• Dr Gerard Lyons

My submission to HM Treasury Committee's inquiry on the UK's economic relationship with EU

Written submission by Dr Gerard Lyons to The Treasury Committee’s ‘The UK's economic relationship with the European Union inquiry’

6th December, 2018

1. There is a strong economic case for leaving the European Union (EU). The longer-term benefits should take precedence in current decisions, despite the near-term challenges of leaving the EU. It is not easy for any country to leave something that it has been a full member of for over four decades. Leaving the EU is an economic shock. Thus there will be near-term challenges. I called this a ‘Nike Swoosh’ during the referendum campaign, as in the very near-term the economy might be weaker than otherwise but the further ahead one projects the economy should perform better than remaining in the EU. While there will be challenges, particularly if leaving is poorly planned and badly handled, the UK economy is remarkably resilient. While the UK is due to leave the EU at the end of March 2019 there is a strong case for a short temporary transition period, and indeed I argued for this last year[1], aimed at removing uncertainty and allowing people and business to adjust and plan ahead for when we leave the EU. To make a success of leaving the EU requires policy focused on three key, interlinked areas: our future relationship with the EU; positioning the UK in the changing and growing global economy; and our domestic economic and financial agenda. It is important that any plan to leave should not tie our future room for policy manoeuvre on the other areas, namely our global ambitions and domestic policy agenda. It is also important that there is clear leadership about the domestic and global vision ahead for the country. This is in order to provide context and clarity, as well as remove uncertainty for people and firms, and aimed at delivering a realistic and positive view about the UK’s prospects. While the aim of our future relationship with the EU should be a comprehensive free trade agreement, as this makes economic and trade sense for both sides, it is important to appreciate that leaving with ‘No Deal’ is a perfectly plausible scenario. This is not the same as walking away. However, No Deal needs to be prepared for fully, with necessary mutual recognition agreements where needed to facilitate trade and statutory instruments to ensure other non-trade areas are addressed. It is opaque how much preparation has been made for this. If anything this should be a trigger for far more to be done now. Leaving the EU is a great opportunity, particularly in a changing global economy facing a fourth industrial revolution, a digital and data revolution and a shift in the balance of economic power towards the IndoPacific (stretching from the US to India), from where the bulk of global growth is expected to emanate in coming decades.

2. This submission is made in a personal capacity. I am an economist, being an expert on the global and UK economy, international financial markets and economic and financial policy. I have a portfolio of roles: Chief Economic Strategist, Netwealth; Economic Advisor, Parker Fitzgerald; Independent non-executive Director, Bank of China (UK); and member of Advisory Boards of the Grantham Research Institute on Climate Change and the Environment at the London School of Economics and Imperial College, Warwick University Business School and the Official Monetary Financial Institutions Forum. I was not involved in the official referendum campaign, but co-founded Economists for Brexit, an independent group, to help ensure the public could have access to the economic case for leaving the EU. As, in any debate, there were economic arguments on both sides. Economists for Brexit was disbanded following the Referendum campaign and I have continued to comment on this issue in a personal perspective. Also, I co-authored a book with Liam Halligan, titled ‘Clean Brexit’[2] that outlines that it is in the UK’s best interests to leave the EU and how to make a success of leaving.

3. To make a success of Brexit, the UK needs to ensure it focuses on having: a good relationship with the EU; positioning itself well with the rest of the world in terms of trade and investment opportunities; and addressing its domestic economic and financial agenda. It is important that this future UK-EU relationship does not limit our future ability and tie our hands in the other areas. The Government’s recently proposed deal threatens, unfortunately, to do that.

4. Since the referendum the economy has demonstrated resilience. This should auger well for the future. The outlook for any economy depends upon the integration between the economic fundaments, policy and confidence. Of these confidence is the hardest to predict, but if it is lacking it is sufficient to deter people from spending or firms from investing. As appeared so at the time, the pre-Referendum predictions of immediate economic recession were misplaced. Instead, since the Referendum, the economy has continued to generate jobs at a significant pace, and until recently growth was similar to its pre-Referendum trend. Recently, there has been a slowdown, although this may be as due to the tightening of monetary policy, alongside uncertainty over Brexit. Despite being far stronger than most forecasters expected, the economy has likely been weaker since the Referendum than it might otherwise have been, as investment plans by some firms may have been deferred by Brexit uncertainty. It is hard to quantity this effect. Julian Jessop of the Institute of Economic Affairs[3] says the level of GDP is around 1% lower than it might otherwise have been, and I would agree. In contrast, a ‘doopleganger’ approach used by some economists to infer a larger temporary setback than this is inappropriate. Not only may specific factors (such as fiscal easing in the US) have boosted domestic demand in other economies, but, as Paul Ormerod[4] makes clear, the challenge with the methodology underlying the doopleganger approach is that the empirical correlation matrix of, say, GDP growth over time in different countries, is inherently noisy. In other words, it is not stable and thus lessons about what might have been, for economies like the UK, cannot be drawn from this. In addition, while domestic investment may have been deferred, foreign direct investment into the UK has remained significant post the Referendum. Data, just released, shows overseas investment into the UK reached its highest level ever in 2017 and while the competitiveness of the pound may have been a factor influencing the timing of such inflows, the longer-term attraction of the UK is likely to have been a major consideration.[5]

5. There is a need to look beyond the short-term. I previously provided written evidence to the House of Commons Treasury Committee in 2016-17[6], on, 'The Europe Report: A win-win situation’, a report produced in August 2014 by The Mayor Of London. That concluded that the best scenario for the UK was to be either in a reformed EU, or that leaving and pursing sensible economic policies would deliver more than the status quo. In its main report, paragraph 86, the Treasury Committee quoted from my written evidence, “that leaving the EU would have negative short-term economic consequences. Leaving the EU would be an economic shock. Most, if not all, economic shocks depress economic activity. Thus economic forecasts that focus on, say, a couple of years ahead would tend to show that leaving the EU is always worse than the alternative.” I stick with that view, but the written evidence went on to say that it “would be more meaningful to look at the likely impact over a longer period of time”. That too remains the case. There is no doubt in my mind that, pursuing sensible policies, the economic and financial outlook for the UK will be better outside of the EU.

6. The recent forecasts from the Treasury and scenarios from the Bank of England should, naturally, be noted but should not be given undue weight. One, the Treasury’s forecasts seem to be a repetition of the approach to the wrong forecasts made before the referendum that predicted an imminent recession in the event of a vote to Leave. Two, the margin of error on such longer-term forecasts is high. Three, the outcomes are heavily influenced by the assumptions made, which are overly pessimistic. Four, the policy response is seen as being either non-existent, or negative for growth, contrary to previous norms, when the policy response to shocks has been counter-cyclical.

7. In the present debate, one factor often overlooked is the direction of travel of the EU that we are leaving and the economic problems that it continues to face. With the euro at its core, the EU is likely to have to move further towards closer political union. Meanwhile, deep-rooted economic problems persist, as seen in the large target two imbalances that are building between euro area central banks. It is also reflected in the continuing challenges facing economies like Italy. The euro area is a slow growth region of the world economy. Also, it should be remembered that in Prime Minister Cameron’s deal, prior to the EU Referendum, the UK was unable to secure a continued future opt-out within the EU for non-euro economies from future policies of the euro area that might impact them. While there is uncertainty associated with leaving the EU, it is rarely acknowledged that there would have been tremendous uncertainty, and potential risks were we to have remained in it. This should not be a surprise given how much the EU has changed since its origins. During 2018, the IMF estimates[7] that just 14% of global growth will emanate from Europe, while Asia for instance will generate 63%. These figures will vary from year to year but in considering our future relationship with the EU, we should note the need to position ourselves to compete in the changing global economy, where the bulk of growth will originate from the rest of the world, with the need to trade more with countries in these other regions. We will be better able to do this outside the EU.

8. In terms of our future relationship with the EU, there are still strong arguments for the UK to be outside the Single Market (SM) and Customs Union (CU), and in addition seek a comprehensive free trade agreement, beneficial to both sides. The later has been referred to as Canada Plus. But even without such a trade deal we should leave the SM and CU. Outside the SM, those firms that wish to sell into the SM can continue to do so. Membership of the SM requires all UK firms – not just exporters – to comply with EU rules and regulations, no matter how unnecessary or costly for them. While migration is good for an economy there is a need for the UK to have a sensible and fair migration policy, but membership of the SM points to continued free movement. Furthermore, we should not overlook that the UK is a large service sector economy and the SM in services did not work properly. Outside the SM, rules and regulations can be set to suit UK needs. This does not need to be viewed as a so-called race to the bottom. Indeed, the UK has been at the forefront of pursuing workers rights[8] and it is vital for the UK to take a lead in environmental standards, as it currently does, addressing climate change. Leaving the CU would provide the best outcome for the UK, allowing the UK to set its own tariff structure and to position itself to conduct trade deals. There are many countries, far smaller than the UK, and with less commercial and diplomatic influence, who have been able to conduct trade deals greater in scope than the EU has been able to. Moreover, outside the EU, the UK will be able to cut such deals that are in the economy’s best interests, as opposed to being one of twenty eight when in the EU. We can also resume our own seat at the World Trade Organisation (WTO), playing a lead role as that organisation evolves.

9. Finally on the domestic agenda. The UK is an innovative economy and has some world class companies and sectors, from universities to The City. An economy based on innovation, greater investment and infrastructure spending and with the right incentives based on low tax and smart regulation would move us significantly away from the low wages and low productivity that mark much of the economy now. This will take time. We will be far better able to address this outside the EU. There is no doubt that there are many things the UK could have done when it was in the EU, but for domestic political, economic and financial reasons it chose not to. For instance, more infrastructure spending. But at the same time, and as the previous Coalition Government highlighted in its series of comprehensive competency reports o n the UK’s relationship with the EU, the EU’s intrusion can be seen in multiple areas of domestic policy. The City was one of many examples. Another was cohesion funds, linked to regional policy. Providing regional assistance from Westminster, not Brussels, would provide greater flexibility in determining priorities. It would likely remove extra layers of bureaucracy via payments made from Brussels. Every three years the European Commission (EC) analyses the competitiveness of the 263 sub-regions of the EU[9]. Three of the top five, and four of the top ten across the EU are in the south of England. London is first, mirroring the fact that across the EU, the capital was the most competitive region in all but three countries, Germany, Italy and the Netherlands. However, the UK has ‘heterogeneous scores’, reflecting a wide regional variation in competitiveness. The least competitive UK regions are Northern Ireland (145th of the 263), West Wales and the Valleys (134th) and Cornwall and the Isles of Scilly (133rd). This should support the argument for greater future fiscal devolution.

10. Attention must be given to our vast service sector, particularly the City. Attitudes in the City have evolved since the Referendum, and it is now recognised widely that London will remain the leading financial centre of Europe. The City’s combination of skills, knowledge, language, law and financial infrastructure is seen as being Brexit proof. Currently the fear in the City is that if we are tied to EU regulations it will limit our ability to compete with New York and other international financial centres. We must avoid inadvertently in any deal tying ourselves too closely to the EU’s plans on a range of areas such as Financial Transactions Tax, bonus cap, regulation and supervision that may favour the EU27 at the expense of the UK and which could spread to market infrastructure.

11. Leaving the EU is, in my opinion, in the long-term economic best interests of the UK. There are, however, transition costs to leaving, and the scale of these depends upon many factors, including the terms of our exit and future relationship with the EU and how much preparation we have done if we were to leave with No Deal. In terms of a temporary transition, Lord Owen[10] has proposed leaving via the European Economic Area Agreement. This has some merits as a stepping stone towards leaving, and is far better than remaining in the EU, but if something like this is adopted, it is important the UK avoids permanently the so-called Norway Option, which would leave the UK as a rule-taker, with free movement and high contributions. However, while a comprehensive trade deal is the preference, a No Deal scenario is not to be feared, with UK–EU trade operating under WTO rules. It is not the same as walking away and despite its name needs to be prepared for fully with, in particular with necessary mutual recognition agreements where needed to facilitate trade and statutory instruments to ensure other non-trade areas are addressed. It is opaque how much preparation has been made for this. It is unthinkable that existing and uncontroversial EU protocols granted to other non-EU members would not apply to the UK, not least as we leave the EU fully compliant. Leaving under WTO rules is often presented as damaging or irresponsible. This is alarmist. WTO tariffs are relatively low and falling. Many other leading economies conduct extensive trade with the EU under WTO rules. Britain can do the same. Much of the UK’s trade with the non-EU, over half our total trade, is largely under WTO rules. While WTO rules would work, it makes sense for the UK to seek a comprehensive free trade agreement with the EU.

Gerard Lyons

6th December, 2018

[1] Gerard Lyons, Financial Times, 17/08/2017, ‘A short transition can help Britain make the best of Brexit’ [2] Published by Biteback Publications, 2017. [3] Julian Jessop, IEA, “No Deal Fear-checker” No 5, 14th September 2018. [4] See Ormerod, P. and Mounfield, C., 2002. The convergence of European business cycles 1978–2000. Physica A: Statistical Mechanics and its Applications, 307(3-4), pp.494-504, and Ormerod, P., Random Matrix Theory and Macro-Economic Time- Series: An Illustration Using the Evolution of Business Cycle Synchronisation, 1886–2006. Also see, Paul Ormerod, Vol. 2, 2008-26, August 27, 2008, Economics (the open access E-journal. [5] GOV.UK News Story, 4/12/2018, “Overseas investment into the UK at highest ever level’ [6] My written evidence was provided to the inquiry, ‘The economic and financial costs and benefits of the UK’s EU membership, First Report of Session 2016–17, HC 122’ [7] Figures contained in a presentation given on 29/11/2018 at CSFI, London by Tahsin Saadi Sedik of the IMF’s Asia and Pacific Department. [8] As highlighted in ‘Clean Brexit’, cited earlier. [9] European Commission Regional Competitiveness Index 2016 [10] See David Owen, 4/12/2018, ‘On the eve of the Commons Debate on the Withdrawal Agreement, Lord Owen writes to all MPs suggesting an exit strategy that avoids a no deal“