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BREXIT BRIEFINGWhat does “Brexit means Brexit” mean?

Sherlock Holmes said that when you’ve exhausted all other possibilities, whatever remains, however improbable, must be the truth.

macronomics™ argues that in terms of Brexit, the whatever remains is likely to be unilateral free-trade by the UK – what we term the zero option, unconventional WTO membership, with zero tariffs on imports. The other Brexit options (the EEA, bilateral agreements or conventional WTO membership) are likely to be seen by the Government as less attractive. The exception might be the zero-zero option (the zero option plus EEA membership), but this is unlikely to be acceptable politically in both the UK and the EU.

“Brexit means Brexit” is a rhetorical tautology, not a guide to policy. In this first edition of the macronomics™ Brexit Briefing service we analyse the potential routes forward as the Government decides its parallel strategy on our divorce from the EU (invoking Article 50) and our future relationship with it.

Part 1 of the briefing paper examines what UK unilateralism would look like, and why it is likely to be pursued.

Part 2 examines why the conventional wisdom regarding the European Economic Area (EEA), bilateral agreements and standard World Trade Organisation (WTO) membership is likely to be wrong.

Part 1: UK unilateralism and zero-zero versus zero options

Throughout the referendum campaign there was very little discussion of one of the key elements of EU membership, namely the customs union and the EU Common External Tariff (CET). Almost all of the discussion focused on the trade benefits of EU membership, without mentioning this trade cost. The CET raises prices for UK consumers and businesses above world levels. This is what macronomics™ refers to as a front door cost on imports into the UK. Most of the debate thus far has focused on the potential back door costs, from exports leaving the UK, but then facing the CET in a post-Brexit world.

In pure economic terms a hybrid model of EEA membership and UK unilateralism might be most appealing to the UK government. It would provide tariff and non-tariff barrier free access to the Single Market, whilst removing the CET on imports from outside the EU at the same time, because the UK would be outside the EU Customs Union. This explains why some might see being in the EEA, and out the Customs Union, as superior to existing EU membership. The UK would have the benefit of Single Market access and could also trade at world prices, if the UK chose to impose zero tariffs on imports. Zero tariffs on imports (from the rest of the world) and exports (to the EU) is what macronomics™ terms the zero-zero option.

However, the zero-zero option would fail to address 3 key political demands arising from the referendum result (discussed in Part 2):

• Ending the free movement of people – all 4 freedoms (goods, services, capital and labour) will almost certainly be required for Single Market access to be granted.

• Ending the UK’s budget contributions to the EU – EEA members have to contribute to the EU budget.

• Ending EU control – EEA membership provides regulation without representation, and could be said to provide even less control than EU membership, where the UK could vote on proposed regulation. There is an old quip saying, if you want to run the EU, stay in the EU, but if you want to be run by the EU, join the EEA.

The zero-zero option also faces a significant political challenge from the rest of the EU. If the UK removes all tariff barriers and effectively trades at world prices, and simultaneously has tariff free access to the EU, it would over time build-up a significant competitive advantage. We don’t think the rest of the EU would accept this threat and would therefore veto EEA membership at the outset. What might be acceptable for a small economy such as Norway, with an oil dependent economy, would not be acceptable for a large economy such as the UK, competing with EU economies across a wide range of goods and services.

Consequently, we think the zero-zero option is unlikely to gain traction in the Government, and is likely to be replaced by what we call the zero option. The zero option is not that big a step on from the normal WTO model with tariffs. But unlike the normal WTO model, it allows the UK to reward consumers with much lower prices (see below) and make a very strong statement to the world regarding the merits of free-trade.

So whilst the economic ideal might be open access at the front (imports from the rest of the world) and the back (exports to the EU) of the house, this is unlikely to be obtainable.

Brexit means Brexit is a rhetorical tautology, not a guide to policy.

B R E X I T B R I E F I N G 2

The zero option

The zero option is zero tariffs on imports into the UK. So what would attract the Government to the zero option? We can think of 7 reasons:

• No choice - Either the Article 50 negotiation or a subsequent trade agreement negotiation could unravel leaving the UK the only option of falling back on WTO rules. The choice would then be standard WTO rules (without the benefit of trading at world prices) or the zero option. A trade deficit with the EU will only provide limited bargaining power in negotiations.

One of the arguments advanced in support of Brexit, was that because the UK ran a large trade deficit with the EU, negotiating tariff free access into the EU would not be a problem. The image conveyed, was that the CEOs of companies such as BMW and Porsche would be hammering on the door of the Chancellery in Berlin, demanding tariff free trade with the UK, to avoid tariffs being placed on their car exports.

Unfortunately the story isn’t this simple. Yes the UK runs a large trade deficit with the EU. The most recent Pink Book shows a goods deficit with the EU of £79 billion. But the breakdown of the figures by country shows that almost £30 billion of the deficit is with Germany alone. Germany has a significant vested interest in maintaining tariff free-trade with the UK. The other largest EU economies (Italy, with a surplus of £7.9 billion with the UK, followed by Spain at £6.8 billion and France at £6.1 billion) do not have a huge incentive to accommodate the UK in trade negotiations. In France, Italy & Spain, the average surplus is around 0.5% of GDP, and these countries know that regardless of tariffs, the bulk of trade would be maintained.

It also needs to be remembered that the UK runs a trade surplus with the EU in services, of around £17 billion. Moreover, the UK is more dependent on the EU for exports (44% of UK exports go to the EU), than the EU is dependent on the UK (17% of EU exports go to the UK).

• Control – Outside the Common External Tariff the UK would be free to pursue a zero tariff model. The EU would have no say.

• Speed - The issue of prolonged uncertainty hangs over the Brexit vote. The zero option could be implemented rapidly. The UK would agree a zero tariff schedule with the WTO and that would be it.

• Consumers – There is a substantial potential gain to consumers over producers (although the scale of this effect is debated, see below), from trading at world prices. There could be a political benefit from lower import prices.

• Kudos – The economies closest to the free-trade option, albeit small, are Hong Kong and Singapore. Some of the ‘sparkle’ from these economies could be sprinkled on the UK. The UK could become the global leader for genuine free-trade, challenging protectionist tendencies around the world.

The zero option is zero tariffs on imports into

the UK. Zero tariffs on imports (from the rest of the world) and exports (to the EU) is the zero-zero option.

However, the zero-zero option would fail to

address 3 key political demands arising from the referendum result.

B R E X I T B R I E F I N G 3

• Soft power – The UK’s success in the Rio Olympics, coming second to the US in the medals table, could have an impact on Government EU policy, making it easier to sell the argument of the UK going alone. It should also be remembered that in measures of ‘soft power’ (the American dream, the Royal Family, English language etc.) the UK ranks number 1 in the world (out of 30 countries), ahead of even the US. According to the Portland Index of Soft Power, soft power seeks to achieve influence by building networks, communicating compelling narratives, establishing international rules, and drawing on the resources that make a country naturally attractive to the world, as opposed to carrot and stick diplomacy. It is about pull not push.

Concerns regarding the zero option

3 concerns have been raised about the zero option, but in our opinion all 3 are misplaced:

Scale - There is a debate over how big an impact trading at world prices would have. Research by Minford (Should Britain Leave the EU? Minford et al, 2015) suggests that moving to trading at world prices would have a very significant economic impact on the UK, with prices reduced by 8% and output up 4%. Minford argues that single market protectionism raises prices by around 20% on food and manufactured goods. In manufacturing most of the effect comes through non-tariff barriers, as tariffs are around 2-4% depending on the method of weighting. Minford argues that protectionism significantly raises prices and lowers productivity. He also argues that the different results he obtains regarding the

impact of Brexit (positive), compared with numerous other recent studies (negative), are attributable to these studies assuming conventional WTO status post Brexit, without unilateral free-trade.

In a critique of Minford, a CEP study (Economists for Brexit: A critique, Sampson, Dhingra, Ottaviano & Van Reenan, Centre for Economic Performance, LSE, 2016) argues that the Minford model overstates the stimulus from world prices because: Firstly, CEP question the scale of price differentials exhibited in the data used. Secondly, CEP challenge the size of the trade elasticity, with small changes in prices having large effects on trade volumes, as people buy from the cheapest supplier. The CEP study argues that the stimulus from world prices would be minimal.

We think the Government could

be persuaded by the zero option, due to the speed, control, kudos, soft power & political

bonus (from lower prices) it provides.

Unilateral free-trade would be a big shift,

on a par with the abolition of the Corn

Laws in the 19th

century.

• Supply-side – External liberalization could be complemented by internal liberalization, as every effort is made to accelerate productivity growth. We envisage 3 effects: (1) Increased infrastructure spending and key decisions finally made e.g. with regard to the go ahead for Heathrow. (2) Lower Corporation Tax, possibly a reduction from the announced 17% in 2020, to 15%, with a commitment to operate an even lower rate, say 10% by 2025 - the lowest rate in the world outside the zero band tax havens. (3) Reductions in the absolute level of regulation, despite relative competitiveness.

B R E X I T B R I E F I N G 4

Three concerns have been raised about the

zero option, but in our opinion all 3 are

misplaced.

However, in their unilateral free-trade simulation CEP assume only that a tariff of 3% is abolished, when price comparison data shows the gap with world prices is around 20% (in other words there is a non-tariff barrier effect of around 17%). They also ignore Common Agricultural Policy (CAP) protection of around 20% (on OECD estimates). Moreover, the CEP focus on the 3% figure, begs the questions as to what all the Brexit fuss is about, if being outside the Single Market only costs 3%!

This is an area where every researcher’s numbers can be questioned, obtaining precise estimates of comparative prices is notoriously difficult because of the need to genuinely compare like with like. The full impact of unilateral free-trade may/may not be less than in the Minford model, but even if it is, there is still a significant impact. Moreover, the price differential between EU and world prices almost certainly means that the gains to consumers (and unprotected producers) will greatly exceed the cost to producers from higher tariffs, if the UK was to be outside the CET. Minford’s figures suggest a ratio of more than 8 to 1.

Diplomatic - Moving to unilateral free-trade reduces the UK’s bargaining hand in future negotiations for free trade agreements, because the UK would have already given away zero tariffs. However, if the Government takes the view that the most important consideration is the gain to consumers over producers, they will resist this objection.

Sectoral - The other key argument against the zero option would be the consequences for the sectors most impacted by trading at world prices. The prime critique of the zero option is the impact it would have on manufacturing in the UK, which would face the stark choice between moving up the value chain, or becoming uncompetitive against the threat from world prices. However, we think the Government might take the long view

here, recognizing that manufacturing output has already fallen from 32% of GDP in 1970, to 10% now. Manufacturing employment as a proportion of total employment has fallen from 35% to 8% over the same period. More than half of UK manufacturing exports already go to non-EU markets, and face the full force of world competition.

Another aspect of the sectoral issue is whether or not cars and the city provide a special case. The fear here is that the CET would add 10% to the export price of cars into the EU, and that the loss of passporting rights could lead to a significant shift in employment away from the City to the continent.

We think both fears are overdone. Even if the UK Government were to fully refund the CET on car exporters, the cost would be around £1 billion. We have suggested above that the UK Government is likely to reduce Corporation Tax substantially, but it is quite possible that at least for a transitional period, the Government might offer some form of financial alleviation to car producers, beyond lower Corporation Tax. The cost would not be a barrier.

With regard to passporting rights, we also think this fear is greatly exaggerated, partly because it is so confused. There is no real Single Market in services. All passporting does is avoid the requirement of multiple offices, but in many cases of retail financial services, multiple offices will be a requirement anyway, to establish tailored marketing functions across different countries. With regard to financial services, from January 2018, MIFID II will establish a new regulatory regime called ‘equivalence’, in which any financial services firm based in a country that is deemed to have an equivalent financial services regulatory regime, will be ‘passported’ into the EU. Our view is that the UK financial services regulatory regime will be considered equivalent.

B R E X I T B R I E F I N G 5

Strategic factors

As if the issue wasn’t complicated enough, we think the Government will need to stir 2 additional strategic considerations into the mix as well:

Physical proximity and physical goods are likely to be less important than at anytime in our economic history. Gravity models of trade emphasise the role of proximity and size in explaining the scale of trade flows between countries. However, in a world of ever increasing connectivity, proximity is likely to become less important.

Since 2008 (the onset of The Great Recession) exports to non-EU countries have risen by an average 5% per annum, whilst those to EU countries have fallen by an average 0.7% per annum. Whilst the poor performance of the Euro-zone is a major part of the explanation for the growth differential, it is also clear that lack of proximity has not been an impediment to export growth beyond our near neighbours.

If total UK exports to the EU were to level off (as opposed to continuing to fall), and exports to non-EU economies were to continue to rise by 5% per annum, the EU share of total UK exports would fall from 44% now, to 29% by 2030. If one assumes 1% per annum growth in exports to the EU, the projected share still falls to 32% by 2030.

Physical goods trade is also losing export share to services. Since the turn of the century, the proportion of UK exports in services has risen from 31% to 44%.

These numbers say that the negotiation needs to look beyond the EU and beyond physical goods. A negotiating mindset, which focuses on the EU (without considering growth potential in the rest of the world) and goods trade alone, is swimming against the tide of history.

The UK requires a trade strategy which maximizes trade tomorrow, not today. The EU share of world output has almost halved over recent decades, from 30% to 16.5%. The UK Government will be mindful of the fact that whilst the EU remains overwhelmingly our largest export market, the decline in the economic significance of the EU, in terms of its share of global GDP, needs to be considered.

It is also clear (OECD database) that over the past 4 decades exports to the EU have increased much faster in the BRIC economies, USA, Canada, Australia, Switzerland, Singapore and Hong Kong, than from the UK or other EU countries. Being outside the EU, and not in close proximity, has not been a barrier to trade growth.

A negotiating mindset, which focuses on

the EU (without considering growth potential in the rest

of the world) and goods trade alone, is

swimming against the tide of history.

B R E X I T B R I E F I N G 6

The conventional wisdom

The current debate focuses on 3 potential ways forward:

• Single Market membership – Essentially the Norwegian model, with membership of the EEA, providing the so-called 4 freedoms (goods, services, capital and people). This is close to, but not the same as, Single Market membership within the EU.

• Bilateral agreement – Essentially the Swiss model with bilateral deals, which would provide preferential access to the EU market in goods (probably excluding agriculture). Tariffs and quotas would be largely removed, and some barriers to trade in services might also be removed by the free trade agreement (FTA). Another form of bilateral agreement is a customs union agreement. Essentially, this is the Turkish model, with the abolition of quotas and tariffs within the customs union, and the application of the EU’s Common External Tariff (CET) to trade with third parties.

• World Trade Organisation (WTO) rules – The UK would trade with the EU under WTO rules and face the same tariffs and barriers to trading with the EU, as any other WTO member, such as the US. This is seen as the natural fallback position should EU negotiations break down.

BOX 1

Part 2: Why the conventional wisdom is wrong

In Part 1 we explained the macronomics™ view as to why the zero option seems the most likely way forward. In Part 2 we explain in greater detail why the conventional wisdom regarding the EEA, bilateral agreements and conventional WTO membership might be wrong.

macronomics™ argues that none of these models, as conventionally understood, is likely to be pursued through to implementation. We think the zero option will either be pursued very early on, or emerge as a result of the difficulties with other options.

B R E X I T B R I E F I N G 7

The Norwegian model

EEA stumbling blocks

The Norwegian model is short hand for membership of the European Economic Area (EEA). The EEA was established as a waiting room for full EU membership and provides high levels of access to the Single Market (though not as complete as EU membership).1 The EEA is probably the most favoured option in Whitehall and Westminster. From an economic perspective, it is the closest option to existing EU membership. It provides continued tariff and non-tariff barrier free trade with the EU, and covers goods and services, as now.

The problem with the EEA option is mainly, though not exclusively, political (see Table 1). The price of access to the Single Market would almost certainly be free movement of people. It is hard to imagine the rest of the EU allowing free movement of goods, services and capital, without the fourth freedom, people. But continuing with free movement of people would almost certainly be a bridge too far, politically, in the UK.

1 There would be customs checks and rules of origin, and there could be problems if EEA law failed to keep up with EU law.

Moreover, EU policies not covered by the EEA agreement would no longer apply to the UK. In the economic realm this would include agriculture and fisheries, the customs union and common trade policy. Membership of the EEA would also offer the benefit of any future liberalisation in the Single Market for services.

At face value this is an attractive option, but on closer examination, the case for the EEA model begins to crumble.

The political stumbling blocks with the EEA don’t stop there. The other price of access to the Single Market would be a budgetary contribution of some form also. Throw in the problem of regulation without representation, and the UK having to abide by Single Market rules it had no say in (and which might be damaging to the City, for example, in the future), and the political hurdles to EEA membership appear too high - pay and no say. Moreover, even if the UK were to seek the EEA option, there is no guarantee it could achieve it. EEA membership requires EU or European Free Trade Association (EFTA) membership, and so there is the possibility of a veto by EFTA countries as well.

The problem with the EEA option is mainly,

though not exclusively, political.

B R E X I T B R I E F I N G 8

Stumbling blocks to EEA membershipTABLE 1

The price of access to the Single Market will almost certainly include freedom of movement of people, which is likely to be politically difficult to deliver in the UK. Highly unlikely to get free movement of goods, services and capital without people as well. EU negotiated hard with Switzerland on this issue.

The price of access to the Single Market will include a budgetary contribution of some sort, rekindling the £350 million per week debate in the UK.

Integration or regulation without representation – membership of the EEA requires implementation of rules determined by the EU, and imposed on the UK.

Single Market rules will almost certainly include areas of employment law, justified by the EU to avoid ‘social dumping.’

EEA countries are all members of EFTA, so risk of a veto. Norway vetoed Slovakia’s bid to join the EEA.

The EEA is not necessarily the same economically, as EU membership e.g. the EEA states lag in incorporating EU legislation, such as covering post 2010 financial regulation.

EEA membership would not mean the UK was covered by existing trade agreements. Unclear how EFTA trade agreements would apply.

Labour market regulation, as part of Single Market law, would still apply.

We are doubtful that any of the suggested compromise solutions are available from the EU either. Rupert Harrison, former economic adviser to the Chancellor, George Osborne, has suggested ‘EEA minus’ with a bit more immigration control and a bit less Single Market. UKIP MEP Dan Hannan, has suggested joining the EEA until an FTA (with SM access) is negotiated.

Enthusiasm for the Single Market is not without criticism. From an economic standpoint 2 influences dampen the arguments that the impact of the Single Market is unequivocably positive. These 2 influences suggest a more nuanced interpretation is required, and this in turn means that Single Market access won’t be pursued at all costs:

• Relative versus absolute regulation performance - Whilst the UK ranks highly (low burden) on measures of product and labour market regulation, this does not mean there is no scope for absolute improvement. Outside the Single Market the UK could pursue more radical deregulation - to the extent that it is politically possible.

• Single Market versus world price effects on competition - The purported gains from trade within the Single Market (lower prices, larger market, greater choice, competition and higher productivity) can be replicated by trading at world prices, without the CET raising import prices.

B R E X I T B R I E F I N G 9

Stumbling blocks to a FTA

Stumbling blocks for the other models

TABLE 2

Likely to only cover goods, or very limited service sector coverage.

To gain access to the Single Market Switzerland had to accept the principle of freedom of movement of people.

Transition - the Swiss relationship with the EU was agreed on the assumption that it would join, not leave the EU. This will make the negotiation very difficult – punishment versus reward.

Not clear whether or not EFTA trade deals would apply to the UK.

Very complicated e.g. Swiss have over 100 bilateral deals with the EU negotiated over decades.

Switzerland doesn’t have an agreement with the EU over financial services.

Veto risk again.

Canadian style FTA also requires compliance with EU environmental, social health & safety rules to avoid social dumping.

Timetable and prolonged uncertainty.

The attraction of a free trade agreement (FTA) is tariff free access to the SM for goods, possibly with some service sector coverage as well.

The free trade agreement option is less attractive in terms of access, given that it is likely to only cover goods, with minimal coverage of services.

The experience of the Swiss also shows that even limited access to the Single Market requires the free movement of people. Switzerland doesn’t have an EU agreement for financial services either. Throw in issues

of complexity and timing (the Swiss have over 100 bilateral agreements established over many decades), and the free trade agreement model has its own set of challenges.

The customs union model, illustrated by Turkey, is just another form of bilateral agreement.

But remaining in the customs union would mean trade policy was still outsourced to the EU and that UK prices would remain higher than world prices, because of the European Union’s Common External Tariff (CET).

B R E X I T B R I E F I N G 10

The trade agreements signed between the EU and Switzerland, and the customs union agreement signed between the EU and Turkey, have to be seen in the context that these economies were thought, at the time, to be on a transition to EU membership.

The deals were part of a carrot to incentivize membership. Reverse the direction, and it is not at all clear that the EU would accept such agreements for countries leaving the EU. The EU is potentially more likely to punish not reward, countries leaving the EU.

Disclaimer

This report is an example of macroeconomic, geopolitical and future megatrends research produced by Macronomics Ltd. which aims to improve economic insight. As such, it does not constitute investment advice, nor does it constitute a solicitation for the purchase or sale of commodities, securities or investments.

Whilst every effort has been made to ensure that the data and information in this report is accurate, its accuracy is not guaranteed. Persons using Macronomics Ltd. research do so entirely at their own risk, and Macronomics Ltd shall be under no liability whatsoever in respect of any errors or omissions.

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