Economic Theory

UK economy should continue to defy the Brexit doomsayers

One year after the British public voted to leave the EU, the UK has avoided the immediate slide into recession that many feared. Admittedly, growth did stall in the first quarter of 2017. But only part of this slowdown was due to Brexit and there are already signs of a revival in the second. Over the rest of this year and 2018 the performance of the economy is now more likely to surprise on the upside – as long as politicians and policy-makers get it right.

Looking back, it is easy to forget that many forecasters predicted that the UK economy would slump in the wake of the Brexit vote in the Referendum on 23rd June. In the event, GDP grew at essentially the same rate in both the third and fourth quarter as it did in the second (0.6% q/q). There are a number of reasons why ‘experts’ apparently got it so wrong.

For a start, there was surely an element of institutional bias. Many official bodies and City institutions openly supported Remain, so it seems reasonable to assume their economists were under pressure to emphasise the negatives. To be fair, many ‘neutrals’ were bearish too, but this may simply reflect the tendency towards groupthink.

Most forecasts also did little more than extrapolate pre-referendum trends. Businesses and investors were increasingly nervous ahead of the referendum. Many economists therefore concluded that things could only get worse if Leave did indeed win. But after the results, officials who had been talking up the risks of Brexit (in a doomed attempt to influence the outcome) quickly changed their tune. In short, ‘Project Fear’ became ‘Project Reassure’. The smooth change of Prime Minister and Chancellor was positive for sentiment (at the time) as well.

Related to this, most forecasts failed to account for likely policy responses. Even those economists who ignored the dire threats of a ‘punishment Budget’ and interest rate hikes assumed that policy would be broadly unchanged. In fact, austerity was scaled back and the Bank of England cut rates further and increased its asset purchases. And while most economists correctly forecast that the pound would fall sharply, they failed to appreciate that this would actually support business confidence (especially among exporters) and asset prices (especially equities). An improving global backdrop also helped.

Above all, most forecasts made the mistake of assuming that consumers and businesses would take the same negative view of the long-term economic damage that Brexit would cause and adjust their spending immediately in response. This was, I suppose, an internally consistent approach, but never made much sense when a majority of the public had voted for Brexit and presumably saw it more positively.

Of course, perhaps the doomsayers only had the timing wrong. It might just be that the more pessimistic economists jumped the gun in predicting an immediate slump. After all, Brexit hasn’t actually happened yet. The full impacts of the fall in sterling on inflation and of potential losses in trade and investment have still to be felt. Perhaps the much weaker GDP numbers for the first quarter of this year are the first sign of the inevitable Brexit downturn?

However, this is far from convincing. The first quarter GDP data were not as bad as the headlines suggested. Yes, growth slowed from 0.7% to 0.2% q/q. But this was mainly due to a large negative contribution from external trade, which is a relatively volatile component. Consumer spending actually grew at the same rate in the UK as in the euro-zone, while investment accelerated. What’s more, most of the hard data and survey evidence for the second quarter point to a renewed pick up. Even retail sales are on track to grow more strongly over the three months as a whole, despite the weakness of the headline numbers in May.

That said, there are good reasons to expect the economy to slow this year. Consumer spending and the housing market are likely to be relatively soft. But much of this weakness would probably have happened anyway at some point soon, given rising household debts and unsustainably high house prices. In other words, the additional uncertainty created by Brexit may only have influenced the timing. Other factors entirely unrelated to Brexit have also contributed to the slowdown, including changes to the taxation of cars and property.

The one unambiguously negative impact of the Brexit vote so far has been the additional pick-up in inflation as a result of the weaker pound, which has tightened the squeeze on real wages. But the upward pressure is now easing (helped also by falling oil prices), meaning that inflation should peak soon and then fall sharply. In the meantime, employment growth has remained strong and consumers still have room to prop up spending by saving a little less.

Aside from inflation, the other big unknown is the impact of Brexit uncertainty on business investment. Here the jury is still out. Businesses are cautious but surveys of activity and orders books are generally improving (helped again by the more competitive currency). Much will depend on the negotiations on the terms of UK’s departure, which have barely begun. However, both the UK and the EU have recognised the case for some sort of interim arrangements, if a comprehensive free trade deal cannot be agreed in time. There are several options which should allow the UK to avoid a cliff-edge departure.

There are also signs that the UK is willing to take a flexible approach on immigration after Brexit. ‘Free movement’ will end and the Tories still aspire to reduce net migration to the ‘tens of thousands’. Nonetheless, it is widely recognised that large parts of the economy – from agriculture to the NHS – would benefit from some continued access to workers from the rest of the EU.

Looking forward, then, there is all still to play for. Many economists who backed Leave acknowledged the risk of a temporary period of economic weakness due to Brexit uncertainty. But some of the more gloomy claims that Brexit has ‘already’ cost the UK so many billions of pounds, or that the economy ‘will be’ X% smaller, are particularly galling. These forecasts are just that – only forecasts. They also typically come from the same sources, using the same pessimistic assumptions, as those whose forecasts have been proved so spectacularly wrong over the last year.

Julian Jessop is an independent economist with over thirty years of experience gained in the public sector, City and consultancy, including senior positions at HM Treasury, HSBC, Standard Chartered Bank and Capital Economics. He was Chief Economist and Head of the Brexit Unit at the IEA until December 2018 and continues to support our work, especially schools outreach, on a pro bono basis.

Leave a Reply

Your email address will not be published. Required fields are marked *