Looking on the Bright Side: UK growth after Brexit

In this article, Laza Kekic, former head of the Economist Intelligence Unit’s Europe region and the creator of the EIU’s long-term growth model, argues that Brexit may involve significant upside potential for the UK economy over the long term.

The UK economy’s better-than-expected performance since the June 2016 referendum has confounded many economists. Nevertheless, most continue to argue that Brexit will be damaging over the long term—on average by around 0.4 percentage points of GDP per year. These projections tend to assume a ‘hard’ Brexit, with no access to the single market or customs union, nor any meaningful offsetting benefits such as further deregulation, fiscal savings or new non-EU trade.

However, many long-term growth drivers are unaffected by Brexit, while several significant advantages of leaving the single market have been overlooked and the disadvantages exaggerated.

Empirical estimates of the benefits from EU membership rely on so-called ‘static’ gains in the form of a one-off impact on income levels. The majority of studies show no evidence of an ongoing, or ‘dynamic’, boost to productivity and income growth. Meanwhile, non-EU exports to the EU have grown much faster than the UK’s since the creation of the single market in 1993; evidently, being outside the bloc has not dramatically affected trade opportunities.

To capture Britain’s long-term growth prospects, and the impact of Brexit, it is necessary to weigh up the following factors (based on the EIU’s long-term growth model):

• Initial GDP per worker (measuring catch-up potential)
• Demography (working-age relative to total population growth)
• Human capital (measured by schooling and health of workforce)
• Trade (the lagged share of exports and imports in GDP)
• Openness to trade
• Government savings (current government revenue minus current expenditure)
• The quality of institutions (rule of law, quality of bureaucracy, property rights protection)
• The regulatory framework (product, credit and labour markets)
• The external environment (terms of trade; growth of trading partners)
• Geography (location; primary products share in exports)
• Historic legacies (duration of independent statehood)

Much of the above, such as Britain’s comparatively low regulatory burden, its strong rule of law, and liberalised markets, will not be affected by Brexit, and suggest a long-term real GDP growth rate of some 1.8% per year.

Of the growth factors that will be affected by Brexit, any loss of EU trade is likely to be offset by expanding trade with faster-growing emerging markets and other developed economies, as well as possible unilateral trade liberalisation. Growth is relatively insensitive to trade shares, which mirrors the aforementioned absence in empirical studies of a significant dynamic effect of integration.

Similarly, shifting immigration patterns will not affect long-term demographic trends, as expected falls in migration from the EU will be compensated by non-EU immigration.

A total net benefit of 0.4 percentage points would raise average annual real GDP growth rate to 2.2% over the long term

On the upside, the UK economy, which is already lightly regulated compared with its peers, has scope for further deregulation, especially in employment, the financial sector, the environment and climate change. This could add 0.3 percentage points to annual growth rates. Net fiscal saving from Brexit amounts to 0.5% of GDP; redirecting this to the domestic economy should increase growth by an additional 0.1 percentage points per year. Thus, the total net benefit of 0.4 percentage points would raise average annual real GDP growth to 2.2%, a gain of US$330bn over 30 years or US$17,500 per household.

A welcome shake-up

Of course, the model could underestimate the adverse trade impact. But two further positive factors should also be considered. The first is the potential ‘shake-up’ effect whereby upending an unsatisfactory status quo could stimulate new ideas to solve longstanding economic ills such as low productivity, insufficient innovation, low investment, inadequate infrastructure and skills gaps.

Second, there is the related possibility of considerable gains from self-rule and sovereignty, not only in the political but also an economic sense. The ‘colonial effect’ in the model is strong and extraordinarily robust in all specifications. Moreover, it is persistent over time, long after the end of colonial rule. Although EU membership is, of course, not literally the same as being a colony, the factor does capture the importance of self-rule, or ‘taking back control’.

The long-term growth model suggests a maximum positive impact from these two growth sources of some 1.2 percentage points per year. But applying just half of this potential would increase annual average growth to 2050 to 2.8%, or 2.4% in per capita terms—a similar rate achieved by the UK economy during the 1950-73 and 1995-2007 booms.