Oral evidence: The UK's economic relationship with the EU, HC 473

Oral evidence, 3 December 2018.

Witnesses

Professor Jagjit Chadha, Roger Bootle and Dr Gemma Tetlow.

Chair

Good afternoon. I thank our three witnesses for being here for the first meaningful vote evidence session. Could you all introduce yourselves? I have reminded Committee members, and I remind the public, that you are not the Government; you will give your views on the analysis published by the Government and others, including the Bank of England. We are very grateful to you for your time and for being here. Mr Bootle, could you start by telling us who you are?

Roger Bootle

I am Roger Bootle, chairman of Capital Economics.

Professor Chadha

I am Jagjit Chadha, director of the National Institute of Economic and Social Research.

Dr Tetlow

I am Gemma Tetlow, chief economist at the Institute for Government.

Chair

Thank you. We have a series of questions and we will try to keep moving through them. We will try to direct questions to particular witnesses if we can, but if you want to put your point of view forward about something, we welcome that. I will start on the Government analysis; other Members will cover the Bank of England’s short-term analysis. Mr Bootle, do you agree with the Government’s analysis on the impact of the different scenarios published last week?

Roger Bootle

In broad terms, I do not. Let me start by saying that this is a subject beset by enormous uncertainty. I am sure the economists at the Treasury and the Bank have done an awful lot of solid work—you can see that they have. This is, however, a subject where the key thing is the assumptions you make and the questions you ask. There are some key issues where the analysis falls short. In particular, there seems to be no recognition of the fact that the EU is a relative economic failure. You would think we were contemplating various forms of exit from something that had been a stonking success—it has not been. You have to ask yourself why. In very brief terms, I can put forward an answer. It has not been a great success—it has been a relative economic failure—because it has made bad decisions, of which forming the euro was the most recent and damaging, but there is a whole host of them: excessive and bad regulations, and bad decisions on all counts, including its trade policy. I expect that moving away from such a failing organisation would bring benefits, but we do not see that reflected anywhere in this document.

Professor Chadha

I am honoured to be here to give evidence on this key question facing the country. The Government’s analysis of the various forms of exit that the UK faces is broadly in line with the institute’s own independent analysis of the impact of leaving the European Union. Essentially, the results are driven by the extent to which we think there are frictions imposed on what are broadly called the four freedoms of being in the European Union: goods, services, capital and labour. We have an economic model that tries to combine those inputs to lead to outputs, which is where the income of the economy broadly derives itself. Generally, we found that the openness towards the European Union has helped that process and would continue to help that process. The extent to which we impose frictions through some form of exit would tend to lead to a reduction in output relative to where we otherwise might be. The more frictions are imposed, the worst the relative outcome for the economy as opposed to alternatives. That is a conditional statement—it is not unconditional about everything else that might happen in the world. If we examine those frictions solely, that is the result we get, the Government get and the Bank gets—I should say very clearly—from independent modelling. This is not a combined effort by any means by Government economists, the Bank or the institute. It is a very clear result. I am happy to go into more detail about that later on.

Dr Tetlow

I very much echo what Jagjit said. My take on the Government’s analysis was that their results were broadly in line with what the vast majority of economic modelling suggests. As Jagjit said, this is independent modelling using different types of models and a range of different potential assumptions. All those models, including the Government’s, suggest that greater barriers to trade are likely to drag on economic growth—not lead to negative growth, but mean that the economy will grow less quickly than might otherwise happen. Broadly, for a number of reasons, economists judge that leaving the EU would, overall, lead to an increase in trade barriers with the EU and that those barriers would not necessarily be offset by any reduction in barriers with our other trading nations around the world. Overall, I would say it seemed in line with broad modelling. As Roger said, this is a very uncertain area; economic evidence and theory do not tell you precisely how much of an impact trade barriers might have on the economy, so the Government chose a set of assumptions. They did show sensitivity and uncertainty analysis to other plausible assumptions, which was very welcome. One point we picked up on was that the choice of assumptions tended to paint the White Paper proposals for the deal as being better than any of the other options on the table, and that was because of the particular set of assumptions that were chosen to go behind that. But, overall, the conclusion that all the Brexit options on the table would be less beneficial for the economy than remaining in the EU is in line with what the vast majority of other economists would say.

Chair

Do you think, Dr Tetlow, that those assumptions that have resulted, as you say, in the White Paper scenario looking perhaps most favourable—if that is the way to put it—are fair? I know there is a range of views, and we are going to hear them, but as a professional in the field of economics, do you think those assumptions are fair ones for Government economists to have used?

Dr Tetlow

There are a couple of points to make. One is that the main scenario that the analysis last week focused on was the White Paper proposals. Obviously, the withdrawal agreement and political declaration that have been published do not necessarily cover quite as deep a trading relationship as that White Paper envisaged, so we might think that some of those trade barriers may be slightly higher than the White Paper suggested. For that reason, it was good that they presented a sensitivity analysis with the 50% higher non-tariff barriers in that example. The specific assumption that seemed most questionable in the White Paper modelling—I don’t think it is completely implausible, but it was the one that seemed most surprising to me and other economists—was the scenario in which you have no customs barriers to goods but you are outside the single market for services. The Government analysis presented that as being better for the UK economy than a world in which we were in the single market for goods and services but facing some slightly higher customs barriers. That seems at odds with what some other people would have modelled as the White Paper versus EEA comparison.

Chair

Professor Chadha and Mr Bootle, do you agree? Are there assumptions made in the Government’s economic analysis that you would question? Mr Bootle, you are nodding.

Roger Bootle

Yes, there are. This issue really comes down to three major questions. First of all, what do you assume about free trade agreements that we might sign with the rest of the world, in two senses: first, what would the coverage be, and, secondly, what would the benefits be, of whatever agreements we came to sign? Secondly, what is the cost of frictions erected between the UK and the EU post our departure? Thirdly, what benefit, if any, can be ascribed to being able to set our own regulations once we leave the EU? Those are the three substantive issues, and on each of those the Treasury document produces an analysis that is, unsurprisingly—and I think very questionably—very negative in terms of the position of Britain once it has left the EU. On free trade agreements, in particular, it is a very negative set of assumptions, where the benefits to the UK of being able to sign free trade agreements with other countries come down to just 0.2% of GDP, which is out of line with its own assessment of the benefit of a free trade agreement with the EU and out of line with other people’s assessments of what happened with Australia. It just looks very odd. On frictions, if I may briefly mention them, there is quite a high value attributed to frictions, which is a combination of all the stuff at borders—paperwork, delays and so on and so forth—plus some other non-tariff barriers that are often very difficult to pin down. What I find unsatisfactory about this—it is a difficult area—is that it has used the usual economist techniques, but we have quite a lot of direct evidence from businesses such as ports, for instance, which tell you that border delays with trade outside the EU are incredibly minimal, with less than 3% of cargo inspected and documentation done electronically before transit. So I suspect, on these three key issues—I won’t go into regulation unless you ask me—it systematically overstates the costs and understates the benefits.

Chair

Professor Chadha, you might want to comment on the assumptions. I also want to ask you about the backstop, because I think the NIESR analysis is one of the only ones to have modelled the backstop as well. Obviously that is hugely politically contentious, but it may come to pass and could therefore have a bearing on our economy. I think your analysis indicates that having a backstop is more advantageous for growth than if the UK were to sign a free trade agreement with the EU. Could you just expand on that a bit?

Professor Chadha

Yes, of course. Perhaps I could say something briefly on free trade agreements, then I will come to the backstop right at the end? I won’t take very long to go through everything. There are a number of issues with free trade agreements. One is whether the free trade agreements that the UK can sign once it is outside the European Union are more advantageous for the UK than those it might be a party to, were it still in the European Union. It is not clear, actually, that the UK would or would not be able to participate in free trade agreements with the rest of the world, were it inside or outside the European Union. That is an important element. On top of any analysis of free trade agreements, one of the issues that we have had over the last two years is that even though we have not left the European Union yet, there has been a considerable degree of uncertainty about the mode by which we might leave the EU that has acted to dampen down on investment in the economy, both internally and foreign direct investment. The time it takes to agree any form of free trade agreement—whether we are outside the European Union, and on whatever terms—will continue to dampen activity in the same way, potentially for a prolonged period, whatever and however we end up with a particular form of free trade agreement at some point in the future. That is often missed when people discuss these things. The next question is really the extent to which regulation prevents trade or acts to help it—

Chair

That is how you are looking at the backstop—it is about regulation.

Professor Chadha

Yes, exactly. Often service trade is a function of a particular free trade agreement that says you have equivalent standards in either healthcare, legal care or accountancy, and particularly in banking. Some people might call that regulation, while others call it the maintenance of standards, and it tends to promote trade between countries in a way that is very important. To think that lowering or changing standards would lead to more trade is not quite right; the way to think about it is to ask: how happy would you be to have your teeth fixed by someone who was not regulated in the same way as in the European Union? I wouldn’t be particularly happy. I wouldn’t like to second-guess the views of those on the Committee, but it is something to bear very carefully in mind when one considers these things. You asked about where the institute has differed from the Government in its assumptions. [Interruption.] Looking at Table 1 in my written evidence, the Government’s analysis of further-away deals is slightly more damaging to the economy than that of the institute, because we have taken a more small-c conservative view of the impact on productivity. One of the important spill-overs from introducing frictions to trade is that it might impact on productivity enhancement in the economy. Trade encourages firms to move as close as possible to the productive possibility frontier. It encourages specialisation and learning by doing. To the extent that that gets limited, particular with wealthy European partners, it might reduce the capacity of the economy to grow its level of productivity. We take that as a risk rather than a central case, which is why our overall view of how bad things are is not quite as bad as the Government’s. We think that is very much a sign of different productivity assumptions. Our ranking of outcomes is identical to that of the Government.

Chair

Dr Tetlow, I want to ask you one final question about the political declaration. I think you have indicated in your evidence, and I agree, that the Government obviously modelled Chequers—the White Paper, including the political declaration—not what is actually on the table. Do you think that the outcomes the Government have looked at adequately represent the possibilities offered by the political declaration?

Dr Tetlow

I think that the scenario in which they included higher levels of non-tariff barriers than were envisaged in the Chequers proposal—

Chair

The sensitivity?

Dr Tetlow

Yes, the sensitivity, which was included in all the main analyses throughout the report, is maybe more what you want to have in mind. I think, on its own, the White Paper scenario was probably at the most positive end of the spectrum, given what is actually stated in the withdrawal agreement and political declaration.

Chair

Does anybody else have a view on the political declaration and what is or isn’t covered in the Government’s economic analysis? No? That is fine. Let me bring in Charlie.

Charlie Elphicke

Professor, I was reading the Bank of England paper that the Governor put out last week, which said that interest rates could go up dramatically, even to 5.5%. Is that in line with market expectations?

Professor Chadha

The Bank of England’s remit for monetary policy, as you will be more than fully aware, is to hit its inflation target of 2%. The Bank rate will be used both in terms of its level and as guidance as to its stance to try to hit that target over time. The particular stress scenario that the Bank portrayed should be thought of as exactly that. If there were a disorderly exit from the European Union, which impacted on the economy in quite a profound manner—we are aware of what that might be—the Bank has a responsibility to understand how the financial sector would respond to that. Is it able to continue to provide lending and allow people to continue their daily business? That stress test is therefore an extreme test of the system, in the same way as you might want to test a bridge under extreme circumstances to see whether it is going to hold together. The results of that stress test are encouraging. In terms of the Bank rate itself, there are a number of interest rates that might respond to a disorderly exit. One is the market interest rates: there might be risk on UK gilts. Recall that when Lehman Brothers collapsed in late 2008, the risk premium on UK gilts went up between 200 and 300 basis points. That serves to dampen activity in the economy. If we move away from the analysis of risk, the question for the Bank rate, in terms of the short-term interest rate, is: what would you have to do to stabilise inflation in the economy? The Bank would be faced with two things that were happening at the same time. The first is what economists like to call a negative supply shock, which is another way of saying that our productive capacity is likely to fall in the event of a disorderly exit. The second is a demand shock, where confidence, consumption and investment also respond in a negative manner because people are not sure about future profitability. Confidence may be hit, and there will be a great deal of uncertainty in the economy. The Bank’s immediate response will depend upon which one of those moves first and by how much. Generally, supply moves more gradually than demand, so what we might imagine under a disorderly exit is a world in which confidence is hit, and investment and consumption respond in such a way that the Bank rate may have to be cut in order to offset what economists call a negative output gap—demand is growing less quickly than capacity in the economy.

Charlie Elphicke

In other words, rates could go up or down.

Professor Chadha

I am sorry to say that that is the case.

Charlie Elphicke

Great.

Professor Chadha

I felt it important to outline the processes that are going on, in terms of setting that rate.

Roger Bootle

It is, of course, very difficult to put forward a worst-case scenario, which the Bank was trying to do—and, dear me, the case was pretty grim. To be helpful, the worst-case scenario should also be plausible, and I think the Bank’s worst-case scenario was thoroughly implausible. The chances of the Bank rate going up to 5.5% are extremely low. This would not, of course, be anything automatic; it is under the control of the Bank of England itself. What Mr Carney and the Bank are doing in this scenario is giving some idea of what plausibly they think the Bank of England might actually do. It rests on a number of assumptions. One is that the pound is going to take a very heavy hit. The Bank seems to pronounce with complete certainty that the pound is bound to be an awful lot lower. Well, a lifetime in the forecasting business has taught me not to be certain about anything, least of all exchange rates. I think the Bank was making an extraordinary judgment. If the pound were to fall a very long way, which I question, it would be open to the Bank to allow inflation to move briefly higher and to look through the rise in inflation, which is exactly what it has done in the past on similar occasions. I think this was thoroughly implausible and was designed to paint a blood-curdling scenario, in which house prices fall by 30%.

Charlie Elphicke

Mr Bootle, I think I noticed that, as the Governor was speaking, the pound rose. Did it surprise you that the pound rose as the Governor was making his “Project Fear” announcement?

Roger Bootle

As I said, nothing surprises me about the exchange markets. Maybe they thought that it made an outcome that they don’t find particularly palatable all the less likely. The key point about exchange markets is that you cannot judge them in the same way that the rest of this exercise is done, relative to some fixed, other-things-equal starting point. What is in the market—what is expected by the market—is absolutely critical to what happens to the exchange rate on the day.

Charlie Elphicke

Picking up on what you were saying about trade deals, Mr Bootle, I recall reading somewhere that when New Zealand joined the TPP, it thought it would result in X benefits—you know, £10 benefits—and in reality it resulted in much more benefits. Do you know much about that, and can you tell the Committee about it?

Roger Bootle

Sadly, I am not an expert on New Zealand trade. I will defer to other panel members for that, but it is true, not just for New Zealand but for a number of other countries as well. One of the strange things about the Treasury study, given that it is produced in a spirit that favours free trade and regards free trade between the EU and the UK as being so tremendously powerful and beneficial, is that when it comes to the UK signing agreements with others, you get these really rather minimal benefits coming through.

Charlie Elphicke

Dr Tetlow, can you say anything about trade deals?

Dr Tetlow

I am afraid I do not know the evidence from New Zealand.

Charlie Elphicke

Professor?

Professor Chadha

Briefly, the impact on New Zealand, certainly in the 1970s, was that it seemed to add to volatility overall in the economy, in terms of both inflation and output. I think the correct lesson to learn from there is that moving from a particular structure of trade, production and employment to something else quite radically different normally does lead to a period of volatility and losses in the economy as it adjusts. We are aware of many parts of the country that arguably still have not adjusted to the manufacturing losses in the 1980s, and we in the institute have done work that suggests that the scale of manufacturing employment losses has accelerated as trade has opened up to China and the A8. It is important to bear that in mind: even if we do something that is overall welfare enhancing, or even something that reduces welfare overall, there will still be important regional consequences that differ quite importantly. That is, to an extent, the New Zealand experience, which we can think of as a small region within a country. I also wanted to come back very briefly on Roger’s point about Bank rate going up or down. As I said, the correct way to think about the Bank’s analysis is not as a forecast of what would happen in the event of a disorderly exit, but very much as a stress test of the ability of the banking system to withstand an almost worst-case scenario. It got through that, and I encourage you to look at one of the charts that shows that lending continues at the same level throughout this period, according to the Bank’s stress test. That is incredibly important. You will, of course, remember the credit crunch in 2008. That was when the economy was hit by a shock, yet that shock was amplified because the financial system retracted credit at exactly the time that the economy needed it. That is an important point to bear in mind. Of course, we could sit here arguing about the path of the Bank rate—and you probably will, for many months. Depending on the shock, they could very well go up or down, but let us think about this as a stress test of our financial system. In that sense, it makes sense to think through a worst-case scenario, and I think the Bank did that.

Charlie Elphicke

Does anyone know what the assumptions are in the Treasury model, and could anyone here build the Treasury model, or are we just dependent on the Treasury telling us what its model produces?

Roger Bootle

Well, I would be interested to hear what the Treasury says about this, but the history of this whole episode is one in which the Treasury has shrouded its working in secrecy. Until recently, it did not admit which sort of model it was using. It was using some sort of gravity model approach in the 2016 so-called “Project Fear” forecast documents. It has moved away from that, which I think is an improvement. It turns out that it has now admitted the model that it is using, which is a computable general equilibrium model developed at Purdue University in Indiana, but it has not given full details of its assumptions. If it wants to be completely transparent—and this Committee could do a great public service by calling for this—it should actually open this model up to some outside experts. I am sure Jagjit would be one of those, but I suggest—dare I say it?—my own group, Economists for Free Trade, since we are depicted as an outlier in all these beautiful charts. Would it not be wonderful to invite us to use the self-same model that the Treasury uses, and to put in our own assumptions? Then you might see what influence the Treasury’s assumptions have had.

Charlie Elphicke

Just following on from that, one thing I am concerned about is that this document that we had from the Treasury produced various models. It produced Chequers, which everyone knows is not going to happen. It did not model a backstop, which I think is 50% likely to happen, or maybe higher. Could anyone model a backstop? The Treasury is refusing to model one.

Chair

I think that NIESR has.

Charlie Elphicke

Then can anyone tell us what the backstop produces as a model?

Professor Chadha

It produces a result somewhere between remaining in the European Union and leaving on the terms of the current Government’s plan on the table. It is somewhere between the two—that is what the backstop will produce.

Charlie Elphicke

Have you published that?

Professor Chadha

Yes, it was published last Monday. I thought we had sent it to the Committee; I apologise if you have not had time. I would be more than happy to go through that result with you subsequently if you wanted to. It is important when we look at the Government’s analysis that it is not the Treasury’s analysis. This should be correctly thought of as the analysis of the Government Economic Service. Economists in all Departments have got together to decide what analysis should be undertaken and what the results were. The results were independently done by Government economists and given over to Ministers in the end. It was not something that was determined by—if I can use the phrase—political masters, as far as I understand it. It was actually a very good example of cross-Whitehall modelling. I must state an interest in this to the extent to which the Treasury is a subscriber of the NiGEM, which is the institute’s national institute global econometric model. The NiGEM has a plug-in, which has a gravity model in there as well, and I think at various times the Treasury have used that to cross-check or calibrate some of the results they have been coming out with. The large part of HMG’s results that were published last Wednesday are from, as Roger rightly said, a computable general equilibrium model. The way to think about that is that, rather than top-down—what happens to inflation, output and Bank rate—it is bottom-up, sectorally speaking, about what is happening to the individual industries and adding them back up to the picture of the economy. That is not a bad way of thinking about a cross-check as to the aggregate numbers. It is interesting to us at the institute that the bottom-up approach came up with very similar rankings and, broadly speaking, very similar welfare losses as opposed to the various deals that might be on the table. Again, it is an industry-by-industry analysis. You could re-array the industries according to the strength they have in particular regions, which could give you a regional analysis. So imagine that the north-east is particularly strong in manufacturing and the south-east is particularly strong in financial services, you could re-orientate the sectoral analysis to a regional analysis. I have not seen that yet in the appendices. It might be of great interest to Members to see that exactly.

Dr Tetlow

In terms of the models that the Treasury has used, as Jagjit touched on, the pre-referendum analysis was done using a gravity assessment of the impact on trade and productivity, and then that was fed into the national institute model. The Treasury’s pre-referendum analysis spelt out quite clearly how its modelling worked. As Roger said, the more recent analysis uses a version of the GTAP model that was developed by a university in Indiana. My understanding is that the Treasury has tweaked that basic model to come up with something a bit bespoke for itself. I do not know whether anyone else has had access to that. The Treasury paper last week spelt out, I thought, pretty clearly exactly what assumptions had been fed into the model to come up with the results that they came up with. In fact, I think Roger’s evidence mentioned that Patrick Minford had taken that set of assumptions, put them into his own model and come with a similar result using a different model. That provides external observers with a sense that you can take the Treasury’s assumptions, put them into your own model, and understand the extent to which the assumptions, rather than the model, are driving the differences.

Chair

Roger is shaking his head.

Roger Bootle

Not this model, Gemma, because we did not have this model. As you rightly said, it has been tweaked, so we produced the same results with a model that we think is like this using different assumptions, but we cannot test on this particular model, because we do not have the full details.

Chair

I think that is what Dr Tetlow just said.

Charlie Elphicke

My final question, Mr Bootle, is, how can we be sure that the Treasury model is producing unbiased answers? On that, professor, you modelled an orderly no deal in which there is a fairly shallow recession before growth resumes in 2020. Do you think that the disruption of a no-deal Brexit could be mitigated?

Roger Bootle

I did not catch the last bit of the question.

Charlie Elphicke

To you, it was, how can we be sure that the Treasury model is producing unbiased answers?

Roger Bootle

I think we can never be sure with any model exercise. The fairest way of tackling this is a policy of complete openness, which the Treasury has moved in the direction of, but still not far enough. It will be good to know what tweaks it has done to the Purdue model. As I indicated earlier, it would be good to feed in a whole set of different assumptions supplied by other groups who take a different view. Then I think we could begin to get a reasonable handle on this.

Professor Chadha

We had an internal discussion about the extent to which we should think about an orderly no deal or a disorderly no deal. I refer you again to page 10 of the paper we published last week. What we did with the various scenarios was to calibrate the different forms of exit in terms of the impact on services trade, goods trade, foreign direct investment, net migration, labour productivity and the budget. That gave us a way of mapping any particular deal into our model. We did that in a linear way, with more frictions the more we moved away from the current system. Through our model and the responses of the whole economy and some monetary and fiscal responses, that gave us an overall view as to the long-run impact on GDP. A disorderly exit from the European Union is what economists generally call a sudden stop, which is when the economy hits its constraint and behaves in ways that we cannot fully understand because it is a crisis situation. There could be all kinds of non-linear responses, which we cannot necessarily get clear in our way of thinking about things. We decided the only way to do that was through a form of stress test. We wanted to do that, but we realised the Bank was going to do that. If we took a very extreme set of assumptions about what would happen as an economic scenario rather than a stress test, we felt that was essentially going to be ad hoc. If you had that extreme case, it would be impossible to imagine that fiscal and monetary policy would not also respond in a substantive manner under those circumstances. You would have had an extreme set of assumptions outside the scope of our model and, on top of that, another set of assumptions about extreme policy responses, potentially cancelling each other out to some degree and not saying very much at all. We therefore decided not to model a disorderly exit in that way, for those reasons. [Interruption.]

Chair

To the lady in the Public Gallery, the only people speaking are the witnesses and the members of the Committee. That is the second time you have interrupted. If you do so again, I will have to ask you to leave—[Interruption.] You are on your last warning. Thank you. Colin.

Colin Clark

Thank you, Chair. It’s not me who is on their last warning? Right—I was a bit worried there. I will be careful what I say. I want to speak about trade with the EU. The Government analysis finds that non-tariff barriers are by far the most important difference between WTO or FTA and the status quo. Do you think the size of the increase in non-tariff barriers under WTO or FTA is plausible?

Roger Bootle

It is just about plausible, but it is very much at one end. If I were asked to give a central fair estimate of how large that increase would be, I do not think this would be it. I would not say it is completely beyond the realms of possibility. You will appreciate that this is one of the dodgiest areas in an economic analysis of this whole question. Non-tariff barriers are very difficult to model and very difficult to measure.

Colin Clark

Is it comparable to an industry having to change its strategic supply or its strategic purchasing? It would have to consider whether there were going to be non-tariff barriers. If a company at the moment buys from Europe and it would have to buy outside the EU for some other reason—but companies do that all the time, don’t they?

Roger Bootle

Yes. I go back to what I said earlier about frictions, of which non-tariff barriers are one possible type. The fact of the matter is that in the modern world, companies switch remarkably easily. Indeed, in my evidence I mention the power of substitution, which in the modern economy appears to have grown. I think it has grown for very powerful, deep-seated reasons. Quite simply, there are more substitutes around and we know more about them. Whatever these barriers are, I anticipate companies being able to get around them much more easily than would have been true in the past, and more easily than the Treasury document suggests. But pinning down precisely how large the barriers will be is extremely difficult.

Colin Clark

Given the size of the increase in EU non-tariff barriers, are the consequences for GDP plausible?

Professor Chadha

I think I agree with Roger to the extent that it is hard to calibrate exactly the impact of non-tariff barriers, but we were able to use evidence from people such as the UK Trade Policy Observatory and others who have done work to try to understand both the increase in non-tariff barriers in the last decade and where they might go vis-à-vis trade with the European Union and elsewhere. We were able to add those to the tariff barriers to get some idea of the impact of what economists call the elasticity with trade with respect to changes in those costs. Again, what we did here was to nest ourselves within the literature, rather than going off to estimate these things ourselves. It was a question of collecting what was out there in terms of the growth of tariffs and non-tariff barriers, and looking at how unlikely exports and imports were to respond to that. Roger is of course right that nimble industries will be very good out there at trying to find alternate supply, but for the businesses we speak to, trusted relationships are also very important. They can take a long time to develop, as can reputation, and it is not always the case that people want to change supplier overnight. It is often a gradual process, the search costs of which are very large as well. There may well be more importance attached to non-tariff barriers than one might think from a casual inspection of how firms may respond to a change in the trade arrangements.

Colin Clark

But you would agree with Mr Bootle that industry is much more global than it used to be, and that companies change their suppliers much more dynamically than perhaps 20 or 30 years ago.

Professor Chadha

If you think directly of transport costs, which would also include the use of digital media, we must be in a world in which it is easier to source things that it was in the past. That does not mean that it does not still take time to develop trust in relationships with suppliers, and to ensure that the quality of what is provided is consistently good.

Colin Clark

What I am trying to get at is that we have identified non-tariff barriers with the EU, but for companies in the last 10 or 15 years, when you think of the technical industry and how dynamic they are about purchasing from China or other countries, transport did not seem to come into it. Are non-tariff barriers as significant an issue as the Government report is trying to suggest? Are we not modelling on history, rather than the future?

Professor Chadha

I understand. One of the clearest results in modern economics is the idea that distance matters in trade. When people try to understand the volume of bilateral trade, even despite the digital revolution that we have had and, as you have said, the excellence of firms in trying to find alternate suppliers, the distance is still an important determinate of the extent of trade between nations. Even if a country in another part of the world grew to the same size as the European Union, we would not expect there to be the same level of trade. There are still costs involved because of distance, the establishment of trust and the need to continue to check the quality of the things that are provided.

Colin Clark

Mr Bootle, would you like to come back?

Roger Bootle

Briefly, I mentioned in my written evidence that I thought the performance of countries outside the EU in selling into the EU is relevant here. There has been a lot of work done by a chap called Michael Burrage, and I made reference to three of his pieces in the written evidence. It is quite striking how well countries around the world have sold into the single market from outside the single market, in terms of both the level and the rate of increase of their sales. Indeed, the rate of increase of their sales is greater than almost all single market member countries to other single market member countries. I think that is very suggestive. We know that the EU common external tariff is pretty low for most things—about 3% on manufactured goods, although higher for agricultural things—but non-tariff barriers, as we have been saying, are very difficult to estimate. My point is quite simply that if these non-tariff barriers were really so difficult, or were insurmountable because they were so high, how is it that the trading performance of all these countries around the world is so impressive selling into the European Union?

Colin Clark

Just on that point, Dr Tetlow, you mentioned the post-Brexit estimate where they said that GDP would drop by 6% and it has grown by 3.2%. What does that say about the analysis then, and the analysis now? What has changed?

Dr Tetlow

It is quite important to draw a distinction between attempts that have been made to forecast the short-term impact of the vote for Brexit and, now, Brexit itself versus the longer-term impact. Economic theory and evidence has much more to say about the potential longer-term impacts—in other words, once the UK has adapted to a new trading relationship with the EU, how much larger or smaller the UK economy would be than in a world in the future in which it is a member of the EU. That is a comparative exercise where all you are changing is the trading relationship between the EU and the UK. Obviously, in practice how fast the UK is going to grow over the next 15 years or so years will be impacted by a huge number of other factors. In contrast, the short-term exercise that the Treasury was doing before the vote to leave the EU was about how much the UK economy was going to grow over a short period of time. Even there it is worth pointing out that the Treasury forecast was much more pessimistic than most other independent forecasters at the time were suggesting. I think NIESR’s forecast for UK growth in the event of a leave vote was much more optimistic than the Treasury’s; I believe it did not include a recession. The Treasury forecast was relatively at the pessimistic end of the scale. I think a more relevant question to ask, looking back, is not necessarily “How did the Treasury forecast compare with what happened in practice?”, but “How might the economy have grown had the vote gone the other way?” It is a very difficult counter-factual to answer, but people have tried looking at this in a number of ways, in particular by trying to construct a synthetic UK using the performance of other countries over the same period. That suggests that the economy has grown less quickly than would have been the case.

Colin Clark

Would you agree that companies that take a medium to long-term view— The UK in the first half of 2018 was the second biggest inward investment destination, so what are you actually saying? Are you saying that industry is taking a different view? If they are making inward investment, they must think that the UK is potentially the right economy to come to.

Dr Tetlow

I come back to the point that the question is not “Are industries still investing?”, but “How much more or less would they be investing had the vote gone the other way?”

Colin Clark

But if we were the second best destination after China, that must say something, mustn’t it?

Dr Tetlow

The UK has been a strong recipient of foreign direct investment for a very long time.

Colin Clark

That is my point.

Dr Tetlow

I have not looked at this myself, but the most recent comprehensive analysis of it that I have seen was from the UK Trade Policy Observatory.

Professor Chadha

The institute thought in May 2016 that if we were to vote to leave the European Union, two and a half years later GDP would be somewhere between 2% and 3% lower than it would otherwise have been in level terms. That was the institute’s view in May 2016, and it has broadly turned out to be the consensus view two and a half years later that the level of GDP is some 2% to 3% lower. What has that been driven by? Even though we have not left the European Union yet, evidence suggests that investment has been 3% lower in each of those two years than it would otherwise have been—that is from a survey. The so-called decision maker panel developed by the Bank of England looks at the impact of exactly the firms that were investing on the basis of their surveys, and they have seen that 3% drop in each of those two years. Also, we have talked about the stock of FDI, but on the growth of FDI, let me first say that inward foreign direct investment is a very volatile series and is often determined by a very small number of choices that drive it up or down. But it looks as if since the tail end of 2016, inward FDI has fallen from something like 10% of GDP to around 3% of GDP—there has been a fall. I am not necessarily arguing, because we have not done the work to sustain this, that it is absolutely connected to the uncertainty over leaving the European Union. However, in conjunction with the fall in investment that has been identified, it is certainly indicative of a reduction in investment that has been driving the lower level of GDP that we have seen.

Colin Clark

Before I move on to the next question, do you want to come in, Mr Bootle?

Roger Bootle

It is, of course, impossible to tell what investment or GDP would have been without the referendum vote, because we lack the counter-factual—that is a problem that besets all of economics. By contrast we do know, or sort of know, what happened to GDP, which is that it grew rather than falling into a recession the way the Treasury forecast. So the big difference here—the really big story—is undoubtedly the fact that the Treasury got this out-turn horrendously wrong. Was there an impact? We will never know the answer definitely. On investment, I concede that it is possible that there was, but the overall impact is tiny compared with what the Treasury thought. Of course, it was not only about GDP; the Treasury also forecast that there would be a huge rise in unemployment, which has not happened.

Colin Clark

I am conscious of time. The Government analysis finds that unilateral free trade, in which the UK imposed no tariffs on imports from around the world, would increase GDP by 0.8%. Is this a larger or smaller benefit than you would have expected, professor?

Professor Chadha

I am not familiar with that result in the Government analysis—that it would increase GDP by that amount.

Colin Clark

So what do you think would happen?

Professor Chadha

A reduction in tariffs to completely free trade would severely impact on import-competing industries in the UK. Whether we think that would be a long-run benefit or not would depend on how overall prices respond to that. There is analysis published in the past by Economists for Free Trade, who suggest that prices in the UK are some 10% above where they should be because of tariffs and that we would be much better off if tariffs fell back. Actually, the external tariffs on average in the UK are around 3%, if we weight them by imports. They are much lower than that 10%. A lot of the price differences are to do with the quality of goods that our consumers want here, as opposed to the ones abroad. A good example would be that it is not clear that the price of shoes is going to be the same always and everywhere, because you might want very different shoes. The weather today would imply that I should be wearing a stout brogue rather than a sandal. Of course, a sandal is going to be considerably cheaper, so it is not clear that all prices would fall to the prices that we would see overseas, if we went down to tariffs. There would be two kinds of problems with the analysis that suggests that we would be better off from moving to free trade. One is that it is not clear that all prices would adjust downwards, because of heterogeneity of production. Secondly, a lot of what we do requires us to put things together, to produce in the way that we do, and if we disrupted that in an important way, by going to free trade, it may take a lot of time for us as an economy to adjust to that, which could lead to quite important transitional effects.

Colin Clark

Mr Bootle, on that basis, what do you think the effect would be?

Roger Bootle

I think it is quite plausible that the effect would be much better than that, but I do believe that the best result for the UK would be to achieve widespread, deep and meaningful free trade agreements around the world. Therefore, the choice between unilateral free trade and free trade agreements depends a lot, I think, on how successful we would be in getting free trade agreements. It is quite clear to me that a policy of unilateral free trade is a viable one and one that has not, I think, received enough attention. One of the benefits is that you can do it yourself. You don’t need years of wrangling and negotiations. You simply declare a policy of no tariff.

Colin Clark

It has been estimated by Lawyers for Britain that of the £95 billion imbalance we have with the EU, it could be costing us as much as £16 billion. It would make products £16 billion cheaper. That would have an enormous effect on the economy, wouldn’t it?

Roger Bootle

It would be significant. I think “enormous” is an exaggeration, but it would be significant.

Dr Tetlow

In terms of unilateral free trade, I am just eye-balling the figures the Treasury had. I think their estimate is probably similar—in the ballpark—to what the LSE team came up with in their previous analysis of the difference between WTO and unilateral free trade scenarios. As Roger and Jagjit touched on, I think a large part of the question about the benefits of unilateral free trade would be less about the abolition of tariff barriers but, as one of the previous questions alluded to, actually it is non-tariff barriers to trade that are much more costly these days. The question would be the extent to which the UK could unilaterally remove non-tariff barriers to trade, and that comes down to the questions of quality and product that the UK would let in, as Jagjit talked about.

Chair

That 0.8% figure, which I was looking for too, is in figure E.3 of the Government’s analysis. We are all learning at the same time.

Rushanara Ali

Good afternoon. Trade with the rest of the world is the focus of my questions. Despite a series of potentially optimistic assumptions, the Government’s analysis shows almost no increase in GDP—under 0.25% from new trade deals, compared with today’s arrangements. How can this be the case? Perhaps Mr Bootle, you could start.

Roger Bootle

It surprised me as well and I remarked on it earlier on. I think it is because the Treasury seems to assume that we don’t manage to succeed to conclude very many free trade agreements and that there is a peculiar assumption that those that we are, as it were, in the process of concluding are not actually concluded during the project period. The net result is that we don’t actually have much coverage of free trade agreements around the world. I think that is the key assumption that they make.

Rushanara Ali

How much trade do we do with the rest of the world compared to the EU at the moment? In your expert opinion, how much do you see that increasing by in the coming years, once we are in a position to get those deals?

Roger Bootle

Roughly speaking, the shares are about 45% for the EU and 55% for the non-EU. This is to some extent a matter of contention, because there is some suggestion that the EU share may be overstated by the direction of trade of goods through Antwerp and Rotterdam that is destined for outside the EU, but let’s say roughly 45:55. The European share has been falling quite markedly over recent decades, and I suspect that would continue anyway, even if we stayed in the EU. That is to do with the fact that the EU has been growing more slowly than the rest of the world. Your question, I guess, addresses the issue relative to that underlying trend: what would the change be as a result of leaving the EU? I can’t give you numbers, but I suspect that we are talking about a few more percentage points three or four years out, let’s say, compared with what would in any case have been a trend continuing in that direction. Jagjit, I would be interested in what your view is.

Professor Chadha

Roger is right about the broad shares of trade between the EU and the rest of the world. I would go back to the point he made about the gravity model. What tends to determine bilateral trade is the size of income in a country and its geography or distance from another part of the world. Brussels is around 200 miles from London. The BRICs are each several thousand miles away from London and, depending on the formulation of the equation you write down, that means that they are going to have to be much larger than Europe in order to get the same level of trade. That is the essential reason why you don’t get the compensating increase in exports and imports from the rest of the world that you would lose on leaving the European Union. So we are starting from the position that they are, in size, smaller than the European Union, and even if they are growing more quickly at the moment, it is still going to take some 10 to 20 years for them to grow to the levels of the EU if that divergence remains. But what actually happens as an economy grows is that the growth rate tends to fall, because it tends to grow at the same rate as the advanced economies in the world, so I would expect their growth rates to fall, but even if they get to the point at which they are the same size, the distance and geography is still going to mean they are not going to compensate to the same degree. On top of all that is that, as well as distance, the negotiation of a free trade agreement in goods and services, by itself, despite the distance, also matters for the extent of trade, and these agreements are very difficult to arrange. You will know very well on this Committee how long it takes to arrange such agreements. And then the question is: is it easier to arrange those agreements if you are within the EU or as a single country standing alone? That is an important question that you might want to pursue with others.

Rushanara Ali

Dr Tetlow, do you think that we have sufficient numbers of trade negotiators to complete the number of trade deals required in time? The Government’s analysis assumes successful trade negotiations with the US, Australia, New Zealand, Malaysia, Brunei, China, India—the list goes on; I’m not going to list them all, because you’re familiar with them. Is that realistic or are we kidding ourselves in thinking that because we are Global Britain and because we have had historical relationships with many of these countries, they are just going to roll over and let us have these deals within the timeframe set out? Mr Bootle mentioned three or four years, not two years, so there are cost implications that he acknowledges. What is your assessment of where we are in terms of getting these trade deals?

Dr Tetlow

I’m afraid I don’t know the numbers of trade negotiators that we have at the moment. Obviously, one problem at the moment is that because we do not know exactly what relationship the UK will have with the EU, it is hard to know what sorts of deals might be possible with non-EU countries and, in particular, which sorts of regulations we may be able to change to more closely align ourselves with other countries. We have not yet seen any countries come out with firm offers of exactly what they would be prepared to offer the UK and, from past experience, we know it takes many years to negotiate deep free trade agreements, so it certainly isn’t going to be on day one that we have all the benefits of free trade agreements opening up to us. One point that is worth bearing in mind is that there has been a lot of discussion about the ability to regain control over our own rules and regulations and take that back from Brussels, but modern free trade agreements are much less about getting rid of tariff barriers, because they are already pretty low for a lot of countries, particularly a country like the US, and much more about the ability of countries to talk to one another and agree that they will take a similar approach to regulations and standards and so be able to remove some of the non-tariff barriers together. So while we may have more control, away from Brussels, modern free trade agreements require you to come to an agreement and cede in some sense that sovereignty to another country to align your production approaches.

Rushanara Ali

In conclusion, none of you can see trade deals, as set out by the Government, within the timeframe that we would expect them to be set up.

Roger Bootle

That would not be my conclusion, actually.

Rushanara Ali

You did say three to four years.

Roger Bootle

I was trying to choose a period in which I thought a certain effect would be clear. That was not a forecast, to quote the Treasury. I want to comment, if I may, on your very interesting point about trade negotiators. I don’t want to pretend that signing free trade agreements will be a walk in the park—it’s not. That is one of the reasons why I think the unilateral free trade idea is not to be dismissed lightly. However, I would be very surprised if a major barrier to getting free trade agreements was a shortage of negotiators. This is yet another benefit of globalisation: if you haven’t got them, you can hire them in from outside. We seem to have done the same thing with the Governor of the Bank of England. We didn’t have enough national candidates, so we brought one in from Canada. We can hire the best trade negotiators from around the world.

Chair

That does sort of depend on the immigration White Paper.

Roger Bootle

That is true. I accept that.

Chair

We don’t know what that will say. On the other point that has not really been discussed, do you agree that it depends on parliamentary scrutiny, which is something that this Parliament hasn’t done for 40 years, and on how politically contentious the terms of a trade deal are? I’m thinking about TTIP and the discussions around the NHS, for example.

Roger Bootle

Absolutely. I agree.

Rushanara Ali

On its visit to the US, this Committee met a number of trade experts from the US who made it pretty clear that it wasn’t going to be a walk in the park—far from it. I think people should be realistic about what should be expected. You might have seen a Sky report over the weekend about trade envoys’ perspective on this and the impact of the uncertainty, and the length of time and painstaking work that goes into trying to build the relationships. I think we need to be realistic about expectations. On the analysis, the Government have announced that they assume a roll-over of all EU free trade agreements to which the UK is currently a party, including those that have been implemented or provisionally applied, such as with Chile or South Korea, and those agreed and yet to be ratified or implemented, such as with Japan. Is it realistic to expect that all those countries will freely allow the UK to roll over their existing trade deals? Or do you see them wanting and attempting to renegotiate, given that we are leaving?

Professor Chadha

It is obvious that every country will want to do what it perceives to be in its national interest. We have had a number of people from various countries talk about their plans in the institute. I am not going to say which countries they are, but it is clear that they would want to rethink the relationship, rather than necessarily rolling over. I am not a legal expert, so I don’t know the extent to which these things could be rolled over, but I think that countries would want to look again at the terms of trade. Any initial agreement was always framed with the UK being a member of the European Union in mind. Once the UK has left the European Union, the new deal on the table is, by its nature, a very different beast.

Rushanara Ali

Do you expect those countries to see the UK very much in need of—desperate for, some would say—free trade agreements with those countries, and therefore that they have much more leverage over this country, given that we need to get those deals? Who would like to come in? Anyone can come in.

Chair

Are these questions that you feel—obviously you are here as economists rather than trade negotiators. I think they are legitimate questions for the Committee to ask, but you are perfectly entitled—I don’t want to lead you—to say that this is outside your experience.

Rushanara Ali

But if you would like to answer, please do.

Dr Tetlow

I have no particular insight on the political machinations of the other countries. I suppose that one point that is important to make in terms of how these free trade agreements might be rolled over, even if that were to be done, is that if you took those free trade agreements and simply deleted “EU” and put in “UK”, there is still a question about the rules of origin of the product that would qualify under those free trade agreements. That is a nitty-gritty point of trade analysis, but quite important in terms of whether UK producers would be able to qualify for those benefits.

Roger Bootle

Like Jagjit, I am no lawyer. But I understand from people who are that there is a difference between different agreements. For some, the roll-over is pretty much automatic, and for a whole series of others it is anything but automatic. That distinction needs to be borne in mind. Of course, as Jagjit says, all these countries will be self-interested—why would they not be?—and so might well, if they were able to, reopen things in their own interests. However, I think it is quite wrong to have this vision of little old Britain sailing on these choppy seas, as opposed to being protected by this wonderful, powerful negotiator, the EU. The fact of the matter is that the EU is a very bad negotiator of trade deals. That is documented. It is very difficult to get an agreement with the EU, partly because there are so many different countries; its very size can be a problem. It is interesting that a number of studies have shown that several small countries around the world have been very successful at concluding free trade agreements. I am not suggesting that it will be easy, but I do not accept the notion that we will be all at sea and helpless and hopeless.

Rushanara Ali

On that point, can I just contend that it is quite wrong—

Chair

If this your final question, Rushanara?

Rushanara Ali

It is linked; this is the preamble, and then I will ask the final question. Would it not be quite wrong for Britain to have a post-imperial complex and to expect these countries to roll over and make deals with us? India, China and a bunch of other countries, as others have already pointed out, will act in their self-interest. If Britain can meet those interests, they might be able to do business together. Perhaps we should have a reality check about that. My final question is: why do you think that the Economists for Free Trade model is much more optimistic than other models about the prospects for economic growth? Did you want to add anything else to the points you have made?

Roger Bootle

First, having a post-imperial complex is always a bad thing, not just with regard to trade issues. I do not think that those of us who think that Britain will be in quite a strong position to negotiate free trade agreements remotely suffer from a post-imperial complex of any sort. Depending on how you measure it, we are still the fifth or sixth largest economy in the world. Although we are not big, neither are we tiny. We have quite a lot to offer. I have forgotten what your question was.

Rushanara Ali

My question was about the Economists for Free Trade model and its greater optimism than other models about prospects for economic growth. Did you want to add anything else to why that is the case, on top of what you have already said?

Roger Bootle

I don’t think so. The details of the model are published and available, so in the interests of time I will leave this to others.

Dr Tetlow

We wrote a paper trying to round up why different people came to different conclusions. Our broad conclusion was that the Economists for Free Trade model of unilateral free trade came up with a much more positive answer because, compared with other modelling, it assumed that there would be no increase in trade barriers between the UK and the EU, even if the UK were to leave with no deal. Conversely, it assumed that there would be a very big reduction in non-tariff barriers and tariffs with other countries by our adopting completely unilateral free trade—in fact, the complete removal of all non-tariff barriers with the rest of the world.

Professor Chadha

I completely agree with Gemma’s analysis of the Economists for Free Trade model. One thing, as the institute thinks about forecasting and trying to think of scenarios and other areas, is that there is a central case—a most likely outcome—in terms of what we think will be the impact on the economy. The central case is, as I said right at the beginning, some increase in frictions that will dampen activity and lead to subdued levels of activity, as opposed to the alternative. If you take some extreme assumptions about the reduction in prices from free trade and the ability to trade with the rest of the world in a very powerful way, you may be able to replicate the Economists for Free Trade analysis. If you take another set of extreme assumptions—that reducing frictions impacts very heavily on productivity and that policy does not respond in a way to attenuate the impact on demand—you maybe can get the Treasury analysis from before. However, I would be wary of people who forecast extremes. We always try to cautiously understand the processes and come to a central view. That is why our forecasts, or our understandings, have generally been in the mid-range of the scenarios.

Rushanara Ali

So we should follow your forecasts?

Professor Chadha

No; that is not exactly what I was trying to say. I was simply trying to say that people should follow the reasoning, and then if they wish to deviate, because they have some strong views, they can.

Chair

This is to all three of you. We started this set of questions with Rushanara talking about the balance between EU trade and rest-of-the-world trade. If you look at page 52 of the Government’s economic analysis, table 4.2 is the summary of the UK-EU trade volume impacts, compared with today’s arrangements. I would be particularly interested in your perspective on that, Mr Bootle. In all scenarios, trade goes down for UK exports and imports to and from the EU, and it goes up slightly in terms of rest-of-the-world total trade volumes. Do you agree with that—perhaps not the specific numbers, but the idea that you lose more to and from the EU than you gain from the rest of the world in the different scenarios? Do you have a thought on that?

Roger Bootle

It goes back to what we were saying earlier. These are the numbers relating to the issues that we were discussing earlier.

Chair

It goes back to the assumptions.

Roger Bootle

Exactly. As we discussed earlier, on the one hand there is the cost of the frictions and the non-trade barriers, and on the other hand there is the ability to get free trade agreements or unilateral free trade. This is just the numerical expression of those assumptions.

Chair

If the assumptions were to be changed, the numbers might change.

Roger Bootle

You would get different results.

Catherine McKinnell

The Government’s analysis has also touched on the impact differentiations on different sectors in the economy. Manufacturing could be hit harder than services in any Brexit scenario. The Bank analysis suggests that there will be a permanent loss of productivity as the UK pivots away from the goods and services that it has been exporting and towards those that it is importing. Do you agree with those two assertions? If so, what do you see to be the long-term impact of those on the UK’s competitiveness?

Dr Tetlow

In terms of the impact on different sectors, broadly the picture painted by the Government’s analysis seemed sensible. The one thing I would say is that the economic evidence base is probably stronger on what happens to goods and manufacturing than it is on services. Largely that is because, in the past, a lot of free trade agreements have focused on removing barriers to the goods trade, and historically manufacturing and goods has made up a larger part of the economy, so more of the evidence relates to that. Whereas the White Paper was very ambitious about retaining a common rule book on goods, it was less clear, for many of the service sector areas, exactly what the future arrangement with the EU will look like. For goods, trade barriers are often about some additional costs to trade, but for services, you can have some areas where there could be a complete lack of market access. If you do not get recognition of your qualifications, you simply cannot serve in that market. It is a bit harder to model the economics of that than the extra costs on goods.

Professor Chadha

I think I would agree with Gemma’s analysis. I will say something about productivity briefly, rather than just repeat that. We have taken a cautious view of the impact of trade on productivity, but the literature is probably a bit stronger than the institute’s view, in that deeper trade is an important part of productivity growth. It helps firms to specialise and exploit natural factor endowments in a country. It means that the fastest-growing firms, with good, new technologies, are able to grow and develop their ideas in the face of global competition. That means that trade and productivity tend to go hand in hand. If we add in knowledge transfers from inward FDI, as well as the fact that it is a promoter of productivity, it seems likely, if leaving the European Union crimps our trade and there is not a substitute, at least in the foreseeable future, from trade in the rest of the world, that productivity will be less than it would otherwise be. That is on top of the productivity trap, as it has been well described, that the UK has found itself in for the past 10 years or so. Its level of productivity is 15% to 20% below the trend that was established prior to the financial crisis. We can argue about whether the trend was appropriate or not, but we have underperformed for a long time, and the fact that trade is potentially going to be crimped, at least for some time, is going to make that problem more intractable, rather than less.

Roger Bootle

Manufacturing versus services is a very difficult judgment. It is clear, while I might be concerned that manufacturing suffers particularly—it had tariffs imposed on it, for a start, whereas services had not—there are some points in the other direction. If the pound does weaken—I said earlier that that was to be debated—that would give some relief to manufacturing. Traditionally, the pound is thought to be more relevant to manufacturing than services. Britain runs a huge deficit with regard to goods with the EU. If we are both imposing the common external tariff on each other’s exports, which we must presume we would be doing, that would tend to reduce trade in both directions. In net terms, that would give a bit of a boost to demand in the UK as demand deflected from imports from the EU towards domestic production, but it is not all one way. Productivity is a very difficult issue, and I fully accept what Jagjit was saying, but it is worth bearing in mind that Professor Paul Krugman, who has been quoted extensively on this recently, does not accept the link between trade and productivity. Indeed, he took issue with the Government’s assessment of the question and the weight they put on it. He thinks that if trade contracts, there will not be a very big impact on productivity.

Catherine McKinnell

Obviously the impacts are not uniform across sectors or regions in the UK. The Government’s analysis suggests that every Brexit scenario they have modelled will leave every region and nation of the UK worse off. Roger, do you agree with that analysis?

Roger Bootle

Well, no, in the sense that the fact that it leaves every sector, region and nation worse off is just the sectoral and regional statement of the earlier conclusion that it will make us worse off. If you do not accept that, you would be able to get a different regional distribution. It does not surprise me that if you have a negative overall outcome as in the document there is not a single region that is better off, but I do not think that is significant.

Catherine McKinnell

And you don’t think more regions may be more at risk than others or more susceptible to some of the impacts than others.

Roger Bootle

I think that is clearly likely, yes, but a lot depends on the detail. As I understand it, the Treasury is particularly negative about the north-east, which obviously depends on a particular view about the car industry. That is clearly a major concern, but if one did not accept the Treasury’s analysis of what would happen to the car industry, one would end up with a different result.

Dr Tetlow

On this point about sectors and everyone being affected, generally speaking the economic analysis suggests that most sectors are affected in the same way as the aggregate result. As Roger said, if it is bad for the economy as a whole, it is bad for most sectors, and vice versa. There are a couple of industries that are expected to buck the trend. In particular, and as Roger alluded to, in scenarios where you imposed EU most favoured nation or WTO tariffs on imports to the UK, most economists predict that the agricultural sector in the UK would do relatively well. That is precisely for the reason Roger mentioned: the cost of food coming in would go up so much that people would buy more domestically. The food processing industry is another one that some of the studies have found to be affected.

Catherine McKinnell

They would do better relative to the current situation.

Dr Tetlow

Relative to what would happen to them in the EU. The benefit for that industry would be outweighed by costs elsewhere, or vice versa, in the models. In the Economists for Free Trade’s analysis of unilateral free trade, that scenario would mean you would have more cheap agricultural products coming in from outside the EU. Similarly, while the UK as a whole would benefit in the Economists for Free Trade modelling, it could be problematic for the agricultural sector and manufacturing.

Catherine McKinnell

Adding to that, it would also be helpful to understand whether you think that there will be difficulties for some regions more than others—the north-east has been cited as an example—in recovering from some of the impacts of Brexit. What timeframes might we be looking at?

Professor Chadha

The analysis we have done at the regional level comes to very similar results to the Government. The extent to which a particular industry has strong import or export competition from the European Union—they are the ones that will be damaged the most. We produced a map to understand how that impacts. I said earlier, for example, that financial services would affect London and the south-east, and manufacturing would be particularly affected in the north-east. The question is that no region seems to do better than it would otherwise, which is something I think that we would all agree on in terms of the analysis that we have on the table. Then the question is, “What kind of policies would we want to put in place to deal with that?” That is very much about education, retraining, and infrastructure that would allow the economies to adapt to the new arrangements.

Catherine McKinnell

That sounds like it will take a little while.

Professor Chadha

It is going to take a little while and a generation to develop. If I could hark back to the de-industrial episode of the 1980s that I touched upon moments ago, I would argue that there are still regions in the UK that have not fully recovered from that process. So we are talking about things that will take a generation or so to solve. To some extent, given the concordance across—some would say—most economists on the impact of leaving the European Union, there needs to be some thought as to what should be done for the regions that we think are going to be affected the most by that. That is a process that should actually be started alongside the exit process, which may yet go on for a couple more years, it would seem to me.

Catherine McKinnell

That goes some way towards answering the other question that I was going to ask, which I will put to you, Gemma. Do you think there is a risk of structural unemployment resulting from this and, in terms of the different Brexit impact scenarios, how do you think that is reflected in the Government’s analysis? I also want to ask about real wages and the predicted impact on those. The Government’s analysis suggests as much as 10% in a no deal scenario and 6% under a free-trade agreement. Does your analysis show that such an impact is likely, and how will that interplay with employment and the potential rise in unemployment, and real wages, in regions like the north-east?

Dr Tetlow

I think that how different parts of the country will be affected is a combination of both the sort of economic activity going on in those areas at the moment and how that is affected by Brexit, and how those areas are able to adapt. If an industry becomes relatively less competitive after Brexit, are those people able to find jobs doing something else? I think that is an important question to ask, precisely for the reason that Jagjit mentioned; Government policy could do something to mitigate some of those impacts and make the transition easier. There was some interesting analysis from the Institute for Fiscal Studies that pointed out that in some of the particularly industrial areas of the country, some of the people who might be most affected are relatively low-skilled older men with quite firm specific skills at the moment. You might be more worried about that group of people becoming unemployed and leading to the structural unemployment questions that you were talking about and that we saw post-deindustrialisation in the 1980s, compared to, for example, younger workers with higher levels of education, who may be able to readapt their skills elsewhere more easily.

Professor Chadha

The long-run analysis that we and the Government have presented is really going from a full employment level to another full employment level that we envisage in the future. There is no permanent increase in unemployment in this story. We are kind of going from one equilibrium to another, but because within that, productivity is not growing as fast as it might otherwise, you are not seeing the same end point in real wages. Real wages are falling by a similar amount to the counterfactual for output. So you have got the some number of people employed, but at a lower level of productivity, which means that the overall level of output in the economy is different. In that sense, there is no unemployment story here, because we are going from equilibrium to equilibrium. Materially, people are worse off in the sense that, under the basic scenario, we are at around 3% of GDP per head lower. That is a measure of how much worse off people are under these scenarios—by around £1,000 a year—compared to the alternative.

Roger Bootle

I do not disagree with what has just been said, but frankly that is not news. The consequences for wages in this document, which have just been discussed, are inevitable given that GDP is lower than in the base case. It is just a restatement of exactly that, deriving precisely from all the facts, as were discussing before. There is nothing specific going on here that shows that it is sensible to assume full employment. If you are convinced that GDP is going to be hit in the way that the Treasury suggests, then there is inevitably going to be that effect on real wages. There is no avoiding it. Equally, dare I say it, if Economists for Free Trade is right about there being a benefit, I am prepared to bet that there would also be an increase in real wages, which follows, pretty much inexorably, from GDP.

Chair

An interesting experiment for our population.

Mr Clarke

One question on trade, and then I will move on to regulatory issues. The trade question concerns new trade deals that the EU might strike while the UK was in a customs backstop with the EU. In that situation, the UK would have to offer the same tariff schedule as the rest of the EU to that third country, but I think I am right in saying that the third country would not have to reciprocate to the UK. Is that correct?

Professor Chadha

I am not sure I am able to confirm that.

Mr Clarke

Is anyone able to confirm it?

Roger Bootle

I cannot confirm it, but that was my understanding as well.

Dr Tetlow

That is my understanding as well, but—

Mr Clarke

That is certainly my understanding. It is not a trick question; it is my understanding. That being so, the question that flows from that is: doesn’t that mean that third countries would have no incentive to offer the UK any trade deals for as long as we remained in the backstop, because they could effectively get access to our market via the EU without needing a bilateral agreement with us?

Dr Tetlow

The customs union and that statement obviously applies to goods, or whatever was covered by the backstop customs union. There might be scope for discussions around the services trade that would not be covered by that backstop.

Mr Clarke

Does anyone else have anything to add on that point?

Professor Chadha

To the extent to which any third country accepted that at some point we would not be covered by the backstop, they would have an incentive to start a discussion about what it would look like on exit from the backstop. Countries are forward-looking in that sense; they are not going to be looking at only the current circumstance. Given what we said earlier—that any of these negotiations are, if not quite geological time, then certainly decades long—countries that were looking ahead would want to start that process, it seems to me, rather than ignore it just because we are under a backstop.

Mr Clarke

Let’s pray it is not geological time; that would be depressing. On regulation, the Government’s analysis suggests that some flexibility is assumed for the UK to determine our regulatory policy, but that increases GDP by only 0.1%. Dr Tetlow, is that overly pessimistic?

Dr Tetlow

That is broadly in line with what some other economists have concluded. For example, Oxford Economics, in the analysis that they published before the referendum, came up with a similar figure. Other people have put larger numbers on that. Open Europe published a paper in which they described a politically realistic figure as 0.7% of GDP, but that did involve a set of loosening regulations around the working time directive, environmental standards, and some other product standards. It is important to be clear about exactly what regulations we think could be loosened. It is also important to remember that some regulations have economic benefits, not economic costs. We have competition policy, for example, because we think that is actually beneficial to the economy, not the reverse.

Mr Clarke

Absolutely. Mr Bootle, do you accept the 0.1% figure?

Roger Bootle

No, I think it is remarkably low. I agree with most of what Gemma has just said. Unfortunately, this is one of the areas of economics where it is very difficult to get hard and fast answers—that tends to be the case with all the really important things, in my experience. I do wonder whether there is a bias among economists to underestimate the importance of regulation. I am very much reminded that before the privatisation of the 1980s the conventional wisdom among most professional economists was that ownership does not matter. Then we had privatisation, which resulted in a huge burst of productivity, and various other things, some of which were not necessarily desirable. Anyway, it was quite clear that ownership really does matter. That is very much my instinct about regulation. There are two difficulties here. One is that we do not know, of course, which regulations would be rescinded. Secondly, we do not know quite what the impact would be. There have to be assumptions on both those things—not an easy area.

Mr Clarke

Professor Chadha, could you give examples of regulation that could be reduced that you think would stimulate economic growth?

Professor Chadha

The thing about regulation is that it seems to me to be an irregular verb. I have standards; you have regulation.

Mr Clarke

Yes. Classic Sir Humphrey—I agree.

Professor Chadha

Exactly. I think we would have to do it market by market to understand where regulations have helped trade, as I mentioned earlier, and where further deregulation may help trade. I have not comprehensively gone through all the markets to understand where it might help and where it might not help. We have had the example of agriculture, where some deregulation may help, but again my understanding of the agricultural sector in the UK is that it is relatively productive and performs reasonably well, so there may not be the scope for the returns that you may find in other areas. I think the whole of regulation policy is, as Roger says, incredibly complicated and there may be different objectives across every sector, so it is very hard for me to summarise briefly here.

Roger Bootle

There is a whole host of regulations that you could mention. I will mention just a few. There is the European working time directive, which is pretty important, the agency workers directive and one that may not seem very important and is quite specific, but I think is indicative of a trend that spreads broadly across the economy: the clinical trials directive, which, as the name suggests, affects your ability to conduct trials of certain drugs and treatments. Various medical experts are on the record as saying how restrictive this is. Obviously, the EU is not being stupid or vindictive; the reason is that it adopts the so-called precautionary principle and it is very tough. That extends across a whole series of other things. One could imagine a regulatory regime that is still pretty good at protecting the consumer’s interest but is not going so far down the precautionary line.

Mr Clarke

Dr Tetlow, do you have any thoughts on this?

Dr Tetlow

I don’t have particular thoughts, no.

Mr Clarke

In fairness, that is entirely excusable; it is quite an esoteric line of questioning. One issue of regulatory divergence that I have looked at quite closely is the concept of free ports, which has attracted a great deal of attention. My own region of Teesside, Teesport, would be an obvious contender for that status, were it to be awarded. What is your view on the potential for free ports to provide an economic boost in a regulatory divergent world?

Dr Tetlow

This is not an area I have looked at in any great detail. My guess would be that it would provide benefit to that area, because it allows firms to effectively bypass regulatory requirements to send the goods on elsewhere. I don’t know what the evidence would be from other free port areas, but my question would be the extent to which that diverts trade from elsewhere in a country or a region.

Mr Clarke

You are quite right, and that is also the Treasury’s question—the extent to which it is deflecting rather than genuinely increasing trade.

Roger Bootle

I am no expert on free ports, but that would be precisely my response, because even if it were just deflecting rather than generating new activity, that is not necessarily a conclusive argument against it. If you want to deliver support to a particular town or region, maybe you have to do some deflection. It is potentially something you would want to consider, but I am no expert.

Mr Clarke

Professor Chadha, NIESR’s analysis includes a 25% reduction in trade with the EU under the backstop. Given that the backstop is designed to remove friction at the border—that is one of its few redeeming features, as far as I can see—why is that such a significant drop, in your opinion?

Professor Chadha

It is the drop that we assume would occur once we have left the single market.

Mr Clarke

But why would it be quite that marked?

Professor Chadha

We have econometric estimates that try to disentangle the impact of free trade, the single market and distance, and the central point of that literature would suggest a fall of that magnitude, in the sense that, if you controlled for everything else and you just joined the single market, that would be the boost to trade you would see from that. This is assuming a symmetrical fall of the same amount. Where I would agree with you is the extent to which there may be an asymmetry: having established that level of trade, which Paul Krugman and others have called a beachhead, would it necessarily be the case that it would fall by the same amount? Within the context of our analysis, which is impartial and following the literature, we decided to present that symmetric result. I should say that, on the other side, what we did to balance that was to take a more cautious view on the impact on productivity. We are making a bunch of assumptions.

Mr Clarke

Am I right in thinking that the analysis in this regard is predicated on Switzerland? Is that correct?

Professor Chadha

It is very close to that, yes.

Mr Clarke

Does Switzerland trade substantially less with the EU than would be expected for an economy of its size and location?

Professor Chadha

I don’t think so.

Mr Clarke

Mr Bootle, what is your take on the idea of a 25% reduction in trade under the backstop? Does that seem reasonable to you?

Roger Bootle

It seemed to me to be extraordinarily high, I have to say. Of course, most of my analysis focuses on the option of leaving under WTO rules as against the EU, but yes, I would have thought that reduction looks to be high.

Mr Clarke

The final question is about the future impact of EU regulation. Obviously, we will lose the ability to shape that. How dangerous do you think that could be for UK business?

Dr Tetlow

There is certainly an important question of how EU regulations evolve without the UK at the table. I think there is evidence that the UK has pressed for a more economically liberal approach in some areas than other EU countries have been inclined to do. My impression is that it probably varies across areas of economic activity. There are some areas, particularly around financial regulation, where the UK clearly is very much a world leader and quite a big player in the international regulatory framework. In other areas, the UK may have much less sway and may be much more likely to have to follow whichever regulatory direction the EU takes if it wants to trade with the EU.

Professor Chadha

Could you just restate the question?

Mr Clarke

It was about the extent to which we are at risk, by dint of our not being a member state of the European Union, from future regulatory changes that we might otherwise have prevented.

Professor Chadha

Gemma is right that we have had considerable influence in EU regulation. Having left, there may be an extent to which other countries may want to pursue similar views to ours—I could think of the Irish and German states having similar views to ours in many areas. That may continue to the extent to which we continue to have strong relationships with them. The loss in influence may not be as great as people suggest, but I think there would be a loss of influence.

Roger Bootle

It depends what position we are in. If we are in the position outlined by the Prime Minister’s deal, that is a very dangerous situation whereby we have left the EU and lost our voice and our influence over these regulations but are still subject to them, perhaps for many years into the future. That is a very big risk. If we leave the EU cleanly and are no longer subject to those regulations, it does not matter, in the sense that businesses that trade directly with the EU have to obey those regulations with regard to the goods they try to sell in the EU—that is true of selling to any market. In that regard, our influence might be greater than if we sat at the table. If the EU begins to over-regulate, which I suggest it is likely to do on past form, and the UK does not go down that path, we will gain a competitive advantage. Over the years, as that competitive advantage becomes clear, I think the EU might be dragged in our direction.

Mr Clarke

Thank you very much.

Alison McGovern

I have some questions on the impact on public finances, but before I come to those brief questions I want to ask whether anyone has any particular thoughts that the Committee should be aware of on why the Government have chosen to model Chequers rather than what we are actually voting on.

Dr Tetlow

It is not clear to me why that was presented as the central case.

Roger Bootle

It is not clear to me, but can I make a speculative suggestion? It is because this work has been going on for a very long time—basically since Chequers—and the recent set-up has emerged only fairly recently.

Professor Chadha

Given the cross-departmental nature of the work, I imagine that is a fairly good answer.

Alison McGovern

Mr Bootle, if I may, I have a follow-up from your response to the question asked by my colleague Catherine McKinnell on disaggregation of the scenarios. Dr Tetlow mentioned the work by the IFS about the impact on the specific group in the population. Has your pro-Brexit group of economists done any work on that disaggregation—on who might be impacted in what ways? Ought we to assume that, essentially, your results are at the aggregate level and cannot be understand from a regional or other disaggregated basis?

Roger Bootle

We have done some work to look at disaggregate totals, for instance services, manufacturing and agriculture—those sorts of things. I could be wrong, but I do not think we have done anything on regional disaggregation. I do not think at this level that is particularly important—not that the regional issue is not important, because clearly it is. They key point is that if you accept the conclusion—I realise others in the panel do not—that we will be better off overall if we leave the EU, even if particular regions are disadvantaged, you have something with which to compensate the regions that are disadvantaged, so you are not made worse off, clearly. If you are made worse off by leaving the EU, and particular regions are made especially worse off, you have a big problem.

Alison McGovern

I will leave that there. I just wanted to know whether you had, in fact, done any work on that question. To return to the public finances, Dr Tetlow, the Government say that the reductions in contributions to the EU budget are greater than the combined costs incurred from the continued selective funding of some EU programmes and the creation of any necessary UK bodies to fulfil the functions that have been carried out by the EU. Has the IFG carried out any specific work looking at that?

Dr Tetlow

We have not attempted to estimate that ourselves. The Government’s position is very much consistent with the fact that the UK makes a net contribution each year to the EU, so even after you take account of the UK’s rebate, the money that comes back for agriculture and all the other grants that UK recipients receive, in particular through research, the UK makes something like a 0.4% of GDP net contribution to the EU each year. I do not think there is a lot of disagreement about that figure, actually, across from Economists for Free Trade to anyone else.

Alison McGovern

To come back to the point about the functions, clearly there is funding programmes and the carrying out of functions. Do you think anybody has an analysis of how costly or otherwise creating new bodies and the administration of those functions might be?

Dr Tetlow

It is probably worth drawing a distinction between the upfront costs of creating those bodies, which no doubt would be quite expensive, if the UK was not able to participate in any of those European institutions, versus the ongoing costs of running them. I am afraid I have not seen a figure for an estimate of all those running costs.

Alison McGovern

That is fine; that is helpful. Professor Chadha, in each of the NIESR scenarios, the debt-to-GDP ratio increases. Could you explain the mechanism for that?

Professor Chadha

Yes. The story is not about any extra subsidies or transfers to the European Union; it is simply a lower level of GDP and the response of automatic stabilisers within the economy leading to higher debt-to-GDP.

Alison McGovern

Does that mean that there will not be a deal dividend?

Professor Chadha

Well, the deal dividend—I hear these things going round—is in terms of output responding in a positive manner to the dividend. What we have seen, as I said earlier, is in the last two years, output has been subdued relative to what we might have anticipated, as investment has responded to the level of uncertainty in the economy. If we had an agreement of a deal, at least some element of that uncertainty would be removed and therefore, that might allow some investment to come back that otherwise would have been lost. That said, there will still continue to be uncertainty. We have a chart in the analysis that I have sent in that describes the different scenarios that might still obtain. Even after an agreement now—were we to reach one—there would still be uncertainty as to exactly what form of agreement the UK would have in the future. We would still expect that to have an impact on investment in the same way, perhaps over a longer period.

Alison McGovern

Could you point us to any of your evidence that demonstrates what proportion of the impact is due to just the GDP effect—the growth effect—and what proportion of the increase might be due to increased Government spending, be it the automatic stabilisers or other factors of Government spending that might reasonably be thought to have to increase?

Professor Chadha

You want me to tell you exactly how much is the response of fiscal policy, as opposed to just a fall in output. Let me see if I can find that.

Chair

Do you want to come back to that?

Professor Chadha

Yes, can I check and come back to you on that?

Alison McGovern

Unfortunately, my next question was also for Professor Chadha, but let me ask a general question of others and then let us come back to that, because I think it would be helpful. The Government’s work is silent on policy changes that might be required. We have somewhat discussed fiscal responses when it comes to dealing with frictional unemployment or replacing agencies or functions that might cease to occur, either under a deal or no-deal situation. Could I just ask any of you for thoughts on fiscal responses you might expect the Government to take, particularly in response to some of the frictional problems that, as we know, can have permanent consequences?

Dr Tetlow

A few thoughts. I suppose one thing is that the sorts of impacts that economists predict for Brexit are not the sort of temporary recessionary impact that we might have seen before. In the financial crisis period, there was a sudden cutback in personal and corporate spending, and the Government responded through a package of measures aimed at targeting money at low-income families to help them spend more, and the temporary VAT cut, for example, to encourage people to spend money today rather than delaying it. We are probably not talking about fiscal responses of that sort, because businesses and consumers would be uncertain about economic growth permanently, so those sorts of temporary stimuli to get people to spend may not be effective, particularly if some of the problem is a supply constraint in the event of no deal. I think we should be thinking about adjustment policies. Some of the other European Governments have suggested that they may give more support to businesses to help them to adjust to the new trading relationship. It may be things of that nature to ease the transition, so that we get, as Jagjit mentioned, the new stable equilibrium in which everyone has adapted to the new world, rather than having any sort of—

Alison McGovern

Just to be specific, Vauxhall Motors, next to my constituency, has seen 900 redundancies made since the Brexit referendum. Do you think the Government ought to perhaps think about some fiscal measures to intervene in the local economy in our part of the north-west of England, to reduce the negative impact on our area?

Dr Tetlow

I think the question that needs to be asked is: is that a permanent effect; or is that a temporary effect because those businesses are not sure how Brexit is going to affect them and so for the moment they don’t want to maintain a level of output that would provide jobs for those people? Or is it a long-term decision that actually this is no longer a profitable, competitive business in the UK and those companies are never going to come back? If it is the latter question, then if we think, as Roger does, that Brexit is overall good for the UK economy, you could use some of that economic benefit which no doubt accrues to some other businesses and redistribute that to the people in your area to ease that transition. If, in fact, you think that overall the UK will be poorer, you have less fiscal capacity to do those giveaways. The question is then more about whether Government can do anything else that might ease their transition—education policies, for example—that isn’t purely redistributing economic output to them.

Alison McGovern

I think Mr Bootle wanted to comment on that.

Roger Bootle

Thank you. To reply briefly to your earlier question whether there will be a Brexit dividend, the answer is most definitely yes. I think the Prime Minister claims to have spent some of it already on the NHS. The question is whether that Brexit dividend will be overwhelmed by costs and losses, or compounded by gains—and we are back to the original question with which we began. If you accept the negative outlook on the effects on the economy as propounded in the Treasury’s document, the Brexit dividend will get lost in the small change, because there would be a severe negative impact on the fiscal position. I think we could all agree on that, actually. Equally, if my side is right and there is a boost in the economy the benefits will be big. They will be bigger, actually, than the Brexit dividend—and 0.4% of GDP is relatively small beer. On your question about policy changes, in the macro sense I think there probably would be. I suspect there would be an inclination to be less tight fiscally, to run the deficit at a higher level. The debt-to-GDP ratio would come down more slowly and might even go up for a time. There is one specific measure I would like to mention, which I don’t think is receiving enough attention. If we leave and we impose the common external tariff on imports from the EU, which I think we would be obliged to do, that will take money out of consumers’ pockets into the Treasury—prices in the shops will go up—which would surely not be what the Treasury would want in those circumstances. I think there has to be a policy to return that money, somehow or other, to consumers, but the question is how. There are two obvious options. One is a reduction in various tariffs, which under WTO rules would have to be imposed equally on EU and non-EU suppliers to this country. The other would be a reduction, presumably temporary, in the VAT rate. In the circumstances we described, we surely do not want a fiscal tightening, which is what the tariff imposition would do.

Professor Chadha

To go back to your question: relative to the stay scenario, we project on page 22, figure 17, a deterioration in fiscal position of around 2.5% of GDP. That is accounted for by about 1.5% of lower revenues, which are directly related to lower levels of GDP—GDP being the tax base, of course—and by about another 1% from extra expenditure. That is where we are getting the high level of debt from, in that order. In terms of adherence to fiscal rules in any sense, and whether the Government ought to deviate from them to offset these shocks, I think the consensus view from economists is that because the country would do less well if it were to leave the European Union than it would otherwise, it is not clear that you necessarily have to follow the particular set of fiscal rules that we have in place at the moment. They are not, in some deep sense, socially optimal; they are just a set of rules that have been adopted by the Government to try to convince people about the reduction in fiscal expenditures.

Alison McGovern

There you are—politics, not economics.

Professor Chadha

Well, those are your words. They are a particular set of choices, and they do not necessarily conform to what society may require in terms of levels of fiscal expenditure, particularly following the kind of trade shocks that I think most of us have in our head and the impact that they will have in various parts of the country, as you have already suggested. Certainly some of the impacts are likely to be permanent and some will be temporary. To the extent to which they are permanent, there is clearly some case for fiscal policy to offset that where it can. That requires us only to decide to borrow from our richer future.

Stewart Hosie

Dr Tetlow, to what extent does the Government’s analysis indicate that restricting migration flows from the EEA will make the UK worse off?

Dr Tetlow

The Government’s main analysis assumes no change in migration policy either for EU countries or for non-EU countries, but it does show a sensitivity that assumes zero net inflow of EEA workers. By their numbers, that adds about a 1.9% hit to GDP.

Stewart Hosie

Am I right in saying that every single one of their assessments gets worse when you factor in net migration of zero from the EEA?

Dr Tetlow

That is true, and it is probably important to say that it is not just total GDP that gets worse, but GDP per capita.

Stewart Hosie

Indeed. May I ask, as an aside, if that were a permanent feature—if those migration flows were suppressed for a prolonged period—what would it do to our long-term productivity?

Dr Tetlow

Generally speaking, economists think that there are a couple of benefits of migrants. They can bring skills that we do not have—those may be higher skills, or they may just be complementary skills that allow British-born people to work more productively. Economists also broadly think that being exposed to knowledge and experience from the wider world may make UK-born workers more productive. For those reasons, economists tend to find from the empirical evidence that migration is positive for productivity. The Migration Advisory Committee report went into that in some detail and came to the conclusion that the net benefits were greater for higher-skilled migrants than for lower-skilled migrants, which is what drove the committee to make its recommendations.

Stewart Hosie

We will come back to the high and low-skilled in a minute. Professor Chadha, is there an argument for saying that reduced migration could have more impact on the UK economy in the long run than the immediate shock of whatever form of Brexit we end up with?

Professor Chadha

Migration relative to the labour stock is low—200,000 migrants a year, compared to a working population of 20 million or 30 million, or whatever the number is—and the margin is not terribly important. However, for the reasons that Gemma has outlined, in general, the marginal migrant is bringing a higher level of human capital into the country, or with complementary skills, raising the labour productivity of indigenous workers, so the net effect on productivity is positive. I should say we did not assume higher levels of human capital for the institute’s analysis, so in terms of output per head, our results are not affected by the level of migration. It just affects the level of output. It is purely an input, rather than affecting productivity, so we have tailed back our estimates. That is another reason why we do not have as strong an impact as the Government analysis, or indeed the Bank analysis. However, to the extent to which migrants are bringing that level of human capital, there is something that would be lost in the long run from that. That would make itself felt over the long run. Again, if over 10 years you have lost 200,000 a year, that is 2 million workers who you do not have who you otherwise would have had, and that would impact accordingly.

Stewart Hosie

Mr Bootle, do you believe it is likely that there will be more migration into the UK from countries outside Europe as a result of the UK leaving the European Union, and if it is deemed to be sensible in economic terms, do you believe that would make up for any reduction in migration from European countries?

Roger Bootle

In principle, yes, but this depends on the Government’s migration policy, which I think is a work in progress. There are two key distinctions to be made here: the first is the impact of migrants on the overall level of GDP; and the second is the impact on GDP per capita. I take it that we are interested in the second, because what is it worth, or what does it mean, to have a bigger GDP because you have more people in the country? GDP per capita is what we should be paying attention to, and that depends critically on the second distinction, which is between skilled and unskilled migration. Some of the work we have done—obviously, a lot depends on where you draw the line—shows unskilled migration to the UK having a significant cost to the UK economy, not a benefit. As far as skilled migration is concerned, that is a different kettle of fish. Of course, that has brought substantial benefits to the UK economy, and I do not think anybody on my side of the debate wants in any sense to have lower levels of skilled migration, consistent with the Government achieving their objectives, whatever they are. The key point here is about discrimination. I see no evidence to point to the conclusion that there is something particular about migrants from the EEA that makes them more productive, more skilled, or more anything than migrants from outside the EEA. In principle, whatever skills we lack and we want, we can get them from outside the EEA.

Stewart Hosie

This is where I have an issue. It may be that lower-skilled migrants have less of an economic impact, as you say, than higher-skilled migrants. However, in the agricultural sector, say—going back to the disaggregation—we employ in the UK around 60,000 what one might call unskilled seasonal workers. If we do not have those, there is not really an economic case to say, “We will not bring in 10,000 kids from eastern or central Europe; we will fly them in from some undefined Asian, African or South American country.” Economically, that makes no sense, does it?

Roger Bootle

Well, I do not know. It depends on the particularities in the case in question, but of course, it would be possible to have temporary access to groups of unskilled workers from the EEA if that were deemed to be desirable. Of course, there would be particular industries and activities that would suffer from restrictions of the sort you have described. That is bound to be the case, and it would be a matter of judgment for the Government to decide whether that demanded some special action, but that is very much a partial way of looking at it, I think.

Stewart Hosie

Generally then, on low-skilled and high-skilled migration, if low-skilled migrants in particular are restricted, does anyone believe that would have a positive impact on wages and economic welfare for low-skilled indigenous workers? Dr Tetlow?

Dr Tetlow

A few papers have tried to look at this. The best evidence I have seen was the paper written by Steve Nickell, which found a statistically significant impact on lower-skilled workers.

Stewart Hosie

Did you say “no significant impact”?

Dr Tetlow

A statistically significant impact—so, slightly lowering the wages of unskilled native workers in areas with high influxes of unskilled migrants. Economically speaking, however, it is a relatively small impact in terms of the actual numbers involved, and it is outweighed by the positive impacts on the economy as a whole. In part, that brings us back to Roger’s previous point: if there is an overall economic benefit from unskilled migrants, the question is whether we could have that and adapt other policies to redistribute to individuals who might be negatively affected.

Professor Chadha

The critical question is the extent to which there is a structural shortfall of labour supply to meet firms’ demands in the UK, whatever they might be. In the recent past, that has been met—both in high-skilled and low-skilled workers—by migration from the European Union. Since the referendum, we have seen a swap: migration from the EU has fallen by almost as much as migration from outside the EU has increased. I don’t know, offhand, the extent to which that is low or high skilled, but clearly there has already been some substitution. Firms looking for high-skilled, European nationals have found it more difficult to hire them in the past two years. Maybe they have had to source those workers from outside the European Union. There is potentiality for improving, in the long run, the way our education system can respond by producing the kinds of workers that industry needs. We have not talked enough about how we might redesign our higher and further education system to meet labour requirements for languages or technical skills, which are clearly in shortfall in many areas. It is one of the main drivers of the migration that we have seen over the past 10 or 15 years.

Stewart Hosie

Just a quick yes or no from each of you in turn. Is there any case for the argument that the relative ability to bring in low-skilled labour has allowed businesses in the UK to substitute that for investment in plant machinery and trade?

Roger Bootle

Yes.

Professor Chadha

It is since the financial crisis in particular that firms in aggregate have changed the capital-labour mix: they have been hiring labour rather than investing in capital. There could well be other reasons. Financial frictions—rather than trade frictions—uncertainty and lack of confidence might mean that they have felt more flexible in dealing with a certain level of production by having labour rather than investing in capital, which might have a variable depreciation rate when we have entered a digital world.

Stewart Hosie

That was a fantastic yes-or-no answer.

Dr Tetlow

I would say it is possible. I haven’t seen any concrete evidence that demonstrates that.

Stewart Hosie

Thank you.

Wes Streeting

Finally, let’s look in a bit more detail at some of the financial services issues. I want to pick up on the NIESR forecast with Professor Chadha. You have said that financial services will lose up to 80% of their market access to the EU in either a WTO or free trade scenario. Could you explain why there is such little difference between the two scenarios in your analysis?

Professor Chadha

With the loss of passporting and regulatory equivalence—passporting is incredibly important when thinking about where financial services might end up, so that is the main reason that we find that—you end up with the results that we have there.

Wes Streeting

What is your assessment of the impact of that loss of market access on the whole economy and on jobs and revenues from taxation?

Professor Chadha

From the financial sector per se, or overall?

Wes Streeting

From the loss of financial services’ market access.

Professor Chadha

The whole of the impact on the financial sector is around 3%, and the whole impact of the Government’s deal on the table is around 3%. It is part of the whole story; I don’t think that I can give you a disaggregated number for the financial sector. It is all fed in, and this is the result that we end up with.

Wes Streeting

Okay. Is it possible to estimate how much market access financial services would lose, based on the future political declaration?

Dr Tetlow

My reading of the political declaration is that it does not provide a concrete guide one way or the other. There are some aspirations, but obviously an awful lot remains to be agreed.

Wes Streeting

Professor Chadha?

Professor Chadha

A large part of the financial sector is domestically oriented—through the provision of mortgages and loans in the UK—and, to a great extent, may not be affected. What might be affected over the long run is the City of London and its ability to strike deals with the rest of the world. There are two types of argument that one may use there. One is that it has a particular set of expertise that cannot be replicated in other European economies, and that it is therefore relatively robust against that. Alternatively, we have seen other European areas lobby for important parts of the cake, and they will probably be able to get them. I worry about it more than the group of people who are not terribly concerned about the loss of competitiveness of the City of London. That is where I see more problems, rather than the domestic financial industry, which is domestically oriented and will continue to be so.

Roger Bootle

May I first reply to your earlier question about the scale of the losses? We take a very different view on this question of how seriously hit the City would be. The fact is that the part of the wide range of services provided by the City of London that is directly hit by the loss of passporting is actually comparatively narrow. That is principally investment banking and parts of corporate banking. There are large parts of the City’s activities that are hardly affected at all, including most of insurance and asset management. There is a considerable amount of evidence from people in these various industries in line with this conclusion. Our view is that the impact on the City of London will be very minor. There are also some offsetting considerations—being able to escape from various EU regulations, were we to have a clean exit. Your particular point about the political declaration goes back to an earlier element in our discussion about regulation. I think that the scenario in which we have no say over regulations but continue to be subject to them is potentially very worrying for the City of London—for the whole country, actually—because heaven knows what new regulations may come forward in the years to come.

Wes Streeting

You lead me neatly into my next question, Mr Bootle. However, before I ask it, I just wonder if any other member of the panel wants to come back on Mr Bootle’s perspective and his organisation’s analysis—that there is nothing to worry about and that insurance will be unaffected. Is that your assessment, Dr Tetlow?

Dr Tetlow

In preparation for this panel, I looked back at the evidence that Huw Evans, director general of the Association of British Insurers, gave to the Exiting the European Union Committee. When asked about the White Paper proposals, he said that, “for the insurance and long-term savings sector this approach poses quite considerable risks.” That is not my view, but obviously it is worth referring back to some of the evidence that some industry specialists have given to other Committees.

Professor Chadha

Some elements of the City—large market making, trading, foreign exchange markets—may, as Roger said, be relatively immune. However, I think that other parts of the City’s operations are eyed at by Frankfurt, Rotterdam, Amsterdam and Paris, and over time I can see them being vulnerable. I am more concerned about that than I think Roger probably is.

Wes Streeting

We will have an opportunity to continue this interplay when I move on to the rest of the world. However, I am conscious of time. Ultimately, who knows what will happen in the next couple of weeks, but I think it is almost inevitable that, next week, the Prime Minister’s deal will be voted down and there will very quickly be a scramble to compromise and to find options to land on. You will have seen the group of MPs who are pushing for the so-called “Norway for now” option. However, I am interested in your perspectives—not least given the differing views you just gave to my previous question—as to whether an EEA relationship is the only way to maintain financial services’ access to the European Union. Mr Bootle, would you like to answer first?

Roger Bootle

I do not think that it is the only way. This phraseology—“access to”—is very interesting and revealing, as it often is. I wonder what it means. The City of London has throughout its whole history been used to finding workarounds. It is immensely flexible. I suspect that the amount of business and jobs that will be lost directly to the continent—that may be what you mean by “access”—will be comparatively minor. However, it is all to play for. It is possible, I think, for our Government and the EU to reach all manner of arrangements about financial services, given good will. Of course, that good will may not be there, so the ultimate risk is, as you say, the loss of the formal arrangements now and no formal alternative being put in place, and therefore the City’s famous flexibility would have to come into play, but I am convinced it would. It is interesting to look at the estimates of job losses put out by the leading banks in the City immediately after the referendum and to trace through what has actually happened and what their current plans are. HSBC, Barclays, Goldman Sachs: for any bank you care to name, the scale of the job losses and transfers to the continent has been on a steady—well, actually quite a rapid descent since that vote.

Wes Streeting

When you say “comparatively minor” in relation to job losses, what are you using as your frame of comparison? Is it compared with remaining in the European Union, compared with estimates—

Roger Bootle

Compared with both. My primary index of comparison is with remaining in the European Union; that is the primary thing. My judgment is that, if we were to leave without a deal under any of the various manifestations, not much business, not many jobs, would transfer to the continent. It’s very interesting that you make reference to the fact that people have been talking about going to different European centres, which is quite right. This is, I think, interesting and very helpful for us. If every bit of activity and job that was being transferred to the continent was going to a single place—for example, Frankfurt—I would be more worried, because that would signal the danger of the development of an alternative European hub. That is not the case: some are going to Frankfurt, some to Paris, some to Luxembourg, some to Amsterdam, some to Milan and some to Dublin. This is, I think, very helpful to us.

Wes Streeting

You are not anxious about the extent to which early agreement around a transitional period has simply delayed these decisions rather than militated against them completely?

Roger Bootle

Well, you don’t know. It’s possible, but if you look at what the heads of the various banks themselves have said on the scale of the transfer of jobs that might be happening, there is, as I say, this steady downgrade, rapid downgrade, since the immediate aftermath of the vote.

Wes Streeting

Let me move to the other members of the panel, then. Is the EEA the only way to maintain financial services access to the EU, or indeed the most desirable?

Professor Chadha

Given the EEA or any form that would allow the level of interaction between the financial services sector and Europe and for us to continue to act as a hub for the euro—we would continue to be important—that would minimise the dangers or risks posed to the City of London, to the extent that it may be able to reinvent itself to do other bits of work. That is always possible. But it seems to me that being outside that passporting ability is going to be a problem. I also note that a number of financial institutions from outside the European Union are sited in London in order to have access to the European Union. One can see that kind of entrepôt function being denuded in London if it were outside that arrangement, with more and more seeking to site themselves within the European Union. Again, I would stress that I can see competition from Amsterdam, Paris and Frankfurt burgeoning over time.

Wes Streeting

Dr Tetlow, do you have anything to add?

Dr Tetlow

I don’t have a huge amount of novel insight to offer on this. Obviously, the big distinction between passporting and equivalence, which other countries have, is the ability, under equivalence, for that to be revoked at any point, so it does not give the same sort of certainty to businesses operating from here. Much of what we have seen so far suggests and certainly my reading of the press is that many of the adaptations so far have been simply moving a small amount of activity or getting new licences to ensure continued operation. I suppose the question going forward is this. We may not have seen big job losses now, but when businesses are considering new investments in the financial sector, would they choose London or would they choose one of the other countries if the UK is outside the single market? I don’t think we have seen any of those decisions being made.

Wes Streeting

At this stage, does the Institute for Government have any view as to how easy it would be for the UK to negotiate a Norway-style arrangement?

Dr Tetlow

We don’t have a view on that, no.

Wes Streeting

This is my last question. Turning to potential trade deals negotiated with the rest of the world, Treasury analysis includes negotiated free trade deals with the US, Australia, New Zealand, Malaysia, Brunei, China, India and other countries. Taken together, and assuming they happen, will such trade deals make up for the loss of financial services to the EU?

Dr Tetlow

Specifically, I don’t know, I’m afraid. Obviously we discussed earlier that most estimates are that the free trade agreements as a whole would not be sufficient. I am afraid that I don’t know how that decomposes down.

Professor Chadha

The work we have done on service agreements shows that they are critical in order to bring about any compensating level of trade. That is particularly important in financial services. Again, it would be very much dependent upon the form of the deals that we had and how quickly we could arrange them with those countries, and then that would still take time before you got any way back to the business that you might lose in the interim, both with the EU and as a result of other countries outside of the EU wanting to do business with the EU by working their way through the UK. Again, you would have to be very patient.

Roger Bootle

Your question, as I understand it, is, as a result of free trade agreements with other countries around the world, how much extra financial activity would those countries—

Wes Streeting

Yes.

Chair

It is specifically on the loss of financial services.

Wes Streeting

Yes—to offset the losses.

Roger Bootle

I have not done a breakdown on that, I am afraid. I cannot give you a precise answer. One issue here that has not been touched upon so far, which seems to be very important for financial services, is what the EU will do with its regulatory regime in the coming years. We are tending to make all our comparisons—for understandable reasons—against a static position. We know it won’t be static. There are all sorts of regulations that the EU has imposed on financial services over the years, which have been opposed by both the lobby groups in this country and the British Government, but which nevertheless have come into operation. We would have the opportunity to withdraw from those. Similarly, in future, whatever new schemes for regulating financial services were introduced in the EU, we would have the ability not to introduce them here.

Wes Streeting

And we would have no voice, vote or veto over those rules if we choose to be a rule taker in the future.

Roger Bootle

I have already made that point. I have said that I think the dangers for us of being a rule taker for financial services are quite serious.

Chair

I have one final question. I think Wes slightly touched on it then. Perhaps I will ask it to Dr Tetlow of the IFG. Could the political declaration be consistent with both a free trade agreement scenario and also an EEA scenario?

Dr Tetlow

Off the top of my head, I think that probably is the case. I cannot think of anything that contradicts an EEA scenario.

Professor Chadha

Are you saying that it allows both to—

Chair

As currently drafted, as the 26 pages currently sit—I think it is generally agreed that they are very high level—could they be consistent with both an FTA path and an EEA path?

Professor Chadha

I think our reading is that it does leave both options on the table and in that sense could be thought to be very valuable.

Roger Bootle

I agree.

Chair

We are grateful for your time and your evidence this afternoon. If there is anything further that occurs to you, having thought about what you have said or anything that comes up, feel free to drop us a note, to add to what you have said. Thank you for being here. Examination of witness

Witness

Andrew Bailey.

Chair

Mr Bailey, thank you very much indeed for being here. Thank you for the note—it is more than a note; it is a document—that you sent through in answer to this Committee’s questions about the FCA’s perspective on the withdrawal agreement and other scenarios. I am going to start with some general questions, particularly in relation to a no-deal scenario. I want to start with the key risks to the FCA’s objectives associated with a no-deal Brexit. For the benefit of those watching, page 7 of your document sets out your strategic objectives to ensure that the relevant markets function well. Your specific operation objectives are to secure an appropriate degree of protection for consumers, to protect and enhance the integrity of the UK financial system, and to promote effective competition in the interests of consumers. How do those objectives sit with a no-deal Brexit?

Andrew Bailey

As we set out, you have to look at this in the short term and in a more steady state. In the short term, as we said in the document, we cannot provide you with assurance, notwithstanding the large amount of work we have done, and will go on doing, to prepare for that eventuality. A very substantial amount of mitigating work has been done at the UK end—a lot of it, I’m afraid, is now in your hands, in the context of the parliamentary process, and particularly the SIs. We cannot provide you with assurance for one or two reasons, at the core of which is the fact that we haven’t got an assurance of complementary actions from the EU side, quite a few of which relate to consumers in the EU. To be clear, our statutory objectives relate to all customers and consumers of authorised UK financial institutions. In one or two cases, the UK end of the mitigating action also depends on action at the EU end. Uncleared derivatives are a case in point. Those are areas where we can’t provide you with that assurance. Although we said in the introduction to the document that we don’t advocate any particular approach, as you will have seen, we conclude that, given the options that you asked us to assess, in that context an implementation period is a better choice, in our view.

Chair

We have talked about the overall financial services. How are consumers—both individuals and businesses—likely to be affected by a no-deal Brexit scenario?

Andrew Bailey

We hope that the very substantial range of mitigating actions that are being planned and implemented will substantially alleviate the position of UK-resident consumers from a financial services point of view. There are obviously other groups of consumers who are not UK residents. I will draw out two, because although they come under the same umbrella, it is worth making the distinctions that we make in the paper. Obviously, all consumers are covered by our objectives, but in the context of the EU end of this, there are consumers who are EU residents and EU citizens, but there are also UK expatriates living in the EU who fall into the group of EU-based—EU-resident, if you like—consumers. We are obviously doing quite a bit of work with the Government on that, but those people are in a different place, in that sense, compared with the assurance I can give you in respect of UK-resident consumers.

Chair

You have said twice that the EU regulators are in a different place, in terms of preparedness. If the withdrawal agreement were not agreed next week—if the motion were not passed, or whatever—do you have any indication that the EU regulators are preparing to step up their no-deal contingency planning and could get to the same place as the UK regulators by March?

Andrew Bailey

That is an important point. Things are moving on that front—indeed, almost by the day. As we set out in the paper, the European Union itself has, in some areas, said that it will take action. We have not yet seen the hard evidence of that action, hence the conclusions that we and the Bank of England have so far drawn on clearing. We welcome the promise, but I am afraid we have to see the hard evidence. There are then also areas where the European Union has said that it does not consider it necessary to take action at the EU level—uncleared derivatives would fall into that category, as would insurance. Two things follow from that. We are now seeing, encouragingly, more evidence of action by national authorities. We have a draft law in Germany, and a draft law, I believe, in Sweden. This morning we heard that the Finns have a draft law. The French have a draft law, and the Dutch believe, I think, that they can do it via supervisory and regulatory authority actions. That ball is rolling, as it were—quite late, obviously. However, let me add one more point. There are some areas of data flows and data protections that are in European Union authority zones, as it were—they are in the European Union ambit. We are told that national authorities cannot take action in that sphere because it can be taken only at the European Union end. That is what we hear, and obviously we think the European Union should take action. We think that some form of mutual temporary equivalence would be the right thing to do there. I have to say that I cannot explain to you in any sense authoritatively why some things that fall under European legislation are being mitigated by national actions. There is at least one area—data—which we are still looking at, where I cannot entirely explain that point. What I would say to date is that, although we are encouraged that national authorities have taken, or are taking, actions, certainly data remains outside those actions.

Chair

Can I just boil it down a bit? For the non-financial services expert listening—the non-economist—we have just heard evidence from a panel of three economists, one of whom was Roger Bootle, who is the former group chief economist at HSBC. You just mentioned insurance, and you also, in your previous answer, mentioned expats. Mr Bootle—Wes was questioning him, so he will tell me if I have got this wrong—asserted that, on the loss of market access in a WTO or perhaps free trade agreement scenario, the impact on the City of London would be minor, and relatively few areas of financial services would be affected by loss of market access. He specifically cited insurance as being one of those areas. Another witness pushed back and cited evidence given by Huw Evans from the ABI to the Exiting the European Union Committee. You just mentioned insurance. For the expat living in France, let’s say, who has an insurance policy potentially with a UK insurer, what does a no-deal scenario mean? What questions should he be asking that insurer both before and after 29 March next year?

Andrew Bailey

Also, what are we asking the insurers to give in terms of consumer communications?

Chair

Absolutely.

Andrew Bailey

Just starting with the UK end of it, I would say that the effect of the transitional legislation, and particularly the temporary permissions legislation, means that we think that UK consumers who have policies with EU providers will be okay. Your question rightly goes the other way around. At the moment, for UK insurers who are doing that sort of business out of the UK, there is a process in insurance called a Part VII transfer under the legislation. That is a court process that you have to go through, and we have done a number of them in other contexts. The insurers are going through that process. It is a court process, so it takes some time. Some of them have already completed; the majority are in train. We do not actually think that all of them will complete by the end of March. We do not think that there is enough time available. A few weeks ago, you may have seen that Lloyd’s of London made a statement. Obviously that was in respect of their—largely wholesale—market, but the position is the same. They do not think, and we can see why, that their Part VII transfer will necessarily go through in time. The reason underlying that, in part, is that they have spent quite a long time trying to work out with EU authorities exactly what form their new European subsidiary is going to take, and where. In the event of it not happening on time, and in the event of this problem where, technically, it is then illegal to service a contract, they have said that they will continue to service contracts. We endorsed that, and let me explain why. The reason we did that was because, of course, under our objectives and our law, it would not be consistent with our objectives for a UK-authorised firm to refuse to pay a claim. If they have a legitimate claim, they must pay it. We were quite comfortable saying that, because under our statutory objectives, they must pay a claim. Of course, they want to pay the claims, to be clear—it is not that they do not want to. Now, that ought to help, but it is not a particularly satisfactory position to end up in. I should also say that you could potentially see the same issue on the life insurance side. The ex-pat issue is a good example. Let us say you are a UK citizen who has had a UK pension and you are now living in Spain and receiving a pension payment under a UK policy from a UK insurer. Obviously you want assurance that you can go on doing that. That would be more complicated in the life market, because a part-sum transfer is not really available. Unlike general insurance, where the contracts are fungible—a property insurance contract here and a property insurance contract on the continent is essentially insuring the same risk—life insurance is not like that. The annuity market, broadly, does not exist on the continent, so you cannot go and say, “Let me get an annuity in wherever and that will replace what I’ve got.” That is more complicated.

Chair

Two more questions from me. First, in your letter to me, you say that we will have more discretion over regulation after transition. Obviously, that is more immediately true in the case of a no deal. You also say, “Consistent with this discretion, it is important that we have appropriate levels of accountability and scrutiny by Parliament.” Can you expand on why you included that?

Andrew Bailey

Yes. I think this is a very important point. It has come up in one or two hearings that I have had, particularly in the Lords. Currently, obviously, a lot—but not all—of our rulebook comes out of Europe. Obviously, that comes out of a European legislative process in which there is greater involvement by the European Parliament than the Westminster Parliament has in parallel. Let me be clear: I am not saying, therefore, that I am advocating the European Parliament system, because we could have quite a long conversation about that, and you might not want to now, but the fact is that is it important for us that there is appropriate scrutiny and accountability over rule making in the future. Obviously, it also has to be established how what is called the level 1, level 2 and level 3 system in Europe maps across. We have fixed it for the transition, as it were, but then we have to decide how it is done permanently. Absent appropriate accountability, my view is that it will go wrong over time and we will, with the best of intentions, do something that will cut us across Parliament in some way, or some issue will arise, and the lack of accountability will be to the detriment of everybody, including the authorities and including us as a regulator. I am very keen that, when we know the way forward—hopefully, as we said in our paper, there will be some form of implementation period—we can give some more consideration all round to that being done. It is obviously a pretty big task in our world—it is not small.

Chair

Finally, before I hand over to Wes, you will have no doubt seen the report in today’s Financial News about the letters. The opening paragraph is, “The City’s financial watchdog has issued a stern warning to banks not to needlessly shift business out of the UK ahead of the country’s exit from the European Union.” Can you confirm the letters that have been written and the details of the report?

Andrew Bailey

I am happy to explain that point. I am not sure, on the scale of sternness, that that is “stern” really, but anyway. There are two groups of consumers who are clients and users: EU-resident clients and a non-EU clients. In the case of an EU client, it is quite clear that the European Union can make laws and use those laws to determine where residents of the EU transact their business. They can make rules and laws to mean that residents of the European Union cannot do business in London or in the UK—they can do that—and our rules and objectives will not override those. That is not the point we make in the letter; the point is about the rest. They cannot make rules and laws to say where are a non-EU counterparty does their business. We are aware that there is some pressure on firms, and there are discussions about what you might call ensuring that a critical mass of business is moved over to a European Union entity that is being created. I know that we have been accused of being political here, but I don’t think we are; it is entirely consistent with our objectives in statute. The point we have made in the letter to firms is this: “If you are considering moving non-EU business, then you have to make those decisions in the interests of the client. That is treating customers fairly. I know you will be under pressure to do a big jigsaw puzzle and move these people here because it will make that entity more self-sufficient, but you have to ensure it is in the interests of those clients.” That is the point.

Chair

One of the advisers to the banks quoted in the article has said that the letters were “clearly politically motivated”. Did you come under political pressure to write the letters?

Andrew Bailey

No, not at all. We wrote those on our own initiative.

Chair

Thank you.

Wes Streeting

Good afternoon. You stated in your written evidence, “Our involvement in the work of ESMA ensures that it understands and takes into account the specifics of UK markets.” What specifics should we have in mind there, reading your evidence, and what might they not take into account on our departure from the European Union and our absence from the formal mechanisms of decision making?

Andrew Bailey

Obviously we have the largest wholesale financial markets in Europe so, without wishing to boast, around the ESMA table we have the largest share of much of what they are talking about. We also include in the documents some figures on, first, how much of the transaction reporting data we have and, secondly, how much of that data we transfer to ESMA and other authorities across Europe. It is a very large amount. From that point of view, historically, and indeed still, we regard ESMA as very important, first of all. We put a lot of work into it—I am the board member for the UK—and that is driven—let’s be honest—first, by bringing our expertise in wholesale markets to bear, and secondly, by the fact that we want to see outcomes that we think are sensible for wholesale markets. That has always been our approach. Looking forward, as we said in the paper, while we know that formally we leave ESMA at the end of March, and we will not be a voting member and we will not be in attendance in some scenarios, we obviously do not know two things. We do not know what our relationship with ESMA will be in any scenarios where the UK is not a member. We also do not know what our relationship and involvement with ESMA would be during the implementation period. That is one area that is uncertain even with the implementation period. We said in the paper that we think there is time to settle that, but obviously not a lot of time.