The Ultimate Exit Strategy: Why a Brexit Could Sink the EU

On June 23 the British people will vote on a historical referendum on whether they want the United Kingdom to stay in the European Union. Just what the economic impact will be is hard to assess, say Wharton experts, because no nation has ever left the 28-member economic and political bloc.

“No one knows what the economic impact will be” and most analysis “is just speculation at this stage,” says Wharton finance professor Joao Gomes. “There are no firm studies. There is no hard data.” What’s more, it is the political consequences that may have the biggest impact on the E.U.’s future, at least in the short- and medium-term because should one nation leave the group, others could follow.

Specifically, the U.K.’s referendum will determine if Britain will exit the European Union, popularly called a Brexit. The idea of a possible British exit from the E.U. was seeded in a campaign promise. David Cameron, now Prime Minister, promised the referendum should the Tory Party win No. 10 Downing Street. There would be a vote by the end of 2017, Cameron pledged at the time, in part to win over the “euroskeptics” in his own party and among the British population more generally.

Olivier Chatain, strategy and business policy professor at HEC business school in Paris and a senior fellow at Wharton’s Mack Institute for Innovation Management, adds: “The people who want the referendum didn’t want to be in the E.U. in the first place.” They have made different arguments against membership at different times. But “the point is they don’t want to be in the E.U.” In his view, however, it’s better for the U.K. to exert influence from inside of the E.U. rather than the outside.

Referendum Mechanics

Recently, Cameron flew to Brussels to negotiate concessions favoring the U.K. from European leaders in order to persuade the British people to vote to stay in the European Union. If the British people vote to leave, the U.K. has two years to renegotiate all of its treaties and trade deals, among other things. It would not be simple. As Gomes points out, a Brexit would require approval by the other 27 countries in the E.U. and their Parliaments might not ratify it.

No one knows what will happen with the politics of it all because no one has done this before, says Chatain. “People want the U.K. to stay in the E.U. because they don’t want uncertainty.”

With a migrant crisis underway, which transplanted more than a million people last year on a scale not seen since World War II, the British people were agitated at the prospect of being forced to comply with  European quotas to take in more refugees than they want to support. Gomes adds that the “next few months will be tougher with migrant pressures increasing. Fundamental trends will work against an E.U. vote. There’s no doubt that that will throw in more fear.… Migration is not going to help as it increases in the spring.”

“Economically, it won’t be a catastrophe but it’s manageable. The political consequence will be worse. Everyone will be worse off politically and the U.K. and E.U. will be weaker.”–Olivier Chatain

Franklin Allen, Wharton finance professor and Brevan Howard Centre director at Imperial College in London, explains that the number of refugees allowed through the U.K.’s borders is “low anyway and not complying with E.U. quotas.” He adds that if there was a Brexit, the “change would be low-skilled people would find it difficult to come [to the U.K.]. For educated people, it won’t change that much.”

More generally, according to Chatain “this is purely a political issue between Cameron and his own party.” He adds the rise of right-wing elements is happening in many nations, notably with Donald Trump in the U.S. and Marine LePen in France. “What distancing oneself from international organizations like the E.U. is supposed to fix is almost beside the point. It’s a deeply political thing. It’s not an economic calculus.”

Moreover, the eurozone recession is also scaring some Britons into thinking that they will be dragged down by a stagnant European economy while the British economy is recovering at a decent pace from the 2008-2009 downturn.

Straws in the Wind?

As the countdown to the referendum ticks closer, the value of the pound has been sliding. According to The Daily Telegraph, Goldman Sachs believes the pound could lose a fifth of its value and plummet as low as $1.15-$1.20 by the time of the vote this summer. Allen adds that the pound will recover rather quickly if the British vote to stay in. However, “if it’s an exit vote, there will be a lot of uncertainty. The value of the pound will probably go down. In 20 years though, it won’t make that much difference.”

Wharton management professor Mauro Guillén points out that the pro-Brexit campaign is downplaying the fact that the “U.K. is tightly integrated in trade and investment with the E.U. They don’t understand or fully grasp the extent of that relationship.”

One of the most vital aspects of the British economy is its financial services sector. Known as the City, London is an international hub for banking, investment services, capital markets etc. By staying in the E.U., the U.K. would retain access to the single market. “The U.K. is more integrated to financial services in the E.U. They get access to euros so the U.K. does really well without being part of [the common currency regime],” says Gomes.

On the macro-economic side, the U.K. has a large current account deficit, the difference between the money flowing in and out of the U.K., and capital could flee the U.K under a Brexit scenario, inflating the current account deficit even more. The Bank of England warns that a Brexit could endanger the U.K.’s economic stability.

Allen notes that the pro-Brexit campaign is arguing that the U.K. will still have access to the single market even if it chooses to leave the E.U. “That’s true in the long run, but in the short and medium-term, it’s not all clear that will happen.” In addition, Guillén explains that the British financial services sector doesn’t like the idea of additional financial integration with the rest of the E.U., and what that could mean for salaries, bonuses and more stringent bank regulations, but they have been resisting some of the regulations that would facilitate this anyhow.

“This will have a disruptive effect. You’re putting everything at risk and you don’t know if you’ll come back to the current status.”–Mauro Guillén

Chatain notes that one of the demands the U.K. has made in recent negotiations is that it should continue to vote on euro-related matters even if the country is no longer part of the eurozone. “Yes, there’s a lot of financial business in London, but they are pushing their luck with eurozone countries. On the one hand, the U.K. is saying the E.U. is terrible and doomed to failure, but on the other hand, they want to help make decisions because they’re profiting from it. The U.K. is not making friends with that stance.”

Killing the Golden Goose?

Would financial services firms relocate out of the U.K. if a Brexit were to happen?  Allen notes “It’s

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