In doing my homework for an appearance at the Treasury Select Committee this morning, I noticed one point which is of some relevance to the debate about whether the OBR is being too pessimistic about the impact of Brexit. Two major ways in which Brexit will have an influence on the public finances is through lower immigration from the EU and lower productivity. The two are linked, because the OBR correctly assumes that lower immigration of skilled labour will in itself reduce productivity. (Productivity also falls in the OBR’s analysis because of reduced investment.)
The OBR also assumes that Brexit will reduce the trade intensity of the UK: less exports and imports. This is pretty obvious to anyone who has looked at international trade: transport costs may not be as high as they once were, but gravity equations tell us that geographical distance is still a key factor in influencing whether trade takes place, which means that reduced trade with the EU will not be matched by new trade outside the EU.
The Treasury analysis of Brexit assumed that this lower trade intensity would also reduce productivity. The OBR do not include this effect, calling it too uncertain. This is a slightly surprising judgement. To see this, look at this piece by Maurice Obstfeld, chief economist at the IMF. Here is a quote:
“Empirical research supports Ricardo’s fundamental insight that trade fosters productivity [by increasing efficiency through comparative advantage]. But the productivity and growth benefits of trade go far beyond Ricardo’s insight. With trade, competition from abroad forces domestic producers to raise their game. Trade also offers a wider variety of intermediate production inputs firms can use to produce at lower cost. Finally, exporters can learn better techniques through their engagement in foreign markets, and are forced to compete for customers by raising efficiency and upgrading product quality (for example, Dabla-Norris and Duval, 2016).”
Now few things are ever certain in economics, but none of these transmission mechanisms from greater trade to higher productivity are particularly fanciful: they all make common sense (at least as seen by an economist). They are all one directional, which means assuming an effect of zero is an extreme point in every case. In this sense, the OBR is being rather optimistic about the impact of Brexit on the UK economy.