The vote to leave the European Union (EU) made by the UK electorate in June 2016, plunged the UK into economic uncertainty.
The debate facing policy makers up to that point in 2016 was how to square the circle of improved economic growth and falling unemployment with a lack of real wage growth, and sluggish productivity.
Those problems haven’t gone away, but have been swept from the consciousness of policy makers, the public, and their financial advisers faced with the challenge of understanding what the economic climate will look like when the UK exits the EU.
Jeremy Lawson, an economist at Aberdeen Standard Investments, says the reason many policy makers, economists and advisers, including himself, are perceived to have been wrong about the economic situation in the aftermath of the Brexit vote, is because the change that happened in the economy was a “supply shock”, and not a “demand shock”.
Mr Lawson explains: “Economists – because most economists are in favour of remain – forgot that if a majority voted to leave, well, that majority were not shocked by the outcome, so they didn’t stop spending or change their behaviour.”
Supply and demand
Demand shocks tend to have a more immediate impact on the economy as people stop spending, while supply shocks lead to lower growth over the longer term.
Mr Lawson’s point is that demand shocks happen when the general public think their immediate economic prospects will become worse, and so reduce spending, causing the level of demand for goods and services to fall, and send the economy into recession.
He says that leave voters were happy with the outcome and therefore didn’t think their economic prospects had weakened, so continued to spend, meaning demand didn’t fall.
A supply shock happened because the fall in the value of sterling caused input costs for goods and services to rise – for example, oil and metals. This makes it more expensive for those who supply goods and services to do so, limiting supply, while investors pulling capital out restricts the supply of capital in the economy, and workers leaving the country restricts the supply of labour.
All of those things are harmful to the long-term health of the economy, but the effects are felt in small doses over a prolonged period of time, rather than as a sharp shock, as many had anticipated.
Andy Haldane, chief economist of the Bank of England, speaking before the Treasury Select Committee of the UK parliament in February 2018 quantified the impact of those supply shocks.
He said the long-term trend rate of growth, which is defined as the level of growth an economy can achieve in normal times without exceptional policies being pursued, will be 1.5 per cent a year as a result of Brexit, rather than the 2 per cent a year that would be the case without Brexit.
His assumptions are based on the Bank of England assuming that a deal is reached between the UK and the EU on the terms of the UK’s exit.
Source: Heartwood Investment Management
Mr Haldane’s boss, Bank of England governor Mark Carney, told the Treasury Select Committee in September that the most immediate impact of a ‘no deal’ Brexit is that interest rates would rise.
The Bank of England has been happy to ignore the higher inflation caused by the fall in sterling that occurred in the immediate aftermath of the vote. The central bank’s view was that this inflation was temporary, and that supporting economic growth through keeping interest rates low was more important than curtailing temporary inflation.
But Mr Carney notes the inflation that would likely be the result of a no deal Brexit would be more permanent in nature, as it would be caused by a worsening of the supply shock.
The Bank of England’s view in that situation is rates would have to rise in order to protect the value of sterling, even if that means unemployment rises and the rate of economic growth slows.
Henry Dixon, a portfolio manager on the UK equities team at Man GLG, observes if sterling were to fall by more in percentage terms than the cost of tariffs on UK exports, then there could be a boost to the economy.
Mr Lawson says the shock to the economy of a no deal Brexit would wipe out any of the gains from a fall in the value of sterling, and that a recession would be inevitable.
The Bank of England’s stress tests, which seek to paint a picture of what the economy would look like in the event of a no-deal Brexit, predicted unemployment and inflation would reach levels seen in the financial crisis.
David Coombs, multi-asset investment manager at Rathbone Unit Trust Management, adds, “it is hard to see” how the UK could avoid a recession if the UK exits without a deal.
Source: FT Adviser