Thursday, 31 March 2016

Economical with the Truth - Academic bias



BSE/Stronger IN have been promoting a report by The Centre for Economic Performance at the London School of Economics and Political Science. 

The report looks at a "pessimistic" scenario where "the UK is not successful in negotiating a new trade agreement with the EU and, therefore, that trade between the UK and the EU following Brexit is governed by World Trade Organisation (WTO) rules".  Such a scenario would imply a serious breakdown in relations and would undoubtedly hit trade, for both the UK and the EU, and around the world.  This outcome is in no-one's interests and for that reason, I do not believe that such a scenario is credible or likely.

The report also looks at an "optimistic" scenario where "the UK (like Norway) obtains full access to the EU single market".  It is this scenario I am interested in and will look at in more detail.

The 'optimistic scenario' / Norway option

The report claims that even the "optimistic" Norway option results in a negative impact to UK GDP, based on a number of assertions and assumptions:

Rules Of Origin (ROO). Norway is not part of the EU Customs Union, which means it is exempt from the EU's Common External Tariff and is also free to negotiate its own free trade deals with third countries (which can mean lower tariffs than the EU). Hence, Norway's exports to the EU need to be certified as to where they originate from to determine whether duties or restrictions apply. Modern finished products are constructed from components sourced from many different countries. Cumulation rules allow products originating from a third country to be further processed or incorporated into a final assembled product and qualify as originating from the final country of assembly.

While ROO does introduce some administrative burden, it should also be noted:  (i) changes coming into force on 1 January 2017, together with revised cumulation arrangements, will significantly reduce the burden. (ii) exports to countries not covered by EU free trade deals (~40% of UK's exports in goods) already deal with ROO.

A study undertaken in 1983 by Koskinen & Matti (“Excess Documentation Costs as a Non-tariff Measure: an Empirical Analysis of the Import Effects of Documentation Costs”) estimated ROO costs under the EFTA-EC Free Trade Agreement (FTA) at between 1.4% and 5.7% of the value of export transactions.  Let us assume an average 3.5% for cost of ROO.  The ONS "Composition of Demand" statistics for 2013 show that UK exports in goods contribute 22.8% to UK GDP (13.4% goods, 9.4% services).  If we exclude the 40% of UK exports to countries not covered by EU free trade deals, we can estimate a Brexit cost for ROO* as 3.5% x 13.4% x 60% of GDP = 0.28% of GDP.

These estimates for cost of ROO above can be considered a worst case:
  • There are many different estimates for the impact of ROO, ranging from 1% (page 99 of Open Europe What If ..? report), 2% (page 5 of HM Treasury report), to 8% (Brenton, P, (2011) “preferential Rules of origin” as quoted by City UK). In practice, if the cost of ROO is higher than the cost of the tariff avoided, exporters will simply pay the tariff (as they do today in relevant cases). Given how low average tariffs are, 3.5% would seem to be an upper limit for ROO impact.
  • Exports to non-EU countries covered by EU free trade agreements (FTAs) already deal with ROO. If these FTA's (including rules of origin and cumulation rules) are simply grand-fathered to an independent UK (as per the convention in international law for continuity of treaties), there would be no additional ROO impact for an independent UK.
  • Hence an optimistic view would be that only the UK's exports in goods to the EU (~40% of UK exports) would face an optimistic 1% ROO impact (as per Open Europe), which provides an estimate = 1% x 13.4% x 40% of GDP = 0.054% of GDP, or about a 1/2000th.

Anti-dumping duties. The EU takes action if a country exports a product to the EU market at lower price than its own its own domestic market - recent action (or inaction) over Chinese steel for example. The EU did pursue anti-dumping measures against Norwegian fish in 2006, withdrawn when the WTO ruled against the EU (Norway of course has a thriving fishing industry outside the Common Fisheries Policy) - but this is the only recent case of EU anti-dumping action taken against a European country.

There is no reason to suppose the EU would pursue anti-dumping measures against UK exports. It does not seem feasible that any UK exporter would or could sustain exporting to the EU at a loss in order to gain a dominant EU market share. This issue seems to be a "red-herring" (one fish species not damaged by the EU's Common Fisheries Policy).

Non-tariff barriers.  Or as they are otherwise known Technical Barriers to trade. These are barriers arising from requirements for products to (i) conform to the export markets trading standards (ii) be assessed as meeting standards in order to pass customs inspection and enter the market. These barriers are overcome via regulatory convergence (having the same trading standards and regulations) and mutual recognition of conformity assessment (so that exporters can undertake assessment in their home country before exporting).  The point of the Single Market is to remove these barriers - the price of which is continuing to comply with all the Single Market regulations.

Bizarrely, the CEP report assumes that the EEA/Norway option would be subject to an arbitrary level of non-tariff barriers (one quarter of the reducible non-tariff barriers observed between the USA and the EU). Norway is in the Single Market (via the EEA agreement) and so follows all the rules of the Single Market. Either following these rules overcomes these technical barriers, or there is no point in the Single Market!

Future trade costs.  The authors also predict an increasing  non-tariff barrier cost over time. They reference an academic paper Méjean and Schwellnus,2009 which analysed French export statistics for the period 1995-2004.  Méjean and Schwellnus concluded that French exports to EU countries reach price convergence 40% faster than French exports to other OECD countries (e.g. USA, Canada).  In theory, this illustrates an efficient Single Market with non-tariff barriers between members states reduced.

It is fairly easy to question the applicability of the Méjean and Schwellnus study to Brexit: (i) the paper states that ~30% of the difference between EU and OECD exports is down to the nature of firms operating in Europe - they tend not to discriminate on price between EU member states as a matter of practice; (ii) the period analysed is the early years of the Single Market - has subsequent globalisation eroded this European single market advantage ? (iii) the study just looks at France, which has historically traded much more with continental countries - would the same analysis yield the same results for the UK, which has much more global trade ? (iv) Other evidence suggests that price convergence is not occurring within the Single Market. See article here.

But the crucial point is that Norway is in the Single Market (via the EEA agreement) so will see the same reduction in non-tariff barriers. Méjean and Schwellnus did not analyse EFTA EEA nations such as Norway - but the CEP report has arbitrarily decided that EFTA EEA will only see half the benefit of reduction in non-tariff barriers that EU EEA states benefit from.  As described above, Norway is following all the rules of the Single Market so will see all the benefits from reduced non-tariff barriers, or there is no point in the Single Market !

Fiscal Transfers - Norways payments. The CEP report attempts to take into account savings made on the UK's contributions to the EU (currently 0.53% of UK GDP), and assumes that the UK adopting the Norway option results in a saving of 17% on current contributions. A more accurate figure would be 50% of current contributions, once the "Norway grants" are excluded (an entirely voluntary foreign aid contribution made by Norway, unrelated to their membership of the EEA). On this basis, the fiscal saving would amount to 50% x 0.53% GDP = 0.27%.

Tariff Liberalisation Outside the EU's customs union, the UK would be free from the EU's common external tariff. On the assumption that the UK removes all tariffs on imports from anywhere in the world, thus stimulating trade, the CEP report conclude a positive impact on UK GDP of 0.3%

Impact on UK Living standards.Whereas CEP arrive at a cost per household of £650 for the "optimistic" Norway option scenario, I arrive at gain per household of £60, based on a correction of their assumptions on non-tariff barriers and Norways EU contributions.

CEP
Me
Trade Costs
-1.37%
-0.28%
Fiscal
+0.09%
+0.27%
Tariff Liberalisation
+0.30%
+0.30%
TOTAL % GDP
-0.98%
+0.29%
Per Household
-£650
+£190
It should be emphasised that these sums do not represent a real change  in household income. The CEP's GDP loss of approx. 1% is equivalent to less than 6 months growth in the UK economy. I doubt that you noticed this change in your household income over the last 6 months.

Long run effects of Brexit 

The CEP report goes on to claim other factors will cause longer term economic impact, stating "The estimates are based on a static trade model that does not account for the dynamic effects of trade on productivity."  These claims also do no stand up to scrutiny:

Foreign Investment. The Norway option retains full single market access, which along with the UK's unique selling points (language; openness to business; legal, financial  & commercial history & expertise) means that there is no reason the UK would be any less attractive for investment.

Migration. Like the CBI before them, CEP assumes that a self-governing UK would choose a "drawbridge up" immigration policy. Polling by British Future suggests that UK public opinion is moderate on immigration and would choose a policy that is in Britain's best economic interests. Current policy provides a strong bias to immigration from the EU over the rest of the world - a balanced approach would widen the pool of available talent and so should provide an immigration policy with increased benefit for the UK economy.

Future Trade deals. CEP raise the spectre of the UK missing out on the EU's coming trade deals: the infamous TTIP deal with USA; and an EU-Japan FTA.  The public is slowly becoming aware of just how poor the EU is at trade. Any EU FTA requires ratification by all 28 member states, meaning the deals typically end up accommodating all 28 states protectionist interests. The EU also insists on mixing political aims with trade policy. The consequence is FTA's that take forever to agree and are watered down when they finally arrive.

The USA is historically the UK's most significant trading partner and it is highly probable an independent UK would have had an FTA with the USA decades ago.  Some 43 years after the UK abandoned its Commonwealth trading links to join the Common Market/EEC, we are still waiting for the EU to establish FTA's with our main Commonwealth allies. Freedom to strike our own FTA's is one of the strongest reasons for Brexit.

Trade between EU nations. The CEP report references a 2008 paper that suggests EU members trade more with other EU members than they do with EFTA states. From this, they extrapolate that Britain's trade with the EU would become more like EFTA's. A facile argument and easily countered - Norway & Switzerlands exports per head to the EU are 4-5 times as much as the UK's - if Britain became more like EFTA states in that respect, Brexit would be a bonanza.

Integration & Productivity growth. The most far-fetched claim though is that political integration within the EU brings additional economic benefits.  The authors quote one of their own papers suggesting that regions in Finland, Sweden and Austria had seen greater productivity growth since leaving EFTA to join the EU, compared with regions in Norway, which remained in EFTA. Note however that the data studied only covers the period 1995-2001, i.e. prior to the prolonged downturn in economic activity in the EU.

And which region had seen the greatest productivity growth in this period ? That would be Oslo, the capital of Norway. The other regions of Norway are dominated by the already productive and profitable oil/gas industry and Norways thriving agriculture / fishing industries (unencumbered by the EU's Common Agricultural Policy & Common Fisheries Policy).  Bear in mind also that the EU has been the slowest growing region in the world economy for the last 2 decades and the EU's best performers tend to be the least integrated states (e.g. UK, Sweden).  The whole argument for political integration driving economic growth is entirely unconvincing.

Conclusion

David Cameron has consistently tried to portray the Norway option in a negative light - precisely because it provides a viable "soft exit" from the European Union that essentially de-risks Brexit. So an academic research paper  purporting to show that the Norway option would be detrimental to the UK economy matters. The CEP report is based on some alarming fallacies, (particularly regarding non-tariff barriers) and on highly dubious speculation about the UK's economic performance post-Brexit. In truth, it would be just as easy to paint an entirely rosier economic counter-factual for Brexit (subject for a future post perhaps).

It can be argued that even the CEP's estimate of 1% loss of GDP is neither here nor there when considering democracy & self-government.  That is certainly my view.  However, this sort of economic calculation can have a psychological impact on voters, as suggested in the Guardian recently - even a small difference one way or the other may swing the vote.

The LSE and the CEP are well-known supporters of European political integration, based on the idea that more integration must always mean more economic benefit.  I have found many pro-EU supporters hold this as an article of faith and tend to argue as if this is an absolute truth. The problem is, the same thinking underpinned the Single Currency project. Milton Friedman's warning in 1997 that the EU did not constitute an "optimal currency area" seems especially prescient now.

It seems to me that the assumption that integration is always good is the starting point for much academic thinking on both economics and politics. This CEP/LSE Brexit report (and others they have produced on Brexit) appears to fall into this category and tends to look for evidence supporting this case - i.e. confirmation bias.  The referendum poses the fundamental question of who governs us - and that is too important a question to be coloured by an academic bias in favour of political and economic integration.

*Updated on 11th April with revised ROO costs (to exclude exports in services)

7 comments:

  1. Nice one Paul!

    Despite the UK's decidedly dodgy educational leadership, see here:

    http://www.theblogmire.com/emotion-scaremongering-nd-meaningless-platitudes-nikki-morgan-makes-her-entry-into-the-eu-debate/

    I really do hope that the British voters have enough sense to work out the truth from fiction, even if like me, they find understanding the sums a bit challenging.

    The principle is far more important.....and I hope that the public remembers all of this when the next general election comes around.

    Keep up the good work!

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  2. Simply brilliant work. Your technical grasp of this matter exceeds most people's in my opinion. This needs to be read far and wide.

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  3. I think you are very cavalier in dismissing other non-tariff barriers faced by non EU Members of EEA by dint of fact that they are not in the EU customs union. Customs inspection and delays are potentially damaging to sectors working in time critical supply chains.

    Also, do you consider the full tariff dismantling gains to be likely realized ? At least in the near term, some tariffs necessary to ensure basis for negotiation of non EU trade deals.

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  4. You need to understand how goods are actually shipped. Using the TIR carnet avoids the need for physical checks at borders. Technology is being adopted (e.g. the e-TIR system) in Europe and throughout the world to remove the need for physical border checks. Like so much about the EU, the idea of a "Zollverein" customs union with physical border checks belongs to a distant past.

    RE tariff liberalisation, the idea as proposed is "unilaterally removing all tariffs on imports into the UK in order to lower the cost of imported
    goods". As often pointed out by the Remain side, modern free trade agreements are much less about tariffs (which are generally low thanks to GATT) and more about technical details.

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  5. Thanks for your reply, I was aware of planned reforms in customs procedures apparently coming into force in 2017, but I wasn't aware of these details. While I have no reason to doubt that the reforms you describe will be beneficial, it nevertheless remains the case that you simply do not have to do it at all in the good old fashioned customs union. There is, therefore, still a cost to leaving it.

    On the second point, you misunderstood me and I think it is my fault for not being clear. I was referring to the likelihood of a post brexit UK making a unilateral and generalized market access offer of zero tariffs for imports into the UK. My question is whether this would be feasible, in view of the need to retain some tariffs in order to to have something to bargain with in the myriad trade negotiations that would necessarily ensue with non EU trade partners post brexit.

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    1. Sorry for delay in replying - I've been a bit under the weather over the last week.

      The TIR carnet system (paper-based) was introduced by UNECE in 1949 and is in process of being upgraded to electronic e-TIR. A trial e-Clearance Vehicle Reservation Border Pass (VRBP) was introduced as part of updagrade to facilities at Russian-Finnish border in 2013. You can read more on this in theses links:
      http://www.eureferendum.com/blogview.aspx?blogno=86003
      http://www.eureferendum.com/blogview.aspx?blogno=86001

      Post-Brexit tariffs. Eliminating all tariffs worked well for New Zealand. Current external tariffs are relatively low in any case, so I'm not sure how much leverage they provide for trad deals in comparison to removing non-tariff or technical barriers to trade. The big exception might be agriculture, where opportunity for cheaper food & fairer trading terms for Africa etc would need to be weighed against UK agriculture, which has suffered over the years under CAP. The current CAP subsidies to UK farmers would be maintained by UK Govt (or even increased - see Owen Paterson's comments) but redirected to increasing productivity. Given that EEA does not include agriculture, one Brexit scenario may see tariffs on agriculture trade with EU, UK more self-sufficient in agriculture plus preferential tariffs for Africa/Commonwealth => cheaper food, i.e. similar to pre common market status. The main point is we would have options & choices.

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