Tuesday, 26 February 2019

Brexit: more teaching notes

I am reading Kevin O'Rourke's brilliant A Short History of Brexit. Here are some notes.

Start first with this very helpful from the excellent Martin Sandbu on thinking about the Brexit negotiations.

“[Too] many UK politicians still don’t seem to know what function an economic border has. So let’s break it down. When goods cross an international border, three things have to be enforced.
First, the collection of any import duties or compliance with import quotas.
Second, compliance with rules of origin, which involve preventing third-country goods from being camouflaged as the trading partners’ own production (when the latter are treated more leniently).
Third, the enforcement of standards, such as food regulations, which must be met for the products to be legal in the territory they enter. “

Now let’s think of an example, following O'Rourke.  Suppose New Zealand exports lamb to the UK.  Suppose too that UK wants to trade agricultural products with France, including British lamb.  Suppose again that there are different tariffs, taxes and standards on NZ-UK trade and UK-FR trade.
Now consider the pre-Brentry position.  UK traded massively with NZ,  ORourke documents that the UK took 90%., 75% and 86% of NZ butter, cheese and lamb products.  Suppose the UK is deciding what kind of trade agreement to sign with France.

Now we have to define the seemingly arcane but what will turn out to be crucial, difference between:
a.       A free trade area:
b.      customs union:

An FTA removes tariffs between FR and UK.  BUT, it allows FR and UK to sign different agreements with NZ.  A customs union removes tariffs between FR and UK but it disallows different agreements with NZ. 

If you had to put this into a single sentence, this turns out to be the heart of the problem.  Let’s work through the example to see why.

A FTA takes care of the first problem of tariffs, by removing them.  Job done!  But careful.  The devil is in the detail.  As O’Rourke explains (p.54 of my kindle version), France will still have to erect border checks. Why?

It has to check all the lamb just in case some of it is from NZ. If that lamb is from NZ, then it’s already paid a tariff, taxes and undergone inspection appropriate to the UK, but then
a.       it needs to pay an additional tariff relevant to FR and NZ trade
b.      it needs to pay an additional tax relevant to FR and NZ trade
c.       it needs an different inspections relevant to FR and NZ trade

To find the “country of origin” might be easy with respect to lamb, but it very much harder with more complicated goods like cars.  It might be even harder with, say planes, which come with a maintenance agreement and so might be counted as a service.  At any rate, the FTA will still need within-EU border checks.

Suppose now that an efficient economy needs frictionless trade.  That might not be true, but it seems important for, say, aerospace and cars.  What are the implications of this?

It’s clear that an FTA won’t do; you have to have a customs union, with unified tax and standards.   

Let’s call that the single market.  But it comes with two very big implications
a.       anyone in a single market will NOT be able to set an independent outside trade agreement.
b.      Anyone in the single market will NOT be able to have independent standards for goods.
We can now see the implications of these facts and they are many: O’Rourke discusses them with wonderful clarity.   Here are a few.

1.      History
The UK was highly reluctant to join the EU originally because it wanted to keep preferable trade relations with the Commonwealth.  But that cannot be done with a common external tariff, and you need a common external tariff to have frictionless trade.  This was the UK issue in the 1950s and seems to be still. 

2.      Sovereignty
Such a trade agreement will need centralized admin and planning to decide on harmonized taxes, standards and common external tariffs.  For example, we cannot negotiate our own trade deals.  This gives away sovereignty to which many might object.  Hence Dani Rodrik’s trilemma, referred to in the Governor’s speech, “As Dani Rodrik (Rodrik, D. (2011). The globalization paradox: Democracy and the future of the world economy) has argued, there is a trilemma between economic integration, democracy and sovereignty. Common rules and standards are required for trade in goods, services and capital, but those rules cede or, at best pool, sovereignty”.  See also here. Perhaps Brexit, if it succeeds, can help with sorting out this trilemma.
Some more examples of sovereignty sacrifice comes from preparations for Brexit.  For example, the EU sets out common safety rules on manufactured products e.g. aerospace products.  But the EU does not recognize UK safety assessment bodies so those goods will need to be reassessed by the EU-recognized body. 

3.      What fraction of our trade really is with the EU?
Once we are in the EU we trade with it AND we trade with countries via the trade agreements that the EU has signed of which are therefore part of.  The BBC covered this neatly.
“Foreign Secretary Boris Johnson told BBC Radio 4's Today Programme that the UK's trade with the EU had been declining rapidly in the last 10 years and that it had fallen to about 44%.”
An hour earlier, Sir Martin Donnelly, who was the most senior civil servant in the Department for International Trade, told the same programme: "If we leave the Customs Union and the single market then we are taking away the equal access that we've got to 60% of our trade”
Can they both be right?  Johnson is talking only about exports, which is 43%.  Donnely is talking about exports and imports which are 49%.  But he was also talking about the additional 12% of trade or so through EU preferential trade deals.

4.      Can we negotiate our own deals outside the EU?
Yes we can, for the reasons set out above, but if we do note the following
a.       Recent news reports suggest this is harder than we thought: if we leave on the 29th Japan is not, it says, for example, simply going to roll over our current EU-based deal but wants to negotiate a new one.
b.      Turkey has a customs union arrangement with the EU (covering some goods).  And it is free to negotiate it’s own outside agreements.  However, as the logic above suggests there are is a very important limits that it has had to agree to: It cannot offer lower tariffs than the common EU external tariff, restricting its bargaining power (and it has no say within the EU about that tariff).  Why not? As above, it is did, then it needs inspections as in the NZ lamb case.  This then gives an individual state limited bargaining power.  Now, the EU as a whole might be sclerotic and might not move fast in signing agreements, individual countries might move faster and so exert their sovereignty.  But, in this example, they would have less leverage. 

5.      The Deal
The current Deal on the table is the “Withdrawal Agreement” (agreeing the divorce bill, EU citizen rights and the Backstop, see below) and political declaration (a broad statement of future direction and a transition period of two years (ending in December 2020, unless an extension is agreed).  The broad objective is to try for trade in goods without restrictions.  But this is not spelt out in detail. In the transition period says the BBC “current EU laws would continue to apply, but beyond that it's not clear what tariffs, regulations or checks might be deemed necessary to allow us to trade in goods or services with EU countries. If no long-term trade deal is agreed and the so-called "backstop" comes into force, the whole of the UK would stay in a "single customs territory", meaning no tariffs on UK-EU trade, but also no freedom to set lower tariffs on trade with other countries outside the EU”.

6.      The Backstop (see here for more details)
We can now better understand the Backstop.  The Good Friday agreement removed border checks within the Irish continent.  That can only continue as long as the UK harmonizes in all the above dimensions with Ireland i.e. the customs union/single market.  This is why the current Deal has in it the Backstop requiring, if there is no deal on a long-term relation that makes the border unnecessary, inclusion of the UK into what is called a “single customs territory”.   It has to, for the reasons above.  And as long as that continues, the UK cannot sign agreements independently elsewhere, it has to adhere to common VAT, standards etc.  So to avoid a hard border, the UK has to stay aligned, perhaps obviating much of what Brexiters want to achieve.  And, during the negotiations, it was conceded that the EU will decide when the UK can exit the Backstop if it enters it.  What can be done?   Technology might solve this in the future, or a border in the Irish Sea: the latter of which the DUP so far will not sign up to. 
At time of writing, there is rumor of some sort of softening of the Backstop provisions so that it does not continue indefinitely if there is no future customs union with the EU or the EU does not have veto power. This would appear to involve some complicated legal maneuvers.

7.      The EEA, Norway plus etc.
The European Economic Area is an agreement between the EU and EFTA. Norway, Lichtenstein and Ireland.    EEA countries can have access to the single market as long as they adhere to EU rules and accept free movements of goods, services, persons, capital.  But The EEA does NOT have frictionless trade, since those countries are not in the customs union and they have control over some areas, such as taxes, agriculture.  As we have seen above, with this control, they cannot be in the customs union.  So these countries have some freedoms, but do have to adhere to EU rules and pay, without any votes on those rules.  Some points.
1.      Being in the EEA removes the Backstop problem.  But it means having free movement and paying in.
2.      EEA members have to accept free movement.  This is a core principle of EEA-EFTA.
3.      One area here is that these countries align with the single market on financial services.  But they cannot shape those rules.  The UK is particularly exposed to financial services.  So what are the pros and cons here?  Lord Hill in the FT, 14th January argues that although there are some joint EU/EEA committes, in practice the EU has almost zero consultation with EEA members on financial services and so the UK would be a rule-taker.  This would expose UK finance.  It is also the case that the EEA can vote not to accept EU rules, but then it would risk losing market access, the expectation of which for finance, would be potentially ruinous.
Norway plus is a version of this whereby the UK joins the EEA and signs a new customs union with the EU.  The current plan by some MPs is to extent Article 50 whilst this new arrangement is negotiated.  But, as we have seen that means no signing of independent trade deals.  And no say on financial arrangements, see above.

8.      How costly are border checks anyway?
What are the gains from frictionless borders?  Here some anecdotes are useful.  A country outside the customs union who wants to export will need: registered exporter: declare export classification and destination to HMRC: prove origin of product; particularly in agriculture and phama, could be subject to standards checks. 
As the Bank Inflation Report says, most of our goods trade is via Dover, who handle 4.5m trucks.  92% aren’t checked, 8% are, they mostly come from outside the EU, and those need 30-60 mins.  HMRC estimate an additional 250,000 firms will have to start filling out customs declarations.
Regarding finance, fragmentation is potentially very costly in, for example, large exchanges of derivatives, since they are by nature global and have platform elements.   
The book includes something on Honda, that was covered also by the FT, June 26th, 2018 (Honda faces the real cost of Brexit in a former Spitfire plant https://www.ft.com/content/8f46b0d4-77b6-11e8-8e67-1e1a0846c475).
“Proud managers describe 2m components “flowing like water” to the factory line every working day. Some orders from EU suppliers arrive within five to 24 hours; others, such as customised car seats, are summoned from local suppliers just 75 minutes before use. Not a minute is wasted.
Honda now fears that the border checks that could be introduced as a result of Brexit will clog up the process. If Britain were to leave the customs union, Honda estimates European parts will take a minimum of two to three days to reach the plant, and possibly as long as nine days. Delivery times of finished cars may be just as unpredictable. To a car industry famed for its clockwork tempo, the potential delays pose an existential challenge.
A warehouse capable of holding nine days’ worth of Honda stock would need to be roughly 300,000 sq m — one of the largest buildings on earth. Its floorspace would be equivalent to 42 football pitches, almost three times Amazon’s main US distribution centre.”

9.      The dark side of common standards?
As Dani Rodrik has noted, common standards is an essential feature of trade deals now (along with a host of other things, like intellectual property protection etc.). Such standards might differ, quite reasonably, between countries, e.g. patent length.  Thus to get them harmonized might create trade, but might not be such a good thing.  The recent Dyson case seems a case in point, as the Court judgement sets out (

Here are some details (and further commentary here.)
“Since 1 September 2014, all vacuum cleaners sold in the EU have been subject to energy labelling requirements, the detailed rules of which were fixed by the Commission in a regulation The energy labelling is aimed, among other things, at informing consumers of energy efficiency levels and cleaning performances of vacuum cleaners.”
All very reasonable.  Now, here’s the key
“The regulation does not provide for testing of vacuum cleaners with the dust receptacle loaded.”.
That means that test can be carried out with no dust.  Well, the point of the Dyson cleaner is that it cleans better with dust (tradinoal bag-based cleaners lose their suction with dust build up).  According to Dyson, it’s the German manufacturers who make the traditional cleaners.  And they managed to get in the standards, even though this didn’t help consumers guage the product.  The Court found, after 5 years of process, that an essential element of the directive was to help consumers.  So they found
            “Since the Commission adopted a method for calculating the energy performance of vacuum cleaners based on an empty receptacle, the General Court holds that that method does not comply with the essential elements of the directive.” 

Brexit scenarios

In November the Bank published some scenarios, https://www.bankofengland.co.uk/report/2018/eu-withdrawal-scenarios-and-monetary-and-financial-stability.  Here’s a summary.

1.      Channels
Figure 2A sets out the channels.  We move from right to left.

a.       The scenarios modelled and assumptions.
On the left we see the three scenarios modelled and next to it, the various assumptions, involvesd. These scenarios were requested by the TSC.  They are set out in  Table 3.1.1, 3.2.1, 3.3.1 and I summarise here

Econ Partnership
No customs checks, no goods barriers, some service barriers, no new trade deals. Non-tariff barriers. Loss of passporting.
Transition to 2020 sufficient for all to prepare
No deal, no transition
Customs checks, All apply common customs tariff, regulatory checks needed.  WTO means services barriers: lost passporting, lost broadcasting, transport licences needed.  In disorderly, UK loses access to existing trade agreements with EU and 3rd countries
Delays at border,
Transition to WTO
Gradual transition to WTO terms, about 3 ¼% tariff on goods. Customs checks.

Within each scenario, more and less severe variants are modelled, such as in no deal, no transition (p.6), “the UK loses existing trade arrangements that it currently has with non-EU countries through membership of the EU. The UK’s border infrastructure is assumed to be unable to cope smoothly with customs requirements. There is a pronounced increase in the return investors demand for holding sterling assets. There are spillovers across asset classes.”

b.      Evidence.
The middle column shows the range of evidence used to model the scenarios.  There are few case studies to go on, with some work on New Zealand who lost access to the UK in the 1970s, but in the middle of an oil crisis.  So the main work relies on (a) gravity equations and a trade/GDP elasticity and (b) a FDI and productivity.

The gravity equations model trade between countries with like GDP and controlling for distance, finding that more trade is with richer countries nearby.  To simulate the effects of Brexit, the idea is to look for how much more or less trade there is between similar countries (distance, relative GDP) who are and are not in trade agreements.  Note that leaving a trade agreement might stop trade between A and B, but it might be taken up between A and C, so this has to be controlled for.  After these terms are estimated, the loss of trade is multiplied by the elasticity of GDP with respect to trade.  This is taken from studies like Feyer which are in turn reduced form estimates of episodes, such as the closure of the Suez canal on GDP per person. 

The FDI link is that FDI might boost domestic productivity via spillovers to the host country.

As a matter of data, most of the work is done in by the gravity equations since the trade elasticity is much larger.  We don’t however, have much a model for services.

There are other effects such as exchange rates and financial conditions, perhaps due to uncertainty. These are harder to pin down.  Still harder is the timing of these events. 

c.       Prospects
The prospects for GDP and inflation etc. are scenarios via some modelling.  There is an interesting paragraph, p. 4 on the difficult issue of timing

“Speed of adjustment:
Given the lack of precedents, there is uncertainty over the speed of adjustment to
reduced openness….
-  A range of evidence suggests that the impact of introducing frictions such as tariffs and customs
checks at the border comes through quickly. A substantial number of firms have little experience
with customs checks and, for many, business models and supply chain management could be
significantly disrupted by delays at the border. Intelligence from the Bank’s Agents suggests that
uncertainty has deterred some companies from investing in preparatory actions, and it is likely that
the corporate sector is generally not yet well equipped to cope were the UK to leave the EU
without a transition period.
-  The discrete nature of some non-tariff barriers means that they have the potential to have a rapid
effect on trade. One example is in financial services where, if the relevant regulations do not allow
for the service to be provided cross border, then the impact on the supply capacity of the economy
may be immediate and coincident with the direct effect to demand.
-  Sectoral evidence points to a need to reallocate capital and labour as patterns of production
change in response to changes in the cost of trade. If resources are unable to move seamlessly this
will quickly disrupt supply.”

The report goes on

“The level of preparedness of businesses and infrastructure (such as ports, excise and customs systems and
transport operations) will be important in determining how the economy adjusts to new barriers. The
extent of any disruption at the border and to transport and financial services will depend on preparations
made by firms, the authorities and on policy decisions yet to be taken by both sides.”

In this way, we can understand the scenario modelling in Chart A.

It sets out two broad scenarios, partnership and no deal.  Around those scenarios are different versions, as set out above, with the lowest scenario the no deal, no transition.

As can be seen the lower scenario with no deal and no transition shows a steep fall in GDP with then a recovery but with an endstate 10% below the May 2016 trend.

Some other points.
1.      Non-tariff barriers have risen a good deal, see below.
And as the report notes:

“NTBs are particularly important because they have the potential to have a rapid effect on trade. This is
because the discrete nature of some barriers means an exporter can either supply the goods or services, or
they cannot. One example is financial services, where if the relevant regulations do not allow for the service
to be provided across borders, then the NTB could impact on trade immediately and fully following the UK’s
exit from the EU. Similarly, under current regulations some services – such as broadcasting – cannot be
exported to the EU without direct authorisation within member states.”

2.      Different sectors
You might think that different sectors are differently exposed.  One is via EU labour

The other is via exposure to possible changes in border and behind border arrangements. The heat map suggests agriculture is particularly exposed.

3.      Direct effects on inflation from exchange rates and food tariffs
The long run contributions depend on both shares in spending and also changes in prices.  Changes in prices are mostly in food and transport as are the contributions: