Will eliminating UK tariffs boost UK GDP by 4 percent? Even ‘Economists for Free Trade’ don’t believe it!

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19 April 2017

L. Alan Winters CB, Professor of Economics and Director of UKTPO.

In this blog, Professor Winters responds to Patrick Minford and Edgar Miller’s recent paper on unilateral free trade in relation to Brexit.

Economists for Free Trade’s Patrick Minford recently suggested that the UK should

simply eliminate our tariffs on them [the EU], and by implication – under WTO rules – on everyone else. By doing so, we would achieve free trade for our consumers with one quick move [and increase consumer welfare by 4%] Minford (2017).

This, he explains in a fuller exposition, is achievable ‘via Unilateral Free Trade’ – see page 8 of Minford and Miller (2017), henceforth referred to as M&M.

But this claim is misleading or worse:

• It is based on a very particular view of the world economy,
• Even in M&M’s own analysis, the benefits of 4% of welfare (or GDP) depend on far more than ‘simply eliminating tariffs’; they also require deeper integration with the EU and a race to the bottom on standards;
• M&M assume that the devaluation of sterling will have no effect on the prices of UK imports!

The Minford Model[1]

Patrick Minford’s model of the world economy divides the economy into four sectors: ‘non-traded and three traded ones, viz. primary, basic (unskilled-labour-intensive) manufacturing and services and other (skilled-labour-intensive) manufacturing.’ (M&M, p.28, although on p.20 they refer to ‘three traded goods, agriculture, manufactures and services’)  Within each sector UK production and all world trade are presumed to be indistinguishable – buying health services from, say, the USA is the same as buying education from, say, Sri Lanka. Of course, all models make approximations and assumptions (they are models, not reality), but it is important to ask whether the assumptions represent behaviour reasonably well.

In Minford’s case, this high level of aggregation is critical because he also assumes that each country purchases these aggregate goods only from the lowest cost supplier, which, in turn, results in even small changes in trade costs having huge effects on the direction of international trade. But in reality, we do not simply buy from the cheapest supplier. Products are different when made in different countries – e.g. the differences in quality between Indonesian and Italian shoes – and this is compounded when we recognise that one country’s bundle of, say, skilled-labour-intensive manufacturing is different from another’s.

Moreover, trade is affected by the distance between countries, their size, history and wealth (the ‘gravity relationship’). Trade costs are not just government-created trade barriers but include things such as time in transit, exchange rate risk, redress in case of error, etc. Product differentiation and gravity are incorporated into modern trade models, and these predict that after Brexit the UK will continue to trade more with the EU than other countries because it remains geographically close, large, rich and of a similar cultural background. Consequently, we cannot just avoid higher trade costs with the EU by increasing trade with, say, China.

Single Market rules have two purposes: first, because they apply across the whole EU, they facilitate trade between members by eliminating duplicate testing and certification and increasing competition between suppliers. Second, many of them provide reassurance about the quality of goods and services – e.g that paint on toys is lead-free, that food-stuffs are traceable back to their origin, that airlines compensate for delays. Minford’s assumption that the Single Market merely diverts trade from non-EU countries is simply contradicted by the empirical evidence.

Getting 4 percent gains requires more than unilateral liberalisation

M&M’s headline result is that UK ‘unilateral free trade’ will increase UK GDP by 4% relative to the status quo. But a careful reading of their technical Appendix B shows that there is far more to it than this – indeed, that gaining 4% requires more integration with Europe than the UK has at present!

Modelling exercises proceed by postulating a ‘base-line’ outcome for the economy and then changing policies and seeing how much the economy changes from the base. Once the model is defined, the key input is the estimate of how much policies change. In M&M UK trade restrictions are assumed to add 10% to the cost of imports. This estimate reflects the assertion that EU protection is currently equivalent to a tariff of 20% and that international pressure will reduce this to 10% within a decade! But the estimate of 20% arises by attributing all the differences in producer prices between the EU and low-cost countries to EU trade barriers, ignoring the obvious differences in safety, quality, product mix etc.[2] The elimination of the remaining 10% amounts to abolishing all such differences.

It is impossible to know exactly what causes prices to differ, but the extra costs of meeting the (often beneficial) high standards needed to sell in the EU must be part of it – for example, not using leaded paint on toys, not using hormones in beef, or fitting emission controls on cars. M&M’s ‘unilateral free trade’ implies eliminating these price differences and so explicitly includes the removal of all such standards imposed on imported goods.[3] See Note 1 to the table on p. 25 which says that under ‘unilateral free trade’ the ‘UK eliminates its non-tariff-barriers (NTBs) with all countries. But Note 1 then goes on to say that the estimate also assumes ‘Broad free trade agreements to be pursued (on investment, agriculture services, property rights, etc) with ROW [rest of the world]. EU agrees zero tariff FTA with UK without conditions; imposes no NTBs on UK (cannot anyway).’

The term ‘unilateral free trade’ is thus doubly misleading: first, it presumes agreements with reciprocal liberalisations with (all?) the UK’s trading partners, including the EU, and second, on the EU, it is just plain wrong. Unless the UK and EU sign an FTA that explicitly removes all EU non-tariff barriers to exports from the UK, WTO rules prevent the EU from eliminating barriers on the UK alone. If achieved, eliminating all tariffs and non-tariff barriers between the UK and the EU would imply deeper integration than the EU Customs Union and Single Market currently deliver, but coupled with a race to the bottom on standards!

In summary, it does matter (a lot) if the EU will not play ball. There is no rosy alternative, even in ‘Economists for Free Trade’s peculiar model.

The effect of devaluation

Having previously been criticised for predicting that unilateral liberalisation will more or less eliminate UK agriculture and manufacturing, M&M assure us now that manufacturing will be just fine: short run (five years) profits will increase by around £23 billion per year! (p.26) The saviour is the devaluation of sterling. The table on p.26 assumes that the devaluation of 15% relative to pre-referendum days will add 15% to the prices that UK manufacturers can earn in each of their home, EU and rest of the world markets. No evidence suggests that exchange rate changes pass through so completely to the export prices of manufactures – precisely because, unlike M&M’s assumption, goods are not homogeneous. Moreover, M&M make no allowance for the way in which devaluation will increase the input costs of manufacturers and, before long, their wage bills as real wages start to make up some of the losses that devaluation imposes on them.

Footnotes:

[1] This and some of the other criticisms made in this section have been made previously by Sampson et al (2016), but have been rejected by Minford.

[2] ‘if we base our estimates solely on OECD prices …. we obtain a price discrepancy at the border or factory level of around 20 per cent.’ (p.18)

[3] M&M write of maintaining UK standards (p. 19), but this is misleading to the extent that any UK standard raises the cost of producing any good or service for sale on the UK market. They all have to go in M&M’s scenario.

References:

Minford Patrick (2017) ‘Even if the EU will not play ball, our optimal strategy is still unilateral free trade’, http://brexitcentral.com/eu-not-play-ball-optimal-unilateral-free-trade/

Minford, Patrick and Edgar Miller (2017) ‘WHAT SHALL WE DO IF THE EU WILL NOT PLAY BALL? UK WTO Trade Strategy in A Non-Cooperative Continent’, https://static1.squarespace.com/static/58a0b77fe58c624794f29287/t/58e770b8e3df286cf6c93008/1491562708766/What-shall-we-do-if-the-EU-will-not-play-ball.pdf

Sampson, Thomas, Swati Dhingra, Gianmarco Ottaviano and John Van Reenen ‘Economists for Brexit: A Critique’ Brexit Briefing Paper No. 6, Centre for Economic Performance, LSE, http://cep.lse.ac.uk/pubs/download/brexit06.pdf

Disclaimer:
The opinions expressed in this blog are those of the author alone and do not necessarily represent the opinions of the University of Sussex or UK Trade Policy Observatory. 

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