The 5 errors of the Free Trade Brexiteers

For many of the proponents of Brexit in the referendum debate (Messrs. Gove,
Fox and Johnson in particular), free trade was a crucial part of their argument
on two grounds.

First, they argued that Britain would be able to agree a satisfactory trade deal with the EU following Brexit because the rest of the EU ran a sizeable trade surplus with Britain. Secondly, they argued that, outside the constraints of the Customs Union, Britain would be able to agree advantageous trade deals with other countries around the world (US, China, India) that the EU had not been able, or prepared, to do.

Some fourteen months on, these pre-referendum theoretical arguments have
come in to contact with real world, and five key errors can now be seen in their
arguments.

1. Their argument was based on the absolute size of the EU’s trade surplus:

Whilst almost half of the UK’s exports go to other EU nations, less than 10% of their exports come to the UK. Though the UK runs a deficit in trade with the EU in absolute money terms, relative to the size of the total EU economy their surplus is not very meaningful. Thus, if political considerations were deemed to be important (which events since the referendum have shown to be the case), it would be quite conceivable that some modest economic loss would be acceptable in exchange for other, more political gains.

2. Their arguments were based on an old economic, and now irrelevant,
theory that tariffs are the only thing that matter in international trade:

Two hundred years ago, Ricardo developed an economic theory demonstrating the advantages of untaxed international trade in boosting the economic well-being of all countries. The UK, with its Empire, large navy and entrepreneurial flair benefitted enormously from conducting trade all over the world. Thus, the UK’s history and attachment to the concept of free trade and drive to reduce or eliminate tariffs imposed on the import of physical goods into a country. This has been supported by a clear consensus of conventional, neoliberal economists through the decades since.

Today, tariffs on goods passing across borders are either zero or fairly close to it. There are specific areas where this is not so, principally agricultural products and cars coming in to the EU Customs Union. For goods, free trade is pretty much the norm and there is limited scope to achieve economic benefits from signing more free trade agreements.

3. Their arguments ignore the crucial role played by regulation as the
protectionist policy of choice today:

However, the key protectionist tool used by governments today is regulation. In general, this is used in service industries and is most prevalent in financial services, where protection of the major local banks insurance companies is typically deemed a political necessity, and pharmaceuticals, where the political need to control healthcare costs often impacts on purchases of specific drugs and treatments. These two industries are very important sources of UK export revenues.

Within the EU, the single market operates on the principle that if a product or service has regulatory approval in one EU nation, then it can be sold anywhere else in the EU, subject to EU-level control on what constitutes acceptable regulation. By leaving the EU, the UK will lose these advantages and will have no say on future regulatory change, but UK businesses will have to adapt to any such change.

The investment management industry is an example of an industry that looks like being particularly disadvantaged by Brexit. A substantial part of the industry’s revenues arise from managing the assets of other EU customers under MIFID regulation for investments in funds or under delegation regulation for segregated accounts. Last month, ESMA (the European Markets and Supervision Authority) published an opinion that, post-Brexit, would force more EU investment management activity to be conducted within the EU.

4. Other countries will expect us to make (politically unpalatable)
concessions in order to agree on new trade deals:

Though the US under Trump has indicated its desire to strike a free trade agreement with the UK, they have particular areas such as the food and
healthcare industries, where they would seek a change in UK regulation, before agreeing to such a deal. These are politically difficult for the UK
government.

Both Australia and India have indicated they would be very open to post-Brexit UK trade agreements but their price would be greater access to the UK for their own people, which would make even more difficult the UK’s ability to control and reduce immigration.

5. They over-estimated the attractiveness of the UK as a free trade partner:

They argued that as the 6th largest economy in the world, Britain was exceptionally attractive as a partner in a trade agreement. However, in practice the larger trading partners are (i) China with 1.3bn emerging consumers, (ii) the EU with 500m mostly wealthy consumers and the US with 300m wealthy consumers are many times more attractive as trading partners compared with the 60m wealthy consumers the UK has. In this global perspective the UK has less than 1% of the world’s population. A trade deal with the UK is a “nice-to-have” rather than a “must-have”.

The likely outcome for the UK is now a life outside the EU, accepting their
regulation of any product or service that we wish to sell to them, whilst losing
any say in that regulation or the key political developments in our most
important trading partner. In financial services in particular it is likely that the
UK will dilute its dominant market position within Europe, as regulations
benefit EU members. The UK will be forced to make greater concessions with
other countries in trade matters than the EU would have done in order to
secure trade agreements with these countries.
The voters believed the marketing hype of the free trade Brexiteers, sadly the reality of their delivered product will not match that hype.

A tide in the affairs of men

Over the last 100 years there have been two turning points in the evolution of the main economic philosophy that have supported economic policy in the UK and the US – the third such turning point appears to be now in progress.

In 1936 Keynes published his General Theory of Employment, Interest and Money in which he demonstrated that the economy could be in a state of equilibrium but with very high levels of unemployment. His policy prescription that the government make up for insufficient private sector demand by borrowing to fund public sector investment spending was the first time that an economist had argued that there was a key role for government within economic policy. This prescription was adopted in both the UK and the US (Roosevelt’s New Deal) in the next few years to deal with the Great Depression of the 1930s. The post-war economic policy conventional wisdom was that governments had a legitimate and necessary role to play by intervening in the economy in order to boost growth.

In 1976, the UK was forced by the weakness of its economy, to go and borrow money from the IMF and put in placer what would now be called policies of austerity. Most famously, the then Prime Minister, James Callaghan said “We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists …”. This was also the year that Milton Friedman received the Nobel Prize for his work on the importance of the money supply in generating inflation and marked a key change in mainstream economic orthodoxy which led to the rise of Thatcher and Reagan who looked to roll back the influence of government in the economy and re-focussed the target of central banks’ policy on containing inflation rather than supporting growth. Terms such as economic liberalism and free market capitalism also reflect the same direction of economic thought and in particular the deregulation of the financial sector that has marked economic policy in both the UK and the US from that point. Globally, free trade was a concept that dominated international policy-making as it was seen as both containing inflation and boosting growth.

In 2016, it appears that the tide of economic ideas is once again turning, and once more it is led by the UK and the US (with the UK again just a little ahead). The motto of the Brexit Leave campaign to “take back control” and of Donald Trump’s campaign to “make America great again”, are both calls to move away from the economics of free markets and the philosophy of free trade.

As in the 1930s, this follows a period in which a laissez-faire philosophy has not delivered improved living standards for the average person, but instead seen the share of wealth amongst the very richest in society rise sharply, boosting inequality. Interestingly is the right-wing of political thought that have understood and sought to exploit this. Trump’s calls to fight immigration and renege on trade deals have strong appeal to the (white) working classes who have suffered most the globalisation of the world economy. Even in the UK, the words of the incoming prime minister have pointed to the need for business to work for all sections of society, rather than the elites. Central banks around the world have for a few years now quietly been pursuing policies designed to increase inflation rather than contain it, though without success to date.

We have passed the point of “peak free markets”, and changes in the direction of the dominant economic meme tend to be long-lasting (40 years going by recent experience). We should expect governments to become increasingly involved in the affairs of men.

For investors, the key correlation to note at these tide-turning points is for interest rates and bond yields. The history of greater government action in economies is marked by rising interest rates and inflation, with real returns from government bonds the key outcome. These were disastrously poor from 1936 to 1976 but have fabulous from 1976 to 2016. A long period of very poor real returns from government bonds is now at hand.