Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday, 6 December 2016

The OBR and the impact of Brexit

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.

14 comments:

  1. 'The former Conservative minister repeated advice he gave 30 years ago saying people in the UK should follow the examples of Poland, Hungary and Lithuania...When asked if people should get on their bikes to look for work Lord Tebbit, 79, said: “Yes. People do it in Poland, in Hungary, in Lithuania. Why are they more willing to do it than we are?”' (Daily Mail, NATHAN RAO, Wed, Feb 23, 2011).

    Funny how the 'semi-house-trained polecat' and his Leave allies weren't making that point during the 2106 referendum.

    But they'll be back to it once the poorer Tory voters have outlived their Leavey usefulness.

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  2. I watched your testimony at the select committee. It must be frustrating being asked misconceived questions when the person sitting next to you shares some of the misconceptions! Well done though, just wish more MPs had bothered to show up to hear it.

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    1. To be fair to the MPs, the previous session (with Portes + Weale) had overrun, so our session went well over time, and maybe some MPs had prior appointments. But knowing some people watch these things helps me in deciding whether they are worth doing.

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  3. I have no idea of the degree to which popular optimism about "making Britain great again" reflects residual imperial thinking. But, looking from afar, I can assure Britons that there is no UK-shaped hole in the world economy waiting your return.

    New Zealand had its own Brexit in 1973 when the UK unceremoniously dumped us to enter the EEC. At that time the residuals of imperial mercantilism were still alive and well. We shipped the frozen carcasses of grossly overweight sheep to London in return for Austin Allegros. Hint: it was a terrible deal all round.

    New Zealand adapted because it had to. But changing after a major trade shock takes time. It feels like 20,30 or 40 years here. And all that time all the other ups and downs in the world are still going on.

    Now we no longer have those special ties and I can't see us ever wanting to recreate them.

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  4. Alexander Harvey7 December 2016 at 04:52

    Well put, and thanks.

    What part of uni-directional don't people understand?

    *****

    Elsewhere:

    Robert Chotes (OBR) is reported to have said:

    "... negative effects are partially offset by a near-term boost to GDP from stronger net trade volumes, as the weaker pound encourages exports and discourages imports and as weaker consumer and investment spending mean less demand for imports."

    I noted the "nerm-term" qualifier.

    FWIW I find him to be a little optimistic, but he is excellently qualified to do his job, so I defer.


    *****


    Further afied:


    The ONS article:


    Explanation beyond exchange rates: trends in UK trade since 2007 (2013)

    Indicates:


    "Economic theory suggests that a country’s trade balance should increase following a depreciation of its currency. Goods produced abroad become more expensive compared with domestic alternatives,
    while the price of domestic goods falls relative to the price of goods produced abroad. Consequently, imports are expected to fall and exports are expected to rise, leading to an increase in the home country’s balance of trade. This broad pattern is evident with a lag following sterling’s exit from the European Exchange Rate Mechanism (ERM) in 1992, after which the UK’s trade balance returned to surplus for much of the period between 1993 and 1998. However, the absence of a clear response of the UK’s balance of trade to the depreciation of sterling during 2007 and 2008 suggests that something more complex has occurred."

    It goes on to comment on a modern tendency for import and export prices to move in tandem, both increasing after a sterling devaluation more or less in step.

    The "textbook" divergence of UK import and export prices and the differential advantage for exporters over importers in volume terms did not hold. This may suggest that much of the "good news" over accelerating export sales is neither going to be across the board nor sustained.

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  5. I think your analysis is perfectly reasonable as far as it goes but it is a partial picture. I realize that it is meant to be a partial picture but Brexit is only one issue that will materially affect the economy in the next twenty or thirty years and one has to place it in some sort of context.

    As far as Brexit is concerned I actually believe that the situation will be worse than even you paint it because I think there are now increasing signs that the Euro may fail and, if this is the case, then there have to be doubts about the future of the EU itself. The turmoil that may be engendered by all this is not good for the UK although of course the UK is not the proximate cause of this. If this does happen it will likely reinforce some of the factors you rightly highlight.

    The more fundamental point is that Brexit is only one of several major structural issues that will determine the future of the UK economy. Both demographics and robotics/AI will be major issues over the next twenty/thirty years and, in my view, will dwarf the effects of Brexit.

    My point is that you may be right about Brexit on what might be termed the ceteris paribus basis but there are other influences that are at least as important that will make a huge difference and will likely interact with the factors that you are highlighting.

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  6. people at the OBR know it, people at the bank of england know it, everyone knows it, but, it has become politically impossible in the UK to "question the merits of brexit".

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  7. No such thing as comparative advantage.

    It's just another failed model using Tiger Woods cutting his neighbours grass.

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  8. The idea is to create MegaCityOne in the UK. In fact if you run the 'clustering' free trade models to their conclusion that is what you end up with - everybody living in a very small space.

    And to think we spent the early part of the 20th century demolishing tenements as slums.

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  9. It might be the case that less trade lowers productivity, but I guess it is pretty hard for the OBR to quantify this. Ie, whether the effect will be significant. Whether it will be significant in the short term or just the long term.

    Also given the fact that normally the direction is from less trade to more trade, it is not necessarily clear that the same would happen in the other direction. Ie. if companies have previously been in a free trade environment, it does not follow that their productivity will drop from removal from that free trade environment (it might just stay the same). Whereas it does follow that their productivity would increase upon exposure to that environment.

    Also more generally lots of other things that might potentially raise productivity that I'm sure OBR do not take account of, given the complete myriad of things that will potentially be affected.

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  10. If Brexit lowers the 'trade intensity' of the UK, then it will presumably lower the trade intensity of the EU.

    Surely, the best way to avoid this would be to have a free trade agreement between the UK and the EU. Yet oddly, the noises from the EU hierarchy are that there will be no such agreement - or that it's conditional on free movement. But I would have thought the EU would be delighted to keep more of their talented citizens rather than have them come to the UK.

    Given your analysis, it looks like what seems to be the UK government's desire (free trade but no free movement) is a win-win for the EU given the UK is currently a 'net importer' of EU citizens.

    Why on earth would the people running the EU not want to have something that would benefit their citizens?

    Or is there something else going on? It almost seems the Juncker's of this world are more interested in 'punishing' the UK than the welfare of their own people. That way they discourage others from leaving the club and get to keep their personal power and privileges.

    Sounds like a protection racket to me.

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  11. Obstfeld's statement ' With trade, competition from abroad forces domestic producers to raise their game' seems intuitively valid, but the problem is that the anatomy of this process is not benign. What happens is that inefficient producers go out of business with attendant job losses, while more efficient ones may or may not expand. Improvements in productivity often occur when business segments shrink to a more efficient core but this may not be accompanied by net benefit to the general population.

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  12. Why are you still using the Tory framing of the OBR? There is more fiscal space than that. Quit playing away from home at Tory united.

    - Random

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  13. Thanks for this article, however can I ask whether the UK economy was in "rude good health" prior to Brexit, or whether the current and eventual impacts of Brexit will make a bad situation worse.

    Since the Referendum there has been a rush to blame most things on the outcome, and I'm just trying on a personal level to put it in context.

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