By Julian Morris From Cayman Financial Review

The U.K.’s decision to leave the EU marks a historic shift in the nation’s relationship not only with Europe but with the world. In the short-term, there will be costs to Brexit, as a result especially of changes to the rules governing trade between individuals and businesses in the U.K. and their counterparts in other nations. In the longer term, however, Brexit presents an opportunity for the U.K. to re-establish itself as a cosmopolitan, classical liberal democracy governed by the rule of law and more open to trade with the outside world. If it takes that path, then its prospects are brighter than they would have been in an over-regulated, increasingly protectionist EU.

For Britain formally to begin the process of leaving the EU, it must – according to Article 50 of the Lisbon Treaty – notify the EU of that decision. The terms and date of exit will then be determined by agreement – but by default will occur two years after notification. Actually invoking Article 50 almost certainly will require an Act of Parliament. While some U.K. politicians have talked of Parliament rejecting the referendum result, it seems more likely that Parliament will pass such an Act and grant (perhaps limited) negotiating authority to the government over the terms of Brexit.

The U.K. government has established an “Brexit Department” to develop the exit strategy. That department, headed by David Davis, must now grapple with the complex task of identifying the best way to disentangle the U.K. from the EU. Key questions to be addressed include: What should be Britain’s trade policy? How should immigration be reformed? And which British regulations required by the EU should be kept and which scrapped? To make matters worse (or at least more confusing), these questions are not necessarily independent of one another.

Taking trade first: At present, the U.K. is part of the EU customs union and practically all trade policy decisions are made on an EU-wide basis. Currently, all trade in goods, services and capital between the U.K. and other EU member states is tariff free. This preferential treatment for trade within the EU boosted trade and created a tendency for transactions to remain within the customs union. However, trade with the EU as a share of all British trade has declined from about 55 percent in 1999 to 45 percent in 2015.

The increasing importance of trade outside the EU has in part been driven by the rapid growth of Asian economies, which was in turn driven in part by unilateral trade liberalization on their part. Britain could potentially benefit enormously by following that route – which in many respects would be a return to the free trade era of the late 19th Century. Unilaterally removing external restrictions on imports of goods, services and capital would be both the simplest and in many respects the best policy, since it can be undertaken without the need for any intergovernmental negotiation. It would ensure that consumers and producers in the U.K. had access to these inputs at the lowest possible cost. This would drive stronger domestic competition, resulting in higher rates of innovation and growth.

A second, largely complementary, option is for the U.K. to revert to independent membership of the World Trade Organization. The advantage of the WTO is that it limits the tariffs and other restrictions other members can impose on British exporters. However, this should not be seen as an alternative to unilateralism.

A third option, which again is largely complementary to both unilateralism and membership of the WTO, is to join the European Free Trade Association (EFTA). This association, which currently comprises Norway, Iceland, Lichtenstein and Switzerland, imposes no tariffs on goods traded between them. Apart from the immediate benefits of mutual free trade, joining EFTA would signal Britain’s continued commitment to trade and comity with other European nations – and perhaps encourage other EU members considering withdrawal to embrace an arrangement based on trade rather than political patronage. Membership of EFTA would also bring the U.K. automatic membership of the 27 free trade agreements EFTA has negotiated for its members.

If Britain were to join EFTA, it might also have the option of joining the European Economic Area (EEA), which currently comprises three of the EFTA nations, Norway, Iceland and Lichtenstein. Under EEA rules, the U.K. would maintain the “four freedoms”: free movement of goods, services, capital and people across all EU and EEA states. But that would effectively leave Britain with almost the same EU migration policy that has become so contentious with many in the Leave camp. Unlike the EU, the EEA permits an emergency brake on immigration, which has been invoked by Lichtenstein, but this might not be sufficient.

Moreover, EEA members are also required to comply with EU regulations related to these four freedoms – without having any say in the content of those regulations. Given that a key reason for the U.K. leaving the EU is the lack of transparency and accountability of the EU’s decision-making processes – and the arbitrary, capricious and economically sclerotic regulations that have resulted – EEA membership looks like a less than ideal option.

However, as Roland Smith has argued, it may be the option that is most acceptable to the establishment.

A fourth option would be for Britain to seek to negotiate trade agreements with various other nations, including Canada, Australia, the United States, China and India. However, there is a danger that such negotiations could become very protracted, so again this option should be considered subordinate to unilateral liberalization. Also, to minimize the complexity of such negotiations, it might be best if Britain were to identity a basic set of principles that could be applied to all potential partners in free trade.

Turning to the question of immigration: If the U.K. does not choose the EEA route or if it is not permitted to join the EEA, it will have to establish rules for nationals of other EU member states currently living in the U.K. The simplest and most logical solution would be to grant any EU national living and working in the U.K. at a specified date, perhaps the date on which Brexit becomes final, permanent leave to remain. But obviously there is then the question of how to determine which future potential immigrants to permit.

There are many potential alternative immigration policies. The libertarian in me wants to advocate for totally open migration but that would be even less politically acceptable in the current U.K. than joining the EEA. So, some kind of restricted migration policy is, I think, inevitable. One way to do this would be to adopt an employment-based system of some kind. Sweden has arguably the best such system; it permits anyone with a qualifying job to migrate – removing much of the uncertainty, delay and cost of the kind of employment-based visa process now in place in the U.K.

But there is a fundamental problem with all employment-based immigration systems, namely that they require immigrants to have a job prior to migration. This imposes high costs on both the firms seeking to employ migrants, which typically bear the cost of visa applications, and on immigrants, who must find jobs in foreign countries, go through selection processes, etc.

An alternative system, proposed by the late Nobel-Prize winning economist Gary Becker is to sell the right to migrate. This idea has the advantage that it does not require a person to have a job prior to migration, nor does it impose arbitrary restrictions based on current location, academic qualifications, or family relationships. The main problem with this system is the difficulty knowing the “correct” price: too high and Britain would suffer from a lack of skilled labor (read: the cost of plumbing would rise unacceptably); too low and there might be a flood of migrants, leading to the same concerns that have been raised by the current opponents of open migration.

An additional problem with selling the right to migrate is that it does not accommodate those who might otherwise be permitted to immigrate on compassionate grounds, such as asylum seekers, refugees or family members. So, accommodation would have to be made for these people.

Last but by no means least, Britain will have to find a way to decide which of the thousands of regulations that derive from EU legislation to keep and which to discard. Britain has on several occasions sought to cut red tape, establishing various Parliamentary committees charged with deregulating the economy. Last year, Parliament passed a new Deregulation Act that again sought to reduce some of the red tape that has become so burdensome. But all of these changes were piecemeal and none could to stem the tide of EU legislation.
Previous attempts at deregulation also simply didn’t have sufficient teeth. One solution would be automatically to sunset all EU-derived regulations at the date the EU exits the EU – which will be two years after it invokes Article 50. During those two years, parliament could investigate the need for those regulations and prioritize the re-instantiation of any deemed, on net, to be desirable. By making deregulation the default and imposing a limited timeframe, parliament will be forced to prioritize more effectively than has previously been the case.

Of particular significance to readers of Cayman Financial Review will be the treatment of financial regulation, especially that which governs firms offering financial services across the EU under the so-called “passport” arrangements. If the U.K. were to join the EEA, the passport arrangement would remain in place for all financial services. Unsurprisingly, the City of London is now lobbying heavily for the EEA option.

If Britain does not join the EEA, the U.K. government will clearly seek a mutually agreeable alternative solution. Under the incoming Markets in Financial Instruments Regulation, many – but not all – of the rights of “passport” holders can be applied to non-EU firms, so it is likely that an important element of the Brexit negotiations will focus on ensuring these rights do apply to financial firms in the U.K.

One of the financial “passport” rights that does not extend to non-EU (or EEA) based firms is for UCITS (Undertakings for Collective Investment in Transferable Securities), a key requisite of which is that they be domiciled in an EU member state. The U.K., which is currently domicile for 12.7 percent of UCITS assets, will almost certainly seek to ensure that U.K.-domiciled UCITS funds continue to qualify. If the U.K. does not obtain such agreement, then U.K.-based fund managers will be required to domicile any UCITS they sell in an EU jurisdiction. However, as long as they continue to comply with necessary provisions of the UCITS regulation, U.K. fund managers will still be able to manage the funds from the U.K.

After the Brexit vote, Britain’s current relationship with the EU is untenable and must change. But that change should be an improvement on the status quo. A looser arrangement, based on open trade with the EU and all other nations, an immigration policy that is more rational and humane, and the removal of many of the arbitrary and capricious regulations developed by bureaucrats in Brussels could lead to a much freer society. That would be a good thing for the people of Britain. It might also set an example for the rest of Europe.

For more on this story go to: http://www.caymanfinancialreview.com/2016/08/02/after-brexit/