If the United Kingdom decides to leave the EU, what then?
First, the UK will have to formally apply for withdrawal from the EU under Article 50 of the EU Treaty. It will then have two years to negotiate its new relationship with the EU before its EU membership lapses. These negotiations will be neither easy nor swift. The talks will oscillate between compromise and confrontation.
The EU cannot allow London to ‘cherry pick’ EU benefits while discarding those obligations of membership it does not like. Such precedent would quickly be followed by other EU countries, with Poland perhaps demanding to be freed from the EU climate policy, Ireland discarding EU social and tax clauses, and France opting out of the free trade of services.
What impact would leaving the EU have on the British economy?
We would expect a market sell-off, since Brexit risk is unlikely to be fully priced in at the time of the decision. Heightened uncertainty will drive up risk premia and borrowing costs for the public and private sector. The pound will depreciate markedly as capital flees the country, which, in turn, will push up import prices. The blow to private consumption and investment – domestic and foreign – could be strong enough to push the UK economy back into recession. The Bank of England then faces a conundrum. A tumbling currency and the associated inflationary pressure would mandate higher rates. While short-term pain after a referendum shock looks certain, the UK would then enter a period of extreme economic and political uncertainty as it sets about negotiating a new relationship with the EU.
And on trade?
Much will depend on the details of the new relationship between Great Britain and the EU. The key question will be access to the European Union’s 11-trillion-euro (excl. UK) single market. Roughly half of British goods exports are currently going to other EU countries. Possibilities post-Brexit range from Great Britain remaining a full member of the single market to trading with the EU under the WTO rules.
If the UK wants to retain full access to the single market, it will have to accept three conditions: continued free movement of workers from the EU, acceptance of all single-market regulations and some contributions to the EU budget. They are unlikely to accept this. Therefore, a more likely outcome is a favorable free-trade agreement with the EU under which the UK trades more restricted access to the single market for a greater degree of policy-making autonomy in other areas. The UK would then find it harder to export to the continent. It would also become a less attractive place for foreign direct investment, in particular for those companies that are now locating to the UK to serve the wider European market.
How would Brexit affect the rest of Europe?
The United Kingdom has the second-largest economy in the EU. If it leaves, the size of the EU economy will shrink by one-sixth. Although the main impact of Brexit will be felt in the UK, the rest of the EU will also be negatively affected. The countries that will suffer most are those with strong financial, trade and investment ties to the UK, most notably Ireland, the Netherlands and Germany.
Exporters to the UK will suffer as the pound plummets and the Brexit shock generally reduces demand for imports. There will also be disruptions in supply chains, particularly in the automotive sector. With financial markets in turmoil, and the economic outlook getting bleaker, the ECB might delay the exit from ultra-loose monetary policy.
What would the political fall-out be?
Brexit would further damage the EU’s international standing, already weakened after the euro and refugee crises. Lengthy and antagonistic Brexit negotiations would sap the EU’s political energy – at a time when political leaders need all their political capital to deal with the refugee crisis, stand up to an assertive Russia and fix the remaining flaws of the euro.
Brexit would also upset the EU’s internal balance of power. The EU policy-making machinery will lose one of its most liberal, outward-looking and strategically thinking members, leaving Germany and the Nordics to fight a rearguard battle against more statist and protectionist Mediterranean member states.