Brexit — U.K. Ante Accepted, Let the Games Begin!

The United Kingdom’s decision to leave the European Union moved to a new stage on Friday, when the leaders of the other 27 EU member states accepted U.K. Prime Minister Theresa May’s offer to honor its obligations to the EU budget, protect the rights of EU citizens now living in the U.K., and avoid a hard border between Northern Ireland and the Irish Republic as signifying “sufficient progress” in the negotiations over the U.K.’s withdrawal from the EU, which takes effect on March 29, 2019.

This opens the way for the U.K. to begin negotiating a new legal framework for its relations with the 27. Without that new legal framework, the U.K.’s political, security, economic, and other relations with the 27 will be governed only by existing international agreements where the U.K., the EU, and/or other EU member states are parties (such as the UN and the World Trade Organization), and by nothing where not.

That the U.K. decision to abrogate its treaty relations with the other 27 EU countries will be difficult and costly is not news: After nearly 45 years of being within the world’s most ambitious trade and investment agreement (by far), the British economy is deeply enmeshed into that of continental Europe,[1] the second biggest economy in the world after the United States.[2] Numerous studies, including by the Organization for Economic Cooperation and Development (OECD) and the U.K. government itself, show that Brexit will harm the U.K. economically; none project otherwise.

A new study, conducted by the highly-respected U.S. research institute, RAND, and unveiled in both London and in GMF’s office in Brussels on December 12, shows the substantial economic downside of Brexit under virtually every possible outcome. Building on the earlier research work, RAND’s model indicates that the U.K. economy would be 4.9 percent smaller ten years after withdrawal if there no new trade agreement between the U.K. and EU. By 2029, the U.K.’s GDP will be $140 billion smaller than it would have been if the two are simply operating under WTO rules. Even if the U.K. and the EU reach a good free trade agreement (FTA), RAND expects the U.K. economy to be 1.9 percent smaller than otherwise in 2029. If the U.K. only concludes an FTA with the United States, as some in London and Washington seem to want, the U.K. economy will be down 2.5 percent. The only scenario under which the U.K. can possibly gain is if it negotiates an ambitious FTA with both the EU and the United States, much like the Transatlantic Trade and Investment Partnership (TTIP). Here, the U.K. economy would be some 2 percent bigger than under current projections … although it would be better off still were TTIP concluded between the United States and the EU with the U.K. still a member. The RAND study also looks at the economic impact of other possible agreements the U.K. might have with the EU, such as membership in the European Economic Area (EEA), a series of detailed agreements that nearly replicates EEA (like Switzerland), or a customs union agreement covering goods only, as Turkey has. While the U.K. would be better off under each of these scenarios than even with a UK–EU FTA, in each case it would be worse off than today.

Starting with the “baseline” scenario of no deal by the time the U.K. leaves the EU in March 2019 makes sense as concluding another legal framework for U.K.–EU trade will be difficult to do in 15 months. In a novel addition, the RAND study combines its economic modeling with a “game theory” analysis of how the U.K. and the EU can achieve the best possible outcome for this next stage. Looking at the interests of the two sides, the sequencing of the agreements, the number of players (only U.K. and EU, or a “multi-party” game where other member states get involved), the rules and the “pay-offs,” RAND concludes that:

• the two-year negotiating period weakens the U.K.’s hand;
• the EU’s position is strengthened by having a new agreement follow the withdrawal talks, whereas doing the two negotiations simultaneously would help London;
• maintaining unity will be critical for the EU, whereas a divided EU would help the U.K.;
• the uncertainty surrounding the rules and structure of the negotiations makes the process more difficult for both; and
• flexibility will be needed on both sides to “avoid an outcome where both sides lose badly.”

Unfortunately, even though the European Council has indicated that it would consider a U.K. request for a time-limited “transition period” (under which the U.K. will be fully subject to EU law and budgetary obligations, but would have no representation in EU decision-making, as it does now), the likelihood of a messy divorce remains high. As RAND rightly notes, politics can all too easily get in the way, especially when many in London are so determined to “recover” their “sovereignty,” while many in the EU do not want an “easy” Brexit to entice others to consider departure.

It does not have to be that way. In finally agreeing that the United Kingdom will fulfill its existing obligations to the EU budget, Theresa May has recognized that how the U.K. comports itself in abrogating its treaty relationship with the other 27 countries determines whether they will find London trust-worthy enough to enter into another legal arrangement. In that sense, RAND’s game theory work — like much of the discourse around Brexit — misses a key point: There was always bound to be a “sequenced” approach with a withdrawal agreement first. And as RAND Vice President Charles Ries stated during his presentation, the U.K. could have changed the dynamics of this process completely had the British government simply stated up front that of course it would honor its financial obligations.

Now that it has, the EU side would do well to move quickly to strike a deal that replicates, as closely as possible, the U.K.’s existing relationship with the EU. To try to penalize the U.K. not only makes no economic sense, but any attempt by a member state to seek a new advantage in any one area will lead quickly to division among them all. And such division, as the RAND game theory analysis suggests, will lead to a worse outcome for the EU.

An U.K.–EU agreement is doable. The two economies are so intertwined that there is no competitive harm in reaching a trade deal with no restrictions at all, even in sensitive agricultural areas where the EU usually maintains import restrictions. Traders on either side will need to deal with new bureaucratic requirements to prove that their products and services can benefit from a U.K.–EU FTA, but that administrative cost is inherent in the U.K. becoming a “sovereign” country. And on the regulatory front, with the laws on both sides of the Channel being the same and the regulators knowing each other so well, they should be able to reach mutual recognition agreements covering all traded goods and services where the EU has rules. Of course, the U.K. will have to live with uncertainty, as the regulators on both sides must have the right to immediately suspend, and unilaterally terminate, any one of these mutual recognition agreements should the rules diverge too much or should they lose trust and confidence in their counterpart. This means the U.K. will be a “rule taker” rather than, as now, engaged in developing the EU rules, but that too is inherent in the U.K. choice to leave. The U.K. should provide the EU a full draft text reflecting these principles at the first meeting on the new agreement next spring, and the EU should be open to accepting the approach. After all, very few other countries, seeing the economic costs and the minimal “sovereignty” gains, will follow the U.K.’s lead.

But doable or not, politics will intervene, and the RAND game theory exercise will come in handy. So let the games begin!