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Why the economic consensus on Brexit is flawed

Ashoka Mody in The Independent

Consensus amongst economists quickly unravels. In April 1999, “Britain’s top academic economists” voted strongly in favour of switching from the pound to the euro. Mercifully, the government had better sense.

In August 2008, Olivier Blanchard, then a professor at Massachusetts Institute of Technology, reported that economists shared a common vision of macroeconomics “because”, he said, “facts do not go away.” But in 2014, reflecting on the failures of macroeconomics, Blanchard conceded that economists were “fooled” because they were not looking at the right facts.

In the past few weeks, virtually all official agencies have insisted that leaving the European Union — a British exit or “Brexit” — will impose enormous costs on the British. Indeed, these agencies have competed with each other in escalating the cost estimates.

Christine Lagarde, Managing Director of the International Monetary Fund (IMF), pithily summarised the consensus: the consequences of Brexit, she said, would be “pretty bad to very, very bad”.

The UK Treasury, the Organisation for Economic Cooperation and Development (OECD) and the IMF say it is a “fact” that Britain will be permanently poorer because it will trade less with the EU. In a terrifying warning, the Bank of England added that financial markets will panic and create senseless havoc.

Adding comic relief, George Osborne predicts that house prices will fall by 18 percent. Not to be outdone, G7 leaders say that the world economic system, as we now know it, will fall apart if Britain exits the EU.

Michael Mussa, my first boss at the IMF, used to say that a number must pass the “smell test” if it is to be used for making decisions. Conducting a “smell test” requires going back to core principles. When we do that, we reach a humbler conclusion: economics is neutral on whether to leave or remain. The battle for Brexit must be fought on other grounds.

All economists – not just the current protagonists – agree that a country gains by increasing its overall international trade. Greater trade makes it possible to produce more of and export what the country does best (its comparative advantage) and import what it does less well. Everyone gains.

But there is no gain in exporting to Germany, Spain and Poland rather than to the United States, Korea and China. In fact, if preferential access diverts trade away from the United States to Germany, then departure from the country’s comparative advantage hurts rather than helps, as Columbia University’s trade theorist Jagdish Bhagwati has long argued.

So the claim that Brexit will impose a huge cost rests on the twin beliefs that British trade with Germany will go down sharply and trade with the United States will not increase. Is that reasonable?

First, British trade with Germany will not decline significantly. As economists have long known, trade is embedded in business and social networks into which partners invest enormous social capital. Studies repeatedly show that businesses make accommodations in profit margins to retain the benefits of trust and reliability.

For this reason, all productive trading relationships will remain intact. For this reason too, German Finance Minister Wolfgang Schaeuble’s threat that renegotiation of Britain’s trade arrangements with the EU would be “most difficult” and “poisonous” is bluster. Germans run a trade surplus with Britain. Mr Schaeuble can humiliate the IMF, but he dare not hurt the interests of his exporters (or his importers).

And even if British trade with the EU falls, trade with other regions will undoubtedly increase. Because Europe has been growing at a slower pace than the rest of the world, trade has been shifting away from Europe for years.

With Europe rapidly aging and struggling to revive productivity growth, the shift to non-European markets is bound to continue. Most firms already sell to multiple markets and Brexit will prompt them to strengthen their non-European networks.

What about costs of transition? Britain exports 13 percent of its GDP to the EU. Say about a quarter of those export products – about 3 percent of GDP – have to eventually be sold either in Britain or outside Europe.

If the adjustment each year costs somewhere between one-tenth and one-fifth of 3 percent of GDP, it is possible that GDP will be lower by about half-a-percent in the peak transition year. Thus the costs will be modest and short-lived.

So how do the Treasury, OECD and the IMF conclude that Brexit could reduce GDP by between 6 and 10 percent forever? The vast bulk of those large estimates come from the further assumption that reduced trade will shrink British productivity growth. This is disingenuous. There is simply no evidence that less trade lowers productivity growth – and there is not even a logical connection between productivity growth and a shift in trade from Germany to the United States.

More trade has been associated with higher productivity growth when countries have emerged from economic isolation. But for the sophisticated British economy, this possibility should be completely dismissed.

The Bank of England’s claims are the most outrageous of all. The Bank says that fear of Brexit is holding investment back and, thus, causing growth to slow down in anticipation. How can it know that? British GDP is slowing for so many reasons.

The economy has moved faithfully with the magnitude of fiscal austerity: gratuitous austerity delayed recovery from the Great Recession, brief fiscal easing in 2014 helped achieve a short-lived rebound, and now the IMF projects more austerity in the pipeline and slower growth. Meanwhile, the world economy is slowing: the United States had a weak first quarter, China is struggling and world trade is barely crawling forward. The Bank of England is cynically exploiting its authority by claiming to detect Brexit-induced anxiety in the cloud of short-term data.

But more outrageous is the Bank’s warning of mayhem if Britain votes to leave. Nobel Laureates George Akerlof and Robert Shiller have explained that people act in accordance with the narratives they live. The Bank is, in effect, building a narrative of panic, which could become self-fulfilling. The central bank’s proper role is to reassure and stand-by to stem panic.

Since 2010, official agencies have repeatedly promised global recovery. The forecasts fail because they all disregard inconvenient evidence. Now, the official consensus on the economic costs of Brexit has crossed the line into groupthink. A numerical illusion is masquerading as a “fact.” And when those in authority distort facts, they also subvert the cause of democracy.

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