Costs and benefits of a United Kingdom exit from the European Union Costs and benefits of a United Kingdom exit from the European Union April 2015 STUDY commissioned by the Bertelsmann Stiftung Term: March 1, 2015 through April 15, 2015 Final report on April 15, 2015 Rahel Aichele Gabriel Felbermayr Center for International Economics Poschingerstr. 5, 81679 Munich Table of contents 1. Introduction 5 2. Historical summary: From Winston Churchill’s “United States of Europe” in 1946 to Nigel Farage’s UKIP today 9 3. The United Kingdom’s economic relationships with the EU over time 13 3.1. Trade relations 17 3.2. Foreign direct investments 24 3.3. Migration 28 4. Net contribution and UK rebate: How much does the UK actually pay? 32 5. Scenario calculations: What costs could a Brexit create for the UK? Static effects 37 5.1. Scenarios 37 5.2. Estimating the effects on trade, sectoral net value added, openness and real income 38 5.3. Static net effects: a cost-benefit analysis of the EU exit 43 6. What costs would Germany and the EU be facing? Static analysis 45 7. Dynamic effects 49 7.1. Dynamic effects of trade (de)integration for the UK and Germany 49 7.2. Effects through limiting the free movement of people 51 7.3. Estimating the maximum damage of a Brexit 53 7.4. Comparison with other studies 55 8. Closing comments and solution options 57 Bibliography 59 2 Figures and tables Figure 1 United Kingdom’s per capita income relative to Germany (GER) and France (FRA) over time (purchasing power parities) ........................................ 10 Figure 2 Economic trends in the UK, Germany and EU, 1960-2013 (growth rates of the GDP per capita in %) .............................................................................. 13 Figure 3 Economic trends in Germany and the UK, Q1 2010-Q4 2014 (growth rates of the nominal GDP) ................................................................................ 14 Figure 4 Long-term interest rates for 10-year bonds, 2010-2015 ..................... 15 Figure 5 Comparison of inflation rates in the UK and Germany, 1996-2014 .... 16 Figure 6 Government debt in the UK and Germany, 2002-2013 ...................... 17 Figure 7 Percentage of British exports and imports to and from the EU over time (in %) ................................................................................................................ 18 Figure 8 Top 10 export destinations (%) UK, 2012 ........................................... 19 Figure 9 Top 10 import sources (%) UK, 2012 ................................................. 20 Figure 10 EU and total FDI stock in the UK ...................................................... 25 Figure 11 Countries of origin for EU27 FDI stock in the UK (in USD millions), 2012 ......................................................................................................................... 26 Figure 12 UK FDI stock in other EU countries and worldwide .......................... 27 Figure 13 Target countries within the EU27 for UK FDI stock (in USD millions), 2012 ................................................................................................................. 28 Figure 14 Foreign population growth in the UK ................................................ 29 Figure 15 EU citizens in the UK (in thousands), 2011 ...................................... 30 Figure 16 UK citizens who live in other EU countries (in thousands), 2009 ..... 31 Figure 17 The United Kingdom’s net financing contribution to the EU budget . 35 Figure 18 Influence of a Brexit on sectoral value added in the UK ................... 43 Figure 19 Influence of a Brexit on sectoral value added in Germany ............... 46 Figure 20 Influence of a Brexit on sectoral value added in Ireland ................... 47 Figure 21 Development of per capita income in the UK and in a synthetic control group before and after the United Kingdom joined the EU ............................... 54 Table 1 Top 20 UK exports to the EU, 2012 21 Table 2 Top 20 UK imports from the EU, 2012 22 Table 3 Top 20 UK exports to Germany, 2012 23 Table 4 Top 20 UK imports from Germany, 2012 24 Table 5 2013 EU budget, gross and net contributions and how they may change due to a Brexit 33 3 Table 6 Costs of a Brexit, different scenarios 40 Table 7 Changes in the UK’s income per capita through reduced trade openness, static + dynamic effects, long term 50 Table 8 Changes in Germany’s income per capita through reduced trade openness, static + dynamic effects, long term 51 Table 9 Changes in the UK’s income per capita through limiting the free movement of people, static + dynamic effects, long term 53 4 1. Introduction “You can’t have your cake and eat it, too.” (famous English saying first documented in a letter from Duke Thomas of Norfolk to Thomas Cromwell dated 1538.1) Or maybe you can? Is it possible to take part in the economic advantages of the European project without having to bear the associated political costs of relinquishing sovereignty? Proponents of the United Kingdom leaving the European Union – the Brexit (“British Exit”) – believe that the answer to this question is yes.2 Opponents see economic unification above all as a means for creating a political community in Europe. And many pragmatists think that true, deep economic integration without a minimum of common political institutions is impossible. Therefore, the idea of gaining economic advantages without sacrificing a certain amount of political leeway is simply fiction. You can’t have your cake and eat it, too. We can’t have both things at the same time - the benefits of deep economic integration and complete political flexibility. The debate about the United Kingdom’s (UK) role in Europe has been marked by this fundamental tension since the beginning. After World War II the country preferred a free trade zone rather than a customs union, which would enable the UK to have flexibility in handling its special relations with its colonies and the USA and could function without establishing common institutions. When the United Kingdom finally joined the European Community in 1973, the course had already been largely set – and the country has been at odds with its fate ever since. The election results for the UK’s House of Commons from May 7, 2015 will be crucial for deciding whether the country remains in the EU. Having been reelected Prime Minister David Cameron, promised his electorate, he will hold a referendum on the Brexit in 2017 to decide whether the country is in or out. Prior to that, conditions for the United Kingdom to stay in the EU are slated to be renegotiated. The discussion about the Brexit is about the future of Europe, because many other EU member states are having similar discussions, although to a less extreme degree. However the potential referendum should turn out and however the other EU members may react 1 British History Online. See also http://www.todayifoundout.com/index.php/2014/01/cake-eat/. 2 The term, “Brexit,” is misleading in that Britain or Great Britain would not be exiting the EU, but rather the United Kingdom, which includes England, Scotland, Wales and Northern Ireland. The geographical term “British Isles” also encompasses Ireland, which is not debating whether to leave the EU. 5 to a Brexit, the case will set a precedent that will significantly influence how the EU continues to develop. What would happen in the event of a Brexit? Since the Treaty of Lisbon in 2009, countries have the opportunity to freely and unilaterally exit the EU.3 But how a country’s relationships with the remaining EU member states would be handled after an exit, and how common policy areas – especially trade policy – should be returned to the national level would need to be negotiated on an individual basis after the intent to exit is announced. The economic costs arising from a Brexit depend heavily on these details. Can the country reach a new bilateral free trade agreement after exiting that would guarantee non-discriminatory access to the goods and services markets of EU members? How would the freedom of labor markets and capital markets be handled? Since the EU negotiates international trade agreements on behalf of its members, the approximately 40 existing bilateral agreements would no longer apply to the United Kingdom should it withdraw from the Union. How well and how quickly could the country successfully replace these agreements? Obviously a great deal depends on the goodwill of the remaining EU members and their trade partners. It is nearly impossible to anticipate what would happen since all EU member states have veto powers. As such, the costs stemming from a Brexit cannot be predicted with great reliability. However, it is certainly clear that a Brexit would have substantial effects on the United Kingdom and other EU nations because the UK’s economic interdependence with other EU member states is significant: 1. The United Kingdom’s trade continues to focus very heavily on the EU: More than 50% of its exports go to the EU, and more than 50% of imports come from other EU nations. In the mid-1960s, these percentages were significantly less than 40%. 2. More than half of the foreign direct investments in the UK come from the EU. This percentage has remained relatively stable in recent years. However, the absolute investment volumes have more than tripled since the beginning of the millennium. 3. A little over 2 million citizens from other EU member states live in the United Kingdom. Just over 1 million of those come from the new member states, primarily Poland, but Ireland and Italy as well. Around 1 million UK citizens live in other EU countries, predominantly in Spain, France and Ireland. Even though predictions are impossible, we can at least say something about the structure of expected effects arising from a Brexit and their magnitude. This study aims to quantify 3 EU Treaty, Art. 50(1) “Any Member State may decide to withdraw from the Union in accordance with its own constitutional requirements.” 6 the economic costs of a Brexit primarily using scenario calculations – thought experiments on the computer that simulate the effects under different conditions to gain new insights.