VoxEU: Some unpleasant Brexit econometrics

11 December 2015

This column argues that EU membership has brought benefits to the UK through three key mechanisms – trade, foreign investment, and finance. The current focus on UK exports to and imports from the EU may severely underestimate the true potential costs to Britain of Brexit.

In or out, remain or leave, the relationship between the UK and the EU will change dramatically.1 In order to assess such changes, one needs to grasp not only the reasons that led Britain to join the EU, but also how the UK has benefited from EU membership. In this column, we focus on the latter by trying to identify key channels. We argue that Britain benefited significantly from EU membership – the three key mechanisms were trade, foreign direct investment (FDI), and finance, though in ways that are seldom discussed. In this column, we:

1. Put forward the infrequent argument that trade is good for UK growth but that intra-industry trade is good for UK TFP growth and hence may matter even more;
2. Present the first estimates (that we know of) of the causal effect of EU membership on UK FDI net inflows; and
3. Argue that the benefits of financial services specialisation in the UK depend a great deal on their interactions with FDI and trade. [...]

Conclusions

Focusing on three main areas (trade, FDI, and finance), we argue that Britain benefited significantly from EU integration. Leaving the EU (“Brexit”), it is likely to entail heavy losses (Ottaviano et al2014) and we expect the severity of these economic losses to increase substantially after the consequences in terms of intra-industry trade, FDI and financial integration are taken into account.

And yet these losses may be even larger when we account for interactions among the three areas. These interaction effects should be large for the relationship between FDI and trade (because intra-industry trade often involves FDI), between financial integration and intra-industry trade (because intra-industry trade is credit intensive; Giannetti et al 2011), and between financial integration and FDI (because FDI in the UK concentrates in financial services.)

Further research on these issues is urgently needed as the current (and almost exclusive) focus on ‘UK exports to and imports from the EU’ may severely underestimate the true potential costs of Brexit. Time may be ripe to paraphrase Churchill – European may be the worst form of integration, except for all the others.

Exit from the EU may have particularly severe effects on the UK financial sector, and through these, on trade and FDI. True there are already pressures within the EU to reduce the relevance of the UK as the main financial centre for euro transactions. However, exiting the EU minimises how the UK can influence these decisions. In March 2015 the UK won an important legal battle against the ECB on the location of euro clearing houses, thanks in large part to its EU membership. It is unreasonable to expect the UK will be granted such powers if it chooses to leave the EU.

Full article on Vox EU

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