16 October 2018
‘“Brexit bonanza” for public finances ruled out by Watchdog.’ This was the headline of an article in the Financial Times on Friday 12th October. It followed the publication of a timely discussion paper (Discussion paper No.3: Brexit and the OBR’s forecasts, October 11th) by the Office of Budget Responsibility (OBR) ahead of Philip Hammond’s Budget on October 29th.
The Independent was even more apocalyptic. It focused on the OBR’s analogy comparing a “no-deal Brexit” with the impact of the three-day working week in 1974 which reduced national output by 3 per cent in one quarter. Yet the OBR’s throw-away comment was a misleading analogy not a prediction: the ‘three-day’ week was the result of a deliberate government policy to conserve electricity use in the face of striking miners, double digit inflation, quadrupled global oil prices, and a ‘global’ recession.
The OBR Report is weighty, but its conclusions have been misinterpreted by many journalists. Chapter 2, the meat of the report, is a comprehensive critical survey of a large number of studies of the impact of changes in tariff and non-tariff barriers (NTBs) on trade flows in general and some with specific reference to Brexit. It focuses on the predictions of gravity models which assume that trade between countries rises in proportion to relative GDP and falls in proportion to distance. The Treasury, for example, employed a gravity model pre-referendum. It predicted that moving from being a member of the EU to trading with the bloc under a Free Trade Agreement (FTA) would lower trade by 18 per cent. However, gravity models are based on data about what has happened in the past. They are not applicable to unknown situations such as the sixth largest economy in the world facing a comprehensive set of new trading rules and opportunities.
The impact of a change in tariffs and NTBs on GDP growth rates and, ultimately, on public finances are more usually handled using computable general equilibrium (CGE) models. The CGE approach analyses all markets together using disaggregated economic data. However, predictions about how a domestic economy responds to shocks, such as a new set of trade rules, depend on the modeller’s assumptions fed into them. The OBR report provides a survey of the predictions of most of the existing studies, but not the inputted assumptions. It states: “Most CGE analyses of Brexit have reached similar conclusions: leaving the EU is predicted to reduce the level of GDP from where it otherwise would have been, and the weaker the integration of the UK and the EU, the larger the loss. Relatively trade-intensive sectors – like motor vehicles – would be most heavily affected.” The OBR surveyed 16 CGE studies of the predicted impact on GDP of the UK facing additional trade barriers with the EU. The average fall was of 4.4 per cent under WTO rules, 3.3 per cent if Britain had an FTA deal and 2.3 per cent if the UK remained part of the European Economic Area.
So what did the OBR itself predict in its pre-Budget report? In reality, nothing new: “The broad-brush provisional forecast adjustments that we made in November 2016 reduced cumulative potential GDP growth between 2016 and 2021 by 2.4 percentage points relative to the level we would have assumed had the UK been set to remain in the EU…We have not updated these judgements since November 2016, while we await the result of the negotiations..”
The OBR did note that “one consequence of Brexit is that it will create scope for future changes in policy that are currently proscribed by our membership of the EU,” such as trade deals with non-EU nations or regulatory reform. “These could have significant consequences – positive or negative – for our forecasts, but we will only be able to incorporate such changes as and when they meet these criteria.” In other words, after they have happened. The report effectively concludes: “We do not know what will happen since we have not modified earlier assumptions about the impact of Brexit and we have not included any potentially positive impact on economic growth arising from a rise in non-EU trade, so we stuck to what we said before.”
The OBR was set up in 2010 in order to provide forecasts of the path of public finances independent of the Treasury. However, its forecasts are reliant on current Government policy. One can be sympathetic with the OBR’s current position. At present, the government’s final withdrawal policy is unclear as it depends on what Theresa May can sell to her divided Cabinet, to Euro-sceptics in the Conservative party, and to Parliament. The promise of a “Brexit dividend”, with an end to austerity and extra spending on the National Health Service, appears to be conditional on an agreement close to the Chequers plan.
The OBR promises to redo its sums when it has more policy information. “When concrete agreement is reached, we will make further adjustments as necessary, “ but it warns, “in doing so, we will be able to draw on the considerable volume of additional analysis conducted inside and outside government since November 2016 – key elements of which we review in this paper. “ By its own acknowledgements and through no fault of its own, the OBR’s report lacks the facts with which to make a full assessment of Britain’s economy post-Brexit; journalists should know better than to treat it as if it does.
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