Using the data and your economic knowledge, assess the impact on the UK economy of a recovery in the EU as a whole. (Exam question set in 2011, thought it would be interesting to formulate a response from this point in time)
The UK’s relationship with the European Union is in a state of flux at this moment in time. The European Union is a political/ economic union of 28 countries that benefit from the free movement of goods, services, capital and labour between member states. The UK became a member of the EU in January 1973 and in the referendum in June of this year, the British public voted to leave the EU in a decision widely known as ‘Brexit’. Currently, Parliament are awaiting the exact implications of Article 50 of the Lisbon Treaty which states that a country that decides to leave the EU has two years to negotiate “arrangements for its withdrawal, taking account of the framework for its future relationship with the union”. Specific legislation in the Article specifies that a parliamentary motion is insufficient to go through with the terms of Brexit. In accordance with this, the Supreme Court ruled that permission from the House of Lords and House of Commons must be given before Theresa May can invoke Article 50 and begin the complex negotiations with the EU. But on the 8th November 2016, the PM has been given appeal by the Supreme Court, starting on the 5th December to overrule the High Court legal ruling.
The economic impacts are dependent on the repercussions of Article 50, the final negotiation terms and fundamentally, how isolated the UK is from the EU. Prior to the referendum in a poll of more than 100 economists for the Financial Times, more than three-quarters thought Brexit would adversely affect the UK’s medium-term economic prospects, nine times more than the 8 per cent who thought Britain’s economy would benefit. I shall assess the impact against the four macroeconomic aims: economic growth, inflation, trade balance and unemployment levels.
The main economic indicator is GDP growth. The most likely fuel of economic growth within the EU is fiscal boosts which inject money into the circular flow of income – some of which will leak out into other economies like our own. As the EU recovers more and more, consumer confidence and business expectations will begin to recover from the uncertainty of post-referendum (which obviously holds a time lag). This would then result in spending on more goods and services in foreign countries because demand cannot be met domestically. Through the multiplier effect, this spending would cause a proportionally larger increase in aggregate demand so as the recovery improves, the economic growth of both the EU countries and their trading partners will exponentially grow. This reflection should extend to the UK but as stated in The Guardian article linked below, “many would see transparency as a threat to EU jobs” which may increase the incentive to go through with a ‘hard Brexit’ and block out the UK completely. When the recovery is finally back to the trend rate of growth, demand will outstrip supply within the EU and force firms to start investing in capital goods; this cycle represents the ‘accelerator effect’ which eventually results in long run economic growth. This would be illustrated above in my diagram as the shift out to LRAS2 as the export market for the UK expands with investment – simultaneously causing a lowered price level to p1 and a higher output level to Y2. From a global perspective, this would aid the UK trade to become more competitive as prices fall more. In order to prosper more, the UK would need to amend swaths of EU regulation to help their own firms reduce costs whilst members of the EU would find it harder to cut corners. Therefore, the economic effects of recovery would overall cause a spurt in growth for the UK, but the stability/ risks of inflation are determined by if investment needs to take place (because investment way below full employment just causes more unemployment).
The UK’s trading relationship with the EU is completely dependent on whether Theresa May negotiates a “soft” or a “hard” Brexit. Prior to the referendum results, the Remain Campaign argued that there would be no guaranteed trade partners whereas Leave proposed that the UK would maintain their position as one of the most valuable trading partners to the EU as a net importer of goods. As mentioned before, the UK trading market is reliant on countries within the EU as 52% of UK trade is linked with their members thus any reduction in this would have an adverse effect on the UK economy, assuming ceteris paribus. As the recovery quickens, economists would expect EU trade balances to tip into deficit as demand grow out of control. Assuming the EU sustains its protectionist mindset, the UK would struggle to keep up with the likes of China (where technology is rapidly improving and plummeting their costs of production) who would appear as a cheaper trading partner than us. So, if May opts towards a soft Brexit which keeps a slight connection to the “European Market” and we avoid the initial bitterness that may cause the trading relationship to suffer, then the EU would be less likely to hold up tariffs and deter their consumers from buying from the UK.
The main determinant of trade between the UK and the EU is the exchange rate; inevitably, the uncertainty surrounding Brexit made the Sterling see a heavy depreciation against the Euro (dropping by around 11% against the Euro just weeks after the referendum). During the recovery of the EU, the central banks were likely to drop interest rates to encourage more spending and economic activity. Following this would mean a sharp rise in the exchange rate, which is shown by the d1 to d2 shift on my Euro market diagram to the left. This, paired with Brexit, meant that people would begin selling the Pound to rise its supply to s2 and cause the fall to p2. Theoretically a weaker sterling currency should provide a competitive boost for the exporting market as it becomes cheaper (therefore improving the trade balance) but, there are doubts about the expansion in export sales as the UK manufacturing sector is barely existent. Although a lot of emphasis has been put onto the trading deals since the idea of breaking away from the EU, we know that the other main forces behind growth – like investment, skilled workforce, competition and innovation – would all still be intact.
During a time of recovery in the EU, it is expected that with the economic growth will come inflation. This is because consumers are demanding more and as the market allocates these goods it must naturally raise the prices. This would be demand-pull inflation, and would mean that EU goods were becoming more expensive than others. So, if the same good costs $1.00 from a country like France and only $0.90 equivalent in Britain, consumers are likely to import from abroad – meaning the UK exports wold actually rise. Obviously, this is dependent on a few other factors, like the Sterling climate, various elasticities and the extent of tariffs and quotas. Because exports are an injection component of AD, this would cause a proportionally larger increase in aggregate demand for the UK. In general, price inflation of one country/ currency will result in better trade for another trade partner.
As the Phillips curve illustrates, there is negative correlation between inflation and unemployment so this inflation would reduce unemployment. This would also be accelerated by EU policies like improved training and construction projects to encourage people to join the workforce. As data taken from the ONS statistics suggests, there is also a strong correlation between EU and UK unemployment as they both increase between the period of March 2008 to 2009. So, as the EU suffers from unemployment, the UK is likely to suffer too.
From assessing the impact on the four macroeconomic indicators, I would conclude that a recovery within the EU would theoretically be beneficial for the UK. But, the outcome of the Article 50 appeal and the Brexit negotiations could easily sway this the other way. So, the main determinant of the effects is actually the political decisions surrounding Brexit. The severity of negotiations will dictate how well the UK comes out of this.
written by Rachel Stanley, pictures hand-drawn or taken from ‘economics online’