These "Notes" are an introduction to structural issues affecting industries such as those of sugar and ethanol. Structural issues are not theoretical: current events often illustrate such topics well.

Brexit is a case in point. (Full disclosure: ProSunergy is based in England and the author of this note is French.)

About Free Trade

Attempting to put a positive spin on Brexit, Prime Minister Theresa May wants “a truly Global Britain”. In summary, she sees the UK implementing a multitude of Free Trade Agreements shortly after exiting the European Union.

There are practical obstacles to getting many FTAs done simultaneously at short notice, so it is improbable that the United Kingdom will emerge in 2020 with a full set of operating FTAs. Nonetheless, this is the British Government’s stated aim.

That free trade is good is an opinion shared widely. However, there is much confusion about what “free trade” is and whether it always is good for economic growth and development. [1]

When is Free Trade truly "free"? The best way to observe and define free trade is to look at it where it happens.

In the UK, trade is free between counties, such as between Kent and Sussex. In the USA, it is free between the states, such as Texas and Michigan. In the EU, it is free between Brest in France, Munich in Germany, Toledo in Spain or Maastricht in the Netherlands. Throughout these territories, resource allocation depends only on physical factors, under what is basically one single set of rules.

These examples help identify the conditions under which true free trade is realized. Among the necessary conditions are a single currency and similar economic and social rules [2] across the relevant area.

It is only through common standards (which address fairness in competition issues) and stable monetary and legal references (which address risk issues) that the market can express economies of scale properly and allocate resources efficiently. Further, beyond the unhindered exchange of goods, optimal efficiency also requires free movement of capital and labour.

Other trade arrangements are neither free nor optimal. What many call “free trade” today is a rather flawed ersatz of free trade.

At best, to paraphrase the new US President, they are “deals” in which benefits are not necessarily shared [3]. Taking the UK out of the EU’s Single Market will reduce the amount of free trade the UK conducts.

Currencies and Free Trade

A particularly unsettling and frequent penchant of free trade supporters is their offhand dismissal of exchange rate issues. Fluctuating currencies introduce uncertainty and transaction costs which must be compensated for by higher returns.

The standard answer to this problem is that over time exchange rates revert to levels that correctly reflect productivity and inflation differentials. Unfortunately, “currencies often move far away from fundamental values for long periods.” [4] Note the expressions “far away from fundamental values” and “long periods”: under such circumstances, industries with higher physical productivities can be wiped out before an exchange rate reverts to reasonable levels. If the affected industries are capital-intensive enough, it is unlikely they will be revived: the result is a drop in overall productivity, as poor performers are saved – indeed promoted – by currency misalignment.

Some extol the flexibility to adjust a nation’s relative competitiveness a floating currency gives. The catastrophic and dramatic situation of Greece, constrained by its use of the euro, is a recent prime exhibit supporting this view. This is politics, not economics: Detroit and Houston share the same currency but their prices – for housing, for labour, for food – differ. In fact, economically distraught Detroit has effectively “devalued”. Similarly, office space is less expensive in Brest than it is in Munich, despite being priced in euros in both locations.

In a single currency area, factor prices will adjust without government intervention. “Liberal” economists should applaud; instead, they often ignore the drawbacks multiple currencies impose on trade.

Free Trade and Development

A persistent myth is that free international trade is always good for economic development.

For example, The Economist correctly wrote “Export-led growth and foreign investment have dragged hundreds of millions out of poverty in China, and transformed economies from Ireland to South Korea.” [5] Ireland is a developed country, a member of the EU Single Market and uses the euro, so its “exports” are similar to those of, say, Massachusetts to other US states. China and South Korea, however, have undoubtedly immensely benefitted from growth in their international exports. In domestic productive capital accumulation, however, neither of these countries can be reasonably considered as running free market economies: in both, state intervention in every aspect of economic life, including exports and imports, was pervasive, or still is. Indeed, their external trade policies were and are unabashedly protectionist.

That exports are good because they provide additional sales is certain. That they alone demonstrate that free trade as commonly promoted is best is questionable.

Foreign trade can be good for economic development, but not under any market rules. Indeed, people who promote international trade should reflect upon the fact that no developed country became developed through what they call free trade – not one [6]. All developed countries managed foreign trade ferociously as they developed.

Indeed, “In the real world, from shortly after the War of 1812 until the Kennedy Round of tariff reductions of in 1967, the United States was the most tariff protected nation on earth. According to the theory of free trade, [it] should have suffered from low technology, low job creation, low wages, and high prices. Instead, [the United States] prospered. [It was] a world leader in technology, created many jobs at high wages, all while prices went down. We also surpassed free trade Great Britain as the leading Industrial on earth.” [7]

Clearly, the “theory of free trade” needs adjusting.

There are logical reasons for free trade not to be always good, nor protectionism always bad.

This does not mean that a country should shun foreign trade. But “free trade” as currently practiced should not be seen as always, automatically and perfectly good for the economies involved in it.

The Curious Economics of Brexit

Immigration and Commerce

Fundamentally, Brexit is driven by the feeling that immigration is excessive and uncontrolled. This sentiment is shared by a majority of the United Kingdom’s electorate; it cannot be ignored if one wishes to govern beyond, or even until, the next election.

That immigration be “excessive” and “uncontrolled” is largely due to deliberate decisions by past UK governments of all stripes. Within EU rules, the UK could have managed immigration more strictly and kept the number of “permanent” immigrants in check. The political will and the necessary resources were never there, and blaming the EU was convenient.

British politicians have been hoist on their own petard, in part because of half-truths and outright lies about the EU but most notably through the surrender of prudent parliamentary democracy to a blunt referendum. Alas, such poor stewardship of the “res publica” is not confined to the United Kingdom: democracies elsewhere also suffer because of ignorant, partisan and sometimes cowardly or unethical elites. As an English friend says, “They have no bottom.”

Speaking at Lancaster House on 17 January 2017, the current Prime Minister, Theresa May, said, “Brexit means Brexit”. Indeed: freedom of movement within the European Union is a condition of single market membership; the UK must leave the single market to control immigration independently. At the same meeting, the Prime Minister vowed also to leave the Customs Union, to allow the UK to set a more liberal trade policy than it has whilst a member of the EU.

Thus defined, Brexit defies elementary economics on purely commercial grounds. Most businesses would argue that freedom to choose employees, service providers, finance suppliers and customers is good, and that the wider such choice, the better. Competition works best in large dollops. Markets are most efficient when capital, labour and goods are allocated freely and in large amounts. That is precisely what the European Union, the largest free market area in the capitalist world, offers. Incidentally, the EU is also the WTO member with the most and deepest Free Trade Agreements with other nations.

If Brexit is a decision made to improve the UK’s wealth, it is insane.

(A remark on Britain’s net annual financial contribution to EU institutions of about £10 to 12 billion:  largely, this pays for operations which the UK has sub-contracted to the EU in whole or in part, such as trade and agricultural policy, drug and food safety, regional and international development aid, etc. Most of these activities exhibit economies of scale and bringing them back “in-house” will entail adding public servants and attendant costs, and diseconomies of scale. Savings are doubtful.)

Sovereignty

It is argued that Brexit will allow the UK to regain sovereignty and implement policies better suited to its characteristics. In particular, it will be able to become “A great, global, trading nation. And one of the firmest advocates for free trade anywhere in the world.” (Theresa May.) For example, EU import duties on bananas, of which the UK is a major consumer, and which support production in EU outermost territories and in traditional suppliers of former colonial powers, could be abolished.

This is true, but with at least three important limitations.

First, the optimal aggregate level at which specific local priorities should be recognised must be agreed. Is it the UK in its entirety, or should policies be designed and managed separately for England, Northern Ireland, Wales and Scotland? Why not for each county? The optimal trade policy for Kent may not be optimal for the whole of the UK. Once one has decided that overall market size is not important, where should one stop policy disaggregation?

Second, other parties’ priorities may not fit with those of the UK. The vote in favour of Brexit was largely a vote to curtail immigration: in initial discussions on a future free trade agreement with the UK, India requested that visa restrictions be relaxed. One senior Indian diplomat stated “mobility issues are of importance to us; we cannot separate free movement of people from the free flow of goods, services and investments”. Some policy targets will be impossible to reconcile with those of potential partners. The United States of America, China and other nations with which the UK wants trade agreements will put limits on British “sovereignty”.

This illustrates a third caveat: in our interconnected world, how much independence can the UK truly aspire to? Selling requires respecting the buyer’s standards. Standing up to large US corporations on issues like privacy, taxation or health and safety rules will be much more difficult once outside the EU. Like all nations, the UK is party to an extensive web of multi-lateral and bi-lateral commitments, many of which are through institutions in which it has less influence than it does with the EU and many of which are less democratic than the EU.

Sovereignty is relative; it would be surprising if Brexit increases the UK’s.

Agriculture, Sugar and the “level playing field”

Despite centuries of practice, organising international trade in agricultural products is challenging. This stems from the political power of the countryside, from the influence of currency exchange fluctuations on competition in undifferentiated products, and from standards which often reflect divergent cultural attitudes to food.

UK agriculture starts from a position of complete regulatory alignment with the EU. (Despite his best efforts, a recent speech by the UK Minister in charge of agriculture, Michel Gove, showed thinking about a future UK agricultural policy remarkably similar to that for the EU’s.)

Nonetheless, Brexit will bring some differences quickly: financial support for British agriculture and tariffs on imports of products not supplied locally will drop. Both these developments will affect trade between Great Britain and the EU27, but the main disturbance will come from unequal support.

In sugar for example, 11 EU member States currently offer farmers a direct subsidy for the beet crop. Although the subsidy is small, it increases annual EU sugar supply by 3 to 4 million tonnes, an amount which represents roughly the single market’s exports. The effect is to lower prices both in the EU (to export parity) and on the world market. Post-Brexit, it would make little sense for the UK to let imports of subsidized EU sugar harm a domestic industry that is competitive on a level playing field. To be fair, a tariff will be needed to correct the subsidy on EU sugar.

In truth, all major sugar production is supported by governments. The vast array of support mechanisms and differences in the amounts involved make an international “level playing field” unobtainable in practice. This is precisely why a “single market” is so precious: homogenized rules allow economic logic to play out. Leaving a single market increases costs.

Back to Immigration

In leaving the European Union, the primary British aim is to limit immigration more stringently than in the past. The electorate wants full control over who enters their country and how. This objective is not based on an economic calculation.

With rising popular unease about immigration elsewhere and in the midst of record humanitarian crises, an important lesson from Brexit may well be that the rulebook on immigration built after the Second World War urgently needs to be updated to satisfy electorates. Otherwise, negative economic, political and social consequences will mount.

(Posted 18 January 2017)