A hard Brexit’s a-gonna fall

Spoiler. Everyone in the EU lose due to Brexit but UK residents lose more. The short-term reduction of British GDP is around three times as large as of EU GDP. As time goes by employment rates are restored but due to less trade and lower productivity growth, GDP and welfare will be lower than without Brexit. Most of the burdens of tariffs and NTBs fall on consumers. As time goes by, we and especially UK residents will be poorer than if the UK had remained in the EU. 

So it seems that it will be a hard Brexit. Or maybe not. Even though Theresa May’s deal was rejected by the Parliament for the third time last Friday, the Fat Lady has not sung yet. According to the media, the Parliament has “taken control”. Which seems to mean that "the Nos have it". Or maybe the Reluctant Brexiteer aka Theresa May sort some thing out with the Reluctant Remainer aka Jeremy Corbyn.

As I showed in previous posts here and here , EU is a more important supplier for UK firms than UK firms are for EU firms. That means that UK firms’ supply chains will be more affected that EU firms’ supply chains. In those posts I did not indicate for UK or EU the importance of different sectors for total exports. Nor did I put any numbers on the effects of Brexit. But luckily there are others who have. There are plenty of studies that have analysed the effects in the short run, before markets have adapted to the new situations, and in the long run. One exampel each of such studies are discussed below.[1]

UK industries are more dependent on EU as suppliers than vice versa…

Enough introduction! The two graphs below repeat some of the information from previous posts and show industry exports’ shares in total exports for EU and UK. The largest export industry in the UK is Wholesale trade (excluding trade in motor vehicles and motor bicycles) . Exports by Motor Vehicles, Chemicals, Basic Metals and other manufacturing industries constitute a large share of UK exports and in particular embody high shares of EU value added. The average EU value added share in UK exports of manufacturing goods amount to some 12%. In gross terms, EU intermediate goods in UK manufacturing amount to some 20%, c.f. Figure 1.[2]

Figure 1 UK industry shares in total UK exports (left axis) and EU value added shares in UK industry gross exports (right axis) 2014.

Source. The World Input-Output Database, www.wiod.org.

Turning to UK as a supplier of intermediate products for EU firms, the highest value added share captured by UK firms is found in “Advertising and Market research” services industries. The average UK value added share in the EU27 industries’ exports amounts to some three percent of total value added exports.

Figure 2 EU industry shares in total EU exports (left axis) and UK value added shares in EU industry gross exports (right axis) 2014

Source. The World Input-Output Database, www.wiod.org.

Looking within the EU27 average reveals that the largest UK value added shares are found in Ireland, Luxembourg and Malta. Relative high shares are also found for manufacturing industries in Belgium, Germany, The Netherlands.

Since UK industries are more dependent on EU industries than the other way around, it seems reasonable to guess that a Brexit with tariffs and NTBs will hurt UK industries more than EU industries. But as mentioned above, everyone loses.

…..which means that effects on production and employment from Brexit will be larger in the UK than in the EU….

Vandenbussche, Connell and Simons ([VCS] 2017) confirm that we are all losers “thanx” to Brexit. VCS analyse the effects of tariffs and NTBs on production and employment in the EU and UK. They show the effects in two scenarios. The first is a “soft" Brexit where the UK continues to be part of the Single Market but faces increased Non-Tariff Barriers (NTBs).  The second is a “hard" Brexit scenario where Most-Favored-Nation (MFN) tariffs between the EU-27 and the UK are put in place in addition to the NTBs.

The results show that UK is hit relatively harder than the rest of the EU-27 whether it is a hard or a soft Brexit:

“In either case, Brexit reduces economic activity in the UK around three times more than in the EU-27. The UK will experience a drop in value added production as a percentage of GDP of 1.21% under a soft Brexit and up to 4.47% under a hard Brexit scenario.”

The authors also find that UK job losses would be relatively larger than for the EU27 (except for Ireland) in both scenarios. A “hard” Brexit would cost 526,830 jobs in the UK, four times as many as in the case of a “soft” Brexit. In EU27, a “hard” Brexit would cost 1,209,470 jobs, four times as many as for a “soft” Brexit. The effects in the case of a hard Brexit in terms of percent in total employment and in GDP for each EU Member State are shown below in Figure 3.

Figure 3 Percentage reductions in employment and value added as percentages in total employment and in GDP in the case of a hard Brexit.

Source. Vandenbussche et. al. (2017b).

Cappariello et. al. (2019) confirm that that the impact of tariffs for producers in the UK is much higher than for producers in the EU. According to their analyses, would total (domestic and foreign) manufacturing input costs increase on average by around 0.9 percentage points compared to an increase by 0.1 percentage points in the EU, c.f. Table 1.

Source: Cappariello, R. et. al. (2019). “EU UK global value chain trade and the indirect costs of Brexit”. https://voxeu.org/article/eu-uk-global-value-chain-trade-and-indirect-costs-brexit

The difference in impacts is due to the interrelations in supply chains between the EU and UK. UK firms are much more dependent on EU suppliers than the other way around. The UK sectors most highly involved in the EU-UK supply chains, such as motor vehicles and chemicals, would experience the largest effect. The authors also confirm the large impacts for Ireland which are visible in Figure 3 above.

…..and over time living standards will be lower...

The results above are based on the technology, allocation of capital and labour across industries and consumer patterns that prevailed in 2014. But that will all change as relative prices change. On the other hand, as I wrote here employment rates are relatively stable over time. This means that employment will be restored after a while as the economies adapt to the new situation.

As time goes by consumers and producers will adapt to the new relative prices. But as trade will be lower than if Brexit had not occurred, living standards (real inccomes) will be lower. Real incomes will be lower than without a Brexit because wages will be lower and prices higher will be higher outside the EU. And also the distribution of income will change.

For the UK, tariffs and NTBs will change relative prices between domestic and imported products. As imported products become relatively more expensive, demand for domesticially produced goods will increase at the expense of imports. UK firms which face lower competition from the EU will be able to increase their production and employ more labour and capital which will be diverted from the export oriented sector that now faces lower demand due to its higher relative prices.

This will make the allocation of resources across the sectors of economy will less efficient than without a Brexit causing average labour productivity and average real wages to decrease. The domestic firms that now face less competition from abroad will be able to charge higher prices for their products.  Domestic firms can charge higher prices because their market shares have increased and also their profits increse. Lower wages and increased profits mean that the labour's share of income has decreased leading to increased income inequality.[4]

….due to lower trade and weaker competition which reduces innovation, R&D and investments.

What are the effects in the long run? The empirical and theoretical economic literature give some hints of the dynamic effects of lower trade and competition.[3] As mentioned above, lower trade means weaker competition as foreign firms are forced out. Weaker competition means that firms find it easier to remain on the markets. The incentives to innovate will be lower and expenditures on R&D will fall with additional dampening effects on productivity and GDP. The implications are that investments and the future capital stock will also be lower.

Lower trade also means lower inflows of FDI since the two are correlated. Lots of studies have confirmed the positive effects on the host economies from inflows of FDI. In short, some of these amount to diffusion of foreign technology to the domestic firms, a higher capital stock per employee, higher real wages and labour share of the economy. These benefits will be lower following Brexit.

Quite a few studies have been undertaken to simulate scenarios including a hard Brexit. Dhingra et. al. (2017) find that dynamic effects of Brexit on productivity implies a decline in average income per capita of between 6.3% and 9.4%. And as I mentioned here, The Bank of England’s analyses indicate that a hard Brexit could lead to UK GDP being around 10% lower in 2023.

The exact numbers may differ but whatever study one consults, the conclusions are the same. Brexit will make Britain poorer.

Read more.

There are plenty of studies about the effects of Brexit and even more on the effects of tariffs and NTBs. The list below only contains a few on the subject.

Amiti, M. et. al. (2019). “The Impact of the 2018 Trade War on U.S. Prices and Welfare”. Center for Economic Policy Research. Discussion Paper DP13564. https://cepr.org/content/free-dp-download-04-march-2019-impact-2018-trade-war-us-prices-and-welfare

Bank of England. (2018). “EU withdrawal scenarios and monetary and fiscal stability. A response to the House of Commons Treasury Committee.”  https://www.bankofengland.co.uk/report/2018/eu-withdrawal-scenarios-and-monetary-and-financial-stability

Cappariello, R. et. al. (2019). “EU UK global value chain trade and the indirect costs of Brexit”. https://voxeu.org/article/eu-uk-global-value-chain-trade-and-indirect-costs-brexit

Dhingra, S. et. al. (2017). “The Costs and Benefits of Leaving the EU: Trade Effects”. Economic Policy, Vol 32, Issue 92.

OECD (2016). "The Economic Consequences of Brexit: A Taxing Decision". OECD Economic Policy Paper April 2016. No. 16. http://www.oecd.org/economy/The-Economic-consequences-of-Brexit-27-april-2016.pdf

Vandenbussche, H., Connell, W. & Simons, W. (2017a). “Global value chains, trade shocks and jobs: An application to Brexit” https://voxeu.org/article/global-value-chains-and-brexit

Vandenbussche, H., Connell, W. & Simons, W. (2017b). “Global value chains, trade shocks and jobs: An application to Brexit”. Discussion Paper Series, DPS17.13.

[1] You can find much better definitions of the short vs the long run somewhere else.

[2] See also, Cappariello et. al. (2019).

[3] The profit share, the labour income share and the capital income share together make up GDP. It is not unreasonable to imagine that also the capital income share would increase thus decreasing the labour income share further.

[4] I should probably be more careful when I write about "short run", "long run" and "dynamic" effects but I'm too lazy and you can probably look it up somewhere else.