Long-Term Economic Impact of Brexit

Introduction

Brexit is clearly a big event in UK history. The economic effects will play a key, if not leading, role in assessing its impact. Understanding what may happen, and why, is important. My goal for this post is to present a digestible (and short-ish) summary of all the work done in estimating the long-term effects of Brexit that illustrates how reports differ in terms of assumptions and methods.

By exploiting the common elements of all expert reports, I hope to clearly convey the differences so that you can make your own judgment on what the cost may be (while at the same time expressing my own opinion on what is more appropriate) without having to read all the reports. At the very least, it will steer you towards reading the reports you find more convincing.

My view? The cost is clearly negative. The closer we remain to maintaining the status quo of EU membership, the lower this cost. Based on a central scenario commonly used, conservative estimates range from a 5% to 7% permanent loss in annual income. In short, a pretty big cost!!

Context

Membership of the EU has a huge impact on the UK economy. This is primarily caused by bolstering UK trade with the rest of the EU via the creation of the Single Market.

The EU Single Market facilitates substantial intra-EU trade. Firstly, by being a customs union, trade is tariff-free with no punitive “rules of origin” border checks. Secondly, all members gain free trade access to around 55 other markets via agreements negotiated by the EU. Thirdly, there exists free movement of capital and labour, a crucial component that speeds up the “catching-up” process of members economically, which greatly enhances services (esp. financial) trade.

On top of this, the EU has made huge progress in creating common regulatory standards, thus removing regulatory barriers that are becoming increasingly important in encouraging trade within a low-tariff global economy. This, however, comes at the price of modest EU Budget contributions.

The result for the UK joining the EU? An increase in the share of UK trade going to the EU (see chart 1 below). This is particularly stark given the declining share of the EU in the global economy.

This vast increase in EU trade volumes has undoubtedly improved the standard of living within the UK. Consumers gain access to more affordable imports via lower tariffs, and also enjoy a wider variety of choices due to the enhancement of import volumes. Businesses benefit from gaining preferential access to a larger market, enabling them to take advantage of what they produce most effectively, thus raising profits. Moreover, this specialization increases the wages of workers assigned to more productive tasks. All-in-all, a great big party!

Brexit Scenarios

So what does Brexit actually mean then? Well, given the complete lack of clarity both before and after the referendum as to what it implies, this is anybody’s guess. All one can rest on is past precedence and broad agreements. Consequently, almost all reputable reports perform comparative analysis based on some or all of the three following broad long-term outcomes for the UK, from least to most punitive.

1. European Economic Area (EEA) — This contains Norway, among others, and the EU. It preserves free trade and maintains substantial regulatory co-ordination, permitting the continuation of many key non-tariff advantages, such as Passporting rights (the requirement to satisfy just one country’s regulations to gain access to all of EEA) that are vital for financial services exports (40% go to the EU!). This, however, comes with EU budget contributions, free movement of labour, “rules of origin” checks, loss of EU-negotiated trade agreements with non-EU members, and a loss of sovereignty by accepting EU regulation that it has no voting power over. This, perhaps, is too far from the Vote Leave Brexit mandate.
2. (European) Free Trade Agreement ((E)FTA) — Unlike the EEA, this is an agreement with the EU specific to each country. Thus, its characteristics are hard to pin down. But based on past precedence, such as Switzerland and Canada, it is likely to contain tariff-free trade. However, “rules of origin” checks return and only moderate regulatory co-ordination is maintained, meaning significant regulatory barriers emerge over time as UK and EU regulation diverge. This will likely result in the loss of passporting rights, a huge blow to financial services. This, however, comes with lower EU budget contributions, no free movement of labour and, like EEA, an ability to make own trade agreements with non-EU members.
3. World Trade Organisation (WTO) — If talks between the UK and the EU completely break down, then trade terms will devolve into WTO terms. This sets a limit on tariffs between WTO members for goods, but nothing on services, thus crippling financial services exports. With no regulatory co-ordination, this will painfully inhibit UK-EU trade, with the silver spoon of no EU budget contributions and full liberty to negotiate trade deals worldwide. For everyone’s sake, let’s hope this scenario is a mere bad dream.

Many economic research hubs have taken these scenarios, have seen how they impact trade volumes, among other factors, and have assessed how such shocks impact the performance of the economy in the long-run, using sophisticated models that incorporate trade linkages that adhere consistently with robust empirical work that explain the determinants of trade volumes and compositions (NIESR’s NiGEM and CEP’s CGE model, for example).

Impact on non-EU Trade

Before going further, note that I only discuss the costs coming from changes to EU trade terms, not non-EU. This may seem like a major omission. However, almost all reports do this. Why? Firstly, deciding what agreements will be is completely arbitrary due to the lack of relevant precedence. Secondly, the status quo is very favourable to the UK given their access to EU agreements, and are highly unlikely to be replicated, or “grandfathered” given the UK’s inferior negotiation power due to its relative size. Thus, if anything, its omission causes an under-estimation of the costs of Brexit.

In any case, as an exercise, CEP and Open Europe assess the long-run impact of removing all import tariffs for all goods and countries (consumer benefit). The increase in GDP is either 0.3% (CEP, 2016(a)) or 0.7% (Open Europe, 2016) by 2030, but requires complete foreign access to all markets, including agriculture. This exposes the UK to fierce foreign competition, resulting in substantial short-term unemployment and gradual reallocation of resources away from inefficient industries. This is surely not something politically palatable if returns are small at best.

So why are the returns so small? Firstly, tariffs are small globally anyway, meaning trade agreements based on tariffs alone for goods provide limited benefits. Secondly, such markets are geographically far away, meaning transport costs are more important. Finally, what’s key now, especially for services, is the removal of regulatory barriers, which take very long to negotiate and require a large build up of trust. Assuming such agreements occur with looming EU negotiations is optimistic to say the least.

I now attempt to bring together all the main Brexit reports to provide you with a solid picture of the general consensus. All estimates are based on the long-run impact to GDP relative to the baseline of remaining within the EU. All reports I use consider either Static Costs or Dynamic Costs.

Static Costs

So what are static costs? These represent the direct impact on domestic production caused by the imposition of trade barriers with the EU. As NIESR, 2016 explains, the dominant effect is the falling market share of UK firms in the EU market as tariffs / regulatory barriers make trade more costly, and so they become less competitive abroad. Also, consumers lose purchasing power with higher import prices, and so purchase fewer goods. Moreover, as NIESR notes, Foreign Direct Investment (FDI) declines as UK becomes a less attractive destination for investment, which lowers GDP. When inserted into models, the consequent £ depreciation only partially mitigates the direct cost.

So what are the main sources of these static costs? As CEP, 2016(b) explains, it can subdivided into three main components:

1. Tariffs
2. Non-Tariff Barriers (NTBs) — this covers barriers that become immediate. This is mostly “border checks” upon leaving the customs union, but also regulatory differences that become immediate.
3. Future Integration — this is the gradual build-up in cost coming from deviations in UK vs EU regulation.

CEP, NIESR and Open Europe perform Static Cost Analysis. I break it down into these three components, FDI and the assumed fall in EU contributions. Both consider the EEA and WTO scenario. The cost is in terms of lost annual output vs. the status quo of EU membership.

The range varies from -0.8% to -1.5% under EEA and -2.2% to -3.1% under WTO. Notice that tariffs have a small overall impact as they remain relatively low under WTO. More importantly, it is because imports are not so price sensitive, and instead are more impacted by NTBs, counter to assumptions made in other non-reputable reports (e.g. Economists for Brexit).

So why the difference in estimates? The key differences in the reports are:

· NIESR’s Trade Reduction figures are considerably larger than CEP. NIESR takes a very comprehensive conclusion from empirical work that assesses how NTBs change with EEA or WTO, whereas CEP hones in on one very conservative estimate. This dampens the CEP’s cost.

· NIESR believes government income gained from EU contributions to have no long-term effect, as it gradually crowds out private consumption in the long run. The other reports assume it retains its full effect.

· CEP has higher costs in the long-run despite lower trade effects as the £ depreciation in their model is smaller than in NIESR’s NiGEM model.

· NIESR includes FDI effects on investment volumes; the others don’t.

· Open Europe assumes that NTBs have a smaller impact on the economy. Each report has its own justification. NIESR and CEP base it on observed differences in market shares between EU and EEA, while Open Europe is much more opaque in this instance, which I suspect is driven by their relatively constructive perspective on Brexit.

Regardless of the report you prefer, the picture is pretty bleak. They are also very conservative. None consider a substantial broad rise in services tariffs under WTO that have no upper bound, unlike goods tariffs.

Dynamic Costs

The static approach, however, assumes that lower trade volumes have no impact on productivity i.e. output per worker. This is an unrealistic assumption. Empirical work abound illustrates how TFP (productivity) rises with trade, FDI, and foreign-based managerial quality (See Feyrer, 2009, 2011, Fournier et al, 2015, Bloom et al (2014), among others). Increased openness to trade allows productive firms to gain access to a larger market, meaning that competitive domestic firms flourish, while unproductive firms succumb to international competition. Rising FDI provides investment into capital for the future production of goods that otherwise wouldn’t occur. EU membership enhances UK FDI flows.

Two approaches are made to assess the impact of Brexit on FDI and so output:

1. Statistics-based — CEP, 2016(a) and HM Treasury, 2016 perform this method. In this case, they take an empirical relationship between TFP vs trade and FDI, using previously chosen values of the impact of Brexit on trade and FDI. No models are used and hence is very ad-hoc. Consequently, both reports are conservative in their analysis by considering the low-end of estimates and/or focusing on trade or FDI only.
2. Model-Based — This builds on the static model by incorporating a TFP shock, the size of which comes from similar estimates used in the statistics method. The model approach, in my opinion, is more consistent as it builds directly from Static Costs.

Naturally, then, it is important to compare what estimates the reports use in determining the impact of trade on TFP. This forms the basis of their results. As Table 2 illustrates, CEP is a clear outlier. However, as CEP rightly points out, Feyrer (2011) only looks at the impact over an 8 year horizon, whereas Feyrer (2009) looks further out to be more consistent with the long run.

In any case, Table 3 below presents the results from the four main reports, where it also shows what kind of TFP shocks are included. I show the estimates from the central EFTA scenario along with the EEA-WTO range. Reassuringly, the results are within a reasonably tight 5–6.5% range from different methods.

(Unfortunately, I cannot include IFS’s estimates in this report due to a lack of available information on its breakdown. I have also deliberately removed the Economists for Brexit report as it’s widely considered to be, well, complete rubbish. Read CEP, 2016(c)).

At first glance, CEP is mid-range despite a higher TFP effect. This is because it excludes any other forms of shocks or static analysis, unlike the Treasury who include TFP shocks from falls in FDI, and the NIESR who incorporate static costs within the model. Consequently, all reports are conservative in their own respect.

Notice how the OECD, 2016 report includes the effects of R&D, regulation and Managerial Quality on TFP. However, I strongly disagree with the inclusion of regulation. Firstly, the estimated deregulation upon EU exit is a “finger in the air” process, unlike the other relations. Secondly, and more importantly, EU exit is likely to cause more burdensome regulation. It is already 6th in the World Bank’s “Ease of Doing Business” ranking, implying that room for improvement is limited, and is hard to justify the EU being the barrier as Denmark, a fellow EU member, is ahead of the UK in the rankings. Granted, some EU regulation is costly, but removing those that are, such as the Working Time Directive and renewable energy incentives, is very unlikely to receive much political support. IN ANY CASE, it is overlooked by the OECD that the UK must satisfy EU “equivalence” in regulation if it wants to trade with the EU, thus inhibiting UK vs EU regulatory divergence in the first place. Thus, the OECD’s Brexit cost estimate is very conservative.

Conclusion

I’ve rarely come across a better example of economic self-harm amongst the developed world than Brexit. This has lead to a quite unfamiliar consensus amongst economists. Conservative estimates of the cost of the central EFTA scenario ranges between 5% and 7% in terms of permanent losses in annual income. The closer we maintain the status quo (e.g. EEA), the lower the cost, while any deterioration in negotiations would exacerbate the damages.

For the meantime, one can only wait and see what the eventual outcome will be, which could easily take over a decade. What happens in the interim is completely dependent on political and economic developments. The longer the uncertainty prevails, the more painful the experience will be. At least from an economic perspective, let’s hope this is all a nuisance of a nightmare that we soon wake up from…

Bibliography

CEP, 2016(a); “Conseqeunces of Brexit for UK Trade and Living Standards”.

CEP, 2016(b); “Should we Stay of Should we Go? The Economic Consequences of Leaving the EU”.

CEP, 2016(c); “Economists for Breixt: A Critique”.

Open Europe, 2016; “The Consequences, Challenges and Opportunities Facing Britain Outside EU”.

NIESR, 2016; “Modelling the Long-Run Economic Impact of Leaving the EU”.

Feyrer, 2009; “Trade and Income — Exploiting Time Series in Geography”, NBER Working Paper No. 14910.

Feyrer, 2011; “Distance, Trade and Income — The 1967 to 1975 Closing of the Suez Canal as a Natural Experiment”, NBER Working Paper No. 15557.

Fournier et al, 2015; “Implicit Regulatory Barriers in the EU Single Market: New Empirical Evidence from Gravity Models”, OECD Economics Department Working Papers, No. 1181, OECD Publishing.

Bloom et al, 2014; “The New Emplirical Economics of Management”, Journal of the European Economic Association, Vol 12”.

Egert and Gal, 2016; “The Quantification of Structural Reforms: A New Framework”:, OECD Economics Department Working Papers.

HM Treasury, 2016; “HM Treasury Analysis: The Long-Term Economic Impact of EU Membership and the Alternatives”.

OECD, 2016; “The Economic Consequences of Brexit: A Taxing Decision”, OECD Economic Policy Paper