The truth about post-brexit trade deals

Another week, another row between the UK government and the European Union about the details of December’s rush-job of a co-operation agreement between the two. This one was ostensibly about sausages. Really, however, it is a reminder that the ‘Irish question’ won’t go away. That much should be self-evident. Post Brexit, Ulster cannot simultaneously be part of the EU’s customs union and be outside it. Somewhere there needs to be a border, with all that entails for barriers to trade.

No matter, the sniff of a trade deal elsewhere can soon deflect attention from boring technicalities in the small print of the Irish protocol. Which is why the UK government is so keen to talk up the opportunities in the Trans-Pacific Partnership (TPP), an 11-state trade deal of mostly Pacific-rim countries for membership of which the UK has just been invited to apply.

Back in January, when the UK government said it wanted to apply, the international trade secretary, Liz Truss, hyper-ventilated in characteristic fashion that membership of the TTP would “create enormous opportunities for UK businesses that simply weren’t there as part of the EU and deepen our ties with some of the fastest-growing markets in the world”. Obviously, that comment adhered to rule one of the UK trade ministers’ handbook – rubbish the EU at every opportunity. For the most part, though, Truss was talking borderline drivel, as we’ll see.

The important point to grasp about trade deals is that their effectiveness diminishes with distance, a notion of economics developed in the 1950s and labelled the ‘gravity model’. Basically, the model says that trade between two countries will depend on the relative economic output of the two. This much should be obvious – a nation that generates lots of gross domestic product (GDP) will have more to trade than a smaller one. Second, the greater the distance between two nations, the smaller the volume of trade between the two. This also seems a fair generalisation. Distance brings higher transport costs and increases the likelihood of cultural and language barriers between two nations trading. The effect is that big countries will do lots of business with other big countries nearby, less with those that are big but distant and still less if they are distant and small.

True, the gravity model is more rule of thumb than well-tested law. But even at the intuitive level, it has its detractors – especially, it should be noted, among UK economists who favoured Brexit. First, there is the difficulty of knowing which way causality runs. Ostensibly, big output by a country is assumed to generate trade. Almost as plausibly, causality may run the other way – the trade generates the output. Second, distance may matter less. That is partly because transport costs tend to fall, but also because the cultural differences associated with greater distance are diminishing as the world becomes increasingly connected. Additionally – and relevant for the UK’s trade – distance means less when services are being traded rather than goods. What do transport costs matter when services can be agreed and delivered, in one way or another, electronically? Yes, except that in those circumstances, the cultural differences might matter even more.

The gravity model can be tested, which, roughly speaking, is what the chart below does. Based on the UK’s exports for 2019, the latest year for comprehensive data, it shows the correlation between the distance that UK exports needed to travel (the chart’s horizontal axis) and the export revenue generated (the vertical axis). Its data are for 23 countries, 10 of the 11 TPP states, seven from the EU and six others, including China and India.

Happily, the chart’s regression line – the average position between all the data points – slopes downwards. In other words, the clear trend is for export revenue to fall as distance from customers increases. That said, the fit between the dots and the line is loose, meaning the variation around the average is high. The two outliers in the chart’s top left-hand corner, showing exports to Germany and France, illustrate the importance of big markets close by and heave the regression line upwards at the start of its ‘journey’. Meanwhile, substantial export business that the UK does with China and Australia serve to defy gravity’s effect and flatten the line’s slope.

The chart excludes data for the US, by far the UK’s biggest market, because it is such an outlier. The UK generated £204bn of revenue from the US in 2019, more than three times its next biggest customer (Germany). The problem with including the US is not that it undermines the gravity model – the line still slopes downwards – but that it causes the other data points to squash messily together at the bottom of the chart.

Nor does it matter much whether the correlation examined is between distance and total exports, just the export of goods, or revenue based on a per-capita measure, which reduces the effect of a customer country’s population size and amplifies its ability to buy. In all variations, on average exports diminish with distance.

What therefore is so attractive for the UK about joining a trade pact built around 11 far-away countries – the average distance of each one’s major city from London is just over 7,000 miles? What indeed. As Table 1 shows, it is not as if the TPP offers free-ish trade with particularly fast-growing economies. Sure, a weighted-average GDP growth rate of 1.8 per cent a year for the period 2011-19 is faster than the EU’s 1.4 per cent. But it is nothing to get excited about, coming in behind the US’s 2.2 per cent and even the UK’s 1.9 per cent. Given that the TPP is dominated by Japan, which accounts for half its $12.5tn output, pedestrian growth is almost inevitable. Japan’s growth has averaged 1.0 per cent, as sclerotic a pace as might be expected from a country where the median age is 49 – the world’s oldest bar Monaco – and almost 30 per cent of the population is over 65.

Yet Japan is already an important customer with whom the UK has a post-Brexit trade deal in place anyway (a cut-and-paste job from the EU’s deal with Japan) so membership of the TPP will bring little extra. Much the same might be said of the UK’s trading relationship with Australia, another TPP member, with whom the UK formalised a deal this week to predictable acclaim. None of these are reasons for the UK to forgo membership of the TPP. They just underscore the point that when all is signed off, the improvement in the UK’s export income will be marginal.

This comment will apply to almost all deals the UK government may make in the coming years, with the possible exception of the US. The two-way trade between the UK and the US is so big – £370bn in aggregate in 2019 – that a free-trade deal could make a difference. Yet, ironically, the US is the one country with whom the UK may not want a deal. Partly that’s because US trade negotiators have the reputation of taking no prisoners (you can do that when you represent the world’s biggest economy). Chiefly it is because, from the UK’s viewpoint, the trading relationship is fine as it is. The UK consistently runs its biggest trade surplus with the US. At £39bn in 2019, nowhere else comes close; trade with an aggregate of ‘residual Gulf Arabian countries’ takes second spot with a £12bn surplus.

Besides, as Table 2 shows and as everyone knows, the function of all trade deals the government can cobble together is to compensate for the present and future loss of trade from the UK’s closest and most important market, the EU. Of the UK’s top 15 overseas customers, as shown in the table, seven are EU countries, which together handed over £297bn of revenue in 2019. In all, EU states accounted for 41 per cent of the UK’s 2019 current-account income. Sure, that is well down on the peak ratio of 52 per cent hit in 2001, which may well indicate the direction of travel of the EU’s buying power. Even so, why hasten the decline?

That the decline in EU trade will continue is a given; what’s not known – and cannot be – is by how much and how fast. That said, the Centre for European Reform, a think tank, is making estimates. By comparing the UK’s actual global trade with the trade done by a ‘doppelganger UK’, using data from 22 similar countries, the centre reckons that cumulatively the UK’s trade was cut by about 10 per cent a month in the 54 months between the Brexit vote and leaving the EU in December. Since then, it thinks the gap has widened and was more like 11 per cent, or £8bn, in April.

Granted, there will never be a counterfactual to leaving the EU so we will never know for certain how much trade the UK loses; most likely, however, more than can be made up by any amount of political hyperbole.

bearbull@ft.com