19 March 2016

Summary: The HMT report does come in higher than many of other recent estimates of the cost of Brexit. This seems to be mostly down to the type of modelling used and some of the assumptions. These result in the HMT’s estimates being less precise though that is not to say they are not credible. The issue is more that the report is, as might be expected, unbalanced. It looks at the benefits of EU membership and the costs of leaving but not the costs of EU membership nor the potential benefits to leaving. HMT is right to say there is likely to be a cost from leaving the EU and that there are trade-offs involved in post-Brexit negotiations – greater access likely means less control over migration and less say over the rules, as we have always said. However, there are potential gains outside the EU in terms of trade and deregulation, the question has always been how large these are and whether there is political support to undertake them. That is a decision for people to make. Unfortunately, the report fails to equip them with the facts on this front given that HMT simply asserts that any gains are small and are likely to be politically challenging. Sadly, so far, the Leave side has equally failed to equip people with the facts regarding the economic impact of Brexit. As such, the report poses hard and challenging questions for the Leave campaign, whose inability to spell out even the basic principles of life outside the EU means that they have once again failed to have an adequate response to the content of an economic assessment of Brexit.

The first point to note is that the HMT estimates are for the most part higher than other estimates out there, bar the LSE Centre for Economic performance dynamic estimates. Below I attempt to explain why this is and examine how credible some of the claims put forth by HMT are.

Different approach to modelling: As the useful graphic from the report below shows, HMT uses a number of models to produce the combined impact of Brexit on the UK economy. This is a more dynamic approach than the one Open Europe used (or PwC) for example. It looks deeper into the spill overs and knock-on effects of the first order disruptions to trade and Foreign Direct Investment (FDI). Of course, these later effects are by definition more uncertain and therefore mean the model is less precise. Using a number of models also increases the risk of double counting and means that some impacts are fed in a number of times via a variety of different channels. That said this modelling approach is common and well established in trade economics. Our research found that the long term economic impact is likely somewhere between -2.2% of GDP or +1.6%, with a more realistic range between -0.8% and +0.6%. The key factors in determining the cost will be in our view: whether the UK strikes a free trade agreement (FTA) with the EU, the impact of leaving the customs union and imposing a border between the UK and the EU, how successful the UK is in opening up to trade with the rest of the world, the choices it takes on migration, the savings from a reduced EU budget contribution and potential deregulation. As discussed in more detail below HMT looks at the first two of these issues in great detail but does not look much at the other three.

Hmt Model itemprop=

Reliance on productivity: The key transition point as shown above is the impact on trade or FDI flows on UK productivity. There is established logic here that free trade and investment flows help to boost productivity. While this is well established on the upside, it’s not clear if introducing trade barriers or trade disruption produces a symmetric impact on the downside as assumed by HMT. It’s possible but hard to say conclusively. Furthermore, as Oxford Economics have noted the headline decline in trade/FDI as well as the amount of pass-through to productivity (known as the elasticity) is higher than their estimates, though it is below that of the LSE. One things that’s been clear from the UK’s recent ‘productivity puzzle’ is that our understanding of policy feed through to productivity is pretty poor.

UK loses all EU FTAs: Exactly how this plays out in the model is not 100% clear, which is strange given 200 pages of explanation. It seems however that the model assumes that the UK is unable to renegotiate its existing FTAs via the EU until the end of the 15 year period. Presumably then, the FTAs lapse after the two year transition period and in the interim the UK trades on WTO rules with these 62 countries. While this is not impossible it is quite a pessimistic assumption and relies on little to no willingness to negotiate from the countries covered by these FTAs, which may result in economic costs for them as well as the UK.

UK does not secure any other FTAs: This plays into the point about the paper being a bit unbalanced. It doesn’t look at the potential upsides from FTAs with other non-EU states. The logic put forward is that such FTAs take a long time to negotiate and are increasingly between regional trade blocs.  As we have ourselves noted it is certainly true to say that negotiating FTAs takes many years. But as we noted in our paper last week and as the graph below shows, other medium sized economies have managed to do well on the FTA front. Striking agreements is possible, though HMT’s concerns that those agreements are unlikely to cover services and may not be as balanced as deals struck through the EU are more valid.

Open_Europe_graph_largest_trading_partner itemprop=

Assertion over deregulation: HMT does address the issue of regulation post-Brexit briefly, raising three points – that the UK is already quite competitive, that deregulation would be politically difficult and that rules are being set at the global level. The first two are valid and true to a large extent, as we pointed out in our recent paper, though HMT presents little evidence for them. They are also up to voters to decide on, as such the potential areas for saving should be presented, even if they are limited and difficult to achieve so voters can better understand them. It is maybe unfair to expect HMT to include these sorts of points given its view, especially given the fact that the Leave side has not explained them either. The Leave side is prone to assertions on this area as well, not fully explaining where gains from deregulation come from or whether there is political support for such cuts.

Rigid Canadian model: The model seems to assume the UK gets exactly the same arrangement as Canada, including the transition times for opening up certain markets (e.g. the 7 year timeline to removing tariffs on cars). In reality it seems unlikely that such transitions would be applied to the UK – the logic behind them is to allow economies time to adjust to new openings, but of course the UK and the EU are already open, so a transition would impose disruptions rather than remove them. But again until Leave spells out its own model it is hard for them to say anyone else’s assumptions are unfair or not credible.

GDP per capita not household figure: The focus on the -£4,300 per household figure is misplaced. This is simply the 6% GDP contraction applied across households – a crude assessment. Much better to look at the GDP per capita impacts which are lower at -£1,800 per person.

Not smaller, just not as large: This is a point to keep in mind with all forecasting of this type. HMT is not arguing that the UK will be 6% smaller in 2030 compared to now. It is arguing that in 2030 the UK would be 6% smaller if it left the EU compared to if it stayed in. In both cases the economy will be substantially larger and will continue to grow over the 15 year period. The executive summary and presentation of the report should have been clearer on this point.

Permanent uncertainty cost: It is noted in the report that there is a permanent cost imposed in the long run due to the short term uncertainty. However, we do not know what it is or how the short term uncertainty looks since HMT will only publish the short term assessment in due course.

Migration stays the same: Here the model just uses the ONS forecast which does not take account of any policy changes and therefore sees migration remaining quite high. Contrary to some reports this is not evidence of migration certainly staying high if we remain. It is a bit of a strange approach, but as we explained in our report last week, we believe migration is likely to remain high even outside the EU. One issue is that the mix is likely to change – more high skilled immigrations might mean a productivity boost for the UK, offsetting some of the productivity costs. That said, the HMT assumption of high migration is actually mostly good for the Leave side in economic terms since, in these sorts of models at least, restricting migration and labour supply would lead to larger negative effects. Of course, this is also an inconvenient argument for a government committed to reducing migration to make – which might go some way to explaining why they left it alone.

Fair points on supply chains: One issue which the report delves into more detail than others is that of cross border supply chains. It makes the valid point that the UK has a larger network of cross border supply chains which would face disruption if a customs border was imposed between the UK and the EU, not least because the UK exports more finished manufactured goods which have components from across Europe and the world. This is supported by the OECD data on foreign value added in UK exports which come in higher than Norway or Switzerland for example.

Poses tough questions for the Leave side

Clearly, there are questions you can ask about the assumptions of the paper and the modelling approach taken. But even when they are accounted for, the paper poses some tough questions for the Leave side – which their response so far suggests they have few good answers to. Yes, the report fails to examine and explain the potential upside of Brexit in trade and deregulation terms but then the Leave campaign has failed to do that itself.  Open Europe has set out its view of the choices Britain faces outside and steps to take to offset the negative economic impact of Brexit – they are not easy and will be economically and politically challenging. However, as long as the Leave side fails to present a model for its relationship with the EU and the rest of the world post Brexit or even the key principles to guide such an approach, it will struggle to respond to this type of detailed economic analysis.