UK Focus: The UK’s future in Europe

This Focus is part of our series of analysis on the “Future of Europe” (see here) and considers the UK’s position. Although it is almost nine years since the UK voted to leave the EU, its relationship with the EU is still evolving. And the recent shift in the geopolitical landscape means the evolution could be bigger and quicker than previously looked likely.

We start by highlighting the impetus for change and considering what’s not going to change. We then highlight how Brexit altered the UK-EU relationship and how it has influenced the UK economy so far. We then consider how the UK-EU relationship may change and what this means for the UK’s relationships with the US and China. Finally, we consider how changes in the UK-EU relationship will influence the UK and EU economies.

The impetus for change

The election of Keir Starmer as UK Prime Minister in July 2024 means the UK now has a government that has a more friendly attitude to the EU. Starmer’s election manifesto pledged to “reset the relationship and seek to deepen ties with our European friends” and to “seek an ambitious new UK-EU security pact to strengthen co-operation on the threats we face”. As a result, more UK-EU coordination on defence and an “EU reset” was always on the cards for 2025. Indeed, Starmer views a closer relationship as a way to boost UK economic growth without a fiscal cost.

But Starmer had no idea how political changes in the US would supercharge his desire for a closer relationship with the EU. Within weeks of becoming US President for a second time, Donald Trump made it clear that Europe needs to take more responsibility for its own defence. Many European countries are increasing their spending on defence as a result. And both the UK and the EU know that they can’t effectively defend themselves without each other.

This shift in America’s attitude towards Europe and Trump’s imposition of import tariffs on every country has demonstrated that the US has become a less reliable ally. This has naturally made the UK and the EU think more about their own relationship.

What’s not going to change

The UK and EU are not considering whether the UK will or should rejoin the EU (nor are we). It’s true that since the Brexit vote, the share of the public that think the UK was right to leave the EU has fallen and the share that think it was wrong to leave has risen. (See Chart 1.) What’s more, there was always more support for Brexit amongst older voters. As more time passes, you would expect the support for Brexit to diminish further.

But Brexit remains such a toxic issue that a whole generation may need to pass before any political party even thinks about trying to reverse it. Indeed, Starmer has been very clear on his red lines by saying “there will be no return to the single market, the customs union, or freedom of movement.” Moreover, the EU will not want to consider the UK rejoining unless there is clear and stable support for it from the UK’s political parties.

How Brexit altered the UK-EU relationship

Before Brexit, the UK was in the EU’s Customs Union, the EU’s Single Market and it was part of the EU’s freedom of movement principle. This meant that goods, services, capital and people could move between the UK and the EU with very few frictions, checks or concerns over standards as the rules and regulations were the same. (See Box 1 for some key Brexit dates and a refresher of Brexit terminology.)

After Brexit, the UK left the EU’s Customs Union, the EU’s Single Market and freedom of movement ceased. At various points, the Withdrawal Agreement, the EU-UK Trade and Cooperation Agreement, and the Windsor Framework began. (See Box 1 for definitions.) These put in place agreements on trade and other issues. But the bottom line is that since Brexit there are more barriers to trade, cooperation and the movement of people.

Box 1: UK-EU relationship before and after Brexit

23^rd Jun 2016 – UK votes to leave the EU.

31^st Jan 2020 – UK officially leaves the EU.

31^st Dec 2020 – Brexit transition period ends.

1^st Jan 2021 – UK leaves the EU in practice.

The UK and EU’s relationship before Brexit

Before Brexit, the UK was in the EU’s Customs Union, the EU’s Single Market and it was part of the EU’s freedom of movement principle.

The Customs Union meant that goods were traded between the UK and all other EU countries without any tariffs, quotas or customs checks.

The Single Market meant that goods, services, capital and people could move freely between the UK and every other EU country. This was possible as the UK and all other EU countries adopted the same regulations, standards and laws.

Freedom of movement meant that citizens of the UK and the EU were allowed to travel, work, study, retire and live in any EU country without significant restrictions.

The UK and EU’s relationship after Brexit

After Brexit, the UK left the EU’s Customs Union, the EU’s Single Market and freedom of movement ceased. At various points, the Withdrawal Agreement, the EU-UK Trade and Cooperation Agreement, and the Windsor Framework began.  

The Withdrawal Agreement outlined the terms of the UK’s exit from the EU, which made it akin to a divorce settlement. It included agreements on the rights of UK and EU citizens, the financial settlement and protocols on Ireland/Northern Ireland.

The Windsor Framework established agreements for the movement of goods between Great Britain and Northern Ireland so as to avoid creating any borders or barriers between Northern Ireland (which is in the UK) and Ireland (which is in the EU).

The EU-UK Trade and Cooperation Agreement laid out limited cooperation on many issues. For example, there are no tariffs on goods moving between the UK and EU, but there are non-tariff barriers such as customs checks. And professional qualifications granted in the UK are not automatically recognised in the EU and vice versa.

How has Brexit influenced the UK economy so far?

It’s impossible to quantify with any precision how Brexit has influenced the UK economy given that so much has happened in the years since the Brexit vote, including the pandemic, the energy price shock associated with the war in Ukraine and more recently the new US tariff regime. But a reasonable gauge can be established by comparing the UK’s performance against the rest of the G7 economies as they have endured the same shocks except Brexit.

Since the Brexit vote, real GDP in the G7 excluding the UK has grown by a total of 11.8%. In the UK, the increase has been 10.1%, 1.7 percentage points (ppts) smaller. (See Chart 2.)

Within GDP, the increase in real investment on the widest measure of gross fixed capital formation has been 6.9 ppts smaller in the UK than the 17.7% rise in the rest of the G7 since Q2 2016. (See Chart 3.)

And while real exports of goods and services have risen by 20.8% in the rest of the G7 and real imports have risen by 15.9%, the rises in UK exports and UK imports are 5.6ppts and 7.1ppts lower respectively. (See Chart 4.)

This underperformance is not due to services. The UK’s real exports and imports of services have both grown by 40% since Q2 2016, which is 10ppts more than in the rest of the G7. (See Chart 5.)

Instead, the underperformance is all due to goods. Since Q2 2016, real exports and imports of goods in the rest of the G7 have risen by 12.3% and 17.3% respectively. In contrast, UK real exports of goods have fallen by 16% and real imports of goods are only 4% higher. (See Chart 6.)

Interestingly, the levels of UK real goods exports to both the EU and the non-EU are both lower than in Q2 2016, by 19% and 14% respectively. (See Chart 7.) Real imports of goods from the EU and non-EU are 3% and 6% respectively higher than in Q2 2016.

This could mean the poor performance of UK goods exports relative to other G7 economies is due to other factors and not just the barriers put up between the UK and the EU by Brexit. Or it may mean that Brexit has played a role in discouraging UK trade in goods in general, perhaps if UK products exported to non-EU countries require components from the EU. It‘s also possible that at least some of it is a statistical mirage as Brexit triggered a change in the way the ONS measures UK goods exports and imports.

Either way, the evidence seems to suggest that Brexit has contributed to the poor performance of UK GDP, investment and exports of goods relative to other G7 economies.

How will the UK-EU relationship change?

When it comes to changes in the UK-EU relationship, the most obvious and biggest ones relate to defence and security.

Two big developments have spurred the UK and the EU to coordinate more in this area. First, Russia’s invasion of Ukraine in February 2022 showed that the peace Europe had largely enjoyed since the end of the Second World War in 1945 was no longer guaranteed. Second, Trump’s policies have created an urgency for Europe to boost the size of its defence capabilities and to produce more of its defence products and technologies at home rather than importing them from the US.

Neither of these developments are temporary. Even if Ukraine and Russia agree to end the war, there’s no guarantee that any peace deal will last. And western European governments will remain wary of Russian policies towards other former-Soviet countries including the Baltic Republics. Moreover, it will take many years for Europe to become self-sufficient in all areas relating to defence.

As a result, the UK and EU are united in their desire to boost their own defence capabilities. They are also united in what they perceive as the threats (mainly Russia’s encroachment on Europe). And they both know that when it comes to defence, they are stronger together than apart.

The UK and EU have already stepped up their coordination on defence. In particular, Starmer and France’s President Macron have been the driving force behind the creation of the “Coalition of the Willing”, which brings together 30 countries and representatives from the EU Commission, EU Council and NATO “to drive progress towards a just and lasting peace in Ukraine”.

What’s more, the UK and many EU countries have also pledged to increase their own defence spending funded via their national budgets. (See here for more on this and what it means for economic growth.)

And the EU has created the “Security Action for Europe (SAFE)” scheme, which will raise €150bn from the capital markets to lend to EU countries to use for defence spending.

At the moment, the UK is excluded from this scheme. But an UK-EU security pact would allow UK companies to bid and win the defence contracts that it funds. The exact details may take months to iron out. For example, it is not clear whether the UK or UK companies will need to make a financial contribution. But the scheme allows for “countries having signed a Security and Defence Partnership with the EU to join common procurements”.

That said, the pre-Brexit relationship is not being restored. The EU has rejected the UK’s request for access to its crime and illegal migration databases.

The upshot is that the informal coordination of recent months will probably be formalised in a joint UK-EU security pact that will be signed at the UK-EU Summit in London on 19^th May. That will probably include an agreement that the UK will have access to the EU’s €150bn defence scheme.

EU reset chipping away at Brexit barriers

It appears that the common ground being reached on defence is setting a more constructive tone for the wider EU reset. As we said earlier, the UK and EU are not reconsidering the full extent of their relationship or reviewing the Trade and Cooperation Agreement. Instead, they are addressing some frictions that weren’t resolved at the time of Brexit and discussing some programmes that are either due to begin or expire in the next few years. Table 1 contains a timeline of the events and deadlines.

The reset will focus on three issues. First, an agreement on food and veterinary standards that would remove the need for customs checks on food and agricultural products moving between the UK and the EU. The idea is that the UK would adopt “dynamic alignment” in this area, which would mean its food standards change when the EU’s change. This would strengthen the UK’s existing rules that restrict imports of food and agriculture that have been genetically modified.

Second, the creation of a youth mobility scheme, which will grant visas for EU citizens aged between 18 and 30 years to live and work in the UK and visas for UK citizens to do the same in the EU. Both sides are keen, although agreements on the number of visas available (the UK wants a cap to limit the extent of net migration), the terms (the UK wants users to pay a health surcharge and to have no access to benefits to limit the fiscal cost) and the length of visas have yet to be decided (between one and four years).

Third, relinking the UK and EU’s carbon markets. After Brexit, the UK adopted a similar emission trading system to the EU, but the UK’s carbon price has been about 20% lower than the EU’s. That’s effectively given a subsidy to the UK’s high-polluting industries. Without relinking the markets, when the EU’s Carbon Border Adjustment Mechanism (CBAM) begins on 1^st January 2026, UK exporters of products such as cement, aluminium, fertiliser and electricity will have to pay the difference between the carbon taxes levied in the UK and the EU. That tax revenue would go to Brussels and not to HMRC.

The latest indications are that agreements can be reached in all three areas. It may be that the details take many months to finalise. But at the UK-EU joint summit on 19^th May, there is expected to be some declaration of common principles. That may lead to further agreements in future on other issues, such as UK professional qualifications being recognised in the EU and vice versa.

Sometimes the reality is harder than it looks

That said, often the details prove to be the hardest part. And it is possible that other issues, such as fish, will slow and/or hamper progress.

The current UK-EU agreement on fishing quotas expires on 30^th June 2026. At that point, 25% of the overall existing EU quota of fish caught in UK waters will have been transferred to the UK. Some of the EU’s fishing nations, such as France, Belgium, the Netherlands and Denmark, would like the EU’s 75% share to be maintained for five years until 2031. The UK favours annual negotiations of the quotas.

Clearly, fishing is not a big issue in economic terms. But it has always had a disproportionate influence on UK-EU negotiations. Indeed, in a flashback to the painful Brexit negotiations, some EU officials have said in recent weeks that agreements on defence or the other areas within the EU reset cannot happen until an agreement on fishing is reached. That’s similar to the EU’s line during the Brexit negotiations that “nothing is agreed until everything is agreed”. It is also thought that the EU may want to link fish to energy. Indeed, on the same day the current fishing agreement expires, the UK is due to lose access to the EU’s internal energy market.

That said, we would be very surprised if the UK and EU put the issue of fish ahead of defence. As a result, we doubt that fish or any other issue will prevent the security pact being announced on 19^th May. But the detail of the EU reset in other areas may take many months to be finalised.

What about the UK’s relationship with US/China?

The bigger challenge for the UK is that its relationship with the EU influences its relationship with the US, its relationship with the US influences its relationship with the EU and both of those influence its relationship with China!

The potential for a UK-EU reset doesn’t appear to have influenced the UK-US trade deal announced on 8^th May. This was not and is unlikely to develop into a full UK-US Free Trade Agreement. Instead, once it is signed, it just reduces some of the tariffs that Trump had previously put in place. (See here.)

The 10% baseline US tariff on all UK goods exports to the US will remain. But for most UK car exports, the US import tariff will be 10% rather than 25% and for most UK steel exports, the tariff will be 0% not 25%. In exchange, the UK will reduce its import tariff on US beef from 20% to 0% (US hormone-grown beef still won’t be allowed into the UK) and allow greater access to the UK market for US chemicals, machinery and industrial products.

Even so, since the UK-US deal has yet to be signed, it’s possible that what the UK agrees with the EU will limit what it will agree with the US. Different requirements on foods standards is the best example.

At the same time, the UK doesn’t seem to know what kind of relationship it wants with China. It would like to be able to tap into the growth opportunities that China brings. But it is wary of the security risks. Those risks will have only been heightened by the UK government feeling compelled to take control of British Steel’s Scunthorpe plant from its Chinese owners in April. Moreover, the UK is aware that the US won’t tolerate it having a close relationship with China.

Chart 8 is a theoretical illustration of the UK’s economic relationships with the EU, the US and China. In an ideal world, the UK would sit in the middle and have a very close economic relationship with all three. That’s illustrated by the dark blue triangle, whose points reach each country.

In reality, in some areas if the UK has a very close relationship with the EU, it has to have a more distant relationship with the US. For example, if in the EU reset the UK agrees to match the EU’s food standards, then that essentially rules out US chlorinated chicken and hormone-grown beef from ever being imported to the UK. Relinking the UK and EU carbon markets would also irk Trump since he dislikes green taxes.

A close relationship with the EU would also limit the extent of the UK’s relationship with China, as the EU is also wary of the security risks China poses as well as the economic competition in areas such as electric vehicles. This situation is illustrated by the pink triangle.

Conversely, if the UK had a very close relationship with the US it would probably have to have a more distant relationship with the EU and an even more distant relationship with China. Aligning more closely with US regulation would result in the UK falling foul of the EU’s requirements. And the US won’t tolerate an ally having a close relationship with China. That’s illustrated by the green triangle.

Finally, a close relationship with China would probably result in a more distant relationship with the EU and an even more distant relationship with the US, as shown by the grey triangle.

In this example, the biggest economic windfall for the UK stems from the biggest triangle. If the dark blue triangle is not feasible, then the pink one is the next best option. That’s the one of a close relationship with the EU, a fairly close relationship with the US and a more distant relationship with China. That’s similar to the current situation and will probably be similar to the situation after the EU reset and any new near-term agreement with the US.

Relationships are always more nuanced

That said, the situation is more nuanced as relationships can be close in some areas and more distant in others.

Chart 9 illustrates this by showing how much of the UK’s trade in goods, trade in services and Foreign Direct Investment (FDI) happens with the EU, the US and China. The EU accounts for around 50% of the UK’s goods exports and imports, while the US accounts for 16% of the UK’s goods exports and 10% of the UK’s goods imports. As a result, it’s clear that the UK and EU are still closely intertwined on trade in goods even after Brexit.

The UK-EU links are not as dominant in services. Indeed, the share of UK’s services exports that goes to the US (27%) is only 9ppts lower than the share that goes to the EU (36%). And when it comes to FDI into the UK, the US is more important. In 2023 (the latest data available), a higher share of inward FDI came from the US (34%) than from the EU (31%).

In fact, the US has been a more important source of inward FDI for the UK since 2021. This is the result of a trend that has been underway at least since the Brexit vote in 2016. Since then, the UK’s share of inward FDI coming from the EU has shrunk from 47% to 31%, while the share coming from the US has risen from 25% to 34%. (See Chart 10.)

On trade in goods, trade in services and FDI, China remains much less important to the UK than both the EU and the US. (See Chart 9 again.)

Given that even in a globalised world proximity plays an important role in determining trade flows for goods, it makes sense that over time the UK and EU will move closer together on trade in goods. This may mean that beyond this year’s EU reset, some of the other trade barriers erected by Brexit will be reversed.

But when it comes to trade in services and foreign direct investment, proximity is less important and common ground on issues such as taxation and regulation are more important. Over time, the US may push for the UK to have lower standards of regulation and taxation of digital services, lower health-and-safety standards for autonomous vehicles and lighter financial regulation than the EU. And the UK may align more closely with the US in these areas. Indeed, the Prime Minister has been clear that he views technology, digital and Artificial Intelligence (AI) as areas that are crucial to the UK’s future. As a result, when it comes to services and FDI, the UK’s ties with the US may become dominant.

What would an EU reset do for the UK economy?

One reason Starmer is keen on a closer economic relationship with the EU is because it’s a way to boost economic growth without a fiscal cost. That said, the measures in the EU reset would reverse only a small part of the barriers erected by Brexit in the first place.

One way to show this is to lean off some modelling done by NIESR in 2018. As with all modelling, the outcome depends on the assumptions made and the results should be taken with a large pinch of salt. So we wouldn’t put too much weight on the absolute economic impact the modelling implies.

But this particular piece of work is useful as it also attempted to isolate the influence of the UK leaving the customs union (in the customs union there were no tariff or non-tariff barriers between goods traded between the UK and the EU). For example, NIESR estimated that Brexit would reduce UK GDP in 2030 by 3.9% and that only 1.1 ppt of that was due to the UK leaving the customs union.

The point is that the bulk of the hit to the UK economy comes from the other consequences of Brexit, including the UK leaving the single market, which introduced barriers on trade in services and prevented the free movement of people. In particular, NIESR attributed a lot of the hit to UK GDP as Brexit “discourages investment in the UK and ultimately means that UK workers are less productive than they would have been if the UK had stayed in the EU”.

It follows that, assuming this model is correct, removing some trade barriers on the flow of food products between the UK and the EU (which account for just 10% of all goods exports and imports moving between the two areas) isn’t going to boost economic growth much at all.

A youth mobility scheme may reverse only a small bit of the economic gains lost from the free movement of all UK and EU citizens. Capping the numbers of people that can use this scheme limits its influence. And if the numbers are broadly balanced, with as many UK citizens moving to the EU as EU citizens move to the UK, the economic benefits may be broadly neutral. As a result, the EU reset may boost UK economy growth perhaps by about 0.1-0.2% over a 10 year period.

What would an EU reset do for the EU economy?

Given that the UK economy is just 22% the size of the euro-zone economy (at market exchange rates), the boost to the EU economy will be even smaller. As a result, we won’t be altering our medium-term GDP growth forecasts for either the UK or the EU based on the EU reset.

That said, as our estimate of the UK’s potential real GDP growth rate of 1.5% is higher than our estimate for the euro-zone of 1.0%, partly due to demographics but also due to productivity, over time the UK will grow relative to the euro-zone and the EU. In fact, our forecast that AI will boost potential growth in the UK in the 2030s by more than in the euro-zone means that by 2050, the UK may have grown to be 27% the size of the euro-zone. (See Chart 11, here and here.)

Conclusion

Overall, over the next five to ten years the UK will probably move much closer to the heart of the EU when it comes to defence, but will only edge slightly closer on economic matters.

While fewer trade barriers on food products and a youth mobility scheme may boost the UK economy a bit and the EU economy by even less, this would reverse only a fraction of the drag generated by Brexit. As a result, the EU reset won’t give the UK the big boost to economic growth that Starmer craves and the UK needs, although every little bit counts.

And further ahead, the UK and EU may find more common ground on trade in goods, while the UK and US may align more closely on other issues such as services, technology, finance and regulation.

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Paul Dales, Chief UK Economist, +44 (0)7939 609 818, paul.dales@capitaleconomics.com