I’m writing this in my hotel room in Shanghai. Being seven hours ahead of the UK meant that I had the doubtful privilege of watching the events unfold which led to the decision of a small majority of the British people to leave the European Union. I’m very sad about it but will try to remain calm and logical in what follows.
1. The UK will be permanently less prosperous
This conclusion follows from assuming that we will have less access to the EU single market in goods and services than before. It’s possible that the UK could have the same access as now, albeit with no influence on the rules in future, but that would almost certainly require continued free movement of people to and from the EU. Since the vote against the EU appeared heavily influenced by a desire to cut immigration, that deal would be unacceptable. So some form of impaired access seems likely.
Economists are almost entirely united in their view that this means lower productivity and income than what would otherwise have happened. Critics of the large amount of analysis coming to this conclusion made two claims: i) economic forecasts are often wrong; and ii) most economists thought the UK should join the Euro, so they’re not to be trusted on this.
It’s perfectly true that macroeconomic forecasting is hopeless – it is very difficult to predict key turning points in the economy. But this is a simpler problem, one of comparative statics, where you start with an equilibrium, assume a change in a key variable such as a price, and examine what the new equilibrium looks like compared with the old. Economists have lots of data on trade and they are confident that lower trade access is a bad thing. I see no significant compensating advantage to the economy of not being part of the EU.
On the second point, there was a fairly even split among UK economists ahead of the creation of the Euro. Many warned it would not work. I was reminded by a former student only last week that I had argued in an undergraduate supervision in about 2001 that the Euro was likely to fail economically.
So there is little doubt in my mind that we face weaker trade and therefore a lower level of GDP per head than we would have done. The only question is how much worse.
2. The exchange rate
The fall in the pound is to some extent a pricing in of the UK’s lower future income. The UK is already poorer; we are no longer the world’s fifth biggest economy, having fallen behind France at current exchange rates. British people can now afford to buy less from the rest of the world. The most immediate example is the higher cost of foreign holidays. The lower pound (the value of which may well continue to fluctuate but at a lower average level) represents a cut in British income.
There is also a price effect: UK imports are more expensive and exports are cheaper. This will help some parts of the economy and assist in narrowing the large current account balance of payments deficit. That deficit has grown much bigger in recent years, mainly on the balance of investment income into and out of the UK. The weaker pound will help. It will also attract more tourists to the UK. I’m in China this week doing business development for our executive education business. China is a tough market and we have overnight become more cost competitive against our US rivals.
3. A recession is now quite likely
The uncertainty over our future relationship with the EU and trading arrangements with the rest of the world will probably lead some companies to postpone or divert capital spending. Some sectors, especially finance, will almost certainly lose jobs and investment, especially in Euro trading and in investment services that require access to the EU. A trade deal on goods is easier to do than one on services and the UK has comparative advantage in the latter.
British households might well save more (that is, cut their spending) both because of the permanently lower income they face and the short term uncertainty. It’s quite possible that house prices will be lower, the only good thing to come out of this from a younger person’s point of view. But that, and lower stock prices, will hit the wealth of average households whose pension prospects will look poorer. All of this will naturally increase saving.
Lower business investment and lower household consumption make a recession quite likely. The Bank of England can’t cut interest rates much because they’re already low (and might worry about the effect of a much lower pound on price inflation, which could force them to raise rates instead). So even a mild recession could be protracted.
4. Longer term possibilities
The saddest thing about the vote was how it revealed the divisions in the UK. A map of the voting shows Scotland, parts of a few large cities plus greater London (including Cambridge and Oxford) voting to remain; the rest of the country was pretty much against.
I have lectured on our Advanced Leadership Programme for about three years now about the worrying economic stagnation of the US middle class. This is a profound concern for the current model of western capitalism because the benefits of growth, especially growth driven by globalisation, are not being shared by the majority of people. The consequent anger and despair over the future lie behind the Trump and Sanders electoral successes.
What I underestimated was the strength of similar forces in the UK. There are many very worried people in our country who see the benefits of open trade and migration as going entirely to other people (such as me). They worry about their children’s futures in regions such as the north east (with lower incomes than neighbouring Scotland but much less political influence) and in many coastal and rural areas which have suffered long term structural economic decline.
The solutions to this problem, which in varying degrees affects most rich countries and might soon come to haunt middle income countries too, are not at all easy to define. I can only hope that the UK will find new political leadership (the current political class is quite discredited) that will be open to new ideas and policies. Among them I hope will be much more investment in infrastructure in the north of the UK. I don’t mean the foolish waste of money that is HS2 (the high speed train to Birmingham and the north). More mundane improvements in roads and railways would help to narrow the gap between the north and London. More educational investment is also needed. But these are just a start.
If the shock of leaving the EU leads to a new programme of regional investment and a fairer sharing of the benefits of globalisation, the UK just might show other countries, above all the US, a way to halt and reverse the anger of those left behind and begin a process of national reconciliation. If that happens then something good will have come out of this sad episode.