Brexit

The UK's vote to leave the European Union in 2016 triggered economic reactions that will define the country's future for years to come. Why does leaving the EU have such a profound impact – and how do economists estimate it?

Shelf stacking seems simple - goods are put on shelves and shoppers choose what they want. But ensuring this process continues smoothly at all times is complicated. And Brexit shone a spotlight on some of those complexities.

Ensuring the UK's shelves are stocked with thousands of products from around the world, requires understanding the international co-operation that keeps those goods flowing.

To start with, there are a lot of goods. How much is "a lot"? Typically, the Port of Dover (one of 51 major ports in the UK), handles 10,000 freight vehicles - equivalent to a queue stretching from Dover to Luton - every day.

As a member of the EU, potential barriers to keeping those trucks rolling through the UK were lowered. Now Brexit has happened, understanding how the changing relationship between the UK and the EU, the UK's largest trading partner, could affect trade is the job of economists.

It is trade economists who study what enables the rise of global trade and the effects of trade on workers, firms and communities.

...even whale-watching holidays on the Pembrokeshire coast are counted in the trade statistics.

And trade isn't just about the 100,000 cargo ships docking in UK ports each year, bringing liquefied gas from Qatar, medicines from the US, vegetables from Europe and toys from China. As well as exporting oil, cars, machinery and clothes, the UK makes money from providing services to other countries' citizens. It sells financial, accounting, architectural and engineering expertise - even whale-watching holidays on the Pembrokeshire coast are counted in the trade statistics.

The Centre for Economic Performance (CEP) has long considered the implications for the UK of leaving the EU, which accounts for about 43 per cent of UK exports and 52 per cent of UK imports.

That work falls into two camps: assessing the likelihood of different long-term economic outcomes - work that began before Brexit gained political traction; and the post-referendum analysis of real-world data.

The pull of gravity models

Predicting the effect of policy changes is not an exact science, and economists are continually updating the way they model how changes - such as Brexit - will affect trade and, by extension, economic activity and our quality of life. And they are getting better at doing it.

Before the 1980s, the economic models used in trade theory accounted for different products, but mostly ignored how the distance between countries affected the trade between them.

But this did not match reality – countries tend to trade more with closer, economically-large neighbours, and less with those countries that are smaller and further away. Models that took these factors into account were proposed in the 1960s, but it wasn't until the 1980s that these gravity models became a cornerstone of trade analysis, particularly in the 1990s in the run-up to the introduction of Europe's single market and the North American Free Trade Agreement .

CEP researchers were front and centre of the work that developed the theory behind gravity models, and this work helped international economics to better explain the empirical facts about trade patterns across the world.

In the 1990s, Anthony Venables - director of CEP's globalisation programme from 1992 to 2005 - considered how trade between countries affected economic activity within countries and thus their economic development. His work with Stephen Redding - who succeeded him as director of CEP's globalisation programme - highlighted that most of the variation in average income per person between less-developed countries could be explained by two factors: how close the country was to the countries it wanted to access, and how close the country was to the supply of items needed to make the goods it hoped to sell. This "market access" would become one of the main issues at stake for post-Brexit UK.

Venables's work with economics Nobel laureate Paul Krugman explained how falling transport costs since the Industrial Revolution initially benefited the UK and Europe, but later boosted the economic performance of Asia. The formation of trading blocs such as the EU countered this competition and facilitated trade between member states, but made it more difficult for countries that weren't members of this exclusive club to access its markets.

The consequences of competition

Venables and Krugman also explained how international trade could generate imbalances in economic activity not only between countries but also between regions within countries. This geographical divergence between "winners" and "losers" from trade was a prescient warning of the crucial issues that would inflame the Brexit debate years later.

In 2012 - four years before the EU referendum - researchers at the CEP built a theoretical model of multi-product firms that highlighted how tougher competition in export markets induces firms to drop their worst-performing products and skew sales towards their best-performing products. This can have striking effects on firm productivity and employment as resources are reallocated across production plants. Firms with the worst performing product lines in their industries may shut down altogether – hard for them – but such a loss means that overall the productivity of that particular industry will improve.

Fast forward to the years leading up to the 2016 referendum, and all this early research came to fruition as the UK began to consider the implications of departure from the EU. CEP researchers were at the forefront of understanding how Brexit would affect the UK economy.

What is the price of Brexit?

In March 2016 - three months before the referendum - the CEP published research on the possible consequences of Brexit for UK trade and living standards. Researchers Swati Dhingra, Gianmarco Ottaviano, Thomas Sampson and John Van Reenen calculated that even if the UK maintained full access to the EU single market, the average financial hit to households in the country would be about £850 – and a no-deal Brexit would raise this to £1,700.

And these costs would be magnified as time went on. As CEP's earlier research demonstrated while trading in larger, more competitive markets pushes firms to become more innovative and productive – the reverse is also true: reduced trade lowers productivity.

"Factoring in these effects substantially increases the costs of Brexit to a loss of 6.3% to 9.5% of GDP (about £4,200 to £6,400 per household)," the authors estimated.

Scenarios by the CEP continued to be published, debated and used to inform Brexit policy throughout the negotiations up to and after the UK exited the EU in January 2020.

Where will the economic shock be felt?

Between the referendum result, and exit in January 2020, two UK general elections were held as politicians struggled to define and deliver Brexit (see timeline). But Brexit was not the only pledge made. Boris Johnson's 2019 government wanted to "level up" the UK - by improving the economic performance of areas across the country.

More than two years prior to the 2019 election, the CEP considered the potential implications of Brexit on UK regional inequalities in its study The Local Economic Effects of Brexit. The researchers found that under both "soft" and "hard" Brexits, all local authority areas lose from leaving the UK.

The City of London was in for a particularly sharp shock, the analysis predicted, owing to its concentration in service sectors. But the authors point out that while London and the south east, were hit hardest in the global financial crisis of 2007-09, they bounced back more strongly than other areas – suggesting that while the immediate negative impacts may be smaller in poorer areas, households in those areas may struggle more to adjust to those negative shocks.

The full impact of Brexit may not be known for years

The full implications of Brexit for the economy will not be known for years - but after 23 June 2016, as well as modelling possibilities, economists could start analysing real outcomes.

The data came in fast. The morning after the vote, for example, the value of the pound fell to its lowest level in more than 30 years - the single biggest drop in the daily exchange rate for any of the four major currencies since the 1970s.

In a December 2019 report, the CEP studied how the depreciation of sterling following the referendum affected UK consumer prices. While many people might not pay much attention when the pound struggles, most will notice when the price of their supermarket shop increases.

Using input-output linkages to account for the variety of ways in which different products are exposed to import costs, CEP economists demonstrated a clearer link between trade-sensitive goods and prices. CEP research suggested that depreciation of the pound after the Brexit vote increased prices by 2.9%, so costing the average household an additional £870 per year.

"In aggregate, this corresponds to £23.5 billion per year additional expenditure for the UK, or £450 million per week," the research found.

Surely, though the relative weakness of the pound would give UK companies a competitive advantage when selling their goods abroad? The figures suggested this was not happening.

Analysis published in May 2019 showed that because UK exporters relied on international supply chains, a weaker pound had increased the cost of materials and negated any advantages in selling abroad. Businesses absorbed some of the increased costs of imports by lowering both worker wages and investment in training. The report earned co-author Dhingra, an Office for National Statistics Research Excellence Award.

Separate analysis by the CEP showed that the UK had slipped from having the highest growth rate in the G7 group of countries before the 2016 vote to the lowest by March 2018.

"The impact of the Brexit vote can now begin to be evaluated with greater accuracy than previous forecasts, thanks to the emergence of new data," the authors concluded. "The negative signs of economic health are confirmed by the outcomes in productivity stagnation. Output per worker has continued to be stagnant since the referendum. Worryingly, the gap between output per worker in OECD countries and the UK has widened since the referendum."

Five big questions

In the years leading up to the Brexit vote, there was a general consensus among economists that leaving the EU would damage the UK economy.

And yet, the people voted to leave. A compelling economic argument failed to convince a majority of voters that remaining in the EU was preferable to leaving it. Were non-economic considerations more important to voters, or were the experts just not believed? The Leave campaign frequently accused remain advocates of "Project Fear" - claiming that grim economic forecasts about the economic impacts of Brexit were overstated.

But, as economists shifted from pre-referendum forecasting to post-referendum analysis, the harsh realities of the UK's departure from the EU were already being observed. The economic arguments may not have convinced everyone, but it would be unfair to label them misleading.

As Brexit progresses, more questions arise. Economists are now asking: Will firms stop trading abroad? Will UK firms move to the EU? How will different regions and workers be affected? How much difference will new non-tariff trade barriers make? And how will all this interact with the economic devastation created by the Covid-19 pandemic?

For trade economists, as for the UK as a whole, Brexit is not over. Instead understanding how the effects are rippling through the economy, and how to ensure those shelves are stocked, will keep researchers busier than ever.

Expert contributors: Swati Dhingra, Gianmarco Ottaviano, Thomas Sampson

With thanks to: Chris Parr