Gravity models, free trade and game theory: How the bien pensant ‘experts’ of the Remain camp allowed their prejudices to distort their thinking

Gravity models, free trade and game theory: How the <i>bien pensant</i> ‘experts’ of the Remain camp allowed their prejudices to distort their thinking

Next week sees the opening of Parliament, the commencement of Brexit talks, and – gloriously – the anniversary of the Brexit vote winning the referendum. As the debate rages on as to what our approach and objectives should be in the negotiations, it is a useful moment to reflect on the continued role of Michael Gove’s infamous ‘experts’ in the ongoing debate. Early on in Michael’s Sky TV interview, on June 2nd 2016, he had got so far into his sentence as to say: “we’ve had enough of experts…” before he was furiously interrupted by Faisal Islam, holder of an economics degree from Trinity College, Cambridge. Faisal expressed outrage at Gove’s unintellectual comments. Gove explained, soon after the interview, that had he been allowed to complete the sentence, it would have been along the lines of “we’ve had enough of ‘experts’ from 3-letter acronymic organisations” (with their doomy prognostications of a Brexit disaster).

Michael’s comments were right on the button. These ‘experts’ – from the IMF, from the Treasury, from the LSE, from the OECD, and on – used, and continue to use, the same economic model, hold the same identical passionate convictions that we are better off in the EU, and during the campaign gathered solidly together in a group of chums, all articulating the same gloom and despair. They said that Armageddon would commence on June 24th, 2016 – a forecast they perforce have had to pull back from, now saying that disaster (these days, postponed on a rolling basis) will come later – but why believe them now when they were last year so wrong? Gove has certainly been proved correct so far: even if, for any one of a number of possible non-EU related reasons, the economy turns down in future years, Gove’s attack on the part these economists played in Project Fear has already been entirely vindicated.

Brexiteers could all see clearly, in May and June 2016, how heavily these ‘experts’ were putting their thumbs on the scales of their analysis. Do you remember the Treasury’s hysterical April 2016 paper? Remember how many thousands of pounds each household was going to be worse off in 2030, due to Brexit? Remember how flaky a conclusion, when we read the small print, that turned out to be? There were, hilariously, under half a dozen lines of analysis, in that report’s 201 pages, that addressed what benefits we might get out of leaving the European Union. Those lines stated something along the lines of “we have not been able to think of anything, under current and popular (therefore unchangeable) legislation, that would benefit the UK from leaving the EU. Therefore, as to what gain there might be from leaving, we have put in zero”. No improved prices to consumers from escaping the Common Agricultural Policy. No improvement to the economy from regaining control of our fisheries. No possible improvement in, for example, the clinical trials industry, where in 2001 we had 12% of the global market – before a Brussels Directive (which could after Brexit be removed) knocked that share down to between 1% and 2%. Nope: nothing.

At the time, it was clear to me, as to many, that these ‘experts’ had gone in with a biased view, but my knowledge of advances in Trade Theory had diminished steadily over time since I left MIT in 1976: I was intrigued, but had no time then, to look into their model. And in the hurly-burly of the referendum most of the small number of Brexit-favouring economists were too pressed to attack those gloomy prognostications at the detailed theoretical level that would be required. (The Economists for Britain group did hard work in this regard, but there was never any systematic takedown of the Remainers’ economic model at the time.)

The approach the UK takes, post Brexit, to Free Trade is clearly going to be absolutely crucial in ensuring prosperity going forward. Analysis of the assumptions and perspectives used by that acronymic horde of Remainer economists is, in fact, a useful beginning in sorting out what the UK’s approach to negotiation should be. With more leisure, even with the briefest of reviews of the models used, it becomes clear that these Remainers allowed their personal prejudices to become mixed with their professional knowledge in such a way that they did all become, entirely incorrectly, convinced – some still are – that Armageddon will result from the Brexit vote. In so doing, these Remainer economists used and still use, or more properly one might argue abused and still abuse, three core economic concepts:

  1. The ‘Gravity Model of Trade’ Theory
  2. ‘Free Trade Theory’
  3. Game Theory.

Let us review each in turn.

  1. The ‘Gravity Model of Trade’ Theory

An understanding of the Gravity model is key to realising why forecasts of disaster were so eagerly and aggressively put forward. If you look at the current state of the art in academia in Trade Theory, you find that the ‘Gravity’ model usually dominates discussion.

What is this model, and why is it so influential? The idea behind this theory is that trade barriers will dominate in determining trade between any two countries. While these barriers are many, the key empirical finding is that distance becomes a predominating factor: the further away a trade partner is, you are going to trade with them dramatically less, the way the force of gravity decreases as the square of distance: the obstacles to trade increase, and therefore its success decreases, logarithmically with distance. Thus, taking the distance element (which seems often to serve in these ‘Gravity’ discussions as a proxy for other more complicated effects), then if the barriers to trade with a very near neighbour have a power of 1, then those of another neighbour not too far further away have a power of 10; go further away and the power is 100; and all the way round to the other side of the world, why then: the power of the barriers to trade is 1000 times as great as that of the barriers of the very near neighbour.

It can be immediately seen from this that, using any model that incorporates that assumption, the conclusion is certain to be that it is insane folly to risk diminishment of trading with the EU, while going for augmentation of trade with the rest of the world. How could it possibly be that anything but disaster for such an approach would be forecast by a model with such assumptions? It couldn’t – think how the logarithmic math in that model will automatically forecast disaster – and so all those acronymic experts were able to assert quite confidently that only an abject ignoramus would advocate leaving the Single Market and the Customs Union, and that only disaster could ensue from Brexit.

Of course, when I put it like this, any ordinary person (and indeed top economic academics) can see that there must be things to take into account other than this alleged ‘gravity’ effect, and that there are a welter of examples around the world that show it can’t be completely dispositive. My point is that first, this gravity model is massively embedded in the lectures at LSE, MIT, Stanford et al. – this is the model that professional economists almost invariably are taught to use to forecast the result of this or that trade action. Second – and crucially – since it so neatly fitted in to what they all wanted to hear, these economists looked no further than such a model in forecasting calamity, and ignored all the caveats that even their own side theoretically acknowledged. Cue for the IMF, OECD, Treasury, MIT, LSE et al to cry ‘woe’, and bring down on us, throughout the referendum campaign, the full weight of Project Fear.

What are the arguments against using that Gravity model (at least, in the way it has been used)? For a start, the original model was built in the mid-1980s. The core data on which it relies are from the 60s, 70s, and early 80s. There’ve been updates on a few individual countries since then, but even those (US 2008, France 2009) had to look back to previous decades to get their data. We were an entirely different world then. Containers had hardly been invented; the rise of China had not happened; and – hello – for most of that time the Internet had not been invented. Thus, barriers to trade, a huge proportion of which have now been smashed, may indeed have imposed, in the 1980s, a ‘tyranny of distance’ on trade success – but then is absolutely not now.

That distance can’t do that good a job on prohibiting trade success can be easily seen from multiple examples of successful trading nations. China is clearly the most obvious example: how could it possibly have been so successful in trading all over the world if the gravity model was true? China’s most successful export market is the US. And beyond China, when we look at other countries, whether Japan, New Zealand, Singapore, Chile, all have showed the ability to grow their trade massively with the rest of the world, despite any ‘tyranny of distance’ or other trade barriers.

Conversely, Michael Burrage’s excellent work for Civitas in early 2016 – see also his take down of the Treasury model – showed that since the advent of the Single Market in the EU, growth in trade from EU country to EU country had been lower than growth in trade to the EU from countries on the other side of the world – a ringing disendorsement of the benefits of proximity, or indeed the alleged ‘benefits’ of the Single Market.

There may even have been a bit of a false positive in those 1986 Gravity results, created by none other than our own dear UK. When we joined the EU in the mid-1970s, we had flourishing trade with the Commonwealth, all over the world. But a few years later, that trade had collapsed, while trade with the EU had tripled or more. Surely this proved the ‘tyranny of distance’ theory, showing that we were better off trading with our near-neighbours? Well: no. All this showed was the power of erecting the EU’s massive tariff barriers against the Commonwealth, and removing them from our trade with the EU. Trade barriers such as lack of common standards, and personal tastes, were worse with the Common Market than with the Commonwealth. But with these new tariff arguments, goods from Germany and France instantly became far cheaper to us, and those from the Commonwealth more expensive. The change in trade patterns had everything to do with tariff trade barriers – something I discuss further in the next section. But, did that UK data skew some of the Gravity model findings?

In any event, overall, an excessive reliance on the Gravity theory and its historical statistics in the acronymic experts’ models, that they used to forecast disaster after Brexit, was in my opinion foolish, displaying the classic blinkers of academia. Yet it fell beautifully into what that crowd wanted to present, so nobody stopped to question how true to the modern world it was. Every effort was made to broadcast its doomy conclusions upon a worried world. Indeed, George Osborne’s Evening Standard is busy resuscitating this discredited line by again banging on about the supposed indispensable benefits of the Single Market. Well done, Michael, for calling out that buffoonery before: please make sure to continue to do so.

  1. ‘Free Trade’ Theory

Now, here’s the puzzle: just as strongly held as the Gravity theory, among academics at all the bien pensant top universities, is the theory that proclaims the wonders of Free Trade. We are all constantly told that Free Trade, at almost any cost – even unilateral Free Trade – increases welfare in the country that adopts it. NAFTA, TTIP, the EU’s as yet unratified deal with Canada: all of these are built on the idea that both demolishing tariff barriers, and allowing competing standards to prevail, are good for everybody.

So, why were all these economists against leaving the EU, so as to allow us to make Free Trade deals with the rest of the world – something that EU membership barred us from doing? After all, the majority of our trade is with the rest of the world, and the EU is only 20% (and rapidly declining) of World Trade.

First, of course, there is the major issue of tariff barriers. While the Remain crowd constantly talk about the benefits of the ‘Customs Union’ and the ‘Single Market’, this wording faux-naïvely conceals the fact that the EU has a formidable wodge of tariff barriers that it has put up against the rest of the world. We were compelled to be inside this protectionist fortress, so long as we were in the EU. Thus we were hobbled in our trade relationships with 80% (and increasing) of world GDP. Since we joined the EU in the 1970s, tariff barriers worldwide, thanks to the WTO, have of course been weakened; the average tariff is now only 3% or 4% – a range that our currency can move beyond (in either direction) in as little as a week, or even a day. We no longer have to fear the dread impact of tariffs that would have been a cause of worry in the post-war years (or indeed in the 1800s). To be sure, there are still some high EU tariffs (designed to protect key EU industries such as German cars or French produce). Most of these are tariffs imposed by the EU on countries outside the EU, which consequently are imposed in turn on the EU by those countries, in retaliation.

So long as we remain (for now) inside the EU, we are inside one of the worst practitioners of anti-Free Trade in the world. And moving beyond tariffs, the EU is terrible at non-tariff barriers, too. Very few people, particularly not the bien pensants, seem to understand that the whole point of the Single Market was to impose non-tariff barriers by insisting on standards for products and services that favoured insider companies within the EU (think Sir James Dyson complaining about how his better-performing motors were banned by EU Directives), so as to prevent that 80% of the world economy that is outside the EU from being able to sell products and services into the EU. (In a recent look at trade theory research at top universities, I found almost no mention of this particular, and very pernicious, kind of non-tariff trade barrier. But research has indeed shown that the Single Market inhibits trade – even in countries within the EU.)

Hang on, you might think: didn’t you just say these acronymic experts were all in favour of Free Trade? Isn’t arguing to stay inside the Customs Union and the Single Market actually against Free Trade? Well: yes. See what I mean about these ‘experts’ blinding themselves, in their eagerness to support us staying within the EU?

It is true therefore that all of us – ‘acronymically expert’ Remainers and Brexiteers alike – agree that Free Trade is beneficial. All of us are going to have to work very hard – perhaps working in harmony for a change – to persuade this next government to avoid some of their worst protectionist instincts (remember: so many in this government were Remainers, which to Brexiteers raises worries that they have strong protectionist instincts). We should all be doing our best to encourage our trade negotiators – whether they’re negotiating with the EU, or with the rest of the world – to have a pro-Free Trade perspective and a desire to liberalise the economy in that respect.

Why were all these pro-Free Trade economists in such thrall to, and joyful wonderment at, the delights of being contained within this protectionist ring? Why did they not sing the praises of the opportunity to escape that protectionist fortress, so that we could trade freely on world markets, making free trade deals around the world in ways that the EU had, over many decades, proved so woefully incapable of making (due to its protectionist history and instincts)? Well, that’s a mystery that at one level I think I understand – those economists from Oxford, Cambridge, LSE, and elsewhere, who tore out their hair and forecast woe and gloom were, unfortunately, incapable of entertaining any thought that went against an unquestioning love of the EU. (I can’t explain why that unquestioning love exists, because you would have thought they were smarter than that.) At another level, were these ‘experts’ in what an economist would call a Kuhnian moment – that is, their paradigm meant it didn’t even occur to them that EU standards would act as trade barriers?

It will always remain, to a degree, a mystery as to why these ‘expert’ Remainers, coming as they did from a Free Trade perspective, were so mute about the clear disaster that the EU was from the Free Trade perspective, and why they so perversely twisted their logic to assert that an exit from the EU would be a retreat from the world, rather than a bold step into it That, I suggest, is now going to have to lie forever in a dialogue between them and their consciences. For now, we should all be united on the Free Trade point. The key question is: what is the best way to approach that, as we in the UK move into a world of trade negotiation, both between us and the EU, and between us and the rest of the world? For that, and the upcoming Brexit negotiations, we turn to Game Theory – another habitat of these acronymic experts.

  1. Game Theory

Part of the fascination of recent months has been watching Remainers tie themselves into knots over how we should approach the negotiation with the EU. Again, a desperate desire to find a way to remain within the Customs Union and the Single Market seems to be at the heart of what would appear to be quite appallingly foolish demands of the Government: we should immediately agree that a Bad Deal is better than No Deal – so that the EU can offer us the worst possible deal they can think of, confident that we will take it in preference to No Deal. We should publish our entire negotiating strategy to Parliament, and allow Parliament to debate that – so that the EU can pick over it, and decide precisely how to dismember it. We should have a debate in Parliament on whatever deal we strike, before the two years is up – so that the EU can offer us the worst possible deal, confident that this is a good way to get Parliament to reject that deal, so all can then insist somehow that we should stay in the EU.

The amusing (well: tragicomic) aspect of that is how sincerely and passionately those views would seem to be argued, when their perversity and foolishness has to be obvious to anybody who has even thought about – far less studied – Game Theory. Economists know all about Game Theory; why then do so many of the hardcore Remainers still support such foolish Ginamillerisms?

The classic way of looking at such negotiations is via the Prisoners’ Dilemma, and as all those who have in any way studied Game Theory know, the best approach in such iterated negotiations is ‘Tit for Tat’ (for those interested, read The Evolution of Cooperation by Robert Axelrod, or the wonderful The Origins of Virtue by Matt Ridley). Tit for Tat means starting out being optimistic and nice to the other side, and continuing to be nice so long as the other side is nice – but giving them a good slap if they respond at any stage by being nasty. A classic example of this would be the infamous 10 Downing Street dinner with Juncker: from what we understand, Theresa May and her team were perfectly nice to the EU delegation at the dinner, but when Juncker’s people leaked a biased account of that dinner, May stepped out in front of the Downing Street microphones and gave it back to them with both barrels. Since then, there has been almost no aggression from the EU side (perhaps in part because they realised that such might have helped May in her election campaign, but undoubtedly also because they were put in their place by her ferocious response). Tit for Tat argues that you have to go on being unpleasant back to the other side until they show signs of having learnt their lesson, with an intent to behave better – which to some degree, now appears to have happened. At that stage, one should offer another positive sign – just as David Davis seems to be doing in offering a unilateral concession on EU citizens in the UK, and as I argued on this site we should do back in March.

If Tit for Tat is the best negotiating approach, then we absolutely have to have cards in our hand to threaten the other side with (see also, of course Getting to Yes). In Game Theory, laying down whatever cards one could use to threaten the other side, and going naked into the negotiating chamber, is known as the ‘Doormat’ strategy. It has been shown, in numberless game simulations, to be catastrophic in terms of the outcome for the side using that strategy. Here, again, it is noticeable that the Remain side, who seem to want us to concede multiple points before we even start the negotiation, abandon all sense when there is any argument to behave in a way that would help the Leave side – yet, as the discussion on the Gravity model showed, they unhesitatingly and unthinkingly support any argument that is favourable to their side.

There are those Free Trade believers who strongly advocate that the moment we leave the EU, we drop all tariff barriers to trade with the rest of the world, just as in the 1840s we did, so successfully, with the Corn Laws – and, if we are going to drop all tariffs ultimately, we should announce that we are going to do that now. Personally, I believe that is a mistake. If we announced that, then there would for example be no incentive on Germany and France and all the other EU countries to drop their tariffs with us in return. In dropping our tariffs, we would, very likely, create a significant welfare advantage for the UK by importing cheaper goods – which would bring benefits to all our population. However, by doing that immediately, we would have missed the opportunity to ensure that in return, there were no or reduced tariff barriers against our exporting to Europe. Our sales of Range Rovers, Dyson vacuum cleaners, pop stars on tour (if we think of visa arrangements as another form of tariff), and, indeed, English sparkling wine and cheese, would suffer unnecessarily.

For now, as we commence the EU negotiations, our posture should in general be Tit for Tat, so that every concession we give looks for a reciprocating concession from the other side, always looking for mutually beneficial trade-offs. And if we don’t get those deals, then we’ll just have to suck it up and look to get them later – if it takes a while, and there is an interim dip, then it will be far more painful for the EU than for us (think of those German cars and French produce); a deal will eventually be arrived at that will be good for all concerned. We will do far better long term, because meantime, we will have focused our export efforts on that 80% of the global economy (and rising) that is not in the EU – and, Gravity model or no Gravity model, perfect or imperfect Free Trade, this will result in a far better future for us than if we had remained within the stagnant, festering, EU economy, surrounded by the tariff and non-tariff walls that so cruelly prevent its citizens from enjoying the great benefits of Free Trade in a global world.

**                           **                           **

What does the above discussion show us about the ‘experts’? Well, I guess that in their baser instincts, they are much the same as any of us. They leap on arguments that support their case, and studiously avoid arguments against that case. They are prepared to fool themselves into thinking that they have sincerely and logically thought the matter through, and – here’s the clincher – get very shouty and upset when the argument goes against them.

For me, I often worry that my own thoughts and conclusions might be similarly coloured, but I (and here I share something with very many fellow Brexiteers) only came to the final conclusion, that we absolutely should leave the EU, quite late in the day, a year or so before the referendum. My conclusion came out as a result of helping produce the 1,000-page book, Change, or Go, produced by Business for Britain, which analysed every aspect of our relationship with the EU to see what changes would be needed in each to make remaining in the EU better than leaving. Before we wrote that book, I had assumed that the needed changes within the EU would be at least possible. Once we had produced it, it became clear from the size of the task (and even more clear after Cameron’s disastrous failure of a ‘renegotiation’ with the EU in early 2016) that for the UK, a life outside the EU would always better than one inside. Many others in the Vote Leave campaign similarly came round to the idea of Leave only after long and careful thought. With Project Fear as their starting and finishing position, however, there is very little evidence that the ‘experts’ had given that same careful, anguished thinking to where they stood on the referendum.

Michael Gove, you were right!

 

(Photocredit: Chatham House)