The Rational Response to Brexit

The Brexit vote was disappointing, for the reasons I wrote about in my earlier post. But, what’s done can’t be changed. What’s the best way to respond to it?

It’s hugely tempting to accuse the Brexiteers of being racist or stupid. We share with glee how some admit that they were conned by Farage and would have voted differently. We paint nightmare scenarios of how bad a post-Brexit world will be. But, this won’t change anything. If your house burns down, don’t blame the fire service for not responding faster, or lament how bad your life will be without your house – you build it back up again. It’s the same here. A post-Brexit world will only be disastrous if we allow it to be. Instead, every single person has a role to play in safeguarding the UK’s future. We should respond to Brexit like any recession or bad event. 9/11 was a far greater disaster than Brexit; those responsible had far worse motives. Yet, most of the world responded not through hatred, but through solidarity, and the economy recovered sharply in 2003-2008.

1. Negativity Is Self-Fulfilling. And So Is Positivity

Patients diagnosed with a terminal illness sometimes beat it through mindset. Leicester City or Iceland punch way above their weight due to self-belief. It’s the same with the economy. John Maynard Keynes referred to this as “animal spirits”, others call it “business confidence”. If companies stop investing, if skilled workers emigrate, if consumers stop spending, then we will indeed have a nightmare scenario – but brought on by our own doing, not by Brexit.

I’m not asking Brits to drink Kool-Aid and think things are rosy when they’re not – instead, to take notice of the many rational reasons to be optimistic. Before the vote I outlined here the sensible reasons for Brexit (which were sadly lost in the negative campaigning). A short summary:

– The EU can’t slam the UK with the worst trade deal possible. Under World Trade Organization rules, the UK has “most-favoured-nation” status with the EU – i.e. is entitled to the best deal that the EU gives to any other country.

– The UK has 2 years to negotiate a trade deal, and will benefit from the Single Market until then. There will be no sudden impact on trade.

– The UK can start negotiating trade deals with many countries the EU never had trade deals with.

– There are many other reasons firms invest in the UK. E.g. London is uniquely attractive due to the English language, low taxes, low regulation, skilled labour, expertise in accounting and law.

– The UK need not turn anti-immigration. It can still welcome immigrants, but adopt a policy tailored to its own requirements, rather than the EU’s (e.g. restrict low-skilled workers and attract high-skilled ones). A progressive policy can keep EU nurses in the UK and not harm the NHS.

– The UK can participate in research funding programmes (e.g. Horizon 2020) by buying back into it, as Norway and Israel do.

2. Brexit Provides Opportunities

Both the pound and stock market tumbled immediately after the result was announced. This gives us the opportunity to buy equities cheaply, or pounds cheaply and invest the money in the money in the UK. I’m not saying that you should necessarily invest right now – wait until things stabilise – but investment opportunities well be more attractive than previously.

For those without spare cash to invest, don’t panic and cash out because markets have fallen. Stock prices depend on (1) expected return and (2) risk. The stock market downturn has been largely due to uncertainty as to what’s next (2) rather than conviction that the post-Brexit world will definitely be disastrous (1). Things are likely to rebound once a new PM is elected, trade deals are made etc. On 24 June, the FTSE 100 plummeted 8.7% immediately after Brexit, only to recover 5.5% by the end of the day, and actually ended the week higher than it started. One caveat is that the FTSE 100 contains many multinationals which will have benefited from the decline in the pound. The FTSE 250 comprises predominantly domestic companies, and also exhibited a rebound, but it was more modest. The initial fall was 9.2%, and it subsequently recovered 2.6% by the end of the day.

3. The Game Hasn’t Changed

Someone on Twitter said he’s just graduated and about to start his career, and asked me what he should do differently post-Brexit. The answer is nothing. Promotion and relocation opportunities exist as they did before. The way to get promotion (hard work and initiative) is the same as before. Skilled workers can get visas and relocate. I spent 10 years in the US surrounded by others on student or worker visas like me.

I joined Morgan Stanley two months before the horrible tragedy that was 9/11. There were four rounds of major cuts in my two years there. But, this again provided opportunities. As a first-year analyst, I had no Associate and so worked directly with a VP and an MD. I went to meetings that I wouldn’t have had a hope of going to if the economy was booming and we were well staffed. Virtually any analyst that stayed for the full three years was promoted to Associate afterwards, because we had so few Associates due to the culls.

The game hasn’t changed for business either. The business environment will be harder if we have trade barriers. But, businesses need to make their products and services so attractive that consumers will buy them despite import duty. And this is entirely possible – most household products (Toyota, Apple) are from outside the EU.

Businesses and employees need to work hard and work smart. But, they needed to do that before Brexit anyway.

4. Keep Engaged

One of the positives of the referendum is that many people who would not normally be interested in economics or politics have been highly engaged. Keep it that way, long after the referendum has blown over: see point 1 below.

WHAT HAVE WE LEARNED?

It’s useful to look back at the whole referendum debacle, not to blame how it was conducted, but to learn lessons for the future. Here’s three I took away:

1. Financial Literacy is Key

Many Remainers complain that Brexit was driven by uneducated people who didn’t know the facts. Well, the solution is then education, not blame. We should teach financial literacy and basic economics in schools (starting before A-level), and even for adults. It’s the absence of basic economic training that allowed Farage and co to delude millions. Economics is often seen as the “dismal science”, and only necessary for those who want to become evil bankers. But, it’s key to ordinary folk being engaged in what affects their own country. The effects extend far beyond voting – predatory lending by payday lenders, and mis-selling of Payment Protection Insurance, exploit financial illiteracy.

2. Democracy Is Overrated

The thinking behind referendums is well-intentioned – to give the public a say. And, referendums may well work for decisions that are largely opinion-based (e.g. gay marriage), but not for complex ones where a deep understanding of the facts is important. We’d never hold a referendum over the government’s health policy as that should be led by scientists. But, for some reason, for economics, everybody believes that they’re an expert, when economics is as complex as medicine.

This applies far beyond national decisions. On the same day as the referendum, I was debating executive compensation with Sir Vince Cable. He said, were he still in power, he’d require employees to be consulted on CEO pay packages. The intent is benign, but the solution is chaotic. CEO pay is an extremely complex issue which extends far beyond the level of pay. Should we give stock or options? Should they vest all at once, or over time? What’s the optimal vesting period? Should we index it to industry performance or market performance? Not even boards of directors understand all these issues, it’s unlikely that the average employee can.

3. Facts First, Then Opinion

The referendum highlighted how knowledge of the facts is essential to make correct decisions. This may seem obvious, but is often under-appreciated. Going back to CEO pay (just because I know this topic well), Sir Vince was arguing that there is no relation between pay and performance, perhaps because there was one example of a CEO who was well-paid despite failing – but that’s simply untrue when looking at firms in general. Forming policy based on a couple of outliers is just as bad as saying that all immigrants are scroungers because the Daily Mail reported one case of a scrounging immigrant. The media will only report the most egregious cases because this attracts attention. A case of a hard-working immigrant, or a CEO paid for performance, isn’t news, just like “London Bridge Failed To Collapse Today” isn’t a headline.

To form an opinion, you need to consider all the evidence, not just one example. And that’s the role of academic research. Academics are often accused of being disconnected. And, we certainly know less about one particular company than a director or even employee at that company. But, this disconnection is a strength, rather than a weakness, because it allows us to study thousands of companies. Similarly, whatever decision we make – on immigration, education, or health – should be based on studying thousands of immigrants, pupils, and patients. With apologies to Jane Austen, rhetoric may incite short-term Pride and Prejudice, but it’s data that drives long-term Sense and Sensibility.

The Case for Remain

Today is perhaps the biggest decision the UK will ever face. Under 18s will be most affected by this decision but can’t vote. Brits can. More important than which way we vote is that we should vote.

I’m normally politically apathetic (only voted once) but this is such a key decision, I’ve spent hours researching the facts and evidence (often misportrayed) with an open mind – in fact, I earlier posted a detailed blog on the case for Brexit). After all that, my personal view is overwhelmingly for Remain.

1) JOBS. Thousands of firms are here because of access to the Single Market – a “passport” that allows them to sell to 500m customers in 28 countries, rather than 60m in 1.

40% of international firms’ European HQs are in London. (#2 is Paris with only 8%.) Many will relocate significantly to the EU upon Brexit. JP Morgan stated they’ll cut 4,000 jobs, HSBC 1,000. 2/3 of the financial services industry is outside London; it’s not just rich bankers. (Source: Alastair Lukies in CityAM).

What about non-UK folks stealing UK jobs? The evidence just doesn’t support this. The LSE’s Centre for Economic Performance found that immigration doesn’t harm wages, jobs, or public services. Immigrants buy goods and services, generating employment for Brits.

2) INVESTMENT. 70% of investors in the UK link their decision to invest to the UK being in the Single Market. Investment provides jobs.

3) TRADE. UK exporters benefit from not needing to pay the EU’s Common Customs Tariff if they export to the EU. The Leave campaign says the EU isn’t important to us. The facts don’t show this. 45% of the UK’s trade is with the EU, versus only 18% with the USA and 3% with China

Much has been made of the UK’s ability to negotiate its own trade deal post-Brexit. But:

– The average time to broker a trade deal is 28 months. It’s true the UK will benefit from the Single Market for 24 months post-Brexit. But, 28 months is the relevant figure. From month 1 (not month 25), firms will reduce investment due to uncertainty. They already have been.

– The UK will still be the world’s #5 economy. But, the RANK is not what matters, but the RELATIVE SIZE. The UK will be far, far smaller than (say) China, and be dictated to in trade negotiations.

4) THE ECONOMY. Stock markets aren’t always right. But, they’re pretty good. The market jumped 3% on Monday upon hopes of Remain. That’s £60 billion pounds. The stock market isn’t owned just by the mega-rich – but also by pension funds and insurance companies. And, it’s not just paper money. Let’s say the probability of Remain rose by 10% on Monday. A £60bn rise means that the UK economy will be worth (in terms of output) £600bn more upon Remain. (£60bn = 10% * £600bn).

The National Institute of Economic and Social Research forecasts GDP in 2019 will fall by 2.1-3.5%, reducing public finances by £20-40bn (AFTER including the reduced EU contribution). The Institute for Fiscal Studies predicts that “Austerity would be extended by another year (optimistic scenario) or another two years” – leading to further job losses.

5) SCIENCE AND TECHNOLOGY. Over 50% of nanotechnology and evolutionary biology funding comes from the EU. A common funding source helps collaboration between EU labs. Otherwise, a project between labs in 3 countries would require 3 separate applications. Digital Science forecasts that Brexit would cost UK science £1 bn. Source: The Economist.

6) PEACE. As Richard Branson wrote, “One of the EU’s most important achievements is that it has kept its members out of conflict in Europe. I represent the first generation of my family not to go to war in Europe. For centuries, almost every generation was at war with one European country or another.”

Both the UK and Eire being in the EU has played a major role in maintaining peace in Northern Ireland.

The UK’s membership of EU was a big factor behind Scotland’s decision to stay in the UK.

7) ENTREPRENEURSHIP / SMALL BUSINESSES. The Single Market catalyses startups, giving them access to 28 countries and helping them get off the ground. TransferWise (Estonia founded, UK based) has used it to expand across the EU. (Source: Alastair Lukies).

8) LESS BUREAUCRACY. Much is made out of EU’s overregulation. But, EU membership /reduces/ a lot of paperwork – in many areas that the public might not even realise.

Over half of channels broadcasting in more than EU state do so out of the UK, like Discovery Channel and MTV, using only one single license. If UK were outside, broadcasters would have to get separate licenses in all EU states (or leave UK). (Source: Alastair Lukies).

9) FREEDOM. A UK passport gives the right to travel, work, study, retire anywhere in the EU – without having to get visas (again, LESS bureaucracy, not more). This provides tremendous job and educational opportunities – but more importantly, culture and life experience ones.

(SOME) ARGUMENTS FOR BREXIT

1) UNELECTED BRUSSELS BUREAUCRATS. There are only 55,000 EU civil servants. The UK has 393,000. We don’t vote for Treasury or Home Office officials, or the Governor of the Bank of England. Source: LSE’s Nicholas Barr.

2) COST. Cost of EU membership is < 30p per person per day. Even a small reduction in trade or investment would dwarf any savings.

The Case for Brexit

I’m strongly in favour of the UK remaining part of the EU. However, I recently went to a talk given by a Brexit supporter, to hear the other side. I believe that he/she gave some persuasive arguments. Even though I don’t agree with all of them, I thought to share them here, since it is important for voters to be informed about both sides. I’ve supplemented them with perspectives from an excellent report by Capital Economics, commissioned by Woodford Funds, at https://woodfordfunds.com/brexit. Feel free to comment if you disagree!

Trade

Current State of Play

  • UK exporters benefit from not needing to pay the EU’s Common Customs Tariff if they export to the EU
    • But UK consumers pay more for imports from outside the EU, since we need to impose the EU’s Common Customs Tariff
  • UK can benefit from the EU’s clout in international negotiations
    • But the UK can’t negotiate its own trade agreements. Having the clout of a large group is not a benefit if the UK has different goals from the rest of the group. E.g. UK is primarily concerned with the City, France with agriculture
  • The UK can help complete the Single Market in services, because it’s part of the club – e.g. reduce discrimination (at present, online offers are only available to people browsing the internet in certain countries)
  • Free trade with the EU is important, but not absolutely critical
    • Tariffs have fallen substantially. Average tariff to non-EU exporters is 4%, vs. 8% in the early 1990s
      • But 4% is only an average. Some sectors will be hit more. Car industry would suffer from a 10% tariff on cars and a 5% tariff on imported components
    • Manufacturing has fallen from 20% of UK GDP in the mid-1990s to 10% now. Tariffs only apply to goods, not services
    • Europe has become a less important export market. 45% of UK goods and services exports go to the UK, vs. 55% in 1999. Exports are 30% of UK output, so goods and services exported to the EU are 14% of the UK economy

Post-Brexit

  • Will the UK be able to negotiate a trade deal post-Brexit?
    • The EU might refuse to deal as punishment for Brexit – in particular to deter others from leaving.
      • But, even this situation won’t be a disaster. The EU won’t be able to “punish” the UK with a worse deal that (say) the US – under World Trade Organization rules, the UK has “most-favoured-nation” status with the EU – i.e. is entitled to the best deal that the EU gives to any other country
      • UK exporters would face costs, e.g. clearing customs or complying with the EU’s rules of origin (documenting that a sufficient % of components in a product come from within the EU, to get tariff-free access). But this would only be an inconvenience – the US and other non-EU countries aren’t too hindered by it
    • The EU might be forced to enter into a deal because, just as the EU is the UK’s #1 export market, the UK is the EU’s #1 export market. Thus, it would be madness for the EU not to deal
  • There’s significant precedent for trade deals between the EU and non-EU countries
    • Norway, Iceland, and Leichtenstein are outside the EU, but part of the European Economic Area
    • Switzerland is outside the EEA, but still has access to the Single Market due to numerous bilateral agreements
    • If the UK leaves, it shouldn’t stay within the EEA. The whole point of leaving the EU is freedom to negotiate our own trade deals with third party countries; this wouldn’t be possible in the EEA. Instead, the UK should be outside the Single Market, and outside all the regulations. Being outside the Single Market doesn’t preclude a trade agreement. Japan, China, the US, Canada all sell into the Single Market
  • The UK would be able to broker its own trade deals with non-EU countries, rather than being bound by the EU’s trade deals
    • There are many countries with which the EU hasn’t reached a trade agreement. The UK might be able to by negotiating alone
    • At the moment, the UK is bound by the EU’s Common Customs Tariff on imports. After Brexit, it might wish to have a free trade policy, leading to cheaper imports (helping consumers and reducing manufacturing costs)
  • The UK has 2 years to negotiate a deal – it will still benefit from the Single Market for 2 years. Thus, there would be no sudden impact on trade

The Public Purse

  • The UK would save on its membership fee, c. £10bn net. This is 0.5-0.75% of GDP, and 1/7 of the government’s annual deficit of £70bn
    • But, the government might have to compensate some sectors that are currently benefiting from EU handouts, or trade agreements (e.g. car industry)
    • The UK might need to continue to contribute to the EU to preserve Single Market access, Norway pays €107.4 per capita (versus the UK’s €139 as an EU member)
    • The gains may be offset by economic disruption and lower migration following Brexit

Regulation

  • The UK suffers the burden of EU regulation across the whole economy, not just the part that trades with the EU. The UK’s exports to the EU are 14% of the economy, but concern for this 14% leads to rules affecting the entire economy.
    • The media likes to cover “annoying” rules, e.g. that hairdressers can’t wear high heels. But, these are relatively unimportant.
    • But, some of the rules are important. E.g. the National Health Service must comply with the Working Time Directive, and retailers with the Agency Workers’ Directive. The impact of the 100 most costly EU regulations for UK business has been estimated at £33bn/year
    • The benefit from axing EU regulations is muted by the fact that the UK would still voluntarily adopt many of them

The City

  • Financial services is 8% of the UK. 4% of this is “City-type” activities; the remaining 4% is retail financial services. Manufacturing (seen to be dead in the UK) is 10%. So, the City is not unimportant, but not huge
  • As a EU member, the UK benefits from “passporting rights”. A US bank with a branch in the UK can sell to the rest of the EU without having a branch there.
    • If the UK loses its passporting rights, its exports of financial services to the EU could halve from £19.4bn to about £10bn.
    • It may be possible for firms to simply set up a “brass plate” subsidiary in the EU for legal reasons, and keep their key activities in London – similar to how many US firms are headquartered in Delaware, but their key activities are in New York
  • It would be very hard for banks to move their major operations from London to Frankfurt. More people work in financial services in London than live in Frankfurt
  • People had the same fears, that the City would be hit, if the UK stayed out of the Euro or left the Exchange Rate Mechanism. But, this didn’t happen. London is uniquely attractive due to the English language, low taxes, low regulation, skilled labour, expertise in accounting and law
  • The UK would be able to broker deals with emerging markets that could help the City, and increase financial services exports to China and Hong Kong
  • The City has been bound by EU rules that it didn’t want to adopt, e.g. caps on banker bonuses (which led to an increase in banker salaries), and restrictions on short-selling (which can lead to bad companies being overpriced)
  • Property prices in the City could fall by 8-15%

Immigration

  • Net migration from Europe has more than doubled to 183,000/year (0.5% of the UK workforce) since 2012. This helps the UK economy to grow without pushing up wages
  • Brexit would enable the UK to adopt a policy more tailored to its own requirements, vs. the EU’s one-size-fits-all policy – e.g. restrict low-skilled workers and attract high-skilled workers.
  • Brexit might lead to a short-term increase in immigration
    • There may be a rush-for-the-border ahead of the restrictions
    • EU migrants already in the UK will stay longer than they might otherwise have, since they fear they won’t be let in if they leave

The EU’s Track Record

  • The economic record of the EU is poor:
    • The Euro. The EU did fine before it. Instead, the Euro has led to
      • Suppressed competition between nation states with respect to economic policy
      • Poor countries being locked into too strong a currency
      • Germany having too weak a currency; amasses huge surpluses, lives off aggregate demand elsewhere
      • The Euro can’t last in its current form. It’s a “light monetary union”. It needs to either go all the way to a common fiscal policy and political entity, or be reversed
    • Extension of the EU to the East without careful consideration of the nature of the extension
    • Schengen
    • Common Agricultural Policy
  • One symptom of the EU’s weakness is European universities. Despite the EU’s strong cultural and intellectual heritage, they’ve vastly lost their influence and position in the world

Counterarguments from the Audience

  • Would Brexit lead to Scotland leaving the UK?
    • Unlikely. The case for Scotland leaving is much weaker now, due to the low oil price
    • Scotland leaving the UK wouldn’t automatically allow it to return to part of the EU. It would have to apply for membership
  • The EU has helped lead to social progress, e.g. equal pay for men and women
  • The EU has helped maintain peace
    • It has been NATO rather than the EU that has kept peace
  • The UK leaving could lead to the EU breaking up
    • This would be good for Europe, since the EU has a poor track record