Brexit – the long run vs. the short run

There are forecasts that Brexit will precipitate a British recession or at least a significant slowdown of economic growth in the short run.

As Paul Krugman argues here and here, the assumption that the Brexit will be a major negative shock to aggregate demand does not follow from standard macroeconomic theory. Hence, according to Krugman, there is no good reason to expect a UK recession.

I agree with Paul Krugman. There is no strong reason to believe that Brexit will be a major negative shock to aggregate demand. And even if a negative shock to aggregate demand were to occur (for example, because of self-fulfilling negative expectations, i.e. firms believe there will be a recession so they reduce investment which then leads to reduced aggregate demand), monetary policy (maybe even combined with fiscal policy) could offset this negative effect by keeping nominal spending stable.

Of course, Brexit will have an effect on the British economy, namely on the long-run supply side of the economy. Krugman argues that this effect will be negative:

Brexit will almost certainly have an adverse effect on British trade; even if the UK ends up with a Norway-type agreement with the EU, the loss of guaranteed access to the EU market will affect firms’ decisions about investments, and inhibit trade flows.

This reduction in trade relative to what would otherwise happen will, in turn, make the British economy less productive and poorer than it would otherwise have been.

Ceteris paribus, i.e. given all other trade arrangements between Britain and the rest of the world and given the current regulatory framework  in the UK (which is, to a large extent, determined by the EU), Krugman is of course right.

But why would everything else stay equal?

By leaving the EU, Britain will be free to adopt a unilateral free trade policy. Many Brexiteers favour this approach and one can only hope that they will prevail.

Britain would benefit from dispensing with barriers to trade even if other countries did not do the same. It would of course be desirable if other countries also removed their barriers to trade: in this case the gains from trade would be even higher. But moving to free trade unilaterally is the optimal policy for Britain independent of whether or not trade barriers in other countries continue to exist.

Furthermore, Brexit makes it possible for Britain to embark on a new approach to, say, financial regulation. In the UK, there was virtually no government regulation of banking until 1979. Instead, the behavior of banks was subject to tight private regulation. The private regulatory framework for banking was then substituted by government regulation in the 1980s.

This approach has not been a success. Brexit gives Britain the opportunity to return to the principles that served financial markets so well before the 1980s.

Will Britain use the opportunities presented by Brexit – or will Britain’s approach to trade and regulations be more restrictive and intrusive than before?

I don’t know for sure. Nobody knows for sure.

But on the whole I am slightly optimistic. In general, smaller political entities are governed better than larger ones. And many Brexiteers have a fairly libertarian world-view.

The most important effect of Brexit may not (directly) pertain to Britain anyway but to the rest of Europe and the world. Brexit may constitute the beginning of the end of the EU, which – by imposing a large, bureaucratic, uniform governance structure on a diverse continent – is basically the opposite of competitive governance.

Let us hope that, in hindsight, Brexit indeed turns out to be the beginning of a trend towards local autonomy and governance diversity. It would be the best possible outcome.