In Box 3.1 of our November 2016 EFO, we discussed several channels through which the UK’s departure from the EU could affect potential output that were not explicitly incorporated into our forecast. This included moving to a less open economy – in terms of both trade and foreign direct investment – which could result in lower ‘total factor productivity’ (the amount of output an economy can produce from a given level of labour and capital inputs) than would otherwise be the case. For example, less openness to trade may reduce the competitive pressures on UK firms to adopt the most productive ways of operating and impede the process of specialisation. And reduced attractiveness to foreign investors could reduce the extent to which UK businesses can benefit from techniques and processes developed by foreign companies (‘technology transfer’).
There is a degree of consensus that leaving the EU will result in greater trade frictions in aggregate and that increasing trade frictions will reduce openness.a But there is much less agreement on whether, and by how much, reducing openness will affect productivity directly – for example, this channel was an important factor in the Treasury’s pre-referendum analysis, but NIESR chose not to include it. The Dutch fiscal council argued in its pre-referendum analysis that “Quantifying these dynamic effects has proven difficult, for two reasons. In the first place, it is difficult to capture the link between trade, knowledge transfer and innovation as one specific mechanism; the relationship is much more complex. Therefore, it is not easy to include in trade models. In the second place, empirical studies quantifying the effect are proven to be faced with a number of econometric problems.”b
The empirical evidence regarding the impact of openness on productivity is mostly drawn from cross-country growth regressions, where much of the information in the data derives from increasing trade intensity in developing countries. That experience may not be relevant to an advanced economy like the UK. There are also econometric qualifications attached to many of these studies, including the possibility that the openness measures may reflect the influence of omitted factors that drive cross-country productivity growth differences.c Finally, there are issues as to how openness is measured and whether the estimated elasticities can be applied to countries with a very different composition of trade; for example, the UK’s share of services in total exports is higher than in most countries and global trade has been liberalised less in services than goods.d
Moreover, much of the evidence relates to increases in openness and rather less to reductions, as would be the case with Brexit, and there may be asymmetries in the impact of changes in trade frictions. For example, one of the ways in which increased openness is thought to increase productivity is through knowledge spillovers, but reducing openness by introducing trade frictions should not lead businesses to forget what they already know. Finally, it is plausible that the productivity consequences of changes in openness will only become manifest over quite a long time horizon, certainly beyond our current five-year forecast limit.
For these reasons, we have chosen not to incorporate an explicit link from lower trade intensity after Brexit to lower productivity growth within our forecast horizon.