After Brexit, an economic fork in the road

After Brexit, an economic fork in the road

The British economy will take one of two very different paths in 2020


SINCE THE financial crisis of 2008-09 Britons have had it tough. Weak productivity growth and high inflation have conspired to keep real wages below their pre-crisis level. But more recently Britain has started to see a genuine recovery in living standards. In the second half of 2019 year-on-year growth in nominal wages rose to its highest rate in more than a decade. Unemployment has fallen to a four-decade low. Whether these positive trends continue will hinge on what happens with Brexit.

Assume first that Britain avoids a no-deal exit from the European Union in 2020—either because Parliament passes a withdrawal agreement with the EU or there is another extension to the exit date. The pound would rise, especially if there seemed any chance of a second referendum. That would support living standards (about a quarter of the basket that makes up Britain’s consumer-price index is composed of imports). The labour market would strengthen further. 

Policies could help the economy along. On the fiscal side, the Conservative government has signalled that it is willing to loosen its purse-strings a little. For Britain’s underfunded public services, that is welcome. The Bank of England has warned that if wage growth gets much stronger, it is likely to raise interest rates. Yet the bank has in the past misjudged the extent to which domestic cost pressures will build as the labour market strengthens. If consumer-price inflation remains below the bank’s 2% target, there will be little need for tighter monetary policy. 

Everything changes in the event of a no-deal Brexit, however. Overnight Britain would become a member of the World Trade Organisation on its own, not as part of the EU. Regulations on everything from financial services to medicines could lapse. The pound would fall from close to $1.30, its current level, to $1.10 or below (and probably reach parity with the euro). Consumers would surely cut back on spending. 
An argument commonly heard among Brexiteers is that businesses will take up the economic slack in the event of no-deal. Since the referendum in 2016, firms have held off investment spending as they wait for clarity to emerge on Britain’s future trading relationship with the EU (in real terms, investment has not grown in three years). The thinking goes that finally following through with Brexit will lift the haze of uncertainty. Yet a no-deal Brexit would not eliminate uncertainty, but ramp it up: Britain would immediately have to start trying to reach a trade deal with the EU. 

If a recession loomed, as would seem likely, the Bank of England would loosen monetary policy. But it would be constrained, because the pound’s tumble would send inflation well above its 2% target. And there are limits to what monetary policy can do. It affects the demand side of the economy (ie, how much people want to spend). But Brexit is just as much a shock to the supply side of the economy (ie, what it can produce), including regulations and the ease with which Britain can engage in foreign trade. Monetary policy “will not increase the proportion of throughput through Dover,” as Mark Carney, the bank’s governor, memorably puts it. 

For their part, Brexit-supporting economists suggest that, though a no-deal Brexit might be bumpy in the short term, in the long term it would cause little damage. They are too optimistic. In the event of a no-deal exit, the EU has agreed to recognise British lorry licences and to allow British airplanes to continue flying to and from the EU, but only for a few months. The economy would suffer if those agreements lapsed. Over time, regulations between the EU and Britain would diverge, hindering trade. 

The long-term impact of no-deal would, therefore, be bad (though economists do not agree on quite how bad—see chart). Pulling out of a highly integrated trading bloc would be an economic shock the like of which few countries have ever seen. Rather than 2020 representing the end-point of Brexit, in short, it may mark only the beginning of discovering what it really means. 

This article appeared in the Britain section of the print edition under the headline "The fork in the road"

Credit: Reuters
Download 'The World In 2020 iOS app'
Download 'The World In 2020 Android app'