Crash-out would be worse than they think

David Warsh 29 March 2019

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Is there anything more worth saying about the analytics underlying Britain’s options under Brexit? I think so – in this case, by an expert on the fate of the socialist economies of Eastern Europe when moving from plan to market, leaving the old Comecon treaty tying them to trade with the Soviet bloc.   

Peter Murrell, an East Anglian, cast his last vote in England in 1975, in the referendum on whether Britain should remain in Europe.  He voted to leave, for many of the same reasons Brexiters cite today.  He believed that Europe was too culturally diverse to expect integration to work well, especially open borders. Free trade agreements would have been enough to further a close relationship, he reasoned then.

The 1975 motion failed. Britain remained. Murrell left for the United States. Today he is professor at the University of Maryland, and the author, 30 years ago, of an unparalleled study of the difficulties facing the socialist economies’ transition. 

In The Nature of Socialist Economies: Lessons from Eastern European Foreign Trade (Princeton, 1990), Murrell offered a detailed empirical study of patterns of trade of nine socialist countries.  He found that the determinants of the most important differences between capitalism and socialism lay outside the scope of the standard neoclassical model. He adopted a Schumpeterian or evolutionary view instead, emphasising innovation and the information sharing that takes place within multinational corporations. He predicted that transition policies based on the standard view might end badly. By then it was too late, of course, but in general he was right.   

In 1975, Murrell says, the cost of Britain leaving the European Economic Community would have been trivial.  The cost of leaving the European Union today will be enormous. Tennyson was wrong when he wrote “Tis better to have loved and lost than never to have loved at all,” Murrell says.  In the case of institutional integration, it would have been better to have never entered a relationship than to have been in one and had to leave. 

It could, however, be worse – much worse – if Britain crashes out of the EU without an agreement. He is, he says, “quite optimistic” about the long-term future of Britain. The problem now is to limit the damage to be wrought in the short run.  It is here, he says, that the official studies are badly wrong.  When I asked Murrell to expand, he jotted down his thoughts.

The formal analysis about the economic effect of a hard Brexit relies on the theory that exiting a set of institutional arrangements simply has an effect that is of the same size and opposite sign of entering the arrangements. The Bank of England's analysis assumes the magnitude of the effects of integration and de-integration are symmetric. The Treasury's analysis simply ducks the issue: “This analysis focuses on the long-term impacts of the UK's exit from the EU...the impact on the UK economy after it has adjusted to the change in economic relationship. Therefore, the analysis cannot incorporate or attempt to forecast any potential short-term disruption or any associated long run impacts.” 

This assumption that exit equals negative entry cannot hold. In a slow evolutionary process, businesses adapt to a specific set of institutional relationships. At the same time, they form relationships with other businesses on whom they can depend, in which trading relationships are supported by a history of trustworthy behaviour and the personal trust that can only come from deep knowledge of one's trading partner.

After a set of rules have been in place for many years, businesses have built up a large amount of productive organisational and relationship capital. Day-to-day operations are dependent on that capital. This capital is also a means by which businesses can be confident that their opportunities in the future will look similar to those in the past, allowing them to plan and invest for the future.

That organisational and relationship capital is destroyed when politicians radically change a set of rules, thereby foreclosing possibilities for trade that go with these rules. There is a resultant drop in productivity in the short term, a fall that has no long-term relevance. There is a ‘deer in the headlights’ phenomenon as well: future-oriented actions are not ken because of the huge uncertainty about what the future will look like.

(A nuance here is often overlooked:  Why does opening up possibilities not do the same thing as the foreclosing of possibilities, since that opening up immediately changes the types of competitors a firm will have? The answer is that when possibilities are opened up, the effect on firms will happen only slowly, as other firms adapt.  In the foreclosing of possibilities by government fiat, that change must happen overnight.)

So how might economists forecast the effects of such exiting? Well the standard procedure would be to look at similar instances in the past, and if there are sufficient instances use them in a statistical analysis. However, to quote the Bank of England, "There is no precedent of an advanced economy withdrawing from a trade agreement as deep and complex as that which the UK has with the EU." 

But this is not quite right. The appropriate precedent is one where a society has chosen to change a large proportion of the rules under which its economy functioned, literally overnight.  The EU is not only about trade but also about the very rules that set the framework for the economy. 

What is the closest precedent of a society overthrowing the rules for its economy in very short order, including asking firms to reorient their trading relationships very quickly? The closest is the transition in Eastern Europe, beginning in 1989 after Gorbachev let those countries determine their own futures.

The general picture that emerged from those times was one of economic chaos in the first years, with production and sales deeply damaged by the loss of suppliers cut off by the new arrangements. In turn, with sales declining, firms could no longer pay their debts, and this led to crisis for all their trading partners. Supply-side recessions resulted, leading to large falls in national income and, in many countries, political reactions that even questioned the turn away from communism. 

For a specific parallel to Brexit, consider Czechoslovakia.

Of all the countries in Eastern Europe, Czechoslovakia would be surely the one that was able to make an immediate success of the transition process. The country had been the best managed of all the Eastern European countries during the socialist era. It entered the transition as the richest, without any legacy of foreign debt to stymie its progress. After its velvet revolution in 1989, there was near unanimity on the general goal of creating a market capitalist democracy.

Bordering the richest part of Europe, the country could expect a huge array of trading opportunities to become easily available. A group of competent technocrats took charge of the economic transition process.

They decided to take their time, to plan for change rather than rush headlong into the process. A year was devoted to planning, with the dramatic change of system to occur on 1 January 1991. That year of planning was a period of economic stability.

Initially, the auspices were good.  Strong in 1990, under the soon-to-be demolished old system, GDP grew by more than 5%, buoyed by very strong retail sales. Therein lies a first lesson for Brexit. The anticipation of problems ahead leads to behaviour that might temporarily boost the economy, with the hoarding of supplies and the desire to buy objects that might no longer be available once the changes hit.

In Czechoslovakia, this indeed was the calm before the storm. During 1991, GDP dropped by 20%, retail sales by 14%, and construction output by 35%, while the number unemployed went from under 10,000 in the beginning of 1990 to over 500,000 by the end of 1991. And the list could go on…

What happened to all those marvellous new opportunities in Western Europe, not much more than 100 miles from Prague? Trade to the West expanded slowly during 1991, and foreign direct investment in Czechoslovakia remained at paltry levels.  Of course, this situation dramatically changed in just a few years, but the fact is that new opportunities do not lead to immediate results. New knowledge has to be developed and new relationships forged.

There we have the most important lesson from transition. The route to the Promised Land begins with a steep downhill section.  Despite its huge inefficiencies and woeful institutions, the old system could provide much more well-being in the short term than the chaotic move to what would turn out to be a much better world in the long run.

And remember that Czechoslovakia was changing to a system that all knew would be more productive in the long term.  This is a very dubious proposition in the case of Brexit.  And the political support for the changes in Czechoslovakia was very strong. Any Brexit will begin with half the country deeply opposed.

A third lesson about the dangers may be learned from Czechoslovakia: the country no longer exists. As always in times of great change, there are those who lose more and those who lose less. In Czechoslovakia, reflecting differential links to the old and new, the Eastern part was hit much harder than the Western part. 

These two parts are now the independent countries of Slovakia and the Czech Republic, separating from each other on 1 January 1993. For sure, old enmities played a part, but so too did the tensions brought about by the widening disparities between the two regions – disparities that could not be addressed in the swift move to the new system.

In Britain, 56% of voters in Northern Ireland and 62% of voters in Scotland voted against Brexit. If Brexit occurs and it brings new hardships, there is no doubt then Brexit will be regarded as yet another instance of perfidious Albion. A break with Scotland and the renewing of the 'troubles' in Northern Ireland are distinct possibilities. 

In Richard II, Murrell notes, John of Gaunt laments over the decline of "this royal throne of kings, this scepter'd isle", observing that "That England, that was wont to conquer others, Hath made a shameful conquest of itself". That's it in a nutshell, he says. Shakespeare had it right.   

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Topics:  Economic history Europe's nations and regions Politics and economics

Tags:  Brexit, Czechoslovakia, European Union

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