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10^th June 2016

The EU Debate

The consequences of leaving

Most of the arguments around the EU referendum have been made but they have been done as salvos, brash statements with little substance. Both sides are guilty, not conceding any point in case as it may be seen as a weakness. The result is that the debate has descended into name calling that does not help those hapless individuals who are trying to make a decision based on the 'facts'. So this is my attempt at reading the crystal ball. Whilst the EU can change we are most probably familiar with what a future will hold if we vote to remain and therefore much of the debate should rightly focus on a leave vote.

So what are the consequences of leaving? An immediate reaction will be that the pound will drop in value as investors with hot money will withdraw it. This is almost a certainty, when the date of the referendum is announced the pound dropped 10c against the dollar to trade at $1.40. It has since climbed to $1.45 as the polls show the remain camp in the lead but should the referendum produce a leave result then it will fall back to $1.40 and more as the markets in herd fashion will overreact. After a few months it will have stabilised at a new but lower norm. It will result in higher prices in the shops for those things that we import which is virtually everything, however it will be good for exporters including those who focus on the EU as the UK will remain a member for another 2 years. Under a conventional interpretation of economics we could expect to see sustained growth over that period but of course this is only one of the factors that will determine our economic future. The first is the terms of exit and then there is the underlining health of the economy. Our relationship with Europe will be key. With the noises coming out of Germany and France it is highly unlikely that we could negotiate a deal that would lead to unfettered access to the single market without meeting the other criteria of free movement of people and a making a contribution. With immigration playing so heavily in the leave arguments it would be difficult to see any compromise from either side. So in all likelihood the UK will cut its ties with Europe. This would mean that British goods could expect to face a 10% or more tariffs on all goods and possibly even quotas on more common goods such as cars and agricultural produce. All of this means that the sterling will fall further to accommodate such a change.

The leave side will point out that there are other markets but this is to ignore two points, 1) there has been nothing stopping us pursuing these markets whilst we have been part of the EU; Germany has found no problems exporting to both the Americas and the Far East and 2) much of our exporting industries are foreign owned and deliberately focused on Europe. With 43% of our exports going to Europe this is a lot of trade to be made up if quotas are imposed, especially if those foreign owned exporter move their factories into another EU country. This is also forgetting that the UK economy is running a 7% deficit on its trade account. Or put another way we are consuming 7% more than we produce. Whilst these points are not encouraging in themselves it is indicative of wider problem within the British economy, that we as a nation have lost the ability to create home-grown industries. It is almost unheard of for someone today setting up a factory that is not making craft goods or producing food. Even the government has got into the same mind set where industrial policy seems to be more focused on attracting overseas investment than nurturing indigenous talent.

Returning to that 7% trade deficit, to bring us back to financial equilibrium and maintain our current ways we will need to increase exports by 7% which will mainly fall on the manufacturing sector but as this represents only 21% of the total economy it would have to grow to 28% an increase in capacity of 33%. That is quite a tall order with even with access to the EU's single market but it becomes a whole lot harder if there are restrictions placed on British exports to the EU. That we have been able to get a position where we can maintain such a large trade deficit is a little bit of corundum. In the past such bad trade figures would have sent the pound plummeting along with rising import costs. But it has not happened. Part of the reason may be that the rest of the world isn't shining either but another reason maybe that the net exporters of Russia and the Far East need both a demand for their goods and place to invest the wealth created, away from the reach of their own governments. Thus a symbiotic relationship has developed between the overseas exporters and the London property market. They sell us goods and use the money to buy property and other assets. This is known as the current account and the stock of British assets remaining is pretty small most of our large companies have been sold off but it turns out there is always property. In fact we can build more and this is what has been happening with the building of off plan luxury developments. Although we cannot physically export buildings the domestic construction industry has now become a surrogate exporter. If this is the case then we don't really need to worry about either the trade deficit or the EU. There again is it sustainable and now much is dependent on rising prices. If values start to fall will these overseas investor sell up? Probably, but not all. The expensive end of the London property market has been quite robust of late perhaps representing those overseas exporters who want to protect some of their wealth but the rising prices have brought in a range of speculators from home and abroad who may be looking for a quick buck or those who have bought on tick. For those overseas speculators a fall in the value of the pound could be enough for them to sell up. Should this become a stampede then the London housing bubble will be burst and with it the house prices in the rest of the country. And with that goes the main engine of growth. Banks will stop lending on mortgages and we will see a momentary collapse in GDP, just like 2009 but not as deep because growth has not been as strong this time round. Then we will see a slow contraction as people pay off mortgages but the banks significantly reduce creating new ones. If we factor in an enforced rebalancing of the economy that such a shock could cause, where consumption moves closer to production, this further contraction could be as much as 7%. The scenario described above, of a collapse in house prices followed by a deep recession will happen one day regardless of the result of the referendum but a leave vote will probably bring it on earlier and make it much more severe.

The economy will recover as it always does and there may even be times of increasing prosperity. Regardless of whether we leave or stay how and when we reach increasing prosperity will depend on the policies of the British Government and the Bank of England. If we carry on with policies as usual that of low interest rates we can expect a rerun of the last 5 years; low growth and low wages followed by another housing bubble. But whatever growth derives from it will be very short term and not reverse a longer term decline. Stoking a housing bubble has become 21st Century's equivalent of turning on the money printing presses. To transform the economy what we need to do is ensure that making things is more profitable than dealing in or improving property. This can only be done by restricting the amount of money made available for mortgages. Such are the economic forces the economy will face we probably lean this lesson quicker if voted to leave but it could still take 10-15 years before we saw the benefits and change in culture that encourages new indigenous companies to develop. There again old habits die hard.

If we were considering our own prosperity as determined by overseas trade only, in the long run (20 to 30 years) it may not make much difference if we left or stayed but in the short and medium term a leave vote would definitely result in more pain. But for me trade is not the only reason to remain in. On a personal level there is visa free access which will probably be lost if we impose visa to full fill a pledge to limit migration and the labour rights guaranteed through membership. As for immigration it may not be as simple as it seems to enforce. One of the reason given as to why Britain did not place any restrictions on the movement of people when Poland and four other east European countries joined was the high level of illegal migration especially in the agricultural sector. It is unlikely that wages will rise enough to draw in locals so can we expect fruit pickers to be on point based list? Or more likely we can expect a shortage to be meet again by illegal migrants. If enforcement proved so difficult in the early 2000s when we were notionally richer it will prove even more difficult in these austere times. The argument could be made to stop them before they arrive but that would mean visas based on the proof of earnings as happens for visitor from other parts of the world and could we expect the EU to allow us to discriminate between the citizens of their richer and poorer countries? Should we also expect reciprocal treatment? It goes without saying that enforcing the travel restrictions will be a bureaucratic and a farce if as likely it is not funded correctly.