Ever since the 2016 referendum, economists have attempted to estimate what Brexit ‘has already cost’ the UK economy and households. It won’t be a surprise to see some of the most depressing numbers dusted off this week to mark the departure from the EU. But all these studies should be taken with a large pinch of salt. It would certainly be wrong to regard these numbers as gospel truth, or 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 business 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 often 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 method 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 per cent 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 using OECD forecasts (when are they ever wrong?), to predict that the output loss will increase to about 4 per cent 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. For example, 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, they 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 always one of the two fastest growing economies in the G7 (as it was in every year from 2013 to 2016), and the euro-zone in particular was 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 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 the UK has actually outperformed Germany again more recently (growing about twice as fast in 2019).
To be fair, John Springford at least has acknowledged this point. The latest (and final) CER report on the ‘cost of Brexit’ noted that excluding the US from the analysis reduced the estimated hit to UK GDP from 2.9 per cent to 2.2 per cent, while excluding Germany (and thus increasing the weight on the US) increased it to 3.4 per cent. 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. As it happens, the slump in sterling in 2016 did little more than reverse the appreciation between 2013 and 2015 (the chart below is the Bank of England’s trade-weighted index). It’s reasonable to argue that the pound was over-valued in 2015 and that the vote to leave the EU simply brought forward a decline that would have happened anyway, at least in part.
However, most studies simply attribute all of the decline in the pound to Brexit. For example, economists at the LSE have suggested that the fall in the pound has increased consumer prices by 2.9 per cent, costing the average household £870 per year. There’s a lot of sophisticated analysis behind this, but in the end all they’ve done is take 0.29 (an estimate of the share of imports in UK consumer expenditure) and multiply it by 10 per cent (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. In addition to assuming that all of the fall in the pound was due to Brexit, the study assumes that higher import costs were passed on in full to consumers and that they were unable to avoid price increases 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. Even the pick up in inflation may not have been entirely unwelcome, given that consumer prices rose only 0.5 per cent in the 12 months to June 2016, well below the Bank of England’s 2 per cent target.
Many of these studies also take it for granted that the fall in the exchange rate is permanent. This 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. I expect that view to be proved wrong. But we can already say that fall in the exchange rate at least partly reflected the increase in uncertainty, and this uncertainty is now easing.
There is plenty of encouraging evidence here. Since Boris Johnson became Prime Minister the pound has risen by about 5 per cent on the Bank of England’s index, despite speculation of 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 per cent) has been well below the average (around 9 per cent) 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 early evidence is encouraging. Business surveys since the decisive election result in December 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 per cent of GDP, 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 per cent by the end of 2020, perhaps twice the rate in the euro-zone. And in the long run there is still all to play for.
This is an expanded version of a piece first published by CapX