Brexit inflation? Trade policy uncertainty raised import prices since 2015

Our new study on the impact of Brexit shows that import prices increased due to uncertainty about future trade conditions with the EU. This occurred early in the Brexit journey, before the referendum, and illustrates how trade policy disagreements can harm consumers even without changes in applied trade policy. We estimate the referendum outcome raised UK import prices by 11% and consumer prices by 0.6% through trade policy uncertainty alone.

In any standard international trade policy course, students learn that import protection typically drives up domestic prices and lowers consumer welfare. The typical import protection policy instruments governments might employ are tariffs, quantitative restrictions, and other non-tariff barriers. The mechanism is intuitive: the policy instruments increase trade costs for foreign firms and thus push up the price domestic consumers pay. Yet these price increases usually happen when trade costs increase, not before. So why would prices increase before anything occurred?

Firms make their investment decisions based on what they expect to earn in the future. In many ways, exporting is an investment decision: It requires setting up logistics, constructing consumer bases abroad, learning administrative procedures and tailoring their products to import markets, among other costly tasks. Once they do so, they can use these resources in the future. In other words, firms acquire export capital that can be employed from then on.

Imagine a new winery in Portugal deciding whether to invest in export capital to introduce its wine variety in Britain in 2016. In its cost-benefit analysis, they must factor in future trade costs. If they are likely to increase, it might be more prudent to wait and see.1 Another established French winery may be deciding whether to improve its production capabilities to maintain lower prices in the UK. Again, doing so may not be reasonable in the prospects of higher future trade barriers. British consumers, in the meantime, lose access to products and face higher prices.

What happened before the referendum that could have made the British market less appealing for European firms? In May 2015, the Conservative Party won the general election with the promise of holding a referendum on the European Union membership. Support for leaving the EU had been latent the entire time the UK was a member of the EU. Opinion polls conducted regularly in the thirty years leading to the referendum showed 30-50% support for “getting out” of the EU.2 However, following the general election, something changed: the prospect of leaving the EU became a genuine political possibility. Surely, this development didn’t go unnoticed by EU firms.

Our research studies the impact of Brexit uncertainty on import prices during the year leading up to the referendum. We interpret a win by the “Leave” option as a trade policy shock, as a result of which tariffs and other barriers to doing business between the UK and the EU could increase. We use betting markets and opinion polls on the referendum outcome to capture the probability of this event happening. We rely on a specific prediction from the theory: the higher the likely future trade policy barriers, the stronger the impact of trade policy uncertainty on current import prices should be. In other words, the higher the public’s belief that Brexit would happen, the more cautious the Portuguese and French firms would be in deciding to invest in their export capital for the British market.

The probability of the “Leave” option winning is not sufficient to identify trade policy uncertainty. Some industries have higher potential barriers than others. EU wineries would not care much about the referendum outcome if the wine industry did not usually face high tariffs or related restrictions. As tariffs are one of the key barriers which vary across products and can be directly measured, we focus on tariffs from the EU and other major economies to identify which products would have been likely to see higher barriers in the UK in an eventual Brexit.

We estimate that the risk of higher import protection following the referendum increased these import price indices by about 11% at the average EU tariff we employ as a reference. Both higher prices for regularly traded products and fewer varieties contributed to the increase, the former being the main reason. We calculate that the referendum increased consumer prices by about 0.6%.3

These results confirm what the theory predicts: trade policy uncertainty is costly for consumers and can work as a form of protection, even in the short run. For this reason, trade policy uncertainty deserves a seat at the table in bilateral and multilateral trade policy discussions alongside tariffs, quotas, and other barriers. In the end, flipping a coin by means of a referendum, in which voters and even politicians have limited information about the full span of current and eventual costs, might not be the most prudent course of action in an increasingly uncertain world.

Footnotes

1. This was argued, but from the British perspective, in a letter to The Times editor written by 1200 business leaders: “Britain leaving the EU would mean uncertainty for our firms, less trade with Europe and fewer jobs.” https://www.thetimes.co.uk/article/british-business-benefits-massively-from-eu-n5bhfw9nd
2. https://www.ipsos.com/en-uk/polling-history-40-years-british-views-or-out-europe
3. As a reference, the Consumer Price Index grew 1.8% on average between June 2016 and June 2017.