Vlogs on the Brexit Debate T.Huw Edwards Loughborough University March 2016

Vlogs on the Brexit Debate 2. ‘Fog In Channel’, or the importance of taking geography seriously.

‘Fog In Channel, Continent cut off.’ Did the Times ever use this headline? Supposedly in 1957.

‘Fortress Europe’: the Customs Union View of the EU. The EU still has some characteristics of a customs union. There is free trade between members – so barriers within Europe have been broken down. But there is a Common External Tariff. [NOTE: the EU has lots of other features, so viewing it just as a CU is probably a mistake. But anyway…here we go…]

‘Fortress Europe’: the Customs Union View of the EU. In the early years (1950s-70s) this issue dominated discussion of whether Britain should join the European Economic Community. A positive historical aspect of Customs Unions is that Germany industrialised in the late 19 th Century under the Zollverein. Petty borders between German states were removed, and replaced by a common external tariff. The economy industrialised fast, as infant industries grew.

‘Fortress Europe’: the Customs Union View of the EU. A Customs Union does two things: 1. Trade Creation. Trade within the CU grows, as barriers are removed. In the case of the early EEC, trade between Germany, France, Italy and the Benelux countries grew very fast. 2. Trade diversion. Without a CU, countries would trade abroad more.

Trade Diversion French Butter costs £1 to produce and ship to UK. NZ Butter costs £0.80 to produce and ship. But a tariff of £0.30 is applied. Now the UK switches to French butter, at an extra cost of £0.20 per unit.

Trade and costs Trade creation reduces the cost of living, by allowing people to purchase goods more cheaply from abroad. Trade diversion pushes up the cost of living.

The European Free Trade Area Before joining the EEC, Britain, Scandinavia, Switzerland, Austria etc belonged to an outer zone: EFTA. This allowed us to set our own external tariffs (less trade diversion, particularly on agriculture). There was still removal of tariffs between members and the EEC, but all kinds of rules and limitations had to be applied (‘rules of origin’) to stop EFTA members acting as rebadging stations for goods produced outside the EEC to be sold within the EEC. This meant that we had less trade diversion, but also less trade creation. Most of the early economic studies showed the trade creation benefits from joining in 1973 outweighed the trade diversion costs (though perhaps not by a lot).

The European Free Trade Area Many economists would have preferred Europe to have developed as a deeper FTA (i.e. a free trade area but with added cooperation). But this option was not on the cards. In part, the agricultural protection was necessary to ensure early French and Italian participation.

Which Side of the Wall Do I Pitch My Tent? Let us start by assuming the alternative to EU membership is ‘no deal’. In other words, our exporters would now have to face 1. tariff barriers to export to the EU and 2. non-tariff barriers (such as product and testing requirements). We will also assume that the EU makes no concession to the UK, and the UK makes no concession to the EU. [Actually it is likely that the two would be linked]. So we are looking at a ‘hard Brexit’.

Would a ‘hard Brexit’ matter? Note that Brexiteers are usually very vague about whether they are talking about a ‘hard Brexit’ (no deal with EU) or a ‘soft Brexit’ (which might change little for the UK except loss of influence, like Switzerland today). But some Brexiteers (Lord Lawson, Patrick Minford) are bullish even about a ‘hard Brexit’. Why?

Would a ‘hard Brexit’ matter? A hard Brexit means Britain can reduce tariffs on imports from non-EU countries (good for UK). But it means we face barriers on our exports to the EU countries.(Bad for UK – but how bad?). 2 views: 1. Unilateralist ‘Free Traders’ believe it doesn’t matter much. We could sell our goods elsewhere (USA? China? Japan?) without cutting export prices much. 2. Many Trade Constructivists believe it could be very bad for the UK.

‘Hard Brexit’: the unilateralist view. We can save money by buying some goods more cheaply from outside the EU. We can export easily to other parts of the World. Individual firms and workers may be hurt, but can be compensated. Why? Because they are modelling Britain as a ‘small, open economy’ (the A-Level Economics model of trade!).

‘Little Britain’? Smallish but not negligible. In 2014 Britain was the 5 th largest economy, accounting for 4% of World GDP. [World Bank] But even smallish countries face downward sloping demand curves for their exports, for 2 reasons.

‘Little Britain’? Our export demand slopes downwards because countries produce differentiated goods. This is backed by a lot of econometric analysis. For example, British cars or shirts are seen as different to Italian cars or shirts.

‘Little Britain’? Our export demand slopes downwards because countries produce differentiated goods. The elasticity of substitution in trade (the sensitivity of trade shares to prices) is estimated at between 5 and 10. To double our exports to non-EU countries would require the following falls in our export prices, even if we were a tiny country:

Second reason: Geography

Trade is approximately GDP of A times GDP of B divided by distance. This is because Trade costs Rise with distance.

How much market potential do non- EU markets have?

Making a crude correction for distance, China has not much more trade potential than Belgium. This is a better proxy for Britain’s relative exports.

How much market potential do non- EU markets have? China does export more to the West than gravity might indicate. This is because it has pursued a very low exchange rate policy, to counteract its remoteness. Does Britain want to follow a very low exchange rate policy to export more to remoter countries? This could push prices in the UK UP, not down.

Further potential arguments. The Rest of the World is growing faster. But the EU still accounts for about half our trade (imports and exports), and will dominate for the foreseeable future.

Further potential arguments. ‘The UK exports services. Services are different.’ This argument is deeply flawed, but needs investigating separately.

To summarise. Britain may be small in terms of World GDP, but would still have to lower its export prices considerably if it faced a ‘hard Brexit’. Even small countries have downward sloping export demand curves. Europe weighs much more heavily in terms of trade potential with the UK than further away countries.