Brexit has set the stage for a retaliatory trade war that neither the U.K. nor the E.U. wants and that will injure consumers (and others) on both sides. Moreover, it could threaten the U.S. as well, if it leads the U.K. to relax its financial regulatory requirements and return to its former “regulatory-lite” policies in order to compete more effectively (and thereby lead a regulatory race to the bottom).

In a paper just posted on SSRN (available here) that I deliver at the University of Paris/Sorbonne in two weeks, I analyze how trade wars begin and play out, applying this experience to the Brexit negotiations. Few today perceive that we are on the brink of such a conflict. But this may be because they have in mind a much too narrow definition of what a trade war is. Fundamentally, such a conflict can be defined as the use of economic means (particularly, the imposition of restrictions on the free flow of goods and services) to obtain either economic or political objectives.

This expanded concept—much broader than the traditional image of a trade war beginning with one side raising tariffs and the other side retaliating—has greater relevance to the contemporary world. Old-fashioned trade wars are today unlikely. For example, 70 percent of the cars produced in the U.K. last year were exported, suggesting that heightened tariffs on autos would severely injure this important British industry. Correspondingly, a river of wine flows from France to Britain, and higher tariffs might make vintages from Australia or Chile more attractive. More generally, the E.U. is the U.K.’s largest trading partner, accounting for 48 percent of all goods and 38 percent of all services exported by the U.K. in 2016.[1] Thus, both sides will try to steer clear of a classic tariff battle, which would inflict needless misery on both sides.

Once we expand our definition of trade war, we must recognize that many new conflicts threaten trade wars. For example, the use of sanctions to punish a “wrongdoer” nation also interferes with the free flow of goods, imposes costs on third parties, and can spark retaliation. In this light, if the U.K. imposes restrictions on immigration after Brexit becomes effective and, in response, the E.U. denies the U.K. the ability to participate in its single market, all the preconditions to a trade war have been satisfied. To be sure, the E.U. would be pursuing a legitimate political end in upholding its basic principle that there must be free movement of goods, services, and persons within its single market, but economic means have been used, and retaliation becomes likely.

So what are the lessons of past trade wars that should be kept in mind during the Brexit negotiations? First, the costs of trade wars are enormous and largely hidden. Although most Americans believe the Great Depression was caused by the Stock Market Crash of 1929, economic historians tend to believe that the Smoot-Hawley Tariff Act of 1930, which significantly hiked U.S. tariffs, played a greater causal role by setting off a frenzy of retaliation. Within three years, the value of world trade in 1933 was just one-third of what it had been in 1930 (when Smoot-Hawley was enacted).

Second, once a trade war begins, it often persists for an extended period, largely because “rent-seekers” (i.e., special interests) lobby aggressively and use the trade war to advance their own objectives. Rent seekers can win, even if the conflict inflicts far greater wealth losses on the public generally. As a result, rent-seeking often delays the resolution of a trade war, and some trade wars have persisted for 200 years (and even longer).

Here, we need to take a closer look at Brexit, where to date rent-seeking has not been evident. For example, most of the organized business interests in the U.K. (and especially the financial industry) opposed Brexit. In truth, Brexit was the product of a populist eruption (much like Donald Trump in the U.S.)

But, in the immediate future, rent-seeking may play a determinative, but behind-the-scenes, role. In the event of a “hard” Brexit in which the U.K. departs both the single market and the customs union, banks, brokers, and insurers now resident in the U.K. may need to open a branch (and obtain a license) elsewhere in Europe in order to avail themselves of the single passport and thus be able to market their financial services throughout Europe. This has set off an active competition, as various E.U. cities are aggressively soliciting the largest international banks. Already, some major U.S. banks have announced plans to open new bases in Frankfurt and Dublin, and Paris has landed HSBC. This migration means an influx of high salaried, high spending (and tax paying) employees into these cities, but it will cost these banks an estimated $20 billion to $30 billion in capital expenditures (according to the bank consulting firm Oliver Wyman).

But that is not where the U.K. is most exposed. Another likely E.U. tactic would be to require that certain activities must occur within the E.U. in order that they can be directly monitored by E.U. regulators. London is today the world’s largest center for foreign exchange trading. The E.U. has long threatened to require that currency trading in the Euro must be cleared in the E.U. Indeed, the European Central Bank (“ECB”) imposed such a requirement in the past, but it was struck down by the European Court of Justice in 2015. After Brexit, the U.K. will no longer have standing to challenge any similar rule if the ECB again demands that the clearing of Euro transactions occur in Europe. Former French President Francois Hollande has publicly demanded that the U.K. should be barred from clearing Euro transactions in order to set “an example for those who seek the end of Europe.” Although his motive may be retributive, others are simply profit motivated.

Thus, the Brexit negotiations may occur on two levels. On the public level, the debate will be about high principles, including the free movement of persons. On the private level, the negotiations will involve the rent-seeking ambitions of those who want to move transactions or bank offices to Europe (and away from London) and who at bottom are seeking to diminish the dominant position that the U.K. enjoys in many financial markets. In 2015, the U.K. exported £24 billion in financial services, of which roughly half went to the E.U. European competitors envy that dominance and see an opportunity to appropriate much of it.

The U.K.’s exposure is hard to exaggerate. According to one study by Ernst & Young, as many as 83,000 jobs in London hinge over the short-term on the fate of whether Euro clearing remains in London (and ultimately as many as 232,000 jobs could be lost to Europe) An Oliver Wyman study finds that somewhere between 15,000 to 17,000 wholesale banking jobs are set to be relocated to the E.U. over the short-term by major banks needing to retain a “passport” to Europe (and possibly 40,000 jobs over the longer term).

Of course, the loss of jobs in London may not motivate the voters in Wales, and thus the U.K.’s government is divided, with some favoring a “hard” Brexit and those with ties to London or the financial community preferring a “soft” Brexit, under which the U.K would remain a member of the single market and the customs union.

Although the exposure of the U.K. to E.U. retaliation for Brexit is well understood, few have focused on how the U.K. might retaliate in turn. Inevitably, it will need to respond. Phillip Hammond, Chancellor of the Exchequer, has outlined the most likely U.K. counter-move, warning publicly that, “if the U.K. failed to secure a deal, the country might change its economic model and start to compete on the basis of its regulatory and tax regime with the European bloc.” This is a thinly veiled, but credible, threat. The U.K. could become a tax haven for foreign companies, while the E.U. has long sought to preclude its own members from doing this (although Ireland tests these restrictions constantly). Similarly, the U.K. has a long tradition of “regulatory-lite” financial regulation with only occasional (and equivocal) enforcement actions. Brussels compelled more aggressive enforcement by most E.U. member states. But freed from Brussels’ oversight, the U.K. could return to its old ways and attract competitors seeking to escape tougher regulation and enforcement. Ultimately, this threatens a new race to the bottom.

Each side has reason to worry that, at the conclusion of the Brexit negotiations, the other side might take retaliatory actions (but probably not involving significant tariff increases). The E.U. could bar the clearance of various financial transactions in the U.K. (and not just the Euro), and the U.K. could seek to attract financial firms (banks and others) through tax and regulatory concessions that the E.U. would be reluctant to match. Neither side would feel that it could trust the other, and this supplies the preconditions for a Prisoner’s Dilemma, which usually produces a suboptimal outcome.

Here, we come to the final lesson from past trade wars: How does one restore trust in order to minimize retaliation? The short answer is: only gradually, and rent-seeking must first be controlled. If the U.K. can recognize its self-interest (and the Tory government seems currently divided), it should pursue a “soft” Brexit. The best means to this end would be an extended transitional period (in fact, the Chancellor of the Exchequer seems to favor this approach, but he has opposition within the cabinet). During this period, the U.K. would remain within the single market and customs union and would need to permit the free movement of E.U. citizens within its borders. Brussels’ rules would continue to apply, and—critically—the European Court of Justice would continue to protect it from attempts to compel the departure of Euro clearing from London. Banks and other firms might open new bases within Europe, but the migration of employees would be more a trickle than a flood, so long as the U.K. still held its passport.

How long could this interim transition period be extended? This is the least predictable question, but it depends on the political mood. Brexit was a symbolic move, and a symbolic departure from Europe may prove to be sufficient. In any event, each year the transition continues, the anger and desire to retaliate may diminish on both sides.

Of course, it may be wishful thinking to believe that this transition can be extended indefinitely. Or, that retaliation can be avoided. Looking at the history of trade wars and the political gains to rent-seekers, the odds seem no better than 50-50.

ENDNOTE

[1] This article is without footnotes, but the support for all the facts, statistics, and quotations in this column is set forth in the longer version of this piece posted on SSRN.

This post comes to us from John C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance. It is based on his recent article, “How Should the E.U. Respond to Brexit and Trump?: The Lessons from Trade Wars,” available here.