How bad is No Deal Brexit?

We have all seen the headlines yesterday with Bank of England estimates of a 25% hit to the currency and the Brexiteers talking about how the economy will be better off.

I will try to lay out what drives their wide disparity.

1 . ‘No Deal Brexit’ will cause limited problems

This is the case made by people like Krugman. Essentially the value of UK exports to the EU is 15% of GDP. Even with a really disruptive Brexit, this would fall by at most 1/3 i.e. 33% loss of exports. Given domestic substitution, the case could be made that this is still far too high a number and so GDP would be less than 1% lower, depending on exact elasticities.

2 . ‘No Deal Brexit’ will cause no problem – it maybe even better than the current situation

Take the analysis above and add in fantastic trade deals with the rest of the world which will more than make up for the lost EU trade. Trade deals may well take a little while to negotiate so there will be a minor cost short term, but longer term the UK will be better off.

I could take issue with any number of assumptions in the argument above. In particular, the gravity model of trade makes a mockery of the idea that you can replace an enormous market on your doorstep with markets halfway across the globe. Furthermore, it is hard to see why the UK would get better trade deals than the EU currently gets; negotiating deals with reduced clout, it seems obvious such a deal will be worse.

But leaving this aside for now, we can see the order of magnitude of potential benefits of new trade agreements with the rest of the world as perhaps 1% of GDP at best.

3 . ‘No Deal Brexit’ is Chaos Brexit

The reason for this is we do trade with the EU is a simple manner – we have highly embedded supply chains across vast swathes of the economy.

The classic example is of course the car industry (https://www.theguardian.com/business/2017/mar/03/brexit-uk-car-industry-mini-britain-eu)

It is important to recognise that these movements of goods do not form part of the official figures for exports to the EU. National Accounts are based upon transactions – i.e. the final sale of goods. When a company moves parts around between different factories in the EU it is not doing a transaction. It does not sell them to itself. Imports within the EU are called “acquisitions” not imports. Note that they are recorded for VAT purposes however, based upon the change in value (value added at each stage in the process), but this does not give a sense of the importance of intra-company physical movement of goods across the border.

The mistake in the analysis of people like Krugman, is to have a very simplistic model in which the UK and the EU are the sole creators of goods and they trade with each other, much like a model of trade between two parties in an economic textbook. The reality is that the UK and EU are intertwined in the production process and the impact of this is grossly underestimated by only looking at the destination of the final product.

It is worth then considering the likely reaction of industry.

If making cars in the UK is subject to expensive issues and frictions in the supply chain with a possible tariff when you try to sell into the EU – then why make them in the UK at all? Make them entirely in the EU. Will there remain a UK car industry selling to UK buyers? Well possibly – but given the enormous economies of scale in manufacturing, it seems far more likely that production moves to the EU. Then we not only stop exporting cars, we have to import even more of them. With over 1 million people in the UK currently employed in the wider automotive industry that is a huge problem.

The way we get to a real economic catastrophe is very similar to what we saw in the financial crisis. You take a well-functioning system and smash it. Then stand back and be very surprised by the unintended consequences.

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