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Takeaway: If the U.K. votes to exit the EU, the economic effects will likely be much smaller than most gloom and doom estimates.

Editor's NoteBelow is a Hedgeye Guest Contributor research note written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. 

Hedgeye Guest Contributor | Thornton: Doom and Gloom Brexit Fears Are Overdone - Brexit cartoon 06.16.2016

I was in Amsterdam recently and listening to news reports of the gloom and doom that would occur if the U.K. voted to exit the EU. The economic motivation for the creation of the EU was that it would permit the free flow of labor and capital among the member nations and would reduce or eliminate restrictions on trade. If this was all the EU did, there would be no rationale for exiting the EU because economic theory shows that the net benefit of removing such restrictions is unequivocally positive. Consequently, any move that would inhibit the flow of labor and capital and reduce trade would be unequivocally negative.

But this is not all the EU does. The EU sets all sorts of regulations, transfers wealth among member nations, etc. These other aspects of being in the EU create winners and losers. But economic theory cannot tell us whether the net benefits of these other aspects of the EU are positive or negative. Consequently, it is essentially impossible to know whether the U.K. would be worse off or better off if it exits the EU.

I have no idea whether the U.K. will be better or worse off, so I don’t have an opinion about how the vote should turn out. Nevertheless, I am very confident that the negative effects of exiting are overestimated by many of those who favor remaining in the EU would like people to believe.

My reason is rooted in uncertainty.

Since it is virtually impossible to know whether the U.K will be better or worse off, those who favor remaining in the EU will have a strong incentive to overestimate the economic consequence of exiting. Of course, those in favor of exiting have the same incentive in the opposite direction. But they have a weaker economic argument. They have to argue that the net benefits of reduced regulations, wealth transfers, and the like are not only positive but more than offset the negative effects from the reduced mobility of economic resources and more trade restrictions. This is much more difficult because there is no fundamental economic theory that says this must be so.

Proponents of staying understand this advantage. Moreover, they can use standard economic models to provide estimates of the effect of exiting the EU on income, employment, trade, etc. It is not surprising that many of these estimates are very large. The more uncertainty and fear they can create, the more likely it is that those who are uncertain whether they should vote remain or leave, will decide to vote to remain.

 

There is another reason to believe that the effect on economic activity will be smaller than many proponents of remaining in the EU suggest. While the movement of labor and capital will be less free and trade more difficult if the U.K. exits, economic forces will tend to mitigate these negative effects. Specifically, trade between the U.K. and other EU members that has been mutually beneficial will remain mutually beneficial. Consequently, governments and firms will have an incentive to maintain those relationships. While some countries might retaliate against the U.K., this is unlikely to persist so long as the continuation of these relationships is in the longer-run economic interest of all parties.

I predict that if the U.K. votes to exit the EU, the economic effects will be much smaller than most of the estimates I have heard. I don’t expect this will happen. I expect the U.K. to vote to remain in the EU on June 23 because two powerful forces—fear of the unknown and inertia—will push the vote in that direction.

However, should it happen, I will write a follow up essay in a year or two to see whether my prediction is correct.