21 August 2017

Why only a hard Brexit will do

By Kent Matthews

All students of economics will be familiar with what is commonly known as the Economic Problem: what to produce, how to produce, and who gets what?

What to produce is dictated by consumer’s desires, their income constraints and the prices they pay. How to produce is determined by the costs of production and the utilisation of resources (land, labour, and capital). Most economists accept that in theory, even as a benchmark, the best way to solve these first two parts of the Economic Problem is by allowing markets to be free, with minimal intervention by the state, and the role of government relegated to the protection of property rights and the provision of a legal framework that enforces contracts.

Of course, the real world is not like that, and the part that has the least agreement is the third one – the share-out. The free market will ensure that the share-out will be depend on the rewards to labour, the returns for risk-taking, and the rents to property owners. This is typically unacceptable in a liberal-democratic society that provides help to the poor and disadvantaged.

Which brings me to the issue of Brexit and how it fits in with the Economic Problem.

Right now, within the EU the UK consumer pays a higher price for food than world prices because of the Common External Tariff (CET) on agricultural products from outside the EU. What to produce is distorted by tariffs that not only raise food prices above world prices they also reduce real incomes to households which in turn distorts the demands for all other goods in the economy.

Subsidies to agriculture and protection of manufacturing distort the how to produce part. Agriculture employs cheap unskilled immigrant labour to extend the margin of cultivation beyond what is economically sustainable because of EU subsidies. Protection of manufacturing results in under-investment in higher productive activities through the dilution of competition. Regulation raises costs to industry and distorts the utilisation and allocation of resources.

In addition to the direct redistributive policies of taxes, benefits and the welfare state that is part of the UK body politic, the EU provides transfers to agriculture, development, research and other areas that may or may not be considered worthy by us as a political society.

How will Brexit alter the Economic Problem? The removal of protective tariffs on agriculture will reduce prices to consumers, raise real incomes – adding an estimated average of £40 a week in real terms to households, and increase demand for other types of goods, resulting in a boost to the economy by an estimated £135 billion a year.

This is the figure calculated by Economists for Free Trade, a group of 16 leading economists – including myself – calling for the UK’s Brexit pessimists to ditch Project Fear for Project Prosperity by seizing this Brexit boost unlocked by leaving the EU’s protectionist bloc. However, this can only can be seized by a ‘Hard’, clean Brexit – giving the UK the ability to open up and embrace the world of free trade as well as ensuring our economy is ready to welcome the positive effects of full competition.

What to produce will be affected by an increase in demand for existing goods and demand for new products that did not exist before. How to produce will be affected by the removal of distortionary subsidies to agriculture which will reduce the need for seasonal immigrant workers. Also the removal of protective tariffs on manufacturing will force industry to increase investment in productive techniques and move up the value chain.

The removal of excessive regulations would result in increased production of existing goods and the production of goods that currently don’t exist to meet the increased demand from the what to produce part. The result is a rise in living standards and an improvement in overall welfare estimated to be 6 per cent of GDP.

Think about the redistributive implications of this policy. In other words who gains and who loses? Farmers, recipients of research funds, and local development agencies will lose direct funding from EU agencies. Firms dependent on protection will lose by facing stiffer competition. However, consumers will gain from lower prices and an increase in real income, but even here there are further redistributive implications.

Think about who gains the most. A fall in the prices of foodstuffs will improve the real incomes of low income families the most. The well-off may hardly notice (although they may buy more Australian and New Zealand wine than French and Italian in the future). So Brexit has a direct effect on reducing poverty and inequality.

But what about the Welsh hill farmers and the hard-pressed universities dependent on EU transfers? First, the UK is a net contributor to the EU coffers and indeed is the second largest. Even allowing for redirected transfers to agriculture and research, the UK is still a strong contributor. Second, the well-known principle in welfare economics that if the gainers can compensate the losers, then there is a net welfare gain, will certainly hold.  The UK contribution to the EU can be used to compensate the universities (already guaranteed by the Treasury) and Famers can be compensated to maintain the countryside rather than distort production.

So what’s the catch? The catch is that this all works only if we are able to remove the tariffs we face, which means quitting the single market and the customs union and negotiating our own Free Trade Agreements (FTAs) – in other words a Hard Brexit. A Soft Brexit or an EEA option is the worst of all worlds as it maintains protection, maintains freedom of migration, and maintains the stifling regulation that chokes innovation and enterprise.

Firms dependent on protection and EU regulation will gain from a soft Brexit; but consumers lose and in net terms the economy as whole loses because productive potential does not improve and we remain in a low-productivity, low-wage state.

This problem will be exacerbated if the UK sticks with its current high tax, high spend and high regulation economy. Brexit, and the freedom it accords, gives the UK a valuable opportunity to rebalance our economy for the better. Economists for Free Trade warns the Chancellor, Philip Hammond that he would be unwise to rule out the UK’s ability to adapt our tax and regulatory regime to suit our new position as a champion of global free trade.

So will Hard Brexit mean the destruction of UK manufacturing and agriculture? Of course not! Manufacturing will survive by investing in technology that moves them up the value chain. Households will buy food products at the supermarket sourced from the global market at low prices or they can go to their local Farmer’s Markets and buy expensive local organic produce. In the words of Milton and Rose Friedman they will be “free to choose”.

Kent Matthews is a Professor of banking and finance at Cardiff University and a member of Economists for Free Trade