A year ago, when no-deal Brexit seemed a more distant prospect, I wrote that if it became the central scenario we’d witness a further large drop in the exchange rate, falls in business and consumer confidence, and some relocation of business activity from the UK to EU member states in anticipation of possible disruption to supply chains.
And so it has proved. Sterling is down by about 7 per cent over the last three months, and there is mounting evidence that many businesses are putting major investments on hold. While this has been slow to translate into hard economic data – particularly because consumer spending has remained relatively resilient – the UK economy is more likely than not to have shrunk in the second quarter.
In the event of a no-deal Brexit, the UK economy will exit the EU with growth already close to zero. Moreover, it will do so against a background of broader global economic weakness, with growth slowing in both the eurozone and US, a trade war already in progress between the US and China, and one between the US and EU a not-so-distant prospect.
The immediate concern for Britain is the impact a no-deal Brexit will have on trade. The most significant costs of no deal come not directly from new tariffs, but from the disruption that an abrupt shift to new regulatory and customs arrangements would incur. Some manufacturers and agri-food businesses will have great difficulty in adapting, particularly those reliant on just-in-time production systems. Others, especially smaller businesses, may not have the capacity or resources to prepare.
The problems don’t end with trade. A no-deal Brexit would likely deal a sharp shock to business and consumer confidence, which would in turn constrain demand. Business would be hamstrung by rising input prices, resulting both from the fall in sterling and the necessity of replacing EU imports with more expensive products sourced from outside the EU. Rising inflation would hit consumers, who have little reason to expect large pay rises, at the same time that they’re attempting to rein in discretionary spending.
Some economists argue that no deal will, for better or worse, at least give business certainty and allow capital investment to rebound. But although the UK economy will eventually adapt, the transition is likely to be slow, and the short-term costs will certainly outweigh any foreseeable benefits.
More importantly, no deal is no guarantee of certainty for businesses or investors. The UK’s trading relationship with the EU, and perhaps other countries, will remain in limbo for some time.
So far, so gloomy. But in other respects the UK is more resilient. With a floating exchange rate, a lower pound can be a useful shock absorber. And with a relatively low fiscal deficit and long-term interest rates at historically very low levels, there is ample space to loosen fiscal policy in the short term.
The new Prime Minister and Chancellor have indicated that they would not hesitate to do so. This could mean targeted tax cuts to support business, through raising capital allowances temporarily, or cutting employer national insurance contributions to support employment; financial aid packages to sectors most directly affected, such as agri-food, or, in extremis, general tax cuts to stimulate consumer demand.
While the UK’s credit rating would probably be downgraded, recent experience suggests that this is almost entirely irrelevant. Long-term interest rates on government debt might rise slightly, but there is no reason to believe that the UK government won’t be able to continue borrowing in its own currency at rates that remain low by any historical standard.
But the overall impact is still uncertain. Forecasting tools used by economists are designed to understand long-run changes, not to predict the short-run effects of a complete breakdown in UK-EU relations. Though economists can imagine scenarios, the actual outcome will depend crucially on how business and consumers react, and on the government’s policy response.
The OBR’s recent “Fiscal Risks” report, which focused on a “less disruptive” no deal scenario drawn up by the IMF, is a useful benchmark. This assumes significant increases in non-tariff barriers, but only limited impact on financial markets. It finds that the economy would enter recession immediately, with the hit to GDP compared to the baseline peaking at 4 per cent in the short-to-medium term.
As Theresa May said, no deal would not be the end of the world, but neither would it be a walk in the park. Crucially, this is the IMF’s “less disruptive” scenario – which assumes that no deal, while a big shock, proceeds relatively smoothly and without major disruption. That’s a big if.
Paradoxically, it is considerably easier to estimate the long-term impacts of no deal. Several estimates of the impacts of “moving to WTO rules” have been produced. The government’s own exercise was the most detailed, and estimated that it would reduce the UK’s GDP by about 8 per cent over the next 15 years (that is, it would reduce cumulative growth over that period from about 25 per cent to about 17 per cent, after taking account of some modest positive impacts from deregulation and trade deals with third countries).
Uncertainties inherent to long-term economic modelling aside, there are additional questions about future policy. Theresa May’s departure opens the way for a more liberal immigration policy. Equally, there are major uncertainties about the potential benefits from future trade deals with third countries. Some argue that potential gains have been underestimated; on the other hand, the political obstacles to a meaningful UK-USA deal are considerable.
Nevertheless, the government’s own modelling is broadly in line with estimates made by credible, independent forecasters. Those that produce radically different and more positive, estimates, like the models used by Economists for Free Trade group, incorporate completely unrealistic assumptions and are not regarded as remotely credible. There’s little doubt that a hard Brexit would prove a significant drag on growth over the medium to long term.