Brexit: Last Nail in the British Economy’s Coffin?

 

barry eichengreen is the George and Helen Pardee professor of economics and political science at the University of California (Berkeley).

Illustrations by miracle studios.

Published July 24, 2023

 

Brexit — the decision of a majority of British voters to leave the European Union — excited both hopes and fears. The hope was that Brexit would liberate the UK from stifling overregulation and unleash a tsunami of productivity growth. In “taking back control,” British officials would be able to untangle the nanny state imposed by Brussels and be free to negotiate their own international free trade agreements opening a bounty of new opportunities.

The fear was that Brexit would eliminate Britain’s assured access to EU markets while offering nothing — or less than nothing — in return. In the process, Britain would be rendered less attractive as a destination for foreign investors and skilled immigrants. Meanwhile, the fraught nature of the long transition and uncertainty about its outcome would depress growth for years.

Yet even today, seven years after the EU referendum, it is not easy to say how much harm was done by Brexit or how much good might come of it. No question, growth in the UK since 2016 has been disappointing compared to Britain’s peers and compared to Britain’s own past performance. The UK has the lowest growth rate among G7 economies, and the IMF forecasts that it will be the only major economy to shrink in 2023.

But there are many explanations for this tepid performance. Not just Brexit, but Covid- 19, supply-chain disruptions, trade wars and the Great Retirement — unanticipated withdrawals from the labor force — have compounded the UK’s economic woes.

Further complicating the picture, there was an earlier break in British economic performance around the time of the financial crisis of 2007-8. British productivity growth flatlined, in contrast to most affluent countries’ modest resumption of growth after the crisis. The reasons are not well understood — but what is clear is that the discontinuity in growth long predated Brexit. Indeed, it predated all serious discussion of whether Britain might leave the European Union. Thus, it is far from clear that the British economy’s recent poor showing is attributable to Brexit as opposed to earlier, poorly diagnosed trauma.

Those of a historical bent will know that criticism of British economic performance is longstanding. Very longstanding, in fact: as early as the middle of the reign of Queen Victoria, pessimistic observers warned that Britain was losing economic ground to Germany. By the end of the 19th century, they noted that the economy had been overtaken by the United States. And after World War II, the UK was dubbed the sick man of Europe because of its singularly anemic economic recovery.

Long periods of economic underperformance have consequences. Over the century and a half that ended with the 2008 global financial crisis, Britain was reduced from its status as the richest country in the world to no more than a middling economy by European standards — poorer even than the lowest- income U.S. state. Against this backdrop, it is understandably difficult to determine whether Brexit was a decisive breakpoint, a body blow to output and productivity growth, or whether the past seven years are just the continuation of a trend.

If there is a consensus to be found here, it is that Brexit is to British economic performance what Covid-19 is to preexisting medical conditions. Covid-19 is all but certain to impair a subject’s health, but the prognosis is more ominous when the patient has been made vulnerable by chronic illness. Likewise, leaving the European Union is apt to have negative consequences for the departing member state, but those consequences will be especially damaging when the country in question suffers from a variety of economic ailments. In the British case, those preexisting economic weaknesses have been conspicuous since the financial crisis — and, many would argue, for much longer.

Decline, by the Numbers

Three data points summarize the current state of the British economy. First, output per hour worked is significantly lower than in the countries with which Britons have historically compared themselves. In 2021, that figure was £44 in the UK compared to £51 in France and £48 in Germany. (At the average 2021 exchange rate, £44 translates to $61.)

So by this measure, German workers are 15 percent more productive than their British counterparts. Once upon a time, the opposite was true: economic historians Stephen Broadberry and Carsten Burhop calculated that output per worker-hour was 20 to 25 percent higher in Britain than in Germany as late as 1938. This reversal of fortunes confirms that British productivity growth has not kept pace over long periods.

 
UK output per worker-hour in 2018 was roughly 20 percent below what would have been expected on the basis of the pre-crisis trend. As Crafts and Mills note, this is the largest shortfall relative to prior trends over a decade in fully 250 years.
 

Second, there was a break in productivity growth relative to Britain’s own trend around the time of the 2008 financial crisis. Nicholas Crafts and Terence Mills have estimated the trend rate of growth of British productivity over several centuries, smoothing short-term disruptions. And they found that 2007-8 represented a glaring inflection point. Output per worker-hour had been rising at an average annual rate of 2.3 percent since the mid- 1970s. This followed an even more impressive 3.9 percent performance between 1950 and 1973. Then, between 2008 and 2018, labor productivity growth abruptly slowed. At the end of 2018, this measure was a scant 2 percent higher than the pre-crisis 2007 peak.

As a result, UK output per worker-hour in 2018 was roughly 20 percent below what would have been expected on the basis of the pre-crisis trend. As Crafts and Mills note, this is the largest shortfall relative to prior trends over a decade in fully 250 years.

Given the timing, some observers point to the financial boom/bust cycle and, in particular, the British economy’s outsize reliance on the financial sector as the culprit. It is not surprising, they observe, that investment and growth should decline in the wake of so severe a banking and financial crisis. Regulation of bank lending was tightened following the crisis, and banks pared back their risky loans, at least temporarily.

As for the productivity of the financial sector itself, value-added in financial services is notoriously difficult to measure. National income statisticians tend to infer it from the volume of financial intermediation, which depends on the rise and fall of loan and deposit transactions. This creates at least the possibility that productivity growth in UK financial services was overestimated before the crisis and underestimated thereafter. That said, other countries, such as the United States, have equally large financial sectors, and they also experienced a significant boom/bust cycle without suffering an equally pronounced growth and productivity slowdown.

Then, there’s the aforementioned third data point: a further decline in productivity growth following the Brexit referendum relative to Britain’s advanced-country peers. John Springford of the London-based Centre for Economic Reform showed that slow growth since the referendum caused UK GDP to fall nearly 5 percent short of the level that would have been reached had Britain grown at the same rate as 22 other advanced economies. This differential suggests that something further has indeed gone seriously wrong since the referendum.

But, of course, Britain differs from these 22 economies along a variety of dimensions. Growth in countries with larger financial sectors, such as in Britain, might have suffered more from the stringent financial regulations put in place after the financial crisis than their less finance-heavy peers. In other words, such differences and not Brexit may account for the country’s disappointing economic performance.

To take such factors into account, Springford constructs a doppelgänger — a hypothetical double — for the UK economy. He considers economic performance in the same 22 economies in the pre-2016 period but constructs the weighted average of those countries that most closely resembles the UK prior to the referendum. He matches the UK and this basket of countries between 2009, when productivity growth first began to slow, and 2016, when the Brexit referendum took place. He then compares the post-June 2016 economic performance of the UK with that of its synthetic double.

Springford finds that the gap in GDP growth between the UK and its doppelgänger (having been zero between 2009 and 2016 by the model’s construction) opened to 5.2 percent by the end of 2021. This is an even larger hit to the UK economy than suggested by more simply constructed comparisons. It seems that Britain’s performance deteriorated further following the referendum when compared to a peer group of economies that differs little from the UK along other dimensions.

Just Getting By

Many explanations for Britain’s poor economic performance precede the Brexit debate, as the longstanding nature of the problem would lead one to expect. But, in each case, there are reasons to think that Brexit aggravated that preexisting condition. Most obviously, the UK has one of the lowest investment rates in the OECD. The country ranks low partly because of low investment in housing, but it is still close to the bottom when the comparison is limited to business investment.

Because investment has been relatively weak for so long, Britain has a smaller capital stock than most of its peers. It has fewer installed industrial robots relative to manufacturing employees than France, Germany or the United States. Straightforward analyses suggest that less capital per worker can explain much of the labor productivity gap visà- vis France and about a third of the gap with Germany.

What is true of physical investment is doubly true of research and development, where Britain spends only half as much as Germany as a share of GDP. The shortfall exists whether one considers R&D spending by the public and private sectors combined, or just enterprise R&D. And the implications for innovation seem pretty direct: new patents per employed person are more than twice as high in France, Germany and the U.S.

 
The public investment still taking place is skewed toward London and the Southeast, while lack of investment on transportation links and other physical infrastructure are widely blamed for the poor productivity of the country’s northern regions.
 

Low investment can be a consequence as well as a cause of slow productivity growth. When productivity is growing slowly, firms will be less profitable, rendering them less inclined to commit to new projects. But British firms also complain of a shortage of patient lenders to finance projects with long lead times. Whereas German firms can tap local banks with which they have long-term relationships, British firms protest that they find it hard to attract the attention of their country’s large, internationally oriented financial institutions. Historians of “capital market bias” in the 19th century will recognize this as another very longstanding — and disputed — explanation for the country’s relative economic decline.

When it comes to investment in plant and infrastructure, Britain is notorious for the difficulty of getting things built. An OECD study of the efficiency of land-use regulation ranked Britain next to last of 18 countries surveyed, after only Latvia.

Or take the notorious case of Heathrow Airport Terminal 5, designed to relieve overcrowding. The planning application was filed in 1993, but permission was only granted in 2001 after a four-year-long inquiry and 36 additional planning applications to a score of different authorities. The terminal finally opened in 2008.

Similarly urgent projects get the same lackadaisical treatment. Offshore wind farms, the UK’s ace-in-the-hole in the energy transition, take as long as 13 years from planning to deployment. Oxford and Cambridge are world-class research universities, but they struggle to build the office space needed to commercialize the fruits of their insights.

Finally, there are those who blame “austerity,” the shift toward fiscal consolidation after 2008-9, for Britain’s disappointingly low investment ratio and for its low level of public investment in particular. When governments are compelled to reduce public spending, they tend to reduce investment spending first since they face more political pressure to maintain transfer payments and public services.

Indeed. Responding to alarms about ongoing budget deficits, the British government reduced net public investment from more than 3 percent of GDP in 2008 to less than 2 percent in subsequent years. Moreover, the public investment still taking place is skewed toward London and the Southeast, while lack of iThrough a Glass Darklynvestment on transportation links and other physical infrastructure are widely blamed for the poor productivity of the country’s northern regions.

Through a Glass Darkly

These issues were longstanding, but then came Brexit. Once British voters made the decision in 2016, there followed a lengthy period of contentious negotiations with the EU that only ended in 2020 when Boris Johnson’s government finally succeeded in “getting Brexit done.” In the meantime, high uncertainty prevailed about whether and on what terms British producers would retain access to EU markets.

The motor vehicle industry is a case in point. In 2017, Toyota demanded clarity from the British government before committing to more investment in its British plants, threequarters of whose output was exported to continental Europe. In 2019, the company’s head of European operations warned that the firm would end production in 2023 were the UK to exit the European Union without a trade deal. Nissan put off investing in new model assembly in Sunderland, as did Peugeot/ Citroën at Ellesmere Port. Honda, for its part, announced that it would be shutting down its assembly plant in Swindon in response to both Brexit-related uncertainty and the conclusion of an EU-Japan agreement permitting Japanese-built cars to be imported into Europe tariff-free.

In 2020, an agreement was finally reached allowing the UK to export electric vehicles to the EU tariff-free so long as less than 45 percent of their content was sourced outside Europe and the UK itself. But this meant that assemblers had to collect and collate detailed information on the origin of components, not to mention juggle their supply chains to meet the requirements.

Then last year, members of Prime Minister Johnson’s Conservative Party proposed to back away from the UK’s trade agreement with the EU over the contentious Northern Ireland protocol. The protocol mandated customs checks on shipments of merchandise from England to Northern Ireland in order to prevent British producers from using Northern Ireland’s open border with the Republic of Ireland as an illicit backdoor to the EU. Predictably, this created renewed uncertainty about British producers’ continued access to EU markets, with yet additional depressing consequences for investment.

Britain suffered a decline in gross fixed capital formation as a share of GDP starting in 2018, when other advanced economies including France, Germany and the United States were enjoying a rise. Though there’s no smoking gun, Brexit-related uncertainty is the obvious explanation for this divergence.

The timing coincided with the Salzburg Summit, where EU leaders rejected Prime Minister Theresa May’s so-called Chequers Plan for exiting the EU Single Market while exempting British exporters from EU customs checks. The share of firms reporting that Brexit was among their top three sources of uncertainty rose from 35 percent six months before Salzburg to nearly 60 percent six months thereafter.

When John Springford applied his doppelgänger analysis to this question, he found that gross fixed capital formation stagnated in the UK in 2018 while continuing to rise at earlier trend rates in his synthetic comparison country. By 2021, according to his calculations, UK investment was 14 percent less than it would have been in an otherwise comparable country not subject to Brexit-related uncertainty.

It’s possible that there will now be some catch-up in UK investment in the wake of agreement on the terms of the post-Brexit trade regime with the EU. The agreement meant that the EU would apply full customs requirements and checks on UK exports in 2021, while the UK would do the same to imports from the EU in 2022. Trade costs went up, of course, but at least trade-related uncertainty went down.

 
British employers complain of shortages of technical workers and skilled tradesmen such as welders. As a result, the share of low-skilled workers in manufacturing jobs is higher in Britain than in other high-performing economies.
 

Correspondingly, the year 2022 saw a sharp drop in the share of British firms citing Brexit as one of their top three sources of uncertainty. Thus, some postponed investment projects may now be revived. But the hope that all of them will be undertaken seems fanciful. Short-term investment decisions — or, more precisely in this case, decisions not to invest — have long-term consequences.

I’m Not All Right, Jack

Other explanations for Britain’s productivity lag emphasize not a capital shortage but shortages of labor with specialized skills. Educational attainment as measured by literacy and numeracy is lower in Britain than in other high-performing economies. Tertiary education may not be a prerequisite for most manufacturing and service-sector jobs, but basic literacy and numeracy most certainly are — and increasingly so with the adoption of information technology in services and robotics in manufacturing.

As measured by the OECD’s Program for International Student Assessment for reading and math, the UK is no better than the middle of the pack. And the scores are significantly below the OECD average for the most recent generation of labor-market entrants, individuals younger than 30.

Not surprisingly, then, British employers complain of shortages of technical workers and skilled tradesmen such as welders. Britan Lacks the Close Cooperation Between Unions and Employer Associations That Supports Vocational Training and Apprenticeship Programs in Some High-Performing Economies, Notably Germany. As a Result, the Share Of Low-Skilled Workers in Manufacturing Jobs Is Higher in Britain Than in Other Highperforming Economies.

Prior to Brexit, Britain was able to import workers with specialized skills, given mutual recognition of technical credentials and free movement of labor within Europe’s Single Market. To be sure, Britain depended on the EU, especially on new Central and Eastern European member states that joined the union in 2005, for unskilled as well as skilled labor. Still, 30 percent of EU-born migrants to the UK were classified as highly skilled. (It’s worth noting that the share of non-EUborn migrants to the UK so classified was actually higher. But non-EU citizens generally had to meet a skills test to gain entry into the UK labor force.)

Predictably, inflows of skilled labor from the European continent declined following the referendum, while many EU nationals who were long resident in the UK responded by going home. The number of EU citizens working long term in the UK was already dropping in 2016 when the old migration system was still in place, reflecting political and policy uncertainty and a decline in the value of pound-denominated income due to exchange rate depreciation — also plausibly Brexit-related. All told, by 2019 the number of EU citizens working long term in Britain had fallen to little more than a third of the peak in 2015.

Following its final exit from the EU in 2020, the UK put in place a points-based migration system, where points are assigned for relevant skills. But regardless of their qualifications, working in Britain has become substantially more onerous for EU citizens. They must now obtain visas and pre-pay a National Health Service surcharge equivalent to $750. Moreover, getting in doesn’t mean they can stay in: ongoing residency rights turn on remaining employed.

In contrast, the EU’s Single Market rules provided the flexibility to spend time outside the UK without losing the right to live and work in the country. Between mid-2018 and mid-2019, EU citizens made nearly 100,000 short-term trips to the UK for employment before returning home, in many cases temporarily. These opportunities went out the window with Brexit and the new immigration system.

To be sure, there has been some substitution of non-EU migrants for EU migrants, but the operative adjective is “some.” Lessskilled workers in several occupations where employers relied heavily on EU migrants, including hospitality, food processing and manufacturing, find it difficult to obtain the points needed to qualify for visas under the new system.

Look Who’s in Charge

Where some critics of British productivity performance point to problems of capital or labor quality, others blame management. John Van Reenen, Nicholas Bloom and others have compared British and foreign management, grading managers on their implementation of explicit productivity targets and performance reviews. British managers come in significantly behind their German counterparts, and even further behind managers in the United States. Fully half of the productivity gap between Britain and the U.S., the authors concluded, is attributable to inferior management.

There is considerable variation in management quality within countries, of course. And it is hardly surprising that well-managed firms are more productive. But while Britain’s best managed, most productive firms rival those of any country, the productivity gap between these world-class firms and others is unusually large. A worker at the 90th percentile of firm productivity is nearly 16 times more productive than a worker at the 10th percentile.

While there is some disagreement about the numbers, most analysts conclude that this productivity gap between best- and worstperforming companies is significantly larger than in Germany, France or the United States. Measuring productivity is especially challenging for service-sector firms. But former Bank of England chief economist Andy Haldane concluded that the gap between the best-and worst-performing 10 percent of companies is 80 percent larger in the UK than in these other countries.

In addition, the distribution of British firms, arrayed by productivity, displays a long tail of low-productivity companies, dragging down productivity economy-wide. If anything, this gap between top firms and the rest appears to be widening. The best-performing firms are significantly quicker to adopt new technologies, and the lag between early adopters and other companies is growing. Evidently, there are serious — and rising — barriers to the diffusion of new management techniques and technologies from Britain’s worldclass firms to the also-rans.

Managers are, of course, responsible for identifying and implementing the practices that make world-class firms truly world class. Studies, including some by the UK government’s own Department for Business, Energy and Industrial Strategy, report a lack of awareness of new technologies and how to use them on the part of managers of small- and medium-size enterprises in particular.

 
It is worth recalling that the promise of increases in efficiency and productivity from enhanced competition was one of the original rationales for creating Europe’s Single Market.
 

Some analysts attribute this management shortfall, at least in part, to longstanding institutional features of the British economy, such as a tax code that encourages family firms to pass down management responsibilities to the founders’ offspring. That may be so, but the greater difficulty of attracting skilled and experienced managers from abroad, post-Brexit, cannot help.

One variable that is systematically related to management quality (and hence to productivity) is the intensity of competition, including international competition. The stronger the competition, the greater will be the pressure for lagging firms to upgrade their management practices. And it is worth recalling that the promise of increases in efficiency and productivity from enhanced competition — what the economist Richard Baldwin dubbed the “dynamic effects” of European integration — was one of the original rationales for creating Europe’s Single Market.

Admittedly, the magnitude of such effects is difficult to quantify. In a survey of the research on the impact of joining the EU, Nicholas Crafts concluded that membership raised UK GDP per capita by 8.6 to 10.6 percent. Whether these effects will now run exactly in reverse, only time will tell.

What is indisputable is that Brexit has reduced the access of EU firms to the UK market and of UK firms to Europe. John Springford has also applied his doppelgänger “what if” model to British trade and finds a large drop immediately following the Brexit referendum. British trade then dropped further between 2019 and 2021, when the actual exit from the Single Market took place.

To be sure, the trade of other countries also declined in this period owing to Covid- 19 lockdowns and supply-chain disruptions. But the plunge in UK exports and imports was significantly slower to recover. In a March 2022 report, the UK Office for Budget Responsibility estimated that UK trade as a share of GDP had fallen by 12 percent since 2019, two and a half times more than in any other G7 country. The Office’s late-2022 economic and fiscal outlook forecast that the UK’s trade intensity would remain 15 percent lower in the long run than if the UK had remained in the EU. As a result, British firms and managers will feel less competitive pressure from abroad.

Brexit’s champions argued that the UK would rapidly conclude free trade agreements with the United States and other major economies, thereby offsetting any decline in market access and competition due to leaving the European Union. It hasn’t turned out that way. The only new trade agreements signed by the UK since leaving the EU are liberalization agreements with Australia and New Zealand, a digital trade agreement with Singapore and, most recently, agreement to join the 11-country Pacific trade alliance known as the Comprehensive and Progressive Agreement for Transpacific Partnership. The government has proudly announced that membership in the latter will raise UK GDP by a whopping 0.08 percent.

Getting on With It

The impact of Brexit on the British economy will be debated for years. One reason is political: political parties and individual politicians made strong assertions that the effects would be positive or negative, and no one now thinks that their political stature will be enhanced by admitting that they were wrong.

Other reasons are analytic; the effects of Brexit are intrinsically difficult to isolate and place in historical context.

Should we expect the effects to be greatest in the period of high uncertainty between 2016, when the decision was made, and 2019, before the terms of the exit treaty were known? Or should we expect them to be greatest starting in 2020, when Britain’s access to Europe’s Single Market was definitively curtailed?

Should we expect to see the full effects on impact, or should we worry about dynamic effects that accumulate with time?

Can we accurately measure the impact of Brexit on an economy that was simultaneously hit by other sources of uncertainty including more adversarial U.S. trade policy after the 2016 election of Donald Trump and the pounding delivered by Covid-19 after 2019?

* * *

The reality that British economic performance had already deteriorated well before anyone took seriously the possibility of the UK exiting the European Union makes analysis especially problematic. It is probably not possible to accurately tease apart the role of Brexit in the economy’s disappointing recent performance from the role played by this earlier break in trend.

But whatever the negative consequences, it’s clear that Brexit is not going to be reversed in the foreseeable future. Rather than endlessly revisiting the fateful break with Europe, it would be more constructive to identify the causes of the UK’s earlier deterioration in economic performance and address them effectively.

main topic: Region: Europe