BREXIT, Economic Forecasting, Economics, European integration, International Market Dynamics, New Political Economy, US

May’s BREXIT Speech Is Contradictory and Signals New International Problems

Prof. Dr. Paul J.J. Welfens, Jean Monnet Professor for European Economic Integration; chair for Macroeconomics; president of the European Institute for International Economic Relations at the University of Wuppertal, (Rainer-Gruenter-Str. 21, D-42119 Wuppertal; +49 202 4391371), Alfred Grosser Professorship 2007/08, Sciences Po, Paris, Research Fellow, IZA, Bonn; Director of the Research Institute of bdvb, Düsseldorf, Non-Resident Senior Fellow at AICGS/Johns Hopkins University, Washington DC

 

+49 202 439-1371               welfens@eiiw.uni-wuppertal.de; www.eiiw.eu;

 

 

January 17, 2017

 

May’s BREXIT Speech Is Contradictory and Signals New International Problems

 

(BrexitUKtrump2017welfensENG)

Dean Acheson, former US Foreign Secretary of State in a famous speech in West Point, 1962

„Great Britain has lost an empire and has not yet found a role. The attempt to play a separate power role apart from Europe, a role based on a „special relationship“ with the US and on being the head of a „commonwealth“ which has no political structure, unity, or strength – this role is about played out.“

 

 

During the first weeks of 2017 the BREXIT path of the UK was still rather unclear. However, the speech of the Prime Minister has highlighted some critical points: Theresa May’s speech of January 17 2017 has emphasized the following British government intentions, plans and preparations:

1) Firstly, for the UK to leave the EU single market – this means potentially giving up free trade, free capital flows and the free migration of workers (obviously free capital flows should be maintained, but the point was not mentioned in the speech). Secondly, for the UK to achieve strict immigration control and, finally, for the UK to be free of interference from the European Court of Justice. The Prime Minister has argued that immigration has depressed wages in the UK. While the issue of free capital flows was not explicitly mentioned as a policy challenge in the speech of Mrs. May, the other economic freedoms of the EU single market came into focus, namely free migration and free trade.

2) To make the UK a center of global free trade. To this end, the British government has already started negotiations with Australia, New Zealand and India; the UK would like to welcome (skilled) workers from all over the world, but would like to have control over immigration dynamics.

3) To remain strongly linked with the EU27 via trade relations.

Point 1) is echoing the anti-immigration rhetoric of Mrs. May’s predecessor, namely that the UK is facing an excessive immigration pressure/burden from EU partner countries. Looking at the facts and figures, this conjecture is very unconvincing as OECD studies have shown that the UK has actually benefitted from EU immigration. It is possible that short-term immigration puts downward pressure on the UK wages of unskilled workers, but the medium and long-term effect is rather different unless there would be rising unemployment – and this was not observed in the UK in 2004-2016, if one ignores the clearly negative impulses from the Transatlantic Banking Crisis. Over time, immigrants from Eastern European countries will learn and improve their English language skills and this will facilitate many immigrants in improving skills through learning-by-doing and training and thus to find a job as a skilled worker in the long run. Thus GDP will be raised and this will, in turn, also generate labor demand so that the wages of unskilled workers should also increase (the potential decline of unskilled workers’ wages in the context of biased technological change is a separate issue).

 

As regards point 2), the UK could unilaterally reduce import tariffs, although existing EU import tariffs are already rather low except in the field of agriculture. If the UK has already started free trade negotiations with other countries, then this would be in breach of EU membership rules since only the European Commission is allowed to negotiate a free trade agreement (FTA) on behalf of all EU member countries. Except for Australia and New Zealand, as well as the US, there are no bright prospects for free trade arrangements and the economic effects will be rather modest except for a transatlantic US-UK FTA. A free trade treaty with India will be rather complex and the Indian government is certain to bring up the question of visa regulation and better Indian access to British labor markets; this, however, is certainly not something the government in London could accept since substituting Indian workers for EU workers is a move which will hardly will be welcomed by the population in the UK.

 

3) The prospects for maintaining strong trade links with the EU27 are not clear. The EU27 countries will certainly want to impose import tariffs in many sectors except for those sectors in which a sectoral FTA is agreed upon – Mrs. May has suggested that an FTA for the automotive sector should be considered. Since the EU will impose import tariffs on British exports and the UK will impose import tariffs on EU27 countries’ exports, there will be a loss of economic specialization in EU27+UK which amounts to increases of price levels both in the UK and in the EU27 and thus there will be real income losses. One may emphasize, that a 6% output reduction in the UK will bring about an output loss of about 1% in the EU27. Such a decline of real income in Ireland and on the EU continent amounts to further negative British output and real income effects, respectively.

 

The speech of Mrs. May has made clear that there will be a hard BREXIT and this message will bring about further depreciation of the British Pound which, in turn, will translate in 2017/2018 into rising inflation rates. As the price level in the UK will rise unexpectedly, real wage rates shall fall and hence – in a kind of a quasi-Phillips-curve effect – the firms’ demand for labor will rise transitorily so that the unemployment rate in 2017 could fall. However, once inflation expectations have adjusted, wage inflation will increase and the unemployment rate will start to increase again.

 

As Mrs. May has emphasized in her speech, the US has already given a signal to the UK that a free trade agreement could be agreed upon rather quickly. This suggests that the UK will try to reinforce economic and political relations with the US which, under a Trump Administration, will adopt a rather protectionist policy stance. This in turn will make it difficult for the UK to pursue much of a global free trade strategy unless it is unilateral. The latter, however, is impossible since the UK would face enormous problems if it would liberalize unilaterally imports from China for example – the UK steel industry, as well as other sectors, would face enormous problems in the rather short term.

 

While one may argue that Mrs. May’s speech is contradictory and rather unrealistic, one may also emphasize that she has backing from Labour Party leader Jeremy Corbyn in the field of anti-immigration policy: Mr. Corbyn has explained in a speech of his own that he favors managed immigration and that he also favors future government intervention in support of ailing British industries. So far, EU membership has made national government subsidization of ailing industries a difficult prospect since the European Commission’s subsidization control puts strict limits on subsidization within the EU single market. This control has, so far, been to the advantage of taxpayers, structural change and growth; if the UK’s economic policy would be to subsidize ailing industries in the future, then there is considerable likelihood that EU27 countries’ governments will also will introduce subsidies in the respective sectors, so that a subsidization race in Europe could become more likely and this will be at the cost of the taxpayer in both the UK and in EU27 countries. As regards downward wage pressure from immigrants this is only a modestly significant problem for unskilled workers (see Bank of England Staff Working Paper No. 574) and UK government support for immigrant entrepreneurship plus a special EU fund to encourage such activities could help to make immigration a general win-win situation; to effectively say no to immigration from EU countries – unless high skilled workers are coming – is very strange for a leading OECD country. Mrs. May’s emphasis on more justice in society can be understood to mean only the British society but the UK is part of a European society; and for a Prime Minister who wants her country to be a globally open economy a purely inward-looking view is inadequate.

 

If the May government seeks further cooperation with the Trump Administration in the US in the future, this will result in a political couple with internal contradictions: Mr. Trump apparently wants to have FTAs only with high income countries and only on a bilateral basis, while the UK is in favor of global free trade. This also raises questions about the role of the World Trade Organization in the future: Membership in the WTO and WTO rules will be of paramount importance for the UK in the future, a strategy of protectionism and bilateralism is only attractive for big countries such as the US or China. All other countries in the world – with the possible exceptions of Japan and India – require a general rule-based free trade system as enshrined in the WTO. It was Adam Smith, whose book An Inquiry into the Nature and Causes of the Wealth of Nations, published in 1776, the year of US independence, emphasized the benefits of free trade for all countries. It is clear from modern trade theory that through protectionism big countries can obtain national welfare gains through reduced world market prices and hence lower import prices. However, for the world economy, a nationalistic economic policy strategy undertaken by the US (or China) will not be acceptable in the long run. The very large majority of countries has an interest in institutionalized free trade, based on international organizations and the rule of law.

 

The May government, with its hard BREXIT strategy, is about to contribute to new international conflicts in Europe – here between the UK and the EU27 – and it is fairly clear that Putin’s Russia is carefully observing the disintegration and demise of the West. President Putin might remain calm in the Ukraine for two years or so (until after the mid-term elections in the US), but later he might consider the new western setting with BREXIT and a US Trump Administration to be the ideal moment for tightening the Russian grip on the Eastern Ukraine and also in the Balkans. Bulgaria, for example, is a country that could be rather easily destabilized by Russia and thus the EU27 might lose not only Western countries joining the UK in a potential new EFTA+ project but it could also face a partial reversal of EU enlargement in the east.

 

Mr. Trump’s emphasis on EU countries spending at least 2% of GDP on defense will put

some fiscal burden on Spain, Italy and Germany, which would each have to increase their respective military expenditure-GDP ratio by about 0.8 percentage points to come close to reaching the 2% threshold. For Italy and Spain, this could help to raise output growth slightly but this would also bring an increase of the deficit-GDP ratio. Italy, which had lost its AAA status with all major rating agencies by January 16, 2017 (DBRS then downgraded Italy to B), could face serious problems from an interplay of BREXIT, the Italian banking crisis – involving two big banks – and higher interest rates plus political instability. This, in turn, could bring new issues of instability in the Eurozone. As Mr. Trump expressed in an interview with a German newspaper (BILD) and the Times in January, he does not care about EU integration and potential nationalistic policies in Europe. With the EU facing BREXIT and Mr. Trump’s policy stance, there is considerable risk of EU disintegration unless the EU27 leaders and the European Parliament adopt a rigorous strategy of reforms for the EU. Such reforms should strongly consider the usefulness of EU integration in the context of a digital single market, more free trade treaties with countries in Asia (for example, not just Singapore in ASEAN but the whole group of ten countries from that group) and also the nucleus of a joint unemployment insurance system – e.g., supranational coverage of benefits for the first six months of unemployment while making an exception for youth unemployment; as regards the latter, it is national policy rules and national minimum wage legislation which are relevant above all for youth unemployment and therefore it would not be wise that the supranational policy layer in Brussels assumes any responsibility here.

 

The UK-EU negotiations will last about two years, by late 2018 all major elements for an agreement – for political divorce – must be ready since the EU will hold European Parliament elections in spring 2019. It is inconceivable that the UK should be on a clear BREXIT course while still being expected to hold elections for UK MEPs. It remains to be seen how BREXIT dynamics will unfold. BREXIT will certainly distract much political attention in Brussels and in the other capitals of the EU. This in turn implies a non-optimal national policy in many EU countries and this is part of the politico-economic price faced by EU countries in the context of BREXIT.

 

While the UK will want to postpone part of the divorce settlement for later – i.e. after 2019 –, the EU27 will have an interest in resolving all of the main problems rather quickly. One key challenge for EU firms is that certain very sophisticated banking services can currently be obtained in London but not in EU banking centers. This means that the EU27 faces some dependency on the UK in terms of financial market services; the best way to deal with this rather unexpected problem is that EU countries – some or all of them – would negotiate a special project for supporting high-tech financial technology in the Eurozone and the EU27, respectively. Funding for such a financial innovation project should come from national policymakers; Germany, with its considerable budget surplus, could easily make a major contribution to such a project in which partner countries, such as France, the Netherlands, Luxembourg, Belgium and Italy, also have a strong interest. Whether or not the planned merger between the Frankfurt Stock Exchange and the London Stock Exchange will be approved by the relevant political institutions remains to be seen.

 

Other integration clubs in the world economy – e.g. ASEAN and Mercosur (not to mention NAFTA, which is already half-buried by Mr. Trump’s political rhetoric) – are carefully watching the EU disintegration dynamics. The worse BREXIT challenges are handled by the EU, the weaker the EU27’s international influence in the future will be.

 

 

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