Upon landing on the coast of Veracruz in 1519, Spanish conquistador Hernán Cortés decided to scuttle his ships, in an attempt to prevent mutiny and motivate his army. It did not end well. After months of travel in difficult terrain and having incurred heavy losses, the expedition faced a revolt from the Aztecs and was forced to retreat. Cortés survived; many of his soldiers did not.
Like Cortés scuttling his ships 500 years ago, Theresa May’s Brexit plan leaves no way back. The UK prime minister has said she will trigger Article 50 by the end of next March. She has also taken a hard negotiating stance, proving unwilling to compromise on issues such as immigration. The EU’s response, as predicted, has been firm: the four freedoms – movement of goods, workers, services and capital – can only go together.
The result is a hard Brexit, an antagonistic negotiation which will likely cause prolonged economic losses to both parties, but especially to the UK. And while Brexit campaigners sold the electorate the prospect of a painless and happy divorce – one where your partner continues to cook for you and you can still see your children – this image is quickly being dispelled by recent events in financial markets: a plummeting pound, rising yields in UK treasury bonds, falling stock prices and a slowing property market.
Estimating the cost of a hard Brexit
There is more damage ahead, and while Brexit was never going to be a zero-cost process, the British government’s lack of a realistic economic plan threatens to make it a lot worse. According to a recent poll by Sky News, half of Britons believe exactly that: that the government has no plan to handle Brexit.
Britain is essentially an importer of goods, capital and human resources, and an exporter of services. A disorderly, poorly planned negotiation that could lead to an exodus of investors and skilled workers would badly damage the economy.
We estimate that a hard Brexit would cost the UK up to 7.5% of GDP over the next eight years, or up to £140 billion. This includes the direct costs from job losses in London’s financial centre, as well as indirect costs from a falling currency and the rising cost of imports: in one word, stagflation.
But the total Brexit bill could be even higher. If Brexit is the economic equivalent of a skydive, the UK government currently has no parachute. To survive the jump, the government needs a plan to re-engineer the UK’s growth model.
A divided Britain
Britain has thrived for decades thanks to its leadership in finance, London’s growth as a global financial centre, and its flexible job market, which enabled American, Japanese and European firms to set up production there.
But if finance boomed in the ‘80s, following the City of London’s Big Bang deregulation, the 2008 crisis put an end to the easy growth of credit, and curbed the intermediation business. Once a leader when it came to growth in Europe, the UK started to slow down.
The Cameron government reacted with fiscal expansion, accompanied by plans to boost private lending, like the Help-to-Buy or the Bank of England’s Funding for Lending Scheme. The result has been good nominal growth, but underneath the hood one of the highest deficits in Europe (4.9% in 2015, second only to Spain) and lagging productivity, which rose only 1.5% from 2008-2015 vs 13% from 2000-2006.
In addition, the continued focus on one industry and one city – finance and London – has produced a deeply unequal society, where the top 1% generates over a quarter of income, and the top 0.1% a fifth.
Not only is inequality at an all-time high, but social mobility is deeply low, too. Just 7% of British people were privately educated, compared to 71% of senior judges, 53% of senior diplomats, 50% of lords, 43% of columnists and 35% of the national rugby team. Nearly half of Britons believe that who you know matters more than your skills.
Britain has become a divided kingdom. Frustrated and feeling left out by the current economic and education system, it is no surprise that many fell for the easy promises offered by a Brexit vote.
A plan for handling Brexit
A recent study by The Economist counted over 50 myths about the European Union that have been spread by British tabloids, some of which are still used in support of Brexit today. But now that Britain is set to go it alone, the vote of international investors and financial markets has become as important as the one of its citizens: a declining currency, rising funding costs for the Treasury and lower foreign investment could all derail an already slowing recovery.
Without a plan, Theresa May’s government is heading straight for an iceberg. The question is whether it will be too late to change direction when she eventually notices or the British people tell her.
There is a clear set of policies that could help Britain regain economic strength and rebalance its economy. Some have been already discussed by the previous government, others have been mentioned more recently. Few have been implemented.
The first intervention should be to gradually raise fiscal stimulus through investment in affordable infrastructure. Over the past three decades, the UK has spent less on infrastructure than the OECD average of around 2.5%-3% of GDP. An analysis from the OECD shows the UK’s infrastructure quality ranks lower than Spain, Portugal, Germany and France, including in the fields of telecommunications, road and air transport.
It took over 20 years to decide whether to build a new runway at Heathrow airport, which operates at 99% capacity every day. While Crossrail will dramatically improve railway connectivity with London, much of the UK railway network remains obsolete, at least by European standards. Fiscal stimulus could improve long-term productivity, absorb potential job losses and take some pressure off monetary stimulus, which continues to run at full steam.
Second, policy-makers should prevent another rise in household leverage to record-high levels, and tackle the housing crisis.
Past governments used housing financing schemes in an attempt to make first homes more affordable – but without building new ones. The result has been only to boost prices of the existing housing stock. In England alone, between 232,000 and 300,000 new units are needed each year – around two to three times the current supply – according to the UK Parliament.
What is needed is a plan to boost supply, rather than incentivizing households to increase their mortgage debt again. The Bank of England should make financial stability part of its primary mandate, giving real teeth to its macro prudential policies. In particular, tighter thresholds on loan-to-income ratios could limit the formation of a cohort of highly leveraged households, which may become vulnerable in a recession.
Making these changes happen
In stimulating the economy, Britain also has an opportunity to diversify away from banking and from London, which make up 8% and 22% of GDP, respectively. The previous government discussed making the UK an “industrial powerhouse” – yet did little to make that a reality.
Entrepreneurs need access to capital, affordable property and infrastructure, and to international talent. The UK is among the European countries with the most start-ups, but they tend to be concentrated in cities like Aberdeen, Belfast and Birmingham, where property prices are lower. A long-term immigration policy that helps attract talent will be key for Britain’s success, both in financial services and in other businesses. There is no evidence that immigration has lowered wages or taken away jobs from British workers, according to research from the London School of Economics.
To finance this economic change, the UK should consider a reform of its tax system, which currently greatly favours wealth accumulation over income. While earnings above £43,000 are taxed at 40% and over £150,000 at 45%, there are no taxes on land or property. Property is taxed through stamp duty, i.e. when it changes hands, but unlike in the US, France, Italy, Germany and most other developed countries, there is no annual tax.
A transaction-based tax incentivizes people to park savings in property investments as long as possible, rather than favouring an efficient allocation of wealth. An annual tax would instead prevent investors from leaving capital unused. This is a politically sensitive topic, but one that UK governments will not be able to ignore in the future.
In addition to rebalancing tax pressure on wealth vs income, the government should also consider a reform of its education system, which currently offers wide access to higher education, but where only 0.8% of Oxbridge graduates make up most decision-making positions.
In recent years, global QE has further bolstered the wealth of asset owners, thereby contributing to the rise in inequality and to a widening generational divide: according to Eurostat, people below 35 years of age only own 15% of total financial wealth. As Theresa May argued in a recent speech, Britain needs to become a meritocracy – but it is currently very far from being so. Increases in housing benefits or in the national living wage only cushion the have-nots from poverty, without offering future generations a real opportunity.
A Brexit plan that works
In June, Britons voted for Brexit. Some wanted to exit the European Union, some to oust the existing government, and others because they saw little hope for the future. They were told Brexit would save Britain over £350 million a week, but we know in reality it will cost them much more than that. Investors and financial markets are voting too – to abandon UK assets. Absent an economic plan, the real costs of Brexit will soon hit the poorest families, with higher food prices, job losses and lower property prices.
To thrive outside the EU, the UK needs a plan to re-engineer its growth model. It may be too late to go back, but it is not too late to rebalance Britain’s economy, shake up its deeply unequal society, and make Brexit an opportunity.