What is happening to the UK post-referendum and how should Labour respond?
The decision to leave the European Union was, amongst other things, a shock to the economy. However, the economic and financial reaction so far has been mixed and has not followed the exact script laid down by the remain campaign. It is important that we understand what has happened so we on the left can devise a credible economic policy, something Labour has been lacking for at least the past six years.
Exit from the EU was predicted to have negative effects on future GDP growth in the UK by many mainstream economic forecasters. These negative effects derive from the range of potential exit and trade arrangements the UK might make. There are, however, both long and short term elements to the Brexit projections and it is the short-term outcome which has so far surprised.
The long-term impact of exit from the EU is expected to be affected by the following factors:
1. Trade: The UK will have to negotiate both an exit from the EU and new trading relationships with EU nations. It is likely that both sets of negotiations will run in parallel. In addition, the UK will need new trading schedules agreed with other nations to replace those it participates in as an EU member, which will require additional negotiation. Projections of GDP growth under Brexit tend to assume the UK achieves some form of European Economic Area access to the single market (but at least some freedom of movement of people), a bi-lateral agreement, or a failure of negotiation leading to standard WTO member status. The impact on GDP growth becomes more negative respectively.
It is easy to see why this is a reasonable projection. Trade and growth are linked and so barriers to trade hit growth potential. The UK is also a large exporter of services, which could be affected outside the EU.
2. Investment: Foreign firms see the UK as attractive due to the combination of relatively low regulation, low taxes, and crucially, access to the single market. Exit from the EU could restrict single market access and raise trade barriers, and so dent investment. This would mean potential GDP was lower than if the UK was in the EU.
3. Migration: Immigration, at the macro level, is seen as positive for growth (there are micro level economic objections and much depends on government policy). Therefore restrictions following Brexit imply lower future GDP.
The precise nature of Brexit conditions will not be known for some time and perhaps for over two years, though political realities may accelerate negotiations.
The short-term impact of Brexit rests on people’s expectations of the future. In particular, higher levels of uncertainty are expected to lead to lower growth now, especially since the UK is expected to have lower productive potential outside the EU. That is because people postpone or cancel big decisions in times of uncertainty. For example, businesses put off or change investment plans. This has already been observed in the run up to the referendum and can be expected to continue. Foreign firms may refrain from investing in the UK, because the future economic relationship with the EU is unknown. Households may postpone big spending decisions. The CIPS/Markit ‘flash’ PMI survey for July (a first estimate with almost all the data in) signalled a significant drop in economic activity, which, if sustained, implies the economy will shrink by 0.4 per cent in the current quarter.
A Brexit vote was expected to hit the exchange rate and this has indeed happened, with sterling around 9 per cent lower on a trade-weighted basis. This anticipates the lower returns expected from UK assets and the future higher cost of trading. However, whether or not sterling has found a stable level is an unknown.
However, there was another short term impact expected by forecasters, particularly HM Treasury, which has not materialised to date. It was believed that risk premiums would rise, due to higher uncertainty. In other words, government bond (gilt) prices were expected to fall, making it more expensive for the government to borrow (because the yield, or long term interest rate, would rise). At the same time, borrowing costs for companies were expected to rise too (the difference between corporate bond yields and gilt yields would rise). The overall effect would be to raise the cost of borrowing. That would set back investment. It would also increase the cost of mortgages, leading to lower house prices than after a remain vote as demand growth for property fell. The effect would be a short term hit to growth.
Instead, the reverse has happened. Gilt prices have risen and yields have fallen. Just before the result, the government could borrow for ten years at 1.4 per cent pa. Now it can do so at 0.71 per cent pa. That is a significant move. Corporate bond yields are also lower, so it is cheaper for companies to issue more debt. This fall in yield has occurred in other developed economies too, so it is not unique to the UK, though the effect has been more pronounced. It reflects to some extent a ‘flight to safety’ by investors worried about the returns on other assets in developed markets and lower GDP growth following Brexit. It may also reflect investors anticipating that the Bank of England will significantly ease monetary policy.
The Bank has been widely expected to look through the projected rise in prices arising from a lower sterling, and cut interest rates. It may also reintroduce quantitative easing, creating money to buy gilts and other assets. The government has also signalled it will ease fiscal policy, though under the current policy if growth is expected to dip below 1 per cent it can already do so.
Thus the economic policy environment is transforming rapidly. In opposition, Labour should not try too hard to anticipate day to day economic news. But it should have a clear message about the kind of Brexit deal we want to see and how a long term economic policy will boost growth potential (pretty much as I outlined in The Credibility Deficit). If we still believe in a ‘People’s QE’ of some sort (as I discussed in the Winter Fabian Review), of which we have heard nothing for a year, why not make the case now, when QE is on the table again?
A word of caution. It seems highly likely that economic confidence was dented by the referendum result, but we do not yet know if the impact was very short term or of longer duration, an uncertainty the Bank will have to face. It could be that the surveys have picked up the initial shock but that conditions are now recovering. After all, companies have reported making no immediate changes to business plans (future investment aside). It could be that we are in a phoney period where, after the initial reaction, things pretty much go on as before until the terms of the negotiations are clearer. The long term hit to growth remains likely but for the meantime we could all be waiting and seeing.
 Note that full PMI data out from 1 Aug (Manufacturing); 2 Aug (Construction); 3 Aug (Services and composite).
Image: Mstyslav Chernov