Two hours…

That was how long the Chancellor’s message of reassurance to market investors lasted today.

George Osborne resurfaced at the Treasury just after 7am to tell investors that the UK economy remains strong, to assure them and households that he would take all necessary contingency plans to deal with the instability following the Brexit vote.

And for a little while, the plan seemed to go pretty well. The main London stock markets did not start the day quite as low as had been expected. The pound even rose, for a bit. Moreover, there has been no sudden stop, where investors abandon a government’s debt. In fact the UK government can now borrow at the lowest rate since 1703 – less than 1% for 10 year debt.

yields1703

But a little after 9am the effect wore off and the market misery that characterised Friday’s trading was back.

London shares slumped back towards the 6,000 mark, with bank shares and a few of those most affected by Brexit doing disastrously: RBS (still 73% owned by the taxpayer, lest we forget) was at one stage down by 25%; Easyjet was down by a fifth. Having risen briefly after Mr Osborne’s appearance, the pound then dropped again to the lowest level in 31 years.

Credit Suisse said that based on leading indicators, the UK is probably already in recession. Indeed, the way investors are behaving – piling money into “defensive” stocks such as utilities and consumer staples – suggests they are gearing up for a slump. The Institute of Directors warned that businesses were actively considering pulling investment and cutting jobs from the UK. Investors are now betting that the Bank of England will cut interest rates in the coming months, perhaps more than once.

Moreover, looked at from another angle, those record low gilt yields could equally be taken to imply that UK growth will be weaker for longer.

Ugh. And, frankly, the bad news is likely to outnumber the good for some time – and for a simple reason. Investors demand stability: stability of taxes, of trade arrangements, of regulation, of immigration policy, of exchange rates. They all play a part in determining whether a company will build that new factory or hire new workers. And the problem with the way Brexit has manifested itself is that, having won the referendum, the Leave campaign is looking towards the Treasury for a plan, who in turn are looking back towards the Leave camp for a plan.

The Chancellor’s appearance this morning illustrated the problem perfectly. There is, he said, a short term plan for stabilising the markets. What there isn’t is a long-term plan for the kind of relationship the UK wants with the EU and other trading nations. And one presumes there won’t be such a plan until there is a new Conservative leader and, perhaps, until after a general election. And even that might not provide a clear guide, since there may not be a clear majority winner.

You get the idea. As long as there is no plan, instability will reign. Investors will continue to be wary of the UK economy, and the economy will be sluggish. The only question is how long the sluggishness, or indeed the potential recession, will last. Another way of putting it: how long until the politicians get their act together, stop squabbling and start leading?

Further thoughts on the EU referendum result 

The problem is not our relationship with the European Union. That can be resolved in the coming years and, who knows, might turn into something more functional than the incoherent muddle it has become in the wake of the euro crisis. 

The real problem today are the shockwaves generated by the referendum result, which go much further – to the very fabric of what has cemented Britain’s place as one of the world’s leading economies. Think about it: what are the key factors that have made the UK a good economic bet in the past – for investors, for employees, for businesses looking to establish themselves somewhere prosperous?

It has chiefly come down to five things: 1. A stable political system; 2. A stable, predictable and reliable legal system; 3. London’s status as a global financial centre; 4. The UK’s reliability as a creditor and 5. The UK’s openness to trade, capital and migration flows. 

The reason markets and investors are quite so disturbed about the EU referendum result is that it puts every single one of these five pillars under question. 

1. The political establishment is now in ruins. The Prime Minister has resigned; much of the cabinet will doubtless follow. 2. The legal system is likely to change wholesale, given it is, for better or marked with EU laws and regulations. 3. Investment banks may well resettle away from the City of London if the UK is no longer a member of the passporting system (basically the single European market in key corporate finance services). 4. The public finances are likely to be thrown into disarray by the short and long term fiscal consequences of the post-referendum downturn; and for the time being there is no clarity on who will preside over those finances in the future. The credit rating is likely to be cut. 5. Finally, while it is possible that an independent non-EU UK could remain open to trade and immigration, those are not the kinds of mood messages transmitted by the a Leave camp during the campaign. 

Now, at this stage it’s worth emphasising that there is no God-given reason why a sensible administration could not surmount all the above issues. But it will take an almost superhuman effort in policy making and financial and legal diplomacy. 

Last night the pound fell by more than it has done in any trading period on record. Consider that for a moment: more than on Black Wednesday, more than during the financial crisis, more than in the 1970s, when Britain had to call in the International Monetary Fund. That is not an academic detail, it will affect everyone. Inflation will go up; Petrol prices will go up; many businesses trading overseas will struggle. It is hard not to presume that there will be a recession, as there has been every other time the pound fell anything like as suddenly and dramatically. The only question is how deep. 

Then there’s a deeper issue. Like most developed nations, the UK has many internal divisions – divisions between the wealthy and the less well-off, between the capital and the rural areas, between each of its regions. While we often make much of those divisions, they are no more entrenched than in many other countries. But, thanks in large part to the electoral system, they are rarely exposed in as brutal a way as they were last night. Every region of England, save for London, voted to leave. Wales voted to leave. Scotland and Northern Ireland voted to stay. Never has the UK looked so divided. 

Whoever takes over at Number 10 faces the greatest challenge of any British Prime Minister in decades 

What the…

Here are some initial stream-of-consciousness thoughts. Apologies if they’re a bit incoherent. 

This much we know: today is already one of the most extraordinary and volatile days in UK economic history.

For the time being, leave aside, if you can, all your questions about the future of the United Kingdom, about the fate of the government, even about whether Britain will be better off outside the European Union. That can wait for at least a few hours.

What can’t is this: overnight, Britain has swung from what economists would call a stable equilibrium to something resembling chaos. And investors are truly terrified.

In the early hours, the pound lurched about more than any other day in modern history. More than on Black Wednesday, the day still cited as the most tumultuous moment in modern British economic policymaking. More than after Lehman Brothers collapsed or at any point in the financial crisis. Broadly speaking, a 1% intraday move in a major reserve currency is considered pretty big. A 10% move (as we have just seen) is, literally, unprecedented.

Now, on the one hand you might be tempted to dismiss this as yet more scaremongering and nonsense. Not so fast. Many of us were sceptical about the Treasury’s forecasts for the UK economy in the event of Brexit. But we also saw worrying signals in the market – that while in the long run Brexit might be an economic opportunity for the UK, in the short run it could spark volatility and capital flight. A few weeks ago we revealed that investors sold off £65bn of sterling assets in the first couple of months of the referendum campaign. It turns out that was only an early tremor of what we are seeing today.

The exchange rate is a useful barometer of a country’s economic prosperity because it reflects the flow of cash into and out of a country. It reflects whether people are buying or selling UK sterling assets. And the scale of the fall in sterling suggests a full-blown firesale. This morning, every single sterling UK asset is worth 10% less, measured in dollars, and 6% less, measured in euros, than it was last night.

Now, you might argue that the pound needs to be lower in the long-run, which it probably does. We have a record current account deficit and a worryingly imbalanced economy. The worry is that the scale and speed of the fall smacks of capital flight.

That traders were taken completely by surprise by the result of the EU referendum is hardly big news – many in the Leave camp thought they were heading for a resounding loss when the polls closed. But it underlines that today is likely to be a bloody day in markets. The Bank of England is likely to step in soon – perhaps to inject liquidity into the markets, perhaps even to cut interest rates.

In the short run, it is in both sides’ interests to ensure markets can regain some stability. The problem is that markets are unstable because the sheer range of possible economic outcomes in the coming years is enormous. Does the UK lift its drawbridge, cease immigration and face WTO-sized tariffs on all its trade? Does it stay in the European Economic Area, like Norway, even though that is effectively EU membership in all but name?

Most economists think the gap in future prosperity between these two paths is far greater than between being inside the EU and out.

And that is before we get onto the questions about who will be Prime Minister, who will be Chancellor, and will the UK exist in its current state in a few years’ time?

In other words, markets may remain unstable and unsteady for some time, until at least some of these big unknowns are resolved. And the longer that instability lasts, the greater the chance that Brexit spawns its own global financial crisis – a newly- independent Britain’s first export to the wider world. 

Anatomy of a scare story

The frustrating thing (well one of the many frustrating things) about the EU referendum campaign is that all too often some of the numbers spurted out by both sides simply aren’t interrogated.

There are a few eye-catching exceptions: the Government’s claim we’ll all be £4,300 worse off; Vote Leave’s EU-costs-£350m-a-week. But many of the other claims are just trotted out without much challenge.

Take Boris Johnson’s recent claim that the UK will be landed with a £2.4bn bill as a result of rising EU budget contributions. This is misleading on two counts: first, because UK contributions always rise as the broader economy expands (they are a constant chunk of an increasing pie). Second, because extra budget contributions on top of this can be vetoed by the UK.

Or take another claim I’ve spent the day trying to get my head round. This one:

£900mclaim

This isn’t the first time we’ve heard a warning from the Remain camp that mortgage costs could go up in the event of Brexit. But it is the first time they’ve put some numbers behind it. And yet if you go to their website to try to find out how they got to this £900 figure, you’ll find just two paragraphs with no statistics and no real explanation.

Now, they did send out a press release to lucky journalists with the following bullet points:

mortgageemail

 

Much of which you’ll have seen cut and pasted into news stories in the papers over the past few days. Unfortunately none of those stories point out a few critical problems with the £900 figure.

Before we get to those problems, allow me to explain how they get to that number in a few bullet points.

  1. They take the calculation in the Treasury’s paper on the short term impact of Brexit that if the UK left household borrowing rates would go up by between 70 basis points and 110 basis points, which is the same thing as saying 0.7-1.1%.
  2. They then take the average house price, as of March, which was £292k, they assume that people will be taking out a 76% mortgage on it (in other words a £222k mortgage).
  3. They then take the average two-year fixed interest rate on a new mortgage, currently 1.87%, and worked out, using the Money Advice Service’s mortgage calculator, how much a 1.87% repayment (eg not interest-only) mortgage would cost each year (£11,123) and how much that mortgage would cost if the interest rate were 2.57% (£12,045)
  4. Voila, they have a figure of a difference of £922 a year.

But there are quite a few problems with this analysis.

  1. It is not a given that mortgages would go up by precisely the same amount as the “household borrowing rate” referred to in the Treasury report. Even if you buy the HMT analysis (and some economists do not), unsecured lending rates typically bounce about less than other forms of lending.
  2. The average outstanding mortgage in the UK is not £219k but £101k. Use this figure as your starting point for the same sums above and you get an increase in average mortgages of £430 a year, or just £35 a month, which sounds significantly less scary.
  3. The fact is that a 0.7 percentage point or even a 1.1pp increase would still leave mortgage rates well below much of their historic levels. You can see that from the following chart:

mortgageratesnewloans

On top of this, one could also point out that were there to be a post-referendum recession, the Bank of England could plausibly cut interest rates, which is not something accounted for in the above working.

Finally, recall that the Treasury have also projected a fall in house prices in the event of a severe shock. If one is using the same methodology, that would also reduce the implied mortgage cost (lower house price = lower loan = lower mortgage repayments).

None of this is to dispute the likelihood (and it is a likelihood) that there would be at least a short term economic shock if Britain left the EU. But the Remain camp do themselves no favours by trying to depict this as a major mortgage shock, especially given the opaqueness of their sums.

 

 

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