Macroeconomics

08 July 2016

Rule Britannia! 

The most comprehensive assessment of the impact of a “leave” vote on the UK economy was carried out earlier this year – before a single ballot had been cast.

 

According to that analysis by HM Treasury (the UK’s Economic and Finance Ministry), domestic growth will be reduced by a total of 6.2% by 2030. That works out at as roughly 0.5% lower annual GDP growth. 

The short-term impact, however, is assumed to be even greater.

The Treasury estimated that in a shock scenario – involving a surge in uncertainty – Brexit would “push the UK into recession and lead to a sharp rise in unemployment.”

This Treasury projection was towards the more pessimistic end of the range of investment bank forecasts, which estimate a short-term negative GDP growth impact of between 1-2%. Given the current annual domestic growth rate of around 2%, these forecasts suggest a not insignificant risk of recession next year. 

The truth, however, is that no one knows how the British economy will fare outside the EU – not even the Treasury. But it is fair to say that the consequences are much more likely to be negative than positive, certainly in the short term. 

Economic activity revolves around decisions on spending, and current uncertainty undoubtedly restrains such activity. On top of this, 13% of UK GDP is dependent on trade with Europe; the prospect of losing access to the single market is therefore a very direct threat. 

Undoubtedly, the UK economy appears vulnerable. If Britain had been part of the euro, however, the consequences of an exit decision would have been far more dire. 

Sterling dropped sharply in the wake of the vote and, if sustained, should provide significant support to the economy. 

There is also scope for policy response from both the government and the Bank of England if the economy appears to be going off the rails. The higher-level policy objectives of fiscal restraint, debt reduction and keeping a tight lid on inflation pressure may well have to take a back seat for a period.

This would mean the Bank of England scaling back its anti-inflation rhetoric, with a rate cut now seeming appropriate. 

But what about the inflation threat delivered by sterling’s weakness and the effect this will have on import prices? The weak economic backdrop appears to very much mitigate against this risk, as it did when sterling plunged unceremoniously out of the EU Exchange Rate Mechanism in 1992. 

The Bank of England sets its policy with a view to the long-term inflation outlook, and it is difficult to envisage a serious inflation threat emerging for the UK at a time when most of the world’s other central banks are fighting against the threat of deflation. 

Although the Chancellor of the Exchequer recently said that tax increases and spending cuts will be necessary, today’s extraordinary circumstances still offer scope for the government to loosen the austerity straightjacket. 

Indeed, the threat of a tax-raising emergency budget looks hugely out of step with the near-term economic risks now presented by the UK’s impending exit from the EU.