Now that negotiations have started on the UK’s exit from the EU, it is more important than ever to make a good judgement on the likely economic costs of leaving the Single Market and Customs Union.
A report published today by Policy Exchange offers an overdue scrutiny of the reports of the Treasury, OECD and IMF, which provided the most authoritative estimates of the economic impact of Brexit during the referendum campaign.
Our report analyses the methods used by the Treasury and the others to reach their pessimistic conclusions. It finds that each of these official reports considerably over-estimated the potential damage to the UK economy, especially in the case of no deal.
The Treasury’s approach began by estimating the gains to both trade and foreign investment from membership of the EU, followed by a calculation of the assumed knock-on gains to productivity from extra trade and investment. These estimates were then entered into a macro-economic forecasting model to reach the conclusion that, without a deal, GDP in the UK could be lower in 2030 by 5.4-9.5 per cent, making each household up to £6,600 per year worse off.
The core of this approach is the so-called “gravity model” estimate that EU membership more than doubles trade between EU members.
Gravity models are a little-known technique even within economics. By analogy with Newtonian gravity, the technique assumes that the volume of trade between two countries depends directly on the size of their economies and indirectly on the distance between them, with other factors like common language or borders also playing a role.
These factors allow the calculation of an “expected” volume of trade between countries. The “EU impact” is the extra trade which occurs above this expected baseline. The Treasury report then assumes that all of this gain to trade will be lost if the UK leaves with no agreement. Moreover, it also assumes that no additional trade will occur outside the EU to compensate for these losses.
Today’s Policy Exchange report replicates the Treasury analysis. The gravity model results are found to vary, depending on whether one includes large numbers of countries with negligible amounts of trade with the UK.
Most seriously, it was found that the Treasury used an average trade gain across all 28 EU members, but neglected to say that the gains to the UK alone were much smaller. This vital point was omitted even though an earlier Treasury paper acknowledged its existence.
Another important omission was to make no mention of the potential impact of a sterling depreciation. Since the average tariff facing UK exports into the EU after 2019 is only 4-5 per cent, the 15 per cent lower value for sterling offsets the higher costs for most sectors, except for food products on which EU import tariffs are very high. Nor was account taken of the fact that the EU share of UK exports has fallen rapidly in recent years.
Our own worst-case prediction is that per capita GDP could be 2 per cent lower by 2025 than would otherwise be the case, but by 2030 would be higher than it would have been without Brexit. If UK firms find new markets more quickly than the slow rate we have assumed, the outlook could be more optimistic than this.