Brexit meets gravity
Theresa May has good reason to seek a ‘soft exit’
As Britain’s self-inflicted Brexit crisis comes to a head, consider some of the economics involved that should be obvious but aren’t, apparently, to Brexiteers. These points explain why Theresa May seeks a “soft Brexit” and why the Brexiteers’ favored approach — trade agreements with the U.S. and others to replace the European Union — won’t fly.
To start, many of the arguments for Brexit were lies, pure and simple. But their claims about trade may arguably be seen as misunderstandings rather than sheer dishonesty.
In the world according to Brexiteers, Britain needn’t lose much by leaving the EU because it can still negotiate a free-trade agreement with the rest of Europe, or, at worst, face the low tariffs the EU imposes on other non-EU economies. Meanwhile, Britain can negotiate better trade deals elsewhere that can make up for any losses on the EU side.
What’s wrong with this story? First is that the EU is not a free-trade agreement like NAFTA; it’s a customs union, which is substantially stronger and more favorable to trade.
In NAFTA, most Mexican products can enter the U.S. tariff-free. But Mexico and the U.S. don’t charge the same tariffs on imports from third parties. This means that Mexican goods entering the U.S. still have to face a customs inspection, to make sure that they’re actually Mexican, not, say, Chinese goods unloaded in Mexico and trucked across the border to bypass U.S. tariffs.
NAFTA also has elaborate rules about how much Mexican content is required to qualify for zero tariffs, and this adds a lot of paperwork and frictions to intraNAFTA trade.
By contrast, the EU sets common external tariffs, which means that once you’re in, you’re in: Once goods are unloaded at Rotterdam they can be shipped on to France or Germany without further checks. So there’s much less friction.
And frictions, not tariffs, are what businesses are complaining about as Brexit nears. For example, the British auto industry relies on “just-in-time” production to maintain low inventories of parts because can count on prompt arrival of parts from Europe. If Britain leaves the customs union, the risk of customs delays would make this infeasible, substantially raising costs.
Still, even if leaving the customs union would be costly, couldn’t Britain make up for that by getting a really good deal with Donald Trump’sAmerica? No.
The U.S. couldn’t offer hugely valuable tariff reductions because our tariffs on EU products — like EU tariffs on our products — already are quite low. You can find examples of high tariffs, but overall there just isn’t muchto give.
What about a Britain-U.S. customs union? That would be hugely problematic. One of many reasons is the asymmetry in size; Britain would effectively be giving Washington complete control over its policy. Also, no deal with the U.S. could be worth as much as Britain’s customs union with the EU becauseof gravity.
What? One of the most firmly established relationships in economics is the “gravity equation” for trade between any two countries, which says that the amount of trade depends positively on the size of the two countries’ economies but negatively on the distance between them. Gravity effects can be charted clearly in trade flows but they are not entirelyunderstood.
The point is that, while America offers a market comparable in size to that of the EU, it’s much farther away from Britain, so that even if the U.K. could make an incredible deal with us, it wouldn’t be worth nearly as much as the EU customs unionit has.
All of this explains why Ms. May is trying to negotiate a deal that keeps the customs union intact. But that, of course, ain’t much of an exit: Brussels will still set U.K. trade policy, except that Britain will no longer have a vote. So what was the point of Brexit?
Good question.