Wrong Kind of Growth

UK inflation hit 3% in September (CPI) and it doesn’t look like reversing downwards soon.  Growth (real GDP) is running at no better than 2%.  Whenever inflation rate > growth rate, it makes one nervous.

Moreover, we have the “wrong kind of growth”: driven by employment growth that is not productivity-led.  Real wages are falling, interest rates and exchange rates are still too low.  The trouble is that cheap labour and cheap money tends to fuel mediocre growth, at best.  Incentives to invest in new capital, innovation and skills are depressed, made worse by current trading uncertainty (BREXIT plus Trump).  Creative destruction is stalled, supporting unproductive ‘zombie’ companies.  Weak sterling offers competitive advantages but can also lower the incentive to do so.

The consensus is that growth will remain subdued through 2018 and  beyond.  Suppressed trade/investment and stretched household/public finances reflect the fundamental productivity gap.  To delay the next recession, we need more investment in the digital revolution in services and, thus, the adjustments needed to skills and innovation that will drive entrepreneurship and competitiveness.  And, that means better inter and intra regional connectivity and higher business aspiration.

The upcoming UK budget/industrial strategy (and the BREXIT negotiations) should focus on these areas of regional development.

Summer of Uncertainty

After an indecisive General Election, and with the BREXIT negotiations now underway, the political runes remain hard to read. Meanwhile, the global economic context is unstable and the economic outlook uncertain.

The financial markets and UK and foreign-owned businesses have reacted warily to the process of regulatory and trading change that is now underway. In contrast, many households are over-borrowing whereas many businesses have robust cash reserves. This and other economic imbalances are profound, especially with respect to productivity, trade and the public finances- regardless of how BREXIT proceeds.

Against this background, the latest data show a mixture of below trend growth and above target inflation, with high employment, low unemployment and, still, low interest rates. Consumer and business surveys remain largely positive but there is a marked contrast between negative real wage growth (hurting average households) and, despite poor productivity figures, improving profitability (net rates of return for average businesses).

Meanwhile, the key business issues are ones of skills deficiencies and tight labour markets contrasting with some caution over investment and competitiveness. Generally, the economy is growing but losing some momentum.

Latest evidence

  Annual (2016) Quarterly Monthly
Real GDP (%ch, yoy) +1.8 +1.7 (Q2 17) n.a.
CPI inflation (%ch, yoy) +0.7 +2.7 (Q2 17) +2.6 (Jun)
LFS unemployment (%) 4.9 4.6 (Q1 17) 4.5 (Mar-May)
Trade deficit* (£bn) -£37bn -£8.8bn (Q1 17) -£3.1bn (May)
Base rate (end %) 0.25 0.25 (Q2 17) 0.25 (July)

Source: ONS   *goods and services

Economic growth may be petering out, with household spending constrained by prospects for real incomes (earnings not compensating for higher inflation, despite high employment). Investment remains modest and net trade in massive deficit (overall, price effects outweighing substitution effects despite some headline successes). Longstanding UK economic weaknesses persist.

It is always regrettable when the inflation rate exceeds the growth rate (see table above). UK growth went from fastest to slowest amongst the G7 over the year to Q1 2017. For April-June, there was a tiny bounce but, it appears to be one of the ‘dead cat’ variety. In the first half of the year, UK real GDP growth was running at half the rate it did in the second half of 2016. Given the uncertainty surrounding BREXIT, most forecasters expect this underlying loss of pace to persist.

On the policy front, the ‘hung’ Parliament suggests some erosion of fiscal austerity might occur. It could also mean a stalling (before it has really begun) of the “Modern Industrial Strategy” – the white paper is now promised before end year. It is to be hoped that uncertainty about the BREXIT negotiations and the government’s lack of a strong electoral mandate do not stand in the way of positive action on public investment at home.

Meanwhile, with inflation above target and expected to remain so, albeit lower in June than May, the Bank of England remains extremely loose. Contrast its unchanged interest rate and QE stance with the actual and pronounced movement to a ‘less loose’ position by the US Federal Reserve, as the US recovery builds. It will be interesting to see if the European Central Bank, already talking about having removed the risk of deflation, abandons its negative interest rates and its QE measures later this year – now that the EU economy is grinding out some forward momentum (at least its better bits).

Financial Stability

The Bank of England’s latest Financial Stability Report (June 2017) describes the current domestic financial position as having risks at a “standard level”, which seems to mean ‘broadly normal, no immediate threats”). Nevertheless, the Financial Policy Committee (FPC) is highlighting four main “pockets of risk” that “warrant vigilance”.

  • Consumer credit is growing too fast (+10.3% in the year to April 2017), especially in unsecured loans for motor vehicles, credit cards and other personal loans. Because the maturity on these types of credit are relatively short, loan viability can deteriorate rapidly if the macro environment becomes adverse. The FPC is concerned about the commercial banks relaxing loan criteria and cutting margins. It is asking whether risk is being correctly priced by the banking sector. Some commentators worry that consumer finances look precarious, as they did in the pre-crisis days of 2007.
  • Mortgage debts are high (average debt/income ratio above 100%) and potentially vulnerable to higher interest rates. Although the latter are unlikely to rise sharply in the foreseeable future, debt levels are high enough relative to incomes to suggest even small changes could prove problematic. Periods of economic adjustment can be worsened by an unbalanced mortgage market because mortgage payments tend to be maintained by households as interest rates rise or incomes are lost, requiring other spending to be cut. This can transmit adverse mortgage effects quickly to the wider macro economy. Indeed, banks with bad loans in housing tend to react by reducing lending to the rest of the economy/unrelated sectors, reinforcing any macro downturn. The FPC is asking banks to stress test their home loan books for mortgage rates 3% above current standard variable rates, indicating where we might be heading on rates over the longer term.
  • Financial market assets may be overvalued. UK bond yields are very low (-c2% for 10-year gilts) and volatility is minimal. Commercial property values are high and some would argue that corporate share values are overstretched. Sudden corrections in these markets could have significant impacts on broad financial stability and detrimentally affect macro growth.
  • Although world growth has accelerated recently, the FPC identifies some global risks, particularly the high debt levels supporting growth in China and the high exposure of UK banks to any correction there. It is also concerned about the continuing high-level of non-performing loans in Italy and ‘peripheral’ Europe. The ‘holes’ in the books of the Italian banks could yet undermine the euro.

Beyond these four risks, the FPC also mentions concern for the banks if disorder from the BREXIT negotiations emerges and vulnerability to cyber-crime is exposed.

Overall, the banks have strengthened their capital positions markedly since the 2008/9 crisis but their profitability remains weak. Stress tests reveal that resilience is good but, given the risks highlighted above, continued vigilance is required. The FPC is right to be watching closely and recommending early action to prevent excesses in UK banking.

Macro Stability

Meanwhile, the Monetary Policy Committee (MPC) of the Bank of England is beginning to talk about raising interest rates and starting the process of ‘normalisation’ – by reducing the overhang of liquidity from quantitative easing (QE). In May, the MPC vote was 5-3 in favour of keeping the base rate at 0.25%. The ‘mood’ music is that the Bank wants to prepare the markets and other economic actors for a slow tightening of monetary policy from here.

Although inflation is now above target, the MPC does not expect this to last because, as yet, there is no momentum towards higher inflation from the labour market. The drop in the ‘headline’ inflation rate from May to June (back to 2.6%) was taken as evidence for this view. Accordingly, there will be no major increase in interest rates soon. Thereby, the ‘awkward’ incentives provided by prolonged low interest rates, which continue to hinder the savings/investment process, and to support unsustainable domestic debts and so-called ‘zombie’ firms, look likely to persist.

Since the General Election, there has been some debate about the future of the governments’ ‘austere’ approach to fiscal policy. Some loosening may be seen in the Autumn Budget but the internal Conservative Party conflict between ‘wets and dries’ and ‘brexiteers and remainers’, and about the future leadership makes any prediction on this front futile. Fiscal policy is just another uncertainty for business and households to deal with.

Macro stability also hangs on the ‘success’ of the UK’s trade negotiations with Europe and other major trading blocs. New impediments to free trade, real (tariffs, quotas, regulation or other trade barriers) and psychological (affecting aspiration and trade engagement by UK and foreign companies), would be a major blow to productive potential, trend and achieved growth, and future living standards. As recent discussion of the demands of the strong agricultural and health lobbies in America indicate, the UK willingness to do non-EU trade deals is confronted by the reality of BREXIT transition and the potential need for difficult compromises and unforeseen consequences.

The Economic & Development Outlook

At the time of the pre-election Budget (March 2017), the Office of Budget Responsibility (OBR) set out modest and largely flat economic prospects for the UK economy.  Since then, other forecasters, including the OECD and the IMF (down from 2% to 1.7% for 2017 real GDP growth and 1.4% for 2018), have been moderating their views and helping to create a more subdued consensus. For example, the latest (June) HM Treasury monthly survey of independent forecasters shows growth at 1.6% and inflation at 3% in 2017 and 1.4% and 2.5% respectively in 2018. The equivalent unemployment rates are 4.9% and 5.1%. The current account deficit and public-sector net borrowing improve a little but remain excessive.

Overall, the UK and local economies are forecast to slow down further over the year ahead, with a small increase in unemployment and still weak productivity. There is a strong real and policy need to break this pattern (see our Local Economy briefing 19 – Productivity Revisited – released with this report). The promised “Modern Industrial Strategy”, including significant real investment in productivity-growing capacities, is sorely needed.

Conclusion

During this summer of uncertainty, UK macro stability is being tested by a global and domestic environment that is undergoing profound structural and psychological change.

The Economic Grand National

Thoroughbred or Plough Horse[1]

With the UK’s economic performance better than feared in the last half year, fuelled by robust consumer spending, but with a number of clouds on the horizon, it is a good time to look ahead and see how the economy stands.

The economy is rather like the Grand National horse race. It’s an endurance test with a number of barriers to overcome where the steeds generally move forward carefully. Sometimes the gallop cannot be sustained for long without problems building up: an overheated horse (economy) may well get pulled up.  Over a racing career (the economic cycle), the horse needs to be fed (by investment) and it needs occasional periods of recuperation (rebalancing) but, once the race is on, it only stops if there is a reason to make the horse falter.  Usually, this occurs because hurdles are put in the way that are too high for the racehorse to jump or the jockey is too heavy for the horse to carry over the distance.

There are four ways the hurdles and jockeys of economic policy can slow the horse down or, indeed, make it fall.

Monetary Policy: Monetary policy, guided by the Bank of England, is about setting interest rates to influence the demand, and setting reserves to influence the supply, of money.  Monetary policy can slow the economic horse by setting interest rates too high, too quickly and by restricting access to funds or speed it up by being “loose” on the reins.  Effectively, monetary conditions influence the height of the fence to be jumped and the style of the jockey.

Theoretically, base interest rates should relate closely to the nominal growth of GDP, linking money to the real economy.  In the UK, given an inflation target of 2% per annum and a trend real growth rate of about the same (as estimated by the OBR), ‘normal’ nominal GDP growth would be about 4.0% per annum.  With official interest rates at 0.25%, the Bank is very far from putting interest rates anywhere near this ‘normal’ rate, largely because of excess savings (driven by an ageing population) and a period of persistent slow growth.  The UK’s poor productivity performance since 2008 reflects ongoing low interest rates, because these encourage the survival of inefficient enterprise.

In addition, after Quantitative Easing and other efforts to supply money to the economy, we have huge excess reserves in the banking system.  These could be a major threat to the horse’s stability (high future inflation) if left intact.  Already, they create a ‘brake’ on interest rate increases.  Right now, the monetary fences for the horse to jump are almost imperceptible.  Moreover, in the foreseeable future, there is little expectation that interest rates will rise and reserves will fall, sufficiently to significantly slow or ‘pull up’ the economic horse.  Unless or until inflation accelerates (above target indefinitely), the monetary fence will remain low and, surely, no barrier to growth (completing the race).

Trade Policy: Trade policy sets the conditions of international exchange and regulates access to markets. It is another potential hurdle for the economic horse.  Economics teaches us that barriers to trade are ‘bad’ and free trade ‘better’ for keeping the horse running.  Trade creates more jobs through supporting a sustained faster running pace of/for output growth.

BREXIT and the policies of President Trump raise the spectre of more protectionism – higher barriers, taxes and tariffs on trade.  The key point is that all parties in the global economy are interdependent.  Economic rationality suggests both importers and exporters will not wish to put the trading system at risk.  Many ‘policy jockeys’ get this.  There is clearly, however, some present danger that political actions, couched as popular nationalism, will undermine the global trading system.  There is a risk that this trade fence goes up sharply and, at best, may slow and, at worse, unseat the economic horse in the years ahead. There is a clear downward risk to growth from trade protectionism.  But, this is not a given.  If all the negotiations go well, there could be a big upside – the promised land of the UK as a multi-agreement trading partner with all parts of the world could increase the sustained and sustainable speed of our horse.

Tax Policy: Taxes on business are used to fund public policies that intervene in the economy in order to address market failures and fund socio-environmental priorities.  The political debate about how big the public sector should be relative to the wealth creating private sector is a long-established and hard-to-resolve chasm.  But, note, public funding comes from taxation or borrowing – both require a drag on the payers.  Essentially, high corporate or sales taxes and a complicated tax code are like having a heavy jockey on the back of the business horse.

UK administrations have been reducing some corporate tax rates in recent years.  Indeed, there has been a competitive race to the bottom by some of our competitors (notably Ireland) on corporate taxes.  Furthermore, President Trump vows to join in (cutting the tax burden – rates and rules – on US corporates).  BREXIT raises the possibility of business, sales, or other UK tax rate changes in future.  It may mean UK governments have scope to simplify the system or they could be looking for ‘new’ sources of revenue.  At present, it is unclear how the UK’s competitive position on tax will evolve post-BREXIT but it is not expected to hinder the horse too much in the near future.  The tax jockey is not expected to overburden the business runner – but these could be famous last words.

Spending/Regulation Policy:  New technologies and process innovations are fuelling economic growth.  Excess regulation and non-productive state spending can hurt this growth process by putting a heavier jockey on the horse.  Too much or misdirected state spending or regulation can change a business thoroughbred into a plough horse – cutting its potential speed (of growth) over the medium term.  Alternatively, reducing business regulation could be an important mitigation for any negative BREXIT effects through trade policy.  Rebalancing from government consumption to government investment could be an important part of a new “Modern Industrial Strategy” in the years ahead.

Overall, then, monetary policies seem set to continue to support the economic horse whilst tax and regulations policies could go either way and trade policies risk hurting it.  The net balance of these factors, as the terms of the UK’s new trading relationships emerge, will be key to how the stamina of the economic horse develops in the next five years.  There is a risk that trade protectionism sets higher fences: turning our steed into a plough horse – worst case, recession.  However, there is an opportunity for a thoroughbred to emerge from good training, especially if trade deals can be done and tax/regulation policies can support growth just as monetary policy becomes ‘less loose’ or even makes a welcome return to ‘normal’.

Place your bets …. But, remember, the Grand National is a lottery.  Uncertainty is the main risk right now and the main dictator as to which horse comes first over time.

[1] Based on a similar approach to the US economy by Bryan Wesbury, Chief Economist, First Trust Portfolios, Chicago, USA

Feeling Fine?

God Save America.  2016 will go down as the year of Brexit and Trump.  REM sang, “It’s the end of the world as we know it … and I feel fine.”  At the moment, it feels like the end of the global economy as lead by the anglo-countries.  It’s hard to feel fine because markets and economies hate uncertainty and we now have uncertainty in profusion.

Why are economists worried?  Uncertainty usually puts the brakes on investment.  Simply, weaker investment means lower output, fewer jobs, weaker productivity and worse standards of living compared with what might otherwise have been.

Intervention to mitigate these negative effects might be possible … but it’s hard to do that in economies where the public debt is already too high and interest rates are far too low.  Without adverse implications, it’s difficult to add to the public debt, spend more and tax less when fiscal policy is over-borrowed.  It is very hard to encourage productivity-enhancing private investment when expected returns are so depressed.

President-elect Trump said in his victory statement that his administration would double US growth and hinted that this would be done by recourse to massive infrastructure renewal.  That may work but it would be a hard task in good times.  Starting from here, it looks impossible without a high risk of scary repercussions – higher taxes, higher inflation and much higher interest rates … eventually.

It feels like the end of the world economic order as we’ve known it over the last sixty years.  Maybe, we can look back in ten years time with relief about how well it all went but, right now, it don’t feel fine.  God save us all.

A ‘new’ Industrial Strategy

The UK economy is at a crossroads.  A turning point for growth, inflation and employment is apparent in recent data.  The BREXIT vote might have been the trigger for the change of mood because it adds a new layer of uncertainty but the economy was already going that way.  Moreover, the fundamental imbalances of the UK economy – exhibited by huge trade and fiscal deficits, now ineffective monetary policy and poor comparative productivity – have yet to be addressed – whether we voted in or out of Europe.

The ‘new world’ of external relationships, as evidenced by the 18% drop in sterling since July, implies an adjustment of costs (up) and investment (down) that will probably mean lower growth and higher inflation than would otherwise have occurred over the next few years.  Further out, the UK business sector has the ability and scope to mitigate such negative effects and, indeed, more than offset any adverse changes.  British firms and people are still inventive, innovative, skilled, entrepreneurial and competitive.  With change comes opportunity.  The big question is whether the policy regimes adopted over the next few years facilitate that process of market-led adjustment.

In the UK Autumn Statement, next month, it is expected that the Chancellor of the Exchequer will promote a new Industrial Strategy.  It is tempting to say that there is nothing new in the world of sub-national development.  A re-hash of established intervention strategies is probable, which may be no bad thing.

It is likely that the SW LEPs will be tasked to support major national investments (including power stations, runways and railways) through their activities towards future growth deals, enterprise zones and/or wider business support.  The target, as always, will be more productivity and export-led growth backed by a strong business voice.

We await the government’s ideas with both trepidation and expectation.  We hope the LEPs and their development partners are ready for the task ahead.  We will blog on the ‘new’ strategy after November 23rd, assuming enough details about the new policy approach are forthcoming.

By then, we will have a new US president-in-waiting.  With this and BREXIT dominating the macro world, these are exciting times for analysts of the regional economy and the world of local development.

 

 

The Economy – After BREXIT

SUMMARY

On 23rd June, the UK electorate voted to ‘leave’ the EU (BREXIT). The immediate economic consequence was a collapse in Sterling, making exports cheaper and imports dearer. Over time, this might help growth and add to inflation. However, the referendum result increased uncertainty about the economic outlook and may reduce net new investment, output and jobs in the months ahead and beyond.

More firms and investors now seem less confident about the outlook for growth. The survey evidence and the forecast consensus has shifted downwards, acknowledging that there is some risk of negative real GDP growth, higher inflation and lower employment.

In addition, upheaval within the leading UK political parties, the lack of terms/a plan to smooth the UK approach to BREXIT, and concerns over the forthcoming presidential election in the United States all encourage a ‘wait and see’ attitude amongst key businesses.

With forward indicators weakening, the economy is still constrained by fundamental weaknesses: low productivity growth and competitiveness (as shown by persistently large trade deficits). For the foreseeable future, uncertainty over BREXIT will not improve these factors.

Latest evidence

  Annual Quarterly Monthly
Real GDP (%ch, yoy) +2.2 (2015) +2.2 (Q2) n.a.
CPI inflation (%ch, yoy) 0.0 (2015) +0.4 (Q2) +0.5 (Jun)
LFS unemployment (%) 5.4 (2015) 5.1 (Q1) 4.9 (Mar-May)
Trade deficit* (£bn) -36.6 (2015) -12.4 (Q1) -2.3 (May)
Base rate (%) 0.5  (2015) 0.5  (Q2) 0.5  (Jul)

Source: ONS   * goods and services

Growth in the UK economy was fairly modest and flat through the first half of 2016. Despite global/national political and economic uncertainty, as the table above indicates, real growth was maintained close to trend (just over 2% year-on-year), inflation remained well below the 2% per annum policy target (though it edged a little higher) and the drop in unemployment may have started to flatten out (at about 5%). The net trade deficit was still enormous and the loose money and austere fiscal policy stance was largely unchanged. Productivity growth remains too low for sustained and sustainable UK growth.

If real GDP growth now slips below 2% per annum, employment growth will ease or reverse and little or no improvement in productivity can be envisaged. Meanwhile, the recent (roughly 9%) drop in Sterling will boost future inflation. The economic outlook, especially in the face of having to unwind or replace trade, regulation and other business-facing agreements within the EU and other partners, has deteriorated.

Local Economy & Development

The latest purchasing managers’ index (PMI) for SW England shows SW output fairly good but employment slipping back in June. These figures were recorded “pre-BREXIT”. Moreover, the SW regional economy tended to soften through the first half of 2016.

For the PMI series, apart from momentum over time, the crucial benchmark is whether the indices are above or below 50. The former indicates growth and the latter stagnation. It will be interesting to see, in response to BREXIT, whether the next reading for SW PMI output, (to be issued mid-August), will edge below the 50-benchmark, as the UK average did in July and the SW employment index already had done in June. Thereafter, the question is whether negative “BREXIT effects” persist.

Other surveys have shown similar recent trends. For example, the British Chamber of Commerce Survey for the latest quarter pointed to “sub-par UK economic growth even prior to the EU-referendum”. With regard to the future outlook, the mood has been generally more cautious than it was, with many sectors from manufacturing, through retailing and car sales, to property and other services declaring a sudden loss of business momentum after the referendum. What little evidence we have suggests there was an immediate drop in household spending, affecting retailing, tourism and leisure locally; a decline in property movements – affecting commercial and housing sales; and a continuation of caution with respect to business investment.  We do not know whether these were temporary or persistent effects.

In response to these developments, and the aggravated risks and eventual opportunities that lie ahead, the development question is how businesses and the various public agents mitigate any negative impacts. The significant drop in sterling will help some (exporters) but not all (importers and exporters dependent on imports of components and materials). In time, the likely increase in a range of input, factory and final prices will affect some supply chains and household budgets. Moreover, there is a fear that the continuing banking malaise (with share values down sharply from already low levels) may dampen the flow of credit – a key ingredient for maintaining growth.

The Bank of England stands ready to support the financial system (e.g. by relaxing banking capital requirements, lowering base rates, and issuing more quantitative easing). It believes the banking and insurance sectors are much more resilient to shocks than they were in 2008. Also, the new “May-Hammond” Treasury has indicated that it may be more willing to borrow and spend than its predecessor. Its ‘new’ industrial/EU-funding policies, however, are far from clear, (especially as the Business Department is being reformed).

Economic Outlook

According to the latest consensus compiled by HM Treasury (see table below), growth will be very sluggish in the next 18 months. The average forecast is for growth rates well below trend in 2016 and 2017 whilst CPI inflation is now expected to exceed the target (2% per annum) during 2017 and unemployment to rise back above 5.5%.

According to these ‘experts’, the outlook has changed dramatically. Indeed, average forecasts for growth in 2017 slumped from 2.1% (June survey) to only 0.8% (July survey) after the BREXIT vote. Moreover, the current account and public debt positions are worse for 2016 and only expected to improve marginally in 2017. The Bank of England perspective (in its forthcoming August Inflation Report) is expected to show a similar warning about a deterioration in economic prospects.

BREXIT has induced a change in mood, with the consensus about economic prospects shifting markedly downwards in recent weeks. Indeed, the drop in forecasters’ expectations has gained real expression with the downgrading of UK debt by the major credit rating agencies, the drop in the value of UK banking and other stocks, and the Bank of England’s FPC recent highlighting of risks to the financial system.

UK Consensus Forecasts: July 2016

  2016 2017
Growth +1.6 +0.8
Inflation +1.3 +2.4
Unemployment 5.3 5.6
  2016/17 2017/18
Current Account (£bn) -103.1 -82.1
PSNB (£bn) 67.4 58.3

Source: HM Treasury

Some of the new negative sentiment may fade after the initial shock but the danger is that the process of extracting the UK from the EU will generate a series of economic and political ‘aftershocks’ to the markets and the real economy and this could deplete confidence at a fundamental level.

As we have written before (see previous posts), the economics of BREXIT are straightforward. In summary, the creation of economic barriers, borders or boundaries, whether real or psychological, always leads to an increase in costs. That increase in costs, exacerbated by broader uncertainty, stalls investment, reduces output and cuts employment compared with what otherwise might have occurred. Thereby, the outlook for productivity and trade deteriorates.

The resulting fall in business profits and household incomes means less revenue for the government, which requires further fiscal austerity unless the government is willing to borrow more and grow the public deficit. In turn, these factors reduce realised and potential economic activity and confidence. At the same time, as higher costs are pushed through the supply chain, more inflation is generated, which, if accompanied by higher state borrowing, means, at some point, higher interest rates – a further dampener on future domestic demand.

It is important to note that in all these economic linkages and trends, we refer to outcomes in net, macro terms. There will be companies and workers in particular sectors that will benefit from the countervailing forces that always occur within any process of economic adjustment. There will be individual ‘winners’ and ‘losers’. The key observation, however, is that the net effect, for the economy as a whole and for the foreseeable future, is one of worsening growth prospects.

BREXIT will affect many Southern businesses and households. Some of these effects will be immediate and obvious; some will be postponed and insidious and some will not have noticeable impacts for several years. But, on average, in due course, less investment means less growth and lower living standards. We must not be distracted by one-off (good or bad) data releases or items of business news over the weeks and months ahead. The important thing is the change to performance potential, and its realisation, over the long run.

In the long run (after 2020), the economy may start to recover (assuming no major global ‘shocks’) from BREXIT.   In the very long term (perhaps, eight years plus), it may be back, or even beyond, where it might have been without BREXIT. The economy is a dynamic creature made up of millions of individual and group actors with diverse characteristics and behaviours. Uncertainty creates opportunity as well as fear. Human beings are inventive, innovative and entrepreneurial, especially as new generations emerge without the baggage of history. It is reasonable, therefore, to remain a long-term optimist about the economy.

For the near future, however, the prognosis is for a period/process of negative adjustment.

  • In the short run, this is likely to harm sectors dependent on current household and business spending first, though these effects may be temporary if incomes and employment hold up over the rest of 2016.
  • In the medium term, it will be the new trading adjustments that matter: 1) sterling depreciation helping exporters unless they are vulnerable to supply chain shifts caused by political uncertainty and higher import prices and 2) trade agreements and new tariff regimes for UK businesses active across the world. Both positive and negative effects are likely to ensue here.
  • In the long run, changes to corporate investment strategies will drive the impact. It is unlikely that global companies will see UK locations and facilities as favoured areas for investment to gain access to the wider European market. Importantly, it is changes at the margin that matter, specifically the potential for erosion of commitment to existing UK operations over time. Behavioural changes will gradually impact replacement and new investment demand. In a decade, the fear is that the next family of aerospace, motors and other engineering and electronics products and services go, at least partially, elsewhere, as trading costs and regulatory frameworks adjust to a new political reality

Analysis of current economic prospects makes regional development activity to boost the drivers of productivity even more vital. The development policy and delivery question is whether the negatives can be mitigated in terms of repairing or building local competitiveness over time. Even as the BREXIT storm rolls over us, we must prepare for better days.

BREXIT 3 – the decision

A small majority of UK voters have chosen to ‘leave’ the EU.  Now we will reap the economic deluge in terms of financial market shocks, lower investment and fewer jobs.  It will take a few years for the negotiations to assert some certainty back on the future path of trade and exchange.  It will take longer for the negative effects on inward investment to work themselves out.  The UK economy will be weaker than it otherwise would have been for up to a decade.  The SW economy will be poorer as key factories and facilities across the region are sidelined or lost, many household incomes are reduced and fiscal transfer resources are diminished.

The question, then, is how we respond to and mitigate these choices and negative effects.  The next Prime Minister, as well as negotiating with all our partners, has to instigate policies that will increase investment, raise productivity and drive development whilst dealing with the probable break up of the United Kingdom.  Hopefully, by 2025-30, we can look back and say “well, it was a painful adjustment but we did it and now the future looks bright again for England” (alone?).  Today, it’s hard to look ahead with confidence but the hard work starts now.

SW Gross Disposable Household Income in 2014

The annual release of sub-regional gross disposable household income (GDHI) data has just occurred.  The latest numbers are for 2014.  They show SW England generating £98.4bn of GDHI that year, up from £96.9bn in 2013: a modest increase of just 1.5%.  (Because CPI inflation was also 1.5% in 2014 that implies there was no real increase in household spending power.)  The annual growth range was from +4.1% in Swindon to -0.5% in Bournemouth and Poole.

The distribution of SW GDHI across the region, by LEP area, ranged from £29.8bn (30.3% of the SW total) in the Heart of the South West (HoSW = Devon and Somerset, including Plymouth and Torbay) to under £10bn (9.4%) in Cornwall and the Isles of Scilly (CIoS).  West of England (WoE = Bristol, Bath and NE Somerset, N Somerset and S Gloucestershire) contributed £20.1bn (20.4%) whilst the Gloucestershire, Swindon and Wiltshire, and Dorset (including Bournemouth and Poole) areas generated £11.8bn (12%), £13.1bn (13.3%) and £14.3bn (14.6%) respectively.

Turning to GDHI per head, in order to compare these areas better, puts Gloucestershire at the ‘top’ with £19,273 (7.3% above the UK average).  CIoS was at the bottom at £16,862 (-6.1% below).  HoSW was also below average (£17,579 or -2.1% below).  Dorset was second highest (£18,907, +5.3% below), then Swindon and Wiltshire (£18,818 or +4.8% below) and then WoE (£18,273, +1.7% below).  Again, in annual growth terms the range was from +3.3% in Swindon to -1.6% in Bournemouth and Poole.

Within these areas, it is striking how relatively ‘low’ the GDHI per head figures are for cities/urban areas and how relatively ‘high’ they are for county/rural areas.  For example, Bristol, Plymouth and Torbay all had GDHI per head readings more than £1,000 below the national average whereas Dorset county, Wiltshire County and non-Bristol WoE were all more than £1,000 above average.  Even in the more ‘balanced’ areas, such as Dorset and Wiltshire, the ‘county’ parts were above average whereas the urban parts were not.  (This is always in marked contrast to the sub-regional gross value added data which usually shows urban areas creating more output per head than rural areas: a reflection of commuting patterns and work/residence differences.

Roughly 70% of SW GDHI and GDHI per head comes from ‘compensation of employees‘.  This category grew by 2.9% in 2014, compared with 6.9% for property incomes received.

BREXIT 2 – uncertainty voting

The forthcoming referendum on UK membership of the EU will strongly influence UK economic ‘capacity, competitiveness and aspiration’ for years to come.

Future economic performance is heavily influenced by the psychology of value and relationships.  Anything that affects business and household confidence, communications and networking, especially if it increases uncertainty, affects behaviour and changes assessments of investment priorities, as based on prospective returns, costs and benefits.  This is why the whole EU debate ‘before the event’ is inherently inconclusive.  Nevertheless, here is some discussion of the key arguments ‘for and against’ based on some economic principles and experience.

Barriers reduce economic activity

Essentially, economists know – from theory and evidence – that borders, boundaries and/or barriers to trade tend to increase costs and decrease investment.  This means lower output and employment than otherwise would occur.  Therefore, most economics-based commentators – including recent analysis from the IMF, the OECD, the Bank of England and HM Treasury – believe there is likely to be a negative economic impact from a vote to ‘leave’ compared with a vote to ‘remain’.  (Of course, that may be a price worth paying for UK ‘control’ – if you think UK-based  politicians and administrators are, or will do, ‘better’ for you than Brussels- based ones.)

What is not clear is whether the adverse economic effects of leaving the EU (termed BREXIT – short for British exit) would have lasting impact or whether these effects might be mitigated – indeed eventually overcome – by future UK measures to support domestic development.  The question to the ‘leavers’ then, is what policies would you adopt to overcome any negative effects of BREXIT?

Importantly and conversely, a ‘remain’ vote is not a vote for the status quo.  There will be changes affecting UK economic prospects within the EU/Euro-Zone whatever the outcome of the referendum – (others may leave the EU even as, within it, the euro-zone gets tighter).  The question to ‘remainers’ is how would you make sure British interests shape the EU in a way that is economically positive?

Whether the UK ‘leaves’ or ‘remains’, the economic development question is still how to improve UK competitiveness over time.  This largely means investment in infrastructure, skills and innovation that raises long-term productivity potential and performance.

In or out, the key UK economic problems of low productivity and a lack of competitive capacity – as exposed by the UK’s huge current account deficits – remain to be addressed.  Whether it is ‘stay’ or ‘go’, the real economic debate is about what is to be done about the fundamental development weaknesses.  No one is addressing this.  If ‘we’ go, there will be costs to consider but the fundamental question is the same: what sort of UK do we want for 2030 and beyond and what/how are we prepared to invest to make it happen?

Meanwhile, the EU debate has already affected sterling, increasing its volatility (so far, down when BREXIT seems more likely and up when it seems less likely) and impairing financial market sentiment towards the United Kingdom generally.  At the margin, this may affect trading values and volumes, at least in the short term.  It will also impact relative inflation and interest rates to come. The question, then, is whether UK and local business have the will and the scale to exploit any opportunities for (short-lived) competitive advantage that emerge

BREXIT will probably not save money

A key analytical conclusion is that BREXIT would not come cheap.  Most if not more of the UK tax-payers’ money allocated to the EU will still be spent: the UK government will have to decide what to do at home for the farmers, the Cornish, for supported businesses and others who now receive significant flows “from Brussels”.

Then, there will be the costs of bilateral negotiation with the EU and all other trading partners around the world.  Diplomats, lawyers and accountants are going to do well from re-writing a vast array of contracts for government and business and plenty of civil servants and business planners will be needed to advise on, and to make, all the changes.  The UK will not fill up its fiscal hole by leaving the EU.

Moreover, trade negotiations always take longer than expected & tend to produce sub-optimal solutions based on compromise.  Judging by other recent trade negotiations, it could easily take 5-10 years to extract the UK from current contracts and processes and to replace them with new ones, especially as many existing commitments to the EU run until 2020 anyway.  The uncertainty in the mean time is an indisputable bad for trade growth.

Further, we cannot assume that all partners (in and out of EU) will be willing and able to negotiate straightaway.  Will the United Kingdom be given the kind of priority it might like and will it be offered the most favourable terms (as might be expected as part of the EU trading block)?  For example, as President Obama indicated recently, US trade representatives will be much more interested in settling (or not) the proposed cross Pacific and US-EU trade deals than they will be in starting any talks with the UK alone. The same arguments imply even more to other trading blocs and emerging markets, including the BRICs.

Meanwhile, the insidious side effects of continental trade preferences and prejudices will be free to work against UK companies and workers.  (Why would EU representatives consider UK business needs unless they happen to coincide with those of their own constituents?  Why would continental businesses and politicians not try to push negotiations towards outcomes that favour their own competitiveness over others?)

Indeed, exclusion of UK representatives from EU panels on trade, products and services to do with rules and regulations, specifications and technologies might move things away from preferred UK standards.  UK trade competitiveness, already inadequate, is unlikely to benefit from BREXIT for the foreseeable future even if positive outcomes can be achieved in the long run.

Investment will tend to be lower than the baseline

Investment is likely to fall with BREXIT.  At present, major academic, scientific, technical, and industrial research budgets are often allocated and used across Europe.  In this world, UK institutions (including our Universities and businesses) often punch above their weight. This will be harder to do after an exit poll.

Then, if you are a foreign-owned, UK-based multinational, faced with the uncertainty as to the eventual effects of a ‘leave’ vote and what it might mean for your business, at the very least, you will:

  • Wait and see – delay or cancel current investment plans – and/or
  • Re-direct investment to facilities still likely to be in the EU or in low-cost centres elsewhere – and/or, at worst, eventually
  • Close UK operations and supply EU/UK markets from elsewhere.
    As foreign direct investment softens, all this is bad for UK investment, exports, productivity and jobs.

Equally important is the wider effect on foreign direct investment.  Fewer non-European firms will see the UK as the best place from which to serve European markets and some of those who have, or would have, moved here from Europe because of the English language, more flexible labour markets, lower taxes and overall business friendly environment, will re-direct towards key EU markets, viz Germany et al.

These reactions mean less spending in the UK economy, lower output and fewer jobs, lower productivity and worse competitiveness.  Living standards will be lower than they might otherwise have been.

Even purely domestically orientated firms and consumers, facing uncertainties about the future prospects generally, may delay expenditure plans, weakening growth.  Moreover, relative UK borrowing costs (interest rates) and sterling volatility will rise, especially if expectations about future UK inflation increase above the continental norm, as they did in the 1970s.  Fiscal management and public borrowing could be disrupted, at least for a while.

Uncertainty and the creation of barriers to exchange damage the wealth creation process by reducing investment from trend and over the cycle, at least until all the new policy/trade arrangements are resolved and activated.

Labour markets will be softer and migration uncertain

If the UK leaves the EU, some workers will face a potentially more restricted labour market and adverse skills environment.  Job creation will be muted by the overall relative reduction in output and investment.

It is more debatable as to how net migration flows will be affected – that depends on what an ‘out UK’ chooses to do on border controls and working/residence visas, as well as how the EU ‘retaliates’.  The message here is that the more we restrict access, the less likely we will get favourable trading and labour relationships from our neighbours. The extent to which that is a ‘trade-off worth making’ is a political as much as an economic decision.

Generally, however, the continental/global opportunities for UK talent and domestic business access to external talent may be more comparatively constrained, at least as long as the period of adjustment to the new reality persists.

The long run is a ‘known unknown’ for the voters

In the long run, it is quite feasible for a positive relationship to arise between an “outside UK” and an “ever closer EU” (or at least more integrated Eurozone) and other parts of the global trading world.  By 2030, no economist, let alone politician, can say whether we will be better or worse off ‘in’ or ‘out’ of the EU.

All we can say is that the economy will be different and there will be winners and losers: some workers/households and some businesses/sectors will face worse prospects and some might get better ones.  Inventors, innovators and entrepreneurs will still exist.  They will adjust to the new realities and emerging incentives and act. There is no reason to be pessimistic about the inherent creativity of human beings in the economy over the long run.  It is the adjustment process from here to there that is uncertain, disruptive and potentially costly.

Sector concern

There has to be some concern for key export industries, such as aerospace (what happens to Airbus’ productive structure and supply chains over time – will French and German bosses in Toulouse change patterns of productive location and buying?.  What happens to foreign owners’ decision-making generally with regard to the spatial placement of future investment?  The SW aero-clusters are vulnerable in the long run.

Moreover, how will financial and other high value services (who can site many activities almost anywhere in a global, digital world) respond to changes in market access driven by the prospect of different requirements and rules, for example, between Frankfurt-Paris and London?

As European attitudes and confidences shift, there will be unpredictable effects on the ‘visitor’ economy, retailers and, indeed, universities/student flows, particularly if sterling moves adversely.  Will Dutch holidaymakers still want to visit SW England and will SW holidaymakers still want to visit the Continent?

Conclusions

Some of the main economic effects of BREXIT will occur through short-term decisions about trade and investment, but there will also be long-term effects as demand patterns and productive and trading structures adjust.

In the years after a ‘leave’ vote – possibly over a decade or more, increased uncertainty will cause the economy to grow less, than it might otherwise have, in terms of output, jobs and incomes.  This is not to judge that BREXIT is right or wrong, per se, as a political or social choice.  It is just to acknowledge that the economics is clear – it is not a cost or risk free option.

But, then, neither is ‘remain’.  Even after a vote to stay, there are bound to be ‘unforeseen’ consequences, as the EU, and the EZ within it, changes.  If the UK votes to ‘remain’, it still has to deal with the German/EZ desire to forge an integrated core based on tight policy rules and regulations and fiscal unity – arguably distinct from the wider EU.  Moreover, there are some ‘dodgy’ candidates for EU membership knocking at the gates. The risk is that we stay in a ‘club’ that develops a strong, two-tier membership and that our sensible aversion to the euro means we are in a group with the dross rather than the elite.

“Remain’ is not a ‘failsafe’ option because it could mean we are more of a ‘decision taker’ rather than a ‘decision maker’.  Furthermore, it does not absolve us from decisions about how our economic future will evolve, including how we address longstanding economic deficiencies at home and how we cope with a change of power relationships abroad.

Damned if you do and damned if you don’t. The key is that, either way, the development priorities remain to be addressed: the only security for future economic health and wealth is that the UK economic team plays at the top of the productivity premiership.  As with AFC Bournemouth, which has survived its first season in the top flight of English football, the trick is now to consolidate and develop the economy further to stay in the running and ‘win’ over the long term.