Who loses more from Brexit? The UK or EU?

A much-repeated claim throughout the Brexit campaign was that the EU needs a trade more than UK because the EU has a large trade surplus with us. It formed a remarkably effective argument as it implies that an unfavourable outcome can only happen if the EU is “irrational” (David Davis’ term)

This claim is, of course, nonsense.
The EU is a far larger economy than the UK (~ 5 times) so if we accept that there is a cost to putting up trade barriers, then the cost is far larger as a share of the economy for the UK than for the EU.

This has been explained clearly many times in other blogs such as https://musealoudblog.wordpress.com/2017/04/03/brexit-they-need-us-more-than-we-need-them/ http://www.niesr.ac.uk/blog/after-brexit-how-important-would-uk-trade-be-eu#.WQiNUBPyvuo.

Economic Model for trade

What I find intriguing is why this argument is so appealing.
It is a common mistake to use intuitive models and analogies from microeconomics and apply them to macroeconomic issues even when they do not make much sense. Take the word “competition” used in international trade, it evokes emotional memories of sport in which there are winners and losers. The one with the surplus is the winner, and the loser has the deficit.

This model gave rise to Mercantilism school of economics and is one of the earliest around, a hundred years before Adam Smith, and notably articulated by Thomas Mun of the Honourable East India Company. From the perspective of a single business, the concept makes sense replacing the term “surplus” for “profit”. Why would a company trade if it was not making a profit? Why would a country trade if it was not making a surplus?

This idea was replaced by Ricardo’s demonstration, in 1817, of the mutual benefits of free trade. In essence, if two countries focus on producing the goods they have natural advantages in, the resulting free trade will make them both richer. Remarkably it’s one of the very few areas economists generally agree about.

However, the more old-fashioned Mercantilist ideas of winners and losers are still very much alive outside academia. Previously primarily on the left and the anti-globalisation movement, but now with the recent rise of the populist right with Trump’s “economic nationalism” and Brexit.


Distribution of gains/losses

If we leave behind the assumption that surplus/deficit defines who will lose most and accept that there is a net loss to be allocated, we still need a model of how this might be allocated. The simplest model, and I think most often used in blogs, is that the cost is allocated according to each country’s gross exports and this is perfectly sensible. Economics reveals another way to think about it. While Ricardo showed that there is a net gain from trade, it was JS Mill who formed the theory of how it would be distributed. What matters is the relative elasticity of demand.

Car Industry example

Let’s take the car industry as an example, commonly cited by Brexiteers.
The UK exports 760k cars to the EU and imports 1.86 million.

If we take a simple ratio, we would expect the EU to face more than double the costs in absolute terms, which is less than the ratio of the economy sizes. Does that model true up with reality?

It is often forgotten than people in the UK like buying EU cars (especially German ones) and would not immediately substitute into buying ones produced in the UK. Due to efficiencies of scale, the UK produces a far narrower range of models than it imports. The 760k cars the EU imports from the UK are largely substitutable for similar models built in Spain. i.e. there is a substitution difference between the UK’s imports and exports of cars. In economics speak, this represents a significant difference in elasticity of demand which by Mills theory suggest UK will take a larger brunt of the costs from the imposition of trade barriers than the simpler model suggests.

Supply Chain

Another factor to consider is how disruptive barriers would be to production and supply chain.
If the UK is outside the customs union, then the current complex supply chains for all goods could be heavily disrupted. This is not just the supply chain for goods we export, it is the supply chain for goods we consume domestically as well.
I do not have numbers for this (if anyone can point me to some that would be very helpful) – so I will work from general principles.

A simple model would be to imagine 11 countries and that each good they produce crosses a border to another country and back just once, and the country it goes to is random. Of these 11 countries 1 is the UK and the other 10 are various EU states.

Of every 10 goods produced by the UK, 10 of them cross a border into an EU state.
Of every 10 goods produced by EU states, 9 of them go to other EU states and only 1 goes to the UK.
So the UK’s supply chains are 10 times more disrupted than the EU’s.

Even without actual numbers, I find this model a helpful example. The UK is at risk of disrupting its entire economy without a deal on free movement of goods. The EU would also lose but to a far lesser extent. My experience of the financial crisis tells me that the plumbing of modern economies is far more interwoven and complex than people understand and untangling it has far larger risks than people assume.

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