The illusion of an easy resolution
The upcoming General Election has been framed as the only possible route out of the Brexit impasse that has plagued the country in the last few years. It remains to be seen whether a Brexit resolution is within reach given the vague plans, ambitious timelines and tendencies to understate the difficulties of negotiating a new network of trade arrangements.
Persistent Brexit-related uncertainty has clearly weighed on business investment, which contracted by 3.5% last year. While a no-deal exit looks unlikely in the short term, even the approval of a withdrawal agreement is unlikely to mean plain sailing going forward. The withdrawal bill will only address the divorce aspect of Brexit, and the future relationship with the EU – including trade and security arrangements – could take years to negotiate.
Moreover, the prospect of a cliff-edge exit at the end of the transition period in December 2020 remains a threat. An abrupt transition would likely cause short-term disruption and if no trade deal has been agreed the UK will fall back on World Trade Organisation rules, which could reduce GDP by 5%-10% in the long-term.
A depleted toolbox
As a result, the risk of a recession has increased as Brexit-related uncertainty, trade tensions and weak global manufacturing activity combines to dampen the UK’s economic prospects. The immediate focus must now be to ensure that the UK’s macroeconomic policy framework is strong enough to respond to all threats on the horizon.
Monetary policy would typically be top of the list of tools to respond – providing about two-thirds of the large-scale policy stimulus during the financial crisis. But with the policy rate at 0.75%, and the Bank of England (BoE) estimating the effective lower bound at about zero, that lever is heavily constrained. Quantitative easing and a Japan-style yield-curve-control policy are possibilities, but even with these measures, monetary policy – both conventional and unconventional – could probably only provide stimulus equivalent to a 150-200bp cut, given that long-term yields are already low. By contrast, the historical average for an easing-cycle cut is about 500bps.
The BoE reinforced its neutral bias at its last meeting, by explicitly referring to short-term scenarios where easing would be required. While they reiterated that limited and gradual tightening may be needed if there is a smooth exit from the EU, the recent decline in external demand, coupled with the fact it could take years to come to a trade agreement, means that a rate cut is a very material possibility. Governor Mark Carney’s tenure also ends in January, which makes the outlook for monetary policy even more opaque.
The diminished potency of monetary easing opens the door for a more active role for fiscal policy and greater reliance on government spending to stimulate the economy. The Resolution Foundation recently highlighted how fiscal expansion tends only to be allowed in response to a 'significant negative shock' and is seen as an exception that is limited to emergencies. But this approach risks limiting the size, timeliness and effectiveness of a policy response.
There is clearly a need for a more explicit and counter-cyclical use of fiscal policy. Automatic stabilisers have weakened in recent years and any efforts to strengthen them would be appropriate. In addition, low borrowing costs – long-term yields are running well below nominal GDP growth - should also help the UK engage in traditional fiscal stimulus
Judging by the government’s recent announcements and party manifestos released this week, fiscal loosening certainly appears to be on the horizon.
The Conservative party – currently leading the polls - kicked off the pre-electoral spending spree in September, when Chancellor Sajid Javid announced an increase in public spending worth £13.4bn, or 0.6% of GDP. The manifesto released over the weekend did not the change the fiscal picture dramatically, as the party is focusing on a low-risk strategy emphasising its Brexit plans. A limited tax increase (consisting of scrapping a planned cut in the corporate tax next year) is supposed to finance a modest spending increase of about £3bn per year and minor tax cuts. In addition, Chancellor Sajid Javid promised an increase in public investment of about £22bn (about 1% of GDP) earlier this month, which would be accompanied by a formal relaxation of current fiscal rules, which cap the deficit at 2% of GDP and commit to reducing the public-debt burden.
The Labour Party – trailing in the polls – adopted a way more aggressive position on fiscal stimulus, by announcing an unprecedented plan for public spending. The announced measures would increase current spending by £80bn in FY 2023-24, which should be funded by an analogue increase in taxes. In addition, public investment would increase by £55bn a year (about 2.5% GDP), which would double current levels.
While a more structured approach to fiscal policy – allowing for an effective counter-cyclical response and built to tackle long-term challenges such as supporting productivity growth – would be appropriate, it is not clear that the parties’ manifestos are inspired by these principles.
Furthermore, recent deterioration in net borrowing trends, slowing growth and the accounting reclassification of some items (most notably student loans) mean that the starting point for the UK public finances is much weaker than envisaged only one year ago. While the UK could soon become a lab to experiment on fiscal policy, there might be too much faith placed in the spending cure.