The politics around the exit process are uncertain but the economics is clearerby Vicky Pryce / September 27, 2018 / Leave a comment
The chances of a complete no deal Brexit were never thought to be very high, but talk of it as a serious possibility has increased considerably. That is since the disappointing Salzburg meeting where Theresa May’s Chequers plan was rejected. Further, May does not appear to have a majority in the Commons for her Brexit vision. What would be the economic consequence of a no deal?
The EU is generally known for managing to achieve a compromise deal at the 11th hour. But if the UK does crash out then the long-term effects will be severe. Work done for the Mayor of London, by Whitehall and the Treasury all predict output being some 8 per cent to 10 per cent below where it would otherwise have been by 2030. In fact, any arrangement with the EU compared to our current position will have costs, as the IMF has recently warned. But the no deal scenario has the largest negative impact of all.
All these forecasts are done blind as we don’t know what the response of the authorities will be and what WTO regime we will adopt. A low-tariff one that means we see the UK manufacturing base decline, agriculture wiped out and plummeting inward and domestic investment? Or a protectionist one which again limits the attractiveness of the UK economy to outsiders? Whatever option, the long term outlook is for slower growth. And the lost output does not get recovered in a hurry—if at all.
But it is the short term that is most interesting. Will the UK have a technical recession, in other words a fall in output for at least two consecutive quarters soon after we crash out? And if so how intense will it be?
The answer to the first question is most probably yes. Unless there are parallel arrangements of some sort to keep things ticking for a while it will be a major economic crisis. Daily commerce and exchange—from flights, to lorries, to just-in-time components to all financial products currently governed by EU laws—would suddenly have to stop, as a no deal crash out implies a repudiation of all existing law governing trade between Britain and Europe.
In this scenario the markets would react very negatively, the pound would fall sharply, inflation would rise, house prices would fall. Business investment, which has been anaemic at best, would go into retreat. FTSE 100 shares may profit temporarily from the lower pound, as revenues from abroad make up some 70-80 per cent of all earnings of the big firms listed on the stock exchange. But this is unlikely to last as the mood darkens.
How long and how severe will this be? That would depend entirely on the magnitude and speed of the policy response and the depth of the political turmoil that is bound to follow such an eventuality.
The Bank of England, which has run tough stress tests for the banking sector under a no deal scenario, would not want to see a 35 per cent fall in house prices or raising of interest rates by 4 per cent to tackle above target inflation. Yet this was the worst-case scenario the banks were tested on. The BoE would probably instead try to intervene as it did after the referendum, to ensure financial stability by reversing recent interest rate increases and injecting fresh liquidity into the system. But it is unlikely to be able to stave off the short term negative response, particularly by consumers.
So yes, a technical recession is the most likely outcome from a no deal situation. The markets would certainly anticipate a political backlash—maybe even a general election and the possibility of a Labour government with clear left-wing policies. Foreign direct investment, on which much of the UK’s productivity depends, would dry out for a while—maybe for quite some time—waiting to see what follows.
The politics of Brexit are confusing but the economics of a hard Brexit are clear. And it’s not good news.