Theme: Political Economy | Content Type: Digested Read

What Brexit Means for the Future of UK Capitalism

Martin Sandbu


Rob Lambert

| 12 mins read

Long before it acquired the name of Brexit, the project of making the UK leave the European Union was a solution in search of a problem.

This EU‐bashing was always based on a fantasy, with concerns ranging from bureaucracy and immigration to the plight of fishermen and farmers, as well as the view that trade with faraway economies is better than trade with Europe.

But two other facts are not fantasy. The first is that the problems of the UK economic model, and its failings, contributed to the Brexit vote. The second is that while that economic model was the result of home-grown political choices, the effects of these choices were shaped by the external economic conditions created by EU membership.

The way in which Britain leaves the EU, too, will shape the workings of the current model and whatever changes future UK governments make it undergo.

‘The other Brexit question’

When Theresa May took office, it looked like she wanted Brexit to be about something, not just against something. That effort quickly ran into the sand, but she was right to identify a frustration with an economy that left too many behind as the core of the Brexit vote. This is ‘the other Brexit question’.

Britain’s economic model can be characterised as follows. First, on the demand side of the economy, the key characteristic is high consumption and a low savings rate, whose counterparts can be seen in low investment and a persistent current account deficit. This is linked to high indebtedness and high house prices driven by fast mortgage credit growth, in turn linked to a large financial system long treated with a light touch by regulators.

Second, on the structure of supply, the share of manufacturing in total output is low by rich‐country standards, and share of services correspondingly high. Even more striking is the very high share of services in UK exports. Britain distinguishes itself among larger economies by exporting about the same value of services as it does of manufactures.

Then there is a starkly polarised labour market. UK economic activity is unusually labour‐intensive for a rich economy. This model has led to high employment numbers, but an excess of low productivity and hence low wage jobs; a problem of the working poor. At the same time, Britain has one of the highest rates of income inequality in Europe.

And finally, the UK suffers from extreme regional inequality. London is among Europe's richest regions, but some areas are on a par with the poorest parts of Slovakia and Portugal. And we know that support for leaving the EU was higher among those living in poorer regions.

The characteristics of the British economic model are not separate ills; they are rather alternate symptoms of the same disease. And they are the results of a set of deliberate policies, charting a course towards a ‘mid‐Atlantic’ position for the UK economy between US‐style liberalisation and private enterprise and continental regulation and state control.

The upshot of all this is, to change anything, one has to change a lot. And that is just what the Brexit referendum established. Whether there is any prospect of such a transformation depends both on what form Brexit takes, and which domestic policies the UK autonomously adopts once it has left.

What ‘Brexit means Brexit’ may mean

Think of the sectors in which the UK does well at the moment. The most obvious area is of course commercial services: finance, and a range of auxiliary and other professional services. Britain excels in cultural service exports too, as well as its university sector.

The other area is high‐productivity manufacturing, despite a relatively small manufacturing sector overall. Of the 1.75 million motor vehicles produced in Britain in 2017, 80 per cent were exported, mostly to other EU countries.

These, Britain's most successful economic sectors, have two traits in common: high productivity and export orientation. These are intrinsically linked. Exporting both requires and fosters high productivity. And they are linked to a third factor: both sets of sectors are deeply integrated with the pan‐European economy and the EU's Single Market.

Jobs in high‐value manufacturing and services are not good British jobs as much as good European jobs located in Britain. Brexit puts them at risk of moving elsewhere, and conventional trade deals (less deep than the EU Single Market) cannot bring them back. This fact is deeply underappreciated in the debate over Britain's post‐Brexit economic policy choices. Britain relies on Factory Europe; the alternative will not be integrating with Factory North America, it will be disengaging from the international supply chain altogether. The same is true for some services.

The most likely consequence of Brexit, then, is to increase barriers precisely to the sectors in which Britain's comparative advantage lies and which offer Britons (and high‐skilled EU immigrants) the best jobs.

Likely effects on the British economic model

As for the form of Brexit, two things matter in particular: the future trade relationship and how it will change (or not) the productive structure of the UK economy and, to a lesser extent, the future of EU migration to and from Britain.

There are roughly three possibilities for the Brexit negotations. There could be a soft Brexit which keeps trade frictions (nearly) as minimal as they are today; this could be achieved by something like European Economic Area membership for the UK and a Customs Union with the EU.

Alternatively, there could be a hard Brexit—a conventional free trade agreement (FTA) which would reintroduce both customs checks and regulatory barriers to trade, but not tariffs. In this case, the EU would insist on sufficient barriers to prevent the entrance of non‐compliant goods circulating in the UK market.

Finally, there is the semi‐soft Brexit that has been official UK policy since the Chequers Cabinet meeting in early July 2018. As set out in the Chequers White Paper, this model aims to maintain frictionless trade in goods, but not single market trading rights in services. Though still possible at the time of writing, some form of trade agreement would follow the scarier alternative the of ‘no deal’ in due course.

In ascending order of hardness – from a status quo Brexit through Chequers to an FTA Brexit – the services export businesses are hit sooner than goods.

The likely effects on the British economic model do not nicely align with the degree of Brexit ‘hardness’. While status quo Brexit will mildly challenge the productive structure across the board, going one step harder to a Chequers‐style deal will protect manufacturing, but hurt services. Going harder still, to the more distant FTA‐type relationship with the EU, will hit manufacturing brutally and make little further difference to services. And the independent trade policy that is the rationale for such a relationship will tilt the economy further towards services, since new trade deals will very probably seek market access for UK service exports in return for greater import competition by manufactures.

A politician who sees as her chief responsibility to put a disjointed society back together again after the Brexit referendum may well give priority to factory supply chains over the City of London. Here, then, is a persuasive political economy reason for Prime Minister Theresa May's Chequers model, which does precisely that, seeking frictionless trade in goods – essential for just‐in‐time manufacturing, not to mention the absence of border checks on the island of Ireland – while regaining regulatory autonomy in services at the accepted price of worsened access to EU services markets. Perversely, this just could serve as a catalyst for a rebalancing of the economic structure to remedy the divisions that pain Britain's political economy.

To be clear, a Chequers‐style Brexit will not by itself do anything positive for the high‐value goods sector or the parts of the economy that depend on it.

Until frictionless trade in goods is secured for sure, these sectors will be hit by withheld investment and relocation of production to continental Europe.

Rebalancing the British model

A concerted policy programme based on the idea of favouring the UK's high‐value goods producing sectors – starting with managing Brexit so as to protect those sectors above all –may be the country's best chance at a growth strategy that prioritises the neglected parts of the economy, even at the price of slower growth in the aggregate.

It is possible to boost modern manufacturing in a country with the right conditions and policy makers set on the task. Read the extended version of my article for ways in which UK policy could encourage investment and productivity growth in high‐value manufacturing or alternative activities for the areas that currently rely on it.

Few of the frustrations that prompted the British public to vote Leave were caused by the EU. And yet both the political economy of Brexit, and its likely economic effects, point towards a profound reform of the growth model that did in fact cause them. While Brexit will result in a UK economy that is less prosperous overall, there is a possibility it will also start to redress some of the imbalances.

To do this, we need a state that is much more comfortable with market‐shaping interventions than has been the case in the UK policy making class for a generation. They are also nigh‐on impossible without accepting a larger state imprint on the economy – simply put, higher levels of taxation and spending. On both dimensions, then, an economic model closer to what is found elsewhere in Europe.

The paradox of Britain's EU membership is that has enabled the UK to fulfil its plausible destiny as a hybrid between a European and a US socio‐economic model. The paradox of Brexit may well turn out to be that it forces Britain to become more European.

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