Can Global Britain Defy Gravity?

Grant Lewis & Samuel Lowe

This essay was originally submitted as an entry to the Rybczynski Prize 2017

Economics has taken a kicking in recent years. Deservedly, some would say. From the failure to predict the financial crisis, to the Treasury’s (and others’) terrible short-term forecasts of what would happen to the economy in the event of a leave vote, its recent public record has been far from exemplary. Even the Bank of England’s chief economist recently said that economic forecasting was “in crisis”, referring to the profession’s inability to foresee the meltdown of 2008 as economics’ “Michael Fish moment”, a reference to the much-maligned weather forecaster who very publicly dismissed a viewer’s warnings of an approaching hurricane hours before the south of England was decimated by a storm.[1]

Leave supporters have inevitably lapped this up, pointing to what they characterise as an out-of-touch academic and financial elite, talking down the sunlit uplands that an untethered Global Britain offers.

Yet the profession’s shortcomings when it comes to short-term forecasting are hardly a revelation; it has forever been a fool’s game and explains why the vast majority of economists don’t engage in it. Unfortunately for the profession, economic forecasting is usually the only bit of the discipline that the media is interested in.

But put to one side the media’s obsession with forecasts and it is clear that economics has plenty uncontroversial to say about Brexit. Indeed, there is a striking consensus among the overwhelming majority of economists about the economic consequences of Brexit. And that consensus is formed not out of guesses about what will happen to GDP and the like in the short run, but is based on the unambiguous conclusion from all economic theory, models and evidence that barriers to trade are economically damaging.

Indeed both sides in the campaign believed in that most fundamental of economic truths: that free trade is beneficial for aggregate economic welfare in the long-run. Leavers didn’t argue that free trade was bad — in fact one of their gripes about the EU was its apparent block on the UK becoming a truly Global Britain, able to strike free trade agreements (FTA) here, there and everywhere.

But where leavers and remainers disagree is on the potential benefits that FTAs with non-EU countries offer relative to the cost that would be paid by losing membership of the world’s largest and deepest, multi-country single market. The following paper attempts to analyse whether it is indeed possible to offset the costs of losing Single Market (and Customs Union) membership via FTAs with other countries.

First, the costs of losing Single Market. Economic theory teaches us that leaving the world’s largest single market (and destination for nearly half the UK’s exports) can only be economically damaging for the UK. Brexiteers have tried to dismiss this by arguing that an FTA with the EU can easily be agreed, allowing trade to continue tariff-free, as it does currently. But that sanguine view demonstrates a deep misunderstanding of the difference between an FTA and the Single Market. It is not tariffs that are often the most important impediment to the ability to trade — it is the multiplicity of non-tariff barriers, particularly in the service sector, that are more often than not the most important factors. Different rules, regulations and standards are the grit that prevents trade even in FTAs being truly free. The EU’s Single Market largely removes that grit by harmonising standards across whole swathes of the economy, allowing firms to compete on a level playing field right across the EU. And it is this that means the combined Single Market (and Customs Union) membership goes way beyond any FTA — it is to all intents and purposes a single economic area without any obstacles to the free movement of goods, services, capital and labour.

Unsurprisingly, therefore, after 43 years of EU membership and more than 20 years of the single market, the UK’s economic structures are inexorably tied to those in the rest of the EU. From the wholesale financial institutions that rely on passporting to operate across the EEA, to the car (and other) manufacturers who rely on the tariff and barrier-free trading arrangements across the EU, Single Market membership is central to the success of many British industries. In that way, EU withdrawal should not be viewed as merely leaving a free-trade agreement — it is more akin to New York deciding to go it alone and erecting barriers to trade with the rest of the US.

So, what are the costs of losing Single Market membership? This is well-trodden territory and there seems little benefit in attempting to produce our own estimates. Let’s start off instead by considering first what others have estimated a move to WTO (the so-called hard Brexit outcome) would entail. Some argue that falling back onto a WTO relationship with the EU would be bearable (and, indeed, possibly better than no deal at all), due to average most favoured nation tariffs being low.[2] However, this argument ignores the importance of the almost complete absence of non-tariff barriers within the Single Market. So while it is true to say that the UK would be starting from a position of regulatory equivalence to the EU, new compliance and safety checks and certification processes would need to be introduced as equivalence can no longer be assumed. These costs and delays, combined with rules of origin and customs checks will all begin to add up for UK goods exporters. And for certain service providers, the newly-imposed restrictions, barriers and obstacles may prove insurmountable.

In terms of the impact on trade flows, work by Dr Monique Ebell at NIESR[3] provides convincing evidence that the hit to trade would be substantial. She estimates that leaving the EU and moving on to WTO terms would result in a long-term decline in UK exports to the EU of 59%. That corresponds to a 30% decline in total UK exports.

Impact on UK exports to different regions

Source: Will New Trade Deals Soften the Blow of Hard Brexit?. Monique Ebell for NIESR (27 Jan 2017) and Daiwa Capital Markets Europe Ltd.

All other reputable estimates produce similar results — crashing out of the EU with no deal and reverting to WTO terms would result in a significant drop in trade with the UK’s largest export market. In terms of the impact on GDP, no shortage of estimates have been done[4]. And, with the unsurprising exception of that from Economists for Brexit, all predict that GDP will be lower in 2030 than it would be if the UK stayed in the EU. For those estimating the impact of a move to WTO rules, the range is from -7.8% (NIESR) to -2.6% (CEP) — either way a substantial hit to the UK’s wealth.

Impact on total UK exports

Source: Will New Trade Deals Soften the Blow of Hard Brexit?. Monique Ebell for NIESR (27 Jan 2017)and Daiwa Capital Markets Europe Ltd.

So, there is strong economic consensus on the costs of leaving the EU with no deal. What about the gains that could be reaped from all those FTAs that the UK will now apparently be able to forge, particularly if it is not particularly fussy about the terms of those FTAs, when it leaves the EU?

Let’s start off with a UK-EU FTA under which tariffs on all goods fall to zero. This would clearly be better for UK consumers as imports from the EU would not be subject to WTO tariff rates. And it would undoubtedly cushion to some extent the blow of no longer being a member of the Single Market. But it would fall well short of Single Market membership. Take the automobile sector, for example. Even the existence of a zero-tariff agreement, and continued mutual recognition of regulatory standards would not be enough to save the UK car industry from enormous disruption.

Putting to one side the re-imposition of customs checks and their potential impact on just-in-time stock management, in order to qualify for a preferential agreement, exporters are required to prove that the good being exported fulfills the country of origin requirements written into the agreement. This is currently not an issue for UK exporters to the EU, due to us being member of the Customs Union and being within the confines of its common external tariff. In the case of cars, this usually requires 50–55% local content. In the UK, the average car currently contains 41% local content.[5] These obstacles can of course be resolved in the context of the future agreement so long as both parties agree to allow for so-called cumulation[6]. However the additional costs associated with obtaining preference are unavoidable and estimated at 2–6% of the final price[7].

Tariffs and ad valorem equivalents of Non-tariff measures for exporters

Source: IoD and Daiwa Capital Markets Europe Ltd.

For the services sector, meanwhile, the existence of non-tariff barriers can be even more problematic as services are usually poorly covered in FTAs. Take the world of financial services, and in particular the wholesale financial services that the City is so successful at. At present, investment firms benefit from passporting, providing any firm registered in an EEA Member State the right to conduct investment business across the entire EEA. This passporting has allowed firms to establish themselves with a single regulated entity in (typically) London and then operate from there unencumbered by any regulatory hurdles anywhere else in the EEA. But the moment the UK leaves the EU, that passporting is lost, requiring firms to either stop conducting that business with EEA counterparties or to establish a separately-capitalised and regulated entity in the EEA. This is both a more expensive way to conduct business for firms, but also moves business (and jobs) that otherwise would have taken place in the UK to another location.

G7 service exports as % of output (2015)

Source: HM Treasury and OECD

The lack of coverage for services exports in FTAs is particularly damaging for the UK because, of all the major economies, it is the one that has the most successful services export sector, which as a share of service-sector output is the highest of any G7 economy. Financial services exports, meanwhile, are more than four times greater as a share of GDP than for any other G7 country, reflecting in no small part the degree to which London has developed as the financial service hub for the EU. Leaving the EU Single Market, but replacing it with a traditional FTA, will do nothing to offset the damage to the financial services sector from Brexit.

Financial services exports (% of GDP)

Source: HM Treasury and UNCTAD

Certainly that is the conclusion of the aforementioned Monique Ebell analysis, which estimates that while an FTA with the EU would mean that the estimated 58% drop in goods trade with the EU from leaving the Single Market would be limited to “only” a 35% drop, there would be no effect on services exports, reflecting the lack of coverage for services in typical FTAs. So, trade with the EU would drop by 45%, as opposed to the 59% drop estimated in a hard Brexit scenario. That would equate to a 22% drop overall in UK trade.

So, a FTA agreement with the EU would lower the costs of Brexit, but not by a great deal, not least thanks to the lack of provision for services. Indeed, according to the analysis from HM Treasury[8] it would reduce the economic hit by less than 1½ppts relative to a WTO scenario, leaving the UK still facing an estimated loss of more than 6% of GDP by 2030 relative to remaining in the EU.

But at least a UK-EU FTA has the benefit of proximity. While ease of access to markets via lower tariffs and non-tariff barriers are important, more important is geographical proximity — distance is an unavoidable trade barrier. For trading purposes, the large, populous, wealthy economies on our doorstep, with which we are already integrated both economically and culturally, will always be more important than, for example, a relatively small (or even very large) island on the other side of the world.

Time and time again, no matter the countries involved, the evidence remains remarkably consistent: “bilateral trade between two countries is proportional to size, measured by GDP, and inversely proportional to the geographic distance between them”.[9]

Indeed, despite a few decades of mathematical hand-wringing, the so-called gravity model of trade is now accepted as “one of the most robust empirical findings in economics”.[10] In 1997, Paul Krugman characterised gravity equations as examples of social physics — one of “the relatively few law-like empirical regularities that characterize social interactions”.[11]

So, when Liam Fox, the UK Secretary of State for International Trade, says the UK is entering a “post-geography trading world”,[12] he is wrong — geography matters now as much as it ever did.

And this is true for both goods and services, where being awake at the same time as the person you are working for, and the ease with which you can have face-to-face interaction, remains crucial. As the chart below demonstrates, the UK is no special case.

UK exports and geographical proximity

Source: ONS

So, can FTAs with other countries make up for what we lose by bowing out the Single Market and Customs Union, even if an an FTA with the EU is agreed?

Taking into account previous warning about assigning precise figures to unknowable events, in the example below the figures are presented not for their precision — what’s +/- 0.03% here or there? — but instead to draw attention to the difference in scale between the predicted long-run economic impact of Brexit and the potential benefits of future FTAs. While the figures presented are not created using identical methodologies and baseline scenarios, they were all created using the same — computable general equilibrium — modelling approach with the purpose of assessing the merits of future trading relationships, making them useful as comparators, if only for illustrative purposes.

As noted above, the long-run Treasury analysis[13] of leaving the EU and moving to an FTA concluded that the UK economy would, by 2030, be 6.2ppts smaller than it would have been if it had remained in the EU. There is no way on earth that FTAs could make up that shortfall. So to be kind to the Global Britain backers, we have instead benchmarked it against the softest of Brexits, the EEA option, where the Treasury finds we would be 3.8% poorer than we would have been had we remained in the EU.

Drawing on the economic analysis done in the context of the TTIP negotiations, it is instructive to measure this against the upper, and very ambitious, estimate of what a comprehensive trade agreement between the UK and US can potentially achieve: a long-run increase in GDP of 0.35%.[14]

This upper estimate assumes a degree of liberalisation — including the inclusion of financial services, zero tariffs across the board and the removal of a quarter of non-tariff barriers — far beyond that which is likely. The more conservative estimate sees a relative increase in GDP of just 0.14%. If this seems small, it should be noted that these figures were paraded around Europe by the UK Government as evidence of the desirability of TTIP.[15]

So, an FTA with the UK’s second-largest (and quite close) trading partner isn’t going to make up much of the shortfall. So, what about the rest? Unfortunately there is no UK-specific forecast for a deal with Japan, but we have instead used the most optimistic forecast for the EU-Japan FTA[16] currently being negotiated — the upper estimate of which is an increase in long-run EU GDP of 0.76% relative to the baseline (the lower estimate finds a relative gain of 0.39%). This is generous of us, given the UK’s reliance on services and the fact that resultant services export gains were only estimated at 5% of the EU total[17] — compared to food, feed and processed food exports, which accounted for 55% of the export gains.

Again, while not UK specific, there are also slightly dated EU forecasts available for an FTA with the ASEAN bloc — Brunei, Myanmar, Cambodia, Indonesia, Laos, Malaysia, Philippines, Singapore, Thailand and Vietnam — and the soon to be provisionally applied EU-Canada FTA.[18] These come in at +0.23% and +0.03%, respectively.

India is particularly disappointing, in that when the EU modelled the impact of a future EU-India trade agreement, it found that “the EU’s large economic base means that the changes are too small to lead to significant changes in percentage GDP growth.”[19] And while that may not apply to the much-smaller UK economy, the fact that the impact was not significant for the EU economy as a whole implies that the impact on the UK economy would also be small.

The assessment of the potential impacts of an EU-Australia and EU-New Zealand FTA is ongoing.[20] However, as trading targets of choice for many leave voters it would be rude to ignore them. So, for the purpose of this exercise, we feel a fair estimate would be along the lines of the predicted gains from an EU-Canada FTA: +0.03% for each. While Canada has lower GDP than Australia (and higher than New Zealand), this is balanced out by the fact Canada, at 3,606 miles away, is significantly nearer to the UK than both Australia (9,443) and New Zealand (11,426).

You are probably getting the idea by now. And after all of this effort, UK GDP will still be, on the basis of these admittedly imprecise, yet deliberately generous, forecasts and calculations, at best 2.37ppts — in trading terms, where every decimal counts, orders of magnitude — lower than it would have been had we simply stayed in the EU. (It should also be noted the EU has signed or is close to signing deals with some of the countries listed, so these benefits would have accrued to the UK anyway if it had remained a member).

And these conclusions align with those of Monique Ebell, who estimates that FTAs with the BRICs countries and the Anglosphere will only offset around 5ppts of the 22% drop in UK trade she estimates as a result of the UK leaving the Single Market and moving to an EU FTA.

Of course, Brexit supporters[21] argue that there are additional gains to be had from leaving the Single Market and its regulatory harmonisation. Perhaps the boost to productivity from being able to use incandescent light bulbs while vacuuming with high-powered hoovers will be significant, but the above suggests new free trade agreements alone can’t do it.

Gravity always wins.

@GrantLewis1

@SamuelMarcLowe

— — — — — — —

[1] https://www.ft.com/content/e94c96a2-d3e3-11e6-b06b-680c49b4b4c0

[2] https://policyexchange.org.uk/publication/clean-brexit/

[3] http://www.niesr.ac.uk/blog/will-new-trade-deals-soften-blow-hard-brexit

[4] See https://www.ifs.org.uk/uploads/publications/comms/r116.pdf

[5] https://medium.com/@SamuelMarcLowe/how-to-save-the-uk-car-industry-from-brexit-kinda-c99c02291026#.ibkpj8ph6

[6] https://medium.com/@SamuelMarcLowe/explaining-cumulative-rules-of-origin-2c13fb4dfca1#.xwx5timly

[7] https://www.wto.org/english/res_e/reser_e/ersd201212_e.pdf

[8] https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/517415/treasury_analysis_economic_impact_of_
 eu_membership_web.pdf

[9] http://www.nber.org/papers/w19285.pdf

[10] http://www.nber.org/papers/w19285.pdf

[11] http://www.cepii.fr/pdf_pub/wp/2013/wp2013-27.pdf

[12] https://www.ft.com/content/e456c008-8642-11e6-8897-2359a58ac7a5

[13] https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/517415/treasury_
 analysis_economic_impact_of_
eu_membership_web.pdf

[14] https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/198115/bis-13-869-economic-impact-on-uk-of-tranatlantic-trade-and-investment-partnership-between-eu-and-us.pdf

[15] https://www.gov.uk/government/news/ttip-an-overview-of-the-eu-us-free-trade-deal

[16] http://trade.ec.europa.eu/doclib/docs/2016/may/tradoc_154522.pdf

[17] ibid, page 57

[18] http://trade.ec.europa.eu/doclib/docs/2011/september/tradoc_148201.pdf

[19] http://trade.ec.europa.eu/doclib/docs/2010/june/tradoc_146221.pdf

[20] http://ec.europa.eu/smart-regulation/roadmaps/docs/2015_trade_040_aus_nz_trade_agreement_en.pdf

[21] http://www.andrewlilico.com/2017/01/09/my-presentation-to-the-aea-annual-conference-on-brexit-six-months-on/