The economic consensus on Brexit has got it all wrong

The economic consensus on Brexit has got it all wrong

My new Politeia paper reviews the economics of the trade deal that will be struck between the UK and the EU under the international legal order of the WTO. I take the view that what will be agreed must be in the economic interests of both sides; and I try to quantify those interests.

The gains from Canada plus and why the alternatives are impossible

First I evaluate the economic gains for the UK and the EU of no Brexit at all – so-called ‘soft Brexit’ – whereby the UK stays in the Single Market and the Customs Union, even though no longer formally in the EU. Leaving aside the political loss of sovereignty involved, the UK would lose decisively from this option, to the tune of 7% of GDP over the coming 15 years, around 0.5% a year off growth. The reasons are straightforward: the UK makes big gains from free trade, so that leaving the Customs Union gives obvious gains and makes the present pushback from Remainers economically incomprehensible; it also makes sizeable gains from self-regulation and border control.

For the EU plainly matters are different: the EU gains if the UK changes its mind, because it continues to sell food and manufactures to the UK at inflated protected prices, it faces less competition from a differentially-regulated UK and it can continue to export its unemployed into the UK job market. Nevertheless, though Michel Barnier is playing a political game with our Remainer fifth column to stop Brexit in all but name, the gains to the EU from this cannot be achieved because such a ‘soft Brexit’ lies behind a plain UK ‘red line’- a line drawn by the politics of the referendum result as well as plain economic interest.

At the other extreme, I calculate the economics of ‘no trade deal’. For this case I assume that both sides adhere to international (WTO) law which dictates non-discrimination in standards and the maximum logistical efficiency in customs; thus customs costs are trivial and there are no non-tariff barriers erected by standards discrimination. This leaves tariffs which are permitted both ways by the WTO; again these must be non-discriminatory under WTO law, so that they would apply to the whole world other than those enjoying Free Trade Agreements. Of course, in the UK case there would be many such agreements so that it could well be that the only tariffs the UK winds up setting are against the EU.

‘No trade deal’ is economically expensive for the EU, for three reasons. The tariffs EU producers would pay the UK come to around £13 billion a year, while the tariff revenues the European Commission would receive would come to £5 billion a year, all of it from EU consumers. The Commission would not receive the UK financial settlement of some £40 billion. Also, Brexit would start two years earlier than under ‘Canada plus’, with the EU losses as just explained. For the UK, however, there are mirroring economic gains: Brexit starts earlier, it avoids the financial settlement, and it receives the extra tariff revenue. In net discounted present value, the UK gains £650 billion, while the EU loses £500 billion. While therefore a ‘no trade deal’ Brexit would be attractive to the UK, it lies behind an EU ‘red line’ and is not available.

Thus are we left with ‘Canada plus’. This consists quite simply of free trade both ways in goods and mutual recognition of service standards so that the same free trade occurs in services, including the City of London. This has the virtue of preserving the free trade that already exists between the two sides.

When one discounts red line territory that excludes the alternatives, this is ‘Win-win’ for both sides. The EU avoids the breakdown inherent in no trade deal. The UK proceeds with Brexit. There are also  gains to the EU from Brexit, even if now unappreciated, in the form of more competition from UK industry via regulatory competition; also the removal of the ‘safety valve’ of UK migration will force more labour market flexibility inside the EU, long an aim of the Commission.

Within the UK, the gains from Brexit enable the use of the Brexit fiscal dividend to reduce taxes and raise spending. These make possible a further round of Brexit gains which will bring austerity to a welcome end.

The economic fallacies from the Consensus

In the paper I also discuss the numerous fallacies that have been spread by economists on the Remain side, both inside and outside the government. They began with the flawed modelling methods of the Treasury and its allies, including the LSE, NIESR, OECD and IMF, during the referendum.  These methods involved relying on ‘gravity correlations’ as implying causal relationships, which they plainly could not, as now freely admitted by the cross-Whitehall Brexit study; the same critique applies to the work at Sussex which looks at a lot of industries under the plainly indefensible assumption that the economy in general does not change. Furthermore, unreasonable assumptions were made about UK Government policy under Brexit by all these and other groups such as PWC, since then plainly contradicted by actual policy – and quite inconsistent with Mrs. May’s Mansion House speech.

Now we have the cross-Whitehall study which claims large losses due to almost any Brexit strategy. This evaluation is a curate’s egg: on the one hand it has correctly discarded the earlier methods of the Treasury et al as unfit and uses a well-known, extremely large and untested, but theoretically well-founded world trade model, the GTAP, to do the work. On the other hand it has adopted even more bizarre assumptions about policy, apparently in a bid to obtain bad results from Brexit similar to those of the earlier Treasury work.

I have reworked these results in several ways. First, I put sensible policy assumptions, in line with Theresa May’s Mansion House speech, into the untested GTAP model and find that they give healthy gains from Brexit. Second, I did the same using a smaller model of World Trade that I have built but one which, when tested, matches UK trade facts; this gives the strongly positive results for Brexit described above. Finally, for the information of believers in ‘strong gravity’, I did the same with a ‘strong gravity version’ of my trade model which, when tested, is rejected by the UK trade facts: but even if one disregards this, the results are just as positive.

So whichever way you slice it, the economic consensus has got it wrong, with wrong modelling and incredible policy assumptions. My team and I may be outliers, but only because the rest have in common been in serious error.