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ICE Graveyard 26/04/2016 Peter Doyle

(Editors Note: references are indicated with *, and listed at the end.)

I very much hope--and expect--that Brexit will be rejected.
But the 200-odd pages of density * from Her Majesty's Treasury (HMT) applying trade theory to Brexit are intended to intimidate, not illuminate. They distract from the key issue; the impact of Brexit on the Euro.
Trade Regime Options
Start with the headline claim--£4,300 loss per household. The plain sleight-of-hand in this fraction has been correctly challenged elsewhere *. But it is revealing that HMT elects to headline its findings with this patent deception.
That subterfuge continues with discussion of the form and likelihood of three post Brexit trade regime options with the EU: European Economic Area (EEA) a-la-Norway etc.; Free Trade Area (FTA) a-la-Canada etc.; and World Trade Organization (WTO) a-la-USA etc. (though Russia and Brazil are cited as exemplars ... )
On EEA, like Gideon Rachman *, HMT notes that free labor movement, EU budget contributions, and obligation to observe EU directives would all remain. But unlike Rachman, HMT does not trouble to mention that this option would be entirely at the discretion of the post Brexit UK Prime Minister. Were the Prime Minister to select it, however substantively Brexit-self-defeating that might be, almost if not all the losses HMT identifies from Brexit would vanish. Thus, a key point emerges: it is not, as HMT implies, Brexit itself that generates losses, but as an Oxford Economics video highlights * , what the Government does with it. Hold that thought.
Then HMT considers the FTA option through a Canada-like-lens; i.e., excluding services. But why-so? Services are usually excluded from EU FTAs only because EU-FTA candidates' services sectors are typically substantively non-EU-compliant at the outset. And defining and securing compliance is fiendishly complex, sector by sector and lobby group by lobby group on both sides. But there is no such obstacle in the Brexit case, including on financial services. The UK is already fully EU-services compliant--and is indeed is typically first-in-EU class on this. Only the handling of future substantive changes in EU standards would have to be determined. Similarly, renegotiating all EU-FTA agreements with third countries on goods, though a bother, would be subject to much-less-than-typical haggling because the default deal is the status quo. Thus, unlike Canada etc, services are completely FTA-doable in the Brexit case, as is renegotiating multiple third-country trade deals.
The substantive issue with the EU-FTA option, therefore, is not services but labor. The FTA option may be preferred by a post-Brexit UK Prime Minister relative to the EEA option because it allows for control over EU migration. But, for that very reason, some key EU governments--Poland, Ireland, France?--may attempt to block it, or demand privileged (possibly grandfathered?) access for their particular nationals to the post-Brexit UK labor market as part of a UK-EU FTA. The incentives facing the various EU governments post-Brexit will determine if this services-cum-part-labor FTA option is on the table. But if so, the "losses" that the HMT ceremoniously tots up for the FTA case really start to wobble. Hold that thought.
On the WTO option, the HMT rightly observes that services are typically excluded and that UK access to EU markets would be at the common EU external tariff. However, it ignores that prior full EU-compliance readily facilitates a services add-on to WTO access, and nor does it see need to highlight that EU common tariffs on goods are typically low or zero for the goods in which the UK specializes, with the notable exceptions of agriculture and vehicles. And, indeed, HMT's discussion of agriculture only considers UK producers' interests, omitting mention of the possibly considerable benefits for UK consumers of escape from the Common Agricultural Policy of the EU.
Perhaps not surprisingly, HMT cannot conceive that any Brexit-induced-loss-of-global-British-influence might be good or indifferent for the UK. But if that loss of influence curbs the dominance of UK producers over UK consumers via EU or global deals, that would be UK-welfare-enhancing. And UK consumers' interests may still be secured post Brexit if EU consumer interests secure the same outcomes as would be sought by their Brexited UK counterparts.
The HMT is right, however, to have little truck with notions that the UK-outside-the-EU would readily match the quality of its policy settings as an insider. The historical evidence of marked sustained rise in UK Total Factor Productivity (TFP) following the commencement of the single market in 1991 suggests that such use of policy discretion just doesn't happen--if it did, one might have expected TFP to have been unchanged or declined after 1991 . Or put another way, HMT's dismissal of the unilateral policy excellence sugestion is tantamout to it admitting that it is not institutionally strong enough within the UK to secure such settings in an out-context. Furthermore, there is little in the tenor of the "leave" campaign to suggest that it would effectively secure such high-quality discretionary policy settings.
And, the evidence of the global crisis from 2008 onwards is that countries with such weaker unilateral policy settings get hit considerably harder by exogenous global shocks than those with stronger settings--a cost of Brexit which the HMT, remarkably, completely overlooks.
So the key issue with HMT's quantification of Brexit costs is not the model used and its black-box workings and elasticities--salivating though it is for economists to pick over those--nor doubts about the quality and consequences of out-UK's policy settings understated as those costs of those might be by HMT, but the particular trade shocks that are run though the model. The EEA option could have almost zero effect if, Tsipras-like, the post-referendum PM swallowed a shovel-load of pride; the FTA option might comprise full inclusion of services and some labor if the EU was willing; the WTO option has an upside in escape from the CAP and a possible services add-on deal; and the "loss of UK global influence" may be far from all bad for the UK. HMT overlooks all this in its pursuit of scary headline numbers and in its eye-drooping prose.
Context is King
If you think this sounds uncomfortably like an apology for "leave", hold your horses.
Instead, return to those two thoughts held in mind from earlier--that the EEA option depends on the UK Prime Minister, and the FTA-cum-services-cum-some-labor option depends on the willingness of EU governments. These highlight that the incentives facing EU and UK policymakers post-referendum will determine what options are open.
So what will those incentives be, after the fact?
This gets to the much-obscured heart of the matter. In a way eerily reminiscent of the HMT's famous "five tests" decision-making framework to determine UK Euro entry--which failed to ask the only key question "does the Euro itself work?"--this HMT paper also misses the big point, namely that Context is King. In so doing, this HMT intervention compounds doubts about the constitutional precedent set by its earlier intervention in the Scottish referendum; it presents its intervention as "independent" and "technical" when it clearly is not.
There are broadly two contextual scenarios for post-Brexit trade negotiations.
The first is that immediate market fallout from Brexit is contained entirely to the UK. This is the implicit assumption made by HMT throughout. In that case, the EU and others will indeed have little incentive to ease the UK's self-inflicted plight. So negotiations will be delayed and options countenanced will be well towards the worse-for-UK end of HMT's spectrum. Coming on top of considerable UK economic imbalances, a current account deficit running at an annualized 7 or so percent of GDP, continued housing overheating, and fallout from renewed Scots independence and Irish reunification initiatives, the market reaction could be severe, causing a loss of UK GDP relative to baseline of perhaps 1 1/2 percent or more over a year or two.
But the very severity of that first scenario makes possible, if not probable, a second scenario under which market fallout spreads to the Euro. Ireland would be particularly hard-hit by the post-Brexit fall in Sterling, but well beyond that, Brexit could compound doubts and prospects for the broader European project * . If so, and if market stresses there also become severe, policymakers on both sides of the channel will come under sharp pressure to negotiate a Brexit cost-minimizing deal at high speed, to calm Euro and global market nerves. This could secure a form of trade deal well beyond the UK-friendliest end of the spectrum considered by HMT--possibly even a FTA-cum-services-cum-partial-labor deal.
But far from this scenario affirming the leave camp's optimism about trading options that will be available, the market stresses that make them possible only underscore the sheer recklessness of the decision to hold the referendum in the first place and of the leave camp's willingness to run those risks. A plague on both of their houses!
Granted, there are fundamental issues of prosperity and sovereignty to weigh in continued EU membership. But there were and are other approaches to settling those which would have avoided the risks--an enthusiastic information campaign to blunt calls for a referendum, a different approach to the internal politics of the Conservative party, and a less stridently Federalist tone from Europe. But neither Messrs. Cameron and Osborne nor the continental Europeans choose those.
And we have seen the heavy long-term toll on output from such crises, notably following the financial and euro crises of 2007-11. It is inexcusable that HMT focuses on the losses from Brexit taken from a narrow trade theoretic framework, while saying nothing whatsoever about the losses that would arise from a macroeconomic crisis that Brixit would engender, for the UK and, likely, for the Euro too.
Where to from here?
Given the risks, the global condemnation of the leave campaign is appropriate, and President Obama has rightly spoken up on the issue too.
But that PM Cameron and Chancellor Osborne join in with it is truly a case of the pot calling the kettle black. They present themselves as "men with a working medium-term plan", and, in this campaign, as being the "responsible" leaders. But not only does their medium-term plan have shortcomings well-described by Jonathan Portes and Simon Wren-Lewis * (among others), but Cameron and Osborne have also unilaterally attached this "referendum suicide bomb" to it. Kenneth Clarke opines that Mr. Cameron would not last a minute after a referendum defeat. But core UK policy, described this way, implies that he and his Chancellor should, in all responsibility, resign either way.
They won't, of course. If Brexit is defeated, they'll declare victory and we'll all be relieved that we got away with their incompetence. But if Brexit occurs, in the bedlam that immediately follows, expect some quick-moves surprising HMT on UK's post Brexit trading relationship with the EU.

HMT Report on Brexit.
Sleight of hand HMT headline fraction.
Gideon Rachman on Brexit
Oxford Economics Analysis of Brexit
HMT Intervention in Scottish Referendum
Implications of Brexit for the rest of the EU.
J Portes & S. Wren-Lewis critique of UK economic strategy.

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