Brexit – one week on

Last Thursday the British people made (in the Prime Minister’s words) a ‘very clear decision’ to leave the European Union. Last Friday they asked themselves (and each other) ‘What happens now?’ And it turned out that nobody knew.

So where are we one week on?

Market reaction
The last week has seen a period of volatility in stock markets and foreign exchange markets, although this has improved recently. This was exacerbated by the fact that markets expected, and had factored in, a ‘remain’ vote, with the result that major corrections were necessary. By contrast, an ‘exit’ decision, if it had been expected, would have largely been taken into account by the markets before the event. Presumably stock markets would still have fallen, and the value of sterling would still have declined, but in a much more controlled way.

It is therefore reasonable to expect the markets to settle down over coming days and weeks, and for there to be some recovery of recent losses. Nevertheless, overall, falls in sterling and in stock values are likely to be maintained to some extent, rather than completely reversed. Probably this result reflects a general feeling in the markets (rightly or wrongly) that Brexit is a mistake from the economic perspective; but perhaps even more than that it reflects a belief that Brexit, however it turns out in the end, is bound to involve a damaging period of uncertainty.

The political perspective
One thing is certain: following an election, a new Prime Minister will be declared on 9 September and will head the government that negotiates both the UK’s exit from the EU and the terms on which it will continue to trade with the member states thereafter.

The choice of the new Prime Minister is absolutely crucial to the way in which matters develop thereafter; partly because of the personal influence that they will have, and partly because the choice of individual will reflect the way in which Conservative MPs respond to the range of proposals put forward by the different candidates.

The Business Secretary said in a radio interview that ‘we are all Brexiters now’, and it is true that any new Prime Minister, and their cabinet, will be committed to implementing the results of the referendum. Nevertheless, a new Prime Minister who is former Remainer may be looking for a less wholehearted withdrawal than someone who has been a consistent Brexiter. A ‘half way house’ might involve a ‘Norway option’ or a ‘Switzerland option’ that involves accepting a certain amount of EU regulation and, crucially, the free movement of people. Even someone who was a Brexiter before the referendum may consider that the slim majority for exit does not give a mandate for the most extreme approach to EU disengagement.

Tax changes
Before the referendum George Osborne threatened (or warned) of a ‘punishment Budget’ involving £30 billion of tax rises and spending cuts. 65 Conservative MPs indicated that they would not support such a Budget, which would have meant that it could not be passed without support from other parties. That Budget is clearly no longer on the agenda, but if Mr Osborne’s assessment of the economic effects of Brexit was correct, it must follow that some degree of fiscal tightening will be required sooner or later. Of course, if (as Brexiters believe) leaving the EU is fundamentally good for the UK economy then nothing remains but to await the benefits and divide the spoils (augmented by the eventual saving of the UK’s contribution to the EU, which all parties are now agreed is not £350 million per week). It is, of course, possible that a new Prime Minister will wish to appoint a new Chancellor who may make a more optimistic assessment of the country’s needs.

In future Budgets (once the exit has taken place) the Chancellor (whoever they may be) will not be constrained by EU rules. This means that it will be possible to introduce or amend tax measures without regard to EU prohibitions on state aid for particular industries, or to the principles of freedom of movement of capital or freedom of establishment of enterprises. In practice this is unlikely to give rise to significant changes of direction; it is simply that some existing constraints that have hitherto limited Chancellors’ freedom of action in points of detail will now be removed.

The UK’s VAT system currently reflects obligations imposed under EU rules. In theory the UK need not continue with a VAT system at all, but in practice no Chancellor will wish to forgo the contribution that it makes to tax receipts. There will, however, now be the freedom to vary rates and exemptions to encourage or discourage particular types of expenditure, and we may expect to see such provision for special cases creeping into the system over time.

The terms of trade
The major question that remains to be negotiated with the EU is the terms on which the UK will trade with the remaining member states in the future. Many Brexiters maintain that, in broad terms, those states want to trade with us as much as we want to trade with them. There is therefore no incentive to impose any tariffs in either direction, and the UK should aim to negotiate a free trade agreement such as that recently negotiated between the EU and Canada.

As regards EU regulation, goods supplied from the UK to the EU would obviously have to comply with EU standards, but this is no different from preparing goods for export to the US in such a way as to meet the requirements of that market. It would not involve any obligation to observe EU regulatory standards within the UK.

If a free trade agreement can be negotiated, then the Brexiters will have got everything they wanted: access to the single market; no contribution to the EU budget; and no interference in UK affairs from the European Commission or the European Court of Justice. That seems just a little too good to be true, and even if it made economic sense for the EU as well as the UK, decision makers in Brussels might be rather unwilling to concede it lest other member states form a queue to take advantage of the same arrangements.

Much will depend on the decisions taken by the UK government under its new Prime Minister. However, even more will depend on developments generated by ill-understood market forces, particularly if these result in movements of capital and businesses away from the UK.

Yogi Berra, widely acknowledged as the greatest of US philosophers, and who also played baseball for the New York Yankees, once said, ‘It’s tough to make predictions, especially about the future.’ Faced with that difficulty, the UK government might well observe his oft quoted advice ‘When you come to a fork in the road, take it.’