New report on macro-economic impact of Brexit questions Treasury forecasts

The economists have also been working with lawyers at the CBR to explore the possible impact of Brexit. They warn that the UK is in danger of remaining a low wage, low skill country unless it can create the conditions for a reorientation of its economic model post-Brexit.  

In a new podcast for the CBR, based at the Cambridge Judge Business School, Graham Gudgin, one of the authors of the new report: The Macro-Economic Impact of Brexit: Using the CBR Macro-Economic Model of the UK Economy (UKMOD), and Simon Deakin, Director of the CBR and Professor of Law at the University of Cambridge, discuss how the UK economy is likely to perform in 2017 and what would be the best model for leaving the EU.

Gudgin says that, according to The Treasury, we should have been in recession by now, but we are not. "Things are maybe a bit delayed but the whole succession of investment announcements we have had from Nissan, Microsoft and others suggests that companies are taking a much more sanguine view of this than the Treasury and others have suggested," he says.

Possible options: from the EEA to bespoke trade deals

Deakin explains the four possible options the UK government could pursue for leaving the EU: re-joining (or remaining in) the EEA (European Economic Area); becoming a member of the EU’s customs union; undertaking a series of bespoke trade deals, such as Switzerland has; or, if none of the above apply, defaulting to the rules of the World Trade Organization. The first two of these would mean accepting the free movement of persons, which the current policy of the British government appears to rule out.

Gudgin suggests that, since the policy of migration control is likely to be maintained, the UK will try to negotiate a new trade deal with the EU, perhaps along the lines of the recent EU-Canada agreement. Some argue that this could take a decade or more to achieve, but Gudgin takes the view that since we are starting from an existing free-trade situation, the task is much easier.

No quick agreement is however likely and whether the EU and the UK can negotiate transitional arrangements to bridge that gap remains to be seen. Any new trade deal will also have to be conducted within the framework of WTO rules, says Gudgin, which will add to the complexity of the negotiations.

Deakin explains: “Nearly every European country is either in the single market or in the customs union. For example, Norway, via the EEA, is in the single market but not the customs union; Turkey is in the customs union but not the single market.  There are a number of other options. Switzerland is not part of the European Economic Area, but has a number of bilateral trade deals with the EU.

"These are conditional on Switzerland allowing free movement of labour (which a recent Swiss referendum vetoed) and capital. Countries in the single market, including those in the EEA, must conform to EU rules and regulations regarding product standards, labour laws and environmental protection, among other things.

"Customs union membership implies internal free trade and a single external tariff, but countries outside the EU which are in that position, such as Turkey, cannot make their own trade deals with third countries. If we went for that option post-Brexit, we would not be bound by all the rules of the single market but we couldn’t do our own trade deals with third countries.     

The WTO also have rules on how migrant workers may be treated in host states which are not that dissimilar to those operating in the EU’s single market

Simon Deakin

“If we were in the EEA we couldn’t avoid rules on free movement of labour or capital. You either accept the four freedoms, the movement of goods, services, people and capital over borders, or you don’t; you can’t cherry pick. The UK could try for a Swiss style option where you try to have free movement but then modify it somewhat, but the Swiss have had to sign up to most aspects of free movement in order to get access to the single market. To get around the rules of free movement of labour and capital it is highly likely the UK would have to be outside the EEA.

"We could still sign up to the customs union, Turkey isn’t subject to the rules on free movement of labour, for example, nor is the EU required to accept free movement of persons from Turkey into the EU, but then we wouldn’t have the freedom to do trade deals with third countries, which the UK has said it wants to have; that is why the International Trade Department was brought back.

“WTO rules do not require member states to accept free movement of labour, they do, however, contain some rules on issues like state aids, to prevent distortions of international trade. The WTO also have rules on how migrant workers may be treated in host states which are not that dissimilar to those operating in the EU’s single market, and are highly contentious for the same reasons. WTO rules on these issues are generally not as strict as EU laws and do not form part of UK domestic law. International law obligations cannot be enforced in the same way as EU laws can be. However, the WTO option is not a blank slate for the UK.” 

Trade deal within two years – unlikely

Deakin goes on to say that as things stand there is uncertainty over what Brexit might mean, even if it is possible to identify some of the main features of each of the principal options: “Lawyers can say what the general framework is for each of these four options, EEA, customs union, Swiss option, WTO, but until we know more about how the government will wish to conduct its negotiations with the EU and about the EU’s position going forward it is hard to make predictions. There are many issues we don’t have a clear answer to.

“We can sketch out broadly what happens for each of these main options but I think there is a case for more research to be done. It is most unlikely that there will be a trade deal negotiated within two years of triggering Article 50, and as the process of negotiation and deliberation unfolds new issues will arise. These may crop up at sector level, particular industries may have issues that need to be worked through, and individual companies may raise points about their position and if they receive guarantees from government there will be issues of state aids to consider under both EU and WTO law. At the moment we just don’t have a good set of answers to these questions.”

Deakin says a transitional agreement with the EU would need to be a one-off bespoke arrangement as there is no provision for such an agreement within EU treaties: “We are bound by EU law until we leave, we are bound by international law to maintain the treaties that we have signed up to until we withdraw from them. Until the European Communities Act is repealed we must apply EU law domestically and even after the so called Great Repeal Act, which the government has promised to bring in, is implemented, many of the same provisions will be replicated within UK law.

Transitional agreement?

“There is talk of a so-called transitional agreement and that could involve staying in the EEA, while things are worked out, but there is no obligation on the side of the EU to offer us a transitional deal.  This would have to be a bespoke arrangement as it is not provided for at the moment under the EU treaties. It remains to be seen if that sort of soft landing is possible, let’s see what is put on the table after negotiations between the UK and the EU begin. Whatever happens, we need to understand the institutional impact of Brexit in order to get a better understanding of what its economic effects will be.

“We do need independent research to be carried out on this question because so far most of the research that has been done on this has been by one or other side of the Brexit argument. The government has its own researchers in the civil service and of course this is objective, high quality research; the OBR is doing independent economic forecasting. However, there is a public demand for independent, non-partisan research, conducted outside government and the political arena. Thus there is an important role for University-based research; this should feed into the process of deliberation as Brexit unfolds”.

We have looked very carefully at what the Treasury has said about this and we find its work very flawed and very partisan

Graham Gudgin

Gudgin agrees with Deakin that better research and economic forecasting models are needed. He thinks that in reality the only option for the UK to leave the EU, other than the WTO fall-back, is under the terms of the so called Canadian model.

“There are probably only two practical options. One is a free trade agreement along the lines of the one Canada has just signed, or else no agreement on trade in which case you fall back on WTO rules. The impact of both of those is pretty uncertain. We have looked very carefully at what the Treasury has said about this and we find its work very flawed and very partisan. It is not objective. I agree with Deakin that we need some more objective economic work on this, the whole debate has been coloured by a lot of hyperbolic discussion.

The Treasury: four quarters of recession?

“The Treasury said there would be four quarters of recession, we have had six months since the Brexit vote, we should have been in recession by now, but we are not. Things are maybe a bit delayed but the whole succession of investment announcements we have had from Nissan, Microsoft and others suggests that companies are taking a much more sanguine view of this than the Treasury and others have suggested.

“We have looked at the Nissan deal in terms of what degree of currency depreciation you would need to offset the 10 per cent tariff that motor manufacturers could face under WTO rules, and the answer to us is that it looks like a 15 per cent depreciation of sterling would offset a 10 per cent tariff. We have already had a 12 per cent depreciation so we are pretty well there. This may have been what the government was relying upon: it is the currency depreciation that bridges that gap."

Gudgin says that the EU has not been very good at agreeing free trade deals with third countries: “Theresa May has said very clearly that there will be control over migration and she rightly recognises that was the key point in the referendum. The EEA and Swiss bilateral treaties all depend on free movement of labour. It shows just how difficult even the Swiss approach is.

"The Canadian model is a free trade agreement which any country can have with the EU, but historically the EU has not been good at having free trade agreements with others. It doesn’t have a free trade agreement with China or the US, and some people such as the Economists For Brexit see the EU as being a highly protectionist organisation. If the EU has a free trade agreement with Canada, good heavens, they surely can have one with the UK.”

Gudgin explains these predictions in the podcast:

• “2017 won’t be a great year but growth of GDP will be between 1.0 and 1.5 per cent rather than the 2 per cent it would have been without Brexit. It could even be 2 per cent but we don’t yet really know much about company investment intentions. GDP growth is slowing but will not be too bad.
• "The sterling depreciation of 10 to 12 per cent will mean inflation will rise to about 3 per cent by the end of 2017. It will be higher than it has been for some years. The big question is will inflation get out of hand and we don’t think it will. Remember most countries have been trying to increase their inflation up to 2 per cent to get their exchange rates down. The UK has done it in one bound.
• "The UKMOD equations tell us wages will start to rise as prices rise. We are pretty close to full employment, so workers have bargaining power. The Bank of England published its forecast for wages recently and we agree wages will rise to something like 3 per cent by the end of 2017."

The above text was originally posted as a blog on the Judge Business School website.