Wednesday 30 October 2019 4:01 am

The economic impact of Brexit tariffs only tells us half the story

Paul Ormerod is an economist at Volterra Partners LLP, a Visiting Professor in the Department of Computer Science at UCL, and author of Against the Grain: Insights of an Economic Contrarian, published by the IEA in conjunction with City A.M.

Brexit is about much more than the economic costs and benefits, but the idea that the former dramatically outweigh the latter has become the received wisdom in much of the media.

Report after report emerges which purports to show that, under any of the various trade arrangements envisaged, the UK will be worse off as a result of Brexit.

These studies are not wrong. They all use perfectly standard economic theory to arrive at their conclusions. But they are misleading.

The real problem is that they miss out key bits of the story. We can think of the classic tale of the person dropping his car keys in the street at night. He only looks for them under the street lamp, where the light is. 

In the same way, standard economic analysis of Brexit only illuminates part of the landscape.

The explanation of why trade occurs between countries was given 200 years ago by the great English economist David Ricardo. It is still the basis of the modern economist’s understanding of trade.

Ricardo imagined, to illustrate his theory, a world with just two countries and two products. His examples were England and Portugal, and cloth and wine – but they could have been any countries and any products.

Ricardo asked a simple but profound question. If England could produce both cloth and wine more efficiently than Portugal, why would trade take place at all? How could the more efficient country, England, benefit from trade?

His answer introduced the fundamental concept of comparative advantage. England had an absolute advantage in producing both cloth and wine, but the country should choose to specialise in producing the one in which its advantage compared to Portugal was bigger.  Both would benefit if England produced only cloth and Portugal only wine, and they traded.

Economics has moved on in the past two centuries, but the concept of comparative advantage, modified by factors such as the distance between countries, is still seen as a key determinant of trade patterns.

In terms of Brexit, introducing complexities like tariffs into the picture essentially affects the amount which is traded, and not the structure of trade in terms of who sells what to who.

If the basic pattern of trade is fixed by comparative advantage, then if Brexit means higher tariffs for the UK, as a country we will lose out. In a nutshell, this is what lies behind all the negative assessments of the impact of Brexit.

However, the key word in the last paragraph is “if”.  Like almost all economic theory, these models are static. They assume that the network of trade is fixed, and analyse the consequences of changing prices through tariffs.

The EU has become mired in regulation and the level of innovation is low. Outside the EU, the UK could alter the patterns of trade by innovating in, say, biotech or AI-related products and services. It is this dynamic response, and not the static one, which will determine whether or not Brexit is a success.

Economic models which claim to analyse the impact of Brexit are true – but only up to a point, Lord Copper, as the saying goes.

Main image credit: Getty

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