The great British trade off

Trade priorities

Currently, more than half (53%) of UK trade is with members of the European Economic Area, which includes all 27 other members of the EU alongside with Iceland, Liechtenstein, and Norway, plus the customs union with Turkey. Adding in 53 existing Free Trade Agreements (FTAs) between the EU and other states, in particular agreements with Switzerland and South Korea, brings the share of UK trade to 62%.

Including the EU FTAs currently being negotiated with other countries around the world brings the share of UK trade to and through the European Union to around 80%. While there is the argument that Brexit will increase trade with countries outside of Europe, such policies can only be established once the UK has left the EU.

There is an argument that trade with the EU can be replaced with more trade outside of Europe. However, this is flawed: physical distance between countries remains a significant restriction of trade opportunities, despite the effects of technological advances on the nature of international trade. Global value chains, which coordinate the production of goods and services across economies, may even add to the significance of trade with next-door neighbours, which by definition is cheaper and easier.

Another problem arises as we consider the methods with which trade is measured. Gross figures on trade reported every day are misleading, as they do not indicate the value added in the UK economy. Many of our exports actually consist of imported goods which are assembled into finished items in the UK. Value added estimates, which are much less timely and which are not official statistics, at least measure the impact of trade on domestic jobs and income (wages and profits), both of which play an important role in domestic policy making.

Furthermore, these figures show that the export of services is more important than that of goods for UK profits and wages. This is a problem, as FTAs are mostly about goods trade and less about services (the latest Canadian agreement notwithstanding).

As with most advanced economies, the UK service sector generates the largest share of national output. Eight out of ten jobs and 75% of output in the UK is in the services sector. However, the main form of selling exports is not included in the official trade flows. Most services are exported overseas through foreign affiliates created by setting up companies overseas or partnerships. A useful proxy measure for exporting through affiliates is foreign direct investment (FDI) statistics.

The UK is the third largest recipient of FDI in the world. More than half (60%) of all inward FDI (into Britain) comes from Europe, of which two-thirds is in the services sector. Additionally, 30% of FDI comes from the United States, implying that trade agreements with Europe and the US are likely to be prioritised over the course of the next couple of years.

Trade Agreements

Global value chains have contributed to international trade rapidly accelerating away from the traditional theories of Ricardo and Heckscher-Ohlin. While their insights are timeless, the assumption of fixed endowments no longer necessarily holds. Through investment in research and infrastructure (broadly defined, including legal processes) countries can change their skill sets.

Techonological advances mean that parts of production processes are now internationally mobile, and as a result, the absolute advantage of certain countries can also play a role in determining trade patterns, alongside comparative advantage in the global market – because trade policy is entwined with regional and industrial policies. This means the UK’s emphasis on industrial policy, and its regional content, is crucial and ought to be considered with trade in an integrated policy approach.

There is also an important role for government. Ironically, free trade is not an issue of governments just ‘getting out of the way’. They have to agree standards, rules and regulations, supervision and enforcement mechanisms (non-tariff barriers) – to name but a few. Trade agreements are really a formalisation of cooperation between two (or more) countries and necessarily imply shared sovereignty.

The countries involved agree to forgo some policies to cooperate and reach a better economic outcome. They all require a robust legal system which recognises the set of rules negotiated in the trade agreement and is able to enforce them. There needs to be an enforcement mechanism to ensure the terms of the trade agreement are met, and in many cases that investors’ rights are protected.

The recent free trade agreement between Canada and the EU (CETA) is a good example here. It covers agriculture (without removing all associated trade barriers), non-agricultural goods (tariffs have roughly halved), services and investment (certain sectors such as education, healthcare, social and financial services excluded), government procurement (enabling preference over domestic supply), intellectual property, and sustainable development, environment, and labour.

A modern trade agreement of such depth could be held up as a model for the UK once divorce from the EU has been finalised; but it must be noted that CETA took 15 years to complete and enact. Also, the fact that CETA has carved out so many service sectors means it falls well short of the sort of framework provided by the EU’s single market (although itself incomplete).

An additional component that could be problematic for the UK while negotiating future agreements is the issue of dispute resolution via international courts. International courts, such as the International Court for Settlement of Investment Disputes (ICSID) in Washington DC, pose a threat to domestic political legitimacy as public interest could be misrepresented and overlooked.

At present, the UK has not established a domestic institution to tackle disputes and needs a new method of resolution in order to continue to attract foreign direct investment. In the EU, fears about dispute resolutions were important reasons behind the failure of TTIP and the objections to CETA.

Looking Ahead

In contrast to negotiating FTAs, some economists and think tanks advocate that the UK ought to unilaterally set zero tariffs on goods imported into the UK. This may even be at a time that our goods producers and agricultural sector may be facing tariffs for the first time with our former EU and EU FTA partners. Campaigners in support argue that unilateral zero tariffs maximise total income for society and may even encourage a zero tariff response from the rest of the world.

However, this debate seems to be more driven by ideology that economics. Such a radical policy would have very significant effects on certain economic sectors (many advocates even acknowledge that most of our manufacturing sector would be wiped out). There would of course be winners: in particular, consumers would enjoy lower import prices and so import more.

But the primary effect of trade liberalisation is on the distribution of income between winners and losers. This is a trade-off. It is economists’ job to highlight this trade-off, perhaps identify the winners and losers and even attempt to measure the costs and benefits.

But it is for the politicians to decide how to choose policy given the trade-off. Decisions in regard to the issues arising from trade liberalisation should rest with politicians and policy makers, after being informed of the trade-offs by economists. For economists to ignore the trade-offs or pretend that they do not exist undermines their credibility and legitimacy in public debate.

In conclusion, the talk now should not be in favour of protectionism, but rather should be a call for an open political discussion informed by real economic analysis, rather than ideology-laden commentaries.

The Social Market Foundation held an Ask the Expert seminar with Dr Angus Armstrong of the National Institute for Economic and Social Research (NIESR). This blog is based on Dr. Armstrong’s remarks at the event.

The views expressed in this analysis post are those of the authors and not necessarily those of the UK in a Changing Europe initiative.

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