By Dr Graham Gudgin and Ken Coutts, Centre for Business Research, Judge Business School, University of Cambridge
The aftermath of the EU referendum initially saw a slew of relatively favourable economic data. Leave supporters took this as vindication of their view that the Remainers’ predictions of an immediate crash had been hugely exaggerated. The Treasury forecast that the immediate impact of a leave vote ‘would result in recession…with four quarters of negative growth,’ shows little sign of being accurate. The one accurate prediction of the ‘Remainers’ was that Sterling would fall, leading to higher inflation.
The expectation of the Treasury, Bank of England and indeed some Leave supporters, that sterling would depreciate was realised immediately after the referendum with a depreciation of 8% in the trade-weighted average exchange rate (relative to the mean level of the previous month). This caused little alarm since it merely restored what had been a stable level for the exchange rate over the five years up to 2013. The rise in Sterling in 2014 and 2015 was widely seen as leading to an over-valued currency, associated with an unprecedentedly large current account deficit. The restoration of the stable 2009-13 level was thus unremarkable.
Until the Tory Party Conference all seemed well, but Prime Minister May’s conference speech, making it clear that the UK was likely to leave the EU single market, set the cat among the pigeons and Sterling has subsequently fallen further to a level 15% below the pre-referendum level. This latest fall has re-energised the Remain camp, who retain their conviction that leaving the EU will prove disastrous for the UK economy.
A range of economic forecasters provided estimates of the impact of Brexit during the referendum campaign and some have produced forecasts since the vote. Most of the pre-referendum projections were dismissed as propaganda, unfairly so in many cases although the two Treasury documents (on the long-term and immediate impacts) were in our view overly pessimistic. Post referendum forecasts should properly be described as scenarios since Brexit is a unique event and there is little solid evidence on which to base a forecast.
Forecasting models - the CBR model
There are two types of forecasting model. The so-called ‘general equilibrium’ models are based on theories about how producers and consumers might behave with strong assumptions on how these ‘agents’ interact. In contrast ‘econometric’ models examine actual trends over recent decades to estimate how different parts of the economy react to external changes such as world trade or oil prices. Neither has much to go on in attempting to judge how UK trade will evolve after Brexit, what degree of short-term uncertainty will undermine business investment or to what extent the Government and Bank of England will attempt to offset any negative impacts.
We have used our own CBR econometric model  to attempt to shed some light on what might happen. This is nothing more than a scenario based on an arbitrary set of assumptions about how Brexit might evolve. Different assumptions would lead to different outcomes. It is up to the reader to judge whether the assumptions are realistic. We have attempted to adopt what we see as fairly negative assumptions to assess what would happen if the fears of ‘Remain’ supporters were realised. Actual outcomes could be better than this but with so little to go on, this can only be a guess.
The assumptions are shown in the Box below. The key assumptions are that the UK will leave the EU in 2019 and in that year the new trade arrangements will involve a loss of 20% of EU markets. Offsetting gains in non-EU markets will be slow to materialise over the following two decades. Reductions in imports from the EU will be smaller than the loss in export markets and will be partly offset by higher imports from non-EU sources. For example new world wine imports will increase relative to EU wines.
A large degree of uncertainty about future trade arrangements will lead to reduced business investment from 2016. The reductions in 2017 and 2018 will be about as large as in the banking crisis of 2009. Most of this reduction will be temporary and a bounce-back in business investment occurs from 2019 as uncertainty diminishes. Permanent losses occur in foreign direct investment in physical plant and structures.
A 10% depreciation in the Sterling exchange is built into the forecasts in mid-2016. There-after the model itself predicts the exchange rate contingent on short-term interest rates which are assumed to be kept low in an accommodating monetary policy which allows consumer price inflation to rise to peak at 5% just as happened during the banking crisis. The bank rate is assumed to rise slowly to 2% by 2020 and to remain at this level. Net migration from the EU is assumed to fall to zero in 2019 (although balancing gross flows continue). There are assumed to be no direct impacts of Brexit on household current spending or on housing although indirect effects occur as the assumptions impact on the scenario.
An important feature of this scenario is a degree of support for the economy through fiscal policy. The Government has already announced an end to targets for fiscal balance and we assume that public spending will be higher than in current government plans. In detail we assume that current spending on goods and services grows a little faster than under previous austerity plans, and that capital spending grows 2% faster than in existing plans. Since the pre-referendum (baseline) forecast a slowing in growth after 2020 as the next downturn in the long-run credit cycle begins to bite, we have assumed a step up in fiscal support between 2020 and 2025.
The initial macro-economic impact of these assumptions is much as expected. The fall in business investment in 2016, and especially in 2017-18, reduces the growth of GDP (chart 1). The worst year is 2017 when GDP growth falls to 0.9%, which is 1.1 percentage points below the rate forecast immediately prior to the referendum. Because most of the reduction is due to delayed rather than cancelled investment, a bounce-back occurs in 2019 as normal capital/output relationships begin to be restored. Paradoxically just as the UK leaves the EU and EU markets are lost, the revival in business investment leads two years of favourable growth in GDP at rates close to 3% per annum.
Chart 1 Real GDP (% per annum)
The impact of a substantial loss in EU export markets proves to be less dramatic than expected. The assumption that 20% of EU markets are lost through higher tariff and non-tariff barriers, translates to 8% of all export markets (i.e. 20% of the 40% of EU exports going to the EU). However further projected falls in the Sterling exchange rate, which leave the pound 23% below its previously projected level, support exports and the level of real exports in 2019 is only 4% below the baseline forecast.
The large fall in the value of Sterling results in higher inflation with consumer prices rising at just over 3% per annum in 2017 and 2018. A further fall in Sterling in 2019 raises price inflation to 5% per annum by 2020. Growth in real wages is reduced by the higher inflation but in this scenario real wages still rise in most years, with an actual decline in only one year. Our model suggests that nominal wages will rise above the current 2% per annum norm in reaction to higher consumer prices.
GDP is projected to be back above the baseline level by 2020, mainly due to higher government spending and lower interest rates (table 1). Unemployment is projected to rise a little up to 2020 and then to fall as fiscal support leads to higher job creation and lower migration reduces competition for jobs (table 1). By 2020 the unemployment rate is expected to be much the same as in the baseline forecast at 5.7% of the labour force.
Table 1 Differences from Baseline (Pre-Referendum) Forecasts due to the Brexit Assumptions
Lower GDP in the next few years, combined with higher government spending, lead to a higher fiscal deficit than in the baseline forecast, although the deficit remains below 3% of GDP in most years. A higher deficit initially keeps the public sector debt close to its peak of 84% of GDP and a little above the baseline forecasts. Inflation is however the fastest way to reduce the debt and the higher inflation in the Brexit scenario causes the debt to decline faster relative to GDP than was the case in the baseline.
Despite relatively draconian assumptions on loss of EU markets, and on delays in investment due to uncertainty, the macro-economic impact of Brexit looks manageable. There are three reasons for this.
Firstly we have assumed that most, although not all, of the short-term fall in business investment is temporary. Once firms become clearer about the new trade arrangements we have assumed that normal capital/output ratios are restored.
Secondly, an important assumption is that a moderate degree of fiscal support is applied, involving higher government spending, and that interest rate policy accommodates an inflation rate significantly above the normal target of 2% per annum. Without these fiscal and monetary policy adjustments the transition to new trading relationships over the next decade would be harder on living standards. Although these policy changes initially lead to deteriorating public finances, higher inflation eventually reduces the ratio of public sector debt to GDP.
Thirdly, the positive impact of fiscal and monetary policy on unemployment is further aided by an assumed lower level of net migration from 2019. Unlike some commentators, the CBR model suggests that lower migration will reduce unemployment even as it also leads to lower job creation.
 The model is described in CBR WP472 at www.cbr.cam.ac.uk/publications/working-papers/2015. The model is a structural econometric model developed on stock-flow consistent Keynesian principles without the supply-side assumptions which dominate the UK Government’s OBR model.