"The Prime Minister should be prepared to break with Conservative budgetary pieties"by Paul Wallace / August 18, 2016 / Leave a comment
Amid the chaos in the wake of the referendum vote to leave the European Union, Mark Rutte, the Dutch prime minister, said that Britain had “collapsed—politically, monetarily, constitutionally and economically.” His verdict looked rash following the swift coronation of Theresa May as Prime Minister, a seasoned and pragmatic politician who had supported the “Remain” cause. The pound, which at first had suffered a dizzying fall, steadied, and the stock market rallied as the political turmoil decreased.
As well as pledging that “Brexit means Brexit,” May explained that her mission was to make the economy work better for all. But that will be a hard task. Brexit may trigger the first recession since 2008-09. If it does, the downturn is likely to be short and shallow, unlike the severe recession that followed the financial crisis. Yet it would make for a miserable start to the new Prime Minister’s tenure, and the economy’s longer-term prospects will be overshadowed by deep uncertainties about Britain’s new relationship with Europe. The dismal leitmotif of May’s government will be one of damage limitation as she strives to negotiate a post-EU economic settlement.
In the elite-bashing that characterised the “Leave” campaign, economic experts were panned for their pessimistic views. The main reason for their gloom in the short-term was the financial and economic uncertainty that would result from a vote for Brexit. If anything, the experts were not pessimistic enough. Philip Hammond, who replaced George Osborne as Chancellor of the Exchequer in May’s new cabinet, spoke immediately after his appointment about the “chilling effect” of the referendum result on the economy.
That effect has yet to be revealed in hard economic figures because of the usual lags in compiling them, but it is already showing through in plunging consumer and business confidence. Consumer confidence, which had already been declining before the referendum, fell after the vote by the greatest amount in 26 years, according to GfK, a market research firm. The survey showed that consumers have become much more apprehensive about the economic outlook over the next 12 months. Such fears will curb household spending—the survey revealed a big drop in people’s willingness to make large purchases.
A bigger worry still is that firms are rattled. According to a survey by YouGov and the Centre for Economics and Business Research, the proportion of businesses feeling pessimistic about the economy jumped from 25 per cent before the vote to 49 per cent after it. Expectations for domestic sales, exports and investment darkened. Business people are like the rest of us: when they are unsure about what’s in store they tend to freeze. They put projects on hold and suspend recruitment and in early July, Credit Suisse suggested that this is exactly what lies ahead. A panel of senior executives convened by the bank reported a drastic post-referendum deterioration in corporate sentiment. Two-thirds of the firms represented on the panel intended to postpone or cut their spending in Britain as a result of the vote. Recruitment plans were also curtailed. Nearly half of the executives said they would postpone hiring staff and almost a quarter said they would cut employment in Britain.
“Already, the falling pound means that big companies on the London Stock Exchange with large foreign earnings are now worth more in sterling”
Much of the economic case for Brexit was that it would allow Britain to cut new international trade deals independently of the EU. The pound has tumbled since the vote, making British exports cheaper, and in theory, more attractive. Sterling’s initial fall was steeper even than after Black Wednesday in September 1992 when it crashed out of the European exchange-rate mechanism (ERM), a system of pegged currency rates that preceded the introduction of the euro in 1999. Although that at first appeared a disaster, a weaker pound then stimulated brisk export growth and the balance of trade went into surplus in the mid-1990s. Brexiters seek solace in this episode, hoping that there will be a similar resurgence in Britain’s trading performance. Already, the falling pound has supported valuations of big companies on the London Stock Exchange whose large foreign earnings are now worth more in sterling. This is why the FTSE100 index bounced back after the initial shock.
However, when working out the potential effect of currency moves it is essential to understand the reasons for them. The pound collapsed in 1992 because it had been held at an overvalued rate in a monetary straitjacket from which it was then mercifully released. Far from harming the economy, departure from the ERM supported a recovery by allowing interest rates as well as the exchange rate to fall. In contrast, sterling has slumped since the referendum because leaving the EU—immeasurably more momentous than exiting the ERM—will make it tougher to trade with the rest of the EU, which buys nearly half of all British exports of goods and services. Firms may now have more of a competitive edge thanks to the weaker pound, but they will be deterred from building up their export businesses in Europe on fears that they will suffer once Britain leaves.
A more recent currency episode also tells a less reassuring story than that of the 1990s. The pound plummeted against both the dollar and the euro during the financial crisis of 2007-08, yet there was little improvement in the trade balance, which stayed deep in the red as exporters struggled to cope with weak foreign demand, especially in the euro area. One important reason was a sharp reduction in the export of financial services, which had been buoyant before the crisis. That is now likely to occur again as banks prepare for a future in which the City faces barriers to doing business in Europe as a result of Brexit (see Nicolas Véron, p44).
As well as the pound falling, yields on UK government debt have also dropped. That has dragged down long-term interest rates more generally. When corporate borrowing costs fall this helps the economy, as long as companies want to invest. But when businesses are instead cutting back on investment, the decline in yields will do little to prop up the economy; rather it indicates weaker economic prospects. In an unwelcome twist, pension liabilities in defined-benefit schemes (providing pensions based on salaries and years of service) increase when long-term interest rates fall, making it more expensive to provide the pensions. The pension deficits of Britain’s 350 largest listed companies jumped by 40 per cent between the end of May and the end of July, according to Mercer, an actuarial consultancy. That will force firms to divert yet more cash into plugging the gaps, inhibiting business investment still more (see Andy Davis, p84).
The impact of Brexit on the economy will be shaped primarily by how consumer spending and business investment respond to the shock. Household expenditure, which makes up over 60 per cent of gross domestic product (GDP), will be curbed as consumers become more cautious and their budgets are pinched by higher inflation arising from the weaker pound. Signs of a faltering housing market are already apparent—new buyer enquiries fell sharply in June according to a survey by the Royal Institute of Chartered Surveyors—and this will exacerbate the slowdown in consumer spending. Business investment, though only about 10 per cent of GDP, is a lot more volatile. Even before the referendum it had weakened and that decline will now intensify.
The role of trade in mitigating these phenomena will be limited. One reason is the effect that Brexit will have on the euro area’s demand for British exports. The International Monetary Fund has already reduced its growth forecast for the currency bloc from 1.6 to 1.4 per cent in 2017 and some private forecasters think it could be considerably lower. Although the euro area has been generally resilient since the British vote, financial markets have again focused on the plight of Italian banks. They are also worried by the prospect of another referendum—Matteo Renzi, the Italian prime minister, has said he will resign if a vote later this year fails to endorse his constitutional reforms. Such a destabilising political upset would further weaken eurozone growth.
The “DIY recession” that Osborne predicted in the event of a “Leave” vote is looking ominously plausible. Although the economy did well in the second quarter, growing by 0.6 per cent, that preceded the Brexit shock. According to Markit, a data-research firm, in July British business activity spanning services, manufacturing and construction suffered its steepest monthly fall in the near-20-year history of the survey, dropping to its lowest level since April 2009, when the economy was still mired in the deep downturn caused by the financial crisis. Although any recession should be short-lived, projections for growth next year have tumbled. New forecasts made in the first two weeks of July and compiled by the Treasury showed, on average, growth in GDP of just 0.5 per cent in 2017, compared with 2.1 per cent projected before the referendum. Before the vote, forecasts envisaged the unemployment rate staying steady at 4.9 per cent—the new ones showed it rising to 5.7 per cent in late 2017.
The Bank of England, which now expects little growth in GDP in the second half of 2016, showed its alarm about Britain’s deteriorating economic prospects with an “exceptional package” of four measures in early August. First, it cut the base rate, held at 0.5 per cent for over seven years, to a new low in over three centuries of just 0.25 per cent. Second, it pledged to provide up to £100bn of ultra-cheap funding for banks to try to ensure that they pass the rate cut through to their customers. Third, it launched a further bout of quantitative easing (QE), whereby the Bank creates money to buy bonds in order to bring down longer-term interest rates. It will purchase an additional £60bn of gilts, raising the total amount it holds from £375bn to £435bn. And fourth, it will also buy up to £10bn of corporate bonds.
No one can accuse the Bank of not trying to help. Governor Mark Carney said on 4th August that a further cut in the base rate to close to zero is likely later this year. But the main difficulty that he and his fellow rate-setters face is the limited scope to ease monetary policy yet further when it is already so loose. Interest rates, both short-term and long-term, are so low that further reductions are unlikely to have much effect.
The Bank, like other central banks, is reaching the limits of the conventional and unconventional measures it can adopt—and that leaves fiscal policy. A low point in the “Remain” campaign came when Osborne threatened an immediate emergency budget to repair the damage done to the public finances if Britain voted to “Leave.” Nothing of the sort will happen. Rectifying the public finances will be necessary but not until the economy is on the mend again after the immediate Brexit shock.
The pressing question for Hammond when he delivers his autumn statement will be whether the Treasury does more than simply allowing the “automatic stabilisers” to work as tax revenues fall and benefit spending rises in a weakening economy. Hammond has said that this would be an opportunity to “reset” fiscal policy if necessary. Though there is a case for a temporary stimulus, he will be wary of a move that investors could construe as putting an end to austerity. After six years of budgetary tightening, the budget deficit in the financial year ending in March was still high at £75bn, or 4 per cent of GDP.
Britain’s startlingly big current-account deficit is a particular source of vulnerability. Arising from recent shortfalls in earnings on investments as well as the long-standing excess of imports over exports, the deficit amounted to 7 per cent of GDP in the last quarter of 2015 and the first quarter of 2016. The slide in sterling could get out of hand if the foreign investors financing the deficit lose faith in the government’s economic credentials. Standard & Poor’s, the last of the three main credit agencies to have maintained a AAA credit rating for Britain, downgraded it by two notches to AA following the referendum vote, saying that it would lead to a “less predictable, stable and effective policy framework.” All of the three agencies now have a negative outlook for Britain. There may be a further downgrade.
“The meaning of Brexit will be defined not just by what the UK wants but what the rest of the EU is prepared to concede”
The longer-term outlook for the public finances hinges on how much permanent economic damage leaving the EU will inflict. That is the biggest uncertainty of all. Brexit may mean Brexit, in the sense that it will happen, but other than that the sound-bite, delivered by May in a speech to supporters, is meaningless until it is defined. There is an array of possible outcomes. At one extreme, Britain could huddle close on terms similar to those accepted by Norway, which though outside the EU has essentially full access to the single market, which removes regulatory and technical hindrances to trade as well as tariffs. At the other extreme, the relationship could be distant. Britain could trade with the EU in the same way as with other countries, following rules set by the World Trade Organisation, which would leave British firms facing the EU’s common external tariff and the non-tariff barriers they are spared within the single market. In between these extremes, Britain might aim for a free-trade deal similar to that negotiated between the EU and Canada.
Although David Davis, appointed by May to head the new department organising Brexit, has contemplated an arrangement similar to Canada’s, his views will be trumped by the prime minister. May is sensitive to the danger that Brexit could in turn break up the UK by creating the opportunity for a second independence referendum in Scotland, which backed staying in the EU. From what both she and Hammond have already said, it appears that her government will aim to retain as close a relationship with the EU as possible. This suggests that Brexit may at least avoid outcomes that would punch the deepest holes in the economy in the longer-term. But the snag is that the main economic goal of the negotiation—maintaining as much access to the single market as possible—runs counter to the politically paramount objective of controlling free migration from the rest of the EU.
Whatever May’s government has in mind, the meaning of Brexit will be defined not just by what the UK wants but what the rest of the EU is prepared to concede. That will have to reconcile the views of countries such as France, which is demanding a tough line, and those like Germany that are less antagonistic. With a presidential election looming in the spring of 2017, François Hollande, the French President, needs to show that leaving the EU hurts, in order to deter voters from backing Front National leader Marine Le Pen, the tribune of French populism who hailed the British result as “the beginning of the end of the EU.” Angela Merkel, who also faces an election next year, has valued Britain as a strategic ally as well as a like-minded partner in promoting liberal markets. The German Chancellor will be more conciliatory than Hollande. But her desire to defend the EU from any further disintegration will require a tough negotiating stance to show that states cannot benefit by withdrawing from the EU. Already she has insisted that there can be no “cherry-picking” and that the “four freedoms,” which include movement of people as well as of goods, services and capital, remain inviolate.
From an economic perspective the least-worst outcome would be “Norway minus.” Norway pays for its access to the single market in two ways. First, it makes a per-capita contribution to the EU’s finances that is close to what Britain pays. Second, and more importantly, it allows free movement of people. As a share of their respective populations, there are more EU migrants living in Norway than in Britain. If the government is to limit immigration from the rest of the EU, then it will have to settle for inferior access to the single market.
Even if a relatively close relationship can be secured, the economy will suffer. Not only will the initial conditions for access to the single market be worse but also they will deteriorate. The single market is incomplete. Many of the gaps are in areas where Britain has particular strengths, such as the tech clusters in London, Manchester and Cambridge that could capitalise on a single digital market. Inside the EU, the government has been able to advocate policies that take account of British business concerns. Outside the EU, it will have to accept terms fashioned for firms in the remaining 27 states, which may be inimical to the interests of British companies.
Britain has already lost influence in the development of financial policy. One of Jean-Claude Juncker’s prime objectives as president of the European Commission since 2014 has been to create a capital-markets union, making it possible for businesses to finance themselves increasingly in the markets rather than having to rely on local banks. The venture is a clear opportunity for British financial firms and London, which hosts so many foreign banks. Moreover, Juncker appointed Britain’s commissioner, Jonathan Hill, to oversee the project as part of a broader financial services brief. Hill instigated a review of 40 or so regulatory changes introduced since the financial crisis to see whether the burden could be lightened, a sensible initiative for Europe and of particular interest for Britain given its financial prominence. But he resigned after the referendum and policies in a field that matters so much to British finance will instead be formulated by Valdis Dombrovskis, a commissioner from Latvia.
The shadow cast by Brexit over the City is a particular worry since hopes of a revival of manufacturing after the banking crisis faded, with output in 2015 still lower than in 2008. Despite the crisis, the financial sector remains a core component of the economy. Financial and business services are an export success story, running big surpluses that are indispensable given the colossal deficit on trade in goods. Helmut Kohl, the chancellor who committed Germany to the euro, believed that pressure from the City would eventually force Britain to join the monetary union. Instead, remarkably, the City became the offshore financial capital of the euro area and the destination for ambitious bankers who might otherwise have headed for Frankfurt, Milan or Paris.
That status is now vulnerable. Before the referendum the British government had already fought off an attempt by the European Central Bank to insist that clearing houses handling large amounts of trades in euro-denominated securities be located in the euro area. The defence was possible while Britain remained in the EU but it now looks a lost cause. If clearing houses have to relocate their business away from London, that in turn will create pressures for other related activities to peel away. Other European countries have long envied the City’s pre-eminence and the French government is already seeking to lure bankers back to Paris.
“The Prime Minister should be prepared to break with Conservative budgetary pieties and push through a fiscal stimulus if that is what is necessary”
A particular concern is that Britain will lose the regulatory “single passport” that allows banks based in London to provide services across the rest of the EU. Hammond has already said that he will seek to maintain this, but it cannot be guaranteed. The City led as an international financial centre before the euro and it retains formidable strengths, notably a deep reservoir of workers with a wide range of specialist financial and related skills in London and the south-east. But it is difficult to envisage an outcome to Britain’s withdrawal from the EU that is anything but unfavourable for the City’s future however hard it tries to drum up business elsewhere.
A host of studies before the referendum estimated the long-term impact of Brexit. The near-universal verdict was that, even if there were a close relationship on leaving the EU, the economy would incur serious damage, as both trade and inward investment by firms suffered. The National Institute of Economic and Social Research estimated that the toll on GDP in the long run would be between 1.5 and 2.1 per cent if Britain secured a status similar to Norway. If instead, as seems likely, the relationship were looser, with terms similar to those of Switzerland whose bilateral arrangements fall short of full single-market access, GDP in 15 years’ time would be between 1.9 and 2.3 per cent lower than if Britain had remained in the EU. Other studies that took account of impaired productivity performance as a result of weaker trade and inward investment were gloomier still.
During the campaign, Brexiters maintained that Britain would be able to make quick, favourable trade deals with countries outside Europe. But, as Liam Fox, the Secretary of State for International Trade and a prominent Brexiter, found when he visited the United States in late July, trade negotiations are for tortoises rather than hares and require a cadre of skilled negotiators that is almost wholly lacking in Britain. Fox met his US counterpart Michael Froman, the US’s Trade Representative. In a statement after the meeting, Froman’s office said: “As a practical matter, it is not possible to meaningfully advance separate trade and investment negotiations with the United Kingdom until some of the basic issues around the future EU-UK relationship have been worked out.” It is likely that Fox will become familiar with that response as he tours other countries including more than 50 that have free-trade arrangements with the EU as a whole. Most important of all, British competitive advantage lies in services rather than goods. Yet whereas trade in goods is relatively easy to liberalise, opening up services is much tougher owing to protectionist regulations that are fiercely defended by domestic lobbies.
The damage done by Brexit both in the next year or so and further ahead will in turn make it harder for May to carry out her mission to make the economy work better for all. In the short term, there is not just a possible recession to face, but also a squeeze on real incomes as inflation rises due to the falling pound. In the longer term the big worry is about the outlook for growth in productivity (GDP per hour worked), the main engine of the economy, which has stalled since the financial crisis. Productivity growth is crucial in sustaining rises in real wages.
Rekindling productivity will now be harder to achieve because of the damage to trade and inward investment. Brexiters lay their hopes on a bonfire of supposedly vexatious regulations that hamper the economy. But EU membership has not prevented Britain from having among the freest labour and product markets of all the advanced economies. Not only does that limit the scope for gains through further liberalisation but also the direction of travel could go into reverse. Shortly before the referendum, the IMF pointed out that “regulations could actually become more restrictive and less pro-growth after an exit” by making it easier for special interests to influence decisions.
In all this, public opinion will be crucial. If polls reveal a big swing against leaving the EU this could prompt a political change of heart. A possible occasion to step back from the brink could arise at the turn of the year if MPs get the opportunity to vote on invoking Article 50, which sets the divorce in motion. Brexit is simply too big and too harmful a decision to be undertaken without either a further mandate from voters in a general election, which despite fixed-term legislation could come sooner than 2020—or a second referendum. What May should focus on is mitigating the short-term setback to the economy. The prime minister should be prepared to break with Conservative budgetary pieties and push through a fiscal stimulus if that is what is necessary. Inaction could prolong a self-inflicted downturn, the first of many bitter fruit as Brexit downgrades the living standards and long-term prospects of millions of Britons. Sadly, damage limitation is now the central task of British government policy.