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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.

5 levers to tackle the economic shock of no-deal Brexit

It’s 11:01 p.m. in London on Friday, March 29 and it’s no deal. Britain will need to take immediate action to try to shield the economy from shocks, probably before markets open, on April Fools’ Day.

Here we take a look at some of the emergency levers that U.K. policymakers can pull.

Britain’s import-dependent economy has never looked so vulnerable in peacetime. An inflation bomb is set to explode. A diving pound and tariffs on key products from the EU such as food would hit consumers hard. Britain runs a hefty trade-in-goods deficit (of about £130 billion in 2016 and 2017), and sources about half of its food from abroad.

Policymakers will have to make hard choices on how to manage the currency — particularly on whether to hike or cut interest rates — when core elements of the economic model will be under fire. Markets have traditionally been tolerant of U.K. debt and deficit levels because the country was a prime venue for foreign direct investment from big companies such as Airbus and Nissan, but these are now in question.

As Bank of England Governor Mark Carney put it, Britain relies on the “kindness of strangers.” This has been drying up because the U.K. is becoming a less attractive investment destination outside the EU single market. Foreign direct investment more than halved to $15.1 billion in 2017, from $32.7 billion in 2015, according to U.N. figures.

Here’s our look at the five responses that the U.K. will need to consider. All have disadvantages.

1. Drop import tariffs to avoid big price hikes

If Britain leaves the EU without a deal, tariffs would be imposed on imports that used to come in freely from the EU. For example, Britain’s tariff on beef purchases would be around 40 percent.

To avoid food price inflation, Britain could lower or completely scrap tariffs on things such as food, car parts or medicines.

Catch No. 1: The World Trade Organization’s “most favored nation” principle dictates that these tariffs must be the same for all WTO members, unless you’re in a trade deal or in a regional bloc like the EU. This means not only French but also South American beef or cheese would come to Britain tariff-free.

Farmers would lose out, as cheap imports undercut their products. The government’s brutal calculation would have to be that farmers are far less important to the economy than supermarket prices for the whole population.

“It would be an incredibly damaging way for the U.K. to start its new role as an independent member of the World Trade Organization” — Dmitry Grozoubinski, former Australian WTO negotiator

Trade Secretary Liam Fox told the U.K. parliament’s international trade committee on Wednesday that waiving tariffs to stimulate trade is a “possibility.” But the “full liberalization of tariffs … would certainly expose the U.K. to sudden competition in sectors to which it’s not currently,” Fox said.

Catch No. 2: By slashing tariffs, you have effectively gifted away your leverage in trade negotiations with other partners. They will already be shipping their goods tariff-free, they don’t need a deal. British tariffs may be down, but those of trade partners won’t be — putting British exporters in a difficult spot.

2. Use the Article 21 ‘nuclear option’

A hard-line solution would be to only lower tariffs to EU imports and ignore the WTO rules. Other countries would probably complain and launch WTO disputes, but Britain could fend them off by calling on Article 21 of the WTO rulebook, the infamous “national security” exemption, favorite of Donald Trump.

British Conservative MEP David Campbell Bannerman suggested this option in a Telegraph op-ed last month, saying the “national security” justification is possible because Britain would be “seeking to avoid security issues at the Northern Ireland border.”

Article 21 has long been a taboo in the trade world, but over the past one and a half years it has gained some dubious popularity as the United States, Russia and the United Arab Emirates invoked the exemption to justify questionable actions such as protective tariffs and border restrictions. The EU is a sharp critic of such steps and has warned that abusive use of Article 21 risks undermining the entire multilateral trading system.

Britain’s International Trade Secretary Liam Fox | Isabel Infantes/AFP via Getty Images

Triggering this “nuclear option” would be risky for Britain too: “It would be an incredibly damaging way for the U.K. to start its new role as an independent member of the World Trade Organization,” said Dmitry Grozoubinski, a former Australian WTO negotiator. He warned that using such an “excuse for breaching most-favored nation rules” could backfire as Britain would likely use all the goodwill it would need in other talks, both bilaterally as well as at the multilateral WTO level.

3. Rates. Should I cut or should I hike?

Money is Britain’s supreme challenge. Many economists think the Bank of England will probably inject the markets with fresh money to try to prevent a meltdown. But this will also come at a cost for consumers, who will have to face higher prices.

Those looking to give the economy a shot in arm also reckon that the Bank of England would likely slash the base rate from the current 0.75 percent, accepting that this will exacerbate inflation.

Such a cut is not guaranteed, however. The Bank of England’s Carney has warned that businesses should not rule out an increase in the base rate. While this would help bolster the pound, a hike poses big challenges in the U.K., where mortgage debt is high and higher rates could create a housing crisis and sap household spending.

The political risk is that deregulation could mean lowering standards on things like food safety, scrapping checks on dangerous chemicals, environmental protection, unemployment, or health benefits and consumer rights

According to the Bank of England, Britain’s economic activity would fall by as much as 8 percent in the case of no-deal. The bank warned that in this scenario “output falls by more than it did in the financial crisis.”

One of the biggest immediate risks on Brexit day is that banks stop lending money to businesses or even to each other, out of fears that they won’t get their money back.

“Like at the moment when Lehman Brothers collapsed or 9/11, the central bank would certainly respond by injecting short-term liquidity,” said ING Chief Economist Carsten Brzeski.

In order to stimulate growth, the BoE may then want to use quantitative easing. “You will have to ask yourself how much you can stimulate without driving up inflation,” Brzeski said. “The pound will be weaker, so there will already be what we call imported inflation.” Further monetary loosening would make this worse.

Another of Britain’s vulnerabilities is that economists caution that a weak pound is not unadulterated good news for exporters. Many manufacturers insist they would prefer a stable to a weak currency because they are so dependent on imported raw materials and components.

The headquarters of the Bank of England in London | Adrian Dennis/AFP via Getty Images

4. Stop customs checks

Slashing tariffs will help soften the blow of higher food prices on consumers. But it won’t help businesses whose shipments are stuck in ports. Customs checks could lead to kilometers of trucks at highways and at the entrance to the Channel tunnel.

That will be one of the main costs of a hard Brexit, some economists say, in that it disrupts supply chains and ruins businesses that rely on just-in-time production. That’s why some businesses and pharmacies have started stockpiling supplies.

To avoid such a mayhem, the U.K. government could decide to wave through imports at its ports. It has already announced that it would do so for EU goods.

The risk of that is obvious: Suspend customs checks for too long, and Britain could become a smugglers’ paradise.

The EU may not do the same for U.K. exports coming in, meaning British exporters will struggle to get their merchandise into their biggest market.

The longer this situation persists, the more manufacturers would move their factories into the EU, meaning the U.K.’s trade deficit could widen.

5. Deregulate to become a fiscal paradise

This is the dream of hard-line Brexiteers like Jacob Rees-Mogg and Daniel Hannan. Once Britain leaves the EU without a deal, it could become a fiscal paradise, dropping taxes and deregulating its industry. This could attract investors as France and Germany show signs of pursuing a more protectionist model.

This is a longer-term solution, however, and will do little to resolve instant shocks.

The political risk is that deregulation could mean lowering standards on things like food safety, scrapping checks on dangerous chemicals, environmental protection, unemployment, or health benefits and consumer rights.

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