Will Brexit really shrink the UK economy by 4 per cent?

“Now it’s official. The Government’s own fiscal watchdog has confirmed that Brexit will shrink the UK economy by 4pc, costing the average household thousands of pounds.”

This is how many are interpreting the latest analysis by the independent Office for Budget Responsibility (OBR), which was published alongside the October Budget.

This analysis seems to be like catnip for many Remainers, who still cite it at every opportunity.

In short, the OBR has assumed that the UK’s departure from the EU will reduce UK productivity, and therefore GDP per capita, by 4pc over the longer term. Most commentators have just taken this number as fact, and few have bothered to dig into the details. Allow me to have a go.

To begin with, the 4pc figure is hardly new. It has been the OBR’s “working assumption” ever since the EU referendum in 2016.

Nor is much of it original work. The OBR’s Brexit analysis has always relied heavily on estimates by external organisations. This is entirely understandable. The OBR is competent, dedicated and its independence is invaluable. But it still only has a small staff, and international trade is not part of its core expertise.

The OBR’s Fiscal risks report, published in July 2019, provides a good example of how this works in practice. This report included a fiscal “stress test” of the impact of a “no-deal Brexit”. However, the economic scenario on which this was based was simply lifted from an earlier study by the International Monetary Fund.

The 4pc figure itself depends on two separate hypotheses.

The first is that total UK imports and exports (not just trade with the EU) will eventually be 15pc lower than if we had stayed in the EU. The second, which is at least as important, is that the resulting reduction in “trade intensity” will reduce long-term productivity by 4pc. Both of these statements are debatable.

To be clear, anything which makes trade more difficult and costly will reduce the amount of trade that is done. This is just basic economics – and common sense.

Nonetheless, the 15pc figure for the long-term impact of Brexit on the UK’s total trade is still just an assumption. In particular, it is based on relatively high estimates both for the costs of new trade barriers, and of the sensitivity of trade volumes to these additional costs.

The OBR (and others) have looked at the performance of UK trade so far this year and concluded that this evidence is at least consistent with the earlier assumptions. But it is far too soon to draw any firm conclusions about the longer term.

Businesses are still adjusting to the new trade rules, and persistent uncertainty about important aspects of their implementation is continuing to hold back investment and trade. However, this uncertainty should ease further over time.

Covid is also still distorting the patterns of trade, particularly in sectors such as energy and transport which are particularly important to the UK. This helps to explain why UK exports to the EU and UK exports to the rest of the world have under-performed to a similar degree (which would not be the case if this was all due to Brexit).

Brexit itself has distorted how the data are collected.

And, of course, there is no hard evidence yet on the benefits of trade deals with the rest of the world that have yet to be done. The OBR has just assumed that these benefits will be minimal.

Some economists have tried to identify the impact of the departure from the EU by using a ‘synthetic control’ method. This relies on a computer algorithm to select a weighted combination of economies whose performance best matched that of the UK before Brexit.

The actual performance of the UK economy since Brexit is then compared to this control group, or ‘doppelganger’, and the difference taken as a proxy for the impact of leaving the EU.

This approach is fine as far as it goes, but that is not very far. There are a number of problems with all these studies, including the sensitivity of the results to the choice of countries in the control group and the weights assigned to them. Successive iterations of each model have often required some large changes in order to ensure a ‘good fit’.

What’s more, even if the 15pc figure for the hit to trade turns out to be correct, there is still a big leap between this and a 4pc fall in GDP. To get this number you have to make a strong assumption about the link between trade openness and productivity.

Again, basic economics would suggest that a reduction in trade is bad for economic growth.

But the hard evidence for the magnitude of this effect is still pretty thin, especially for economies like the UK that are already relatively open and developed.

Even the historical studies typically relied on by Brexit pessimists show results that are imprecise and only marginally significant in statistical terms. Others have found no link at all, or that productivity appears to drive trade, rather than the other way around.

Indeed, productivity is notoriously hard to explain or predict – as the OBR itself has repeatedly found. While it is plausible that a reduction in trade intensity alone could reduce productivity, Brexit might have positive effects on productivity too. For example, better management of immigration could help to shake the UK out of a low pay and low productivity trap.

The upshot is that we still only have assumptions about the long-term economic impacts of Brexit, not hard facts. There is at least some evidence on the impact of Brexit on trade, but none at all on the impact on productivity, which is just as important for the 4pc figure for the hit to GDP. The OBR’s latest analysis is, therefore, not the “final proof” that many would have us believe.

This article was first published in the Sunday Telegraph on 21st November 2021

2 thoughts on “Will Brexit really shrink the UK economy by 4 per cent?

  1. It seems to me that your big argument is you don’t agree with the OBR’s assumptions and it’s ‘too early’ to tell how bad Brexit is going to be on GDP figures. It’s clearly going very badly, but the real question is how badly until HMG changes course and re-enters the Single Market.

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    1. Yes, this is a piece about how I don’t agree with the OBR’s assumptions. But I also don’t agree that Brexit is ‘clearly going very badly’. Ps. re-entering the SM would be incompatible with the Brexit aims of regaining control of borders and laws, so IMHO it would require another referendum to overturn the one in 2016. I wouldn’t bank on that happening!

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