The truth about the Single Market

With Brexit negotiations about to get underway, one area that continues to get a lot of attention is Britain’s future trading relationship with the European Union. People still opposed to exiting emphasise the economic costs they fear from leaving the Single Market. Many fret that the two-year limit for Article 50 negotiations is too short a time to come up with a replacement trade deal. Moreover, if one is eventually agreed, possibly after some interim arrangement beyond the two years, they say it is bound to be a poor substitute for the advantages of full membership. Even many Brexit supporters seem to accept that more expensive and reduced levels of trade with the EU would be costly for the British economy, depicting this as a necessary, if unfortunate, expense of regaining sovereignty.

We should all be less negative about the economic consequences of changing Britain’s trading relationships. Countries around the world, and throughout history, have traded successfully without formal trade agreements. Today, Britain’s biggest single export market is the US – a country it has no trade agreement with. Meanwhile none of the top three exporters into the Single Market – that’s China, the US and Russia – have trade agreements with the EU.

To be a successful exporter, much more important than trade deals is the ability to produce goods and services efficiently so you are competitive internationally. Foreign trade is not a determinant of our productivity and prosperity levels, as is often asserted. It is the other way around: trading success is a function of productivity levels and competitiveness.

Moreover, if we, and especially British ministers, remain too focused on a future EU trading agreement, we will be doing the economy a huge disservice. Looking backwards at how to replicate the supposed benefits of the Single Market would distract and divert us from seizing the direct and indirect economic opportunities from Brexit. One of the great things about Brexit is that it means change, not just political change but economic change, too. And if there is one thing our zombie economy needs more than anything else, it is to be disrupted by change.

It would therefore be self-defeating to approach any economic aspects of the Article 50 negotiations by trying strenuously and narrowly to ‘make the best from a bad situation’. Rather, negotiators should be maximising the freedoms that come with departing the EU to help get on with implementing the economic policies that are needed to shake up the economy.

On trade, they should simply work for the freest trade agreement possible, without accepting any controls from EU institutions. In the meantime, developing those more ambitious pro-growth policies, domestic and international, can start now, and we should exercise whichever of them are possible prior to the formal leaving date. For example, lawmakers should already start reviewing all the EU rules and regulations we will no longer be bound by and determine which can be amended or rescinded to help revitalise the economy. One helpful objective that can be agreed immediately is to abandon the regulatory guide of the ‘precautionary principle’. This has institutionalised restrictive risk-aversion, not least on matters to do with innovation, science, medicines and food production.

Any trade agreement, however free, is still a sideshow compared to the ever-more urgent task of getting to grips with the fundamental economic problems causing slow to non-existent productivity growth. What drives our economic future is not the terms of the trade relationship we negotiate but how we act, or don’t act, at home in seeking to transform the economy. In particular, how we remove barriers to investment and encourage more technological change and innovation across the economy.

External trade and other international economic relationships can amplify or mitigate what is happening within a country’s borders. But they are not an economic panacea. Any country’s economic dynamic is predominantly homegrown. What has always been key for prosperity is the condition of domestic production. This is why subordinating everything to the EU negotiations would be a terrible waste of another two years. It would be a self-fulfilling harbinger of unnecessary woe caused not by exiting the EU, but by further postponing getting stuck in with the priority home-based tasks for economic renewal.

So how significant is the Single Market for overall trade? The claim we often hear is that Leave voters didn’t know they were voting to leave the Single Market. This is despite the fact that Remainers constantly told us this is what would happen, as they talked up the long-term economic damage Brexit would cause. It was alleged that losing Single Market membership would curtail trade and put off inward investment decisions. This, we were told, would lower the rate of productivity growth, resulting in all of us being much worse off by the end of the next decade.

But if the Single Market were so important to Britain’s future prosperity, we would have seen clear signs of the benefits of membership over the past 24 years. What has happened to productivity, to Britain’s exporting performance into the EU, and to the relative importance of the EU as an export market compared to the rest of the world? The reverence attached to Single Market membership would imply all three have improved since its launch in 1993. Let’s take a look.

If productivity were to be badly hit post-Brexit, that would be a grave consequence. Productivity growth – producing more in the same time – is core to future prosperity. The underlying reason earnings have been flat or reduced for most British families since 2007, before the financial crash, is because real output per hour only returned to 2007 levels at the end of last year, almost a decade later. But hang on. That was during the time of Single Market membership. Where was the Single Market vigour?

If you compare two equal periods of just over two decades before and since joining the Single Market, you see that Britain’s rate of productivity growth has actually slowed substantially. From 1971 to 1993 productivity grew at 2.3 per cent a year, falling to 1.4 per cent between 1993 and 2015. (Source: US Conference Board Total Economy Database.) And recall, the earlier period included a time when Britain was often derided as the ‘sick man of Europe’, while some have described the post-1992 years, at least before the 2008 financial crash, as a new ‘golden age’ for Britain.

In rough terms, the productivity slowdown meant that average living standards grew by almost two-thirds in the two decades before the Single Market, and by just less than a third in the subsequent period. This marked deterioration is not quite in line with what we might expect from the claim that retaining Single Market membership, or something similar, is incredibly important to productivity.

Turning to Britain’s trading performance, we can compare the earlier, looser Common Market years from 1973 to 1992 with the ‘more developed’ Single Market years from 1993 to 2015. We might think Britain’s growth rate for goods exported to other EU countries would have accelerated as a reflection of the advantages of being part of the closer Single Market. It didn’t. Initially, until around the end of the century, the average annual expansion rate remained steady at around five to six per cent. Then, from the early 2000s, it fell away to about half that level. (See Michael Burrage, Myth and Paradox of the Single Market, Civitas, 2016.) So the assumption of the Single Market enhancing Britain’s trade relationship with the EU is numerically false.

Third, what happened to the relative importance of the EU as an export market for Britain during Single Market membership compared to its trade with the rest of the world? We might expect it to have grown, given the apparent Single Market benefits. In fact, the EU peaked in its relative importance as an export market for British goods and services in 1992, just before the Single Market began. That peak market share was at about 60 per cent, up from 40 per cent when Britain joined the Common Market in 1973. Today the share is back down to about 45 per cent, and has been falling pretty steadily since 2000. See the chart below. Ironically, Britain’s export performance since joining the Single Market, and especially since the start of the 2000s, has been relatively better in the rest of the world beyond the EU than within it.

(Note: Data covers trade with the rest of the original EU 15: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain and Sweden. Source: Swati Dhingra, Gianmarco Ottaviano and Thomas Sampson, ‘Should the UK stay or go? The economic consequences of Britain leaving the EU’, LSE Centre for Economic Performance Election Analysis, Paper No CEPEA022, March 2015.)

In particular, it was since the start of this century, at a time when export growth to the rest of the EU slowed significantly, that Britain’s export growth to the emerging markets really began to take off. Some Brexitsceptics say it is wishful thinking for Britain to replace EU markets by exporting elsewhere. Yet despite Britain’s dire productivity levels, its export focus has already been shifting from the EU to the faster growing parts of the world for at least a decade and a half.

This trajectory provides another illustration of the exaggeration of the importance of trade agreements. Of Britain’s big five fastest growing emerging-market export destinations since 2000, four have no free-trade agreements (FTAs) with the EU: China, Russia, India, Brazil. And the exception, the fifth market, South Korea, is not much of an exception either, as the EU-Korea FTA only came into force two years ago, in 2015, at the end of the analysis period. (See PwC, UK Economic Outlook, November 2015.)

To summarise, since 1993 and joining the Single Market, British productivity growth has declined, its export growth into the EU has slowed, and British exports to the world beyond the EU have been doing relatively better. The relative importance of the EU as an export market has shrunk.

Facts alone, of course, do not prove anything. We can never know how Britain would have performed in the counterfactual situation of not being in the Single Market: maybe productivity would have been even worse, maybe trade growth into the EU would also have been even worse. However, this look at Britain’s performance over the past 45 years, and its deterioration over the two-and-a-half decades of Single Market membership, makes the assertion that leaving will necessarily be economically calamitous dubious at best. This might also explain why the ‘economic case’ for EU membership was based on model-derived projections about the possible future, rather than from an assessment of the real Single Market history.

The exaggeration of the economic importance of the Single Market reflects two big flaws in the conventional discussion about trade agreements and productivity. First, trading success reflects the international competitiveness that derives from the relative productivity of goods and services. A country is a flourishing exporter when its products are sought by others because they are better value than domestically produced ones, or of those of other international competitors. Against this, there is no automatic reason why selling more goods or services abroad boosts productivity. That can only happen indirectly if greater sales volumes encourage transformative investment and technological improvements.

Second, trade agreements don’t themselves enhance trade levels. They are pieces of paper agreed by the representatives of different economic countries or regions. They provide no guarantee of a country’s producers selling anything. They can’t force anyone else to buy from you. That is down to the decisions of businesses and individuals, which brings us back to the relative competitiveness of production. And since trade agreements can’t generate trade directly, they can’t create more value or jobs, never mind higher productivity, in the way economists assert.

It is true that when other countries practise trade protectionism, then without preferential free-trade agreements those foreign state-imposed barriers will interfere with the home country’s trading options. If your goods and services are restricted from being sold in other countries or regions – such as the EU – because of tariffs or, more commonly today, because of non-tariff barriers such as having to meet particular regulatory standards, then potential sales to that area’s businesses, people and other public and private buyers are lost. For example, EU rules banning GM foods prevent many exports from countries like the US. But this means that the responsibility for the reduction in trade is protectionism, rather than the absence of a trade agreement.

This is why it is so misleading to claim that Leavers are isolationist, economic nationalists, while Remainers are internationalist free traders. By most measures the EU is the most protectionist trading bloc in the developed world. Levels of EU tariffs are generally higher, often much higher, than those imposed by other advanced industrial economies. According to the World Trade Organisation (WTO), the intergovernmental organisation which regulates international trade, the simple average of tariffs applied by the EU is 5.1 per cent, above Canada at 4.2 per cent, the US at 3.5 per cent, Australia at 2.5 per cent and New Zealand at two per cent.

Take some specific tariff examples. The car industry: it has been widely stated that if a British-EU FTA is not agreed, then ‘under WTO rules’ the EU will impose 10 per cent import tariffs on cars exported by Nissan, Vauxhall, Jaguar Land Rover and the other car manufacturers based in Britain. But this reference to ‘WTO rules’ can mislead us into believing that the WTO sets this particular level of tariffs. Not so.

The WTO’s ‘most favoured nation’ (MFN) rule says that the lowest tariff you offer to any one ‘favoured’ country, outside of a registered FTA, has to be applied to all other countries: a level playing field of protectionism. So without an FTA, British car manufacturers will be penalised by an effective 10 per cent price hike. But the 10 per cent is not some globally agreed figure. The decision to set it so high was made voluntarily by the EU, to protect EU-based car manufacturers, not least Germany’s and France’s. What are car tariffs in the rest of the advanced industrial world? Canada: 6.1 per cent; Australia: five per cent; US: 2.5 per cent; New Zealand: 0 per cent. There is nothing to stop the EU dropping its car tariff to the New Zealand level, except its protectionist bent.

Or take a drinks product: roasted coffee. Again the EU has taken its own decision to protect its coffee producers, in particular (again) German ones. It sets a 7.5 per cent tariff on imports from other advanced economies. Again this is relatively high, compared to New Zealand’s five per cent, with Canada, Australia and the US all applying zero tariffs. This means that if Britain finds its goods becoming less competitive in EU markets, the immediate source of this problem is the EU’s protectionism, not the absence of a trade agreement. Trade agreements are primarily required in order to get around such protectionism.

This reveals another of the opportunities Britain can seize from leaving the European Union. We will be breaking from the EU protectionist comfort blanket. When people warn that without an FTA with the EU, Britain will have to ‘fall back’ on WTO rules, it is made to sound like a terrible place to go, and a great burden. But these WTO rules are simply the foundational structure around which the vast bulk of international trade is conducted. (See Shanker Singham, ‘Brexit: World Trade Organisation Process and Negotiation of Free Trade Agreements’, Legatum Institute Special Trade Commission, February 2017.)

Most of the world, currently 164 countries out of about 200, trade under WTO rules, including all EU members. Formal trade agreements like the EU Customs Union operate on top of this foundation, and remain subject to the same rules. This means that today, while inside the EU, about half of Britain’s trade is conducted by ‘falling back’ on to WTO rules. That is, it is trade with countries outside the EU Customs Union – beyond the, roughly, one-tenth of the world economy with which the EU has negotiated FTAs over the past half-century.

Many people also presume that, ‘bound by WTO rules’, Britain will have to be as protectionist as the EU currently is. The opposite is the case: escaping the EU Customs Union allows Britain the freedom to do two things it is prevented from doing today. It can negotiate FTAs with whichever country or region it wants: hence the preliminary discussions that are already underway with countries like Australia, the US, India and China. And it can set tariffs levels as low as it wants.

So the fears of inevitably higher shop prices due to Brexit are also exaggerated. This year we should expect to see the currency price effects of sterling’s recent depreciation, triggered by the Brexit vote, feed through into higher import costs. This is one of the main contributors to the current uptick in inflation levels. But there is no inevitable follow-on of further hikes in prices due to the post-Brexit imposition of tariffs on presently tariff-free EU imports. On day one outside the EU, Britain will most likely inherit the EU’s existing schedule of commitments to the WTO. While those set maximum tariff levels, Britain doesn’t need to maintain the existing applied schedule of the EU’s Common External Tariff. Britain will have the freedom to reduce these on an MFN basis.

It can do this immediately upon exit, though a gradual reduction over a limited transition period would be one way to enable British producers, including, not insignificantly, its farmers, to adapt to operating at world prices rather than protected EU ones. If this was the free-trade course adopted after Brexit, we could see lower, not higher, prices in our shops: cheaper cars, cheaper roasted coffee, other cheaper foodstuffs, and so on.

The potential benefits from escaping EU protectionism go beyond cheaper prices in British shops and of imported components for British producers. For an advanced market economy like Britain, trade protectionism is always a regressive act. As explained earlier, it restricts everyone’s ability to trade, curbing the global efficiency benefits from the greater specialisation of production and a wider international division of labour. Second, it inflames inter-country political tensions and rivalry, which rarely ends well.

And third, it is a restraint on domestic economic growth, mostly because it mollycoddles domestic businesses through shielding them from pressures to be more efficient and productive. This takes us back to where the emphasis of economic thinking and policy needs to be. Not on the EU negotiations over trade or much else, but on shaking the economy out of its torpor.

Leaving the EU, leaving the Single Market and the Customs Union, will have no definitive pre-determined effect on the economy – either for bad or good. Over the past 300 years, Britain has been in lots of different trading relationships. Sometimes it has been mercantilist and openly protectionist; sometimes it has favoured freer trade. Sometimes it has sought preferential trade deals with certain regions, including British Empire countries and more recently with Europe; sometimes it has mostly traded under multilateral arrangements, like the General Agreement on Tariffs and Trade, the WTO predecessor, during the postwar boom years.

None of these different external relationships have on their own either made or broken Britain’s economic health. Being outside the Single Market will be no different. The point always to keep in mind is that Britain’s productivity growth and its trading performance have deteriorated since the 1970s, not because of the Common Market or EU membership but regardless of it. Fixating on the EU trading relationship for the next two years distracts us from getting on with fixing this decay.

Phil Mullan’s new book, Creative Destruction: How to Start an Economic Renaissance, will be published by Policy Press on 29 March 2017.

Phil is launching Creative Destruction at a special Bookshop Barnie event on Monday 3 April at the Building Centre in London. The event is free, but make sure you reserve a place here.

Picture by: Getty Images.