Wednesday 15 June 2016 2:52 pm

Osborne’s Brexit Budget is blackmail based on fundamentally flawed economics

I want to phone the police and ask them to arrest George Osborne and former chancellor Alistair Darling, and charge them with threatening behaviour.

For that is exactly what the latest episode in Project Fear – the spending cuts and tax hikes the chancellor says he’d have to enact due to the economic impact of Brexit – is. There must be quite a few economists in HM Treasury who would sign the arrest warrant, given that the credibility of that once venerable institution is being systematically shot to pieces.

The Treasury’s short-term analysis of the economic consequences of Brexit is fundamentally flawed. First, it is based on VAR models, which are not designed to capture a structural change such as leaving the EU. Second, it assumes a transition effect to a poorer economy, but the poorer economy is based on the forecasts of a long-term gravity model, which is flawed as well. For those wanting more on the Treasury’s use of a gravity model, I recommend the recent paper by Cass Business School’s David Blake. Here are just a few takeaways on the gravity model approach:

  • The UK’s recent trading experience with the EU is completely at odds with the findings from the gravity model. The EU’s share of UK exports has fallen from 54 per cent to 44 per cent over the past decade.
  • The Treasury’s recent use of a similar gravity model, in its analysis of Scottish independence, suggested that cross-border trade between Scotland and the rest of the UK would fall by 80 per cent with independence. An absurd figure.
  • HM Treasury has the EU as the centre of the universe in the gravity model, not the rest of the world. This in turn leads to the implication that the UK would be better off not just in the EU but the euro as well. Does anybody believe that?
  • More controversially, could the gravity models be attributing trade expansion to the EU, when much of the growth was driven by the economic reforms of the 1980s?

Doubt regarding HM Treasury’s short-term analysis is reinforced by two key assumptions in the modelling process. First, the assumption that the Brexit “shock” factor is equivalent to 50 per cent of that seen in the Great Financial Crisis. Second, the assumption that there is no monetary or fiscal policy response. Assumptions, assumptions, rubbish in, rubbish out.

Clearly any vote for Brexit could create an initial hiatus of uncertainty, which could lead to postponement activity by households and companies. But the following illustration shows how confidence and animal spirits could be revived and uncertainty reduced with a creative response:

  • Announce a move to unilateral free trade, highlighting the gains to consumers in the form of lower prices and higher discretionary income.
  • Announce an aim to use some of the proceeds of the end of direct payments to the EU to reduce corporation tax to 10 per cent over time – the lowest rate in the world outside tax havens.
  • Announce the go-ahead for runway expansion at Heathrow.
  • Announce the intention to use some of the proceeds of direct payments to Brussels to compensate car producers in the UK, faced with a 10 per cent common external tariff on exports into the EU.
  • Announce limited deregulation of planning law to facilitate new residential construction on agricultural land. This would simultaneously boost economic growth and reduce the need for direct fiscal compensation to farmers, in the wake of Brexit.
  • Announce a clear commitment to roll back the regulatory burden on business. The UK already performs well on relative measures of labour and product market regulation, but this doesn’t prevent a continued absolute improvement.

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