I’m writing this article on an historic day, and as my mind wanders over the history of the UK’s relationship with the EU, an economic history question springs to mind. Have economists made an enormous mistake? Are the economic benefits attributed to EU membership in fact largely attributable to a completely different source? Stay with me, I’ll explain.
Less than a year ago, HM Treasury published its study on the long-term impact of EU membership on the UK economy. It focused on so-called gravity models. Gravity models quantify how trade depends on mass (the size of GDP and/or population), distance (costs of transport) and barriers to trade (such as tariffs). Based on this approach, the Treasury argued that a powerful positive EU effect was evidenced in the past, and that leaving the EU would have a powerful negative effect in the future.
There are two problems with this approach. First, historical relationships may not hold in the future. Second, the historical relationship may be due to correlation not causation.
Gravity models establish an historic correlation, but this is due to the economic policies and economic shocks (positive or negative) that prevailed at the time. They don’t provide a robust methodology for assessing the impact of a completely different policy environment in the future, i.e. Brexit.
A similar critique can be levelled at the way in which the Treasury modelled foreign direct investment. The problem was then compounded by estimating the relationship between productivity, trade and FDI, in order to produce the full impact on GDP. Here again, historic relationships may not hold in the future, in a very different policy environment.
But there’s a much deeper problem around the issue of correlation versus causality. What if the improvement in trade, competitiveness and productivity evidenced by the UK in the 1980s and 1990s was ultimately driven not by the EU, but by the Thatcherite reforms of the 1980s?
The economic reforms of the 1980s are probably the ultimate explanation of economic performance in the 1990s. This means that economic models attributing productivity gains to trade and FDI associated with the EU are actually measuring productivity gains attributable to domestic reforms in the UK. Of all things, this must qualify as the ultimate irony.
This has profound implications for the future. Those attributing economic success to the EU have a muddled message. The Single Market suggests liberalisation but interventionist EU policies elsewhere suggest something different.
If UK economic success was ultimately driven by the market-led Thatcherite reforms of the 1980s, the answer now is surely more of the same. And the ultimate guarantor of this effect is what I call hyper-competition or unilateral free trade. Unilateral free trade requires zero tariff and non-tariff barriers, and provides maximum exposure to the competition created by trading at world prices.
There is an economic law of gravity and that is that competition works, and the more the better. You don’t need an economic model to understand it. You have all the empirical evidence in the economic history of the world.
As the Prime Minister seeks counsel from her ministers and advisers for her Article 50 strategy, remembering a simple truth will serve her well. Whatever the question, the answer is more competition. And in the context of Brexit, that must mean unilateral free trade. On an historic day, her place in history will be determined by her grasp of this truth.