Friction burns

Three reports on Brexit came out last week. Two of them were risible. The one by Economists for Free Trade (the re-branded Economists for Brexit), advocating what trade expert Samuel Lowe called “unilateral tariff disarmament“, has been well and truly ripped to pieces, even by Leave supporters.

In a similar vein, a report by the Institute of Economic Affairs  assured us that we will still be able to trade tariff-free with the EU after Brexit, even without a free trade agreement. This, as Samuel Lowe said, is simply wrong;

Once the UK leaves the EU, the EU is obliged by WTO rules to apply the same tariffs as it does to any other country without a free trade agreement. It can’t do anything else. Even I, merely an enthusiastic amateur, understand this.

Neither report is worth dwelling on but, sadly, that’s just what a lot of the media did. As a result, a  report with proper evidence, by people who know what they are talking about, was blown out of the headlines. In case you missed it, which you might have done with all the fuss about the other reports, the Institute for Government’s Frictionless Trade? explains why all the UK’s post-Brexit options will make trade more difficult than it is now and why, even so, some options are better than others.

Essentially, there are three reasons why EU countries operate customs checks on imported goods:

  1. To impose tariffs and quotas;
  2. To confirm the imports’ country of origin;
  3. To ensure compliance with EU regulations.

A free trade agreement (FTA) would get us over 1 but not 2 and 3. Therefore, even with a FTA with the European Union, goods coming from the UK would still be stopped at EU customs posts.

The EU needs to check on the origin of goods to stop people using countries with FTAs as a back door to the EU. Let’s say the UK negotiates a FTA with the EU and one with the USA but there is still no FTA between the EU and USA. Without customs controls for UK goods, it would be easy to export goods from the USA to the UK and from there to the EU without paying tariffs.

A customs union would get us over point 2. By levying a common external tariff, the EU could be sure that any goods imported into the UK have already paid tariffs, so there is no need to check for their origin.

But that still leaves point 3. The EU has strict rules (those famous EU regulations) especially on the import of food. Without inspections to confirm compliance, again assuming the above scenario, what would stop US companies exporting GM foods, hormone injected beef and chlorine washed chicken into the EU, via the UK?

To satisfy point 3, the UK would have to shadow EU regulations, effectively remaining part of the single market, with all the obligations that entails, such as free movement and payments to the EU. Once we do that, there is really no point in leaving the EU at all.

There is a 2.5 option, a customs union with a series of Mutual Recognition Agreements on standards, which could significantly reduce the amount of border checks but it would not eliminate them completely. This is what Michael Barnier meant when he said that there could not be frictionless trade once the UK had left the EU. Much of the discussion about the UK’s post Brexit relationship with the EU has focused on free trade agreements and tariffs but that is, at best, one third of the picture.

Whatever option we end up with, there will be significant disruption to supply chains. As the Institute for Government report says, the UK is not an island factory. It has been in the single market for 24 years and the EU for 44. This has enabled companies to specialise and so many have become part of European-wide supply chains. As a result, many of the UK’s exports are dependent on imports.

It is increasingly the case that, to export, the UK imports. In 2011, almost a quarter of the value of UK exports came from imports (up from 18% in 1995; see Figure 3). In those sectors where the UK is more closely integrated into a global value chain, the figure is significantly higher; 44% of the value of UK car exports comes from imported products.

Of the UK car industry’s car industry’s £64 billion output, £12 billion is spent importing goods from the EU. A third of its exports to the EU are in the form of parts to go into other EU made vehicles.

So although we might talk about making cars in Sunderland, for example, it is just one part of an international factory floor. Parts enter and leave multiple times on their journey towards coming together as a finished vehicle.

In most UK manufacturing sectors, trade is deeply integrated with the EU. Brexit therefore brings considerable risks:

This integration – and the economic activity arising from it – is what is at stake when we describe the risk of introducing costs into UK–EU supply chains.

The UK’s integration into global supply chains ows in two directions:

  • downstream integration – parts or inputs imported by the UK from other countries to be used for further production
  • upstream integration – parts or inputs exported by the UK to other countries to be used for further production.

In some sectors, this level of integration is extremely high, some two-thirds to three-quarters of their supply chain.

Any disruption to this value chain will increase costs. Many companies now operate on a just-in-time basis and don’t have much slack to allow for delays. Companies within the EU can mitigate this risk by sourcing more of their parts from other EU countries, where there is very little chance of a truck being stopped. They have plenty of other countries to choose from. UK companies, on the other hand will have to swallow the increased costs at the same time as losing markets in the EU.

As the IFG points out:

[E]ven minimal increases in the cost of moving individual parts back and forth across the EU–UK border could accumulate into significant overall increases in the cost of finished products. A study by Oxera in June 2016 found that around 8% of the cost of importing goods by sea arose from customs clearance.

Nissan and Jaguar, two of the UK’s largest car makers, hold only two hours’ of stock of some items at their sites, in order to minimise inventories and save on costs. Even the threat of delays would mean the companies would have to invest in holding more inventory or localising suppliers. UK suppliers of parts face the risk of missing out on ‘just-in-time’ contracts if they cannot guarantee delivery on time.

And finding markets elsewhere won’t make up for the loss.

There have been suggestions that any decrease in trade with the EU as a result of Brexit could be offset by an increase in UK trade with other partners. There are many problems with this approach, not least that the sheer size of the EU market for UK exports means that a small percentage decrease in EU trade has to be offset by very large percentage increases in trade elsewhere.

But that pivoting strategy will be even more di cult for UK exports of intermediate products. A nished car can be sold to an Australian or to a German. But a car part can only be sold to countries that have car factories – which Australia doesn’t. As we have seen, cross-border supply chains often mean that countries specialise in particular parts of industries and the industry of another country may not be adapted or may have no need for specialised UK products.

You can’t sell parts to people who don’t make stuff.

A free trade agreement, even one like the EU has negotiated with Canada, would remove the need for customs checks because the EU would want to confirm rules of origin and regulatory compliance. The report gives an example from the chemical industry.

Steve Elliott, Chief Executive of the Chemical Industries Association, has stated that ‘the cost of providing the technical proof that a chemical or any other manufactured product originates from the EU or the UK, bearing in mind that in our case there could be several stages of synthesis involved … would clearly outweigh the benefit of duty-free sales.

And the result of this:

A range of estimates collected in the Trade and Investment Balance of Competence Review shows that ‘British firms would be exposed to a combination of administrative and compliance costs linked to rules of origin, ranging (based on existing estimates) from 4 percent to perhaps 15 percent of the cost of goods sold.

Enough to make customers in the EU look elsewhere.

As Frances says, there is something very nineteenth century about a focus on tariffs and free trade agreements. The UK economy in 2017 doesn’t work like that any more. It is no longer the workshop of the world. It is a section within a vast production line that stretches across Europe. Disrupting that will do severe damage to all its parts but it will be easier for the rest of the EU to repair its parts than it will be for us to repair ours. The more obstacles we put in the way of trade, the worse it will be. Whatever happens, this is going to cost us dearly.

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23 Responses to Friction burns

  1. Dipper says:

    My standard response: “Yes – and so?”. This kind of analysis from Remainers never asks the obvious “what next?” question.

    My view was at referendum time, and remains, that if we cannot leave the EU without lots of harm to our economy, then we are in effect captives of the EU. In the long term that leaves the UK in a deteriorating political position with the UK government unable to perform the primary roles of a national government which are to protect the people and promote their interests.

    So I invite you to draw the logical conclusions of your partial analysis.

    • Brendan says:

      I can’t end my relationship with my girlfriend without lots of harm to my happiness; that doesn’t leave me a captive of her!

    • Charlie says:

      This doesn’t make us ‘captives’ of the EU, it demonstrated that this country would be screwed without it. Looks like people like you will have to learn the hard way!

    • Person_XYZ says:

      Imagine believing that relying on other people and institutions for wellbeing amounts to ‘captivity’. What a dismal viewpoint.

    • Jitensha Oni says:

      An argument I read fairly often is that the UK has some good bargaining chips when it comes to getting its way with leaving the EU, including potential damage to the latter’s economy. Does this not mean that the EU are in a sense “captives ” of the UK? Why is this is allowable, if the counter-situation isn’t?

    • Guano says:

      Dipper – you appear to want something along the lines of the autarkic economy favoured by the Labour Party up until 1983. At the time this was greeted with hoots of derision by the Conservative Party and newspapers such as the Mail and Telegraph. Yet in 2017 this appears to be what the Conservative Party and the Mail and the Telegraph want in order to “take back control”.

      We have moved a long way in the last 30 years towards integration into European production lines. The costs of moving away from this European integration, and towards an economy integrated at the national level, are very much higher than they would have been in 1983. The UK no longer has the factories to make complete cars or washing machines and it would require a lot of capital and planning to recreate them. It is, I agree, one of the hidden assumptions of what Minford is proposing, but it is the exact opposite of what his heroine Margaret Thatcher set about to do (and those who propose it appear not to have any idea of what would be required to make it happen).

      If the UK government “punches above its weight”, which is what it never ceases to tell us it does, then it should have had a strong enough voice in the EU to protect the interests of UK citizens while benefitting from economic integration and mutual cooperation. If it doesn’t, it runs an even greater risk of letting the UK become a captive of the USA or Saudi Arabia.

    • Dipper says:

      To take all the comments in one … I understand the bit about integrated economies and interdependence, but the EU was very clearly wanting to move beyond a group of interdependent economies to political union, and moreover a union in which due to historical reasons there would be dominant central European block.

      The question the post and comments avoid is where heavily integrated economies leave the nation state as an entity. The EU is clearly using economic integration as a lever to bring about political integration with the effective demotion of national governments to local councils. Greece is the clearest and most obvious example of this. The post, and the comments, by noting the costs of disruption to economic integration but avoiding discussion of the political consequences of the erosion of the nation state either deny that is happening or implicitly accept that it is happening and it is the favoured option.

      • Guano says:

        “The EU is clearly using economic integration as a lever to bring about political integration with the effective demotion of national governments to local councils.”

        It isn’t clear that this is happening. There is a risk of this, but it is far from clear that other ways of reducing this risk have been explored. There are presumably other members of the EU who don’t want to be demoted to local councils, so a UK would have some allies if it were really interested in avoiding this (without losing the gains made from cooperating with 27 other European nations).

  2. liminalt says:

    Great analysis, much better than all the incoherent waffle that’s been put about lately!

  3. Shane O'Mara says:

    There’s a fourth reason to add to your list above – opportunistic arbitrage in goods and services (aka smuggling). Having an external border with defined access points helps reduce this. NI is going to be a problem, isn’t it? Currency fluctuations, hundreds of crossing points and many, many businesses sitting astride the border.

  4. P Hearn says:

    The EU cares about the EU as a project, not a collection of nations, and most certainly not the ordinary citizens therein.

    This is proved by the fact that Brexit discussions are first centred around exit payments from the UK to the EU, and not trade, jobs or what’s best for industry in the EU and UK. Screw them – they’re only paying for the whole shebang.

    No, to Barnier and his ilk, the top priority that will take as long as it takes is hard cash for the EU to buy popularity in the member states with projects on which they can hang an EU flag.

    If there’s time to discuss trade, that thing which directly affects the citizens, then they may get round to it, but that’s clearly a far lower priority than ensuring Brussels can continue on its merry way.

    China, the USA, Japan, Canada all trade with the EU quite successfully using WTO. If we choose not to impose tariffs and customs checks on imports, half the problem with manufacturing integration across Europe goes away as components can stream into the UK unhindered. The other half (tariffs for goods going back into the EU) is already solved by Sterling’s devaluation/Euro appreciation.

    Who will get utterly screwed is the Irish. T’was ever thus.

    • Andrew Adams says:

      Barnier has a negotiating mandate agreed by the other 27 EU states.

    • gunnerbear says:

      There are about 25 trade agreements on specific things relating to EU-US trade….so it’s not just ‘WTO rules’ that EU-US trade falls under….

  5. Keith says:

    Brexit is in other words incoherent rubbish. Dipper has no explanation for why suddenly the right has ditched the logic Margaret Thatcher embraced of economic integration maximising productivity and wealth. Political integration is a political choice, which economic integration makes easier, but not unavoidable. So far all UK Governments both Labour and conservative have had no problem opting out of those aspects of integration they objected to at the time. Brexit is a solution looking for a problem. Ginned up by hysterical racists and flat earth reactionaries. For some reason in both the UK and USA politics has taken on the character of an exercise in irrational stupidity with the political right acting like a senile mentally incompetent man. They have even made one President to embody in living form the mental decline of the right. Trump is the living embodiment of intellectual incoherence. Spouting ideas rejected by most mainstream economic and political thinkers decades ago.

    • Dipper says:

      It wasn’t the right that ditched Thatcher’s logic, it was the EU and the European Commission. They are clearly using economic integration as the basis on which to push an agenda of federalism.

    • gunnerbear says:

      Because immigration – mass uncontrolled immigration – has f**ked the UK for anyone who isn’t at the top o’ the pile….

      It’s not ‘irrational stupidity’ to want to be out of a system that allows business access to a never ending supply o’ cheap labour. It’s irrational to stay in a system like that.

  6. ChrisA says:

    Why is it not considered unambiguously evil for the EU to punish the UK? Surely every right thinking person would say that the EU and UK have great mutual interest in working out these issues in a sensible fashion, to avoid too much disruption by either side. What possible reason could the EU want for having bad trade relationships with the UK? I will answer my question – it is because the EU is basically a mercantile bloc – they don’t believe in free trade but in barriers in the belief this makes their own economies stronger. This approach is fundamentally wrong and it would be wrong for the UK to be stuck in such a structure. We will struggle of course in in the initial stages, but in the longer term we will be better off. Hopefully it will be the case that the EU will have the example of the UK and want to reform, rather than digging in deeper.

    • Dipper says:

      Yes. agree. the Leaver position is that independent nations should work together to promote trade, prosperity, and peace. So we should expect the EU to want to come up with a good deal with us. To not do that is a hostile act on the integrity of a nation state.

      The Remain position is at best muddled and illogical. The EU is acting in a way that completely undermines the Remain logic that we can be a free independent state in the EU and there is no challenge to our independence by remaining. Like the argument that Freedom of Movement is an economic benefit – if that were the case, then Freedom of Movement would be universally embraced by every nation on the planet rather than the actual position which is it is an exception in the EU and a couple of other countries. FOM exists to undermine the notion of a nation state within the EU.

  7. Pingback: Friction burns | Barking at cars

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