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Ryan Bourne is Chair in Public Understanding of Economics at the Cato Institute.
Perhaps torture works. The collective waterboarding that is the impending Brexit deadline is forcing confessions, anyway.
Philip Hammond was in a government whose stated policy was a desire for new post-Brexit trade deals once it could exit the Northern Irish “backstop” of a single UK-EU customs territory. Now, with Boris Johnson tunneling for just that, the former Chancellor’s official position has shifted. Economic sense, he says, actually means Britain should stay in the Single Market for goods anyway, abide by “level playing field” commitments with the EU, and junk dreams of an independent free trade agenda. Buccaneering Britain, Hammond thinks, is an illusion.
Brexiteers who foresaw May’s backstop as an excuse by her to bounce us into Brussels’ permanent trade and regulatory orbit have seemingly been vindicated. But the danger has not passed. Alongside The UK in a Changing Europe’s new report, Hammond’s intervention pressures wavering Labour MPs and former Conservatives to reject Boris’s proposed “Canada Plus” destination as “too hard a Brexit” for Great Britain. At stake here is whether Britain ultimately repatriates meaningful economy policy, or becomes a rule-taker that’s only ever one small step away from EU re-entry.
Hammond couches his argument in economic terms. Everyone acknowledges trade-offs exist between policy freedom and EU trade frictions, with the latter more easily quantifiable, and the former dependent on active choices. But Hammond’s preferred modelling by the Treasury and others is based on assumptions. Results that suggest a free trade agreement Brexit must reduce GDP by 4 to 7 per cent by 2030 relative to Remain, while new free trade agreements and regulatory freedoms could only possibly compensate by 0.2 to 0.5 percent of GDP, do not pass the smell test.
Pre-referendum, such results came from “gravity models,” built around observed relationships showing trade volumes rise in proportion to the size of economies and fall with distance between them. Treasury analysis back then had estimated EU membership raised trade volumes for members, on average, by 115 per cent beyond these factors, suggesting leaving full membership for an FTA would produce a large, long-term 6.2 per cent loss of GDP. Importantly, liberalising trade elsewhere could only weakly compensate, because of longer distances to new export markets.
Those results were challenged extensively. The model risked chalking up gains from general deregulations over recent decades (which wouldn’t be lost after exit) as EU membership benefits. Cambridge economists pointed out that the model itself overpredicted UK exports to the EU compared to real trade flows, suggesting a UK-specific trade uplift of a much smaller 20-25 per cent. Global evidence suggests services trade is much less influenced by distance anyway. Treasury results then looked biased towards big negative effects.
Since then, Hammond’s Treasury has changed model but not conclusions. Their November 2018 publication estimated a permanent net loss of 4.9 percent of GDP from a simple FTA Brexit, rising to 6.7 percent if net EU migration ceases. This is much higher than the more static estimates of trade expert and Nobel Laureate Paul Krugman, who estimates first-order net costs of about two per cent of GDP (before any compensatory trade liberalisation). When you hear much larger results, the findings are usually based on “black box” assumptions about large effects of trade on productivity (analysis where economists agree on the direction but disagree on magnitudes).
Four large assumptions that we can assess drove the Treasury’s results:
Do these stack up? At the point of exit, UK exporters will be fully compliant with EU product standards after decades of integration. Assuming then that we’d face the same non-tariff barriers (NTBs) as existing FTA partners looks like a significant overestimate of initial new frictions. Yes, there would be economic costs associated with rules of origin requirements (though the WTO thinks these are small), and a loss of some mutual standards recognition outside the EU legal system. But bigger NTBs arise if regulations deviate. One would hope that sensible governments, Jeremy Corbyn notwithstanding, would only pursue regulatory change if it perceived net economic benefits anyway.
Indeed, it’s baffling to presume both that there will be no upside to repatriating regulation (the Treasury assumes a GDP gain of just 0.1 per cent) but that standards will significantly deviate. Current political moods might be non-conducive to widespread deregulation, but Open Europe once estimated politically feasible changes worth 0.7 per cent of GDP; let alone the potential benefits long-term of avoiding further EU labour market harmonisation, financial sector regulation, and shirking the EU’s precautionary principle in agriculture, health innovation, AI, and robotics.
Customs costs at the border look exaggerated too. Swiss estimates suggest these could be as small as 0.1 per cent. The UK’s would be higher outside the single market, of course, but Paul Krugman thinks the UK would adopt new systems relatively quickly, unilaterally lowering standards if necessary. Previous meta-analysis has found that extensive FTAs have a bigger trade boosting impact than customs unions, suggesting customs costs aren’t really prohibitive to trade flows. NAFTA, for example, is not a customs union.
But it’s really on external trade where the analysis was most slanted. Not only did Hammond’s government say the UK would not unilaterally liberalise tariffs or meaningfully reduce EU non-tariff barriers on the rest of the world; it suggested signing free trade agreements with the US, Australia, New Zealand and TPP countries would only raise GDP by 0.1 to 0.2 per cent. Closer inspection shows why: it assumes only half of the non-tariff barriers on goods and a third on services are “actionable” through these deals, and then only a quarter of these get eliminated in new FTAs. Overall then, given the countries examined for FTAs, the model assumes that the upper-limit for NTB liberalisation is eliminating 6.25 per cent of the very high level of NTBs we are assumed to want to keep.
If anything has become clear recently, it’s that Conservatives have an appetite for a far more expansive free trade agenda. Economists agree free trade boosts growth. Australia’s government estimated it has increased GDP by over five per cent over 20 years through manufactured goods trade liberalisation alone; the government’s own analysis suggests a UK FTA with the EU would life GDP by three per cent relative to WTO terms. So the conclusion that free trade policies don’t matter, especially in regards an FTA with the US, is baffling, even accounting for trade distance. Of course, the gains from a UK-US deal are bigger still when it and the EU look set for a trade war. And the UK is arguably much more likely than the EU to pursue service sector-heavy FTAs as the world becomes richer, to our own benefit.
Now I’m not arguing here that there’s no risk and uncertainty to “breaking free.” It’s difficult to ascertain precise GDP effects from trade negotiations that haven’t happened, regulations that haven’t yet been avoided, and new customs procedures that haven’t been tested. But it’s important to remember Hammond’s favoured analysis largely assumes no upsides to Brexit by construction and calculates downsides based on evidence for policies that the UK shouldn’t want to pursue, or relationships elsewhere that we wouldn’t replicate.