December 2nd, 2019 
Roch Dunin-Wasowicz How has the Leave vote affected the UK economy, ask Swati Dhingra and Thomas Sampson (LSE) in this second of two blogs based on the CEP Election Analysis briefing on Brexit. It summarizes CEP research on how the referendum outcome has affected the UK economy since 2016. The first blog, which reviews work on the potential long-run economic effects of different forms of Brexit, can be found here.
The full economic impacts of Brexit will not be known for many years. But three and a half years after the referendum, we can assess how the Brexit vote has affected the UK economy since June 2016. The vote has already had economic impacts because economic behaviour depends upon both what is happening now and upon what people and businesses expect to happen in the future. The referendum changed expectations about the future of the UK’s economic relations with the EU and the rest of the world. Not only is Brexit likely to make the UK less open to trade, investment and immigration with the EU, but it has also increased uncertainty. Researchers at the CEP and elsewhere have studied the effect of the Brexit vote on the value of the pound, output, prices, trade, wages and investment.
Sterling
The immediate economic impact of the Brexit vote was a depreciation of sterling. On referendum night, sterling saw the biggest one-day loss that has ever occurred in the four major currencies of the world since the collapse of Bretton Woods. Between 23rd and 27th June 2016, sterling declined by 11 per cent against the US dollar and 8 per cent against the euro, and it has remained around 10 per cent below its pre-referendum value.
Image by Images Money, (CC BY 2.0).
Output
A broad indicator of economic performance is the growth rate of GDP. While the UK started with a steeper growth trajectory, it has fallen behind other G7 countries since the referendum (Figure 1). The Brexit vote is estimated to have reduced UK’s GDP by between 1.7 and 2.5 percentage points lower, or between £1,300 and £2,000 per household in pound terms (Born et al. 2019).
Figure 1: GDP Growth in the UK and Other G7 Countries 2012-19
Source: CEP calculations, updated from De Lyon and Dhingra (2019). GDP values are deflated by country-specific GDP deflators. Other G7 countries include France, Germany, Italy, Japan and the United States.
Prices and the cost of living
Consumer Price Index (CPI) inflation rose dramatically from 0.4 percent in June 2016 to 3 percent in January 2018. Breinlich et al. (2019a) study whether this increase in inflation was caused by the Brexit depreciation. If the sterling depreciation is responsible for higher inflation, we would expect product groups where consumers buy more imported goods, such as food and clothing, to have experienced bigger price rises than groups less sensitive to import costs, such as restaurants and hotels. And this is exactly what Breinlich et al. find. After disentangling the effect of higher import costs from other factors that affect prices, Breinlich et al. estimate the Brexit vote increased consumer prices by 2.9 percentage points in the two years following the referendum, which equates to an £870 pound per year increase in the cost of living for the average UK household. It would be wise to view the precise magnitude of this effect with some caution, but the cost is undoubtedly substantial.
Trade
By making UK exports cheaper, the depreciation of sterling following the referendum could, in principle, give UK firms a competitive advantage in foreign markets leading to higher exports. However, real export growth has not increased since the depreciation, compared to other G7 countries, as shown in Figure 2a. For firms with global supply chains, currency depreciations also raise import costs, mitigating the competitive advantage of the depreciation for exporting. The growth in real imports into the UK has been broadly similar to that in other G7 countries, as shown in Figure 2b. The nominal value of imports has risen, but this is largely because of a rise in import prices due to the sterling depreciation. Analysis by Costa et al. (2019) finds that the rising cost of imported inputs has dominated the potential revenue gains from exports brought about by the depreciation.
Figure 2: Real exports and imports in the UK and other G7 countries, 2012-19
(a) Exports
(b) Imports
Source: Updated CEP calculations from De Lyon and Dhingra (2019). Trade values deflated by country-specific producer price indices (PPIs). Other G7 countries include France, Germany, Italy, Japan and the United States.
Wages and employment
The increase in inflation due to the Brexit depreciation has not been accompanied by faster income growth. As shown in Figure 3a, higher inflation after the referendum led to a decline in real wage growth. Real wages dropped from a pre-referendum annual growth rate of 1.1% to less than 0.1% after the referendum. Research by Costa et al. (2019) sheds more light on the causes of this real wage stagnation. After the referendum, workers in sectors that saw bigger increases in the price of their intermediate imports experienced slower wage growth and reductions in job-related education and training. Comparing sectors in the top and bottom halves of the intermediate import-weighted depreciations, Figure 3b shows real wages in the top half of sectors were growing at 1.3% annually before the referendum and this dropped to -0.6% after the referendum. This is a slowdown of 1.4 percentage points, compared to less exposed sectors in the bottom half, which saw an increase in their annual real wage growth from 1% to 1.4% after the referendum. While wages had been growing in the pre-referendum period, real wages have stagnated since then and this effect is more pronounced in sectors that have been hardest hit by rising costs from the sterling depreciation.
Rising import costs have not translated into job losses or reductions in hours worked, except paid overtime hours which have seen reductions since the referendum. Overall, the drop in training opportunities and anaemic wage growth at a time of high employment rates raises serious alarm of a deepening of the productivity slowdown that has plagued the UK economy for years.
Figure 3: Wage growth, 2012-18
(a) Nominal and Real Wage Growth In All Sectors
(b) Real Wage Growth in Sectors at the Top and Bottom of Import Cost Exposure
Source: Office for National Statistics and CEP calculations based on Costa et al (2019). Wage growth is the percentage change year on year in the three month average of Average Weekly Earnings – Regular Pay. Real AWE is Nominal AWE deflated by CPI. The dashed vertical line shows the date of the referendum (June 2016).
Investment
Uncertainty makes businesses less willing to invest in risky new projects. Bloom et al. (2019) find that firms that report experiencing higher Brexit-related uncertainty have had lower investment and productivity growth since the referendum. They estimate that anticipation of Brexit reduced business investment in the UK by 11 percent in the three years following the referendum. The Brexit vote has also started to affect investment flows into and out of the UK. Reduced openness makes the UK a less desirable investment destination because it increases the costs of using the UK as a base for serving EU markets. CEP research by Breinlich et al. (2019b) shows that the Leave vote led to a 17% increase in new investment projects by UK firms in the EU by March 2019, but did not affect UK investment outside of the EU. Looking at flows in the opposite direction, Breinlich et al. find that the referendum reduced new investment projects by EU firms in the UK by 9 percent over the same period. Together these estimates suggest that Brexit is making the UK a less attractive place to do business.
Final words
It is too soon to evaluate the accuracy of forecasts that estimate the potential long-run effects of Brexit and as time passes, new evidence will continue to provide fresh information on the response of the economy to Brexit. However, even before Brexit has happened evidence on post-referendum changes in output, prices, trade, wages and investment shows that the UK is paying an economic price for its decision to leave the EU.
This post represents the views of the author and not those of the Brexit blog, nor the LSE.
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The changing size and shape of the UK state ahead of GE2019
Political consensus is a rare commodity these days. But following a decade of austerity, and with borrowing costs at historical lows, a severe bout of accord has broken out across the big political parties about the efficacy of turning the spending taps back on.
With the party manifestos now published, we can see just how significant spending ambitions are. Analysis from the Resolution Foundation suggests that Conservative plans involve pushing government expenditure to around 41% of GDP over the course of the parliament, whereas Labour’s manifesto sets a course to 45% of GDP (with the Lib Dems sitting somewhere in between). That leaves a big gap between the big two, equivalent to more than £100 billion a year – the consensus only stretches so far it seems. But stepping back, the bigger point is that the two biggest parties are plotting a significant change of direction relative to recent years: spending averaged just over 37% of GDP in the quarter century leading up to the financial crisis. As the chart below suggests, the size of our state appears to be heading back towards 1970s levels, whoever forms the next government.
But the backdrop to the plans also matters. More specifically, it is worth reflecting not just on how the size of the state has changed over time, but also its shape. Spending priorities naturally move over time, reflecting shifts in political, economic, and demographic backdrops. Yet the changing role of the UK state has been particularly pronounced over the course of the austerity decade, with the prioritisation of some key aspects of spending within a tight overall budget inevitably squeezing resources for many functions.
Departmental spending has been particularly constrained – reflecting the fact that it is the element of spending that government has most control over. And within that restricted departmental total, an increasing share has gone to health and international aid, leaving many other departments facing very sizeable reductions in spending.
As the next chart shows, the local government budget is on course to have been cut by 77% in 2020-21 relative to a 2009-10 baseline when measured on a per-capita basis. Other departments have fared only a little better, with real-terms per-capita spending down by a half in Housing and Communities, Transport and Work and Pensions, and by a third in Scotland, BEIS, DEFRA and Justice.
In contrast to the shrinking departmental total, spending on social security has risen in real terms over the last decade or so. But there have once again been some big changes in the profile of that spending. Expenditure has shifted increasingly from working-age welfare to pensioner payments: a change that has been driven not by demographic change (with the rising State Pension age pushing back against the ageing of the population in recent years), but by deliberate policy choice. More specifically, the introduction of the ‘triple lock’ in 2011 (whereby the value of the State Pension grows each year by highest of inflation, earnings or 2.5%) alongside roughly £12 billion of cuts to working-age benefits has led to a situation in which the State Pension now accounts for 44% of all welfare spending, up from 37% just ahead of the financial crisis.
The next chart brings all this together, focusing on how overall government spending splits across different functions. By far the biggest growth over the last two decades relates to ‘old age’ social security spending and to health spending. Taken together, these two functions have gone from accounting for 29p of every £1 spent by government in 1997-98, to 33p in 2007-08, and 37p in 2018-19. The share of spending flowing to many other functions – including defence, public order and safety, and housing and community services – has been correspondingly squeezed.
It is of course up to the government of the day to determine where public spending should be directed. But the suspicion is that at least some of the recent shift is the product of a series of politically pragmatic decisions taken in isolation as part of the austerity agenda, rather than a carefully crafted strategic overview. As a country, we haven’t ever stopped and asked ourselves what the state is for, yet we have just lived through a significant reshaping of its role. That matters because, as we move beyond the election, demographic forces are set to steer the UK state further down the path already struck out on as a result of policy decisions over the last decade. Absent any further policy change, our ageing population will significantly increase the share of spending accounted for by health and old age social security.
The next chart plots the policy neutral outcome associated with the Office for Budget Responsibility’s long-term projections. It shows that old age social security and health expenditure could together account for half of all non-debt interest spending by 2067-68. Within this, health spending on its own could account for close to one-third of the total. In contrast, the share of total spending accounted for by non-old age social security drops from 19% in 2017-18 to 13% in 2067-68. And the share flowing to education falls from 13% to just 9%.
Crucially, these shares are based on an assumption that spending on all functions outside of health and old age social security continues to grow in line with the economy. If health and old age social security spending is to rise to match demographic change then, the overall size of the state as a share of GDP must rise quite considerably.
That’s the scenario set out in the final chart. It relates to non-debt interest spending only, so isn’t directly comparable with the first chart in this article. On a like-for-like basis, however, it translates into spending that falls just short of 49% of GDP – a figure well above the post-war peak of 46.6% reached in 2009-10. And of course, if the next government chooses to increase spending on some functions above that demanded by the demographic headwind – as the various manifesto promises suggest it might – then the country could end on an even higher spending trajectory.
This means there are tough choices ahead: from meeting the increased healthcare and pensions bill by squeezing spending on other services, to altering the healthcare or pension offer available to citizens, or very significantly increasing the tax take. None of the options is particularly voter friendly, so we might forgive the parties for saying little on this front for the moment. But we can’t duck the difficult questions indefinitely. There may be consensus about the need for a bigger state, but we urgently need to reflect on just what we want the state to be doing – and what trade-offs we’re prepared to make in the pursuit of that goal.
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Note: the above draws on the author’s report for Resolution Foundation.
About the Author
All articles posted on this blog give the views of the author(s), and not the position of LSE British Politics and Policy, nor of the London School of Economics and Political Science.