Would I lie to you? Part 2

For all the trials and tribulations which the British media have over the years elevated to the status of great political dramas, none has had the resonance of Brexit – an episode in which the political establishment appears to have lost its collective reason. In many ways, it is reminiscent of the McCarthy era in the US 70 years ago when a political ideologue used the legal process to conduct a witch hunt against those who did not share his extreme distaste for communism. As in the McCarthy era, a small coterie of politicians has hijacked the British parliamentary process and appears intent on delivering their version of an ideologically pure Brexit whatever the cost to the British economy.

Wikipedia defines McCarthyism in a wider sense as “the practice of making accusations of subversion or treason without proper regard for evidence.” Elements of that definition certainly apply to Brexit: Indeed, some of the more rabid commentators even accused those seeking to minimise the impact of a hard Brexit as treasonous – notably this Daily Mail article, lest we forget. Those advocating Brexit not only pay no regard to the evidence – they make up their own. It was bad enough to lie during the referendum campaign but now that we are seven months away from the UK’s EU departure, they are still at it!

Earlier this month, former cabinet minister Peter Lilley argued that the UK had nothing to fear from a no-deal Brexit because “WTO terms are designed to provide a ‘safety net’ ensuring all members can trade without discrimination.” Lilley claims to know what he is talking about because “as Trade and Industry Secretary, I spent 10 days incarcerated in the Heysel Stadium negotiating the Uruguay Round which set up the WTO.” That’s a bit like saying if you incarcerate someone in Ornenburg’s Black Dolphin Prison for 10 days, they will emerge with an intimate knowledge of Russia.

In fact, the WTO fallback option is not much of an option at all. Brexiteers seem to believe it confers some special status which will allow trade to continue much as it does today. But if it is such a great deal, why do countries seek free trade agreements which confer considerably greater benefits? As Alan Winters pointed out in a blog post, “since the WTO came into being, 243 new Free Trade Agreements have come into operation … None of this suggests that 'WTO terms' are viewed generally as a satisfactory option.” Even the head of the WTO has suggested it is “unlikely” the government will have agreed tariffs and quotas with all other member countries by next March.

And most Brexit supporters clearly do not understand the most favoured nation clause. This merely defines the lowest possible set of barriers that a country will be prepared to offer all other WTO members. It does not mean that the EU will offer the UK any concessions that it is not prepared to offer the likes of Russia, China or the US. In fact, Lilley’s article is full of economic nonsense, as Winters points out. Amongst the highlights was the claim that “we will be free to join the Trans-Pacific Partnership.” Wonderful: Except the TPP does not even exist as it was nixed by Donald Trump soon after he came to office. Moreover, “without a trade deal, Parliament will reject any Withdrawal Agreement offering the EU £40bn … That leaves Britain £40bn better off, and ends our annual £10bn net contribution immediately[1] – boosting our GDP, balance of payments and public finances.” It is hard to know whether this is a deliberate parody or just plain stupidity. My own calculations suggest a no-deal Brexit imposes costs which are roughly three times the monetary savings – a view which is broadly in line with the literature estimates.

Then of course, there is Brexiteer-in-chief, Jacob Rees-Mogg who suggests that the UK could maintain an open Irish border but still impose checks “as we had during the Troubles” – a suggestion that is as laughable as it is offensive. In a functioning democracy, the near half of the electorate which voted against Brexit could expect some parliamentary representation. But the opposition Labour Party has refused to oppose the Conservatives which have taken back control of Brexit policy despite being a minority government. Labour leader Jeremy Corbyn is widely seen as a Brexit supporter and in a TV interview last week he refused six times to answer the question whether he believes the UK would be better off outside the EU.

To compound the sense of the absurd the government last week issued a series of reports on how various sectors should prepare in the event of a no-deal Brexit. Although DExEU claims that leaving without a deal “remains unlikely given the mutual interests of the UK and the EU,” the fact that it has seen fit to issue such a series of papers suggests it is taking the prospect seriously in the wake of EU pushback against the Chequers plan. There is no reassuring news in the policy papers which effectively highlight all the things that the experts said would happen in the event of no deal (more red tape, higher compliance costs and a need to stockpile in key areas such as medicines). Whatever happened to “they need us more than we need them”?

In short, Brexit is a looming disaster of the government’s own making compounded by the failure of the opposition to set out a credible alternative. It is hard to shake off the suspicion that it represents a coup by right-wing Conservatives desperate to grasp this one chance offered by a non-binding referendum. But heed the lessons of history: Like Brexit, public support for McCarthyism only ever peaked at around 50% in January 1954. Within six months public support had dwindled to only 34%. Joe McCarthy himself was censured by the Senate at the end of 1954 and he was dead within three years.

As William Bennett, noted in his 2007 book America: The Last Best Hope, “The cause of anti-communism, which united millions of Americans and which gained the support of Democrats, Republicans and independents, was undermined by Sen. Joe McCarthy ... his approach to this real problem was to cause untold grief to the country he claimed to love ... Worst of all, McCarthy besmirched the honorable cause of anti-communism. He discredited legitimate efforts to counter Soviet subversion of American institutions.”

A similar epitaph may yet be written for Brexit: genuine concerns about the EU undermined by the efforts of Brexit supporters. But a no-deal Brexit is like McCarthy unleashing the nukes to solve the Soviet problem. And even he was not that stupid.

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[1] Didn’t the leavers claim the cost savings would amount to £350 million per week, or £18bn per year? Saving £10bn per year amounts only to £192 million per week.

The Brexit impossibility conundrum

Events over the last week have taken us further into the looking glass world which we now seem to inhabit. Donald Trump is never far from the headlines and his trip to Europe last week raised some uncomfortable questions – some of which did need to be raised and many that did not – but I will deal with those in my next post. However, it is the surreal events in the arcane world of Brexit that are currently top of my thoughts.

The government’s White Paper, published last week, was supposed to be the moment when we finally got some clarity on the post-Brexit nature of the relationship between the UK and the EU.  After all, it is the document that the EU has been requesting for the past 16 months. “Tell us what you want,” they demanded of the UK. But when they finally saw what the UK was proposing, they probably wished they had never asked. In short, the UK is asking for an Association Agreement with the EU which preserves many of the rights and privileges which it enjoys now. It is suggested that the UK and EU create a free trade area for goods governed by EU law, underpinned by elements of the customs facilitation plans which the EU has already derided as unworkable. Moreover, although “the UK would not have a vote on relevant rule changes, its experts should be consulted on the same basis as Member States.” Meanwhile, it intends to end the free movement of labour and proposes only paying into “those EU agencies that provide authorisations for goods in highly regulated sectors” without any mention of more meaningful budget contributions.

As a brazen piece of cherry-picking, this document is up there with the best. There is absolutely no way that the EU can agree to a free trade area whilst the UK seeks an opt-out from one of the four freedoms and at the same time shows no interest in paying into EU schemes. As a starting point in negotiations, the document has its merits but it is the paper that should have been presented a year ago – and ideally before the Article 50 process was even triggered. It is very late in the game to be presenting a plan which has virtually no chance of success, especially when the UK hopes that it can determine the basis of its future relationship as soon as the EU summit in October.

Then of course, there is the small matter of domestic opposition. The ideas set out in the White Paper satisfy neither the pro-Leave nor the pro-Remain camps because the former see it as an attempt to remain in the EU by the back door whilst the latter group view it as a far worse deal than the UK enjoys today. And both are right. There is little point in leaving to get a worse deal than we have now (as I have argued all along) and the Brexiteers are right to argue that the plan crosses many of the red lines that Theresa May has delineated over the past two years. So both have been betrayed.

To add insult to injury, the plan focuses on trade in goods and downplays services trade. This makes very little sense given the importance of services to the overall economy. As the German newspaper Handelsblatt pointed out (in English) “Theresa May's long-awaited White Paper aims to keep manufacturing in Britain, and is willing to surrender London’s financial access to the EU in return. That suits Germany just fine.” Indeed, the financial services industry can argue that it has been thrown under the bus – the one part of the economy that generates a trade surplus – with the government opting not to pursue a policy of mutual recognition for financial regulation but instead relying on enhanced equivalence in which recognition will take place on a piecemeal basis. It is not the deal that the City was looking for to remain competitive at a time when life is already being made difficult by overarching regulatory changes and general trading conditions.

Yet, despite all the carping, it is probably the best that the government could deliver under the circumstances. The hard Brexit vision championed by David Davis, Boris Johnson et al risks driving the economy over the cliff (see this clip of MP Anna Soubry blasting the ideological nature of the Brexiteers’ case). Thus, in order to avoid the worst case outcome, the government has no choice but to accede to many of the EU’s demands in order to secure access to the continental European market. Hence we will end up with a half-in, half-out Brexit that satisfies nobody.

Increasingly, there are calls for a second referendum, to which the Brexiteers respond that this would be to sell out what was decided in June 2016. Yet they have had more than two years to present an acceptable plan as to how to proceed with Brexit and have failed to do so. But they oppose the government’s plans which envisage a closer relationship than they deem acceptable, and all the while we get nowhere whilst the clock ticks down. If politicians cannot come up with an acceptable compromise, they may be forced to throw the question back to the electorate. I am no fan of a rerun (Brexit II) but I am increasingly of the view that there may be little option. Former education secretary Justine Greening yesterday called for a ballot with three options: the prime minister's Chequers deal, staying in the EU or a clean break from Europe with no deal. At least the electorate will have to think about the implications of leaving in a way that they did not two years ago.

In a way, these are the choices that we always faced: The choice was never about a straight “in” or “out”. It was always “in” or choosing the least worst version of “out”. The prime minister predictably has ruled out a second referendum. But with her position weaker than ever and with an increasingly impressive track record of saying one thing and doing another, it would be unwise to rule out the second referendum option altogether.

The laws of economic gravity

As the debate over the costs of Brexit continues to rage, it is worth taking a look at the different approaches which have been used to try and quantify the impacts. There are two main types of analysis: (i) gravity models and (ii) computable general equilibrium (CGE) models, both of which have strengths and weaknesses. Gravity models have long been used in the literature and are the economic analogue of Newton’s law of gravitation which states that the attractive force between two objects is the product of their mass proportional to the (squared) distance between them. In 1962, the economist Jan Tinbergen proposed that a similar model could be applied to international trade with the basic relationship shown below:

In other words, the trade flow (F) between two countries (i and j) depends positively on the respective size of the economies and inversely with the distance between them. In broad terms we can think of distance as a proxy for trade costs, which can have a significant impact on cross-border flows. If we take the logarithm of this equation we have a linear expression which can be estimated using standard regression techniques (in reality, the estimation methods are today quite complex but we will leave this aside). Over the years, the basic equation has been augmented with variables to take account of factors such as shared borders, common language, colonial links and whether they share some form of trade agreement (partly to explain why trade flows between countries such as the UK and US are so large), but the basic idea still holds: Large countries which are located relatively close to each other are likely to have significant trade flows. (Here for much more detail on gravity models, including a paper by Keith Head and Thierry Mayer covering all you ever wanted to know and much that you did not).

I looked at data for goods and services exports from the UK to 33 countries, representing 86% of total UK exports, over the period 1999 to 2016. If we fit a trend relationship between them, the slope of the line is negative – as theory predicts (see chart). But it is interesting that the line is less steep today than at the turn of the century. This reflects the notion often put forward by proponents of Brexit that rapidly growing markets such as China have become significantly more important for UK trade. Indeed UK exports to China rose from 0.3% of the total in 1999 to 3.1% by 2016. Over the past 20 years many commentators have suggested that distance is increasingly no barrier to trade, reflecting technological advances which have led to improved inventory management techniques and the like. But although the curve may have flattened, it is not flat, nor is it likely to be at any point in the foreseeable future. Rumours of the death of distance have been greatly exaggerated.

CGE models are much more computationally onerous but they do try to account for all the linkages between the various sectors of the economy to examine how a disturbance in one area feeds throughout the rest of the economy. They rest on the idea that there is a circular flow of income between sectors and also assume optimising behaviour by economic agents (subject to certain constraints). A CGE model of trade, looking at various sectors of the economy across a range of countries, involves a huge amount of data and one of the criticisms is that such models are often based on calibrations which may not necessarily be validated by the data (in contrast to gravity models which are estimated and therefore data coherent). But they are a useful way to understand how shocks percolate throughout the system and to that end are a valuable tool in trying to quantify Brexit shocks.

It is notable that the analysis of Gretton and Vines, which I cited in this post,  is based on a CGE model and as I noted, the welfare losses they report are significantly lower than other estimates I have seen. But the pro-Brexit group Economists for Free Trade, led by Patrick Minford, stretched the limits of CGE-based modelling too far in their latest paper by claiming that Brexit will actually lead to welfare gains. Their analysis is based on some highly dubious assumptions (which Chris Giles in the FT skewers here). I will return to the details of the Minford et al paper another time in order to look more closely at why this is a case of “garbage in-garbage out,” but aside from any issues regarding the basic assumptions, CGE analysis allows no role for economic gravitational effects. No serious analysis of trade can ignore this factor.

As the WTO put it, “the numbers that come out of [CGE] simulations should only be used to give a sense of the order of magnitude that a change in policy can mean for economic welfare or trade. But much more can be done to create confidence in the results.” This is not to say that gravity models are perfect either. But so long as the lines in our chart have a negative slope, we should never dismiss what they have to say.

Bombard(ier)ed by bad news

The news that the Department of Commerce has proposed a 219% tariff on sales of Bombardier aircraft into the United States bodes ill for the future. This stems from a complaint by Boeing that the Canadian government is subsidising sales of Bombardier’s C Series aircraft and thus undercutting Boeing’s sales of its 737 models. On the surface it thus looks as though the US government has sided with the US manufacturer in what may be the thin end of the protectionist wedge threatened by President Trump as his America First policy begins to take shape. Ironically, this comes just weeks after Boeing won an appeal against the WTO ruling in the case brought by Airbus that the US company had benefited from tax breaks in order to site a production facility in Washington state. However, the companies have been at daggers drawn for many years, with each accusing the other of receiving subsidies and there are still cases pending at the WTO between the two parties.

Ironically, one of the biggest subsidisers in the commercial aircraft business is the state-owned Commercial Aircraft Corporation of China (Comac). According to the BBC’s business editor Simon Jack, “Boeing sources tell me that the only reason they haven't taken a case against Comac to the WTO is that they cannot point to any commercial harm – yet.” But as Jack also points out, with China estimated to require another 3,200 new aircraft over the next decade, neither of the big two western manufacturers will be too keen to take China to the WTO for fear of the damage it will do to their future business prospects in China.

Indeed, this highlights the dichotomy at the heart of global trade negotiations. The US can inflict much greater economic pain on a smaller player such as Canada without fear of major repercussions than if it were to try the same tactic on China. This should serve as a wakeup call to any deluded Brexiteers who believe that the UK will simply be able to roll out of the EU in 2019 (or 2021) and blithely sign a wide variety of trade deals which will suit the UK. Ironically the news of Bombardier’s problems broke on the same day that the pro-Brexit MEP Daniel Hannan (described on his Wikipedia page as an Anglo-Peruvian journalist) announced the launch of the Institute for Free Trade which “makes the intellectual and moral case for free trade, and sees Britain’s withdrawal from the European Union as a unique opportunity to revitalise the world trading system.”

What Hannan fails to recognise is that by leaving the EU, the UK is leaving the largest and most successful free trade bloc in the world. He continues to cite the platitude that there are 165 non-EU countries with which the UK can strike better deals once outside the EU. But of these other countries, the only ones which matter are the US, which accounts for 16% of UK exports, China (5%), Switzerland (3%), the UAE (2%) and Japan (2%). If we are generous, we can include India (1%) more for its future than current importance. Adding the export share of the EU27 (47%) to these figures means that just 8 blocs account for 75% of UK exports. To put it another way, 159 countries account for 25% of UK exports. Only a crazed ideologue would believe that the risk-reward of jeopardising relations with its largest trading partner is a worthwhile endeavour. Moreover, with the US, China and India having considerably larger domestic markets than the UK, they will be in a stronger position to engage in trade deals with the UK designed to suit their own interests, as the Bombardier spat illustrates.

It is not exactly news to anyone that EU membership acts as a form of protection for the UK against the trade actions of larger economies. With politicians across Europe expressing reservations about the international repercussions of the mercurial Trump’s America First policy, it is ironic to say the least that the pro-America free traders on the Brexit wing of the Conservative Party continue to express few doubts that the UK will be able to cut a deal with the US. Yet there is potential fallout for the UK from the Bombardier dispute. The company employs around 4,500 people in Northern Ireland and at the behest of the DUP, the prime minister is believed to have raised the issue with Trump – apparently to no avail – which does not bode well for post-Brexit Transatlantic relations or indeed the future of Theresa May who relies on DUP support to remain in government. If anything, this should act as a wakeup call to those who still believe that no deal is better than a bad deal following Brexit. It cannot be stressed often enough how wrong this view is.