It is now ten years since the financial crisis struck, gaining ferocity in September 2008 with the collapse of Lehman. Recession began in 2008 with a fall in GDP of 0.5%, followed by a fall of 4.2% in 2009. It took three slow years to get GDP back to its pre-crisis 2007 level. By 2017 GDP had grown by an accumulated 11.2% above that level.
This recovery from the Great Recession has been accompanied by an ‘austerity’ programme conducted first by the Coalition Government of 2010 and since the 2015 election by the Conservative Government. Public debt as a percentage of GDP, excluding the Bank of England’s monetary operations and also the various bank bailouts, peaked at 81% in 2015 and is now down to 76%. Public Sector Borrowing fell in the 2017/18 financial year to £39.4 billion, or 1.9% of GDP. This borrowing rate would lower the debt/GDP percentage by about 1 percentage point a year, as GDP growth would more than offset the effect of new borrowing. But on present minimalist Treasury policies the PSBR is also falling steadily as a percent of GDP. It follows that the UK is now moving, slowly but encouragingly, towards a target safe debt percentage of around 60%.
The latest PSBR figures up to end-June are more encouraging still. Compared with the same period last year, borrowing over April-June was £5.4 billion lower, at £16.8 billion. This suggests that we are well on track for our previous full year forecast of £35 billion for 2018/19. This compares with the OBR Budget forecast of £39.5 billion. However, with employment still growing and inflation at around 2%, incomes will be growing steadily during this financial year and revenue has a strong response to such steady growth. Income Tax and VAT both grow about 1.5-2 times as fast as money GDP. We have revised our forecast downwards to £30 billion. On unchanged policies our forecasts now suggest that the UK will reach the 60% public debt to GDP target within five years.
Other indicators suggest the economy is picking up steam again after the weak, weather-affected, first quarter. Best estimates of GDP growth for Q2 are around 0.4%, while the Purchasing Manager Indices are pointing to 0.5% in Q3. The latest PMIs for June are well above the neutral no-growth level of 50: manufacturing 54.4, services 55.1, and construction 53.1, continuing to recover from its weather-related level of 47 in March.
Meanwhile retail sales in the three months to June surged by 2.1% on the previous quarter; they were up 2.8% on a year earlier, establishing that consumer spending is rising rather strongly again. Unemployment continued to fall, to 4.2% from 4.5% a year ago, and employment to rise, to 75.7% from 74.9% a year ago, defying the labour market’s increasing tightness. Total weekly hours have risen 0.3% over the past year but are no longer rising each quarter; this suggests that productivity (per hour) may at last be recouping some of its past sluggishness as the labour market tightens.
The economy is also rebalancing away from its excessive balance of payments deficits on current account. The quarterly deficit peaked at 6.7% of GDP in 2015 and averaged 5.9% of GDP in 2016. By Q4 2017 it had fallen to 3.8% of GDP. Most of this has been due to trade, with some coming from net foreign income. It is plainly due to the Brexit devaluation which has stimulated net exports ate the expense of consumption demand.
For an economy so long in the tooth in its recovery from the shock of the Great Recession, this is a good picture as we move into the age of applied AI and robotics, which supposedly threaten jobs but promise large gains in productivity. A strong labour market and a budget in good shape is a good background from which to cope with this promise and threat. Jobs can be relocated instead of lost for long periods and demand can be supported by fiscal expansion. As we have explained before, the opening of the economy to free trade and better regulation via Brexit should boost productivity and further strengthen the budget.
This is also a time to move monetary policy away from its ‘emergency loose’ settings before they trigger more serious distortions in asset markets and the economy; savers and small firms must once again be treated normally by the markets for borrowing, and the government and large firms must stop having their privileged access to ultra-cheap money. Besides if this is not done we will have lost the monetary policy tools to sustain the economy when the going gets difficult again.
Has Brexit hit investment?
It is frequently asserted by Remainers that ‘investment has been hit by Brexit uncertainty’. Could it be true that with no Brexit at all we would have had an investment boom? If we compare the situation with the US – where there is now an investment boom on the back of Trump’s tax cuts and widespread deregulation, plus the shale oil bonanza – it is hard to believe. In any case, as we have seen, it could not have affected demand for GDP as that is at a maximum, given existing capacity and available labour. Had there improbably been such a boom, it would have led to a tightening of monetary policy as that by the Fed, to head off excess demand. So whatever ‘Brexit uncertainty’ has done, its effect on demand would have been nullified by monetary policy.
Could it have reduced the supply of GDP? Suppose for argument’s sake investment had been cut by 5% by Brexit as some argue. What effect would this have on capital capacity? Capital is around five times GDP, and investment is around 15% of GDP; this implies that annual investment is about 3% of the capital stock. So a 5% fall in investment would reduce the capital stock by about 0.15%. Given that there is currently excess capital capacity, this would have virtually no effect on supply. All the numbers above can be argued about but no plausible adjustment would change this point.
It follows that Brexit cannot have had any non-trivial effect on GDP during this period.
But of course in the long run investment is part of the necessary process of growth in productivity. Once Brexit has occurred capital plans will be adjusted to meet the post-Brexit needs of the economy. Any delays due to previous uncertainty will be made up by acceleration later. The level of planned capital will be the same in the long run for any given Brexit outcome.
What matters therefore is the sort of Brexit we have. If it is one that goes to free trade and improves regulation, besides ending the subsidy of EU unskilled immigration, then the gains are considerable: they raise the marginal product of capital and so will raise capital and the investment path compared with no Brexit.
Of course if it is a ‘soft Brexit’, continuing the status quo, these gains will not materialise and investment will not rise compared with no Brexit.
Coud a World Trade Deal lead to Canada+?
This brings us to the astonishing developments in the Brexit negotiations, where Mrs. May finally threw off all subterfuge and pushed through the Chequers proposal under which the UK effectively stays in the Single Market for goods. This volte-face from her Mansion House speech is described by her with her typical respect for the English language as an ‘evolution’.
These proposals cannot, even if agreed to by the EU in their present form, get through the House of Commons because of massive Brexiteer opposition both in the Commons and in the country. Furthermore, the EU will anyway insist on further ‘evolution’. They may also be vetoed by the European Parliament.
What then is likely to happen as we approach the end-March 2019 deadline for the end of Article 50 and our departure from the EU? It is possible that the talks with the EU on trade could break down totally, so that the final Withdrawal Agreement provides for no transition period and an immediate move to a World Trade Deal on WTO rules. The Agreement would then simply deal with all non-trade matters, where apparently both sides say that ‘80% is agreed’.
This route of WTO-based trade would achieve for the UK the gains available from Brexit, and indeed by avoiding the transition arrangements would bring them forward. The agri-food and manufacturing associations such as the CBI and the NFU, representing some 11% of the economy, claim this would lead to barriers from customs and standards compatibility. But any such barriers would be illegal under WTO rules, since UK-EU standards are now identical and customs procedures must be seamless as they are already. These industries need to get ready for the new world outside the EU and stop their endless lobbying to avoid it by such means as the Chequers proposal.
However trade on WTO rules and no transition would be extremely difficult for the EU, as we have explained before: the tariff burden would fall on EU exporters and importers, there would be an immediate financial crisis for the Commission in the current budget period with the loss of the UK contribution, and world competition with EU sales in the UK would begin with no delay from transition. For this reason it is likely that the EU would restart negotiations on trade after the false start of the Chequers proposals on the basis of the Canada+ concept which would allow tariff-free UK-EU trade in goods to continue.
We may well therefore find that ultimately the Withdrawal Agreement contains a commitment to negotiate a Canada+ trade deal on goods, together with the ‘equivalence’ Chequers proposals for the City that appear to be getting a near-welcome from the EU; and that it preserves the transition period on the basis that this deal will be translated into detail during this time. This would be an outcome that finally might well be agreed with some goodwill on both sides by both the UK and the European Parliaments.
To read Professor Patrick Minford’s piece in full, click here.