12 May 2022

It’s nonsense to blame Brexit for the cost of living crisis

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So it’s official: the UK is teetering on the brink of another recession. If you believe some of the commentary, this is mainly the fault of an uncaring Tory government, or Brexit, or both. The reality is that the problems are just as acute in the rest of Europe.

The suffering of others is, of course, no consolation. The UK economy ground to a halt in March, strengthening calls for an Emergency Budget to ease the cost of living crisis. Even if the UK avoids a technical recession (usually defined as two successive quarters of falling output), it will certainly feel like one for many households struggling to pay their bills.

The Chancellor might still hope that he can wait until the autumn before taking any further action. After the hike in April, domestic energy bills are at least now capped until October. In the meantime, there is already more help coming in July, when the threshold for paying National Insurance is increased.

However, the cost of living crisis has now spread to food prices, and inflation is likely to remain higher for longer than anticipated in the Spring Statement. Consumer confidence is also so fragile that it may be too risky to delay the announcement of additional help until the autumn.

An effective package should include a mix of benefit increases, tax cuts and measures to lower energy prices, and mainly be targeted at low-income households. Options include bringing forward the next uprating of benefits, reinstating the temporary uplift to Universal Credit, eliminating VAT on domestic energy, and removing some of the policy levies from standing charges.

None of these measures would require an arbitrary ‘windfall tax’ on energy companies. If necessary the Government should be willing to borrow more to prevent a recession, an outcome which would be even worse for the public finances. But in practice the Treasury is already raking in more money than expected, as higher nominal incomes, profits and prices all help to boost tax revenues.

It also makes little sense to argue that providing more support to low-income households would itself add to price pressures. Even if this were true, it is the Bank of England’s job to worry about the overall level of inflation. If this means that looser fiscal policy has to be offset by tighter monetary policy, then so be it.

It is, however, also quite wrong to claim that the UK is some sort of outlier. The UK economy grew by 0.8% in the first quarter as a whole, which was well above the European average. As a result, UK GDP is now marginally higher, relative to its pre-Covid peak, than in the Euro area.

Admittedly, the UK data for the first quarter were flattered by the lifting of Covid restrictions at the start of the year, and by the way the Ofgem energy cap protected UK households. But the latest business surveys suggest that the outlook for the next few months is just as grim in the rest of Europe, and worse in Germany in particular (reflecting the greater exposure to Russia and China).

It is reasonable to argue that Brexit has added something to cost and price pressures in several ways, including the disruption to international trade and supply chains, additional dislocation in labour markets, and lower business investment. Nonetheless, there is remarkably little hard evidence of any significant impact on inflation. Claims that Brexit explains as much as 80% of the UK’s inflation problem are clearly nonsense.

Just look at the numbers released elsewhere in Europe in the last few days. German inflation was confirmed at 7.8% in April on the EU harmonised measure, with food price inflation accelerating to 8.6%. The German press is full of stories of foodbanks struggling to keep up.

Inflation was even higher in the Netherlands, at 11.2% on the EU measure. Dutch energy prices were still up 136% on a year ago, despite a cut in fuel duty, while food inflation also rose further, to 8.5%.

Headline inflation has been lower than the Eurozone average in the UK, but it will probably jump above this average in April and could be slower to fall than in many other countries. However, as the Bank of England explained in its latest Monetary Policy Report, this mainly reflects the operation of the Ofgem price cap.

There are two key points here. First, the UK government is allowing more of the increase in wholesale energy costs to feed through to final prices (as in the Netherlands, and Belgium) and focusing instead on providing more support via the tax and benefit system. This contrasts with countries which have intervened more aggressively to keep prices down (notably France).

Second, it should not be taken for granted that UK inflation will remain higher for longer, or that the economy will underperform. Like other official forecasters (including the OBR and IMF), the Bank of England bases its forecasts on current government policy, rather than what is actually likely to happen (especially on the Ofgem cap), and on market expectations for interest rates and energy prices (which are probably too high).

In short, it is plausible that the departure from the EU has added at least a little to the upward pressures on UK prices. This underlines the importance of efforts to ease trade frictions, reduce uncertainty, and exploit new Brexit opportunities to offset these additional costs.

However, the UK’s stagflation problems are not, as former MPC member Adam Posen claimed again today in the Financial Times, a reflection of the ‘realities that Brexit has wrought’. Any Brexit impact on inflation in particular has been dwarfed by other factors.

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Julian Jessop is an independent economist.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.