Brexit economic opportunity from the perspective of the Minneapolis Fed
Whether economies prosper is determined by their economic policies. Size and factor endowments appear to have much less of a role in determining economic outcomes than the character of the policies that a political community pursues. Open and flexible economies that can adjust to changing circumstances do better than closed inflexible economies that resist change. That was the message the Prime Minister of Australia, Malcolm Turnbull, offered last week, when he collected Policy Exchange‘s Disraeli Prize. It is also consistent with the economic research literature.
An important aspect of openness is a willingness to accept and welcome foreign direct investment (FDI). Since the 1980s, the UK has generally welcomed FDI, and, as part of the freedom of the movement of capital — one of the four freedoms of the EU’s Single Market — the UK has been particularly open to FDI from other EU countries. Part of the economic critique of the UK’s decision to leave the EU is the potential negative consequences for flows of direct investment to the UK.
Macroeconomic models rooted in microeconomic analysis
The Federal Reserve Bank of Minneapolis, one of the Federal Reserve System’s twelve regional reserve banks, has a very good economics research department. It has, moreover, benefitted from a close collaboration with Edward Prescott. Prescott received the Nobel Prize in 2004 for research on the way in which economic agents adjust their behaviour to take account of what they expect policy makers to do, and the way that changes in technology and supply determine both long-term living standards and account for a significant part of the fluctuation in output over the business cycle. A distinctive part of his intellectual contribution to economics has been to provide macroeconomic models with stronger microeconomic foundations.
Research undertaken by the Minneapolis Fed has examined FDI and what Brexit may mean for the UK economy. Ellen McGrattan and Andrea Waddle’s paper, The Impact of Brexit on Foreign Investment and Production, explores different scenarios — from both the EU and the UK closing their doors to FDI investment flows, to the UK becoming more open to FDI from the rest of the world than at present. Following Policy Exchange’s own demonstration that the Treasury’s economic models of the impact of Brexit were overly pessimistic, it is worth reading the Minneapolis economists’ paper to be reassured that the UK’s economic future outside the EU is very much in our own hands.
Brexit from the perspective of a neoclassical general equilibrium model
McGrattan and Waddle use an analysis based on a multi-country neoclassical dynamic general equilibrium model, as distinct from a gravity model approach. The main features of this approach are that technology capital is accumulated from investments in R&D, brands and organisations. This type of capital is not location specific; it is often deployed by multinational firms in their foreign subsidies. At present, such capital can be deployed around the EU but after Brexit, doing so will potentially become more costly. The research team at the Minneapolis Fed set out to explore the implications of this for the EU and UK economies.
They looked at three scenarios: 1) the UK unilaterally imposing constraints on FDI into the UK; 2) both the UK and EU tightening restrictions on investment in both directions; 3) restrictions being imposed on FDI between the UK and EU, but the UK deciding to open itself to more investment from non-EU partners, starting with the US. In each of the stylised scenarios, the EU treats FDI in the same way that it treats FDI from Norway, which is not a full member of the EU.
In the scenarios predicated upon the ‘cut your nose to spite your face’ approach to public policy, the UK is damaged. Unilateral constraints imposed by the UK would reduce economic welfare in the UK by 3.6 per cent. A mutual imposition of constraints on FDI would probably do more harm to the EU than the UK. In the scenario where the EU and UK mutually impose constraints on FDI, the EU is hurt more than the UK, however. Higher costs result in UK firms lowering capital investment in technology capital and shutting down operations in EU subsidiaries. Given the number of countries in the EU, increased bilateral restraints on FDI have a greater impact on UK firms than EU firms. Output from UK firms falls at home and abroad, and the UK shifts from being a goods and services producer to being a lender financing the production of non-UK multilateral firms. The resulting net interest from these financial transactions offsets the drop in profits, and, as the Minneapolis Fed economists put it, ‘the UK ekes out a modest welfare gain of 0.3 per cent’.
In contrast, EU economies are significantly worse off in this scenario. The EU has to shore up its own technology capital in the absence of UK investments. The result is a welfare loss of 1.6 per cent on the assumption that the EU employs the restrictions on FDI that are comparable in terms of their burden to those that presently impede direct investment between the EU and Norway. The EU consumes less, works more, and produces less. In effect the erection of barriers to FDI transfers provides other economies a comparative advantage, which results in production shifting to Australia, the US and Canada.
A UK economy open to the world will have higher levels of economic welfare than the EU
In the third scenario — where the UK responds to an EU restriction on FDI by lowering its restrictions on new investment partners starting with the US — UK economic welfare rises by 2.3 per cent. In this scenario American multinational companies bring significant technology capital, increasing production. In the EU, welfare falls by 1.7 per cent. The UK then progressively opens itself to investment from Japan, China, and other countries — including the EU. Net exports boom, while UK citizens work less. Each new partner improves the economic performance, with the UK economy exhibiting rising consumption, increasing wages, and business output falling less than would have been the case under the second scenario: ‘as the UK opens investment globally, its welfare climbs to 4.8 per cent above the pre-Brexit level’.
This economic analysis from the Minneapolis Fed provides, as they point out, a notable contrast to work from other economists working in official organisations whose analysis of the consequences of Brexit have been uniformly pessimistic. They explain their optimism by noting that much of the existing literature employs historical data to estimate foreign investment in the UK as if it had never joined the EU. In their judgement, such backward-looking data may be ‘less applicable to a world of intangibles like R&D and brands’. It also neglects the impact of the cost of higher outflows of investment from the UK. They argue that, as the world’s fifth largest economy, with one of the leading financial centres, the UK could attract significant foreign investment from outside the EU. Being open to such investment will be the key to improving the UK’s economic well-being.