Beyond the realms ...

The economic analysis that underpinned the Remain campaign ahead of the EU referendum was widely dismissed as the tool of Project Fear. It is not hard to see why. After all, the Treasury’s analysis of the short-term costs of Brexit sat rather uncomfortably, even at the time, and as events transpired it now looks hopelessly wrong. Indeed, the Treasury suggested that “the economy would fall into recession with four quarters of negative growth. After two years, GDP would be around 3.6% lower in the shock scenario …. the fall in the value of the pound would be around 12%, and unemployment would increase by around 500,000.” As we now know, the UK did not fall into recession and unemployment has fallen, rather than risen. But the Treasury was broadly right about the fall in sterling, and its prediction that “the exchange-rate-driven increase in the price of imports would lead to a material increase in prices, with the CPI inflation rate higher by 2.3 percentage points after a year.”

But the fact that large elements of the analysis used by Remainers was so far off the mark has allowed the Brexiteers to claim they were right all along and that leaving the EU will not be the economic disaster that is claimed. Indeed, the Economists for Free Trade Group (EfFT), led by Patrick Minford, uses the Treasury’s analysis as a counterpoint to suggest in fact there will be significant benefits to leaving the EU, of between 2% and 4% of GDP relative to the baseline of remaining. Their report issued last year was dubious enough (see here for my take on it) but their latest report, released this month appears to be even more of a desperate effort.

It begins with the premise that consensus economic forecasts cannot be trusted, and argues that the economics profession has been wrong on many of the big issues over the years (Thatcher reforms; leaving the ERM in 1992 and failure to join the euro). That is a pretty bad place from which to start because it is a claim that since the consensus was wrong on all the big issues, we should trust Minford and his pals. To quote the report, “Fortunately, a number of leading economists with considerable expertise and good forecasting track records suggest a very different outlook.” We’re so glad you could help out!

But it is a disingenuous claim. Even now there are many who would argue that the Thatcher reforms did not produce the improvements that Minford et al claimed – certainly the costs of those policies were high and their after-effects linger today.  It is certainly wrong to suggest that the economics profession in 1992 “argued that if we left [the ERM] disaster would ensue: inflation would soar and this would necessitate higher interest rates that would lead to an even deeper recession.” (I know because I was there). Similarly, whilst there may have been some prominent commentators suggesting that not joining the single currency was a bad idea, the majority view was not in favour. Nor do EfFT give the Treasury credit for the 2003 report which argued against euro membership.

One of the tactics of irritant groups like EfFT is to set up straw man arguments which they can easily dismiss, thus bolstering their case. “Being  proved  so  wrong  about  the  immediate  impact  of  the  vote  to  leave  has  not  deterred  the economics establishment from continuing to predict disaster in the long term.” The “disaster” in this case is the likelihood that incomes will grow more slowly in the absence of EU membership. Nobody is now seriously arguing that the UK economy will hit the rocks – merely that it will grow more slowly. Not what I would call a “disaster” – more a relative disadvantage.

Aside from the bluff and bluster, it is once we start digging into the details of the EfFT analysis that the weaknesses really emerge. As I mentioned in my previous post, EfFT assume no role whatsoever for gravity. Their claim that gravity effects have “been totally bypassed by the progress of technology” is simply not true. It is less important than it once was, admittedly, but to dismiss it because it does not fit with the story you are trying to tell is intellectually dishonest.

Even more significant is that the empirical work is based on a computable general equilibrium (CGE) model. They are great in theory but suffer from so many practical drawbacks that their results are often little better than guesswork. In brief, a CGE model is based on an input-output matrix and assigns a significant role for prices by assessing how much demand, supply and prices have to change following an economic shock in order to order to restore equilibrium. Amongst their many disadvantages is that it is difficult to determine the functional form used to model at the disaggregated level required by a CGE model. Moreover, because they are not estimated using standard statistical methods, but instead are calibrated (i.e. the parameters of the model are assigned using judgement), we have little idea whether the structural form of the model is consistent with the data in the real world. This is totally unacceptable for policy reasons (and to be fair, the Treasury’s own regional estimates of Brexit costs which are based on similar models, are subject to similar criticisms).

 So the models are somewhat dodgy, but wait until you hear about how Minford and his colleagues bend them to give the number they first thought of. EfFT start from the premise that the UK will benefit from unilateral tariff abolition. They cite the work by Ciuriak and Xiao who point to a 0.8% gain in GDP on the basis of unilateral tariff abolition. But theirs is a relatively cautious work and is obviously based on the assumption that the UK’s trading partners will necessarily reciprocate. EfFT blithely adopt the assumption as a matter of fact. Furthermore, they argue that Ciuriak and Xiao’s analysis suggests that “the combination of tariffs and non-trade-barriers eliminated is just 4 per cent ...” but if we “eliminate non-tariff barriers set up by the EU against the world … Ciuriak’s and Xiao’s results can be multiplied five times.” In other words, a cautious technical result is magnified by a factor of five.

But think about what that statement means. EfFT assume that the EU will reduce its non-tariff barriers. But why should it? It is one thing to talk about tariffs but quite another to quantify the impact of non-tariff barriers which are there to protect EU firms in their home market. This is a race-to-the-bottom assumption which appears to suggest that many of the standards we currently employ today will be swept away. And it is also worth heeding Ciuriak and Xiao’s conclusion that “in a long-term perspective, if the world (including the EU) moves to a similar free trade equilibrium, the first mover advantages to the UK of full liberalization against the rest of the world would eventually be eroded.” In other words if everybody adopts the policy, the UK will be out-competed in a number of key markets.

We could go on but it might be wise just to draw a veil over the nonsense. Suffice to say, with the same model as that applied by EfFT I could come up with a different set of results. But the reason that the economics profession does not buy these results is simply because EfFT assumes that EU membership today is all about costs with no compensating benefits, and if we leave then the costs will simply fall away. Most of us do not see it that way. There are costs, but they are offset by the benefits and leaving the EU will reverse that situation. It is, of course, possible that the majority view will be wrong but I wouldn’t put money on it – even to hedge my bets.