Author: Alan Shipman

Does Brexit defy gravity?

Updated Thursday, 21st December 2017
Alan Shipman asks if research showing how trade declines with distance, endangers the vision of a post-Brexit UK thriving on global markets.

The pro-EU march from Hyde Park to Westminster in London on March 25, 2017

Among the economic arguments for Brexit is the claim that, even if it means the return of some tariff and non-tariff barriers to trade with the EU, these will be outweighed by the UK’s greater scope for forging free-trade deals with other, faster-growing regions. Economists for Brexit, reconstituted soon after the 2016 referendum as Economists for Free Trade, have countered recent backsliding towards a ‘soft’ Brexit by arguing that the cleanest break would be the most beneficial - boosting annual national output (GDP) by 6% in the long run and reducing living costs by 8%.

Many other economists have, however, questioned these optimistic claims because of the overwhelming concentration of the UK’s present trade on Europe. China, India and other large emerging markets will, as the Brexiteers rightly claim, be the major source of world trade growth over the next 20–50 years. But their currently small scale means these additions add comparatively little to the amount of UK trade. A rise of 0.1% in UK exports to the EU ($194 billion in 2016) would currently be worth more than a 1% rise in UK exports to China ($18 billion).

The gravity of the situation

While Brexiteers say that the present concentration of UK trade on Europe reflects ‘trade diversion’ into the EU, so that leaving will re-open lost trade opportunities elsewhere in the world, pro-Remain economists argue that the EU will inevitably remain by far our largest trading partner. So losing barrier-free access to the single market and customs union could do lasting damage.

This conclusion is largely supported by ‘gravity models’, which have emerged in the past thirty years as a particularly simple, accurate way to explain and predict global trade patterns. Gravity models assume that one country’s demand for the goods and services of another falls away as the distance between them increases. Many empirical tests have shown that one country’s exports to (and imports from) another decline approximately in proportion to the square of the distance.

This makes trade volumes fall away rapidly as destinations get further away. So the UK’s trade flows across the Atlantic would be a fraction of those across the English Channel, even if North America were as large a market as the European Single Market (ESM). Pacific flows will stay smaller still, however, large Greater China grows. Gravity models have proved highly accurate in accounting for migration as well as trade flows, and economists adopted them rapidly from the 1990s as their links to theories of trade were refined.

Campaigners from global citizens movement Avaaz demonstrate after UK general elections

A typical independent gravity-model assessment of Brexit’s future impact on UK trade is that of the respected National Institute of Economic and Social Research (NIESR), which in 2016 estimated that the impact on trade of leaving the EU while rejoining the European Economic Area (EEA) would quickly lop 2.5–4.4% off national output (GDP). Reverting to baseline World Trade Organisation (WTO) trade terms would raise the loss to 5.4-8.2%. The UK’s reliance on services for around 80% of its national output amplifies the damage, as service trade is especially vulnerable to any loss of present ESM access. Even if Brexit puts only small frictions in the way of short-distance trade, their negative impact could far outweigh any removal of barriers to trade with places further away.

Unspecific gravity

Many economists remain critical of gravity models, citing (among other problems) their long detachment from any theory of gains-from-trade, complications in broadening them from two to many countries, and the possibility that they will break down as value-added moves to telecommunicated services (transmissible anywhere in the world) from physical goods that are costly to move long distances. The EU’s slowness to liberalise service trade has been acknowledged as limiting UK membership benefits, even by those whose calculations still suggest that these exist.

Gravity models’ empirical results are also sensitive to the assumptions made when feeding trade data into them. Departing from conventional assumptions can greatly reduce the anticipated damage from leaving the EU. Early in 2017 a team at Cambridge tested the Treasury’s gravity-model estimates, which point to annual GDP being 3.4–4.3% lower after 15 years (compared to continued membership) if EEA-style terms are retained, and up to 7.5% lower (with a sharp enough initial loss to cause recession) if a no-deal exit forces a lapse onto WTO terms. Using a different macroeconomic model (which takes more account of the impact of credit expansion on GDP growth), they found the losses were much reduced even when sticking with the Treasury assumptions. Longer-term damage is even smaller if (as they argue) the Treasury over-estimated Brexit’s downward impact on business profits and consumer spending.

This dissenting study came under swift attack from other gravity modellers, who view it as having used too little data and omitted important dimensions of Brexit’s trade effect. But the widespread optimism they expressed shortly before the 2008 financial implosion counsels caution when economic forecasters cluster around a consensus.

The 58 sectoral assessments which Brexit secretary David Davis has been pressured to release represent a different, bottom-up way of analysing Brexit’s trade impact and may also tell a different (more favourable) story from the gravity models’. When the trade benefits of the ESM were first calculated in detail, the EU’s predictably large ‘costs of non-Europe’ were not fully reflected in studies of major industries, which found their larger firms already engaged in a global market and sometimes (even 25 years ago) more concerned about their access to its faster-growing regions.

Although the Treasury used to hail their accuracy before the 2016 referendum, casting doubt on the gravity model consensus is now vital for the UK’s negotiations ahead of March 2019. Success depends on convincing the European Commission (and member-states) that the UK can thrive after Brexit even if the EU gives it a raw deal. If Brussels believes this, it may be motivated to let the UK “have its cake and eat it”, with little-changed access to the single market and customs union. Anything less would needlessly deny EU producers access to a UK market made richer by its unleashed access to other parts of the world.

In contrast, if Brussels keeps faith in gravity modellers’ usual conclusion, it will know that the UK will lose heavily from any new obstacles to trade with the EU - and so will bargain much harder for ongoing contributions and unflexing conformity to single-market rules.