Read more by Tony Yates: The worst thing for Iain Duncan Smith's "have nots" would be Brexit
The Remain campaign have long stressed the economic consequences of a “Brexit shock” following a vote to leave the European Union on 23rd June. Both George Osborne, the Chancellor, and Mark Carney, the Governor of the Bank of England, have warned of the dangers. This week we learned more following the release of a Treasury report.
The nature of the risk is that, following a vote to Leave, investors, firms and consumers decide that the economy is going to be less prosperous in the long term and, along with the other political and economic uncertainties, this causes a sharp drop in confidence and demand. That triggers a fall in Sterling, a temporary spike in inflation, and a contraction—relative to a vote to Remain—in output, employment, and a fall in real wages.
The risk is real enough. That’s why I was one of the now 287 economists who signed a letter to the Times pointing out that we shared the concern. But while they have warned of some danger, neither the Chancellor nor the Governor are coming entirely clear about this risk, nor what they would do about it.
Mark Carney’s Monetary Policy Committee (MPC) chose to publish their quarterly forecast for inflation on the assumption that the UK will vote to Remain. The consequences of a Leave vote were sketched only vaguely, and the conclusion was offered that rates might either rise or fall. This will have struck many—as it did me—as deliberately obscure.
Two forces are likely to put upward pressure on interest rates after a Leave vote and a Brexit shock. First, the drop in sterling will push up on import prices and therefore consumer price inflation. Second, the recession will cut investment, and this will shrink the economy’s potential. The more supply shrinks, the more this forces up prices and inflation.
Yet we can be fairly confident that both of these forces will be more than offset. To start with, the MPC will look through the effects of import prices on inflation, since they will be temporary and initially welcome, inflation having undershot recently. After all, the MPC looked through the effects of the last notable appreciation of sterling, which led to the inflation target undershoot that we're suffering. And the supply-side shrinkage that would accompany a recession would be small and slow to take effect. The flow of investment in any one quarter is a very small proportion of the size of the total stock of capital.
In short, the downward pressure on interest rates caused by the fall in confidence would be much stronger than the upward pressure. Given this, it’s a shame that the Bank weren’t more frank about how they see the future. Carney has made admirable progress instilling a culture of transparency at the organisation, and this episode goes against that trend. But if Carney were clearer, it would throw the spotlight on just how little room the Bank has to respond, and therefore just how little, with interest rates close to their natural floor, it could compensate for the recession.
In April, Osborne claimed that interest rates might rise after Brexit: perhaps it was this that made the BoE uncomfortable about openly contradicting it. It’s not inconceivable that people might end up paying higher mortgage rates. If the drop in confidence were to trigger a panic in the markets for bank funds, then banks might scale back lending and raise its price. In this event, the Bank would be cutting rates as much as it could and signalling that they would stay very low for a long time—still, the rates on mortgages and corporate loans could rise. But this is a pretty remote scenario.
In the Treasury report published on Monday there is a corresponding silence about the likely policy response on the side of the government to the Brexit shock. Mild and severe versions are simulated.
The report maintained the assumption that there would be no fiscal response to the Brexit shock save that engineered by the ‘automatic stabilisers’ the tendency for spending on benefits to rise and the tax take to fall as the economy shrinks. In the most mild of the two scenarios covered, this is probably realistic. In the most severe, it is moot. With very low interest rates for the foreseeable future, and many high-return social investment projects (energy, housing, rail and so on) around, the case for an increase in government investment – already strong – would be overwhelming.
A fiscal stimulus would need careful calibration. Depending on how you measure it, government debt to GDP now stands at around 80 per cent, compared to about 40 per cent in 2008. At some point—though nobody can be sure when—investors will start to worry about how the debt will be rolled over or repaid. Yet the consequences of not responding strongly enough to a recession can scar the labour force for a generation.
In such a situation it helps to be clear beforehand how firmly you will act, since if that message can instil confidence and rule out some of the worst outcomes. The Charter for Budget Responsibility allows the OBR to help with advance signalling, providing that it can announce that such shocks “will occur” and not merely diagnose them after the event. It would have to do the sensible thing and stretch to breaking point the meaning of the word “will,” (sensible precautions are taken for things that are simply likely, not just certain to occur) but the OBR should be able to help with the reassurance before 23rd June.
Given how important it is to manage expectations, it’s a shame that the government and the Bank have chosen to deliver stark messages about the Brexit shock—yet have not explained all that they could have about what the real risks are and how they think they would respond to them.
Now read: Michael Gove misunderstands
The Remain campaign have long stressed the economic consequences of a “Brexit shock” following a vote to leave the European Union on 23rd June. Both George Osborne, the Chancellor, and Mark Carney, the Governor of the Bank of England, have warned of the dangers. This week we learned more following the release of a Treasury report.
The nature of the risk is that, following a vote to Leave, investors, firms and consumers decide that the economy is going to be less prosperous in the long term and, along with the other political and economic uncertainties, this causes a sharp drop in confidence and demand. That triggers a fall in Sterling, a temporary spike in inflation, and a contraction—relative to a vote to Remain—in output, employment, and a fall in real wages.
The risk is real enough. That’s why I was one of the now 287 economists who signed a letter to the Times pointing out that we shared the concern. But while they have warned of some danger, neither the Chancellor nor the Governor are coming entirely clear about this risk, nor what they would do about it.
Mark Carney’s Monetary Policy Committee (MPC) chose to publish their quarterly forecast for inflation on the assumption that the UK will vote to Remain. The consequences of a Leave vote were sketched only vaguely, and the conclusion was offered that rates might either rise or fall. This will have struck many—as it did me—as deliberately obscure.
Two forces are likely to put upward pressure on interest rates after a Leave vote and a Brexit shock. First, the drop in sterling will push up on import prices and therefore consumer price inflation. Second, the recession will cut investment, and this will shrink the economy’s potential. The more supply shrinks, the more this forces up prices and inflation.
Yet we can be fairly confident that both of these forces will be more than offset. To start with, the MPC will look through the effects of import prices on inflation, since they will be temporary and initially welcome, inflation having undershot recently. After all, the MPC looked through the effects of the last notable appreciation of sterling, which led to the inflation target undershoot that we're suffering. And the supply-side shrinkage that would accompany a recession would be small and slow to take effect. The flow of investment in any one quarter is a very small proportion of the size of the total stock of capital.
In short, the downward pressure on interest rates caused by the fall in confidence would be much stronger than the upward pressure. Given this, it’s a shame that the Bank weren’t more frank about how they see the future. Carney has made admirable progress instilling a culture of transparency at the organisation, and this episode goes against that trend. But if Carney were clearer, it would throw the spotlight on just how little room the Bank has to respond, and therefore just how little, with interest rates close to their natural floor, it could compensate for the recession.
In April, Osborne claimed that interest rates might rise after Brexit: perhaps it was this that made the BoE uncomfortable about openly contradicting it. It’s not inconceivable that people might end up paying higher mortgage rates. If the drop in confidence were to trigger a panic in the markets for bank funds, then banks might scale back lending and raise its price. In this event, the Bank would be cutting rates as much as it could and signalling that they would stay very low for a long time—still, the rates on mortgages and corporate loans could rise. But this is a pretty remote scenario.
In the Treasury report published on Monday there is a corresponding silence about the likely policy response on the side of the government to the Brexit shock. Mild and severe versions are simulated.
The report maintained the assumption that there would be no fiscal response to the Brexit shock save that engineered by the ‘automatic stabilisers’ the tendency for spending on benefits to rise and the tax take to fall as the economy shrinks. In the most mild of the two scenarios covered, this is probably realistic. In the most severe, it is moot. With very low interest rates for the foreseeable future, and many high-return social investment projects (energy, housing, rail and so on) around, the case for an increase in government investment – already strong – would be overwhelming.
A fiscal stimulus would need careful calibration. Depending on how you measure it, government debt to GDP now stands at around 80 per cent, compared to about 40 per cent in 2008. At some point—though nobody can be sure when—investors will start to worry about how the debt will be rolled over or repaid. Yet the consequences of not responding strongly enough to a recession can scar the labour force for a generation.
In such a situation it helps to be clear beforehand how firmly you will act, since if that message can instil confidence and rule out some of the worst outcomes. The Charter for Budget Responsibility allows the OBR to help with advance signalling, providing that it can announce that such shocks “will occur” and not merely diagnose them after the event. It would have to do the sensible thing and stretch to breaking point the meaning of the word “will,” (sensible precautions are taken for things that are simply likely, not just certain to occur) but the OBR should be able to help with the reassurance before 23rd June.
Given how important it is to manage expectations, it’s a shame that the government and the Bank have chosen to deliver stark messages about the Brexit shock—yet have not explained all that they could have about what the real risks are and how they think they would respond to them.
Now read: Michael Gove misunderstands
