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.

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.

The economic benefits of Brexit (or how to oversell your case)

Patrick Minford is a heavyweight academic economist whose work on macro modelling is first rate. He is also the front man for the group Economists for Free Trade (EfFT) which provides the intellectual ballast in favour of Brexit and which has recently published the main results of a study due for release in the autumn. Minford and his collaborators argue that “Brexit could boost the UK economy by as much as £135 billion a year” which is equivalent to 6% of annual GDP, and that “’Hard Brexit’ is good for the UK economically while ‘Soft Brexit’ leaves us as badly off as before.” Obviously, when someone as able as Minford produces detailed analysis of this sort, it deserves to be taken seriously. But the view across the economics profession is that it is – to put it politely – flawed.

One of the key premises of the paper is that unilateral abolition of all UK tariffs should be a key plank of the post-Brexit world. But most economists do not buy the analysis. For one thing, it assumes that most of the benefits to the UK are derived from the import side. In the view of EfFT, there will be an immediate increase in UK living standards as a result of the abolition of UK import tariffs. This will put competitive pressure on domestic business to improve its relative position and as a result the economy will emerge stronger in the long-term. Minford et al justify this with reference to the example of Sir Robert Peel’s abolition of the Corn Laws in 1846 which “greatly reduc[ed] the price of food and help[ed] to stimulate the industrial revolution.”

There are just a few tiny problems with this Panglossian view of the world. 

• First, it will lead to a massive initial widening of the trade deficit which will likely result in a sterling depreciation which boosts inflation and squeezes household incomes – a bit like we are seeing today.
• Second, it will wipe out large chunks of UK manufacturing industry which are unable to compete with low cost Asian producers. Even if there is a competitiveness response, it will take years to show through and we would have to balance out the short-term welfare losses against any potential long-term gains. 
• Third, Minford argues that “to offset the long run effect of losing EU protection, manufacturing productivity needs to be raised, compared with no Brexit, by only about 1% a year for a decade, which looks entirely feasible.” Given that one of the main macroeconomic problems we face today is the weakness of productivity, which has flatlined since 2008, raising productivity growth to 4% per annum, as he implies, looks entirely infeasible. 
• Fourth, the 1846 example is misguided. In a world of much more intense global competition, it is not clear that the UK could easily cope with the near-tripling of the trade deficit that occurred in 1847 and which was left permanently higher as a result.

Nor do most economists buy the view that unilateral tariff elimination is a sensible strategy. If you don’t believe in unilateral nuclear disarmament why should you believe the same principle applies to trade? You might promise to cut tariffs during trade negotiations but you certainly do not throw away one of the main bargaining chips before even entering the negotiating chamber. He may be a good macroeconomist but he’s a lousy game theorist.

Alan Winters, at the University of Sussex, has been a major critic of Minford’s analysis all along and his latest blog piece does a good job of skewering some of the assumptions. The detailed breakdown of the EfFT numbers suggests that the gains from free trade alone will amount to 4% of GDP. Winters points out “EfFT claim that current EU trade barriers are equivalent to a tax of 20% on both agriculture and manufacturing. In manufactures only about 3.5% of the extra cost is tariffs, so what is the rest? If the 20% is correct, much of the remaining 16%-17% is standards.” Applying the arithmetic, abolishing trade barriers might only be expected to produce a boost equivalent to 0.7% of GDP (4%*3.5%/20%).

Indeed, this hits upon a major problem – standards and other non-tariff barriers are much bigger obstacles to trade. One simple example is differing car pollution emission limits: Even if tariffs could be eliminated, the fact that cars are subject to different standards around the world significantly raises production costs. Indeed it was the raising of US emissions standards in the 1970s which killed off the classic Jaguar E Type. Another example is financial services, in which a passport allowing regulatory equivalence enables banks to trade their products across EU borders without let or hindrance. It may not be everyone’s idea of a great industrial role model but the UK does at least run a consistent external surplus in financial services trade.

Leaving the EU Single Market will require the UK to massively raise its foreign trade with non-EU countries to make up for the loss of tariff-free access to the EU market. Analysis by NIESR suggests that if the UK left the single market but made unilateral trade deals with major developing economies and the Anglosphere, it would only claw back about one-third of the 20-30% reduction in lost total trade resulting from leaving the EU. Moreover, deals on services trade are far less comprehensive than those for goods, and as NIESR has also indicated, it will be hard to replicate the EU deals that we have now.

Winters also points out that “EfFT believe that we can get all the benefits of the European Single Market (SM) unilaterally. That is not true. The SM boosts our exports, which confers benefits over and above those achieved by liberalising imports.” It is precisely because the UK has some say over single market regulations it can influence them to benefit certain industries, such as financial services. Small economies simply cannot decide their own trading standards in a globalised world and the UK will become a rule taker rather than a rule maker. The bottom line is that by leaving the single market, the UK will be giving up a lot of influence over its ability to set terms and conditions. Far from taking back control, we will be throwing ourselves on the mercy of the global economy.

One of the ironies associated with this analysis, which has been criticised for being given far too much prominence, is that it is the mirror image of the doom-laden scenarios produced before the referendum which were dismissed as Project Fear. So why should this be treated so reverentially by the media? After all, it was produced by the “experts” we all thought we had heard enough from.