Joao Gomes and Sebastian Mallaby on the consequences of a Brexit

As British citizens cast their votes tomorrow in a referendum on whether the U.K. should remain in the European Union or leave it, uncertainty runs high over the economic and political repercussions, whichever way the result goes.

The precise question British voters will face tomorrow is: “Should the United Kingdom remain a member of the European Union or leave the European Union?” According to Wharton finance professor Joao Gomes, U.K. voters will likely choose to remain in the EU. He cited latest opinion polls, which show the momentum to leave has abated. “When push comes to shove, people will find it very hard to vote for something they are not quite sure what it actually is,” he said. Nevertheless, uncertainty prevails until the votes are cast, he added.

Sebastian Mallaby, senior fellow for international economics at the Council on Foreign Relations, said there was a 30% risk of Britain voting to leave, and so the greater likelihood is that Britain will remain. “When people are polled two or three weeks before a vote, they tend to tell the survey questioners that they might vote because of immigration or health or education or something, but when you get back to the same people the day after they voted, they tend to say they voted on the issue of the economy,” he noted. “If they do that in this case, the economy [will] be stronger and more prosperous if Britain votes to remain [in the EU].”

Gomes and Mallaby discussed the possible scenarios ahead of the Brexit vote on the Knowledge at Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)

The murder last Thursday of British Labor member of Parliament Jo Cox caused the campaigns on either side of the referendum to be suspended for a couple of days. Cox was a pro-EU advocate. “The atmosphere in Britain has become so politically toxic that people took a step back and were horrified,” said Mallaby. “There is a sense that overplaying people’s fear of migration is something which the exit side – [people] who want to leave the EU – may dial back on,” he noted. Mallaby last year cofounded the web publication, which seeks to make a facts-based case for Britain to remain in the EU.

“When push comes to shove, people will find it very hard to vote for something they are not quite sure what it actually is.” –Joao Gomes

The sentiment was markedly different before Cox’s murder. Mallaby said polls a week ago showed that the “remain” side had an advantage of about five points on the economic issues, but the “leave” side on migration had a bigger advantage of 35 points or so. “There was just a massive sense in Britain that being completely open to migration from the European Union has caused a massive influx of people and is very unpopular amongst Britons,” he said. “In policy terms, that doesn’t make sense, because migrants are a net positive for the economy [and] create a multicultural society, which I view as attractive — but the fact is, politically it is unpopular.”

According to Gomes, numerous studies on the likely outcomes of the vote to remain or leave the EU fail to capture them with accuracy. “The factors are so many that any model is not going to capture any accurate estimate of what is going to happen in the next two, five or seven years,” he said. “The main factor is exactly that: We don’t know what is going to happen, and that is going to create a lot of uncertainty.”

Mallaby agreed. “One thing we do know precisely is that there are a heck of lot of things we don’t know,” he said. He advised against underplaying that uncertainty, and expected it to last not weeks or months, but years.

If the Vote Is to Leave

A “leave” vote will have some clearly identifiable repercussions. For one, it would prompt Britain to renegotiate its relationship with the EU, said Gomes. He added that it is unlikely that David Cameron will continue as prime minister or George Osborne would continue as the chancellor of the exchequer.

Mallaby agreed that a “leave” vote would likely cause the fall of Cameron’s government. But he also thought that the Conservative Party could take up to three months to choose a new leader.

A new U.K. government would review issues with the EU such as trade relationships and mobility of people, among others, said Gomes. “[The financial] markets will be scared for the next few weeks or months. We probably could expect an interest rate cut in Europe, a sharp depreciation in the value of the British pound, [and] some short-term capital outflows out of the U.K.”

A “leave” vote would be good for the U.K., according to Gomes. He said a sharp depreciation in the value of the pound could boost its competitiveness and could “do wonders for economic growth.” That, in fact, would be what a new government in the U.K. would go after, he added.

“One thing we do know precisely is that there are a heck of lot of things we don’t know.” –Sebastian Mallaby

Franklin Allen, Wharton finance professor and Brevan Howard Centre director at Imperial College in London said in a recent Knowledge at Wharton article on the Brexit issue: “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.”

Renegotiating U.K.-EU Ties

A “leave” vote would compel the U.K. to renegotiate its ties with the 27 remaining EU member countries. Gomes noted that such a vote would trigger “some resentment within the EU towards the U.K.” At the same time, it is a good idea for the U.K. to continue with much of the existing arrangements it has with the EU. “It makes absolute sense for the U.K. to let trade be run more or less through the EU, [and] to have capital continue to flow to and from the U.K. relatively easily,” he said. “It makes no sense to renegotiate any relationship that doesn’t promote growth in the years ahead.” He did not expect the referendum to do any damage to Europe one way or another, “other than the short-run uncertainty and unpleasantness.”

Mallaby also predicted a “constitutional limbo” for the U.K. regarding Scotland in the event of a “leave” vote. “Scotland is pro-European, and if the Scottish feel they are being dragged out of Europe by English voters who they didn’t much like anyway, they may ask for a second referendum,” he said. In the first referendum in 2014, when the Scots voted to remain in the U.K., the economic argument was that it would cost them to leave the U.K., he noted. “In a ‘leave EU’ scenario where Brexit has won and the U.K. economy would be in serious difficulty, it’s not clear the Scots would feel that they were better off staying in.”

Gomes said that if the U.K. sees a sharp depreciation of its currency and that leads to greater economic growth, that would make it easier to convince Scotland that it made the right decision to leave the EU. It also makes it a lot easier for other EU member countries to reflect on why exactly they are in the EU, he added.

A “leave” vote would create other complications, such as between Ireland, or the Republic of Ireland, and Northern Ireland, which is part of the U.K. He said Ireland achieved some economic stability in the late 1990s based on a porous border that allows free movement of people in search of work or business. “If you re-harden that border because the Republic of Ireland is inside the EU and Northern Ireland is out, that completely undermines the economic basis for Northern Ireland,” he said.

A “leave” vote would also mean a lot of fresh paperwork. Domestic laws in the U.K. would have to be rewritten since much of it derives from the EU, noted Mallaby. Building a new status quo takes “an affirmative agreement,” and that is “extremely difficult” to achieve with 27 EU members, he said. He noted that when Greenland exited the EU in 1985, it cared about only one issue, and that was fish. That negotiation for Greenland to leave took three years, he said. In the case of Britain, it would take four to five years for it to finally leave the EU, he added.

That process of “leaving” the EU would cause an extended period of uncertainty that would freeze business investment, Mallaby warned. “Britain is highly dependent on foreign direct investment because it has the biggest current account deficit of all the major economies.”

“We have treaties, we have referendums, we have votes, and every time we go from one crisis to the other.” –Joao Gomes

Much of the argument on the “leave” side stems from fears of the migrant influx into Europe seeping uncontrollably into Britain. Other factors strengthen that case. “As much as the migration issue is a vote-getter, the U.K. sees itself tied to a part of the world that is not growing, where people are not working [and] getting old, productivity is low, and we have these bureaucrats in Brussels – as they perceive them – just making life more difficult,” said Gomes. “And [British citizens] want to decouple themselves from that scenario. They want to be tied to other parts of the world like Asia.”

Impact on Businesses

Mallaby noted that in the event of a “leave” vote, London would lose its allure as a headquarters location for many businesses. “Europe is the biggest market in the world with 500 million people, and London is the choice for the European headquarters for 60% of non-European companies,” he said. “If the premise for that location goes away because Britain leaves the EU, then some chunk of that corporate leadership will have to shift.”

Mallaby said the impact on the financial services industry would be especially hard. He noted that Britain has a service-based economy with 78% of its GDP coming from services, and financial services forms the biggest part of that. If the U.K. loses membership in the EU single market, British firms will lose the ability to sell financial services across borders.

If the Vote is to Remain

Gomes said that if the vote is for the U.K. to remain in the EU, “it is not the end of the world.” For Europe, the British referendum is nothing unusual, he said. “We have treaties, we have referendums, we have votes, and every time we go from one crisis to the other,” he said. “None of this is going to address the substantive problems of Europe, whatever the vote turns out to be.”