Brexonomics 101

The basic economics of Brexit revisited

In the second week of April, the IEA held its annual Future Thought Leaders seminar. The IEA’s Editorial Director Kristian Niemietz was one of the speakers. The article below is an abridged version of one of his talks.

Brexit was undoubtedly the dominant political topic of the second half of the 2010s. To say that it divided the country would be an understatement. Interestingly, the dividing lines ran across as well as between preexisting political camps. Habitual allies who usually agree with each other could find themselves on opposite sides of the Brexit divide, often with habitual opponents with whom they normally disagree.  

This institute was no exception. People at the IEA and in its orbit had different views on Brexit before the Referendum, and different views on how to proceed once the vote had been cast.

But I am not going to talk about that. I will give neither a pro-Brexit nor an anti-Brexit talk. It has become a cliché to say that education should be about how to think, not what to think. But that is indeed what I will try to do: I will talk about how we should think about the various economic trade-offs that are involved in a process like Brexit, not about which conclusion we should reach once we have done that.

I say “a process like Brexit” rather than “Brexit”, because Brexit is only unique as a package. The economic questions it threw up come up in other contexts too – just not all at once.

Photo by Rocco Dipoppa on Unsplash

Although the title of the talk is “Brexonomics 101”, I am, of course, fully aware that Brexit was not primarily about economics. It was more about matters of culture, national self-image, and identity. This was particularly obvious on the Leave side. Their argument was that Britain should be a sovereign, independent, self-governing country, and that the nation state should be the primary unit of political decisionmaking. If you share that conviction, and feel strongly about it, it will probably not interest you that much whether Brexit makes the country a little poorer or a little richer. You will see it as a matter of the nation’s soul, not its wallet. The Remain side is a bit more complicated in this respect. Their campaign concentrated heavily on economic arguments, their main message being that Brexit will make Britain poorer. However, after the Referendum, the Continuity Remain camp pivoted to identity-based arguments as well. The people who listen to James O’Brien’s show are not hugely interested in GDP figures either. They see Brexit as a project of the ill-informed, the stupid, and the uneducated, a project driven by xenophobia, insularity and chauvinism. They see themselves as the educated, cosmopolitan and sensible part of Britain. Of course, part of the reason why they think Brexit is stupid is that they see it as economic self-sabotage – but their animosity towards Brexit is way out of proportion with even the most pessimistic estimates of its economic cost. Quite clearly, neither the arch-Leavers nor the arch-Remainers are driven by economics.

Nonetheless – nobody would say that the economics is irrelevant. Brexit has undoubtedly had a number of economic impacts, because it has affected at least three major drivers of economic life: trade, regulation, and immigration. That is because it involved leaving the European Customs Union, leaving the European Single Market, and ending the free movement of people. I will go through these three in turn.

The Customs Union

Let’s go back to the very basics. Let’s imagine a very simple world, in which there are just three economies: A, B, and C. Let’s also suppose that A and B have a free trade agreement (FTA) with each other, that B and C have a free trade agreement with each other, and that there is no such agreement between A and C. So, there are two overlapping free trade areas in this world: A-B and B-C. Overlapping, because B is in both.

Now, what stops someone from transporting goods from A to B, and then from B to C? Or from C to B, and then from B to A? Each of these movements is a movement within a free trade area. But there is not supposed to be free trade between A and C. So what stops it?

The answer is customs checks. There has to be a customs border between A and B, and there has to be a customs border between B and C. You can transport goods from A to B, but if you then tried to move them on from B to C, they would be filtered out at the B-C customs border. You can transport goods from C to B, but if you then tried to move them on from B to A, they would be filtered out at the A-B customs border.

FTAs alone are not sufficient to guarantee borderless trade. An FTA between B and A means that you can export as much from B to A as you want, without tariffs and without quantitative limits. But you still need to pass through a customs border, to prove that the goods you are bringing in from B really are from B.

Now let’s suppose that A and B are very close trading partners, and they want to get rid of the customs border between them. How could they do that?

The answer is: the reason why they need that customs border in the first place is the fact that they have different trade relations with the rest of the world (with “the rest of the world” being just C, in our ultra-simplified example). B has an FTA with C, A does not. If A and B adopted a common trade policy vis-à-vis the rest of the world, they wouldn’t need a customs border between them anymore. That is one way to define a customs union: an area with a common trade policy vis-à-vis the rest of the world, and a common external customs border, but no internal ones.  

A customs union does not need to be a union between countries. A nation state can be a customs union. If an imported good arrives at Bristol harbour, and is then transported to London, it does not need to pass through any additional customs checks. That is because London and Bristol are part of the same customs territory. Britain is a customs union.

Customs unions are not, in themselves, good or bad. It depends on the specifics. The benefit of a customs union is that they enable borderless, frictionless trade within it. You save the compliance costs of customs checks, and the cost of maintaining a customs bureaucracy. The cost of a customs union is that you lose your independent trade policy. A member of a customs union cannot have an independent trade policy anymore. They need to agree with the other members of the customs union on a common trade policy.

So, back to our example. If A and B form a customs union, they need to agree on whether they want a joint FTA with C, or not. The old arrangement, where B has an FTA with C while A does not, cannot continue. There can be no trade agreement with one individual member of a customs union in isolation. There can only be a trade agreement with the customs union as a whole. This is obvious enough at the level of the nation state: you cannot have a trade agreement with London or Bristol in isolation (except maybe a symbolic one); you can only have a trade agreement with the UK as a whole. But it is seemingly less obvious at the international level. Just after the EU Referendum, one senior Brexit politician boasted about his plans to travel to Berlin to work out a trade agreement, seemingly unaware of the fact that, as a member of the Customs Union, Germany does not have an independent trade policy, and can therefore not sign any meaningful FTAs.  

If A and B have very similar ideas about what kind of trade policy they want to pursue, and find it easy to agree with each other, the cost of forming a customs union is low. But if A and B have very different ideas, and would go in very different directions without a customs union, the cost of a customs union goes up.

Suppose A is vehemently opposed to any kind of FTA with C. This means that in order to form a customs union with A, B would have to sacrifice its FTA with C. In that case, for B, increased trade with A is the benefit of a customs union, while decreased trade with C is the cost. Whether that is worth it depends on which of the two is bigger.

We can think of “A” as the EU, “B” as the UK, and “C” as any economy or group of economies that the UK might enter into an FTA with.

The Single Market

Within any customs union, there has to be free trade. It would make no sense otherwise. There are no internal customs border, so if there were overt trade barriers within the union – how would you enforce them?

But it is possible to be in the EU Customs Union without being in the EU Single Market. That is because the Single Market is a free-trade area – but it is also more than that. We have thus far treated FTAs as binary: you either have one, or you don’t. In reality, though, FTAs differ hugely in depth and scope. Take the North American Free Trade Agreement (NAFTA). Before Trump’s mad tariff war, there was tariff-free trade between Mexico and the USA. But nobody would treat the USA and Mexico as one single market, or one single economy.  They are very clearly not. That is because NAFTA has always been a fairly basic FTA. It is mostly about the removal of explicit barriers to trade, which are tariffs and quantitative imports restrictions (quotas). If you want a deeper degree of economic integration, you need to go beyond that. You need to remove non-tariff barriers (NTBs), and issue that Donald Trump is obsessed with. He is right about their importance – just not in the way he thinks.

NTBs are differences in regulatory standards which can impede trade although that is usually not their intention. A historic example is the German Beer Purity Law (Reinheitsgebot), which states that beer can only contain barley, water, hops and yeast. On the face of it, this does not look like a trade barrier, because it applies to all brewers alike, regardless of where they are from. It is not that non-German brewers face more demanding standards than German ones. But in practice, it did act like a trade barrier, because all the brewers that fell foul of it were foreign. Belgian brewers, in particular, often use ingredients other than those four. It was never the intention of the Reinheitsgebot to rig the German beer market against Belgian brewers. But irrespective of intentions, that is what it ended up doing, for a while.

You can see why getting rid of NTBs is trickier than getting rid of tariffs or quotas. If you want to lower or abolish tariffs and quotas, you can just do it. Regulatory standards, though, can vary for perfectly justifiable reasons.

There are two main ways to deal with them. One is harmonisation: adopt common (or very similar) regulatory standards. The other one is mutual recognition: if it’s good enough for you, it’s good enough for us. The EU, in creating its Single Market, does a mix of both. For example, I have a university degree which does not exist in Britain. People can’t even pronounce the title. But when I applied for a job at King’s College 16 years ago, that was not a problem: they accepted it as equivalent to its British counterpart. That is mutual recognition (in this case, of professional qualifications and academic titles).

In the meantime, though, higher education degrees have become a lot more similar across Europe. That is harmonisation.

Single markets are not per se good or bad either. It depends on the specifics again. By joining a single market with your neighbours, you can achieve a deeper degree of economic integration than you otherwise could. That is the benefit of a single market. But you also lose some regulatory independence. That is the cost of a single market. If you largely want to do the same thing as your neighbours anyway, that cost is very small. But the more you want to diverge from them, the larger that cost is.

Freedom of movement

One component of a single market is free movement of labour. Once a country is in a single market, it has at least two parallel immigration systems: freedom of movement (FoM) within the single market, and whatever immigration policy it wants to have for people from outside of it.

Whether FoM is good or bad depends, once again, on the specifics. For example, if you have two neighbouring countries with major cultural tensions and hostilities between them, completely open borders is probably not a great idea. If it’s just about the vanity of small differences – why wouldn’t you? There is, for example, FoM between Australia and New Zealand, and they are not even aiming to establish a full single market (although they have a comprehensive FTA).   

If one country has a vastly more generous welfare system than another, and if it is impractical to limit access to it, FoM can also create problems. You might get a negative selection effect, where you disproportionately attract people who come for the welfare services, rather than people who come for the job opportunities. 

FoM is also easier between economies with similar income levels.

On that basis, I can see why the US, even if you ignore the Trumpistas, might not want a completely open border with Mexico. I can see no reason whatsoever why they would not want an open border with Canada.

But that’s their problem. Let’s talk about FoM in Europe. We know, empirically, that EEA nationals who moved to Britain under the old FoM rules are, in aggregate terms, fiscal net contributors. They pay more in taxes than they consume in public services and benefits. In that sense, EEA migration has been positive for Britain, although we cannot just chalk that up as a win for FoM: a different immigration system could have produced the same results.

One unambiguous upside of FoM, compared to other immigration systems I can think of, is the fact that it is very unbureaucratic. I moved here under the old FoM rules, and it meant that, pre-Brexit, I never had any dealings with the Home Office. If I didn’t work in Westminster, I might not even have known that there was such a thing as “the Home Office”. That was not just convenient for me. It also meant low compliance costs for my employers, my landlords, my bank, and so on.

The main economic advantage of FoM is that a larger labour market leads to a more efficient matching of jobs to talents. This is, again, obvious enough at the national level. Imagine you have great acting skills, and a passion for it. But you live in Shanklin, Isle of Wight. Shanklin is a fine place, but there is no film industry there. So if you stay there, your acting skills will be wasted. If you want to develop them, you have to move to where the film industry is. The same logic applies, if to a weaker extent, at the international level.

A perceived downside of FoM was that the UK government had no control over who came here, or what for. It could neither affect the numbers, nor the composition, of the EEA population. For non-EEA migrants, the UK government could reduce the number of visas, either in total or in a more targeted way. For people from the EEA, it could not do that.

There was also a perception that Britain could only absorb a certain number of newcomers, and if EEA migration went up, non-EEA migration had to come down. The perception was that the Polish construction worker was crowding out the Indian doctor.

The promise was that once FoM ends, the UK government would be able to pick and choose the best and the brightest from around the globe, the ones that are most likely to fit in well and make a positive contribution. Whether that will sound like a good idea to you or not will depend on how much faith you have in the ability of governments to get such things right, relative to a system that relies on self-selection.

Conclusion

So – those are the trade-offs. Note that I still haven’t said a word about whether Brexit was good or bad, and today, I’m not going to. I have merely spelt out three trade-offs.

In a way, they are all variations of the same trade-off. Every Brexit-related decision means disrupting an integrated economic territory, and introducing barriers which did not previously exist. That is a cost. It is not a short-term cost, which you can adapt to, but a permanent one. But the same decisions also give you the ability to do things which you were not previously able to do. That is a benefit, or at least, it could be one.

Leaving an integrated customs territory comes at a cost. You are introducing a customs border which did not previously exist. But is also gives you the ability to pursue trade opportunities which you could not previously have pursued.

Leaving an integrated single market comes at a cost. You are introducing non-tariff barriers which did not previously exist. But it also gives you the ability to pursue regulatory reforms beneficial to your economy which you could not previously have pursued.

Leaving an integrated labour market comes at a cost. You are introducing a visa bureaucracy which did not previously exist. But it also gives you greater control over immigration, which you can use in a way which suits you.

This is a framework which rational opponents and rational supporters of Brexit should be able to accept. They can come to different conclusions within that framework, but if you cannot accept the framework itself, I do not consider you a rational participant in this debate. Because the alternative would be to frame the argument in such a way that your side is right by design. That’s not economics. That’s just petty tribalism.

I said at the beginning that for most people, Brexit is not about economics. It’s about their sense of themselves, and of the country they live in. And that’s fine. That’s a legitimate way to approach an issue like this. But if that’s what you’re doing – just say that. Don’t hide behind economic arguments when it’s clearly not about economics for you.