The UK, EU and the distance effect on trade

Despite the notion of hyper-globalisation, most trade happens with countries in close geographic proximity. Tendencies towards regionalisation and the UK’s strong dependence on EU imports seem to have been forgotten in the Brexit debate

A persistent feature of the Brexit debate is the conviction among Brexiteers that the UK will be able to offset any losses from trade with its European neighbours by striking global trade deals. This conviction is highly questionable when we consider that despite the notion of hyper-globalisation, most trade happens with countries in geographic proximity.

In economics, there are probably very few empirical results as persistent as the distance effect on bilateral trade. In an influential article, Anne-Célia Disdier and Keith Head analysed close to 1500 estimated distance effects in more than 100 papers. Their findings indicate that the negative impact of distance on trade increased during the middle of the twentieth century, and has remained high ever since. Contrary to arguments proclaiming hyper-globalisation as the new normal, this negative relationship between distance and trade persists today. As Colin Hay has argued, the case for hyper-globalisation simply does not hold, as ‘globalization is a tendency that has, in the majority of cases, been swamped in recent decades by a regionalizing counter-tendency’ (2016, p.309). The following graph from the World Trade Organisation’s international trade statistics 2012 illustrates how trade flows within regions are far greater than trade flows between regions.

Nevertheless, globalisation, in the sense of an integrated world market, remains a powerful idea – and despite strong counter-evidence it still lies at the heart of the arguments of those who believe that the UK will easily overcome any disadvantages from its economic disintegration with the European Union (EU), its closest and largest trading partner. We should be clear, there is no theoretical or empirical reason why the UK would overcome one of the most persistent tendencies in the global political economy. Furthermore, the UK has become incredibly dependent on European imports, and its finance-led growth model casts serious doubts as to what extent import substitution policies outside the customs union are likely to be effective over the years to come.

British trade with its European neighbours

The extent of British dependencies on EU imports can be visually shown through data discovery tools and for this blog, I have done this using data from the IMF’s Direction of Trade Statistics. Bilateral trade imbalances are usually computed as the surplus or deficit of every ith country with the partner country d in a given year t, in relation to the trade volume. This gives the following formula:

Trade Balanceidt = (Exportsidt – Importsidt) / (Exportsidt + Importsidt)

To illustrate which countries the UK is running a deficit or surplus with (rather than showing the partner country’s deficit or surplus with the UK), I multiplied the resulting vector with a factor of -1. The outcome is a trade imbalances scale that ranges from -1 to +1, whereby both extreme values indicate that the entire trade consists of imports or exports respectively. For example, if Country A exports goods for $10 billion to the UK, and the UK in turn exports goods valued at $5 billion. In this case, the UK is running a $5 billion deficit with Country A. As this deficit is put in relation to the total bilateral trade volume ($15 billion), the resulting value is -0.33. This example shows that the prima facie balanced value of -0.33 actually indicates a significant trade imbalance, as imports exceed exports by 100%.

The following animation shows the development of UK bilateral trade imbalances between 1999-2016. Countries shown in green are those that the UK ran a surplus with in that year. The red colour signifies a deficit, whereas the intensity of the colouring reflects the extent of these imbalances.

Whilst in 1999 the UK had comparatively balanced bilateral trade relationships and ran surpluses with most of Eastern Europe, this picture soon changed. By 2004, the UK had a deficit with almost every country in Europe, and these deficits largely intensified over time. In fact, since 2011, the only countries with whom the UK had a bilateral surplus were Estonia, Greece, Ireland, and Switzerland (though the latter turned into a deficit in 2016). With some of its most important trading partners, including France and Germany, these deficits became extremely large. In the case of the former, imports exceeded exports in 2016 by 46%, in the case of the latter, this figure climbed up to 117%, leaving the UK with a deficit of roughly $11 billion and more than $50 billion respectively. Overall, the trade deficit with the partner countries in the dataset increased from 1999 to 2016 by a factor of almost 5, from $37.02 billion to $178.63 billion.

Of course, one could argue that bilateral trade balances can also be result of, for instance, diverging savings rates, international capital flows, or distorted exchange rates. Furthermore, a deficit per se does not have to be necessarily bad. In fact, much depends on whether a country can borrow in their own currency to finance its deficit without generating too much inflation. However, problems do arise if an ideological bias against trade deficits and (often concomitant) current account deficits trigger austerity policies, and/or if the mode of production has simply degenerated so that a country becomes increasingly dependent on imports. In the case of the UK, one could argue that both of the above apply.

Whilst the UK government has implemented austerity policies from 2010 in response to the budget deficit, the fact that the UK constantly runs trade deficits with the vast majority of its European trading partners is an indication of a severe import dependency (in particular when considering that more than 50% of all of the UK’s trade is with its EU trading partners). The reasons for this lie, to a large extent, in the legacy of Thatcherism, which has devastated the industrial structure and left haute finance as the great master of economic policy. However, if the mode of production of an entire country depends on a group of people and institutions in financial services, the goods and services that people actually need have to be imported from elsewhere. That is not to say that finance is irrelevant, but an overly financialised economy extracts value from the ‘real economy’ and fosters a massive degeneration of productive capacities. If the UK leaves the customs union it seems highly unlikely that a drop in imports can be substituted by domestic production in the short-run, so prices are likely to rise and squeeze incomes at the bottom and middle of society. As far as the long-run is concerned, a lot depends on to what extent the UK manages to get rid of its excessive reliance on markets to solve its problems, and actively embraces a new industrial strategy. This challenge to return to a balanced economic development would be amplified outside the customs union, as British firms would face a significant competitive disadvantage with its main trading partners.