Lord Frost, and whether/how lower trade makes us poorer

I am very far from being any kind of an expert in trade. My policy is to rely on comparative advantage; spend less time on it and rely on others to do the work, more efficiently.  My familiarity with the topic goes only as far as some of the obvious signposts: apart from Ricardo’s comparative advantage, a knowledge that geography matters (double the distance, half the trade, or something), some vague awareness of what Paul Krugman showed (a combination of agglomeration and economies of scale lead to a lot more international trade than you’d expect from pure CA) – and whatever I can pick up reading Trade Secrets by Alan Beattie et al, and rubbing shoulders with the experts at the FIG.

I ought to know more – as someone who has banged the drum for a closer trading relationship with Europe, and tends to agree that friction will cause productivity problems. As a lazy gotcha polemicist, I have tended to quote Nigel Lawson on the advantages of being in the Common Market – increased competition in a larger market forces business to “wake up or go under”.  I have also relied on the OBR, which has documented the fall in trade post EU and (Box 2.5) says “this reduction in trade intensity drives the 4 per cent reduction in long-run potential productivity we assume will eventually result from our departure from the EU”.

Anyway, I had parked this in the “issue settled” box, till I read Oliver Lewis’s encomium to Lord Frost on ConHome and his recommendation that we all read Frost’s speech of February this year, which he said should be “a key source for future historians of this period” – which seems reasonable. Frost is a significant figure, this is what he thought, and he sets it out quite seriously.  And, talking of Brexit studies that foresee a fall in productivity from less trade, it has this bit:

But, in brief, all these studies exaggerate – in my view – the impact of non-tariff barriers they exaggerate customs costs, in some cases by orders of magnitude. Even more importantly, they also assume that this unproven decline in trade will have implausible large effects on Britain’s productivity. Yet there is at least as much evidence that the relationship is the other way around – that it is actually productivity which drives trade. The claims that trade drives productivity are often in fact based on the very specific experience of emerging countries opening up to world markets, beginning to trade on global terms after a period of authoritarian or communist government – these are transitions that involve a huge improvement in the institutional framework and which make big productivity improvements almost inevitable. And I think the relevance of such experiences drawn from that for the UK, a high-income economy which has been extremely open for over a century, seems highly limited to me.

So I thought I would try to trace back why the OBR feels so confident asserting the opposite.  Starting with the most recent EFO, we have that quote above, which is preceded by the statement that “Since our first post-EU referendum EFO in November 2016, our forecasts have assumed that total UK imports and exports will eventually both be 15 per cent lower than had we stayed in the EU”.  But dive back to November 2016, and this is what the OBR said:

exiting the EU will reduce growth in exports and imports during the transition to a less trade-intensive economy. We have not modelled the effect of specific post-exit trading regimes, but have instead drawn on a range of external studies to calibrate a downward adjustment to exports and imports that we assume would be complete by 2025. We have assumed that exports and imports are similarly affected, so that the effect on net trade and GDP growth is broadly neutral. We have not revised trend productivity growth lower explicitly to reflect lower trade intensity (as the Treasury did in its pre-referendum analysis) given the lack of certainty around this link

My italics.  So they (correctly) foresaw lower trade, but did not back then use this as the reason to lower productivity, and see the link between trade and lower productivity as less well understood. Instead, they lower their estimates for productivity growth because of the sharp drop in business investment (see this much-noted tweet).

Eighteen months later, they addressed this question in a standalone piece – which, while mentioning many of the common sense reasons openness leads to productivity gains (less competitive pressure, less knowledge transfer) actually foreshadows some of Frost’s caveats.  Studies that link increasing trade to increasing productivity have seldom covered Brexit-like moments where trade is actually reduced, leading to this arch observation: “one of the ways in which increased openness is thought to increase productivity is through knowledge spillovers, but reducing openness by introducing trade frictions should not lead businesses to forget what they already know”.

Yet, by November 2020, discussing the risk of last year’s no deal scenario (there have been so many), the OBR writes

a ‘no deal’ Brexit could reduce real GDP by a further 2 per cent in 2021, due to various temporary disruptions to cross-border trade and the knock-on impacts. As these abate, the longer-term effects of lower trade intensity continue to build such that output is 1.5 per cent lower than our central forecast after five years, and 2 per cent lower in the long run

With a trade deal in the bag, the next (March 2021 EFO) keeps with its cut to productivity growth, but now pins it more specifically on services

the introduction of non-tariff barriers in services, which accounted for 42 per cent of the UK’s exports to the EU in 2019, is far more significant. It is this channel that accounts for much of the long-term reduction in productivity, in line with the findings of some of the studies that informed our previous assessment

I looked for the studies, and found this by the World Bank – which looks like an excellent paper, but is largely concerned with (what looks like quite correct) predictions about the fall in trade because of Brexit.  For the links between that falling trade and productivity/living standards, I had to look in ITS footnotes, and found this: “Dhingra, Swati, Gianmarco I. P. Ottaviano, Thomas Sampson and John Van Reenen. 2016. “The Consequences of Brexit for UK Trade and Living Standards” – which states the effect very baldly – “In the long run, reduced trade lowers productivity” – and lists familiar effects (reduced competition, smaller size of markets, less incentive to innovate).  It is another excellent paper.

But here I find myself at a dead end.  The Dhingra et al paper is pre-referendum, essentially, and the OBR immediately after the referendum decided not to count these dynamic effects. I am not sure why they didn’t, nor do I understand why now they do, in light of that earlier acknowledgement that the discussion is much less settled than in other areas. 

In the meantime, Lord Frost has stated the Brexiteer position quite baldly: paraphrasing, “We don’t think reduced trade with the EU does in fact hurt our productivity, and all the evidence out there in the real world is in fact about different scenarios to this”.  The second bit may well be right – no other country has ever done anything like Brexit.

So I end this with a plea. I tend to think the connection between damaged trading links with the EU and lower productivity should be pretty strong.  We have lower trade, less investment since the vote, and we have had poorer GDP outcomes. It is all very suggestive. But Lord Frost captured the blithe, Brexiteer contrary view well: this stuff is all for other economies, other situations (and fails to capture the benefits of our new, free-wheeling nature).  Does anyone have any more up-to-date and definitive study that I can look to?[1]              

[1] Since starting this, I found this paper https://www.wto.org/english/res_e/reser_e/gtdw_e/wkshop18_e/manova_e.pdf which finds that “exogenous shocks to both export demand and import competition generate large gains in aggregate productivity. Decomposing these gains, we that both trade activities increase average productivity, but export expansion also reallocates activity towards more productive, while import penetration acts in reverse” – but I am otherwise impressed by how little strong evidence there is out there.

We can also see that businesses that trade are more productive – https://www.ons.gov.uk/economy/economicoutputandproductivity/productivitymeasures/articles/uktradeingoodsandproductivitynewfindings/2018-07-06 – but selection effect?

Published by freethinkingeconomist

I'm a mid 40s, former special adviser (Downing Street 2017-19, BIS from 2010-14), former FT leader writer and Lex Columnist, former financial dealer (?) at IG, student of economic history, PPE like the rest of them, etc. This blog has large gaps for obvious reasons. The name is dumb - the CentreForum think tank blog was called Freethink, I adapted that, we are stuck now.

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Freethinking Economist

Economic advice. No longer special.

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