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22 March 2016

LSE: The question is not whether Brexit will cost the UK in economic terms but how much


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The LSE's Centre for Economic Performance latest report focuses on the impact of Brexit through changing trade patterns. Under ‘optimistic’ assumptions, there is a fall in national income of 1.3 per cent (about £850 per household). Under ‘pessimistic’ assumptions, this doubles to 2.6 per cent.


Figuring out the economic costs and benefits of Brexit

An obvious benefit of Brexit is that the UK will not have to send so much money to Brussels. On net this is around 0.31 per cent of our national income. An equally obvious cost of Brexit is that trade between the UK and EU will be lower if the UK leaves than if it stays. The degree to which trade costs will be higher outside the EU is a big question. But it’s a fact that even when countries have comprehensive trade deals (such as Norway’s deal in the European Economic Area, EEA) there are still non-tariff barriers due to regulatory differences, border checks, rule-of-origin requirements and anti-dumping actions. This is why even Norway has been found to have less trade with the EU than would be expected from such a deep level of integration. [...]

Since it is hard to know precisely how trade costs will change after Brexit, the CEP looks at two stark scenarios. An ‘optimistic’ scenario is that the UK swiftly strikes a deal so that it gets deep access to the EU single market, like Norway. A ‘pessimistic’ scenario is that the UK is unwilling to accept the free movement of labour and the associated regulations that are part of the ‘access price’ to the single market and so will prefer the usual EU external tariffs. Trade will fall by more in this case.

The table shows the results of our analysis. There is a drop in income per person of 1.3 per cent in the optimistic case, which doubles to 2.6 per cent in the pessimistic case. This translates to a fall of between £850 and £1,700 per UK household.

Is the pessimistic scenario too optimistic? Probably yes

The calculations the authors make are very narrow. They assume away any positive effects that trade may have on productivity through more competition, innovation, foreign investment and migration. The authors also abstract away from the economic damage induced by the policy uncertainty in the very difficult negotiating period following a Brexit vote. Negotiations over new trade agreements could stretch over many years.

An alternative ‘back of the envelope’ way to estimate the effects of Brexit is to look at what actually happens when countries joined the EU compared with being in free trade areas like the European Free Trade Area or EEA. The trade effects are big – a jump of a quarter or more. Combining this with estimates of the impact of trade on GDP from real falls in trade costs leads to an implied fall of UK national income of between 6.3 per cent and 9.5 per cent. Interestingly, this is squarely within the range of values that others have estimated have been the historical benefits of the UK joining the EU of around 8 per cent to 10 per cent.

This tripling of the costs of trade loss are also consistent with the literature of economic research comparing the actual benefits of trade liberalisation (big) with those predicted from static models like those presented here (much smaller). Naturally, UK trade with the EU does not disappear in any scenario – there remains a ‘trade deal’ in all cases. It is simply that there is less than it would have been had the UK remained a member. [...]

Is the optimistic case too pessimistic?

How could things turn out better? First, could the UK negotiate a sweetheart deal much better than Norway or Switzerland have managed? This seems unlikely. About half of the UK’s exports go to the EU, whereas only 10 per cent of the EU’s exports are destined for the UK, so the bargaining power is lopsided. What’s more, the EU will not want to be seen to be offering generous rewards for leaving as this will encourage other members to try the same trick. And in addition, all this assumes that everyone is behaving reasonably and rationally – unfortunately divorces tend to be much messier. Kicking the EU when it is undergoing a major refugee crisis and a long-running monetary crisis might provoke some very grumpy outcomes.

Second, could the UK strike better trade deals with non-EU countries like the United States, China and India than with the EU? Although the UK will not have to compromise with other EU members when doing such deals, it cannot offer access to the biggest single market in the world as the EU does (UK GDP is under a fifth of the size of the single market).  The EU is in the final stages of negotiation with the United States and Japan on deals estimated to raise GDP by 0.6 per cent. If the UK cannot replicate these deals (and the United States has stated it is not interested in a UK-only deal), this will be a further income loss on top of the estimates here.

Finally, what about the promised bonfire of red-tape when we leave the EU? Being outside the EU would enable the UK in principle to jettison some irritating regulations. But it’s worth bearing in mind that being in the EU has not stopped the UK from having one of the most flexible product and labour markets in the OECD (behind only the United States and sometimes Canada).

The real question is whether much better regulation will really be forthcoming after Brexit. We often hear by Eurosceptics that “the 100 most burdensome EU regulations have been estimated to impose annual costs of £33.3 billion”. But what they neglect to mention is that the government impact assessments they cite also estimate that the same 100 regulations bring benefits to Britain of £58.6 billion per year! It’s been argued that by getting rid only of those regulations where costs are deemed to outweigh benefits, 0.9 per cent of GDP could be saved. About half of this is estimated to come from the Renewable Energy Strategy and the Working Time Directive. It’s unclear that tearing up these environmental and employment protections will be politically feasible or really as economically beneficial in the long run as the impact assessments find. [...]

Full report



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