The famous baseball player, Yogi Berra, once said that “the future ain’t what it used to be.” Economic forecasters grappling with unprecedented changes brought about by Brexit recognise the nugget of truth in this observation. The new rules for our economic future are yet to be decided. But for the purposes of deciding the right level of interest rates and even the amount the state can afford to spend, a detailed economic forecast is required.
In May this year, the National Institute of Economic and Social Research published analysis that showed that under all of the most likely Brexit scenarios UK citizens would be poorer over the long run as a consequence. It is now six months later and we have published our latest quarterly forecast for the world economy in our "National Institute Economic Review." This article assesses Britain’s performance and how our forecast has changed throughout this extraordinary period.
Our analysis of Brexit begins in the long-term and works back to the short-term. Whatever our future arrangements outside the EU are likely to be, Brexit presumably means less integration with the EU. We may get equal access to the Single Market, but we will not share the same institutions. Less integration is likely to lead to less trade and investment. Our concern is less for goods, where tariff rates outside the EU are fairly low, but more for services. In terms of domestic wages and profits, services exports are more important than goods exports for the UK. Services exports depend on sharing the same regulations and allowing our companies to set up overseas as if they were in the UK.
If Brexit means lower trade and investment, then this implies less specialisation and lower productivity and therefore output than otherwise would have been the case. How much lower output will be depends on our new economic arrangements with the EU.
In May we provided a range of estimates based on different future economic arrangements. Our most optimistic case of joining the European Economic Area would see output 1.5 per cent lower and the most pessimistic case of reverting to the World Trade Organisation (WTO) of 3.75 per cent lower by 2030, with a Free Trade Agreement somewhere between the two. We see no reason to revisit these figures. Very recent news gives little to no information about the longer-term impact, whatever our new economic arrangements might be. We would add that based on government statements, the balance of probabilities appears to have shifted towards the WTO or “hard Brexit” outcome.
It is true that being outside the EU and a Customs Union would allow the UK to strike its own new trade deals with faster growing countries. Yet a consistent finding around the world is that neighbouring countries of the same size tend to trade more together than those farther apart. Doubling the distance roughly halves the trade. A 10 per cent fall in exports with the EU would require a near doubling of exports to China just to leave the UK in the same place. This may happen, but we forecast based on actual policy, and nothing over the last six months suggests this will be any easier than we envisaged.
What about the short-term? We expected a sharper slowdown in third quarter output than the provisional estimate of a 0.5 per cent increase. The Bank of England provided some welcome stimulus, but it is likely that the underlying rate of momentum in the economy was greater than we anticipated. We also expected the increase in uncertainty to have a more pronounced effect. While measures of uncertainty have receded, the fundamental issues are far from resolved. We also note that all of the growth was concentrated in the services sector; the sector most exposed to Brexit.
While we are on the short-term, we correctly predicted the sharp fall in sterling. This was in anticipation of lower investment returns and risks for our leading services export industries. We are already seeing significantly higher import prices. As these are passed on to consumers in the coming months, we expect consumer inflation to reach almost 4 per cent by the end of next year. If we are right, and wage growth fails to keep up with consumer price inflation, then many households will see little if any growth in their purchasing power next year. Those who face public sector freezes and welfare cuts will see their real incomes decline; many households will also be poorer in the short-run as well.
The only way for consumer spending to grow in this environment is for households to save less and spend more of their disposable income. Yet with the saving ratio at only 5 per cent of incomes, a large fall in the ratio seems both unwise and unlikely. We expect a slight benefit from an improvement in export performance. However, trade volumes show very little sensitivity to currency movements in the short term. We estimate that a 10 per cent fall in the trade weighted exchange rate is likely to lead to a 2-3 per cent improvement in export volumes next year.
Taking all of these factors together, we have raised our forecast for GDP growth from 1 per cent to 1.4 per cent for 2017. Most of this is the result of changes to economic data prior to and including the third quarter of 2016, rather than a change to the future outlook. This will be the slowest economic growth since 2012, when the Euro Area crisis weighed on the UK economy.
There is a silver lining: the fall in sterling will lead to a considerable improvement in our current account balance. Unlike many countries, the value of our net foreign assets, or international investment position, tends to improve when our currency falls. This is why the sharp depreciation of sterling in late 2008 did not turn into a full scale rout. Our holdings of foreign assets are worth almost six times GDP at £11 trillion, and are mostly denominated in foreign currencies while our liabilities to the rest of the world of roughly the same amount are mostly denominated in sterling. This means the appreciation of foreign currencies against the pound will lead to a significant revaluation of our foreign assets and their returns when translated back into sterling. Together with the improvement in the trade balance, we expect the current account deficit to fall from 5.4 per cent of GDP last year to less than 2 per cent in 2017. With Brexit, that 2010 ideal of a more balanced economy appears achievable, but it will be partly delivered through us becoming a little bit poorer.
The future really isn’t what it used to be.
On the 17th of November, Prospect launched Brexit Britain: the trade challenge. A publication designed to act as a guide for parliamentarians, officials and businesses with a stake in the UK’s changing relationship with the world following Brexit. To see the complete contents of the report please click here.
For speaker and partnership opportunities, please contact david.tl@prospect-magazine.co.uk.You can also receive the full “Brexit Britain: the trade challenge” report as a fully designed PDF document. To do so, simply enter your email below. You’ll receive your copy completely free—within minutes.
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