Sunday 25 September 2016

Dan O'Brien: The UK economy will certainly slow - and could well slump

Published 03/07/2016 | 02:30

How is the British economy doing? What are its strengths and weaknesses - and what are its prospects?

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The past 10 days have been as tumultuous as any in living memory in the politics of our nearest neighbour and most important trading partner. At this early juncture, there are many indicators that the real economy will slow considerably in response to the shock of Brexit. The chances of full-blown recession are considerable.

The meltdown of both of the main political parties means that the leadership capacity to handle the fallout is reduced. The growing risk of a constitutional crisis over Scottish independence merely adds to already multiple uncertainties.

The wider range of possible outcomes for Ireland and Europe is enormous - from Brexit triggering other in/out referenda and ultimately the break-up of the EU and the euro, to a second referendum in Britain which sees our neighbour staying with us in the bloc.

But one thing is certain: uncertainty is an investment-killer.

That was clear from UK economic performance even before the Brexit referendum. Business investment started to contract in the second half of 2015. It is almost certain that the risk of Brexit was a factor, if not the main factor, in causing that.

This component of GDP - known in the jargon as 'fixed capital formation' - accounts for almost one fifth of the UK economy.

As elsewhere, it tends to be much more volatile than consumer and government spending, which means that when it slows, it can contract by a great deal. A big contraction in any component of an economy has knock-on effects for others.

Business investment tends to be volatile because companies are highly sensitive to uncertainty. Given the extent of the uncertainty unleashed by the vote to leave the EU, it is very difficult to see investment recovering over the remainder of the year.

The better news on the British economy, at least until 10 days ago, was that the recent contraction in investment had been more than offset by the continued growth in other components of the economy. In the first three months of 2016, overall GDP grew by 0.4pc quarter on quarter, after expanding by 2.3pc over full-year 2015.

In comparative terms, the EU as a whole grew slightly faster, at 0.5pc, in early 2016.

When the full-year 2015 growth rate is compared, it was vice versa, with the UK expanding at a rate a bit above the average for the bloc as a whole (2pc) and more rapidly than any of the three other major economies - Germany, France and Italy.

What about the other big indicator of economic performance - employment?

Here, there is more unambiguously good news for/from Britain. Last year, the UK had 30 million people at work for the first time ever and the jobs performance since the end of recession in Europe has been one of the best in the rich world. As the first chart shows, the number of people at work in Britain was almost 4pc higher last year, compared to the pre-crisis employment peak of 2008. Among the long-established EU countries, only Luxembourg has done better.

Although by historical standards that is not a strong rate of jobs growth, when one notes that even countries with well-functioning labour markets - Denmark, Finland and the Netherlands - have recorded net declines in employment over that period, it is more than decent.

Britain also does well on other measures of labour market performance. More than three out of four people of working age (20-64 years) are employed. That, again, is a record, and one of the highest in the EU - only a handful of countries, such as Germany and Sweden, have higher levels.

If there is any cause for concern, it is that the rate of employment growth had been slowing even before the referendum. With both the output and employment measures already decelerating, along with some (but by no means all) other indicators, momentum can only be weakened further by the Brexit shock.

A longer-term point is also worth making. While the UK has many strengths - a strong traded services sector and a large stock of inward FDI - it also has weaknesses.

As the second chart shows, per person GDP is on the low side compared to its rich peers in northwest Europe. The eagle-eyed will also spot that it was only a tad higher in 2015 than in 2007, its pre-crisis peak. That shows that Britain's good demographics account for much of its comparatively good headline growth performance in recent years. That, in turn, reflects long-term weaknesses - low corporate investment and problems with skills and education.

But these are very long-term challenges. What of the more immediate ones? At the beginning of the week, Fitch and Standard & Poors - two of the three big ratings agencies - cut the UK's rating by one and two notches, respectively.

That was followed by chancellor George Osborne repeating his pre-referendum pledge that there would have to be another dose of austerity if the electorate chose to leave. That would take further momentum out of the economy, in the short run at least.

If pro-cyclical fiscal policy deepens the downturn, the Bank of England will be in an even more difficult position. If sterling stays at its current low level, the price of imports to the UK will rise. If it falls further, as the British balance of payments numbers suggest it will, then the price level will rise by a lot. That would put pressure on the BoE to raise interest rates.

However, the more immediate concern is weak growth or outright recession. Last Thursday Mark Carney, the governor of the Bank of England, said that as "the economic outlook has deteriorated, and some monetary policy easing will likely be required over the summer".

But, as central bankers have learnt in the post-2008 era, stimulating the economy is difficult when interest rates are already close to zero. The BoE cut its basic lending rate to 0.5pc at the height of the crisis in 2009. It has not budged since.

Carney hinted on Thursday that even the current ultra-low interest rate would be cut further. Another round of unorthodox measures, along the lines of financial asset purchases and/or more direct measures to get credit to home buyers and businesses, is back on the table too.

These are issues that will be faced over the next 18 months. By the end of 2017, the actual departure from the EU will be looming over the following 18 months (if it does indeed go ahead). The prospect of new barriers to trade going up will have a short-term negative impact on the economy.

When they are actually erected, the impact will be much longer-lasting, pushing trade onto a permanently lower trajectory.

The UK economy will not sink into the North Atlantic - but it will be less prosperous than it would otherwise have been. And that will be bad for Ireland, as well as for our neighbours.

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