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Neglected options for a Brexit deal in the UK

andrew hughes hallettEven the government’s preferred deal gives us no idea of the trade and investment arrangements after the transition period. Yet it – or no deal at all – appear to be the only options on offer. Andrew Hughes Hallett (George Mason University and the University of St Andrews) looks at the impact they would have on the UK economy, and Scotland in particular, concluding that ruling out every other option is, to put it mildly, unwise.

A careful reading of the UK government’s proposals for a new deal with the EU gives the impression that everything comes down to a choice between two “no deals”. One is the no deal case (leaving without any agreement with the EU) and the other is the government’s preferred option, which is a ‘no trade’ deal with two restrictions (that the Irish border shall be allowed to settle in the Irish Sea; and that the UK shall remain in an EU customs union till 2020 and perhaps beyond).

glasgow

View of Glasgow. Photo: ben matthews via a CC-BY-NC-SA 2.0 licence

There are discussions of other topics, but, as yet no material on the trade and investment arrangements. The government’s preferred “deal” therefore describes a transition out of the EU, but allows us to forget that there are decisions to be made in the transition period – and that making certain decisions now may rule out those options after the transition.

The options

Any discussion of what arrangements could or should be made between the UK and EU must be based on the arrangements that the UK government adopts with respect to the EU. That will remain unknown until a parliamentary vote in London. But on past experience, this is unlikely to pay little attention to regional interests generally (jobs, investment) or specifically (eg fishing)

i) A number of models to replace the single market have been in discussion, but they all involve trying to achieve the near-impossible feat of maintaining free EU market access (including for investment and passporting), while limiting the free movement of labour. This implies a difficult compromise, especially in the EU – for whom free movement of labour is a “fundamental freedom” that, if lost, would sit badly with the continued free movement of capital and investment that the UK values so highly. This explains why the negotiations have been so difficult with so little room for improvement.

ii) The main contenders are the Norwegian model (stay in the Single Market, contribute to its costs but with no vote on its regulations); the Swiss or Canadian models (bilateral free trade deals in selected sectors, allowing the UK the freedom to exploit her comparative advantages); stay out with bilateral free trade deals with the EU and other outsiders (not feasible so long as the UK has to remain in an EU customs union); a rules of origin approach much like NAFTA (cumbersome and hard to implement in industries whose inputs are mostly human capital, knowledge or skills-based — eg financial services).

(iii) A more explicit compromise would be to stay outside the EU but make bilateral free trade deals with the EU and outsiders to replace the Single Market without invoking WTO membership; or to stay inside with compromises on certain articles in the Single Market itself — for example, with quotas to replace the free movement of labour in return for concessions on aspects of EU membership outside the Single Market. This model has been proposed in the unofficial French–German ‘‘Continental Partnership’’ idea.

iv) The “no deal” option in which the UK leaves the EU without any agreement. Under this option, the UK would progress to WTO membership in her own right. However, all WTO members have to agree. Currently seven countries, including the US, say they oppose UK membership. Even if that obstacle is overcome, the UK would have to accept the WTO’s rules on international and bilateral free trade. The cost of the latter might be reduced by invoking the “most favoured nation” status between UK and EU, but how much benefit that would bestow is not known.

The gains in trade from the single market for the UK

Estimates have been made of the impact of Brexit on the UK, but few for regional economies such as Scotland. They produce UK losses of about 1% to 2% of GDP. These losses are about the same as reversing the gains estimated for membership of the single market when it was first set up. The Cecchini report estimated gains of 5% in GDP over five years in 1992. The EU’s post-mortem study completed in 2000 showed GDP gains of 1% by the time the euro arrived. Later estimates put the figure at 2.15% of GDP in 2006, or 2.13% of GDP in 2014. For Scotland, the Fraser of Allender Institute has estimated the costs of Brexit (gains lost) at about 2.8% of GDP or 80,000 jobs. These gains will not have been distributed evenly, of course. So the gains in the single market (or losses under Brexit) will hit some sectors, such as manufacturing, and some countries much harder than others depending on their industrial structures and trade patterns.

For the UK, the UK Treasury now estimates (rather late in the day) that UK GDP will be lower by 3.9% after 15 years of Brexit (an average of ¼% lower each year) if the government’s preferred plan is used; but 9.3% lower (or 0.62% each year) if there is no deal at all. This is costly in terms of losses, given that it does not yet account for the potential investment or productivity increases foregone. Interestingly, none of the Treasury’s calculations evaluate any of the compromise models available.

Scottish government figures for Scotland alone suggest losses of 7.4% after 12 years, or 0.62% per year. This lies half way between the government’s proposal and the “no deal ” solution. So Scotland would appear to be made worse off than the rest of the UK (rUK); although that damage could have been less, on UK Treasury figures, with any of the compromise arrangements that are currently ruled out (5% under a free trade association with the EU, 1% in a Norway type deal). Interestingly, the Treasury’s argument is that the smaller losses would arise because Scotland is partly sheltered by the energy sector. I am not aware that London has announced any plans to devolve oil or gas revenues to provide any financial sheltering, so it is not clear where this result is coming from.

Nevertheless, the argument is of interest because it shows how easily the economic outcomes can shift with rather small changes in the rules governing trade in any new association with the EU. On this basis, the loss of productivity improvements will explain 60% of the losses between no deal and continued EU membership by 2030; restricted migration 26%; but new trade barriers and tariffs only 14% [Scottish Government]. Clearly the loss of investment and productivity gains are the major driving force here, with restrictions on EU migration second. Comparable figures for the UK as a whole are not available. The reason why the trade impacts are not larger is that EU tariffs against outsiders average 2-3%. Since the pound has depreciated 15% post the 2016 vote, the cost of UK exports to the EU has fallen. As a result, UK firms are now reporting increased business. But imports cost more (23% more so far), raising the prospect of inflation. Since UK inflation is still within its 2%-3% target range, this is not (yet) a problem. So, reversing the argument across the EU as a whole, there will have been some downward pressure on prices as a result of Brexit, but rather small.

How important is investment in the Brexit deal?

Investment spending plays three key roles. First it builds capacity: the ability to produce competitively in the future. The specific quantity spent therefore has a magnified effect on output and employment going forward; and investment lost through Brexit would likewise have a magnified effect in lost growth. It is hard to put numbers on the investment gains where we lack comprehensive investment data. But, in the Scottish case (a region in an existing union), we can make estimates: grossing up the figures for public investment in the same proportion as the UK shows that new investment runs at around 3.3% of GDP annually, a little over half the UK rate (6%). On these numbers, Scotland could ill afford further losses in investment from Brexit, whether due to a slowdown or lost passporting. They also show the investment gains are almost certainly larger than the trade gains in the Euro project.

Second, an inability to passport your services/goods into the EU could be very damaging to investment spending. For obvious reasons we have no data on how much investment in Scotland is made to facilitate passporting. But given that 15.3% of Scottish exports go to the EU (ex-UK), and 63.8% to rUK (surveys report 70% is passported on), the loss of passporting rights directly or via the UK would mean a loss of more than 16% in investment. Scottish government figures are more sanguine (7.7% or between 6.3% and 9% lost over 12 years), the difference being that the loss of passporting exports through rUK is not included.

Third, and most important, investment is the way productivity growth enters into the economy. In fact, productivity growth is the only source for permanent increases in growth and employment (Scotland’s working population is static or shrinking). Hence lost investment for Brexit reasons would inflict greater long-run damage to the Scottish economy than the current weak investment performance because the capacity to incorporate new productivity gains would shrink. Again, this example shows how important investment has been to the EU participants.

The link to productivity

Scotland’s labour productivity  is 3% lower than the UK. Yet wages are roughly 6% lower. This implies that unit labour costs are 3% lower in Scotland. However, overall production costs per unit are not lower, since otherwise the Scottish economy would have grown faster. Hence productivity (meaning the way in which the inputs to production are combined) must be lower in Scotland. Scots work harder than their counterparts, but to less effect because cheaper labour is substituted for capital and productivity increases. In short, we need more investment to exploit trade and Scotland’s comparative advantage, not less, as will happen under any Brexit deal.

Digging deeper, Scotland ranks highly on R&D and innovation in the public sector (higher education) but does less well in business and industry. Most R&D spending is done by US, Scottish and EU owned firms: very little by UK based firms. In figures, 53% is done by US firms, 25% by Scottish firms, 16% by EU firms and 3% by UK firms. The best strategy, then, is to find ways to bring high productivity activities into the economy by investing in productivity growth underpinned by access to foreign trade and ownership – the opposite of what Brexit would bring. In fact, it appears that, by 2030, 60% of the loss of output/jobs under no deal vs. EU membership would be due to an emerging productivity gap; and only 14% from trade barriers and market access issues that have occupied so much negotiation time.

Might it not be wiser to keep the Brexit options in play, rather than rule them all out ex-ante?

This post represents the views of the author and not those of the Brexit blog, nor the LSE.

Andrew Hughes Hallett is University Professor Emeritus of Public Policy and Economics at the Schar School of Policy and Government, George Mason University, and an Honorary Professor in the School of Economics and Finance, University of St Andrews.

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