such costs, it is important to outline the shape of future economic relations as quickly as possible, and a transition phase after 2019 should be defined, where the existing rules for trade will continue to apply for a number of years to avoid disruption.

Migration

While there is no doubt that the UK wants full control over migration, the open question is what that means in practice. Protecting the existing rights of foreigners living in the UK will be a necessary condition for an agreement with the EU. Regarding future migration it would be conceivable to provide for a kind of emergency brake to be activated in the case of an excessively high wave of immigration and along similar lines to the Swiss arrangement. However, since limiting immigration played a central role in the Brexit referendum, that may not be enough from the UK perspective.

Economically the gains from trade in goods and services are even higher when migration is restricted. But politically achieving a comprehensive free trade agreement will be more difficult, the more restrictive the UK wants to be on immigration.

The EU Budget

The last point is the EU budget. The European Commission has unofficially suggested a “Brexit bill” of 60 billion euros. This bill covers various and partly contingent EU liabilities, including EU officials’ pension claims and the ‘reste à liquider’, that is past spending commitments in the EU budget that have not been paid yet. The argument is likely to be particularly heated over this point, but an agreement will be reached. Agreements in other areas of the negotiations may even be facilitated through compensatory payments.

Hard or Soft Brexit?

How likely is it that there will be a deal between the UK and the EU, and how constructive will the deal be? The British government has threatened to deny cooperation in security policy if the EU does not cooperate economically. This was received quite badly on the EU side, where critics argued that there should be no trade-off between security and economic benefits. At the same time, the Brexit coordinators of the European Parliament have announced that ‘a State withdrawing from the Union cannot enjoy similar benefits as a European Union Member State and ... therefore that it [The European Parliament] will not consent to any agreement that would contradict this’.

An important factor for the negotiations is that there are considerable conflicts of interests between the EU 27 Member States. For instance, Germany has a strong interest in maintaining free trade with the UK whereas other Member States will place more emphasis on migration. Another key issue on the EU side is how to deal with the fact that there will be a gap in the EU budget when the net contributions of the UK disappear. A possible deal among the EU 27 could be that Germany pays more and gets free trade in goods and services with the UK. But whether the public debate on both sides, which is charged with emotions and resentment, allows for a rational compromise along these lines is an open question.

To reach an agreement which minimizes the economic costs of Brexit will require considerable energy, goodwill and political skills on both sides.

 

Clemens Fuest is Professor of Economics at the University of Munich and President of the Ifo Institute. 

 

This post is part of the ‘Brexit Negotiations Series’, a series of posts based on contributions at the ‘Negotiating Brexit’ conference that took place in Oxford on 17 March 2017.