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Some unpleasant Brexit econometrics

Author(s): Nauro F. Campos, Fabrizio Coricelli

Whatever the result of Britain’s upcoming in-or-out referendum on EU membership, its relationship with the EU will change substantially. To assess these changes, it is important to understand how Britain has benefited from EU membership. This column argues that EU membership has brought benefits through three key mechanisms – trade, foreign investment, and finance. The current focus on UK exports to and imports from the EU may severely underestimate the true potential costs to Britain of Brexit

From VoxEU:

As if terrorism, refugees, Schengen, debt, and Greece were not sufficiently big worries in each of themselves, the EU now has also to face the “English Question”. A referendum on Britain’s EU membership will take place before the end of 2017 (Copsey and Naughton 2014). In or out, remain or leave, the relationship between the UK and the EU will change dramatically.1 In order to assess such changes, one needs to grasp not only the reasons that led Britain to join the EU, but also how the UK has benefited from EU membership. In this column, we focus on the latter by trying to identify key channels. We argue that Britain benefited significantly from EU membership – the three key mechanisms were trade, foreign direct investment (FDI), and finance, though in ways that are seldom discussed. In this column, we:

  1. Put forward the infrequent argument that trade is good for UK growth but that intra-industry trade is good for UK TFP growth and hence may matter even more;
  2. Present the first estimates (that we know of) of the causal effect of EU membership on UK FDI net inflows; and
  3. Argue that the benefits of financial services specialisation in the UK depend a great deal on their interactions with FDI and trade.

Joining up is hard to do

Why did Britain join the European Community? In a companion column (Campos and Coricelli 2015), we analyse the evolution of the ratio of UK GDP per capita to that of the six founding members of the EU, since 1950. We report econometric evidence for a structural break circa 1970. Although explaining this break requires multiple factors, it is clear that EU membership played a substantial part.2

Campos et al. (2014) estimate net benefits to the UK from EU membership to be positive but, until around 1986 (Single Market), relatively small. Measured in terms of per capita output, net benefits peak around 1992 and remain constant until 2010. On the other hand, net benefits in terms of labour productivity (GDP per worker) increase year after year from 1992 until 2010.3 What factors related to European integration may have contributed to the dynamics of these net benefits? We argue that the answer lies in trade, FDI, and finance, although in ways seldom discussed to date.

Figure 1. UK net benefits from EU membership

Source: Campos et al (2014).

Trading up is hard to do

Article 2 of the 1957 Treaty of Rome sets a common (single) market as a main goal of the European integration project (Sapir 2011.) Trade in this project would serve a dual purpose – it would deter violent conflict (Martin et al. 2012) and would fuel economic growth. The benefits of trade are one of the few items that command widespread agreement among economists. Trade openness is associated with increasing competition and technological innovation, which lead to welfare improvements and growth.

Did joining the EU increase the UK’s trade openness? Yes it did, but in an unexpected way. The UK actually experienced a step change in the level of trade openness when it joined in 1973. According to the latest Penn World Tables (PWT) trade openness data, from the late 1950s to 1970, the UK averaged about 40%, rising to about 55% for 1973-2010.4 One usual explanation is that the economy specialised in services. The latest UNCTAD data in Figure 2 reveal the limits of such reasoning. Trade in services have grown at very much the same rate (from rather similar initial levels) in both the UK and Eurozone countries. Yet for trade in goods one observes divergence instead.5

Figure 2. Trade openness (as % of GDP) in the UK and the Eurozone, 1980-2013

Source: UNCTADstat.

If not trade openness, then what? The answer is perhaps intra-industry trade.6 Reaching the limits of overall trade openness among the EU6 (intra-EU6 trade increased from about 35% in 1958 to 50% in 1973) was accompanied by a substantial rise in intra-industry trade. The increases range from 42% in 1958 to 57% in 1973 in Italy, to an increase from 62% to 72% for the same period in the Benelux countries. Although intra-industry trade increased globally (Bullhart 2009), the fact that Western Europe starts from a relatively high level does not make its progress less impressive.7 UK intra-industry trade experienced massive changes around 1973 – average levels rose from less than 50% in the 1960s to more than 70% in the late 1970s and beyond (OECD 1987).

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