Brexit fait accompli

Spoiler: The Brexit-deal is finally done. A hard Brexit was fortunately avoided. The EU-UK Trade and Cooperation Agreement is perhaps the freest trade agreement concluded so far. Yet it raises barriers to trade compared to when the UK was part of the EU. The agreed zero tariffs and quotas are a fantastic achievement. But that only applies for trade in goods. Trade in services restricted. And services constitute 70% of UK GDP.

The zero tariffs and quotas do not mean that there will be frictionless trade between the EU and UK. Customs declarations and procedures will make trade between the two parties more expensive. Also rules of origin procedures will add to the costs of trade as well as the increased frictions for air and road transport. All the details and overviews can be found here.

Boris and his Brexiteers have been praising the deal emphasising its consequences for “sovereignty” and the alleged future seamless trade of manufacturing goods. As pointed out above, it will not be seamless. But that is not the main point. The main point is that there will be substantial barriers of trade for the Services industries.

The zero tariff and quota deal does not apply for the largest industries in the UK

British service suppliers will as from tomorrow no longer have free access to the Single Market. Until 2020, UK Service firms benefitted from the “passport” approach. Furthermore, there will no longer be any automatic recognition of professional qualifications for UK employees working as doctors, nurses, dentists, pharmacists, veterinarians, engineers or architects. This means that firms in UK Services industries will find it more difficult to compete on EU contracts.

And this is a big deal as Services industries make up for 70% of UK GDP, c.f. Figure 1.

Figure 1. Manufacturing and Services Industries shares in GDP 1996 and 2019 (%).

Source: Worldbank database. https://databank.worldbank.org/source/world-development-indicators#

The story does not end with effects on direct trade between EU and the UK. Many UK firms are today deeply involved in the supply chains of EU firms and vice versa as I showed here and here.

Indirect UK trade as suppliers to EU firms will suffer from Brexit

When exporting, countries and industries participate directly by using foreign intermediate goods in its exports and indirectly by supplying intermediate products for the use in production of other countries’ exports. For large countries, as the UK, these indirect (value added) exports are higher than direct (foreign value added) exports. In fact, UK had one of the largest indirect value-added exports of all EU Member States. In percent of total exports, indirect exports amounted to 29% and direct exports to 19% of total UK exports in 2014, c.f. Table 1.

Table 1. Foreign value added and UK indirect value added as shares in UK total exports 2014. (Percent).

Service industries will suffer more than manufacturing industries

Brexit will affect EU and UK trade by disrupting the supply chains. For the UK, Brexit will be most felt in knowledge-intensive service industries such as Business Services. Participating in EU supply chains generates much more value added in Service Industries than in Manufacturing, c.f. Figure 2.

Figure 2. Indirect value-added shares in UK industry exports 2014.  (Percent of total industry exports).

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

Whether one thinks Brexit is a good idea or not, one should be aware of that the decision to leave the EU will severely disrupt UK industries’ global value chains. This will be mostly felt by people working in Service industries.

The long-run effects will be lower UK living standards and increased inequality

domestic market therefore have an incentive to raise their prices and profits. This is bad for inequality. The impacts of price increases will be larger the lower income people have. Owners of capital will benefit at the expense of labour who will experience less scope for real wage increases. As the capital share of income rises, the labour share will fall and lead to increased income inequality.

In the longer run, less trade will impact on living standards through lower productivity growth. Trade is essentially a technology. Less and more expensive imports than before means that a country will produce more products itself. By doing this, resources must be taken from elsewhere. Since exports will be lower, due to decreased competitiveness on international markets, labour and capital previously devoted to produce for exports now can be used to produce for domestic consumption.

This reallocation of resources means that the economy now will produce and consume fewer products at higher costs than previously. As a consequence, the economy will grow at a lower rate and that future income levels will be lower than in a situation with larger trade.

But it could be worse as I feared when I wrote this post. I’m not sure that can serve as a comfort when all Brits enter the new year. I hope to see them come back some time not too far away in the future. And since it is New Year’s Eve my wishes extend especially not only to the brave people of Ukraine but also to all Brits.

Happy New Year!