The Economists for Free Trade group has argued that contrary to the predictions of many economists, Brexit could provide gains to the UK economy of around £135 billion. Kent Matthews argues that the differences between Economists for Free Trade and other economists stem from distinct theoretical assumptions about how trade functions, and that the only way to resolve this debate is with careful empirical testing of each model.
Sunrise on Canary Wharf, Credit: Davide D’Amico (CC BY-SA 2.0)
Distinguished economists (let’s call them Economists for Remain) challenge the argument made by Economists for Free Trade that leaving the EU will be positive for the UK economy. In particular, even under the best case assumptions, exit from the EU, according to these economists, will lead to a loss of trade, a loss of investment and a loss of welfare to the UK. In contrast, Economists for Free Trade estimate a gain in trade, a gain in investment and a gain in welfare to the tune of £135 billion. Economists are notorious for disagreeing with each other, but such diametrically opposing views deserve some explanation.
The economists in favour of remaining in the EU make the point that a hard Brexit, meaning leaving the Customs Union and the Single Market, will damage UK exports to the EU and also weaken Foreign Direct Investment (FDI), leading to a rise in unemployment and a fall in long-run GDP. They base their reasoning on the ‘gravity model’ of trade which assumes that a country has the greatest trade with geographically closer countries. Hence reducing trade with the EU will not be made up by increasing trade with the rest of the world that is further away. This sort of reasoning has a Keynesian flavour to it – a reverse Says Law, which is that demand creates its own supply. In contrast, Economists for Free Trade use the ‘Classical model’ based on comparative advantage, where the marginal reduction in exports to the EU is assumed to be sold to the non-EU at world prices. In this world, Says law operates as in Classical thinking – ‘supply creates its own demand’.
A hard Brexit means that the UK will face the Common External Tariff (CET) that all countries face exporting to the EU. This in turn will lead to a fall in demand and there will be no seamless production space between the UK and the EU. The result will be a fall in FDI and domestic investment, which reduces productive potential and lowers full capacity GDP. But what about the Brexit devaluation of sterling? Surely this must mitigate some of the damage of the CET? Not quite say the economists in favour of remain. First, the biggest barrier to trade is non-tariff barriers (NTBs), and second, exporters to the rest of the EU will notice that while their selling prices have fallen in euro terms, the cost of their imported intermediate inputs from the rest of the EU will have risen by the extent of the devaluation. The competitive advantage of the devaluation is lost because of the deep integration of UK manufacturing into the rest of the EU supply chain.
One might make the point that the UK is currently in the Single Marker and therefore meets all current non-tariff barriers. These non-tariff barriers are basically common quality standards and of course the EU can create new ones that raise costs for UK exports (they also raise costs to themselves by doing that but let’s ignore that possibility). But any exporter to a country must meet the quality standards expected from that country and that will be true for trade with the rest of the world as for the EU. So let’s look at the second issue which is the effect of the devaluation on competitiveness. The selling price of exported goods will be made up of the unit cost of imported intermediate products and the cost of domestic factors of production. Because the sterling devaluation will raise the price of imports and therefore domestic prices, these will feed into the cost of domestic factors of production and so the gains from the devaluation will be marginal, according to these economists. UK exporters to the EU will face the full force of protective tariffs.
At this point we can discern the first major difference between the two camps. Economists for Free Trade interpret hard Brexit to mean a commitment to free trade and the removal of all tariff barriers to imports, and the abolition of the Common Agricultural Policy (CAP). Second, Economists for Free Trade assume a bonfire of EU red tape and a more balanced approach to regulation. The latter is expected to generate investment and improve productivity, but the former reduces the price of food which feeds into the general price level which in turn will moderate any effect the devaluation has on domestic costs.
So there will be a significant competitive gain. The effect of lower food prices will also increase the real income of households but particularly at the low end of the income distribution – tackling poverty at a stroke and improving welfare. The removal of the CAP will reduce the margin of cultivation in agriculture, as production becomes uneconomic, and reduces the demand for unskilled EU labour. This will also have the benefit of eliminating the taxpayer subsidy to unskilled EU immigrants in the form of health and welfare state benefits. The net effect of all this is to increase real GDP by about £135 billion or 7 per cent of GDP.
The Minford Research Team at Cardiff use a calibrated model to estimate that the adoption of free trade and the abolition of CAP will increase GDP by 4%. A further 2% comes from the removal of EU regulations that hinder innovation and productivity. A further 0.2% comes from the removal of the taxpayer subsidy to unskilled EU migrants, and a further 0.8% gained from the saving of the net contribution to the EU.
Of course these numbers come from the numerical exercise of a Classical type of economic model and critics might want to examine the structure and parameters of every behavioural equation contained therein. Nobody would deny that free trade is superior to protection. It is what I was taught as an undergraduate at LSE. But in the context of Brexit, in essence we have two views of the world – ‘gravity’ versus ‘Classical’, and two scenarios; free trade and all its regulations within the protective wall of the EU, or free trade outside the EU facing EU tariffs and with regulations determined by the UK government.
Perhaps the Cardiff team have overestimated the parameters that drive the benefits and underestimated the parameters that drive the costs. But in the end this is an empirical matter rather than a theoretical one. The debate should be based on empirical testing of the different models (views of the world). The economics profession and the policy maker would value such a debate.
Please read our comments policy before commenting.
Note: This article gives the views of the author, not the position of EUROPP – European Politics and Policy or the London School of Economics.
_________________________________
Kent Matthews – Cardiff University
Kent Matthews is Sir Julian Hodge Professor of Banking & Finance at Cardiff University.
It is refreshing to see a view other than the doom and gloom predictions of economists with a Remain, institutional bias.
That doesn’t mean the Leave economists MUST be better predictors – but surely it is better to be aware of two models and test both?.
The problem with the Remain economists is that they assert with absolute confidence two things that “will” happen – and even if they do, no mitigations are likely.
“ ….that a hard Brexit, meaning leaving the Customs Union and the Single Market, WILLl damage UK exports to the EU”
“A hard Brexit means that the UK WILL face the Common External Tariff (CET) that all countries face exporting to the EU “
Neither is a given.
The EU could behave rationally and accept that the continuance of free trade with the EU’s biggest export market is desirable.
The EU could recognise that product standards are immediately complient – so a seamless (non “cliff-edge”) transition is do-able.
The EU could decline to impose the CET assuming that the UK does likewise.
Remain economists may take the view that the EU is NOT rational (or has a different “rationality”).
OK – so say “probably” !!
Then there is :
“UK exporters to the EU will face the full force of protective tariffs. “
Some have said that the average tariff (assuming applied) is 4%.
So in reality any problems would be the sectors where tariffs are much more than 4% – e.g agriculture.
But the UK is NOT self-sufficient in food – so with co-ordination and planning even these impacts can be reduced as home (and non-EU) markets develop.
Meanwhile the rest of the economy can surge ahead free from the restraints of the EU and its Single Market (with all its extra baggage)
These comments are a little off, if I may say. There isn’t a concrete definition of what a hard Brexit entails, but if the term has any meaning it’s that we would leave and trade with the EU on WTO terms. Yet you’ve said that it would be a mistaken assumption to assume that a hard Brexit means “the UK WILL face the Common External Tariff (CET) that all countries face exporting to the EU”. If it doesn’t mean that then I’m not sure what the utility in using the term hard Brexit is (and so we enter a semantic loop of what a hard Brexit really means).
Under all reasonable assumptions, as Kent Matthews pretty much says above, we would expect trade with the EU to be on worse terms after leaving and pursuing a hard Brexit. For that not to be the case we would need to have exactly the same access as we enjoy today, have no non-tariff barriers (probably meaning we have to implement EU regulations as our own), and yet opt out of ECJ oversight, free movement, and all the other promises the PM has earmarked at the same time. I can’t see a single reason to think that is going to happen and any model is going to be based on reasonable assumptions. The scenario you’ve sketched out here is something that is technically possible if the EU decides to give us that deal, but unthinkable for anyone following the negotiations. There isn’t any great merit in constructing models based on scenarios that most people are aware are not going to happen. Nor is there any great merit in raising these scenarios for the sake of using them as a stick to beat the EU with.
Matthews doesn’t do that here and I’d say his argument is a lot more sensible. He’s starting from the point that leaving the EU on WTO terms would be a negative and proposing a policy that can make up for that shortfall. He’s not saying that leaving the EU on WTO terms won’t affect trade with the EU, he says that “the marginal reduction in exports to the EU is assumed to be sold to the non-EU at world prices” (or to put it another way, we make up for losing trade with the EU by being more open with the rest of the world).
“Removal of red tape: How is it cheaper to fulfill 27 different sets of rules, regulations and standards than just one (for single market)? Or does the Minford group assume no trade at all between the UK and EU after Brexit?
Contradiction in paragraph: Following the author’s line of argument, the elimination of CAP will also “educe the margin of cultivation in agriculture, as production becomes uneconomic”. so less food production in the UK and even more dependance on food import; imported food will be, however, more expensive due to the devaluated £. So how does this support lower food prices again?
GK
Where are the “27 different sets of rules, regulations and red tape”?
Isn’t there one set in the EU?
And the point is – the UK will be perfectly compliant.
If you are talking about the idea that each country in the world sets its own requirements – yes, a sovereign country can do that.
But in reality there are over a hundred World Trade bodies, constantly trying to co-ordinate and standardise.
Take cars. There may not yet be one world standard – but how many national variations are there?
Two, four, eight, ten ?? – but not 212 (or whatever UN membership is)
Agriculture /food costs.
I admit my memory is hazy …. but doesn’t the EU impose tariffs on imported food – from (say) 12% to 27%???
If the UK can import those foods without having to charge those tariffs then that would mean cheaper food.
Whether that offsets a lower £ is another thing.
(Feel free to correct me.)
“If the UK can import those foods without having to charge those tariffs then that would mean cheaper food.”
It would also mean all of the farmers who are protected by those tariffs would no longer be protected and would go out of business. Shouldn’t we ask farmers what they think about that first?
We already have some empirical testing of economic models. The Treasury predicted the short term outcome in the event of a Brexit vote. They gave particular figures for the first 2 years after the Referendum. So far it doesn’t look like their model is that good.For example they predicted a fall in employment where we are now being told that business are suffering because there is a shortage of immigrant labour.
I appreciate the arguments put forward in this article. Although I disagree with them, I think they are put forward in a fair way, which is nice to see given the disingenuous style of campaigning that we often see from those in favour of leaving the EU.
With that said, we know, and this article agrees, that leaving the EU on WTO terms and trying to carry on as normal would do economic damage. What Economists for Free Trade are arguing is that if we did something incredibly radical (abolishing all tariffs unilaterally for every state in the world and subjecting the economy to extreme deregulation) the effect of these new policies would cancel out the negative effects of having trade barriers develop between us and our largest export market. It’s a bit like saying we’ve lost the game of chess so let’s throw the board on the floor and play a different game.
The problems with this kind of solution are obvious. No government could possibly implement this model the way it’s described. Governments have to protect sectional interests like the livelihoods of farmers, which is one of the main reasons why we have tariffs on food produce. Doing what’s being prescribed here would wipe out our own agricultural sector, as the author acknowledges in saying that “the removal of the CAP will reduce the margin of cultivation in agriculture, as production becomes uneconomic”. That’s another way of saying almost every farmer in the country will go out of business because they can no longer compete with the cheap produce that will flood into the UK market. It’s fine to make that argument for free trade (that farmers losing their livelihoods will be counterbalanced by people getting cheap food making society better off overall) but how can any government actually do that in practice? It would be politically impossible and would have farmers up and down the country protesting on the streets.
Deregulation is a similar story. Someone can create an economic model saying that scrapping huge amounts of regulation would boost the economy by a certain amount of GDP. But if you do a cost-cost analysis of what regulation brings to the economy it’s always going to end up in a negative figure. We have regulations to protect society from undesirable consequences (we’ve seen plenty of these recently: Grenfell, food scares, protests about zero hour contracts, abuse of the minimum wage – which, we have to mention here, Patrick Minford was very strongly against and claimed would see a very large increase in unemployment that never occurred). There’s no reason to think that extreme deregulation of the economy would be any more politically palatable than unilaterally scrapping all tariffs. What we’re doing here is taking theoretical extremes that couldn’t possibly be used in reality and using them to tilt the scales to make up for the real world deficiencies in what a hard Brexit will actually mean for the economy.
In fact I would argue that if this kind of extreme solution is necessary to make Brexit work then we already have proof it’s a failure. If this is the best case anyone can make for it (and I think that it is – you can see that by the fact Economists for Free Trade are the only group ever quoted by leave campaigners) then that’s even more damning.
It will always be possible to tilt all the variables to one end of the scale like this to try and win an economic debate (in Scotland there was the same thing with the pro-independence side saying they could just refuse to pay any of the UK’s debt and make up for any economic weaknesses that way). What matters is what’s feasible in reality and there is nothing feasible about this. That’s even assuming it would work in the first case and wouldn’t just create huge unintended consequences, which it undoubtedly would do. I can’t imaging anything like a majority of UK citizens would vote for this kind of radical reshaping of society – the Leave vote was far more inclined to back protectionism, not a unilateral abolishing of all tariffs.