In recent days, we have again seen the UK economic establishment, notably the Bank of England and the Office of Budget Responsibility (OBR) claiming that Brexit will have a large negative long-term effect on the UK economy, cutting several percentage points off GDP (4% in the OBR assessment, even with a free trade deal).
As we noted two years ago, these kinds of claims rely heavily on an assumed link between trade ‘openness’ and productivity. Typically, negative effects of Brexit on productivity account for between a half and two-thirds of the total estimated effect on long-term GDP. You might think such massive estimated productivity effect must have a solid empirical foundation. But far from the trade-productivity link being well established in the economic literature, the evidence for its existence is at best inconclusive and at worst non-existent.
The first problem is that, even if a trade-productivity link can be shown, it is not obvious which way the causation runs – does higher trade lead to higher productivity or does higher productivity drive higher trade?
A literature review in Wales et al. (2018) suggests the weight of evidence favours the notion that productivity drives trade, noting that ‘there is considerably more evidence that more productive businesses choose to enter international markets. Evidence of the ‘learning through trade’ channel – which posits that businesses become more productive as a consequence of exposure to international markets – is scarcer’. Meanwhile the study by Frankel et al. (1999) – which uses sophisticated techniques to try to get round the causation problem and is cited in earlier Treasury studies – admits its results are ‘not very precisely estimated’ and only marginally statistically significant.
The second problem is that the association of trade and productivity growth found in many Brexit studies is frequently based on studying large samples of mostly emerging economies. For high income economies, and for the UK alone, no statistical link between trade and productivity is visible. For a sample of nineteen high-income OECD economies, there is zero correlation between growth in trade and growth in two measures of productivity between 1980 and 2019 (see charts 1 and 2).
Looking just at the UK, we observe that there seems to be no historical association of trade openness and productivity since the 1960s. Productivity growth actually dropped in the years immediately after the UK joined the EU in 1973, although trade openness (here measured as the share of exports of goods and services in GDP) rose modestly. More striking still, the decade or so after the inception of the EU single market in 1992 saw UK productivity growth flat despite a clear rise in the export to GDP ratio. And since 2007, UK productivity growth has slumped even as the export/GDP ratio has trended higher still (see chart 3).
A firm-level study by the ONS from 2018 also doesn’t support the notion that Brexit will lead to large negative effects on UK productivity. It shows that exporters to non-EU countries are about 20% more productive than non-exporting firms – but for exporters to the EU, the ‘productivity premium’ over non-exporting firms is minimal. The study also shows evidence of a negative link between export intensity and productivity. These findings make it hard to argue that reduced exports to the EU, resulting from Brexit, would have large negative effects on aggregate UK productivity.
Given the above, it should be clear that the strong trade to productivity link assumed in many Brexit studies is based on extremely shaky foundations. Indeed, given the nature of the evidence it is hard not to sympathise with Harvard economist Dani Rodrik who has dismissed productivity effects of this kind as ‘bells and whistles…used…to produce exaggerated benefits from trade agreements’.
As such, it is very disappointing to see the UK economic establishment lazily continuing to assert the existence of this trade-productivity link. Indeed, given how crucial this supposed link is to generating big negative effects on UK GDP from Brexit, asserting its existence in the face of strong evidence that it may not exist is worse than lazy – it is downright misleading.
Harry Western is the pen-name of a senior private sector economist.