The free market case for hard Brexit doesn't add up

Ryan Bourne is a great guy, but I think he’s wrong about ‘hard Brexit’ being desirable, as opposed to the ‘open Brexit’ alternative. By ‘open Brexit’ (aka ‘soft Brexit’) I mean leaving the customs union but staying in the Single Market or getting a trade deal that is very similar in practice. His recent City AM piece makes strong claims about this without, I think, sufficient evidence to back them up.

First off, he contrasts a European Commission report, which concluded that the Internal Market has added 2.1% to the GDPs of EU member states, with a pre-referendum Treasury report, which suggested that we would suffer permanent losses of up to 6 percent of GDP if we were to leave the Single Market and Customs Union.

Ryan suggests that there is a contradiction here, but these estimates are looking at different things: the Commission’s study only looks at the gains from the post-1992 integrations that took place (the Single Market proper), not the gains from pre-1992 economic liberalisations the then-European Economic Community brought on. 

So it doesn’t make much sense to compare this with the scenario the Treasury modelled of the UK leaving the Single Market altogether, which obviously includes all the GDP-boosting reforms that took place before 1992 as well. So Ryan isn’t comparing like with like here – and that explains why the Treasury study seems much worse than the European Commission study. If they’d been looking at the same question, it’s quite possible that they’d have agreed entirely.

So Ryan’s point doesn’t add up, but maybe the Treasury’s model is wrong for other reasons. I’m sceptical of economic models at the best of times. But the ‘gravity’ model of trade, so-named because it assumes that countries’ size and proximity is an important predictor of how much trade can profitably take place between them, is a very robust one. It makes predictions that are very reliable – indeed John van Reenen, who is a very good and pro-markets economist, has described it as "the most reliable empirical relationship in international economics". As empiricists we should be careful about dismissing it.

This approach also compares favourably to Patrick Minford’s models of the GDP gains from unilateral free trade, because Minford makes several very unrealistic assumptions. These include the premise that distance does not affect ease of trading (so it’s literally just as easy for British firms or consumers to buy goods from Mongolia as it is to buy them from Ireland or France) and that the quality of items is the same in every country in the world. 

Let me give an example: socks may cost £3/pair in the UK, and 30p/pair in Mongolia. Minford’s approach assumes that the only reason we don’t all buy and wear 30p/pair Mongolian socks is tariffs, and that by abolishing tariffs we could all save £2.70 per pair of socks. This is probably not true, because (a) those 30p socks might be made out of polyester rather than cotton and hence actually be inferior as a product to the socks we wear here, and (b) the cost of transporting socks from Mongolia to Britain is probably higher than zero. I am sympathetic to the idea of unilateral free trade, but people like Ryan and Minford have an over-optimistic idea about how much better off it can make us.

With this in mind, the budget payments to the EU, while annoying, are probably not the biggest issue on the table. If those budget payments net out to 0.5% of GDP but our GDP shrinks by between 2% (let alone 6%) by leaving the Single Market, we’re not exactly better off keeping them. Shrugging off 2.1% of GDP (the low-range estimate Ryan cites) is not sensible, to my mind – since it’s a permanent loss it means that over time, it’s like shrugging off a year’s worth of income.

I’m surprised also to see Ryan, and so many other free marketeers, say things like “The depreciation of the pound already vastly outweighs any adverse tariff effect on exporters to the EU”. I suspect Adam Smith and Milton Friedman would have been too: both realised that exports are things you give up to get imports, and depreciation in a currency’s value really just means you’re getting less for what you’re giving up than you used to. 

This might still be good for exporters, but it effectively means that importers (that is, consumers) are losing out to help them. It is puzzling to see this argument in a free market case for a hard Brexit.

When Ryan refers to the opportunities open to the City from leaving, there's just no plausible market of a meaningful size anywhere in the world that we can gain share of if we lose regulatory access to EU27. Ryan’s point about not listening too much to established firms is well taken, but we have to weigh against that the fact that most people not involved in finance don’t know all that much about passporting, equivalence and so on. We shouldn’t simply ignore the people that do because they might be looking to keep rivals out, and I suspect if they were saying things in favour of a hard Brexit Ryan would be less sceptical about their motives.

Ryan doesn’t make the point here, but he has elsewhere, that there are lots of successful countries that are outside the Single Market like Japan and Canada, so why not Britain? Well, yes. But to get there would mean liquidating a lot of what we’re good at and, over time, the UK economy developing entirely different comparative advantages. Think of it like someone who has to re-skill after their old skilled job ceases to exist. It’s do-able, but the transition can be painful and costly. And there's no guarantee we'll be as rich as we were before. (By the way, maybe Canada would be richer if it was in the Single Market – they're certainly keen to get an extensive trade deal with the EU passed.)

Finally, I am somewhat annoyed by free marketeers describing the Single Market as a ‘single regulatory zone’ or similar. Yes, it involved harmonising some regulations. But mostly it relies on mutual recognition of other countries’ rules, and that harmonisation is overall a restraint on interventionist national governments. It also, obviously, makes trade substantially easier across borders. Governments like to protect domestic firms with regulations, not just tariffs, and the Single Market goes some way to preventing that. Just because it involves regulation does not make it automatically anti-market: if the alternative is more domestic regulation, and I think generally it is, the Single Market is the liberal option.

I strongly dislike many of the regulations that the EU passes. I don't like rules that stop kettles from boiling 'too fast'. But I think it's noteworthy that people criticising the Single Market focus on these annoying but relatively trivial regulations, because in terms of the big regulations that actually matter I don't think it does too badly. Outside the Single Market, even if we do scrap stupid laws about straight bananas and kettle heating times, I fear that we'll get much worse laws that cap energy prices and part-nationalise industries – many of which would be illegal in the Single Market.

My own view is that Brexit can and quite possibly will be a success but it depends on us being smart about it. I think many Brexiteers object most of all to symbolic aspects of the EU – the flags, the passports, the irritating and stupid lightbulb and kettle regulations – and we will probably end up with something that in practice is ‘soft Brexit’ but looks like and is sold by the government as ‘hard Brexit’, and ditches most of those symbols that they really hate. It may, in effect, be the EEA Option. That would get us out, and do it without turning Brexit into something that makes us poorer.