Is This Now Brexit?

More than six years after the referendum that witnessed the victory of supporters of the United Kingdom's exit from the European Union (EU), Brexit has yet to be completed. The United Kingdom left the bodies of the EU on January 31, 2020, but remained in the single market during an 11-month transition period in order to give the United Kingdom and the EU time to negotiate exit terms. On December 24, 2020, a trade and cooperation agreement was signed at the last minute between the EU and the United Kingdom, making it possible to avoid an exit without an agreement, a hard Brexit. Tensions have persisted, particularly over the issue of Northern Ireland. The replacement of Boris Johnson by Liz Truss as Prime Minister in September 2022 could mark a new phase of Brexit, one of deregulation.

The first part of this article recalls the main points of the December 24, 2020 agreement. The second part presents a status report on the implementation of the agreement and its consequences for the British economy as of mid-2022, an agreement that was deployed against the backdrop of two crises of exceptional magnitude – the Covid-19 pandemic in early 2020 and the Russian invasion of Ukraine beginning in February 2022. The third part discusses the future relationship between the EU and the United Kingdom. Liz Truss wants to remove the regulations inherited from the EU in order to make the United Kingdom more attractive, but she seems ready to revive discussions with the EU on the Northern Ireland Protocol and to join the European Political Community.

THE DECEMBER 24, 2020 AGREEMENT

The December 24, 2020 agreement ended five years of debate and negotiations on the United Kingdom's exit from the EU, which began with the June 23, 2016 referendum. Here we present a status report on the implementation of the main points of the agreement regarding commodities trade and financial services1.

Trading commodities

The agreement is a compromise that avoids creating tariffs and quotas for commodities trades. This long text (1,246 pages) sets out in detail the future relationship between the United Kingdom and the EU27. It establishes a Joint Committee and eighteen sectoral committees to ensure proper implementation. These committees will be able to utilize joint expertise or arbitration processes, since the United Kingdom does not recognize the authority of the Court of Justice of the European Union (CJEU).

The text includes a commitment to “free and undistorted competition”, the right of each party to define its own regulations, recognizes the need for collaboration on this, and guarantees that strong regulation of labor rights, as well as of social and environmental protection will be maintained. Subsidies to businesses are regulated. Any protracted disagreement will have to be decided by an arbitration tribunal, which can allow the injured party to take compensatory measures.

This will not prevent the emergence of non-tariff barriers (NTBs) – regulatory barriers, rules of origin, sanitary and phytosanitary standards (SPS) checks, customs checks, and administrative costs. The issue of regulatory barriers will arise only if regulations, which are currently similar, diverge between the United Kingdom and the EU. The question of rules of origin and SPS standards arose at the very beginning on January 1, 2021 – in order to be exported to the EU duty-free, British products must respect the rules of origin, i.e. contain a minimum percentage of materials originating in the United Kingdom and the EU, a percentage that varies according to the product; food products must present certificates attesting to their compliance with the EU SPS standards. Businesses must fill out forms in preparation for customs checks.

According to various estimates (OBR, 2018), under a traditional free trade agreement these barriers represent on average an increase of around 6% in the cost of traded commodities. They are expected to curtail British exports to the EU, may discourage some firms from setting up factories in the United Kingdom, and will be passed on in United Kingdom prices.

Financial services

It was financial services that were most overlooked by the agreement, although they accounted for 7% of value added in Britain, more than a million jobs, and a surplus of £16 billion in trade with the EU in 2021, and £45 billion with the rest of the world, or nearly two points of GDP. By leaving the single market, British financial firms gave up the financial passport that allowed them to operate in the EU. The British had hoped to obtain equivalence agreements. In the December 24 agreement, the two sides simply agreed to reach a memorandum of understanding by the end of March 2021.

But on the EU side, no decision was subsequently made, other than to maintain equivalence for clearinghouse activities for an initial period of 18 months, or until June 2022, which has since been extended to 2025. The EU is clearly acting in its own interests: keeping equivalence only for those businesses that today cannot be performed in the eurozone, and making no decisions on other businesses. This is the sector in which the United Kingdom had the most to lose by leaving the EU. Many may be surprised that in negotiating the agreement the British government did not seem to worry about the interests of the City, unlike the interests of its fishermen. It is likely that the British government trusted the City to maintain global leadership by developing new businesses (such as green finance or Islamic finance) and by reorienting itself towards dynamic growth areas, particularly in Asia. In addition, British financial companies anticipated the United Kingdom's exit from the single market by making sure they kept offices in the eurozone.

The Northern Ireland question

This was one of the most difficult issues in the negotiations. The protocol signed on October 27 made it possible to avoid establishing a physical border between Ireland and Northern Ireland. It set up a complicated system. On the one hand, Northern Ireland continues to follow a series of single market rule – commodities legislation, SPS rules, restrictions on government aid, and VAT and excise duties. On the other hand, it continues to be part of the United Kingdom customs area. It is part of the free trade agreements that the United Kingdom concludes with third countries. Goods entering Northern Ireland must comply with EU rules if there is a possibility that they will enter the EU single market. For each type of commodity, a joint committee evaluates the risk that it may later circulate outside Northern Ireland. The required checks are made by the British authorities, but the protocol provides for setting up EU control and monitoring mechanisms. EU rules concerning government aid apply when they affect trade between Northern Ireland and the EU.

The negotiations have been marked by a high degree of unity and a certain resolve from the EU27 countries. Given the difficulties the United Kingdom has in defining a clear exit strategy, the EU is clearly emerging stronger politically.

A STATUS REPORT

A visible impact on foreign commodity trade in January 2021

The EU introduced controls on the entry of goods from the United Kingdom immediately on January 1, which especially caused problems for food products. This was not a problem for EU exporters to the United Kingdom, as the rules did not change on the British side. The British government had originally planned gradually ramping up controls on goods from the EU in April and July 2021, which it has since pushed off several times, currently to January 2024. In practice therefore, Brexit has resulted in NTBs for United Kingdom exports to the EU, but not for EU exporters to the United Kingdom.

After a sharp rise in 2020, linked to precautionary purchases, British imports of goods from the EU, like British exports to the EU, fell in January 2021 by 33% and 45% respectively (see Chart 1), while the fall in imports from outside the EU was only 7%, with British exports to that area rising 3%. There was indeed a specific Brexit-related shock to commodity trade. Since then, British imports from both the EU and non-EU countries have grown faster than British exports to both areas, without it being possible to clearly identify the impact of Brexit. The commodities deficit widened to 10 percentage points of GDP in the second quarter of 2022 (a 25-year low).

Source: ONS (Office for National Statistics).

Financial services: little impact so far

The negative impact of Brexit on British financial business has so far been limited. In 2016, financial firms in the City of London estimated that they would relocate 12,500 jobs to the EU, but have since steadily revised their plans downwards to 7,000, according to the March 2022 EY barometer. Data published by the ONS show an erosion of United Kingdom exports of financial services to the EU in 2020, which was not the case with the rest of the world (see Chart 2), followed by stabilization. In the first quarter of 2022, however, the bilateral surplus with the EU remained at an annualized rate of £17bn (and £45bn with the entire world), close to its level at the beginning of 2016.

Source: ONS.

Macroeconomic impact

Most studies published during the campaign leading up to the June 2016 referendum, as well as those afterwards, anticipated a strong negative impact of Brexit on the British economy, with a median impact of –2.5 % on GDP (Mathieu, 2020). Macroeconomic indicators suggest Brexit has had only a limited impact so far, hard to distinguish from the shock caused by the Covid-19 crisis beginning in early 2020, and then the shock caused by the Russian invasion of Ukraine in February 2022.

Before the referendum, the United Kingdom's growth had been higher than that of the eurozone countries, which were mired in austerity policies (1.3% on average per year from 2005 to 2016, compared with 0.85%). In 2016, the unemployment rate in the United Kingdom was 4.8%, compared to 10% in the eurozone. Between the referendum and the start of the health crisis, GDP grew 6.4% in the United Kingdom, compared to 6.9% in the eurozone (5.5% in Germany); unemployment fell to 3.7% in the United Kingdom, compared to 7.6% in the eurozone.

In the second quarter of 2022, GDP had not quite returned to its pre-Covid-19 level in late 2019 in the United Kingdom (–0.2%), compared to +1.8% on average in the eurozone, 0 in Germany, +0.9 in France, +1.3 in Italy, –2.2 in Spain, and +3.5 in the US.

Across the Channel, annual inflation was 9.9% in the United Kingdom in August, compared with 8.8% in Germany, 6.6% in France (thanks to the price shield), 9.1% in Italy, 10.5% in Spain, 13.7% in the Netherlands, and 9% on average in the eurozone. This inflation, and the wage demands it drives, therefore did not result from Brexit. The unemployment rate (as defined by the International Labour Organization) was 3.6% in the summer of 2022 (6.6% in the eurozone), compared with 3.8% before the Covid-19 crisis. The percentage of those employed, however, remained one point below its pre-crisis level.

Following the June 2016 referendum in favor of Brexit, the pound sterling fell 11% against the euro, from €1.30 to €1.16, which was a more satisfactory level for British competitiveness. Since then, the pound has fluctuated between €1.10 and €1.20. At the end of 2020, it was worth €1.10; by August 2022, it rose to nearly €1.20, so there has been no recent Brexit effect on import costs. However, the pound did slightly weaken to around €1.16 at the end of August 2022. The growth plan announcements by Liz Truss and her chancellor, Kwasi Kwarteng, on September 23 (HM Treasury, 2022) sent it down to €1.11 before it bounced back to nearly €1.15 a few days later.

For many months, the spread between British government 10-year borrowing rates and the German rate was limited to around 1.3-1.5 percentage points; the announcement of the growth plan increased the spread to more than 2 points and led the Bank of England to take emergency measures (a £65 billion government bond purchase program through October 14, 2022), which resulted in the spread stabilizing at 2 points.

During the health crisis, the budget deficit rose from 2.4% of GDP in 2019 to 13.1% in 2020 and then 8% in 2021. It is expected to be around 5% in 2022, so a policy of large tax cuts for business and the wealthy, in line with supply-side policies, could only unsettle the markets. It will take time to see any lasting effects of Brexit on trade, especially since one crisis has followed another: the waves of Covid-19, which led to a business decline, and the Russian invasion of Ukraine, which led to price increases in raw materials and supply chain problems.

There is the eventual risk that businesses will choose to relocate some of their investment and production from the United Kingdom to the EU. Boris Johnson's government was committed to a strategy of opening up on a worldwide scale under the slogan “A Global Britain”. As soon as it left the EU in January 2020 and during the phase of negotiating an agreement with the EU, the British government, with Liz Truss as Secretary of State for International Trade, concluded trade agreements with many countries, first by replicating the agreements those countries have with the EU and then by negotiating free trade agreements. Two free trade agreements are emblematic of the United Kingdom's “Global Britain” strategy of opening up to the world – the agreement signed with Japan in October 2020 and the agreement with Australia in June 2021. Japan and Australia do represent only a small share of British foreign trade, respectively 1.8% and 1.2% of exports in 2019, compared with nearly 50% for the EU. However, in this way the United Kingdom is increasing its chances of joining the Comprehensive Progressive Agreement for Trans-Pacific Partnership (CPTPP), which currently encompasses 11 countries: Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore and Vietnam (or around 14% of global GDP). Moreover, the United Kingdom signed a free trade agreement with the three member countries of the European Economic Area who are members of EFTA (Iceland, Liechtenstein and Norway), as well as with Albania. It is continuing its negotiations with African countries (a trade agreement was signed with Kenya in December 2020). Negotiations have begun with India. Discussions on a free trade agreement with the United States, which began in April 2020, were interrupted in October 2020 as the US presidential election neared. Among the sticking points were the issue of phytosanitary standards, which a majority of Britons do not want to see lowered, and that of health care, which the British refuse to privatize. Signing a trade agreement with the United Kingdom is also not a priority of the Biden administration. Furthermore, Biden has expressed a desire to see the Northern Irish Protocol implemented. By the end of August 2022, the United Kingdom had signed trade agreements with 68 non-EU countries, accounting for 15% of British foreign trade, many of which are continuations of existing agreements between the EU and these countries.

Delicate relations with the EU?

The implementation of the Northern Ireland Protocol has caused tensions in Northern Ireland and has strained relations between the United Kingdom and the EU – the EU wants the protocol regarding the entry of goods into Northern Ireland to be strictly applied and for the rules in force in the EU to be observed, including in the case of goods destined only for the Northern Ireland market, while the United Kingdom wants a flexible application of the protocol based on the country for which the goods are ultimately destined. Anxious that the EU no longer be allowed to intervene on its territory, the United Kingdom published a Command Paper in July 2021 calling for a broad revision of the protocol. It is threatening to trigger Article 16, which allows either party to suspend the application of the protocol if there is a risk of “serious societal, economic or environmental difficulties liable to persist, or diversion of trade”.

At the same time, Boris Johnson announced in November 2020 a sharp increase in British military spending to help strengthen NATO. He has displayed especially important support for Ukraine, which is a victim of Russian aggression.

TOWARDS A HARD BREXIT?

The arrival of Liz Truss as head of government in September 2022 could herald a turning point in the implementation of Brexit, and revive the scenario of London becoming a “Singapore on the Thames”, i.e. a tax and regulatory haven. The plan for growth presented by the Chancellor of the Exchequer on September 23, 2022, set a target of 2.5% trend growth for the British economy through supply-side measures. These included keeping the corporate tax rate at 19%, a rate that was supposed to be raised to 25% in April 2023, and the creation of investment zones (not subject to normal taxation). This is the return of tax dumping as a weapon to make investment more attractive; the easing of regulations; lowering payroll taxes; removing the cap on compensation for bankers; and the authorization of shale gas extraction. Her plan also included eliminating the 45% income tax bracket, which was abandoned following an outcry, even from within Conservative ranks.

In her speech to the Conservative Party Conference in October 2022, Liz Truss announced that all regulations inherited from EU membership would be removed by the end of 2023. This could make it more difficult to export British goods to the EU, as the December 2020 agreement limits the extent to which British rules may diverge from those of the EU. At the same time, the government resumed negotiations with the EU on the Northern Ireland Protocol, which had been put on hold since February 2022, with both sides saying they hoped to see a compromise agreement reached in the coming weeks. The government is therefore moving towards a harder Brexit, while renewing the dialogue with the EU.

JOINING THE EUROPEAN POLITICAL COMMUNITY?

The European Political Community, an initiative suggested by Emmanuel Macron in May 2022, could be a means of renewing relations between the United Kingdom and the EU. Initially reluctant to participate, Liz Truss attended the first meeting of this informal body held in Prague on October 6, 2022. The war in Ukraine and the energy crisis are currently bringing the United Kingdom and the EU countries closer together. It is difficult to say what form this Community of 44 participants, including Azerbaijan and Turkey, might take. But the initiative could lead to a Europe of circles.

The awkward departure of the United Kingdom, the wayward path of certain Central European countries (Hungary and Poland), and the hesitations of Denmark and Sweden could lead to a Union with several circles. The first circle would include the countries of the eurozone willing to accept new restrictions on national sovereignty and who would build up a budgetary, fiscal, social, and political union2. This could be an opportunity to make democratic progress: a parliament of the eurozone could be set up and a commission of the eurozone be responsible to this parliament, which would be able to censure the commission. A second circle would include those EU countries that could not or would not want to participate in this close union. Finally, the third circle would include countries linked to the EU by a customs union or a free trade agreement: the countries of the European Economic Area (Iceland, Liechtenstein, and Norway), Switzerland, the United Kingdom, the countries of the Stabilization and Association Agreement (SAA: Albania, Bosnia and Herzegovina, Kosovo, North Macedonia, Montenegro, and Serbia), the countries of the Deep and Comprehensive Free Trade Area (DCFTA: Georgia, Republic of Moldova, and Ukraine) and tomorrow, Armenia, Azerbaijan, and Turkey.

This project would allow European countries that so desire to move more quickly towards a more comprehensive union, without being paralyzed by countries that are more reticent. It would provide a unified framework for the EU's partner countries, whereas the disparity between the current agreements has led to unsatisfying complexity. These countries could enjoy the benefits of free trade without losing any sovereignty (in political, fiscal, or social matters).

However, it presents numerous problems. The European Commission is opposed to it, because it would jeopardize the project of all EU countries moving together towards an “ever closer union”. The EU countries outside the eurozone are hostile to such a setup, which would marginalize them as “second-class” members in a lasting way.

European institutions would have to double up between eurozone institutions operating in the federal mode and EU institutions continuing to operate in the union of member states mode, between a European Parliament and a Eurozone Parliament, eurozone and EU Commissioners, eurozone and EU budgets and financial transfers, eurozone and EU directives, etc. Many issues would have to be decided twice or three times (at the eurozone, EU, and free trade area levels). The question of the composition and powers of the CJEU would arise. For each question, the relevant circle would have to be identified, which would not be simple for many questions of regulatory, fiscal, or social harmonization. For example, it would have to be decided whether the third circle has to accept the freedom of movement of workers (which the United Kingdom and Switzerland refuse and which the EU has refused for the SAA or DCFTA countries); whether the third circle is entitled to the European financial passport (which assumes that member countries be subject to the rules of the European Banking Authority); whether it must enforce minimum tax rates for companies and the rich (but will it also be possible to impose these minimum rates in the eurozone on Ireland and Malta?). A single market with several levels of criteria would have to be envisaged, which is unworkable. For each question and each circle, there would be the question of voting procedures – unanimity, qualified majority, or simple majority.

The countries in the third circle would be in a difficult situation if they were forced to comply with regulations over which they had no power. In order to avoid that, specific bodies to deliberate and make decisions would have to be set up at the level of this third circle, particularly concerning questions of trade agreements with third countries or technical and health standards. But such regulations would have to be negotiated in technical committees where public opinion, national parliaments as well as the European Parliament, would have no say.

The makeup of the circles would be problematic. Not all countries in the eurozone want such a close union, with the fiscal and social harmonization that it would imply. This is particularly true of Ireland, the Netherlands, Finland, and the Baltic countries, which have joined together in the New Hanseatic League. There would have to be a first circle – 0 – within the eurozone, of countries accepting this close union and a circle of countries that refuse it. Depending on the question, the member country could choose its circle (0, 1, 2 or 3). This would quickly lead to a union “à la carte”, hardly compatible with democracy on a European scale, since it would practically require a parliament per question.

Finally, the basis of the third circle could be economic – a vast free trade market whose norms would spread throughout the world; social – defending a certain social model and moving towards fiscal harmonization; ecological – making the change in course that is crucial in order to avoid catastrophe; political – promoting cooperation between European countries and on a global scale, avoiding military conflicts, and defending democratic and republican principles. But are the 44 European countries in unanimous agreement on each of these bases?

Preserving close cooperation with the United Kingdom in the fields of foreign policy, defense, security, and the fight against terrorism is necessary, but cannot be done at the level of the third circle if it includes countries such as Turkey, whose regional hegemonic aims are incompatible with the EU's views.

Moreover, there is probably no agreement among the nations of Europe, even for those countries at the heart of the eurozone, to move towards a federal Europe, with all the convergence and losses of democratic control that this would entail. In the present situation, few nations would accept that their budget, their taxation, and the reforms of their social system be decided by a federal body. Yet such a transformation of the EU should be accepted democratically, in each country.

The existence of a third circle would facilitate the issue of enlargement: countries applying for EU membership could be part of this circle before being admitted to the second circle. Some countries might prefer to remain in the third circle.

The Europe of circles would be a way of continuing the integration process, of reinforcing the political weight of Europe, but its implementation would not be easy.

CONCLUSION

In the fall of 2022, beyond the temporary shock of Brexit on foreign trade at the end of 2020 and the beginning of 2021, macroeconomic indicators mainly reflect the effects of the Covid-19 pandemic, as well as those of the energy crisis, two shocks of greater magnitude than the impact expected from Brexit.

Beyond this very short term, a range of scenarios is possible. For the pessimists, the United Kingdom will withdraw into itself. This would result in an immediate loss of productivity and a decline in the rate of productivity growth. The Office for Budget Responsibility estimated in October 2021 (OBR, 2021) that the impact could be a 4 points drop in productivity. But this is debatable, because the United Kingdom wants to remain open. Moreover, when she came to power, Liz Truss committed herself to a liberal strategy, in which the United Kingdom, freed from EU constraints, could deliver a shock of deregulation (although the country is already very deregulated), make progress in efficiency and competitiveness, and strengthen its orientation towards “the wider world”, as illustrated by the trade agreements signed with countries outside the EU. There is no guarantee that Liz Truss' government will stay the course, as it has been heavily criticized from the beginning, even among the Conservatives, for the measures in its “Growth Plan”. But one thing is certain, Brexit is not over.

(October 17, 2022)