Wednesday 11 May 2016 4:59 am

How the Treasury cooked the books in calculating the impact of Brexit

Three weeks ago, the Treasury released its report into the long-term implications of Brexit, predicting widespread economic destruction.

There will soon be a sequel, analysing what the short-term impacts of leaving the EU might be. One doubts you’ll need the foresight of those who successfully predicted a Leicester City Premier League victory to guess what this will conclude.

Yet the economic methodology of the Treasury’s work really does need to be questioned. Due to the rapid response nature of modern media, it was impossible for those favouring Brexit to offer up a thorough critique of the first report quickly. One could only show it was riddled with bizarre assumptions. Not least, it assumed away by construction any benefit of Brexit in terms of signing third-party trade deals or deregulating the economy.

For those on the Remain side, of course, it sufficed to merely herald the Treasury’s results as reflecting the “economic consensus”. Surely if anything has been proven in the economic history of post-war Britain, it is that economic consensuses are a weak appeal to authority.

To fill the void of analysis on the Treasury study comes the second publication by the new group Economists for Brexit. In this report, professor Patrick Minford provides an accessible history of trade theory before critically evaluating the Treasury’s work.

Minford explains that the way the Treasury models Brexit is to focus on “openness”, the sum of imports and exports relative to GDP, and foreign direct investment (FDI). These two factors are each assumed to follow a so-called gravity model – where openness is related to things such as distance – estimated from multi-country data. The degree of openness and FDI are then assumed to determine productivity – the ultimate driver of living standards, estimated from industrial data. Finally, this productivity effect is added into a macro model to find the general effects on investment, GDP etc.

The broad story the Treasury tells is thus this: Brexit will make the UK less open and less attractive for FDI. This will lead to lower productivity and therefore less investment and lower living standards.

Read more: Osborne is entirely wrong: Voters would gain from Brexit

There are several major problems with this method. The first relates to identifying the effect of EU membership per se. In order to find this, large regressions over time and across countries are run to isolate the “EU effect”. But this is estimated using a binary assessment of whether a country is in or out. This throws up all sorts of potential biases because it calculates the EU effect across periods with many other different policies. Many of these factors may be related simultaneously to a country’s openness or FDI and its decision to be an EU member.

The second problem is that the Treasury modelling assumes that openness and trade drive improved productivity. While intuitive and in many cases true, this need not be the direction of causation. In fact, it might be that an industrial shock can cause increased trade, FDI and productivity simultaneously. In other words, the UK may receive FDI precisely because an industry becomes more productive. To assess how Brexit would affect this, you’d need to do far more extensive work on industries and causal testing than the Treasury attempts.

Finally, the Treasury comes to vastly different conclusions to Minford’s previous Economists for Brexit modelling (which suggests that we would be better off out of the EU) primarily because it assumes that, if we leave and do not sign a trade deal or remain in the Single Market, Britain will maintain EU-style tariffs on EU partners and non-EU trading partners who have EU trade agreements. These assumptions therefore generate large effects on openness and on FDI – and hence living standards.

Read more: Osborne has made a fatal error by showing his Brexit hand

In fact, if instead Britain were to adopt unilateral free trade (abolishing all tariffs), exiting the EU’s protected customs union would lead to UK consumers enjoying lower prices and would shift the structure of production towards non-protected sectors, enabling us to focus on real areas of comparative advantage and raising productivity. We would, of course, have full control over regulation too.

The need for a smoothed transition may prevent this “big bang” disruptive approach. As Roland Smith of the Adam Smith Institute pointed out this week, the government and Parliament that will negotiate our exit settlement will be overwhelmingly pro-Remain and may well choose the least disruptive short-term path: remaining in the Single Market in the European Economic Area. But the largest long-term gains from Brexit require an independent, free-trading Britain.

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.