Would leaving the European Union without an agreement plunge the UK into a severe recession, as some – including perhaps the Treasury and the Bank of England – expect, or is this Project Fear Mark 2?
We know that the most pessimistic pre-referendum forecasts were too pessimistic by far. The performance of the UK economy since the Brexit vote has been mediocre, but not disastrous. Growth has slowed, particularly relative to other advanced economies. On the other hand, the labour market has remained buoyant, with employment growth continuing on its pre-referendum track.
However, that doesn’t mean there hasn’t been some damage already. 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). The immediate cause of this was the fall in sterling, and corresponding rise in import prices, that followed the referendum result. Uncertainty and its consequence for business investment, and the Brexit-related fall in EU migration, are also likely to have depressed growth.
After a no-deal Brexit, the UK and EU would revert to trading under rules governed by World Trade Organisation (WTO) agreements. Credible estimates of the long-run impact of this on the UK economy suggest that it would reduce output by up to 10 per cent. However, these estimates in themselves tell us little about the immediate impact of no deal. Rather, they are designed to capture the long-run impact of trading on WTO terms, allowing for a gradual adjustment based on a negotiated withdrawal agreement.
Predicting the short-run effects of a chaotic no-deal Brexit is more difficult. The biggest costs would come not from moving to new regulatory arrangements for trade, but from a partial or complete breakdown of the regulatory arrangements that make trade possible at all. In our comprehensive new report, “Cost of No Deal: Revisited”, we at UK in a Changing Europe explain that aircraft could be grounded; British meat may not be certified safe to enter the EU market; just-in-time production systems used by manufacturers and food producers could break down; and border crossings on both sides of the Channel could be gridlocked.
Even in the run up to no deal, there would be economic impacts. Sterling is likely to fall further, pushing up import prices and inflation and reducing real wages. So will business and consumer confidence, reducing business investment and consumer spending. We are already seeing some businesses relocate from the UK to the EU27. And business and government will be preparing for the worst, by stockpiling and contingency planning.
To some extent, policy actions from government will mitigate this. The Bank of England would be likely to raise interest rates more slowly than it otherwise would have done (indeed it has already done so). At a minimum, the government is unlikely to fund any necessary increase in spending by taxes or other spending cuts. Instead it would let borrowing take the strain. There would be no repeat of George Osborne’s threat of a “punishment budget”, which was widely, and correctly, perceived as scaremongering.
It is also important to note that some of these impacts could in principle boost GDP rather than reduce it – preparedness spending or stockpiling by business (or indeed hoarding by consumers!) would boost demand and hence be positive for GDP in the short term. UK growth in the second half of 1999, when businesses were worried about the “millennium bug”, and spending to mitigate its potential impacts, was strong.
If and when no-deal Brexit actually hits, will the result be a crisis in financial markets? I think not. Sterling would almost certainly fall in the run-up to no deal and remain low. But, with a floating exchange rate, this doesn’t in itself constitute a crisis. Nor would falls in equity markets (which in any case would be cushioned by any fall in sterling, since it would make UK companies with foreign currency earnings more valuable). And while it is possible, indeed likely, that the UK’s credit rating would be downgraded, recent experience suggests that this is almost entirely irrelevant. While it is possible that long-term interest rates on government debt would rise (partly as a result of anticipated higher inflation, partly as a result of anticipated higher government borrowing) there is absolutely no reason to believe that the UK government won’t be able to continue to borrow in its own currency at rates which remain low by any historical standard.
More worrying would be the impacts on consumer and business confidence, and hence spending. Business would be hit by rising input prices, resulting from the fall in sterling, the imposition of import tariffs on EU goods, and in some cases perhaps the need to replace EU imports with more expensive ones 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. A nasty recession, while not inevitable, is clearly a possibility.
Again, however, note that the measured impact on GDP may be less than we might think. One remarkable aspect of modern economies is how resilient they are to short-term disruptions, whether the result of war, natural disaster, or interruptions to trade flows. Fifteen months after the 1995 Kobe earthquake, which killed 6,500 people and caused more than $100bn worth of damage, manufacturing output in greater Kobe was back to normal. Overall, the earthquake probably boosted Japan’s GDP temporarily. More recently, Qatar has survived the cutting of trade and transport links with its nearest neighbours (Saudi Arabia and the UAE) with relatively limited economic damage, although of course being one of the richest countries in the world with huge natural gas reserves has helped.
What about the long-run impacts? Paradoxically, it is considerably easier to estimate these. Historical experience suggests that short-term disruption, even if potentially severe, is unlikely to make a material difference to the long-term economic potential of the UK economy. Overwhelmingly, 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 impacts of Brexit. And – unlike the inherently unpredictable short-term consequence of a “chaotic Brexit” – these can be modelled quantitatively using standard economic models.
Under a no-deal scenario, the default assumption must be that the UK will trade with the UK on WTO terms (that is, without a free trade agreement, although, after the dust settles, various bilateral agreements to facilitate trade within the WTO framework would be likely be agreed).
A variety of estimates of the impacts of “moving to WTO rules” have been produced. The most detailed exercise was that conducted by the UK government, which estimated that a WTO scenario would reduce UK GDP by about 8 per cent over the next 15 years (that is, it would reduce cumulative growth over that period from about 25 per cent to about 17 per cent). This is after taking account of some modest positive impacts from deregulation and trade deals with third countries, in particular the US, and assumes the UK implemented a relatively restrictive immigration policy after Brexit.
This estimate is – given the uncertainties involved – broadly in line with estimates made by credible external organisations, such as the Centre for Economic Performance at the LSE, the OECD, and others, using both similar CGE models to that of the UK government and the alternative “gravity” modelling approach. Models which produce radically different, and more positive, impact estimates (like that used by Economists for Free Trade) incorporate unrealistic assumptions (for example, that UK prices immediately converge with “world prices” after Brexit, and that the UK imposes no tariffs or non-tariff barriers – even basic safety standards – on any imports), and cannot therefore be regarded as remotely credible.
The reduction in GDP implied by the government’s modelling would also have serious fiscal impacts – even after taking account of reduced EU budget contributions, the net (negative) impact would be about £80bn per year by 2033.
Of course, whatever happens with Brexit, many other factors – including UK domestic economic policy – will drive economic growth between 2018 and 2033, whatever happens with Brexit. Nevertheless, there is little doubt that a no-deal Brexit would prove a significant drag on growth over the medium to long term.
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