Monday, 7 November 2016

Brexit cannot have a favourable outcome

By Tom O’Leary

There is no realistic possibility of Brexit resulting in a favourable outcome. Following Brexit, the living standards of the population will be lower. In addition, the capacity for government spending on public services will fall along with its capacity to invest. As a result, it is likely there would the continuation of current trends, where there is a government-sponsored rise in racism, hate crime and xenophobia, in order to distract from the crisis created by government policy.

Forecasting Brexit effects

Economic forecasting is an inexact science. But its findings are also often presented and understood inexactly too. Forecasts can be presented as a range of probabilities but should nearly always be conditional, as outcomes depend on a series of factors outside the main elements of the analysis. So, for example, it is certain that prices will rise much higher than they otherwise would because of the Brexit-induced slump in the value of the pound. But the precise level of consumer price inflation in 2 years’ time must be an unknown without foreknowledge of the level of global commodities’ prices, knowledge of the ability of firms to reduce profit margins, the response of consumers and so on. Yet there is still the certainty that prices will be higher, and that any tariffs will make prices much higher still. Real incomes and living standards will fall.

So it is with GDP forecasts. There are two main documents setting out the central projections for the economy if Brexit goes ahead. The first is the analysis from the UK Treasury, the second is from the grouping Economists for Brexit. Both have been subjected to critique and readers interested in those can find them here and here.

There are some surprising similarities in the analyses and some huge differences. There are also some important omissions.

Taking first a point of agreement, in discussing versions of ‘Hard Brexit’ which would involve the unilateral removal of all trade barriers by the UK, all sides are generally agreed that incomes fall significantly, although the Treasury is the least concerned with this important matter. However, in the model formulated by the principal author for Economists for Brexit Patrick Minford prices will fall much further than incomes, as the UK economy enjoys the fruits of an unfettered and largely unregulated free trade. As a result, in this scenario real incomes rise significantly. This is flatly contradicted by the UK Treasury analysis and the Brexit economists’ critics. Finally, there is widespread confusion about the role of investment in the economy, which means even the most apparently pessimistic scenarios may underestimate the negative effects.

Falling prices?

Patrick Minford did not receive as much publicity as Alan Walters in terms of his influence on the Thatcher governments. This was almost certainly a mistake as his work was crucial in formulating the ‘supply side miracle’ of Thatcher’s efforts to create unfettered markets in goods, capital and labour. Everything from banking deregulation and Big Bang through to privatisations of state -owned industries, the end of the ‘closed shop’ and now zero-hours contracts all owe something to Minford. He is an important figure in recent British economic history. 

He also bears some responsibility for the entire economic debacle of this period and now the crisis caused by the Brexit vote. This is not an ad hominem attack, but is used to show that Minford’s ideas have already been tested in the real world and they have been disastrous. He begins with the reasonable proposition that barriers to trade impose a cost to the idea that the removal of all barriers must be a benefit. This is clearly logically false. There is a cost to imposing fire safety standards on all new homes and public buildings. But there is a far greater cost if buildings frequently burn down and lives are lost.

The Minford claim that prices will be lower after Brexit rests on two spurious propositions. The first is that prices are on average 10% higher in some EU countries (or were 14 years ago when the data Minford relies on was collated!) so that these must arise from non-tariff or regulatory barriers inside the EU, which will no longer apply if his ‘Britain Alone’ model is adopted. Secondly, he argues, ignoring both geography and history, that other countries will supply those same goods or services to the UK at prices equivalent to the non-tariff EU prices. Notably in his view, all of this benefit will lead to the elimination of British manufacturing and the huge growth in inequality, even while the economy as a whole is boosted by 4% over the long run. 

This is nonsense. Minford’s analysis takes no account of the quality of products. Take housing, the single largest component of household expenditure. The UK housing stock is much more dilapidated than the EU average. Approximately half the proportion of homes in the EU are more than 70 years old compared to Britain. Price should be adjusted for quality, and Minford makes no effort to do that. Higher prices can just as easily denote higher quality goods.

But the assertion that other countries will meet the removed EU goods and services is outlandish on two grounds. The British economy is tied through a network of increasingly complex supply chains to the European economy. If those supply chains are severed, it will not be by US or Chinese firms inserting themselves. They cannot under EU rules pass themselves off as EU producers once the UK has left. Nor would they be interested in removing all the non-tariff barriers that protect their firms just to sell into the British economy, which is simply not that important on a world scale.

On this issue, the Economists for Brexit are wrong and their critics are right. Prices will rise post-Brexit. They are rising already. As all analyses accept that incomes will fall, this can only mean that living standards as whole will fall significantly.

Misunderstanding investment

The Economists for Brexit pay almost no attention to investment, despite frequent references and a chapter nominally devoted to it. Instead, it is simply asserted that investment will rise following the (spurious) forecast of vastly improved trade at lower prices. 

But the Treasury analysis, while much more serious in its examination of the effect on investment, is sorely lacking. In effect, the focus is almost exclusively on the negative impact on Foreign Direct Investment of leaving the EU. As FDI is defined as the ownership of 10% of equity or more, FDI conflates two different things, a change of ownership via overseas acquisition of equity and actual fixed capital investment.

The UK economy is in precarious position, with a record current account deficit. FDI inflows offset that, and without it living standards would immediately fall even further. This would be expressed as a further slump in the currency and rising long-term interest rates. 

This is a run-down of UK assets to finance UK consumption that exceeds UK production. It is only possible to begin to reverse that with actual fixed capital investment to raise production. 

However, Brexit itself makes this both less likely and less effective. Private sector investment becomes less likely with Brexit because investment is driven by returns, the key factors being the size and growth of the target market. Outside the EU, the UK economy is a far smaller market than a component of the Single Market. It will also experience slower growth. 

All UK investment also becomes less effective outside the EU. As Adam Smith demonstrated long ago the effectiveness of investment is determined by the size and scope of the market, including, but not confined to well-known factors such as ‘economies of scale’. As the size of the market in which the UK can operate is restricted, the efficiency of investment declines.

As a result, of the two main scenarios outlined by the Economists for Brexit makes little sense, while the UK Treasury analysis underestimates the long-term effects of leaving the EU. Things are likely to be worse than they suggest.

No ‘People’s Brexit’

It would be possible to overcome all of these negative factors if investment were to rise by a large factor. But as we have seen private sector investment will fall.

In effect, in order to offset these negative effects public sector net investment would need to both replace reduced private sector investment and increase the aggregate total to compensate for the lower efficiency of investment outside the EU. From about 1.5% of GDP, public sector net investment would have to rise to something like 20% of GDP. This is not a realistic possibility in the current economic and political circumstances in Britain.

All likely and realistic Brexit scenarios entail a significant diminution in the living standards of the population. This will include rising prices and lower real incomes, job losses especially in manufacturing and high value-added sectors as well as cuts to public services as government finances deteriorate. The Tory government over 6 years has not been able to generate popular enthusiasm for policies that have led to falling living standards. It has deliberately fostered racism, Islamophobia and xenophobia as a distraction, with some effect.

Labour cannot possibly stand on this ground. Aside from the moral bankruptcy and the economic illiteracy this would entail, it could prove fatal. The Tory party can and does subsist on promoting reaction. Labour would risk annihilation as its natural supporters, who overwhelmingly voted Remain, deserted it in droves.

The arguments used to support a ‘Lexit’ are spurious and misleading. Overseas workers cannot possibly drive down wages as on average they are more highly paid then UK workers. They are net contributors to public services, not a drain on them. They are not taking anyone’s jobs; record levels of immigrant numbers coincide with record low unemployment. 

There is no prospect of better protections for workers, greater environmental protections, better health and safety rules under any likely Brexit government. Unwilling to increase public investment to the required level, they will tolerate or even foster a race to the bottom. It is impossible to fight neoliberalism via Brexit. The UK will become an archetype of neoliberalism.

More technical arguments that, for example, EU state aid rules prevent a radical programme of nationalisation are equally spurious. Jeremy Corbyn and John McDonnell do not propose a large-scale programme of nationalisation, for very good reason. There are not the spare funds to purchase the equity of the energy, transport, building and other firms and the banks. And the political situation simply does not allow any nationalisation without compensation. It would just be posturing to suggest that court orders ruling in favour of private property rights would be overturned or physical seizures of property take place.

The limited retrieval of the rail franchises as they fall back into public hands that is planned is realistic and would not at all contravene EU state aid rules. On the contrary, after the Brexit vote the UK is now set to hand out state aid to major manufacturers simply to keep them here.

Conclusion

In the concrete circumstances of the UK economy Brexit can only lead to a fall in living standards. Prices will be higher, real incomes lower, and living standards will fall. All political forces who wish to raise living standards will have to fight against it, or overturn it if necessary. There can be no idea of embracing Brexit as a road to prosperity. That is an impossibility in the actual circumstances of British politics and the British economy.

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