The dangers of the R word

Even if you weren’t following the referendum campaign closely you’ll probably remember a few of the economic highlights (lowlights?): the Vote Leave £350m bus; the “punishment Budget” and George Osborne predicting that there would be a recession if Britain left the EU.

Now we know that all three of these claims were, in their own way, wrong.

There will be no £350m a week public finances dividend (in fact the latest statistics, out today, imply the deficit this year will be even bigger than expected, before any discretionary giveaways the new Chancellor wants to add).

Even Mr Osborne ditched the idea of an emergency budget (punishment or otherwise) before he was booted out of 11 Downing Street.

And now it transpires that Britain looks like it will avoid a recession.

Now, in practice, this final point should be neither here nor there. The definition of a recession – two successive quarters of economic contraction – is, to say the least, pretty arbitrary. Other countries, most notably the US, prefer to declare recessions based on a whole range of other factors – but for some reason in Britain the convention of two quarters of contraction stuck.

So, for instance, if UK GDP shrinks by 0.1% for two quarters, that is a recession. If GDP is -0.9% one quarter and 0.1% the next, that is not a recession. Barmy – and totally misleading, since we are considerably poorer in the latter example (remember that gross domestic product is simply a measure of how much income the country is generating).

And yet, if only in public discourse, the distinction matters. People take much more notice of the R word than the threat of an “economic slowdown”. So, when, a month before the vote, the Treasury published its forecasts for the short-term impact of a Leave result the Chancellor made much of the fact that the HMT models suggested there would be a recession. The press office mocked up various placards saying the UK “would fall into RECESSION”, with the R word in a terrifying horror movie font.

This was, as I said at the time, misleading. In fact, the Treasury’s central forecast was for a 0.1% contraction for four quarters. This would, had it transpired, have been the shallowest recession in economic history. Moreover, in economics, 0.1 percentage points is essentially neither here nor there.

None of that seemed to matter to the Chancellor. He had his recession forecast and he spent the next month warning that the economy would indeed tip into it.

Roll forward to today, almost three months after the vote, and it simply doesn’t look as if the UK economy is in recession. The OECD has cut its forecast for growth next year, but has actually raised its projection for this year. And as Joe Grice, chief economist of the Office for National Statistics says, “the referendum result appears, so far, not to have had a major effect on the UK economy. So it hasn’t fallen at the first fence but longer-term effects remain to be seen.”

Indeed, whereas last month the average forecast from City economists was indeed for a recession, they now expect zero growth this quarter and next. So no recession.


Now in practice, what matters is that, if you believe the economists, this is nonetheless much weaker than the 0.5% a quarter growth rate that was anticipated before the referendum. In other words, our national income is still forecast to be much weaker than previously. However, because of our fixation, because of the Treasury’s fixation with the r-word, the economic fraternity has been discredited again.

The elephant (not) in the room

At the time of the Bank of England’s interest rate decision, no-one in the room knew who was going to be Britain’s new Chancellor. This might seem like an odd thing to mention, given right now the main story people will be obsessing with is the element of shock – that the Monetary Policy Committee decided not to cut rates. But it matters. 

But before we get to that, let’s consider the decision itself, and why so many investors and economists got it wrong.

In the run-up to the Bank of England’s interest rate announcement today, investors were placing an 80% probability on the Bank’s Monetary Policy Committee cutting interest rates. Instead, not only did it leave Bank rate on hold at 0.5%, only one of its nine members voted to cut them to 0.25%.

As I tweeted this morning, the market’s apparent confidence that rates would be reduced to their lowest level in history was always misplaced – for four reasons. 

First, we don’t yet know the full impact of Brexit on the economy – and the Bank only very rarely makes big call on rates without at least checking the data or updating its forecasts. 

Second, the fall in the pound is likely to push up inflation – perhaps even beyond the Bank’s target.

Third, when Mark Carney hinted about rates being cut a couple of weeks ago, he was actually rather vague about how soon it would happen – but he mentioned August a few more times than July.

Finally, back to that point I made at the beginning: at the time it made its decision, the Bank did not know who would be Chancellor. This might seem like an odd, pedantic point, but it is significant.

It is an under-appreciated fact that these days the MPC decides interest rates the day before the official announcement. And, as I understand it, the MPC voted to hold rates yesterday afternoon, before Theresa May was appointed Prime Minister – and before she made Philip Hammond her Chancellor.

Now, on the one hand, the MPC is independent to decide rates as it sees fit. On the other hand, it cannot ignore the government entirely. For one thing, if there was to be an emergency Budget (we suspected there wasn’t but that has only been confirmed this morning), the MPC might have considered it prudent to wait and see whether the Government was planning a major splurge. There is less point, after all, in loosening monetary policy radically if fiscal policy is also going in the same direction.

Moreover, were the Bank going to do more quantitative easing, it would have needed the Chancellor’s approval. Which would have been difficult since, at the time, there was no Chancellor. George Osborne was on the way out and Hammond on the way in.

Such considerations don’t surface explicitly in the minutes – and why would they? There are enough reasons above for the Bank to pause this month rather than cutting. But it underlines the fact that these decisions are a bit more complicated, and involve a little bit more second-guessing, than you might have thought.

Anyway, the expectation now is that rates get cut next month. But will it actually happen? Probably, but these days you never know. 

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. 

The new new normal

It says something about the state of the world economy that as of the latest data Britain was the G7’s fastest growing economy in the final quarter of 2016. With growth of only 0.5%.

And yet that is the world we now seem to be living in. One where growth is weak, where inflation is at zero or thereabouts and where no one is sure what to do about it.

Today’s GDP figures were unchanged from the first estimate, and for that matter unchanged from the last quarter. This was actually a bit more encouraging than you might have thought. A lot of the data from the manufacturing and construction sectors was suggesting that there might have been a cut to the headline figure.

However, a dive into the figures themselves underlines what’s going on here. In short: unbalancing, the opposite of the rebalancing George Osborne has frequently called for. As you can see from the chart below, while the services sector has grown relatively quickly since the crisis, the same could not be said for the other sectors of the economy.

Of course, there are a number of different ways of measuring economic growth. One is to look through the prism of businesses (the breakdown you can see in that chart above). Another is to look at the nature of spending in the economy. After all, national income is simply a calculation of how much we are spending and earning each year – the two should be the same since one man’s spending is another’s earning.

Here’s how the economy looks through the expenditure prism:

Note that in every recent quarter households are responsible for the large part of growth. Again, not the net exports that the Chancellor had hoped would increase.

Now, to some extent none of this is surprising, nor is it disproportionately worrying. Services account for 80% of UK growth. You would have expected them to remain the key contributor of economic activity. Similarly, household spending has long been the biggest driver of overall expenditure. But the fact is that the divide between them and other sectors of the economy is widening, not narrowing.

 Still, the good news is that at least GDP per capita is comfortably above its pre-crisis peak.
The problem is that the underlying imbalances and weaknesses of the economy have not been fixed. And, as I pointed out at the start, we are now in a world which looks more brittle than it has done for some time.