July 2017 newsletter – Letter from Germany: Brexit seen from Berlin II

Michael Burda, at Berlin’s Humboldt University, reports rather gloomily on the prospect for a UK economy faced simultaneously with the effects of Brexit and stagnating productivity growth.

A year later — and none the wiser. Writing in my Letter from Germany (June 2016, days before the referendum) I warned against the unforeseen consequences of Brexit. While I didn’t dare try to predict the outcome, I did say ‘there was a very real probability’ of a ‘leave’ vote, and that the consequences would be worse than we ever could have imagined. Sure, the UK recession hasn’t really started yet, because a 12 per cent drop in Sterling has cushioned the fall, but the macro data are not encouraging. And then we Yanks got Trumped. So it’s only natural for me to talk about Brexit again. I have a sinking feeling that things may still get much worse than they already are, before they get any better. This is because emotions, culture, traditions and other non-economic elements have taken over. Facts don’t seem to count for much, and experts even less. I came to Europe believing that wars were a thing of the past but it seems that trade wars have since become a distinct possibility. This is not going to be an academic letter, but rather a political-economic one. I am swimming in deep water, but it is a late submission and fortunately not refereed (except by the editor).

The context: I have just returned from the ECB Forum on Central Banking in Sintra, which felt more like a Forum for European economists simply to talk to each other. (The cacophony was unsurprisingly intense.) The overarching topic was ‘Investment and Productivity,’ a hat tip to recent speculation that we are in the middle of medium-term TFP and capital expenditure slowdown. Indeed, it is striking that productivity growth across the globe has slowed down so much. Figure 1 is a breathtaking picure presented by Robert Hall — showing the evolution of total factor productivity as an index centered on 2000.

As he points out, it is fascinating but at the same time unnerving to think that we economists are unable to explain the heterogeneity across countries. (Adding levels to the story using Hall-Jones estimates generally makes things worse, not better). There were some fascinating hypotheses put forward, all of which are pure speculation. But fact is fact: Measured TFP, using imperfectly measured GDP, capital stocks and labor inputs, is not only slowing down everywhere, but it is actually declining in some countries. And we know that it is not only ‘technology’ that represents a great dollop of distance to the frontier — poor infrastructure, overregulation, corruption, but most of all deficient implementation of best practices. If you don’t like TFP, we can look at another, less contentious measure of productivity, market output per hour worked, in figure 2. The correlation of level labor productivity withthe evolution of TFP since 2000 is striking. Taking these numbers at face value, the UK seems to suffer from the same productivity malaise as southern Europe, except that it has been able to grow by using (importing) a lot more capital (FDI) and keeping its labor force utilization high, but it is ‘fake news’ to claim that Britain is leading the TFP pack.

So what does this have to do with Brexit?
One of the thought-provoking talks in Sintra was given by Mariana Mazzucato, who argued that spurts in inventions, innovation and TFP come on the heels of deep commitments of the public sector to developing new ideas. Governments generally provide a hefty amount of coordination, financing or guarantees, and overall direction of developing new ideas (and rarely participate in the profits). Although usually a skeptic, I have to admit the evidence is convincing: the Apollo project and ARPANET were wildly important for all sorts of technologic advance. Yet I am reminded that World War II, the Manhattan project, the Vietnam conflict and 9-11 were also just as galvanizing in driving technological innovation. So one would hope that size and scale, and not another military adventure, holds the secret to restoring economic progress.

Brexit seems like such a bad idea already, but in the context of secularly stagnating productivity it looks positively atrocious. The horrible lesson of the last secular stagnation phase was that ‘war will do the trick’ of focusing innovative efforts. What will be the great project for Great Britain in the next two or three decades? Solving the common external European border problem? Preventing or at least coping with climate change? Developing the next generation of electric batteries? Achieving and commercializing sustainable nuclear fusion? These are all European projects, and being ‘in’ means being part of a large-scale approach to these challenges. Being out will either mean striking out alone, or jumping into bed with the Americans, who are unlikely to treat them as equals. Doesn’t look like an attractive way out of the slump.

The UK has less than two years to negotiate a proper exit from the EU. A well-conceived and orderly Brexit is essential for maintaining economic growth and prosperity, especially growth shared by a large fraction of the population. Yet as the negotiations proceed, it is hard not to conclude that Brexit will be messy, by any definition, and possibly very ugly.

Let me first talk about messiness. Naturally, it is never easy to enter into divorce proceedings with élan. Yet every wasted moment settling the division of the surplus and the responsibilities for the aftermath will mean more losses of output down the road, but just as important, lost effort and time so badly needed for innovative activity. I am increasingly convinced that lawyers and consultants — and their wasteful rent-seeking activities — are driving this process. As usual, Mancur Olson’s insights apply: concen-
trated interests with large investment in Brexit and a tough EU negotiating position will maintain momentum while those with reasons to oppose it — consumers, taxpayers and workers — are disorganized and will drop the ball.

Yet even being small and focused may not be sufficient. UK farmers already seem to have lost the public relations battle: as Charles Goodhart pointed out, sheep farmers will likely lose their agricultural subsidies and have to re-route their animals to the US. One of the most important drivers of UK productivity overall, finance and insurance, will almost surely suffer from the loss of European market access. One might argue that financialization is one root cause of the UK malaise, but this doesn’t seem quite right either, given the enormous success of London over the past quarter century. Being a wallet for China and India seems far-fetched in any case, especially if banks and clearing-houses are moving to the continent.

And then there is the ugliness. I am talking about ugliness on both sides of the Channel. The UK-EU dialogue is becoming increasingly poisoned by those who profit from misinformation and distraction. On the UK side, there is increasing anger over an estimated £60bn bill — honestly, peanuts in light of the potential trade losses. On the EU side, there is an obsession with making an example of the recalcitrant British to prevent a run to the exit. Brussels refuses to admit that Brexit was mostly about immigration, less about intrusive EU regulation, and not at all about the free movement of goods and services. The surge in migration was a result of Eastern accession and special deals made with…the Germans. Maybe it’s time to rewrite the EU’s ‘four freedoms’ —- maybe even with the UK’s help. Most economists agree that the set of acceptable alternatives to the hardest variants of Brexit are huge — the gains from UK-EU trade are simply enormous when the outside option is WTO status. What could be the issue here? I can’t help but think it is all about loss of face, resentment and recrimination. Europe has been here before, and often, in the past millennium.

In my last letter, I opined that the globalization inflection point had been reached or even exceeded in most OECD countries. Judging from opinion polls, society’s apparent lack of concern for the redistributive aspects of free trade and international labor market integration as well as economists’ own disregard for the compensation principle have alienated those who have lost ground due to these developments. But this insight doesn’t imply that the solution is to throw out the baby with the proverbial bathwater. I am hoping earnestly, but not optimistically, for a more conciliatory tone from both Brussels and London in the months to come. This means that the EU elite needs to make concessions to keep the UK as ‘in’ as possible. There are too many consumers, taxpayers, and workers who will suffer should hard Brexit come to pass.

Best regards from Berlin!

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