Costs and benefits for the UK to leave the European Union
Using the Gravity Model of Trade
By
Ben Ratanaprukse 160964677
Poomi Phanutaiwat 160955837
Priteesh Joshi 160684144
John Philip Goller Buhl 160870149
Simon Christian Roth 160248843
The Gravity Model of Trade is an empirically proven method to predict the amount of trade flows between countries. We use the simplified version of the model to evaluate the economic impact of the United Kingdom’s exit from the European Union. Costs arise because of the introduction of impediments to trade and other factors. We show that benefits, like the elimination of contributions to the EU budget do not outweigh the costs of an exit from the European Union. Brexit will, in any case, involve a loss of total welfare for the British economy and have a negative impact on trade flows both in the short and long run.
Word Count: 1651
I. Introduction
On 23rd of June 2016, the United Kingdom of Great Britain and Northern Ireland held a national referendum on whether to retain membership of the European Union. The result of the referendum, which had a remarkably high voter turnout, saw a majority of people (51.9%) voting to leave the EU (Statista, 2016a). As a consequence, the British government is set to appeal Article 50 of the Treaty on European Union to start the process of withdrawal in the near future (Official Journal of the European Union, 2012). In this paper we will discuss the costs and benefits for the UK to leave the European Union using the Gravity Model of Trade.
The conditions linked to an exit from the EU and the future relations between the UK and the EU are still unclear at this point of time. Therefore, in terms of a trade policy perspective, there are numerous possible scenarios. As it is unrealistic that there will be a full isolation of the UK, we are looking at two main scenarios: a “Soft Brexit” where Britain retains access to the EU single market in similarity to Norway and Switzerland, or a “Hard Brexit” in which case the UK loses access to the EU single market and all trade agreements with the EU. This means that existing tariff-barriers would be increased and that new ones would be introduced. For the purpose of this essay we will mainly be focusing on the last and likely scenario of a “Hard Brexit”. We also assume that, after Brexit, the EU will continue to exist and does not change in terms of economic policy.
II. The Gravity Model of Trade
The Gravity Model of Trade describes the result of two factors between two entities and is based on Newton’s law of universal gravitation. The idea is that geographical patterns in economic activities such as trade flow can be predicted by only two variables: size and distance. In its basic form the equation for trade flow between two countries (i and j) is as following:
(1)
Where T is the value of trade flow between country i and j, Y is the economic size in terms of GDP of each country i and j, D is the distance between the two countries and A is a constant. An increase in size of either country results in an increase in trade flow, while an increase in distance between the two countries results in a decrease of trade flow (Krugman, Obstfeld and Melitz, 2012, p.13).
Despite its simple nature, the Gravity Model of Trade “correctly reproduces the backbone of real world economics” in various studies (Skowron et al., 2015). However, certain anomalies arise. Möhlman et al. emphasize that the distance factor needs to include other dimensions than just geographical distance between the two countries: cultural and institutional distances, transport costs, tariffs, trade barriers, search costs or the reliability of the trading partner. Using the model, free trade is the decisive factor for growth in trade flow and increase in welfare due to the use of comparative advantages in either country (Eaton, Kortum, 2002).
III. Costs and Benefits
Not only are the UK’s trade costs with the EU lower, but they have declined at a 65% faster rate (1996-2010) than with non-EU trading partners with which UK conducts most trade (Springford et al., 2016). This has boosted the amount of trade with EU members and reflects the advantages of being inside the EU single market. The UK’s trade is heavily focused on the EU, where 44% of total exports go to EU countries and 55% of total imports are from these countries (Office for National Statistics, 2015). Additionaly, the UK’s strongest trading partners are located within the EU. Among others, they include Germany (10.1% of trade), France (5.9%) and the Netherlands (5.8%) (Office for National Statistics, 2015).
A “Hard Brexit” therefore imposes trade barriers to some of the most important trading partners. Applied to the gravity model, it would not only result in the introduction of impediments to trade to its geographically closest countries, but also to historically long lasting trading partners with similarities in culture and political systems. In other words, this means increasing the political distance between the UK and all EU countries.
The EU has newly concluded agreements with countries and other trading blocks and is expecting positive effects on trade, growth and employment from these agreements. Trade agreements are an essential part of EU foreign policy (Brenton, Manchin, 2003). Thus, Brexit not only leads to costs from losing out on the EU single market, but also to bargaining and opportunity costs.
Furthermore, leaving the single market means that the British government has to re-negotiate all trade agreements with non-EU countries. Some of which might be willing to inherit the previous trade agreements, but not all of them. As the relative GDP falls, UK will have less power to negotiate those trade agreements. This time consuming task will leave UK exporters with a lot of uncertainty.
Looking at the cost side, we have to include some of the main factors that have to be taken into account when looking at the size of the British economy after an exit from the EU. Multinational corporations, especially the banking and finance industry have their headquarters in Britain. For them, losing access to the EU single market involves an increase in costs and a decrease in revenue from EU customers. Considering that those companies would move to a country within the single market (e.g. Ireland), the British government could react and provide incentives like a low corporate tax to keep them in their current location. However, leaving all else constant, with a loss of GDP through trade restrictions with EU countries and the loss of access to the single market, the UK will lose attractiveness to Foreign Direct Investment and international corporations, whether there are tax incentives or not. The effect of a country inside the EU single market has a positive average impact on FDI by 28%. (Dhingra, Ottaviano, Sampson, Van Reenen, 2016).
Moreover, the result of the referendum itself introduced uncertainty about the future relations with EU countries, which has an impact on the decisions of those corporations. This uncertainty and loss of confidence can, among other indicators, be seen by the fall of the Great Britain Pound currency of over 15% relative to the US-Dollar (Plakandaras, Gupta and Wohar, 2016).
Whether there will be “Soft” or a “Hard Exit”, there will be a cost in terms of a loss in GDP. When taking into account the investment and innovation behaviour as mentioned above, Dinghra et al. 2016 have found that these costs will amount to a loss of GDP between 1.37% and 2.92% directly after Brexit. These numbers were calculated by using a standard quantitative general equilibrium trade model with multiple sectors, illustrated in Graph 1.
Graph 1: Impact of Brexit on GDP in different regions
This calculation does not take into account the effects of reduced productivity because of less foreign competition, the creation of more vertical product supply chains or a decreasing variety of goods and services for consumers (Dhingra et al., 2016). Therefore, these numbers are likely to be even higher in reality. In regard to this decrease in size (GDP), the simple application of the Gravity Model results in decreased trade flows overall with both the EU and other non-EU countries as illustrated in Graph 2.
Graph 2: Change in UK trade Flow after Brexit
Note: Short run horizon is 1 year after Brexit, Long run is 10 years after Brexit.
In contrast, losing membership of the EU can imply some benefits. After all, the UK is a net contributor to the EU budget and generally gives more than it receives in rebate. The contribution of 7 billion GBP in 2010 has increased to 13 billion GBP in 2015 and Euro sceptics have emphasized this number heavily before the referendum (Begg, 2016). In case of a hard Brexit, this fiscal benefit could result in an increase of GDP of up to 0.31% (Dinghra et al., 2016). This increase in GDP would likely be lower in the case of a soft Brexit: members of the EFTA still do contribute in order to maintain access to the single market.
EU regulations prohibit member countries to reach trade agreements with non-EU countries (EUR-LEX, 2016). The very fact of having to renegotiate trade agreements with non-EU countries can also be seen as an opportunity. Considering the difficulties of the EU to find consensus about free trade agreements with non-EU countries (e.g. CETA), which lie in its bureaucratic and diverse nature, Britain does not have to account for other nation’s interests and can act more independently. This independence only comes with a smaller bargaining power (Dhingra, Sampson, 2016). Nevertheless, it can be seen as a possibility to arrange trade agreements with emerging economies outside of the EU.
IV. Conclusion
The aim of this essay was to discuss the costs and benefits of the UK’s exit from the European Union. We have focused on the scenario of a “Hard Exit” where the UK will be more independent, but lose its access to the EU single market. We have shown that a “Hard Brexit” results in a cost in terms of a loss in GDP of 2.92% due to higher tariffs, non-tariff trade barriers and exclusion from future EU integration. Discounting what we have found as the fiscal benefits of 0.31% of GDP, the total welfare loss of a “Hard Brexit” is still going to be 2.61% of GDP. Applied to the gravity model this relates to a decrease of the size factor and increase in distance, resulting in a total decrease in UK total trade flow after Brexit. As illustrated, British exports and imports are likely to decrease by 12% in the short run and by up to 15% in the long run.
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