How the Treasury’s model suggests the UK could grow faster outside the EU

Strange as this might sound, under the Treasury’s post-Brexit economic model it’s conceivable that the UK economy could, for a period, grow faster outside the EU than inside.

Let me explain why.

If you were reading this blog yesterday you’ll recall my point that the Treasury had not drawn up a simulation of what could happen to the economy if the UK left the EU and stayed in the single market.

For those who didn’t see that story, a quick recap: back when the Treasury published its analysis of the long-term impact of Brexit, it considered three scenarios of what might happen after Britain left: 1. That it stayed inside the European Economic Area (the EEA or single market), 2. That it left and agreed a bilateral trade deal with Europe (the Canada option) and 3. That it left and simply relied on World Trade Organization rules to trade with Europe and everyone else. The economic impact of each deal was as below:

longterm

However, when the Treasury published its short-term analysis yesterday, looking not at where Britain could be in 2030 but how it could do between referendum day and Q2 2018, it only provided two scenarios: a “shock scenario” where growth fell 3.6% and a “severe shock” scenario in which it fell 6%.

shorterm

As I wrote yesterday, the two scenarios were both based on the presumption that the UK would not join the EEA – in other words the least negative option from the top table above was simply ignored.

The suspicion was that this most conservative option was omitted because the scenario would not result in the scary recession the other scenarios projected.

However, I’ve since been told by government insiders that, in fact, something similar to these two scenarios – the shock and severe shock – could nonetheless apply even if the UK left the EU and then eventually decided to stay a member of the single market. In other words, a small or even deep recession could ensue whatever post-EU path the UK decided to take. This is because there are three factors that could cause a recession: the uncertainty factor (people get scared), the transition factor (people make particular plans because of how they envisage life will be outside the EU) and the financial market factor (the City faces big trouble following Brexit). It turns out the uncertainty factor is one of the biggest elements- and that would apply whatever post-Brexit path the UK takes.

On the one hand, Leave campaigners will see this as a blow. People are generally unlikely to vote for economic pain, after all. However, there is a thin, albeit hollow and technical, silver lining for them, which goes as follows: if the UK leaves the EU, suffers a severe shock and then opts to remain a part of the single market, according to the Treasury’s own models it could actually grow faster for the following decade and a bit than it would had it simply stayed in the EU.

How does this work? Well, 1) let’s presume the UK had that severe shock and shrank by 6% between Q2 2016 and Q2 2018 compared with its path if the UK remained. 2) Assume, too, that the Treasury’s long-term assumption stands, that if the UK took the EEA route then by 2030 it would be 3.8% smaller than if it stayed in the EU. 3) In that case, the economy would need to recoup some of that lost ground in the following years. In rough terms, one might expect that between Q2 2018 and 2030 the UK economy could grow 2.2% faster than it would do if it stayed in the EU.

You can see the point from the line in the below chart, which compares how UK GDP would fare compared with its current expected path (the zero line). As you can probably tell, I jotted in the line myself:

swoosh

In other words, on the basis of the Treasury models, the UK economy would be smaller in 2030 than if it stayed in the EU, but there would also be what Gerard Lyons, Boris Johnson’s economic advisor, has called a “Nike swoosh” effect as it regained some of that lost ground in the following years. What this means in practice is that the economy would grow ever so slightly faster between 2018 and 2030 than it would if the UK stayed in (perhaps 0.2 percentage points a year, which is pretty small in the grand scheme of things).

Moreover, it’s something of a Pyrrhic victory, since the growth comes from a smaller base and the UK economy would, on this basis, nonetheless be smaller in the long term than if it stayed inside. Plus, Treasury insiders say there’s also a significant chance that if the UK suffered a major recession in the first few post-EU years, then the 2030 end-point could be even worse than it thought in last month’s analysis.

Finally, you could, quite reasonably, retort that this is just proof that you can use an economic model to prove basically anything. Which is quite right. So why are we paying so much attention to them in the first place…? etc etc

Why is the Treasury ignoring arguably the most likely post-Brexit deal?

If you follow these things, you may recall that last month, when the Treasury produced its analysis of the long-term impact of Brexit, it furnished us with three potential scenarios: 1. that Britain leaves the EU and remains in the European Economic Area (the EEA, or single market), a little like Norway; 2. a bilateral agreement option (a bit like Canada) and 3. following World Trade Organisation rules.

You probably recall that the EEA option was the least damaging, with GDP in 2030 3.8% weaker than it would otherwise have been, followed by the Canada option (-6.2%) and the WTO scenario (-7.5%).

Roll forward to today’s short-term analysis of Brexit and you might have noticed that there are only two scenarios mapped out by the Treasury. There is the “shock” scenario, which projects a 3.6% hit to GDP over two years (relative to where it would be otherwise), and the “severe shock” scenario which projects a 6% hit.

As you can see from this chart, the “shock” scenario is based on the Canada path in last month’s paper. The “severe shock” scenario is based on the WTO path (you’ll notice that the colours correlate, and this is not accidental).

comparisonscenarios

But there is no line to simulate the EEA option.

This is odd. For while many members of the Leave camp have indicated that they would not want to remain inside the single market, this is hardly a final decision, and is, for many, still the most likely option.

Either way, it is odd and inconsistent for a respected institution like the Treasury to simply change the terms of its analysis so abruptly. And it leaves one wondering whether the short-term impact of the UK leaving the EU and following the Norway path might actually not be all that harmful at all.

Might it have excluded the Norway option because, dare I ask, it didn’t result in a recession at all?

 

PS I’ve written a longer piece of analysis on the Treasury document on the Sky News website

The most telling chart from the Treasury’s Brexit report

What is the EU? Not all that long ago, we all knew the answer. These days, what constitutes Europe has disintegrated so dramatically that the beginnings and ends of Europe are extremely fuzzy. Consider the following chart from the Treasury’s Brexit report.

EUmembershipvenndiagram

Look at where the UK is. Inside the European Union, outside the fiscal compact, outside the euro, outside the countries obliged to join the euro. And not all that far away from Norway and Iceland, which are technically outside the EU.

If I were a Leave campaigner I would make much of this chart. Not only does it show, quite viscerally, that the UK is clearly outside the centre of gravity in Europe, one might also quite reasonably ask how dramatic it would be if the UK were simply one ring further away from that euro core, sitting alongside Iceland and Norway.

Then again, the Remain camp might point out that the UK is already so semi-detached from Europe that, well, why make all the fuss?

Probably right, definitely not accurate. The Treasury on the impact on Brexit

Economics is an art masquerading as a science. Always has been, always will be.

An economic model looks complicated, full of factors and equations, but it is invariably balanced on a bunch of assumptions that are, if not plucked out of the air, then at the very least guesstimates. Art plus science equals economics.

The Treasury’s analysis of the impact of Brexit is a case in point. It is a well-researched, chunky piece of work. It has some of the best inverse gravity modelling known to man. It has many equations which look impenetrable and intimidating. It is shrouded in a cloak of science.

eqquations1

And yet underneath its surface there are a whole load of assumptions and guesstimates.

mainbox

To understand how and why, consider how those big numbers above (for instance, the 6.2% hit to UK economic growth, £4,300 for each household, by 2030) were forged. It was a long-winded six-step process. By way of explanation, allow me to paraphrase the bottled Treasury argument.

  1. First, trade matters, really matters, to the economy: UK trade flows are now over 60% of gross domestic product. So any fall in trade would naturally impact UK economic growth. This is pretty uncontroversial.
  2. Under any of the three Brexit scenarios they’ve looked at (the UK becoming a. more like Norway, b. more like Canada, or c. more like Brazil/Russia in terms of its economic relationship with the EU) trade and foreign direct investment would fall. This is an assumption. A reasonable one, but an assumption all the same.
  3. If trade falls, so does productivity and with it the performance of the wider economy. Again, this is a reasonable assumption, but there is a question mark over how you model the extent of the impact. The Treasury used a load of academic research based on previous episodes of trade trauma, including the Suez crisis of the 1950s, when the canal was briefly closed, to model this.
  4. Then they plug that resulting number into a broader model of the world economy, supplied by the National Institute for Economic and Social Research.
  5. After that they lop an extra bit of growth off the UK economy to account for what they call the “persistence effect” – the permanent chunk of growth that goes as a result of business firms putting off investment, households cutting spending, because of the fear and shock of the departure. The “persistence effect” means in each of the scenarios modelled in the HMT paper the economy is 1% weaker by 2030. Quite why the effect is the same in every scenario is unclear. It is yet another guesstimate.
  6. Once the Treasury has this growth number, it puts it into its public finance models and calculates the impact on tax revenues and spending. Unsurprisingly, because the economy will be weaker, so will the public finances (to the tune of £36bn in the Canada scenario). Provided you believe the headline numbers, this is totally uncontroversial. What is a little more odd is that in each case, the Treasury has lopped off £7bn to account for the fact that the UK would no longer have to contribute to the EU budget. This is oddly imprecise, given that these scenarios imply totally different grades of relationship with the EU.

You get the idea. There is plenty of detailed, forensic analysis throughout this report. But there are also a fair few unscientific assumptions thrown in to boot.

There’s the presumption that migration won’t be affected at all in any of the scenarios. There’s the fact that the report gives short shrift to the idea that regulations might be cut if the UK leaves. There are those slightly unscientific touches, like assuming the change in contributions to the EU is the same in every scenario, and lopping a seemingly arbitrary extra 1% off the growth impact for each scenario as a result of the “persistence effect”.

Now, economists would reason that all of the above is simply what happens in economic exercises like this. The more specific you get in each case, the more hypothetical your modelling looks, and the easier it is for critics to pick apart, so perhaps better to apply the same numbers and assumptions to each scenario.

However, it underlines that this is not a purely scientific exercise. That £4,300 figure is the product of a cocktail of equations and assumptions, some precise, some unexpectedly crude.

But ‘twas ever thus. Any economic assessment of the impact of some unknown future event will have to incorporate many imponderables. And in broad terms, the Treasury has been relatively conservative. Its forecasts are more pessimistic than those from Oxford Economics, but less so than those from the London School of Economics. It has attempted to measure not just the impact on trade but also on the broader economy (a dynamic rather than a static projection). You can quibble to your heart’s content, but at least the Treasury has been open enough about its assumptions.

And if one takes the mass of evidence from economic analysts over the past few months, one overarching lesson is emerging from the statistical clouds. In most scenarios, the UK would probably be worse off in the event of Brexit. Whether that loss is a price worth paying for extra sovereignty is something the Leave camp must  confront. It seems increasingly difficult to argue that people would be better off in the event of the UK’s departure.

But to suppose that the Treasury is able to put a two-decimal place precision on the impact of departure is frankly a little silly. Not that that will stop them.

Why the Bank of England is closer to a cut than you might think

Watching the Bank of England is an exercise in what old Cold War hands used to call Kremlinology. Because Moscow never used to make open statements about its plans, the only way to get a sense of its future actions was to watch the smoke signals coming from the Kremlin, to look at the body language rather than the actions.

When it comes to the Bank of England, the best way to get a sense of its future actions is to run a fine toothcomb over the Monetary Policy Committee’s members’ comments to see which way they’re leaning. And it so happens there has been a subtle shift over the past few months – a shift most economists seem to have missed.

Remember that only a few months ago the Bank’s Governor declared that the next move in interest rates would be up, not down, and that all members of the MPC agreed on that. Then, in February’s Treasury Committee hearing, he subtly changed his position.

Now have a look at these two sentences, the first from the February MPC minutes:

The MPC judges it more likely than not that Bank Rate will need to increase over the forecast period to ensure inflation remains likely to return to the target in a sustainable fashion.

Now compare that with this one from the March minutes (emphasis mine):

The MPC’s best collective judgement is that it is more likely than not that Bank Rate will need to increase over the forecast period to ensure inflation returns to the target in a sustainable fashion.

In other words, the MPC is no longer unanimous that rates will go up over the forecast horizon.

To some extent, this is just a formalisation of what markets are already telling us. Not long ago they (and the Bank) were predicting rates were going up within months. Now they don’t expect an increase in borrowing costs at all, at least until 2021(!) Indeed, they think there is more chance of a cut than an increase.

My understanding is that at least two of the MPC members are strongly considering cutting rates, if wages and inflation do not pick up considerably in the coming months (a look through the cuts and it won’t take you long to guess which ones).

Smoke signals like this don’t seem to have been noticed very widely in markets, and yet the reality is that the MPC is closer than many think to being split on interest rates, with some members voting for a cut, rather than a rise.

All the same, there is a difference between considering a cut and actually doing it (a distinction which seems to have been lost on some day traders who got very excited when I tweeted words to that effect earlier today – and then very angry when the MPC did nothing). The latest minutes (which, significantly, repeat that latter line) hint that until the referendum is out of the way, the Committee is unlikely to do anything to rock the boat.

Screen Shot 2016-04-14 at 12.25.15

But if the economy has not shown convincing signs of pick-up by July, the smoke signals from Threadneedle Street suggest that some members are poised to vote for a cut in rates.