The British Economy after the Referendum

It is possible that the relationship between the UK an the EU will remain in limbo for of years. The uncertainty that is depressing business confidence and investment will linger. A column by Barry Eichengreen.

Barry Eichengreen
«We can thank our lucky stars that it was not Italy, with its broken banking system, that voted to exit.»

The Brexit vote on June 23rd was a shock to expert opinion. (So far 2016 has not been a good year for experts.) But the pundits then overreacted, as pundits put on their back foot are prone to do. Brexit was a catastrophe for the British economy. The country’s imminent ejection from the European Union spelled doom for the London real estate market and jeopardized the role of the City as an international financial center. This was a more disruptive economic and financial shock than the failure of Lehman Bros. in 2008. David Cameron’s decision to call the referendum would go down in history the most serious mistake by a British leader since Neville Chamberlain’s appeasement of Hitler in 1938.

Now that almost two months have passed, it is possible to assess the implications of the referendum for the British economy more dispassionately. A dispassionate view suggests that while the vote to leave the EU and the extended period of uncertainty that now follows will undoubtedly have a significant negative impact on UK business confidence and investment, the resulting downturn is likely to be noticeably less deep than that which followed Lehman’s failure and the global financial crisis.

On the surface, the business reaction looks disturbingly like 2009. The Business Optimism Index of the Confederation of British Industry and Lloyds’ Business Barometer, based on data gathered several weeks after the referendum, plunged to their lowest levels since 2009. The Purchasing Managers Index released by the research group Markit on July 22nd, one month after the vote, showed activity contracting at the fastest pace since 2009. Although we will have to wait a bit longer for data on output and employment, the negative consequences are clear.

Financial system in better shape than in 2009

That said, the recession is unlikely to be as deep as that of 2009, for the simple reason that the British financial system is in better shape. The Bank of England has been one of the more serious players on the regulatory scene in forcing the banks to toughen their capital and liquidity standards. That puts the banks in a better position to absorb the shock.

And while the dominant view in financial circles was that British voters would opt to remain, the banks were aware that the result was uncertain, and they had prepared their balance sheets for any outcome. In contrast to Lehman’s failure, the Bank of England was able to run through various war-game scenarios in advance.

History tells us that what turns a recession into a crisis and a depression are problems in the banking and financial system, 2008-9 being a prime case in point. Britain’s own experience in the Great Depression of the 1930s serves as proof by counterexample. In contrast to the United States, the UK experienced no major bank failures, and the decline in GDP between the peak in 1929 and trough in 1932 was mild by U.S. standards. Hence there is reason to think that the decline in activity will be less sharp than in 2008/9. Put another way, we can thank our lucky stars that it was not Italy, with its broken banking system, that voted to exit.

Monetary policy alone can’t neutralize the negative impact

Much will depend, of course, on the policy response. The Bank of England’s decision not to cut interest rates at its first post-referendum meeting, widely praised at the time, now looks like a mistake. The argument of the Monetary Policy Committee was that it was prudent to wait and see whether the British economy was contracting.  In fact, the relevant question was not «whether» but «how fast,» as the committee should have understood at the time. The contraction has now accelerated as a result of the Bank’s inaction, and its momentum will be harder to break.

But we shouldn’t waste too much breath over a three-week delay in cutting interest rates. The fact of the matter is that monetary policy alone can’t neutralize the negative impact of the referendum. Marginally lower borrowing costs, which are all the Bank of England can engineer given the already low level of interest rates, can’t offset the impact of elevated uncertainty on business investment. It helps that now former Chancellor of the Exchequer George Osborne’s plans for tax increases to balance the budget have been shelved. But a very large increase in public spending would be required to compensate for the fall in business investment, and this is not in the political cards.

The most effective response to the fall in business investment would be a cut in corporate tax rates or an investment-tax credit. But tax cuts for business are not feasible in the present political climate. And investment credits like those the Republic of Ireland offers to multinational corporations would be criticized by other countries as beggar-thy-neighbor policies. They would complicate exit negotiations with the EU and free trade negotiations with the United States.

No conclusion by the end of 2018

Bringing us to those negotiations. It is increasingly clear that these will not be concluded anytime soon. The new prime minister, Theresa May, insists that «Brexit means Brexit» and that Article 50 of the EU Treaty, which opens a two-year window for negotiators, will be triggered by December. But it is becoming increasingly evident that the UK lacks the capacity to bring those negotiations to an acceptable conclusion by the end of 2018, much less to prepare itself for the post-EU world.

To start, it has no experienced trade negotiators, long since having delegated responsibility for trade talks to the European Commission. The offer by the government of New Zealand to loan the UK its trade negotiators would be comical if it was not, in fact, indicative of a serious problem.

Then there is the fact that Parliament will have to pass a raft of new legislative measures to replace EU laws and regulations that no longer apply. New regulations insuring adequate regulation of medicines and protection of the environment, for example, where EU rules have prevailed, will have to be designed and implemented rapidly.

This time rather U- than V-shaped

All this means that the government will come under intense pressure to delay invoking Article 50 while the necessarily time-consuming preparations get underway, even if it remains convinced that «Brexit means Brexit.» Finding a solution to the problem of border controls between Northern Ireland and the Republic to its south, and resolving the question of whether the Scottish Parliament can block the passage of legislation necessary for the UK to leave the EU, make the process thornier still.

Thus, it is not inconceivable that the UK will remain in this state of suspended animation, where its government is committed to exiting the EU but is not yet ready to invoke Article 50, for a period of years. This in turn means that the uncertainty that is depressing business confidence and investment will linger.

In 2008-9 the UK experienced a V-shaped slump and recovery. Output slumped sharply but then recovered as the bleeding in the banking system was staunched and monetary and fiscal stimulus were applied, resolving uncertainty about in which direction the economy was heading. This time the UK is instead headed for a U-shaped recession and recovery. The slump will be less severe because dislocations in the banking and financial system are less.  But the recovery will be much longer in coming, since there is less scope for policy makers to effectively address the uncertainty problem.