Tag: Brexit

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.

Game theory

Game theory can be a great way to look at negotiating strategy.
Even when we do not have full information on the individual decision process and perceived payoffs of the participants, we can attempt to reverse engineer what they might be and then think about likely outcomes.

First important point is to recognise about the Brexit negotiation is that it is a negative-sum game. Brexit has large economic costs so thinking about how they are allocated will be contentious. Negotiations on dividing profits are generally less problematic than allocating losses due to the endowment effect. It will be hard for either side to go back to the electorates with any form of loss, so a complete failure of the negotiations is definitely more likely than markets are currently pricing.

Second, there is no clarity or agreement on how large these costs are. It is entirely possible that the Brexiteers genuinely believe that there are net gains to the UK from leaving the EU. Disagreement on the payoff between outcomes can lead to mutual incomprehension and poor decisions. It has been argued that WW1 could have been avoided if the participants had had more time to work out how destructive it would be. However, the Schlieffen Plan put Europe on a rapid and rigid path to war.
If the tight timetable of Brexit does not give the participants enough time to understand how bad some outcomes are, they may not avoid them. I think that markets are not correctly pricing how destructive these bad outcomes are.

What is UK negotiating position?

The UK approach so far has been to take what they would describe as a “firm” negotiating stance. The EU might describe it as unreasonable. This could be because the plan is

1. Start at an extreme and expect to compromise towards the middle
2. Believe your starting point is reasonable and the EU will be forced to agree to it
3. The outcome of no deal is a good one and only an extremely favourable deal with the EU is preferable.

My fear is that the UK government is at 2.) or 3.) and not 1.) as it is consistent with their rhetoric. Another reason to believe that 1.) is not their view is that they are actively whipping up anti-EU feelings, representing their negotiating stance as a moral one against an immoral enemy.

Even if the plan is to start extreme with both sides moving to a compromise, it is unclear they are going about it the right way. The theory behind this approach is laid out in “Influence” by Robert Cialdini. Humans have a desire for reciprocity, if you start out by asking for more than you want and then make concessions, the other side will find themselves compelled to concede as well.
This is such an effective method that it becomes the norm in a variety of bargaining situations: whether you are buying a house in London, a teapot in Morocco or getting a Bill through Parliament.

There is one instance where it is counter-productive. “If the first set of demands is so extreme as to be seen as unreasonable, the tactic backfires” as we are “not seen to be negotiating in good faith”. As described in the last post, the EU does not see the UK’s approach as reasonable and so will be unlikely to move to a position closer to the UK’s desires.

If we look at 2.), I think that no-deal is preferable to the EU than the deal the UK is offering. Allowing the UK to leave and retain all the benefits of membership would fatally undermine the very existence of the EU and the Single Market. A no-deal result is a poor economic outcome but a lower magnitude than for the UK so I do not see outcome 2.) as viable.

Option 3.) is a bad strategy to me given that I think no-deal is a disaster for the UK. But that is a large topic and needs to be explained properly in later posts.

Comparison to Greece

The dangerous precedent I see for this negotiation is what happened with Greece in 2015. Syriza and Varoufakis acted as though compromising with the EU was a bad idea so that if they were completely intransigent, the EU would back down. When the EU did not back down, they refused the deal and called a referendum. The Greek government won this on July 5th , in which they gain support to not accept the EU bail-out terms. Then on 13th July, Greece accepted a deal with worse terms all round. Somehow, they represented this as a victory in which they had stood up to and beaten the EU.

We have clear precedent on how the EU will behave in tough negotiations. The danger is that the UK misunderstands both the game they are playing and the nature of their opponent.