UK: What Will Brexit Do To Britain's Growth Rate?

Last Updated: 16 November 2016
Article by Deloitte LLP

So far the effects of Brexit on UK growth have been muted. Most activity data published since the referendum have come in on the high side of expectations. The pace of growth slowed a bit in wake of the referendum, but not much, and less than most had feared.

Last week the Bank of England upgraded its forecasts for growth in 2016 and 2017. Agreed, the Bank, in common with virtually all forecasters, expects the pace of UK growth to slow sharply next year and beyond 2017. But talk of recession in 2017, which was widespread four months ago, has all but disappeared and the near-term Brexit slowdown looks a bit less threatening than it did in late June.

None of this is to say that we should be sounding the all-clear on Brexit. That would be reminiscent of the apocryphal story of the man who hurled himself off the top of the Empire State Building and was heard to remark, as he passed the 18th floor, "So far, so good".

In any case the real question is not how the economy responds to Brexit in 2017 or 2018. The big issue is how the post-EU settlement affects the environment for business and the UK's long-term growth rate.

The recent resilience of the economy testifies to the difficulties even of short-term forecasting, let alone long term forecasting. In August UK's leading independent forecaster, the National Institute of Economic and Social Research (NIESR), forecast that the UK economy would contract by 0.2% in the third quarter in response to the Brexit vote. In the event the economy expanded by 0.5%. The error in a forecast for activity in the current quarter, made ten weeks before the release of the data, was 0.7 percentage points. Moreover, it was an error of direction – the economy expanded, not contracted.

This is part and parcel of forecasting in times of exceptional uncertainty. But it underscores the challenges in trying to make forecasts for five or more years ahead on the basis of an unknown post-EU settlement.

Yet despite the uncertainties forecasts are important. They cut through a morass of detail and provide a straightforward way of assessing, and comparing, informed thinking on the effects of Brexit.

We have gone back to the post-Brexit growth forecasts made earlier this year by six organisations – the NIESR, the Treasury, the OECD, the London School of Economics, the Confederation for British Industry and Open Europe – in the run up to the referendum. Their methodologies and assumptions varied enormously, as did their results.

Of the Brexit scenarios examined by the six organisations virtually all show long-term growth running lower than had the UK remained in the EU.

These forecasters think that the risks to UK growth would be reduced by pursuing a 'softer' Brexit which replicates the UK's current access the single market as closely as possible. This could be achieved through either adopting a Norwegian-style arrangement or retaining membership of the European Economic Area (EEA), or through securing a favourable free trade agreement (FTA) with the EU.

But the forecasters believe that even with such settlements UK growth would decline. On average the most optimistic EEA or FTA options reduce forecast GDP growth by an average of just over 0.1 percentage points a year over the next 14 years; lowering the UK's trend growth rate from 2.3% to about 2.2%. (For the purposes of simplicity we show the effects of Brexit in terms of average long-term growth rates. In reality all forecasters see the economic damage from Brexit being "front- loaded" to the early years of the process, with the negative effects easing through the 2020s).

The most costly form of Brexit in each of the forecasts comes from the UK adopting the most distant form of relationship with the EU, operating under the trade rules of the World Trade Organisation (WTO). This is described by some as a 'hard' Brexit. Across all forecasters the WTO option reduces GDP growth over the next 14 years by an average of 0.3 percentage points a year, taking the trend growth rate to just under 2.0%.

On the basis of all the forecasts Brexit could reduce the UK's current trend growth rate, around 2.3%, to 1.8% a year or raise it to 2.4% a year. The average post-Brexit growth rate across all scenarios is 2.1%.

Everything hinges on the assumptions made. The resilience of the UK economy since the referendum shows that we cannot assume, in the famous phrase beloved of economists, that "everything else is equal". Aggressive deregulation, the implementation of pro-growth policies or success in trade negotiations could help offset negative effects of Brexit.

More fundamentally, the consensus often gets it wrong – it over-estimated the damage to the UK economy from the sterling's ejection from the Exchange Rate Mechanism in 1992, it failed to spot the brewing financial crisis in 2007-08 and it has consistently overestimated growth prospects for the rich economies in the last eight years.  

That said these six forecasts provide the most obvious starting point for assessing the effects of Brexit. If we stick with the average assumption, and assume UK trend growth drops from 2.3% to 2.1%, by 2030 the UK economy would be about 3.0% smaller – and incomes 3.0% lower – than had we stayed in the EU.

That is a material, but not a catastrophic loss. Even at 2.1% UK growth would be towards the top of the growth league for big industrialised nations. The latest consensus estimates forecast US growth will average 2.2% up to 2026, followed by Canada at 1.9%, France at 1.3%, Germany and Italy, both at 1.2% and Japan at just 0.6% a year. In this sort of slow-growth, world UK growth of around 2.1% a year doesn't look too bad.

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On another note last week's High Court ruling on Article 50 has stoked speculation about an early UK General Election. For an early election to take place two-thirds of MPs would need to vote in favour of the repeal of the Fixed Term Parliament Act or 51% of MPs would need to pass a motion of no confidence in the government. The latest opinion polls suggest Mrs May's Conservatives would win a handsome majority in a General Election and around 30 Labour MPs would lose their seats. Labour MPs with seats in the Midlands and the North of England, where scepticism about the EU and Jeremy Corbyn is rife, and where UKIP have polled well, would be vulnerable. An early General Election is possible, but for now it doesn't look like the most likely outcome.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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