Both sides of Britain’s EU debate claim the mantle of free-traders. Pro-Europeans emphasise the potential loss of access to the single market if Britain quits the EU. Outers point to the EU’s declining share of world trade, and the opportunities that might arise from signing free trade agreements with countries outside Europe, without having to find consensus with 27 other states. A central question in the campaign has become: ‘Would Brexit boost or depress Britain’s international trade?’
One way to answer the question is to imagine that Britain has no trade agreements with other countries, including the EU. Which countries should be the first port of call for its trade negotiators? Three principles would guide its choice: gravity, comparative advantage, and the ‘dynamic’ gains from trade. Together, they suggest that, if it were developing a trade strategy from scratch, Britain would be straight on the phone to Brussels.
In the 1960s, Dutch economist Jan Tinbergen discovered that there was a close analogy between Newtonian physics and trade flows. He was inspired by Isaac Newton’s law of universal gravitation: that the gravitational force between two objects is proportional to their mass and the distance between them. Tinbergen’s insight was that trade flows between two big economies were larger than between two small ones. But trade was larger between neighbouring countries than those that were distant from one another. This is intuitive – it costs less to ship goods between neighbouring countries, and the value of trade between big economies will always be higher than between small ones, simply because large economies suck in more imports.
In its 2014 report on the economics of Brexit the Centre for European Reform put together a gravity model, and found that this principle held with Britain’s trade with the rest of the EU. For every percentage point increase in a country’s distance from Britain, Britain’s trade with that country fell by 0.6 per cent. And for every percentage point increase in a country’s GDP, Britain’s trade with that country grew by 2.5 per cent. Consider Table 1. If the EU buys just under half of British total exports, but its economy comprises just 18 per cent of world GDP, why does Britain trade so much with it? The answer lies in the proximity of EU member-states – on average, they are only 1,200 kilometres away from Britain. Meanwhile, the OECD members that are not in the EU – the US, Japan, Australia and so forth – are far more distant, on average, which explains why Britain exports far less to them than to the EU. Of course, other factors explain why Britain exports less to the ‘BRICS’ emerging economies (Brazil, Russia, India, China and South Africa), despite the fact that they make up more of the world economy than the rest of the OECD. Mainly, it is because their GDP per capita is lower – poorer countries are less likely to buy Britain’s expensive, high value-added exports than richer ones.
Principle 2: Comparative advantage
Over the last four decades, the principle of comparative advantage has driven the global division of labour. After he came to power in 1978, Deng Xiaoping’s reforms allowed China to use its comparative advantage in low-value added manufacturing. Other developing economies followed. This process enriched Britain’s consumers: electronic goods, toys, clothes and steel became much cheaper in real terms. And over time, labour and capital were redeployed to more productive sectors of the British economy, raising incomes further. Together, these two effects made Britain richer.
However, trade with poorer countries is not without cost. It makes Chinese and British people richer on average, but the scars of deindustrialisation are still visible in Britain’s unbalanced economy, with higher unemployment rates and lower productivity continuing to blight the UK’s northern cities. As manufacturing and industrial work dried up, many poorer people moved into low-paid services work. Productivity growth in low value-added services sectors has been slower than in manufacturing. These trends have contributed to the ‘hollowing out’ of the British labour market, with more low- and high-paid jobs being created than those which provide middling earnings.
The benefits of such trade are skewed toward the rich, and the costs are locally and socially concentrated. The economic scars from plant closures – the industrial churn that is the process by which trade raises productivity – can be felt for decades. That does not mean that an independent Britain should eschew a trade agreement with China – but it does suggest that agreements with richer countries should be its priority.
Principle 3: ‘Dynamic’ gains from trade
After the 2008 crash, Britain’s productivity plunged and then stagnated. It had been catching up with US levels over the preceding decades, but after six years of weak growth, the UK’s output per worker is now a quarter lower than the US. Thus Britain’s trade strategy should make productivity growth its ultimate aim.
Higher trade and investment with developed economies are more likely to raise productivity than with poorer ones. This is because of a fact that is often lost on politicians and the public alike – that the biggest gains from trade come not from exports but from imports. Imports boost competition in the domestic economy, which raises the incentive for domestic firms to make productivity-enhancing investments.
Indeed, more imports and inward investment, especially from rich countries, can raise the rate of economic growth, and this process is known as the dynamic gains from trade. Two economists, Nauro Campos and Fabrizio Coricelli, recently pointed out that UK trade with the EU is largely ‘intra-industry’ – that is, competition between companies in the same industry. This is the opposite of comparative advantage, by which countries specialise in different sectors. Imports from more productive EU firms encourages their British competitors to raise productivity and spend more on research and development in order to keep a foothold in the market. The constant pressure of competition from more productive overseas companies raises productivity growth – not just productivity levels. For its part, trade driven by comparative advantage reduces the cost of imports and encourages labour and capital to shift to more productive sectors of the economy. But this effect is one-off – once a British steel mill has been closed and its workers and capital have been redeployed, that’s it: there has been a one-time boost to Britain’s total income.
Outside the EU, Britain could unilaterally and fully open its markets to the US, Japan, Australia and the EU in order to take advantage of those dynamic gains. But without unimpeded access to the EU market, foreign direct investment (FDI) would be lower. Such investment is a major source of dynamic gains, and is to a degree dependent on EU membership. The UK has been the largest recipient of FDI in the EU because it offers a bridgehead to European markets. And, since the UK cannot control what tariff and other barriers the rest of the EU would impose on the country after withdrawal, foreign investment would be at risk: Nissan, whose Sunderland factory now produces more cars per year than Italy, has plants elsewhere in the EU, and higher trade costs would prompt it to expand production inside the single market.
These rules of trade economics give our imaginary trade negotiators a clear order of priorities. First, seek to open markets with more productive, rich countries. Second, seek to open markets with countries that are nearby. Measures to boost exports with distant emerging economies come third. Were it not already a member of the EU’s single market, Britain might seek to join it, especially if the EU’s putative free trade agreements with the US and Japan come to fruition. Sadly, if Britain wanted single market membership without joining the euro or Schengen, the EU would probably force it to join the European Economic Area, like Norway or Iceland, and not become a full member of the club. Then it would have next-to-no say over the single market’s rules. The underlying principles of trade point to an obvious answer to the referendum question: Britain should remain in the EU.
John Springford is a senior research fellow at the Centre for European Reform.