Should Brexit trade policy changes be delayed because of Covid-19?

Brexit has happened – but the nature of the UK’s future economic and political relationship with the European Union is yet to be determined. There is a strong case for extending the transition period to allow both sides to focus on dealing with the Covid-19 crisis.

The UK left the European Union (EU) on 31 January 2020. In this sense, Brexit has already happened. But the nature of the UK’s future economic and political relationship with the EU is yet to be determined. Under the terms of the UK’s withdrawal, we are currently in a standstill transition period until the end of 2020 while the future relationship is negotiated.

Agreeing the terms of the future relationship in a few months would be a tough challenge in the best of circumstances. With the UK entering a Covid-19-induced recession, both government and businesses have more pressing concerns than Brexit and a downturn is not the time to inflict further economic disruption.

Covid-19 may also affect trade and supply chains in ways that alter what the UK and the EU want from a deal. In these circumstances, there is a strong case for extending the transition period to allow both sides to focus on dealing with Covid-19 in the short term and reach a better agreement in the longer term.

What does evidence from economic research tell us?

Brexit is expected to make the UK worse off due to the introduction of new barriers to trade, investment and immigration between the UK and the EU. After 10-15 years, the UK’s income per capita is expected to be between 1% and 10% lower than if Brexit had not occurred.
The EU also faces economic losses as a consequence of Brexit, but as a share of income they will be many times lower than for the UK. Brexit will be less costly for the EU because it is a larger economy than the UK: UK-EU trade is more important to the UK than to the EU.
In the short run, Brexit will be more disruptive if the UK and the EU fail to reach an agreement on a new trading relationship, leading to sudden changes in trade barriers at the end of the transition period.
Brexit has already hurt the UK economy through slower GDP growth and higher inflation. UK GDP is estimated to be around 2% lower than it would have been if the UK had voted to remain in the EU (Born et al, 2019). But UK trade has yet to adjust to the prospect of higher barriers to doing business with the EU.

How reliable is the evidence?

Forecasting the effects of Brexit is complicated by the fact that it has no close historical precedent. In addition, we still do not know exactly how UK-EU relations will change once the transition period ends. Consequently, all estimates are subject to considerable uncertainty and should be treated with caution. Nevertheless, there is a strong consensus among economists that Brexit will hurt the UK economy (Sampson, 2017).

The consensus view is based on an extensive body of research documenting that higher trade barriers reduce trade (Fajgelbaum et al, 2020); and that lower trade reduces productive efficiency and income per capita (Frankel and Romer, 1999; Feyrer, 2018). There is also evidence that joining the EU in 1973 boosted the UK’s GDP per capita by 8.6% after 10 years (Campos et al, 2019).

Most Brexit forecasts are based on ‘general equilibrium’ trade models of the global economy. These models simulate Brexit as an increase in trade costs and calculate the consequences for trade and income in different countries and industries.

No model is a perfect representation of the real world. But the state-of-the-art models used to study Brexit (such as Dhingra et al, 2017) are designed to be consistent with key empirical regularities in trade data (Costinot and Rodriguez-Clare, 2014).

For example, these models incorporate a ‘gravity equation’ whereby trade flows are higher between bigger economies and smaller between countries that are more distant from each other. Gravity equations are known to explain a high share of variation in trade flows (Head and Mayer, 2014).

Less is known about how the economy will react to changes in UK-EU trade barriers in the short run. This uncertainty stems from the difficulty of predicting how quickly consumers and firms will adjust their behaviour, particularly in response to new non-tariff barriers and lower immigration from the EU. Ending the transition period is likely to be less disruptive if policy changes are announced in advance and phased in over time, allowing for a gradual adjustment.

The transition can be extended for up to two years if both sides agree, but the decision to extend must be taken before 1 July 2020. To date, the UK has ruled out extending the transition and has legislated to this effect – though the government could choose to reverse this legislation (Institute for Government, 2020). Once the July deadline has passed, extending the transition becomes more challenging, though with sufficient political will on both sides it could still be done.

If the UK and the EU fail to reach an agreement before the end of the transition period, then from 1 January 2021 onwards (or later if the transition is extended) each side will lose preferential access to the other’s market and trade will be governed by most-favoured nation market access commitments governed by the World Trade Organization (WTO). This means that tariffs will be charged on imports, goods trade will be subject to customs checks, producers may face different regulatory barriers in the UK and the EU, and many services firms will lose market access.

Why Covid-19 strengthens the case for extending the transition period

There are three main reasons why Covid-19 strengthens the case for extending the transition period.

Reason one: optimal policy should be countercyclical

As Keynes famously argued, governments should aim to smooth out economic fluctuations. This requires supporting the economy during downturns to reduce the costs caused by consumption volatility and unemployment. It follows that the best time to introduce a change that is expected to have negative economic consequences, such as introducing new trade barriers, is during good times – not when the economy is already struggling with the consequences of Covid-19.

Reason two: capacity constraints

A fundamental principle of economics is that resources are limited. Both government and businesses have limited capacity to deal with Covid-19 and Brexit simultaneously. At least for the new few months, overcoming the challenges posed by Covid-19 will be the most important priority for the UK government and UK firms.

For the government, this means that it will have fewer staff and less attention to devote to negotiations with the EU and to successfully implementing changes in policy once the transition ends.

For businesses, it means that managers and workers will have less time available to adapt to higher costs of trading with the EU. In some cases, staff responsible for the logistics of international trade may even have been furloughed. Extending the transition would allow the UK to focus on Covid-19 now, before turning its attention to Brexit later.

Reason three: information constraints

Trade agreements involve an exchange of market access commitments. For example, the UK could agree to tariff-free access for EU agricultural goods if the EU allows financial services firms to use the UK as a base to serve EU markets.

Determining the costs and benefits of alternative commitments requires a detailed knowledge of bilateral trade flows. But we do not yet know whether Covid-19 will have long-lasting effects on UK-EU trade patterns. Extending the transition period would enable the UK and the EU to learn about the trade consequences of Covid-19 before negotiating the future relationship.

What else do we need to know?

There is much that remains unknown. To understand the implications of Covid-19 for Brexit, we need to know not only how long the pandemic will last, but whether it will have permanent economic effects.

In particular, how will it affect European cross-border supply chains? And will it change the amount of trade between the UK and the EU, or which goods and services are traded? The data needed to answer these questions will start to become available over the next 12 months.

Focusing on Brexit, we do not have enough evidence on how quickly firms and trade flows will adjust to higher trade barriers, or on which non-tariff barriers have the biggest effects on trade. The aggregate economic effects of Brexit will also depend on the extent to which changes in trade costs affect UK productivity, about which relatively little is known.

Where can I find out more?

Brexit transition period: the Institute for Government provides an overview of what the transition period is and how it could be extended.

The consequences of Brexit for UK trade and living standards: Swati Dhingra, Gianmarco Ottaviano, Thomas Sampson and John Van Reenen analyse the likely long-run effects of Brexit on the UK economy.

Brexit: the economics of international disintegration: Thomas Sampson summarises research on the economic consequences of Brexit.

The economic impact of Boris Johnson’s Brexit proposals: the UK in a Changing Europe research programme evaluates the economic implications of Boris Johnson’s desired deal with the EU.