Still arguing over Brexit costs

A lot has been written recently about the costs that Brexit will impose on the UK economy. Unfortunately a lot of the discussion has been at cross purposes. Remainers claim that whatever form Brexit takes it will leave the economy worse off than it would otherwise be, whilst Leavers rubbish those claims and point to the fact that the economy has held up much better than suggested by the worst case outcomes of 2016. In fact both are true. If we assume that the UK economy grows at an average rate of 2% per year, which is true over the period 1990 to 2016, then last year’s 1.8% growth rate represents an underperformance. This is thrown into even starker relief by the fact that the likes of Germany, which in recent years has grown more slowly than the UK, did indeed grow more rapidly last year. But the UK’s performance was far from a disaster, and there was certainly no recession.

What happens thereafter will be determined by the nature of the trade relationship between the UK and EU27. The leaked Treasury analysis suggests that in the absence of a trade deal with the EU, output would be 8% below the pre-referendum baseline over a 15 year horizon. A free trade agreement with the EU would result in a 5% decline in output whilst the soft Brexit option (i.e. continued single market membership) would result in a 2% decline in GDP. A recent paper by David Vines and Paul Gretton (here) suggests that the impacts are much smaller. According to their estimates, the effects of exiting the Single Market & Customs Union would cost just 0.6% of GDP. The effect is small because tariff barriers are low, although in industries such as agriculture and autos the impacts are higher because tariffs are higher.

Vines and Gretton point out that the benefits of signing up to a free trade agreement are also small because of the difficulties of negotiating the agreement in the first place and the impact of rules of origin restrictions which will preclude many sectors from gaining much benefit. To the extent that the government wishes to sign a form of FTA with the EU27, it suggests that this will not deliver many of the benefits which its proponents hope. But Vines and Gretton argue that unilateral liberalisation by the UK would reduce these losses by much more than the effects of joining FTAs. For example, not levying tariffs on imports from the EU27, might raise GDP by as much as 0.2%. Removing tariffs on all imports from the EU could raise GDP by another 0.2 %. It is worth noting that this is the same approach advocated by Patrick Minford, but his analysis was heavily criticised for the heroic assumptions on which it was based.

Whilst I am persuaded of the view that the gains from FTAs are small, the losses reported from the Vines and Gretton paper do appear to be on the low side. There has already been a 0.25% hit to GDP even before the UK has left the EU, and leaving the Customs Union and Single Market is likely to impose much bigger costs than anything seen so far. In any case, much of international trade theory is rooted in a world of goods whereas the real damage to the UK will be caused by the hit to services, where non-tariff barriers are far more of an issue.

In the course of this week I have also had numerous conversations with senior civil servants, past and present, whose views on Brexit I was particularly interested to hear. There was universal agreement that the government appears to be oblivious to the damage that a hard Brexit will cause. One well-connected official was scathing about the government’s approach to the Brexit negotiations, and suggested that not only has it no clue about the magnitude of the task at hand but it has absolutely no appreciation whatsoever of the EU27’s position. The UK takes the view that regulatory equivalence will be enough to ensure that it will be able to sign an FTA with the EU. But as this individual pointed out, such equivalence is not merely a process whereby the UK voluntarily agrees to adhere to regulatory harmonisation. The EU27 sees equivalence as part of a regulatory architecture in which adherence and enforcement are monitored by institutions such as the ECJ from which the UK wants to break free.

The recent spat between the UK and EU27 negotiators in which the EU’s chief negotiator Michel Barnier suggested that “I don’t understand some of the positions of the UK” goes to the heart of the problem. Both Leavers and Remainers, and the UK and EU27, occupy different ends of the spectrum and either cannot, or will not, understand the other’s position. It is going to be hard to salvage a favourable deal from this sort of wreckage. Meanwhile, we are less than 14 months away from the UK’s departure from the EU. Something has to give.