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Take trade experts and their models with a bucket of salt

The negative impact of Brexit on trade, and the economy at large, is still being overstated

An honest comparison demonstrates that the UK’s new trade deals and reshoring of production can mitigate the economic costs of Brexit

When the UK left the EU, it wasn’t just the EU single market and customs union we left, but also all the trade agreements with third countries negotiated by the EU which we had benefited from.

As the FT put it, after Brexit: “the UK will need to renegotiate at least 759 treaties with 168 countries for Britain to just stand still”.

Lord Hannay, Britain’s former EU ambassador stated that:

“The challenge of replacing them falls in the same category as Alice in Wonderland running furiously to stand in the same spot.”

The expert consensus was this was impossible. That isolated “little Britain” did not have the administrative resources to manage this feat and that even if we did we were far too economically and politically insignificant to be able to replicate them on the same terms as the (then) 28 members of the EU had been able to agree.

However, not for the first — or the last — time, the experts were proven wrong. The UK hired New Zealand’s top trade negotiator, whose team rolled up their sleeves and got to work. Third countries chose to either roll over existing deals or negotiate new deeper arrangements especially in the areas of Services and technology which were noticeably lacking in the EU deals. 

As this chart by trade commentator @TerraOrBust outlines, the UK ended September 2023 with the largest number of free trade deals of any independent country in the world.

Undeterred, the experts redirected their attacks away from the impossibility of negotiating these trade deals to the minimal contribution they would add to trade and GDP. The UK in a Changing Europe, for example, stated:

Of the 71 free trade agreements or trade deals the UK has signed since leaving the EU, 68 are rollover deals identical to the deals the UK had with those 68 countries when it was in the single market…as conduits for trade growth, they will do little to expand the UK’s trade reach further than when it was in the EU.

And the BBC

Since Brexit, the UK has signed trade deals and agreements in principle with about 70 countries and one with the EU. However, the majority of these are simply “rollovers” – meaning they copied the terms of deals the UK previously had when it was an EU member, rather than creating new trading arrangements. And some of them are with countries with which the UK does very little trade.

Economists Terence Hugh Edwards and Mustapha Douche, writing for The Conversation, went further:

The problem with this fanfare is that the government’s own economic analysis of the benefits of joining this bloc is underwhelming. There is an estimated gain to the UK of (just) 0.08% of GDP.

It is true that the Government’s own model on the CPTTP deal forecasts only an increase in UK GDP of £1.8 billion (+0.08%) in the long run. It is also true that the Government’s own estimates for the GDP benefits of the UK/Australia deal is also only + 0.08 per cent. The OBR calculates that together the Australia and New Zealand deals “might increase the level of real GDP by a combined 0.1 per cent by 2035”.

But it is also true that the deals are expected to increase trade quite considerably, with Australia by 53 per cent, New Zealand by 41 per cent and, on average, the 11 CPTPP members by 65 per cent (ranging from 29 per cent to 149 per cent). The UK in a Changing Europe estimated that a trade deal with India which removed only the current average 18.7 per cent tariff on UK goods exports (which is still mooted for later this year) would boost trade by between 40-79 per cent. However, here too the effect on overall UK GDP would, by their calculations, still be small (+0.12-0.22%) by 2035.

It may surprise you that a UK/CPTTP trade deal which removes 99.9 per cent of tariffs on a combined GDP of about £12 trillion — equivalent to EU GDP — where trade is already growing at more than 8 per cent a year and is expected to be boosted by a further 65 per cent, would only add 0.08 per cent to GDP. Surely with all the fuss about trade deals and the need to boost exports the economic effects should be many times higher? 

Well actually, no. The EU trade deal with Canada — CETA — which at the time was hailed as the most comprehensive free trade deal anywhere in the world (representing a combined 20 per cent of global GDP) cut 98 per cent of goods tariffs, saw a 65 per cent increase in bilateral trade but is estimated to have added just €12 billion per year to EU GDP of € 45 trillion. The most bullish estimates for the EU GDP benefit of a US/EU trade deal TTIP (now defunct) were in the region of just €100 billion per year despite the two economies combined representing (then) nearly a third of global GDP.

In short, tiny GDP effects are the normal outcome of the trade models we currently use to measure the impact of trade deals on GDP and are a function of the limitations of the models themselves. 

Take the effect on GDP of the UK leaving the EU single market and customs union with a free trade deal (TCA). The EU represents  about 40 per cent of UK exports and 45 per cent of UK imports, yet when we study in detail from trade models the estimates of the cost to UK GDP just from the additional trade friction from non-tariff barriers alone, we find the consensus cost in the region of only 0.6—1.2 per cent of GDP.

  This is not (as some people argue) because the benefits of free trade deals are in reality negligible. But because current trade models fail to fully capture the benefits of specialisation and comparative advantage that, as Adam Smith and David Ricardo explained, are the true benefits of free trade. 

Trade experts and economists are aware of the limitations of their models and much research has been done to try to adjust for this. One such area is the possible effect of trade deals on productivity. You will have noticed above that I refer to the GDP cost of the UK leaving the EU single market and Customs Union with a free trade deal from trade friction alone as about 1 per cent. Yet this is well below the OBR’s forecast of a Brexit hit of 4 per cent. The difference between the two numbers comes from the OBR’s attempt to calculate a productivity cost to the whole UK economy from leaving the EU. To quote the OBR:

The post-Brexit trading relationship between the UK and EU, as set out in the ‘Trade and Cooperation Agreement’ (TCA) that came into effect on 1 January 2021, will reduce long-run productivity by 4 per cent relative to remaining in the EU. This largely reflects our view that the increase in non-tariff barriers on UK-EU trade acts as an additional impediment to the exploitation of comparative advantage.

There is some logic to this argument. Intuitively, one would think that companies which are more open to alternative ways of operating and have access to a wider pool of suppliers, customers and capital providers should be more innovative. Yet contrary to the arguments of some, the academic literature and analysis on this subject is far from definitive.

Bhattacharya, Okafor and Pradeep in their research studying Indian manufacturing firms find the evidence to be “mixed”. Patricia Hofmann in her research of German manufacturing exporters finds the data to be “ambiguous”. In the UK, the Office for National Statistics (ONS) in 2018 found that companies who trade goods (import/export) outside the UK do have a higher productivity, although the “productivity premia” differed by geographical market:

These results suggest that businesses which export to (import from) the EU are around 4.3% (1.7%) more productive than otherwise equivalent non-traders. However, these effects are much smaller than the equivalent estimates for non-EU trade: businesses which export to (import from) non-EU nations are around 19% (18%) more productive than equivalent non-traders.

But importantly, they add:

In particular, our results are not causal: they cannot say whether these businesses are more productive because they trade or whether they trade because they are more productive.

The reality is the academic research on the effect on productivity from trade is inconclusive. Even those who find companies who trade to be more productive cannot determine if that is because they trade or why they trade. The science is far from settled. Yet trade experts (and the OBR) have chosen to apply a negative effect on whole UK productivity as a result of leaving the EU whilst not applying the same calculation method to new UK trade deals outside the EU.

Why? Well the OBR argue that their productivity estimate is based upon a direct link between the amount of trade and productivity. What economists call trade intensity (imports plus exports).It states:

Since the June 2016 EU referendum, our forecasts have assumed that the volume of UK imports and exports will both be 15 per cent lower than if we had remained in the EU.

Ignoring the fact that this isn’t true — the OBR’s forecasts have not always been based on lower trade intensity since the referendum in June 2016, whilst the academic analysis on the link between trade and productivity as a whole is inconclusive and hotly debated — a direct link between trade intensity and productivity has even less supporters. 

The Department for Business and Trade, for example, finds:

At the UK – national and sectoral level, there is a lack of evidence on what role trade can play in facilitating productivity gains … At the firm-level, data issues have rendered simple statements like “if trade goes up or down by x% then UK productivity increases/decreases by y%” difficult to infer.

And you can see why that would be. With manufacturing representing only 10 per cent of UK GDP (and less than half of exports) versus more than double the GDP contribution for Germany (and over three quarters of exports), you can quite understand how ludicrous the idea is that there could exist one magic formula or global equation to measure the productivity effect on all countries from trade intensity.

One might be more likely to believe there exists a direct link between the overall quantity of trade and productivity for the whole economy if overseas trade was widespread throughout the economy. Among many different sectors and many different companies. But that isn’t the case at all. Rather trade is very heavily sector weighted and only about 5 per cent of UK companies trade overseas at all.

Of those 5 per cent of companies which do trade overseas, the vast majority of trade is actually performed by a relatively small number of businesses. According to the ONS, just 50 UK companies produce between 35—40 per cent of all UK (goods) exports. Just 2000 UK companies produce 75—80 per cent of all UK (goods) exports.

The ONS also found that the number of markets with which a business trades is also related to their level of labour productivity. But again there is a geographical difference. For example, each additional non-EU nation a UK business imports from is associated with a 0.6 per cent boost to their level of labour productivity. But each additional EU nation imported from is associated with a 0.7 per cent reduction in labour productivity.

The ONS productivity data clearly shows that UK companies which trade outside the EU have a considerably higher productivity (18—19 per cent) than those UK companies who only trade with the EU (1.7—4.3 per cent). If you really believed that trade generates a higher whole economy productivity, and considering that the UK trade deals with the CPTTP, Japan, Australia, New Zealand etc are forecast to generate significantly higher trade growth (41—149 per cent), surely a shift in trade towards countries which demonstrate higher UK corporate productivity from countries which demonstrate lower UK corporate productivity — even if overall trade is slightly lower — should provide an uplift to whole UK productivity?

If the argument is that non trading companies are forced to compete with those who do trade — raising the overall economy productivity level — why would more productive trade not boost overall economy productivity?

The ONS productivity data also clearly shows that companies which import from more non EU markets gain higher productivity whilst those who import from more EU markets “lose” productivity. Again, if you believe that trade affects the whole economy productivity, why would you not adjust your UK productivity forecast for higher non EU imports and lower EU imports — when that is exactly what you expect to happen from higher non-tariff barriers (to trade) with the EU and lower tariff and non-tariff barriers with the rest of the world?

Personally, I am less than convinced that there is a direct calculable link between productivity and trade and certainly not between overall trade intensity and productivity. Indeed I agree with the OBR’s own statement in March 2018 when they said they had decided it would be wrong to “incorporate an explicit link from lower trade intensity after Brexit to lower productivity growth within our forecast horizon” because the evidence to support such a contention is just not there. It seems strange to me that the OBR should recognise that fact for five years into the future but at the same time argue the opposite in the longer term.

Whilst I — and the OBR in 2018 — might not believe that there is enough evidence to justify a general whole economy productivity effect from leaving the EU (trade deals), that does not mean I am trying to argue free trade deals have little or no value at all. Rather I am arguing that existing trade models fail to fully capture that added value, especially in terms of benefits to consumers through greater choice, higher quality and lower prices of goods and services.

There has been some research trying to capture this effect as well. Breinlich, Dhingra & Ottaviano writing in 2016 for the LSE, for example, studied two decades of EU trade deals to see if they could calculate the effect on product variety, quality and price for consumers using detailed import price and expenditure data. 

They found that:

On average, trade agreements the EU has entered into over the past two decades increased the quality of UK imports from its FTA partners by 26 per cent and lowered the quality-adjusted price of imports by 19 per cent.

They estimate that as a result of these deals alone “total consumer prices fell by 0.5 per cent for UK consumers.” Now that really does begin to move the dial. Now it is really possible to begin to see how consumers can benefit from better quality and lower priced imports driven by free trade. 

But what is more, this consumer benefit has no geographical limitations. It doesn’t matter if the product you consume is manufactured in Germany, France, Japan or the USA. The consumer benefit of the quality-adjusted price of the import is the same. This is why free trade deals can be valuable. And this is why they do not need to be only with your closest neighbours to work. Indeed, it is implicit in free trade theory that the more free trade deals you have with more different countries the more specialisation and comparative advantage you will capture through lower quality adjusted consumer prices. 

However, as the authors themselves admit, calculating a quality–adjusted price is both highly subjective and difficult to apply to each and every trade deal in isolation. So whilst we “know” free trade deals can add much more to well-being than traditional trade models demonstrate, they are currently the best we have. We are forced to live with them and base our comparative analysis on them, limitations and all.

And if we do that — exclude a productivity effect and base our numbers on traditional trade models alone — then the hit to UK GDP from leaving the EU single market and Customs Union (as I show above) is only in the region of 1 per cent. Not the 4 per cent the OBR suggests.

More than that, with the new post-Brexit trade deals the UK has signed outside the EU (with more to come) adding about 0.2 per cent to GDP that means about 20 per cent of this loss has already been mitigated. Add a benefit from the reshoring of manufacturing as a result of Brexit and a fiscal multiplier on the EU net membership payments the UK no longer has to make, and the overall net economic hit of leaving the EU ends up being not much more than a rounding error in total GDP. 

The OBR and other trade experts are not being honest with the public about the limitations of their models nor the assumptions contained within. They are not comparing apples with apples. As proponents of the theory of free trade — of the benefits of specialisation and comparative advantage — they should be celebrating the expansion of free trade with the rest of the world as a means of maximising consumer well-being, not decrying it. 

If they were more open, we would all be able to see that the economic cost of Brexit is at worse marginal and at best no more than a rounding error once mitigated by new trade deals and the reshoring of production. 

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