Brexit: Thelma & Louise edition
Everyone who only casually observes the UK-EU negotiations for the relationship after Brexit is frustrated with the developments. And one can only imagine how frustrated the negotiating teams on both sides must be.
Apparently, to shake things up, the UK government intends to give the negotiators a deadline until 15 October 2020 to find a resolution or accept a hard Brexit. Furthermore, the FT reports this morning that the UK government intends to introduce an “internal market bill” to Parliament on Wednesday that would undermine some parts of the withdrawal agreement. The bill apparently would remove the requirement of Northern Irish businesses to fill out customs forms for goods shipped to Great Britain and put the jurisdiction on state aid for businesses in Northern Ireland to UK courts which would have to obey UK law, rather than the withdrawal agreement. According to the FT, this “nuclear option” was drawn up and driven by UK’s chief negotiator David Frost.
In essence, the move reminds me of the famous closing scene in Thelma & Louise where the two protagonists, on the run from police, end up facing the Grand Canyon. Instead of accepting that they have lost the chase with the police, Thelma turns to Louise and the following dialogue ensues:
“Thelma: Ok, then let’s not get caught.
Louise: What’re you talking about?
Thelma: Let’s keep going.
Louise: What do you mean?
Thelma: Go.
Louise: You sure?
Thelma: Yeah, yeah. Let’s.”
However, unlike in the movie, where the scene ends with Thelma & Louise in mid-air over the Grand Canyon, real life doesn’t stop, once you have jumped off the cliff. Instead, if this negotiation tactic backfires and the EU abandons the negotiations, the UK and the UK would face a hard Brexit, with dire consequences for the economy.
Hard Brexit vs. Covid-19
To be sure, the year 2020 has provided its fair share of economic hardship for the UK economy. But, while the impact of Brexit is only felt over many years, the impact of Covid-19 is short and sharp. The London School of Economics held a symposium on Brexit just two weeks ago assessing the likely economic impact in the light of Covid-19. Thomas Sampson provided a simple comparison of the impact of the pandemic and Brexit on the UK economy.[1] He looked at the estimates of the Bank of England for Covid-19 until 2023 and compared it with the long-term estimates of Brexit by HM Treasury. He assumed that the long-term impact of a 7.6% loss of GDP in the case of a hard Brexit was equally distributed over time, though it is most likely front-loaded with most of the pain coming in the first two years.
Estimated impact of Covid-19 and Brexit on the UK economy
Source: Sampson (2020), Liberum.
The chart shows that the long-term impact of Brexit in terms of lost economic output is clearly larger than the long-term impact of Covid-19. If one uses a discount rate of 4%, then one can calculate the present value of this loss of output over time. In the case of Covid-19, the decline in present value of future economic growth is 2.1%, while a soft Brexit would lead to a decline of 3.7% and a hard Brexit to a decline of 5.7% in today’s values. In other words, even if we discount the future with relatively high rates (and thus reduce the present value of future lower growth), a hard Brexit is likely to cause almost three times as much harm as Covid-19.
On ultimatums in negotiations
If we accept that this bill is not to be taken literally, but is just a negotiating tactic to force the EU to make concessions, then the UK government must be remarkable naïve or inept at strategic games. Game theory explains how people should rationally behave in games and this kind of brinkmanship can be modelled as an ultimatum game.
In an ultimatum game, one player is given the task to divide a pot of money between himself and a second player. The second player can then accept that offer or reject it. If the second player accepts the offer, both players go home with the share of the pot proposed by the first player. If the second player rejected the offer, both players go home empty-handed.
The rational behaviour for player one would be to keep as much of the money for himself and offer player two as little as possible. The rational move for player two would be to accept any offer, no matter how little he was offered by player one. After all, going home with a little bit of extra money is still better for player two than going home with nothing.
Acceptance rates in the ultimatum game
Source: Wallace et al. (2007), Liberum.
However, every ultimatum game ever played with human actors shows that unfair offers are widely rejected by player two. The perceived unfairness of the offer is such a strong motivation for player two to punish player one, that player two is happy to incur a small cost to himself if it means a much larger cost to player one. For example, if player one offers player two just 10 percent of the total pot, the offer is rejected 90% of the time and both players will go home with no deal. Even if player one offers a share that is slightly less than half, the offer well only be accepted 50% of the time. For an offer to be acceptable to player two it has to be fair, i.e. player two has to get at least 50% of the pot.[1] This desire for fairness is so ingrained that even chimpanzees follow the same pattern and reject unfair offers from other chimps.[2]
So, what is the UK offering the EU with this bill? In essence, the UK government says, take our current offer or face a hard Brexit. If you accept our current offer for a deal, both get to go home with whatever they have now (i.e. gaining whatever would be lost in case of a hard Brexit). In the case of a hard Brexit, the EU economy and the UK economy will both suffer but to a different degree.
The chart below summarizes different forecasts for the long-run impact of a hard Brexit on the UK and the EU (ex UK). We have used the most prominent and most respected economic forecasters available and added the forecasts of Patrick Minford for completeness, because his forecasts are typically used by hard Brexiteers to show that Brexit will be good for the country.
Expected cost of a hard Brexit in the long run
Source: Liberum. Note: BOE = Bank of England, PIIE = Peterson Institute for International Economics, PwC = PricewaterhouseCoopers, Rand = Rand Organization, Minford et al. (2016) = Patrick Minford (2016). “Brexit and Trade: What are the options?” Economists for Brexit.
The consensus impact of a hard Brexit for the UK is a decline of 4.6% of GDP vs. a decline of 1.0% of GDP for the EU. If we take only sources that give both EU and UK forecasts, the consensus decline in GDP after a hard Brexit for the UK is 5.4%. In the case of a hard Brexit, the UK economy would suffer about five times as much as the EU economy.
In the terms of the ultimatum games that is the equivalent of the UK offering the EU about 16.7% of the total while trying to keep 83.3% for itself (83.3% is five times the gain of 16.7%, or, alternatively, by rejecting the offer, the EU would suffer one fifth the loss the UK would). Looking at the acceptance rates in the ultimatum game above, we can see that for such an unfair offer, the likelihood of acceptance is just about 10%. There is a 90% chance that the EU will reject the offer and go with a no deal Brexit.
Once the EU has rejected the UK ultimatum, the ball is again in the UK’s court and the UK government will either have to decide to step back from the brink (and lose face by making concessions it previously ruled out) or follow through and go over the cliff. It turns into a lose-lose situation for the UK. If it goes for a hard Brexit, the economy will suffer for years to come. If it turns around, the EU negotiators will know that the UK government isn’t willing to risk a hard Brexit and become even less willing to make compromises.
[1] Sampson, T. (2020). “A no-deal Brexit may still be more costly than COVID-19”. https://blogs.lse.ac.uk/brexit/2020/08/26/a-no-deal-brexit-may-still-be-more-costly-than-covid-19/
[2] Wallace, B., D. Cesarini, P. Lichtenstein, and M. Johanneson (2007). “Heritability of ultimatum game responder behaviour.” PNAS, vol. 104 (40): 15631-15634. [2] Darby, P., R. A. Williamson, F. B. M. de Waal, and S. F. Brosnan (2013). “Chimpanzees play the ultimatum game.” PNAS, vol. 110 (6): 2070-2075.