19 October 2017
The Economic Consequences of Brexit Uncertainty
Pre-referendum concerns are being justified.
by Frank O’Nomics
With UK unemployment running at its lowest level for over forty years and the stock market continually testing new highs, it might seen that all the concerns regarding Brexit were misplaced. UK manufacturing has seen a significant boost from the depreciation of sterling and the economy is continuing to grow, albeit slowly; there has been a considerable boost to government finances, which many hoped would give the Chancellor room for generosity in next month’s Budget. However, whether you are for or against leaving the EU, the high level of uncertainty as to whether we can reach a lasting deal with Brussels is having a significant effect on forward looking estimates for the economy. The Office for Budget Responsibility has announced that it is reviewing its forecasts in light of the continual low productivity in the UK, something that appears to be a direct consequence of Brexit uncertainty, and this is likely to seriously constrain the Chancellor’s scope for stimulus. Add to it the inflationary consequences of the currency depreciation, which could further slow the economy if interest rates are raised as a result, and you have a much bleaker outlook than current market euphoria would suggest.
If you want an example of hope triumphing over experience, take a look at the OBR’s latest Forecast Evaluation Report, where productivity forecasts showing a marked upturn with each year’s revision, against the actual outturn which is virtually a flatline. The OBR’s economic forecasts have tended to assume that UK productivity growth would, over time, return to the long-term average of 2% per annum, despite having been running at one-tenth of that rate for the last 5 years. They have now relented from this misplaced optimism and have said that they will be “significantly reducing” their productivity assumptions. This matters because it will have a profound impact on long-term growth forecasts and the prospective tax take – the key factor in determining government spending plans and, not least, prospective public sector wage increases. We will have to wait until the Budget to get the new forecasts, but it does seem that an effort is being made to warn us of a more austere environment than we had hoped for.
We have discussed the low UK productivity conundrum before in these columns, and the puzzle still remains. Given that we measure productivity as output per hour worked, the nature of the UK labour market bears some responsibility, with a tendency for firms to hoard labour after the financial crisis, in the hope of an upturn and a wish to avoid future hiring costs. Similarly, the low level of interest rates has meant that many firms have been able to survive when they perhaps shouldn’t have – in a so-called “zombie” state. There may also have been a sectoral shift from higher to lower productivity industries – which you may argue does not matter if it helps a drive towards higher employment. None of these factors is particularly new. However, what seems to be the most important explanation for the OBR’s awakening is the continued low level of business investment. Business investment is only around 5% above its pre-2008 financial crisis peak, compared to a levels of 30-60% at this stage in the previous two recoveries. Prior to the referendum, business investment growth in excess of 8% per annum was being forecast, but the leave vote has put an end to such optimism, with the Bank of England now forecasting investment to be 20% lower than it would otherwise have been by 2020. Compared to Europe this looks particularly bleak, given that German output per hour is 36% higher than in the UK and France almost as high.
Given that there seems to be no sign of an early resolution to Brexit negotiations, it is difficult to see how this gloomy outlook can be reversed. Stimulating business investment without greater clarity surrounding the future will be difficult, but making it more tax effective for industries with high growth potential should help. A process of encouraging and helping higher productivity industries can do something to reverse the sectoral shift. The apprenticeship scheme, if adopted more effectively than is currently the case (apprenticeship starts are down almost two thirds on last year despite the new funding scheme), could, for example, help move some of those working in the growing profusion of coffee shops to more productive manufacturers. The costs of such encouragement could prove very low compared to the potential long-term benefits.
The only alternative is to address the other drivers of poor productivity. A rise in rates should have some bearing on the perpetuation of zombie firms, and the uncertain outlook should ultimately have some impact on labour hoarding.
There are then some steps that can mitigate the economic consequences of Brexit uncertainty, but other than those that would receive cross-party support, most will be hard to enact by a government with no overall majority. For investors there remains the solace that most FTSE companies generate the majority of their earnings outside the UK, but such solace will not be shared by those hoping for pay rises to be sanctioned in a Budget that could be severely cash-strapped.
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