In our first ESRC-sponsored Ask The Expert seminar of the year, Dr Angus Armstrong of the National Institute for Economic and Social Research (NIESR) discussed the UK’s priorities in its future Brexit trade negotiations. You can listen to a recording of the event here.
Trade priorities
Following brief remarks on the role and performance of economists in recent debates, Dr Armstrong stressed the importance of keeping analysis separate from ideology as far as possible to restore some confidence in so-called ‘experts’. He provided a quick review of NIESR’s published short- and long-term forecasts, compared to the outcomes so far, and then turned to look at trade priorities.
Currently, more than half (53%) of UK trade is with members of the European Economic Area, which includes all 27 other members of the EU alongside with Iceland, Liechtenstein, and Norway, plus the Customs Union with Turkey. Including existing 53 Free Trade Agreements (FTAs) between the EU and other states, in particular agreements with Switzerland and South Korea, brings the share of UK trade to 62%. Including the EU FTAs currently being negotiated with other countries around the world brings the share of UK trade to and through the European Union to around 80%. While there is the argument that Brexit will increase trade with countries outside of Europe, such policies can only be established once the UK has left the EU.
A flaw in the argument that trade with the EU can, if necessary, be replaced with more trade outside of Europe arises is that physical distance between countries remains a significant restriction of trade opportunities, despite the effects of technological advances on the nature of international trade. Global value chains, which coordinate the production of goods and services across economies, may even add to the significance of trade with next-door neighbours, which by definition is cheaper and easier, becomes more important to the creation and supply of the final goods and services.
Another trade priority arises as we look into the methods using which trade is measured. Dr Armstrong showed that gross figures on trade reported every day are misleading as they do not indicate the value added in the UK economy. Many of our exports consist of largely imported goods. Value added estimates, which are much less timely and not official statistics, at least measure the impact of trade on domestic jobs and income (wages and profits), both of which play an important role in domestic policy-making. These figures show services are more important than goods trade for UK profits and wages. FTAs are mostly about goods trade and less about services (the latest Canadian agreement notwithstanding).
As with most advanced economies, the service sector generates the largest share of national output. Eight out of ten jobs and 75% of output in the UK is in the services sector. However, the main form of selling exports is not included in the official trade flows. Most services are exported overseas through foreign affiliates created by setting up companies overseas or partnerships. A useful proxy measure for exporting through affiliates is foreign direct investment (FDI) statistics. The UK is the third largest recipient of FDI in the world. More than half (60%) of all inward FDI (into Britain) comes from Europe, of which two-thirds is in the services sector. Additionally, 30% of FDI comes from the United States, implying that trade agreements with Europe and the US are likely to be prioritised over the course of the next couple of years.
Trade Agreements
Global value chains have contributed to international trade rapidly accelerating away from the traditional theories of Ricardo and Heckscher-Ohlin. While their insights are timeless, the assumption of fixed endowments no longer necessarily binds. Through investment in research and infrastructure (broadly defined including legal processes) countries can change their skill sets. Dr Armstrong reasoned that, when parts of the production process are internationally mobile, so-called footloose industries, as a result of technologically allowing the production process to be broken-down, then absolute advantage can also play a role in determining trade patterns alongside comparative advantage in the global market as trade policy is entwined with regional and industrial policies. This means the UK’s emphasis on industrial policy, and its regional content, is crucial and ought to be considered with trade in an integrated policy approach.
There is also an important role for government. Ironically, free trade is not an issue of governments just ‘getting out of the way’. They have to agree standards, rules and regulations, supervision and enforcement mechanisms (non-tariff barriers) to name but a few. Legal infrastructure is particularly important. Trade agreements are really a formalisation of cooperation between two (or more) countries and necessarily imply shared sovereignty. They agree to forgo some policies to cooperate and reach a better economic outcome. Both countries require a robust shared legal system which recognises the set of rules negotiated in the trade agreement and is able to enforce them. There need to be an enforcement mechanism to ensure the terms of the trade agreement are met and in many cases that investors rights are protected.
Dr Armstrong described the current Free Trade Agreement between Canada and the EU (CETA) as the most comprehensive agreement between any countries of sufficient size. CETA covers agriculture (without removing all associated trade barriers), non-agricultural goods (tariffs have roughly halved), services and investment (certain sectors such as education, healthcare, social and financial services excluded), government procurement (enabling preference over domestic supply), intellectual property, and sustainable development, environment, and labour. A modern trade agreement of such depth could be held-up as a model for the UK once divorce from the EU has been finalised, however it must be noted that CETA took 15 years to complete and enact. The limits on services trade mean that CETA well short of the sort of level playing field of the Single Market (although itself incomplete).
An additional component that could be problematic for the UK while negotiating future agreements is dispute resolution due to international courts leading to a trade-off between trade and sovereignty as trade partners can seek legal action in response to changes in domestic policy. International courts, such as the International Court for Settlement of Investment Disputes (ICSID) in Washington DC, also pose a threat to domestic political legitimacy as public interest could be misrepresented and overlooked. At present, the UK has not established a domestic institution to tackle disputes and needs a new method of resolution in order to continue to attract foreign direct investment. Dr Armstrong cited dispute resolution as the reason behind the failure of TTIP and the objections to CETA.
Looking Ahead
The final part of the talk at UK policy once the UK has left the EU. In contrast to negotiating FTAs, some economists and think tanks advocate that the UK ought to unilaterally set zero tariffs on goods imported into the UK. This may even be at a time that our goods producers and agricultural sector may be facing tariffs for the first time with our former EU and EU FTA partners. Campaigners in support argue that unilateral zero tariffs maximise total income for society and may even encourage a zero tariff response from the rest of the world.
Dr Armstrong returned to his opening theme. While not wishing to argue for protectionism, the debate seemed to be more driven by ideology that economics. Such a radical policy would have very significant effects on certain economic sectors (many advocates even acknowledge that most of our manufacturing sector would be wiped-out). There would of course be winners, in particular consumers would enjoy lower import prices and so import more.
But the primary effect of trade liberalisation is on the distribution of income between winners and losers. This is a trade-off. It is economists’ job to highlight this trade-off, perhaps identify the winners and losers and even attempt to measure the costs and benefits. But it is for the politicians to decide how to choose policy given the trade-off. We also do not live in a first-best world of perfect competition where trade is costless, distance does not matter and there is no unemployment as labour is perfectly mobile to move across sectors. If we are in a world of second best, then economists cannot rank policies against one another as they will each have other distortions. Therefore decisions in regard to the issues arising from trade liberalisation should rest with politicians and policy-makers, after being informed of the trade-offs by economists. For economists to ignore the trade-offs or pretend that they do not exist undermines their credibility and legitimacy in public debate.
Political legitimacy needs to play a part in addressing regional policy and inequalities. Seeing the decision to leave the EU as sovereignty issue, Dr Armstrong criticised the arguments claiming that there should be a second independence referendum in Scotland. Sovereignty is clearly a reserved power for Westminster. However, those arguing for unilateral zero tariffs add some justification for a second referendum. The distributional consequences would fall heavily on Scotland, and deciding UK tariffs and quotas on agricultural products contradicts the idea of devolved powers. These consequences are unforeseen and not even being thought about.
In concluding remarks, Dr Armstrong stressed that the talk was not in favour of protectionism, but rather a call for an open political discussion informed by ‘positive economic analysis’ rather than ideology-laden commentaries.
Click here for the full presentation.
This blog post was written by SMF research assistant Nicole.
Ask the Expert is the SMF’s lunchtime seminar series, run in partnership with the Economic & Social Research Council (ESRC).
Building on from the success of Chalk + Talk, the SMF Ask the Expert series brings the best policy output from the world of academia into the heart of Westminster.
This series of events is aligned with current government consultations and parliamentary inquiries, giving policymakers the opportunity to engage with experts in those policy areas.
To suggest a subject for a future Ask The Expert event, please contact the SMF’s events officer Hannah Murphy via hannah@smf.co.uk.