29 January 2020

The problem with the big ‘cost of Brexit’ numbers

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Ever since the 2016 referendum, economists have attempted to estimate what Brexit ‘has already cost’ the UK economy and households. It wouldn’t be a surprise to see some of the most depressing numbers dusted off this week to mark our departure from the EU. But all these studies should be taken with a large pinch of salt. It’s certainly wrong to regard them as gospel truth, or as a reliable warning of even worse to come.

There are two main approaches to answering the question of what impact the referendum result has already had. One is ‘top-down’, which looks at the overall performance of the UK economy compared to its peers, usually measured by headline GDP growth. The other is ‘bottom-up’, which focuses instead on specific indicators, notably inflation and investment, where it is relatively clear that the vote to leave has had a negative impact.

I’m not keen on the first of these approaches. Studies here typically rely on the ‘synthetic control’ method, which uses a computer algorithm to select a weighted combination of countries whose growth best matched that of the UK economy before the 2016 referendum. The actual performance of the UK economy since the referendum is then compared to this control group, or synthetic ‘doppelganger’, and the difference taken as a proxy for the impact of the vote for Brexit. In other words, the performance of the doppelganger is assumed to be the ‘counter-factual’ (or what would otherwise have happened) if the UK had voted to remain.

This approach is well explained in studies by the CEPR and John Springford at the Centre for European Reform (CER). Others using it include the investment bank UBS, the Bank of England’s Gertjan Vlieghe and the latest IFS Green Budget. These studies typically conclude that the level of UK GDP is now around 3% lower than it would otherwise have been, or a shortfall of around £60 billion a year.

Indeed, there are now so many of these studies that authors have had to come up with new ways of coming up with ever bigger numbers. The CEPR team has extrapolated their results forward, by using OECD forecasts, to predict that the output loss will increase to about 4% of GDP by the end of 2020.

Not to be outdone, Bloomberg (using a simpler method based on the past correlation between the UK and other G7 economies) has added up the annual figures to conclude that the accumulated cost of Brexit has already hit £130 billion, with a further £70 billion ‘set to be added by the end of this year’.

There are a number of problems with all these studies, including the sensitivity of the results to the choice of countries in the control group and the weights assigned to them. Successive iterations of the CER model have required some large changes in order to ensure a good fit. But the biggest weakness is the assumption that all the difference in the relative performance of the UK since 2016 is due to Brexit, rather than other unrelated factors affecting the UK or the control group.

In reality, there may be some very good reasons why the UK would have slipped down the growth league tables anyway, regardless of the outcome of the 2016 referendum. Much as I’d like to think otherwise, the UK isn’t normally the strongest economy in the G7, and some eurozone economies in particular were due a period of catch up.

What’s more, any international comparison is usually dominated by what has happened in the US, where the economy has recently benefited from a substantial fiscal boost under President Trump. In contrast, UK GDP has grown at roughly the same pace as Germany since 2016, and actually outperformed Germany over the last two years.

To be fair, John Springford at least has acknowledged this point. The latest (and final) CER report noted that excluding the US from the analysis reduced the estimated hit to UK GDP from 2.9% to 2.2%, while excluding Germany (and thus increasing the weight on the US) increased it to 3.4%. But that’s a substantial margin of error.

I therefore think it makes more sense to adopt a ‘bottom-up’ approach. There is no doubt that the UK economy has been held back since 2016 by Brexit uncertainty in two main ways. But again, most studies are too pessimistic.

One of these channels is the inflationary impact of the fall in the pound. For example, economists at the LSE have suggested that this has increased consumer prices by 2.9%, costing the average household £870 per year. There’s a lot of sophisticated analysis behind this, but in the end all they have done is take 0.29 (an estimate of the share of imports in UK consumer expenditure) and multiply it by 10% (an estimate of the fall in an import-weighted sterling exchange rate index).

In my opinion, this is at the upper end of what’s plausible. The study assumes that higher import costs are passed on in full to consumers and that they are unable to avoid them by switching to domestic goods and services. It also ignores other channels through which the fall in the exchange rate might have had a positive impact on the economy and on at least some households, including the boosts to competitiveness and asset prices. But my main objection is the assumption that the fall in the exchange rate is permanent.

This assumption is obviously consistent with the dispiritingly common view that the long-run economic impact of Brexit will be negative, and substantially so. Indeed, some have seen the weakness in sterling as evidence that this view is right, which seems dangerously circular. Indeed, that view may well yet be proved wrong. But we can already say that fall in the exchange rate at least partly reflected the increase in uncertainty, and this is now easing.

There is plenty of encouraging evidence here. Since Boris Johnson became Prime Minister the pound has risen by about 5% on the Bank of England’s trade-weighted index, despite speculation about an imminent interest rate cut. Obviously, sterling has a long way to go to reverse the fall in the wake of the 2016 referendum. However, that may not be such a bad thing, given the benefits that a more competitive currency can bring.

Similar points apply to the impact of Brexit uncertainty on investment. According to the latest official data, business investment has stagnated since EU referendum. Even looking at the broader measure of Gross Fixed Capital Formation (GFCF), investment growth in the UK (around 3%) has been well below the average (around 9%) in the rest of the G7. This suggests there is plenty of pent-up demand.

Of course, Brexit pessimists will continue to argue that investment has been held back by the reality of the long-term damage that they believe leaving the EU will do, not just uncertainty about the process, and that this reality hasn’t changed. But even if Brexit has some negative effects, at least companies will know what they are dealing with and how to respond, and Brexit won’t dominate the news in the negative way it has since 2016.

Again, the evidence is encouraging. Indeed, business surveys since the decisive election result in December (such as the Deloitte poll of CFOs) have already shown a marked improvement in corporate sentiment, including investment intentions.

In short, it is reasonable to conclude that Brexit uncertainty has undermined the economy, but the estimates now grabbing the headlines all seem to be at the high end. In my view, the hit is more likely to have been in the range of 1 to 2% of GDP, an estimate which sits more comfortably with the continued strength of the labour market.

But, more importantly, the initial impacts on consumer spending and business investment should be at least partly reversed as uncertainty eases. I expect this to help the UK economy to grow at annualised rates of 2% by the end of 2020, perhaps twice the rate in the eurozone. And in the long run, there is still all to play for.

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Julian Jessop is an independent economist