Brexit is already shaping the economy for the better

Brexit is already shaping the economy for the better

Conveniently for Consensus economists, the mandatory end-of-year reviews of 2016 and 2017 never included the forecasts they made in August 2016 at the height of their panic over Brexit. The 2016 forecasts they reviewed were all made at the end of 2015 when they did not expect Brexit and the 2017 forecasts they reviewed at the end of last year were all made at the end of 2016 when their panic had largely subsided and been replaced by sullen expectation of slowdown in some vaguely-specified future.

It is instructive to evaluate how the economy has turned out since the referendum since it is a good test of the Consensus negativism towards Brexit, led sadly by HM Treasury in its two Brexit Reports (short- and long-term). This consisted of two strands of thinking: Brexit would cause damaging uncertainty in the short term which would cause a collapse in demand, with a likely recession, and would also inflict long-term damage on the potential growth in the economy due to a contraction of trade with the rest of the EU.

The broad picture turned out quite differently on both counts. First demand did not collapse but continued to grow rather normally; during 2017 the consequences one would expect from a large devaluation showed themselves, with consumption slowing and net exports rising on the back of enhanced profits in the traded sector – the so-called ‘expenditure-switching’ effect of a devaluation. While a number of economists pounced on the slowdown of consumption as evidence of the forecast ‘demand slowdown’, this was plainly a misinterpretation of that usual expenditure-switching effect, now more obvious in the data as CBI and PMI (Purchasing Managers) surveys reveal the extent of the new upswing in manufacturing and other traded sales.

Second, there is no evidence of long-term decline in potential growth. Much has been made of the ‘productivity puzzle’ whereby since the financial crisis UK-measured productivity has grown well below its past trend of around 2% a year: the Office for Budget Responsibility notoriously revised down its projections for future UK productivity growth in its November 2017 Budget forecasts. Without ascribing this to Brexit, it managed to fit into the general Treasury-inspired gloom about the consequences of Brexit with this forecast.

Yet there are two key issues involved here which should inspire scepticism about the supposed UK productivity slowdown – discussed at some length in my A Budget for Brexit. First, measured productivity (i.e. output per person) is highly responsive to the business cycle; bad recessions like the Great Recession in the financial crisis have a huge effect on it. This is due to the fact that labour is more and more like a fixed asset, in which like capital the firm’s own specific knowledge and ‘human’ capital is lodged. In recessions it is much under-utilised. Then in the slow recovery we have had where labour became extremely cheap as people were desperate to find jobs, firms acquired more labour – a ‘good time to buy’ – and essentially hoarded it, building it into its capital stock. It is particularly significant that in the second half of 2017, when employment has stopped growing with an increasingly tight labour market and little available spare supply, output has grown solidly and with it productivity has taken off.

Second, the productivity of a service economy is plainly under-measured, even when one gets past this problem of cyclicality. Service quality is notoriously hard to measure; and Statistics Offices do not even try (as they have started to try with the quality of goods like computers and washing machines). Yet there are plenty of reasons to think it is rising steadily as services incorporate the effects of computerisation into their product – think of how much easier it is to book hotels or travel with the internet. Even government services have become more productive. Getting your car licensed or fines paid can now be done online.

Of course the problem for the UK is that services are now 80% of GDP: the easily-measurable productivity gains in manufacturing, only 10% of GDP, now contribute only a small proportion of growth in GDP. The same is true of the US and of most advanced economies, hence the ubiquity of the productivity puzzle in the developed world.

When one looks at the Consensus forecasts for August 2016 one can see that it greatly underestimated the growth rate since Brexit. For 2016 they expected a near recession in the second half worth 0.1% growth in each quarter whereas in fact the quarterly growth rate was 0.65%; the Treasury notoriously predicted an immediate recession after the Brexit vote. For 2017 the Consensus expected growth to continue at a similarly slow rate, 0.6% per annum, whereas in fact growth has proceeded at 1.8% per annum. By December 2016, the Consensus forecast for 2017 had risen to 1.3%; however this was still well below the 1.8% outturn. The December 2017 Consensus forecast for 2018 is 1.5%. It too will be surely much too low.

My own forecasts were for the continuation of previous growth rates in the 2-3% range through the rest of 2016 and for 2017. In fact, soon after August 2016 the ONS sharply revised downwards its estimate of Q1 growth, from 0.4% to 0.2%; this meant that growth in the first half of 2016 was now estimated to be at around 1.8% p.a.. Essentially what this revealed was that the pre-Brexit growth rate had slowed below the 2-3% rate. In our subsequent forecasts we revised down our growth projections closer to 2%. However, we remain doubtful about the ONS estimates for 2017 (and also 2016) and expect them to be revised upwards, as they often are; they have been systematically below what would have been implied by the PMI surveys. Also as noted later, the ONS has just (December) discovered a large error (£3.6 billion) in its estimate of net exports in Q3: on its own, correcting this would add 0.7% to Q3 GDP, nearly tripling the Q3 quarterly growth rate! We await the next revision of Q3 GDP.

As for any Brexit effect, it will have come through the Brexit devaluation. Projecting exactly how rapidly a devaluation will work on each of the different spending categories is fraught with difficulty; the lags are variable though typically longer for business spending and net exports than for consumption.

The main point to come out of all this for the economy’s behaviour is that it has not reacted much in its overall growth to Brexit. The gloom of the Consensus was not justified: growth has remained pretty much unaltered, and certainly has not dived to near-recession rates as the Consensus forecast. Moreover it is reacting rather healthily to the Brexit devaluation, with a consumption slowdown, some investment growth and an improvement in net exports; were it not for the feverish ‘despite Brexit’ atmosphere that has gripped the forecasting community such a short term trend would have been widely welcomed.

How the latest indicators look

Let me end this backward look at forecasting outcomes with a forward look at where available surveys suggest the economy is headed.

Starting with productivity, where so much ink has recently been spilt, we may note that in Q3 and Q4 growth looks as if it will have been around 0.9% for the second half of 2017, at least as seen by the ONS at this time. Meanwhile the latest estimates of employment suggest that it has fallen by 0.2% between May-July and August-October. Supposing there is no further fall in employment by the year end, this would imply that in the second half of the year measured productivity per man jumped by 1.1%, an annual rate of 2.2%, roughly around its previous trend pre-crisis. Just for the third quarter the latest ONS estimate of productivity per manhour is +0.9%, an annual rate of 3.6% (Hours worked dropped 0.5% in Q3 while output rose 0.4% on the estimates so far).

How strong is current growth, going into 2018? Fairly strong according to two major sets of indicators. The CBI survey of private sector business across distribution, manufacturing and services reported a positive balance of +19% in the quarter to December, strengthening from +6% in the quarter to November – any positive balance indicates growth. Its recent surveys of manufacturing have been the best since 1988, underlining strong optimism on export orders.

The Purchasing Managers’ Indices, where a number over 50 indicates growth, are similarly positive. The manufacturing PMI for November was 58.2, for services it was 53.8 and for construction it was 53.1. These all support the idea of growth continuing for now at its current rate of 2% or so.

An important element in all this is the movement of net exports, which we would expect a large devaluation to push upwards especially when world growth is proceeding at a moderately good rate, just below 4%. The goods and services trade balance was averaging -£10 billion a quarter during 2016. In the third quarter this was down to -£5.8 billion, almost half the 2016 rate. This is an improvement of no less than 1.0% of GDP in just over a year. In volume terms the improvement is around £4 billion, about 0.8% of GDP, this being the contribution to the growth rate over the period. Here the ONS has needed to make large upward revisions of the data in the last month, discovering substantial extra exports of services.

A similar improvement is occurring in the net income balance of the current account. This has been running at a deficit since the financial crisis, before which it was in surplus; in 2016 this averaged a negative £18.25 billion per quarter. By Q3 2017 this had improved to £16.9 billion, a 0.3% boost to Gross National Income.

These are all encouraging figures which suggest that the UK economy is entering a period of steady growth and an improving balance of payments. Plainly given that the current account deficit was running before Brexit at around 7% of GDP, this had to be corrected since it revealed that the economy was spending this much above its income, an unsustainable situation. It is encouraging that since the Brexit devaluation this situation has been improving and the current account deficit had in 2017 Q3 come down to 4.5% of GDP. It is a further unfortunate manifestation of Brexit fever that the economic forecasting community is hardly picking this up in its ongoing commentary.

It remains true that answers to ‘confidence’ questions remain either uncertain or negative. This is true for example of the CBI and the Bank of England agents’ surveys of confidence, as well as consumer confidence surveys. However, it must be said that these surveys generally mirror media commentary on the outlook and do not correlate well with what businesses and people actually do in reaction to their own situation.

With media – especially BBC – comment relentlessly downbeat, with the constant refrain of ‘despite Brexit’, it is entirely natural that when questioned businesses and people express doubt and concern about the future. This is clearly worsened by the general ‘noise’ of the political process both here and in the EU over trade negotiations. Nevertheless, what is clear is that people and businesses are weathering this process and carrying on robustly with their own business and personal agendas. We often forget that uncertainty is endemic in the economy even in the best of times and that it is usually dealt with pragmatically on the basis of direct individual circumstances and judgements;  ‘general confidence’ indicators on their own are often for this reason a poor guide to actual intentions.

Conclusions

The economy is performing robustly in the face of a Brexit process which is still incomplete. The sooner the negotiations with the EU can be successfully concluded the better in terms of general confidence factors. As I have argued elsewhere, the UK would do well under ‘No Deal’, indeed it would in purely economic terms do better than with a Canada-plus trade deal, in that there would be a quicker movement to free trade and a big gain in our net financial payments to the EU. However what is important is that a united government proceeds to deliver its current clear policy to get agreement with the EU and non-EU trade partners on free trade, with the UK resuming control of its domestic regulations and its borders. That will pave the way for a decade of faster growth.