With the Conservatives having lost their majority in Parliament in the recent UK election, there is renewed discussion of the form that Brexit might take. EU states are members of the single market and the customs union. A ‘hard Brexit’ involves leaving both and this was the government’s stance prior to the election. But there is now talk of a softer Brexit, which might mean retaining membership of the single market and/or customs union.
The single market
Belonging to the single market means accepting the free movement of goods, services, capital and labour. It also involves tariff-free trade within the single market and adopting a common set of rules and regulations over trade, product standards, safety, packaging, etc., with disputes settled by the European Court of Justice. Membership of the single market involves paying budgetary contributions. Norway and Iceland are members of the single market.
The single market brings huge benefits from free trade with no administrative barriers from customs checks and paperwork. But it would probably prove impossible to negotiate remaining in the single market with an opt out on free movement of labour. Controlling immigration from EU countries was a key part of the Leave campaign.
The customs union
This involves all EU countries adopting the same tariffs (customs duties) on imports from outside the EU. These tariffs are negotiated by the European Commission with non-EU countries 
on a country-by-country basis. Goods imported from outside the EU are charged tariffs in the country of import and can then be sold freely around the EU with no further tariffs.
Remaining a member of the customs union would allow the UK to continue trading freely in the EU, subject to meeting various non-tariff regulations. It would also allow free ‘borderless’ trade between Northern Ireland and the Republic of Ireland. However, being a member of the customs union would prevent the UK from negotiating separate trade deals with non-EU countries. The ability to negotiate such deals has been argued to be one of the main benefits of leaving the EU.
Free(r) trade area
The UK could negotiate a trade deal with the EU. But it is highly unlikely that such a deal could be in place by March 2019, the date when the UK is scheduled to leave the EU. At that point, trade barriers would be imposed, including between the two parts of the island of Ireland. Such deals are very complex, especially in the area of services, which are the largest category of UK exports. Negotiating tariff-free or reduced-tariff trade is only a small part of the problem; the biggest part involves negotiating product standards, regulations and other non-tariff barriers.
All the above options thus involve serious problems and the government will be pushed from various sides, not least within the Conservative Party, for different degrees of ‘softness’ or ‘hardness’ of Brexit. What is more, the pressure from business for free trade with the EU is likely to grow. Brexit may mean Brexit, but just what form it will take is very unclear.
Articles
Free trade area, single market, customs union – what’s the difference? BBC News, Jonty Bloom (12/6/17)
Brexit: What are the options? BBC News (12/6/17)
After the election, the real test: Brexi The Economist (8/6/17)
May’s Ministers Plot Softer Brexit to Keep UK in Single Market Bloomberg, Tim Ross, Alex Morales and Svenja O’Donnell (11/6/17)
UK’s Hung Parliament Raises Business Hopes for a Softer Brexit Bloomberg, Stephanie Baker and James Paton (12/6/17)
Do not exaggerate the effect the election will have on Brexit Financial Times, Wolfgang Münchau (11/6/17)
What is soft Brexit? How could it work as UK negotiates leaving the EU? Independent, May Bulman (12/6/17)
Brexit-lite back on the table as Britain rethinks its options after election The Guardian, Dan Roberts (11/6/17)
Review plan to quit EU Customs Union, urges FTA FoodManufacture.co.uk, James Ridler (12/6/17)
Freight leaders urge government to review decision to leave EU customs union RTM (12/6/17)
Paper
Making Brexit work for British Business: Key Execution Priorities M-RCBG Associate Working Paper No. 77, Harvard Kennedy School, Peter Sands, Ed Balls, Sebastian Leape and Nyasha Weinberg (June 2017)
Questions
- Explain the trading agreement between Norway and the EU.
- How does the Norwegian arrangement with the EU differ from the Turkish one?
- What are meant by the terms ‘hard Brexit’ and ‘soft Brexit’?
- How does a customs union differ from a free trade area?
- Is it possible to have (a) a customs union without a single market; (b) a single market without a customs union?
- To what extent is it in the EU’s interests to negotiate a deal with the UK which lets it maintain access to the customs union without having free movement of labour?
- The EU insists that talks about future trading arrangements between the UK and the EU can take place only after sufficient progress has been made on the terms of the ‘divorce’. What elements are included in the divorce terms?
- If agreement is not reached by 29 March 2019, what happens and what would be the consequences?
- Will a hung parliament, or at least a government supported by the DUP on a confidence and supply basis, make it more or less likely that there will be a hard Brexit?
- For what reasons may the EU favour (a) a hard Brexit; (b) a soft Brexit?
Economists were generally in favour of the UK remaining in the EU and highly critical of the policy proposals of Donald Trump. And yet the UK voted to leave the EU and Donald Trump was elected.
People rejected the advice of most economists. Many blamed the failure of most economists to predict the 2007/8 financial crisis and to find solutions to the growing gulf between rich and poor, with the majority stuck on low incomes.
So to what extent are economists to blame for the rise in populism – a wave that could lead to electoral upsets in various European countries? The podcast below brings together economists and politicians from across the political spectrum. It is over an hour long and provides an in-depth discussion of many of the issues and the extent to which economists can provide answers.
Podcast
Should economists share the blame for populism? Guardian Politics Weekly podcast, Heather Stewart, joined by Andrew Lilico, Ann Pettifor, Jonathan Portes, Rachel Reeves and Vince Cable (23/2/17)
Questions
- Why has globalisation become a dirty word?
- Assess the arguments for and against an open policy towards immigration?
- In what positive ways may economists contribute to populism?
- Do economists concentrate too much on growth in GDP rather than on its distribution?
- Give some examples of ways in which various popular interpretations of economic phenomena may confuse correlation with causality.
- Why did the proportions of people who voted for and against Brexit differ considerably from one part of the country to another, from one age group to another and from one social group to another?
- In what ways have economists and the subject of economics contributed towards a growth in human welfare?
- What are the advantages and disadvantages of the trend for undergraduate economics curricula to become more mathematical (at least until relatively recently)?
Both the financial and goods markets are heavily influenced by sentiment. And such sentiment tends to be self-reinforcing. If consumers and investors are pessimistic, they will not spend and not invest. The economy declines and this further worsens sentiment and further discourages consumption and investment. Banks become less willing to lend and stock markets fall. The falling stock markets discourage people from buying shares and so share prices fall further. The despondency becomes irrational and greatly exaggerates economic fundamentals.
This same irrationality applies in a boom. Here it becomes irrational exuberance. A boom encourages confidence and stimulates consumer spending and investment. This further stimulates the boom via the multiplier and accelerator and further inspires confidence. Banks are more willing to lend, which further feeds the expansion. Stock markets soar and destabilising speculation further pushes up share prices. There is a stock market bubble.
But bubbles burst. The question is whether the current global stock market boom, with share prices reaching record levels, represents a bubble. One indicator is the price/earnings (PE) ratio of shares. This is the ratio of share prices to earnings per share. Currently the ratio for the US index, S&P 500, is just over 26. This compares with a mean over the past 147 years of 15.64. The current ratio is the third highest after the peaks of the early 2000s and 2008/9.
An alternative measure of the PE ratio is the Shiller PE ratio (see also). This is named after Robert Shiller, who wrote the book Irrational Exuberance. Unlike conventional PE ratios, which only look at average earnings over the past four quarters, the Shiller PE ratio uses average earnings over the past 10 years. “Because this factors in earnings from the previous ten years, it is less prone to wild swings in any one year.”
The current level of the Shiller PE ratio is 29.14, the third highest on record, this time after the period running up to the Wall Street crash of 1929 and the dot-com bubble of the late 1990s. The mean Shiller PE ratio over the past 147 years is 16.72.
So are we in a period of irrational exuberance? And are stock markets experiencing a bubble that sooner or later will burst? The following articles explore these questions.
Articles
2 Clear Instances of Irrational Exuberance Seeking Alpha, Jeffrey Himelson (12/2/17)
Promised land of Trumpflation-inspired global stimulus has been slow off the mark South China Morning Post, David Brown (20/2/17)
A stock market crash is a way off, but this boom will turn to bust The Guardian, Larry Elliott (16/2/17)
The “boring” bubble is close to bursting – the Unilever bid proves it MoneyWeek, John Stepek (20/2/17)
Questions
- Find out what is meant by Minksy’s ‘financial instability hypothesis’ and a ‘Minsky moment’. How might they explain irrational exuberance and the sudden turning point from a boom to a bust?
- Is it really irrational to buy shares with a very high PE ratio if everyone else is doing so?
- Why are people currently exuberant?
- What might cause the current exuberance to end?
- How does irrational exuberance affect the size of the multiplier?
- How might the behaviour of banks and other financial institutions contribute towards a boom fuelled by irrational exuberance?
- Compare the usefulness of a standard PE ratio with the Shiller PE ratio.
- Other than high PE ratios, what else might suggest that stock markets are overvalued?
- Why might a company’s PE ratio differ from its price/dividends ratio (see)? Which is a better measure of whether or not a share is overvalued?
Economic forecasting came in for much criticism at the time of the financial crisis and credit crunch. Few economists had predicted the crisis and its consequences. Even Queen Elizabeth II, on a visit to the London School of Economics in November 2008, asked why economists had got it so wrong. Similar criticisms have emerged since the Brexit vote, with economic forecasters being accused of being excessively pessimistic about the outcome.
The accuracy of economic forecasts was one of the topics discussed by Andy Haldane, Chief Economist at the Bank of England. Speaking at the Institute for Government in London, he compared economic forecasting to weather forecasting (see section from 15’20” in the webcast):
“Remember that? Michael Fish getting up: ‘There’s no hurricane coming but it will be very windy in Spain.’ Very similar to the sort of reports central banks – naming no names – issued pre-crisis, ‘There is no hurricane coming but it might be very windy in the sub-prime sector.” (18’40”)
The problem with the standard economic models which were used for forecasting is that they were essentially equilibrium models which work reasonably well in ‘normal’ times. But when there is a large shock to the economic system, they work much less well. First, the shocks themselves are hard to predict. For example, the sub-prime crisis in 2007/8 was not foreseen by most economists.
Then there is the effect of the shocks. Large shocks are much harder to model as they can trigger strong reactions by consumers and firms, and governments too. These reactions are often hugely affected by sentiment. Bouts of pessimism or even panic can grip markets, as happened in late 2008 with the collapse of Lehman Brothers. Markets can tumble way beyond what would be expected by a calm adjustment to a shock.
It can work the other way too. Economists generally predicted that the Brexit vote would lead to a fall in GDP. However, despite a large depreciation of sterling, consumer sentiment held up better than was expected and the economy kept growing.
But is it fair to compare economic forecasting with weather forecasting? Weather forecasting is concerned with natural phenomena and only seeks to forecast with any accuracy a few days ahead. Economic forecasting, if used correctly, highlights the drivers of economic change, such as government policy or the Brexit vote, and their likely consequences, other things being equal. Given that economies are constantly being affected by economic shocks, including government or central bank actions, it is impossible to forecast the state of the macroeconomy with any accuracy.
This does not mean that forecasting is useless, as it can highlight the likely effects of policies and take into account the latest surveys of, say, consumer and business confidence. It can also give the most likely central forecast of the economy and the likely probabilities of variance from this central forecast. This is why many forecasts use ‘fan charts’: see, for example, Bank of England forecasts.
What economic forecasts cannot do is to predict the precise state of the economy in the future. However, they can be refined to take into account more realistic modelling, including the modelling of human behaviour, and more accurate data, including survey data. But, however refined they become, they can only ever give likely values for various economic variables or likely effects of policy measures.
Webcast
Andy Haldane in Conversation Institute for Government (5/1/17)
Articles
‘Michael Fish’ Comments From Andy Haldane Pounced Upon By Brexit Supporters Huffington Post, Chris York (6/1/17)
Crash was economists’ ‘Michael Fish’ moment, says Andy Haldane BBC News (6/1/17)
The Bank’s ‘Michael Fish’ moment BBC News, Kamal Ahmed (6/1/17)
Bank of England’s Haldane admits crisis in economic forecasting Financial Times, Chris Giles (6/1/17)
Chief economist of Bank of England admits errors in Brexit forecasting BBC News, Phillip Inman (5/1/17)
Economists have completely failed us. They’re no better than Mystic Meg The Guardian, Simon Jenkins (6/1/17)
Five things economists can do to regain trust The Guardian, Katie Allen and Phillip Inman (6/1/17)
Andy Haldane: Bank of England has not changed view on negative impact of Brexit Independent, Ben Chu (5/1/17)
Big data could help economists avoid any more embarrassing Michael Fish moments Independent, Hamish McRae (7/1/17)
Questions
- In what ways does economic forecasting differ from weather forecasting?
- How might economic forecasting be improved?
- To what extent were the warnings of the Bank of England made before the Brexit vote justified? Did such warnings take into account actions that the Bank of England was likely to take?
- How is the UK economy likely to perform over the coming months? What assumptions are you making here?
- Brexit hasn’t happened yet. Why is it extremely difficult to forecast today what the effects of actually leaving the EU will be on the UK economy once it has happened?
- If economic forecasting is difficult and often inaccurate, should it be abandoned?
- The Bank of England is forecasting that inflation will rise in the coming months. Discuss reasons why this forecast is likely to prove correct and reasons why it may prove incorrect.
- How could economic forecasters take the possibility of a Trump victory into account when making forecasts six months ago of the state of the global economy a year or two ahead?
- How might the use of big data transform economic forecasting?
The linked article below from The Economist looks at whether the election of Donald Trump, the effects of the Brexit vote and policies being pursued elsewhere in the world mark a new macroeconomic era. We may be about to witness rising inflation and the end of the era of tight fiscal policy and loose monetary policy. We might see a return of a more Keynesian approach to macreconomic policy.
According to the article, since the financial crisis of 2008, we have been witnessing economies stuck in a liquidity trap. In such cases, there is little scope for further reductions in interest rates. And increases in money supply, in the form of quantitative easing, tend to be held in idle balances, rather than being spent on goods and services. The idle balances take the form of increased bank reserves to rebuild their capital base and increased purchases of assets such as shares and property.
Even if people did believe that monetary policy would work to boost aggregate demand and result in higher inflation, then they would also believe that any such boost would be temporary as central banks would then have to tighten monetary policy to keep inflation within the target they had been set. This would limit spending increases, keeping the economy in the liquidity trap.
With a liquidity trap, fiscal policy is likely to be much more effective than monetary policy in boosting aggregate demand. However, its scope to pull an economy out of recession and create sustained higher growth depends on the extent to which governments, and markets, can tolerate higher budget deficits and growing debt. With governments seeking to claw down deficits and ultimately debt, this severely limits the potential for using fiscal policy.
With the election of Donald Trump, we might be entering a new era of fiscal policy. He has promised large-scale infrastructure spending and tax cuts. Although he has also promised to reduce the deficit, he is implying that this will only occur when the economy is growing more rapidly and hence tax revenues are increasing.
Is Donald Trump a Keynesian? Or are such promises merely part of campaigning – promises that will be watered down when he takes office in January? We shall have to wait and see whether we are about to enter a new era of macroeconomic policy – an era that has been increasingly advocated by international bodies, such as the IMF and the OECD (see the blog post, OECD goes public).
Article
Slumponomics: Trump and the political economy of liquidity traps The Economist (10/11/16)
Questions
- Explain what is meant by ‘the liquidity trap’.
- Why is monetary policy relatively ineffective in a liquidity trap? Use a diagram to support your argument.
- Why is fiscal policy (in the absence of public-sector deficit targets) relatively effective in a liquidity trap? Again, use a diagram to support your argument.
- Examine how the Japanese government attempted to escape the liquidity trap? (Search this site for ‘Abenomics’.)
- In what ways may the depreciation of the pound since the Brexit vote help the UK to escape the liquidity trap?
- Could a different form of quantitative easing, known as ‘helicopter money’, whereby government or private spending is financed directly by new money, allow countries to escape the liquidity trap? (Search this site for ‘helicopter money’.)
- Why may a political upheaval be necessary for a country to escape the liquidity trap?
on a country-by-country basis. Goods imported from outside the EU are charged tariffs in the country of import and can then be sold freely around the EU with no further tariffs.
