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The economic impact of Brexit tariffs only tells us half the story

The economic impact of Brexit tariffs only tells us half the story

Brexit is about much more than the economic costs and benefits, but the idea that the former dramatically outweigh the latter has become the received wisdom in much of the media.

Report after report emerges which purports to show that, under any of the various trade arrangements envisaged, the UK will be worse off as a result of Brexit.

These studies are not wrong. They all use perfectly standard economic theory to arrive at their conclusions. But they are misleading.

The real problem is that they miss out key bits of the story. We can think of the classic tale of the person dropping his car keys in the street at night. He only looks for them under the street lamp, where the light is.

In the same way, standard economic analysis of Brexit only illuminates part of the landscape.

The explanation of why trade occurs between countries was given 200 years ago by the great English economist David Ricardo. It is still the basis of the modern economist’s understanding of trade.

Ricardo imagined, to illustrate his theory, a world with just two countries and two products. His examples were England and Portugal, and cloth and wine – but they could have been any countries and any products.

Ricardo asked a simple but profound question. If England could produce both cloth and wine more efficiently than Portugal, why would trade take place at all? How could the more efficient country, England, benefit from trade?

His answer introduced the fundamental concept of comparative advantage. England had an absolute advantage in producing both cloth and wine, but the country should choose to specialise in producing the one in which its advantage compared to Portugal was bigger.  Both would benefit if England produced only cloth and Portugal only wine, and they traded.

Economics has moved on in the past two centuries, but the concept of comparative advantage, modified by factors such as the distance between countries, is still seen as a key determinant of trade patterns.

In terms of Brexit, introducing complexities like tariffs into the picture essentially affects the amount which is traded, and not the structure of trade in terms of who sells what to who.

If the basic pattern of trade is fixed by comparative advantage, then if Brexit means higher tariffs for the UK, as a country we will lose out. In a nutshell, this is what lies behind all the negative assessments of the impact of Brexit.

However, the key word in the last paragraph is “if”.  Like almost all economic theory, these models are static. They assume that the network of trade is fixed, and analyse the consequences of changing prices through tariffs.

The EU has become mired in regulation and the level of innovation is low. Outside the EU, the UK could alter the patterns of trade by innovating in, say, biotech or AI-related products and services. It is this dynamic response, and not the static one, which will determine whether or not Brexit is a success.

Economic models which claim to analyse the impact of Brexit are true – but only up to a point, Lord Copper, as the saying goes.

As published in City AM Wednesday 30th October 2019 
Image: Dover by Oast House Archive via Geograph licensed for use CC BY-SA 2.0
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Britain is more optimistic about Brexit than gloomy forecasts suggest

Britain is more optimistic about Brexit than gloomy forecasts suggest
The International Monetary Fund (IMF) is up to its usual tricks. Last week, it predicted a two-year recession in the UK in the event of a no-deal Brexit. Even in the main forecast, involving a mild Brexit, GDP was projected to grow by only 1.2 per cent this year and 1.4 per cent in 2020. These are very gloomy numbers. If they were correct, it would be the weakest period of growth since the financial crisis itself in 2008 and 2009. The IMF has form on this matter. Six years ago, in the spring of 2013, mainstream economists were full of doubt that the government’s policy of austerity would work. In January that year, the IMF projected only one per cent growth, which in April it slashed to just 0.6 per cent. In fact, economic growth accelerated from 1.4 per cent in 2012 to 2.0 per cent in 2013 and 3.0 per cent in 2014.   In line with the thinking of Project Fear, in the middle of June 2016 the IMF predicted an immediate recession if the UK voted to leave. Exactly the opposite happened. The economy continued to grow, and unemployment to decline.   To be fair, this time around there does seem to be evidence of a slow-down. The Office for National Statistics (ONS) suggests only modest growth at an annual rate of around one per cent in the last three months of last year. A recent Deloitte’s survey of chief financial officers found only 13 per cent of them more optimistic about prospects than they were three months ago. Does the online world tell us anything different? The ONS is making progress here. The agency is starting to use so-called big data to try to get faster and more accurate fixes on what is happening to economic activity. Online information such as value added tax returns and road traffic is being analysed. Given that this is the first time it has ventured into this field, the ONS is understandably cautious about its initial estimates. It says, rather cryptically, that the indicators they are using are broadly in line with their long-term averages and paint a mixed picture. Since 2016, with my UCL colleague Rickard Nyman, I have been monitoring on a daily basis how people in London are feeling. The conventional measurement of wellbeing is based on responses to surveys. In contrast, the Feel Good Factor (FGF) extracts the sentiments which people reveal, knowingly or unknowingly, in their online posts, using advanced machine learning algorithms. There were big drops immediately after Brexit and after Donald Trump’s election. But the FGF recovered in a matter of days. Averaging the data over each quarter, optimism peaked at the start of 2017. By early 2018, a sharp drop took place, but sentiment was still around its 2016-19 average. During early 2019, the FGF is down again, but only slightly, and the past few weeks show no change compared to the same period last year. Uncertainty over Brexit does seem to be having a negative impact on sentiment in the short term. But the overall trend offers some sunny perspective on the IMF’s dismal economic forecasts.
As published in City AM Wednesday 17th April 2019
Image: British Weather by Wikimedia is licensed under CC BY 2.0
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This Nobel-winning economist can tell you why there’s no Brexit consensus

This Nobel-winning economist can tell you why there’s no Brexit consensus
Should pure blue sky research be funded? Certainly, the answer from government-backed research councils seems to be “no”. The emphasis is increasingly on research which has immediate practical applications. Yet seemingly esoteric research can shed light in quite unexpected areas. For example, a PhD thesis written by a then obscure research student 70 years ago helps us understand the difficulties encountered today in resolving the current Brexit problem with a series of votes. The number of alternatives suggested as the outcome of the Brexit process has been bewildering. During the past week alone there has been: Theresa May’s deal; her deal plus a customs union; her deal plus a customs union and the Single Market; a Canada-style free trade agreement; another referendum; revoking Article 50 and cancelling Brexit; and leaving without a deal at all. Little wonder that MPs have struggled to produce an overall majority in favour of any particular option. So now we come to the idea of so-called “indicative votes”. MPs are due to vote on each of a large range of options to see which, if any, command a majority. A variant would be to get MPs – or the electorate as a whole if there were another referendum – to rank explicitly the alternatives in order of preference. When we elect the London mayor, we have to express our preferences rather than just cast one vote, as we do in a General Election. All of these approaches seem plausible. They share the same basic idea: test the options with a voting system based in some way on preferences among the alternatives, and see which comes out top. It seems common sense. But unfortunately, as is often the case, common sense is not a very good thing to rely on. The PhD thesis mentioned above was written by Kenneth Arrow, who went on to win the Nobel Prize in economics. He demonstrated the inherent problems of preference-based voting systems. Arrow, who died in early 2017 at the age of 95, is virtually unknown to the general public. He spent his life in the sheltered groves of American Ivy League universities. But he made some of the most profound contributions to economic theory in the whole of the second half of the 20th century. One of these was his so-called Impossibility Theorem. He proved that, whenever voters have three or more alternatives, no system of ranked voting can convert the ranked preferences of individuals into a set of preferences at the aggregate level which is guaranteed to be consistent. Arrow’s result applies not just to a given practical example, but to all systems of this kind. Paradoxes abound. For example, even if all voters prefer X to Y, it is entirely possible that at the group level the result may not reflect this. When once asked about the practical implications, Arrow himself said: “Most systems are not going to work badly all of the time. All I proved is that all can work badly at times.” Brexit is an excellent example not just of this, but of the value of high quality, blue sky research.
As published in City AM Wednesday 27th March 2019
Image: Brexit via Pixabay
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Europe has suffered from the euro – just ask the Greeks

Europe has suffered from the euro – just ask the Greeks
One of the entertainments of the holiday period was reading Adults In The Room, the book by Yanis Varoufakis. It describes his time as finance minister of Greece, and his negotiations with the IMF, the European Central Bank, and the European Commission. Varoufakis was only in the job between January and July 2015. He had the unenviable task of trying to renegotiate the massive debts of the Greek government. Reading between the lines, Varoufakis cannot have been an easy person to deal with. Indeed, he was effectively forced out of his position by the far-left Prime Minister Alexis Tsipras. Still, the academic-turned-politician had many bright ideas. But he could get no traction. Some of Jeremy Corbyn’s shadow cabinet will undoubtedly have read the book. The more reflective among them will realise that negotiating with international bodies when you have a large burden of public sector debt is not exactly fun. In the end, exactly like the Greeks, you will be forced to adopt policies of austerity which you have spent your political life criticising. But many of our more ardent Remainers would also benefit from reading the former Greek finance minister’s analysis and descriptions of events. To them, the EU represents a kind of Garden of Eden, where milk and honey (as well, of course, as sweetness and light) flow in abundance. The harsh reality is that, in their fanaticism for greater European integration and its crowning symbol of the euro, Europe’s elite are quite unable to get to grips with the fundamental problems which the continent faces. The financial crisis of the late 2000s began to take hold of the wider economy during the winter of 2007/08. The year 2007 represented for most countries the peak level of output before the crash. Over the past decade, western European countries in the Eurozone have grown much more slowly than comparable ones which have their own currencies. Greece, of course, has experienced one of the deepest and longest recessions in the entire history of capitalism. Greek output in 2017 was 22 per cent lower than it was in 2007. Even leaving Greece out of the calculations, the growth performance of western European economies in the Eurozone has been poor. Their average growth over an entire decade has been just 5.6 per cent. In contrast, average growth in a group made of the US, Canada, Japan, Australia, the UK, and smaller non-Eurozone countries like Norway and Switzerland has been 16.2 per cent. The UK itself is below the average for this set at 11.4 per cent – still, a lot higher than the Eurozone average. Towards the end of last year, much was made of the fact the growth in the Eurozone as a whole had slowed from 0.4 per cent in the second quarter of 2018 to just 0.2 per cent in the third quarter. But Europe’s problems are much deeper-seated. The evidence of an entire decade shows the stultifying impact of the euro. The best decision that Gordon Brown ever made was to keep us out of it. If only Greece had done the same.
As published in City AM Wednesday 9th January 2019
Image: Street Art by Aesthetics of Crisis under CC BY 2.0
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The Ghost of Christmas Past could tell us where the negotiations all went wrong

The Ghost of Christmas Past could tell us where the negotiations all went wrong
In Charles Dickens’ A Christmas Carol, Scrooge finds being haunted by the Ghost of Christmas Past unbearable. He begs it to stop. The Ghost replies: “These are the shadows of things that have been. That they are what they are, do not blame me.” It might almost be the Prime Minister speaking about the whole Brexit process. How might things have been different? And are there any pointers about our future dealings with the countries of the EU? A fundamental concept in game theory is that of the non-credible threat. This means making a threat in a sequential game – one in which there is a sequence of moves by each side – which a rational player would not carry out because it is not in their interest to do so. But in order to be effective, the other side has to believe that you will in fact carry it out if necessary. Donald Trump is a master of making such threats. China and North Korea both respect and fear him precisely because he conveys the impression that he might indeed do something completely irrational. The UK held – and still holds – two major bargaining chips in the Brexit negotiations: our armed forces (specifically the nuclear deterrent) and GCHQ. But at an early stage, Theresa May ruled out using either of these in the negotiations. At the moment, for example, British troops are stationed on the border of Estonia and Russia. They have taken part in war games to offer deterrence to Vladimir Putin. The Baltic states live in fear of a Russian invasion. They all have sizeable Russian-speaking minorities. In 1940, they were taken over by the then Soviet Union, and only regained their independence in 1991. They may not count for much in EU circles. But Britain could have made it clear that, unless these countries supported us, they would have to rely on, say, the Germans to defend them, and not the UK. Similarly, GCHQ is acknowledged to be the best cyber intelligence organisation in the EU. The head of the agency said in June that it had played a critical role in thwarting terror attacks in four other European countries in the past year. Letting just one of these attacks go ahead would have brought instant credibility to Britain’s leverage – though it would of course have come with a significant cost. On a more positive note, a number of EU governments are openly critical, and almost actively hostile, to the European Commission. Poland, Slovakia, Hungary, and the Czech Republic all have major concerns over migration. Matteo Salvini in Italy has never made a secret of his dislike of Brussels, and since his election has had a fierce argument with the EU over the Italian budget. But the Prime Minister seems not to have tried to build an alliance with him, nor with these other eurosceptic nations. Some may argue that these governments are not necessarily in the liberal tradition. They are, however, potential allies. And as the great nineteenth century Prime Minister Viscount Palmerston said: “Britain has no eternal allies, and we have no perpetual enemies. Our interests are eternal and perpetual, and those interests it is our duty to follow.” If May had heeded this, how differently things might have turned out.  
As published in City AM Wednesday 19th December 2018
Image: Theresa May by Arno Mikkor under CC BY 2.0
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Economies of the future will have to engage with the world, not just the EU

Economies of the future will have to engage with the world, not just the EU

The fire and the fury rage from day to day around the outcome of the Brexit process.

The discussion has lost sight of the longer-term context in which both the UK and the EU will operate, regardless of the precise deal which is or is not struck.

In the 1960s, the countries which are now in the EU-bloc represented just under 30 per cent of world output. This has already fallen to less than 15 per cent.

And on any reasonable extrapolation of trends, it will dip under 10 per cent at some point in the next two decades.

This does not mean that Europe is getting poorer. Far from it. It means that the rest of the world, especially Asia, has been becoming richer much faster.

The Brookings Institute calculations released last week were a marvellous piece of news.

For the first time in human history, just over 50 per cent of the world’s population, or some 3.8bn people, live in households with enough discretionary expenditure to be considered either “middle-class” or “rich”.

This has been achieved by capitalism. Until the 1980s, for example, in their own ways both India and China were centrally planned economies. Once they shifted to the principles of market-based economies, they have boomed.

The Brookings authors estimate that in 2030 – just a decade and a bit away – the middle-class markets in China and India will account for $14.1 trillion and $12.3 trillion, respectively.

This compares to their projection of the US middle-class market at that time of $15.9 trillion.

Okay, so their decimal points give an air of spurious accuracy to the forecasts – but the general point is clear. Whether Europe likes it or not, the vast majority of world trade will take place outside the EU.

The second key point to note is that Europe has hardly been a major economic success story. The narrative peddled by Remainers seems stuck in the past.

If we travel back in time to, say, 1970, it becomes easy to believe that the European economies are so dynamic that it is essential for us to have the closest possible links with them.

In the 1950s and 1960s, annual real GDP growth in the economies which then made up the EU averaged over seven per cent. In contrast, the UK barely scraped above three per cent.

Since then, the long-term average growth rate of the original EU countries has fallen more or less continuously to less than two per cent a year.

The UK’s has also dropped, but not by much. Over the past 20 years, our GDP has risen by 2.1 per cent a year. France registers 1.6 per cent, Germany 1.5 per cent, and Italy a mere 0.6 per cent.

Regardless of the eventual Brexit terms, successful economies in the future will simply have to engage with the rest of the world, rather than depend upon the EU.

As published in City AM Wednesday 10th October 2018

Image: Chinese Girls by David Stanley licensed under CC-BY_2.0

 

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