The Region

A Post-Brexit Prescription

Investment opportunities outside the EU could offset losses from breakup

Ann Harrington | Senior Writer

Published July 11, 2017

Even before the United Kingdom voted to leave the European Union, experts were nearly unanimous in predicting that “Brexit” would have disastrous effects on Britain’s economy. Indeed, the political fallout has already been considerable. New research from the Minneapolis Fed carves out new ground, however, in pointing toward a policy option that could offset the damage caused by the breakup: opening up foreign investment with other global partners after the split.

Ellen McGrattan

In “The Impact of Brexit on Foreign Investment and Production” (SR 542), Minneapolis Fed consultant Ellen McGrattan, of the University of Minnesota, and Andrea Waddle, at the University of Richmond, find that while unilaterally tightening restrictions on EU foreign investment would be harmful to the British, more liberal investment from non-EU members such as the United States, Japan and China could bring significant welfare gains to the UK.

Building on previous work with Thomas Holmes and Edward Prescott, McGrattan and Waddle use a multicountry model that features technology capital, defined as “accumulated know-how from investments in R&D, brands and organization.” This type of capital is not location-specific, and so is often deployed by multinational firms in foreign subsidiaries. Before Brexit, this capital is able to move freely within the union, but after the breakup, it will become much more costly. The big question: How costly?

Bad (and not-so-bad) breakups

The economists use their model to analyze three post-breakup scenarios:

  1. The UK unilaterally imposes constraints on EU foreign direct investment (FDI) into the UK.
  2. Both the UK and EU tighten restrictions on investment with each other.
  3. Same as #2, but the UK opens up more to foreign investment from non-EU partners, starting with the United States.

In all three scenarios, FDI from the UK is treated like that from Norway, which is not an EU member.

In the first experiment, EU firms react to the higher costs on their FDI by investing less in technology capital. The UK has to scramble to make up the gap, pouring resources into intangible capital they used to get for free. UK citizens end up working longer hours and consuming less; welfare (economic well-being) plunges 3.6 percent. The restrictions backfire, hurting Britain. Meanwhile, the EU continues to enjoy access to UK technology capital in many European subsidiaries, and its citizens enjoy modest welfare gains from working fewer hours.

In the second scenario, the EU and UK mutually tighten restrictions on investment. Facing higher costs, the UK drastically lowers its investment in technology capital and shuts down operations in its EU subsidiaries. Since there are many countries in the EU, higher bilateral restrictions on FDI impact UK firms more than EU firms. Production of UK firms falls at home and abroad. The UK shifts from being a goods and services producer to a lender, financing production by non-UK multinational firms. The increase in net interest from these loans offsets the drop in profits, and the UK ekes out a modest welfare gain of 0.3 percent.

EU countries, however, are significantly worse off. Without the UK’s investments, the EU must shore up its own technology capital. The EU produces less, consumes less and works more, resulting in a welfare loss of 1.6 percent if the FDI restrictions are as onerous as those between Norway and the EU. The barriers set up by the UK and EU give other economies a comparative advantage to innovate, and production shifts to Australia, the United States and Canada.

The third scenario starts out the same, except that the UK lowers restrictions on new investment partners, starting with the United States. American multinational companies bring in considerable technology capital, bolstering production. Welfare in the UK improves dramatically, 2.3 percent, but falls 1.7 percent in the EU.

Foreign investment from outside the EU might ultimately be key to improving the UK’s post-Brexit economy. In any case, blocking technology capital would be a disaster.

The UK’s invitation to invest is extended, in turn, to Japan, China and other countries until all foreign inflows (including from EU members) are treated the same. Net exports boom, while UK citizens work less. With every new partner, the UK economy gets better in important ways—consumption rises and wages recover, while business output falls less than it would have under scenario #2. As the UK opens investment globally, its welfare climbs to 4.8 percent above the pre-Brexit level. Meanwhile, the effect on EU welfare remains negative, because the EU has much less access to UK innovation.

Why so optimistic?

This third scenario contrasts sharply with other economists’ pessimistic predictions for post-Brexit capital flows. That’s partly because the existing literature uses historical data to estimate foreign investment in the UK if it had never joined the EU. By definition, then, it is backward-looking. This method may be less applicable today and in the future, especially in a realm where intangibles like R&D and brands play such a critical role. It also neglects the impact of higher costs on outflows of foreign investment from the UK.

The UK is the world’s fifth-largest economy, with one of its leading financial centers. That it could attract significant foreign investment from outside the EU isn’t far-fetched. Being open to such investment may seem contrary to the nationalist impulses that led to Brexit in the first place, but might ultimately be key to improving the UK’s economic well-being. In any case, the lesson from McGrattan and Waddle’s research is clear: Blocking technology (or technology capital, in this case) would be a disaster.