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UK economy came through the referendum ok, now comes the hard part

10th January 2017

Discussing the UK economic outlook in a TV studio interview recently, the other economist turned to me at one point and said ‘Look, the economy’s fine, you should cheer up’. In one respect, of course, she was right. As the Bank of England’s Chief Economist, Andy Haldane acknowledged last week, the pre-referendum warnings from the Bank, Treasury and others about a post-referendum ‘technical recession’ proved to be way off the mark.

In another respect, though, she was, as the Americans say, whistling Dixie. She meant that I should cheer up about the economic prospects for the UK outside the EU over the next few years. To do that, though, you either have to have belief, which belongs in your preferred place of worship, or you have to have an idea about what drives growth, productivity and living standards. Belief may make you feel better, but won’t make things happen.

In the interim, what is the basis for reasons to be cheerful, and what, if anything, does it portend?.

Evidence is good, as things stand

The so-called purchasing manager surveys all showed businesses ending the year on a high note. Service industries were expanding at the fastest rate since July 2015. Manufacturing activity was at the highest level since 2014. Separately, we know that housebuilding has been picking up – though levels remain significantly lower than before the financial crisis – that homebuilder share prices are performing well, and that a record 2.69 million new cars were registered last year, albeit largely in the fleet rather than personal sector.

These high frequency economic indicators give us a decent snapshot mostly of what’s happening to growth. The official GDP releases and revisions, though, inform about the economy as a whole. What we know is that after a slow start at the beginning of the year, GDP rose by 0.6 per cent – or 2.4 per cent at an annualised rate – in the second quarter, in which the referendum came at the end – but that it continued expanding at this pace in the quarter ending September, a far cry from the stall that had been predicted. The Office for National Statistics said that the post-referendum boost was entirely attributable to service industries, since construction and production industries were both weaker than before. The leading lights were concentrated in communications industries, driven mainly by the film, video and TV sectors, sound recording, music publishing and computer programming.

The first estimate of fourth quarter 2016 GDP will be published in just over 2 weeks on 26th January. On the basis of admittedly still skimpy data sets for the quarter, analysts are expecting a quarterly GDP rise of about 0.5 per cent, which is pretty much the UK’s average quarterly growth rate for the last 20 years. It will bring the annual growth rate to about 2.2 per cent.

Some forecasts wrong, but not meaningless

So why did the Bank and the Treasury get it so wrong?  There is one over-riding explanation for why official and other forecasters were too pessimistic: they got household consumption wrong.

The assumptions that a Leave vote would shock confidence and change household behaviour were perhaps rooted our experience of what happened in 2008-09, and to a more limited extent in 2013-14. In the event, the policy environment changed – with the Bank of England cutting interest rates a bit and relaunching QE. And Sterling fell sharply, boosting tourist receipts and the local value of income and profits from abroad, and perhaps inducing households to bring forward some spending before goods and services became dearer. Most important of all, the savings rate, which had been 6.1 per cent in the quarter of the referendum carried on falling to 5.6 per cent in the following quarter, helping to propel household consumption growth of about 0.6 per cent. This was all the more remarkable because real disposable income actually fell by a similar amount. The corollary, of course, is that there is a limit to how far consumption can keep driving GDP if it depends on falling saving (or more borrowing), and if real incomes stagnate.

And that is precisely why most forecasters now still expect a worse, if not awful year in 2017. Following the fall in Sterling, the rebound in energy and industrial materials prices, and the slight hardening of wage and salary formation, inflation is expected to rise to about 3 per cent or so by the end of this year or early 2018. With money wages growing by less, people’s real incomes therefore will decline.

Elsewhere, business investment grew by a mere 0.4 per cent in the third quarter, but was still over 2 per cent weaker than a year earlier. The referendum aftermath may have been marked by reasonable consumption, but the  blue touch-paper for investment by businesses remains quite damp.This doesn’t augur well for productivity growth. Output per hour is growing at a snail’s pace and is only just back to where it was before the financial crisis. If the economic outlook is to improve markedly in 2017 and beyond, we will need the government to nurture a durable revival in investment spending, as well as in home-building and modern manufacturing.

Remember also that looking at a decent economy through the rear view mirror and out the side windows, so to speak gives a different view from looking ahead at the implications of weak investment and productivity, and fragile financial deficits. The recent Autumn Statement included estimates for public borrowing that were £150 billion higher for the period 2016/17-2020/21 than had been previously estimated, and the latest current account of the balance of payments numbers showed a negative balance of over 5 per cent of GDP. Neither of these deficits are immediately alarming but they limit the government’s scope for policy. As the Office of Budget Responsibility stated recently, over half the £150 billion is due to more adverse economic conditions, and most of the rest is attributable to the consequences of Brexit.

How to think about the economy now

It is quite appropriate that those who warned of a post-referendum economic funk eat their fair share of humble pie. In a nutshell, without the disruptions to trade, investment and confidence that actual Brexit threatens, most things have carried on as normal.

But there is the rub. Sooner or later, Article 50 will probably be triggered, with timing depending partly on the Supreme  Court’s decision this month. By 2019, the UK will either be out of the EU without an agreement to govern subsequent relations, or there will be some sort of transition arrangement during which a host of legal, trade, financial, and human rights issues will be allowed to evolve. In practice, the focus for businesses will not be the 2019 deadline, but how things are shaping up between this spring and the middle of 2018. And remember, it isn’t just that the UK doesn’t seem to know what it wants at the moment, but also that France and Germany will be otherwise preoccupied with elections.

If it looked as though a ‘hard Brexit’ were unavoidable, the accompanying uncertainty would very likely trigger a more drastic response by businesses as regards relocation, and investment spending and this would spill over into trade and the rest of the economy. I assume here that the government will not be sufficiently focused to be working on a Brexit mitigation strategy at the same time, in which it would be devising policies to boost investment, education, health and productivity.

If it looked as though there would be some transition arrangement that suited both the UK and the EU, the economic outlook would be brighter because of greater certainty about arrangements, contracts and so on. But companies are in a precarious position: it is in the UK’s interest to have a transitional agreement soon, but in the EU’s to have it at the eleventh hour. The UK government thinks it has leverage because its strength lies in commerce and transactions, the EU thinks the UK has never understood and doesn’t get now the political glue that binds Europe together, regardless of commerce.

The UK’s economic outlook depends crucially on how these political phenomena play out: arguing about the post-referendum months is irrelevant.