How will next week’s Brexit votes affect the UK economy, jobs and wages?

By next Friday, the UK will either have accepted Theresa May’s deal; decided to request an extension of Article 50; or we will be heading for a no-deal Brexit on 29 March

Jonathan Portes
Wednesday 06 March 2019 13:00
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Next week, a series of votes in parliament will determine the immediate course of events on Brexit. By next Friday, the UK will either have accepted the deal agreed between Theresa May and the EU; decided to request an extension of the Article 50 process; or we will be heading for a no-deal Brexit on 29 March.

But amid all the breathless political manoeuvring and the detailed analysis of the intricacies of the Irish backstop, it’s easy to lose sight of the actual effects of these decisions. What will these votes mean for the UK economy, jobs and wages?

Where does the UK economy stand now?

The Brexit vote has hit growth. There is a strong consensus that, to date, the UK economy is perhaps 1 to 2 per cent smaller than it otherwise would have been (and, correspondingly, real household incomes are 1 to 2 per cent lower). That was mostly down to the impact of the fall in the pound in the immediate aftermath of the referendum.

More recently, growth in the final quarter of 2018 was 0.2 per cent – weak, but not disastrous. But the most up-to-date data is considerably worse; looking at the monthly data, there’s been essentially no growth since the summer. Part of this reflects global economic developments – the eurozone economy is also weak.

But there are obvious Brexit effects as well, in particular the slowdown in business investment and a record rise in “stockpiling”, as factories try desperately to ensure that they won’t run short of vital components if trade is disrupted by a no-deal Brexit.

The impact of no deal

If no deal actually materialises, it seems likely we’d see a further significant fall in sterling, pushing up import prices and inflation, and reducing real wages.

Considerably more worrying, however, would be the impact on consumer and business confidence, and hence spending. Businesses would be hit by rising input prices, resulting both from the fall in sterling and the need to replace EU imports with more expensive ones sourced from outside the EU.

Consumers would face rising inflation at a time when they will be trying to reduce discretionary spending, and with little prospect of large pay rises. Any actual disruption to business activities, through the disruption of supply chains or cutting off access to EU export markets, would come on top of this – and could be very severe indeed.

To some extent, these could and would be mitigated by policy actions from the UK government. The Bank of England would be likely to raise interest rates more slowly than it otherwise would have done. And although the deficit will widen if the economy slows, the government will – very sensibly – respond to that as Gordon Brown did in 2008 by spending more, not less. The government has learnt from George Osborne’s mistakes.

Would all this mean a recession? I’d be very surprised if it doesn’t – and indeed I’ve put my money where my mouth is, but it will of course depend crucially on political developments.

If the UK and the EU keep talking and try to minimise the damage, we might get away with a relatively limited downturn. If things spiral out of control with tit-for-tat measures, then it could be very grim indeed.

Over the longer term, it will be the future trading arrangements between the UK and the EU27 (and, to a lesser extent, the rest of the world) that determines the long-term economic impact of Brexit. Under no deal, the UK and the EU would revert to trading under rules governed by World Trade Organisation (WTO) agreements, although the default assumption must be that when the dust settles, various bilateral agreements to facilitate trade within the WTO framework would likely be agreed.

Credible estimates of the long-term impact of this on the UK economy suggest that it would reduce output by up to 10 per cent. And – unlike the inherently unpredictable short-term consequences of a “chaotic Brexit” – these can be modelled quantitatively using standard economic models.

The government’s own estimates are that this would reduce GDP and wages by 8-10 per cent over the next 15 years. Of course, whatever happens with Brexit, many other factors – including UK domestic economic policy – will drive economic growth between 2018 and 2033.

The expectation is still that the UK economy will continue to grow. Nevertheless, there is little doubt that a hard Brexit would prove a significant drag on growth over the medium to long term.

May’s deal

What about if the deal is passed? Business will undoubtedly breathe a sigh of relief as the immediate threat of no deal is lifted. But while the government claims that the deal offers business certainty, that is only true only in the short term, and only by comparison to the chaos of no deal. A transition period will guarantee the status quo until at least the end of 2020, but we still know little about what happens after that.

The deal sets out a broad framework – the “political declaration” for the future relationship between the UK and the EU – but only a framework, which is not binding on either side. And given that political instability both in the UK and continental Europe seems far more likely than not, it is unclear how much it will constrain negotiations. What is certain is that just, as in the Article 50 negotiations, the UK will have by far the weaker hand, and will need to make big concessions on issues from fish to financial services.

Sterling would rise and confidence would recover to more normal levels, but the long-term question marks over the UK economy and its access to European markets would remain. For these reasons forecasts of a “Brexit boom” after a deal seem misplaced; it’s more likely to be a “dead cat bounce”. Particularly given that – for reasons that have nothing to do with Brexit – world trade growth is already slowing, UK growth seems likely to remain fairly disappointing this year.

What about the long-term impact of May’s deal? Assuming that the future relationship is indeed based on the customs backstop written into the withdrawal agreement, then there will be no tariffs on UK-EU trade, no customs checks at the border and no need for firms to satisfy rules of origin requirements. All good news, especially for manufacturing. However, for the UK’s dominant service sector – 80 per cent of the economy, nearly half of exports to the EU, and almost certainly the main driver of future export growth – the news is much worse.

Leaving the single market will mean substantial new barriers to UK companies, and there is little or nothing in the political declaration to suggest we will get much in the way of special treatment. And we are not just talking about the City and financial services here, but a whole range of sectors from broadcasting to transport. Indeed, while UK manufactures are furious with the government’s handling of the negotiations, most economists find it even more baffling that the UK government has essentially done nothing to protect the interest of some of the most dynamic and successful sectors of the UK economy.

Nor are trade deals with non-EU countries likely to make up the difference. Recent days have shown how large the obstacles will be to any UK-US trade deal, which would inevitably involve major concessions by the UK in politically difficult areas – not just chlorinated chicken. Indeed, the UK is likely to be in a considerably weaker position in negotiating such deals than it would be within the EU.

So the overall impact of May’s deal, while considerably smaller than no deal, will still be negative – the government’s estimates, which may be optimistic, are of a hit to GDP of 2 to 4 per cent; our own estimates are 2 per cent to 5.5 per cent. And if Theresa May is replaced by a more hardline Brexiteer who seeks to negotiate his or her way out of the backstop, and hence a customs union, the prognosis will be considerably worse – much closer to the no-deal scenario.

What this means is that while no deal is clearly worse for the economy than the deal on the table, and comes with further unpredictable downsides, there are big negatives to Theresa May’s deal; both continued uncertainty for the next couple of years and the likelihood of a very damaging outcome for important parts of the UK economy, leading to a significant drag on growth for the medium term.

Extending Article 50?

And finally, what if we “kick the can” and seek an extension of the Article 50 process? In the short term, this is the outcome which maximises uncertainty, since nothing will be resolved. Most businesses would nevertheless prefer it to the certain downsides of no deal; but it clearly is not a solution.

During the period of extension, businesses would still have to plan for the possibility of no deal, even while hoping for something better. If – and this is of course a big if – it led to a softer Brexit, which at least left open the possibility of continued customs union and single market membership (including freedom of movement) then the long-term economic downsides of Brexit would largely vanish.

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But if it simply leads to a delayed no deal, or a slightly tweaked version of the same deal, then it’s hard to see what we would gain.

So our MPs are in a bind. There is no option that will resolve the cloud of uncertainty that hangs over the UK economy any time soon, and none which can credibly claim to avert the risk of substantial long-term damage. The chancellor famously claimed that “no one voted to be poorer”. Maybe, maybe not. But next week most of our elected representatives will almost certainly – one way or the other – do just that.

Jonathan Portes is a senior fellow at academic think tank UK in a Changing Europe and professor of economics and public policy at King’s College London.

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