Raffaele Giammetti – The Effects of Brexit and Alternative Scenarios

Many estimates of the effects of Brexit overlook one fundamental element: the integration of our economies into global value chains. That will be negative for other European countries. For Britain, there is a possible way out.

Raffaele Giammetti is a post-doctoral researcher at the Università Politecnica delle Marche, Ancona

Originally posted in Italian at economiaepolitica

Translated and edited by BRAVE NEW EUROPE

The decision taken almost three years ago, and not yet metabolised by the British establishment, seemed immediately irrational and dangerous. According to the dominant vision in the economic debate, belonging to a single market with free movement of goods, people and capital is an essential opportunity to achieve stable economic well-being (Campos et al., 2018; UK Treasury, 2016). Therefore, the vote in favour of Brexit appeared to be a completely unjustified and unpredictable event (Jennings and Fisher, 2016). Yet there had been some premonitory signals. Actually, well before the surprising outcome of the referendum, several scholars had wondered about the effective capacity of the European project to trigger mechanisms of convergence between the economies of the member countries (Bayoumi and Eichengreen, 1992; Buiter et al., 1993; Graziani, 2002; Brancaccio, 2008; AA.VV., 2013). In particular, in explaining the European crisis, many economists have underlined the impressive and incessant widening of trade imbalances between EU member countries in the years following the establishment of the single market and especially following the introduction of the single currency (Arestis and Sawyer 2011; Bellofiore and Halevi 2011; Brancaccio, 2012; Cesaratto and Stirati 2011; Parguez 2011; Pianta, 2014; Realfonzo and Viscione, 2014). In fact, most of this literature concerns the euro zone and perhaps this is why, with a few exceptions, the post-Brexit debate has found little space in the question of the trade imbalances that the United Kingdom has continuously accumulated in recent decades towards Europe. Yet, as Realfonzo and Viscione point out, the monetary sovereignty and flexible exchange rate enjoyed across the Channel have not been enough for the United Kingdom to shelter itself from a dynamic of structural features that have contributed to the deindustrialisation and financialisation of the British productive and commercial system (Coutts and Rowthorn, 2013). As shown in Figures 1 and 2, over the last few decades the United Kingdom has accumulated a growing trade deficit with European countries, especially in manufacturing, which has only been partially offset by a surplus in services, especially financial services, to non-European countries.   Already at the beginning of the millennium, Thirlwall (2001) warned of the pervasiveness of this process which, if not curbed could offer fertile ground for the generating feelings of resentment towards countries and institutions across the Channel. Today, these observations find empirical comfort in the studies that, in the aftermath of the referendum, have been struggling to find an explanation for the pro-Brexit vote. According to the results obtained by one of the main research groups dealing with the causes and consequences of Brexit, the adverse trade relations with Europe have contributed to spreading a feeling of intolerance towards the single market and the European institutions (Los et al. 2017), and of rejection of globalisation (Colantone and Stanig, 2018; Rodrik, 2018).

Figure 1. UK net exports from 2000 to 2014 (million dollars). Source: Giammetti (2019).

In particular, looking at the territorial distribution of the results of the referendum we find that the votes to leave Europe came mainly from the regions led by the manufacturing sector and characterized by high economic interdependence with European markets (Los et al. 2017; Becker et al. 2017); vice versa, the votes to stay in Europe came mainly from the regions that most benefited from globalisation and that depend less on European markets (Springford et al. 2016).

Figure 2: Sectoral balances of the United Kingdom between 2000 and 2014 (million dollars).

Key: A- Agriculture and Fishing, B- Mining, C- Manufacturing, D-E- Electricity, Gas and Water Supply, F- Construction, G- Wholesale Trade, H- Transportation, I- Accommodation and Food Services, J- ICT Services, K- Finance and Insurance Services, L-Real Estate activities, M- Scientific Activities, N- Administrative Services, O-U- Public and Other Services. Fonte: Giammetti (2019).

From these results, and from the analysis of the UK trade balance, two different interpretations of the possible consequences of Brexit have arisen. On the one hand, the most widespread literature has emphasised the UK’s high trade exposure to European goods to support its dependence on the single market. Therefore, although with different estimates, the common result of these studies is that Brexit will have a negative economic impact that will weigh almost entirely on the United Kingdom (UK Treasury, 2016; OECD, 2016; Dhingra et al., 2017). On the other hand, some economists have instead judged Brexit as a possible route to rebalancing the current account (Bickerton et al., 2018; Skidelsky, 2016). According to this interpretation, the restoration of trade barriers and the control of goods, together with a massive plan of industrial investments, could prove useful to defend and relaunch British manufacturing and reverse the process of deindustrialisation. In such a scenario, the economic effects of Brexit for the UK would be almost insignificant in the short term, and even positive in the long term.

On closer inspection, the opposing conclusions reached by the two currents of thought are driven by the fact that both result from a partial and incomplete reading of trade. To date, in fact, empirical and theoretical analyses of the economic consequences of Brexit do not take into account the degree of integration and fragmentation of production processes and indirect trade that takes place through ‘third’ countries. For example, the main studies that have emerged so far, when they estimate the loss that Europe could suffer as a result of lower demand in the United Kingdom for German cars, do not consider the source of the inputs needed to produce a car in Germany, and therefore do not consider the indirect impact that Brexit could have on the Italian metal industry, the French glass sector and so on. This is crucial as the UK is involved in long and complex global value chains (Gallegati et al., 2019) and trades mainly intermediate products with Europe and the rest of the world (Giammetti, 2019). Therefore, a complete estimate of the direct and indirect economic effects of Brexit cannot ignore the study of input and output relations between the United Kingdom and European countries.

By introducing the global value chains and indirect effects of Brexit into an inter-country and multi-sector model, estimates are obtained that differ from the results of the prevailing literature. Figure 3 shows the results of a forthcoming article (Giammetti, 2019) which shows that the trade barriers that could arise as a result of the UK’s exit from the single market would be risky and costly not only for the UK but also for many EU countries. In a soft Brexit scenario where, as in Norway, trade with European countries would be restricted by non-tariff barriers alone, the UK would face a loss in value added (LiVA) of around $36 billion, or 1.35 per cent of GDP. On the other side of the Channel, however, things do not seem so different. Ireland, Belgium, the Netherlands and Germany, countries that are highly interconnected in their production and commercial processes with the United Kingdom, would risk losing between 0.5% and 0.6% of their GDP. Europe as a whole would suffer an even greater loss in absolute terms than the United Kingdom. In a hard Brexit scenario, i.e. in the absence of an agreement with Europe that would lead to the establishment of customs and tariff barriers, the losses would be greater for both macro regions.

The estimate of losses that the UK would face in the two scenarios is fully in line with the main literature. However, the addition of global value chains and indirect trade to the model leads to very different conclusions regarding the possible losses that Europe would have to face – losses, which would be far higher than we have seen to date. In any case, in the scenarios just considered, as well as in all the empirical studies on the economic consequences of Brexit, it is assumed that the United Kingdom’s exit from the single market catches the Government and businesses totally unprepared. To use a word dear to the jargon of the economy, we could say that in this model Brexit has all the characteristics of an idiosyncratic shock in which the establishment of trade barriers would discourage trade between the United Kingdom and Europe, producing a general decline in production and direct and indirect trade.

Figure 3. Brexit as an idiosyncratic shock. Value-Added Losses (LiVA) in soft and hard scenarios

Note: Blue bars indicate absolute losses while red circles correspond to percentage losses. Source: Giammetti (2019).

However, if we assume that the UK’s exit from Europe is accompanied by planned action to replace imports of intermediate and final goods with domestic inputs and goods and to divert part of the trade to third countries, the results would be very different. As shown in Figure 4, the planned implementation of protectionist trade policies would have the effect of reversing the prevailing consensus on the attribution of post-Brexit losses between the UK and Europe. Germany, Ireland, France and Europe as a whole would face the higher cost of Brexit in both scenarios. The UK, on the other hand, would suffer a negligible loss in the case of Brexit software and could even benefit from a Brexit hardcore scenario.

Figure 4. The effects of planning: import substitution and trade diversion. Value-Added Losses (LiVA) in the Brexit soft and hard scenarios.

Note: Blue bars indicate absolute losses while red circles correspond to percentage losses. Source: Giammetti (2019).

To summarize, from the results emerging from the two models above we can derive two main indications. First, the results suggest that, given the high integration of production processes between the UK and Europe, any type of Brexit will impact not only on the UK but also on several European economies. Secondly, the analyses carried out tell us that this impact can be limited by a number of counter-measures: by entering into a trade agreement between the UK and Europe (soft Brexit); or by planning a mix of industrial and commercial policies to support their respective domestic markets. However, the uncertainty surrounding the future post-Brexit options leaves the door open to the worst possible scenario: a no-deal on UK-Europe relations accompanied by the dangerous lack of a plan to support domestic economies.

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