Brexit And The Scottish Economy: Don’t Panic But Do Worry!

by Brian Ashcroft, Fraser of Allander Institute. First appeared on Scottish Economy Watch.

In this blog I shall set out some notes on the nature and direction of the impact of Brexit on the Scottish economy. The Fraser of Allander Institute will be revising its forecasts of Scottish GDP growth, job creation and unemployment in the coming weeks in the light of Brexit where specific numbers will be put on the forecast effects. This blog should in no way be seen as anticipating what the Fraser of Allander Institute will forecast or the nature and direction of anticipated effects identified by the Institute. What I write here is my personal view.

It is useful to use the analytical time frames of the short run and the long run in considering the economic effects of Brexit – see the excellent analysis by theNational Institute for Economic and Social Research back in May.

By the short run, I mean a time horizon that stretches from now until roughly the end of 2017. By the end of 2017 the medium to long-term effects gradually start to kick in. But such effects only begin to make themselves felt after Britain has gone through the Article 50 process and finally leaves the EU with a new trading relationship between the EU and the UK agreed and that won’t be until 2019 or even later.

Short-Term Effects

The short-run effects are largely what economists describe as macro stabilisation effects. We have seen over the last few days and are still seeing significant turbulence in the financial markets: a large fall in the exchange value of the pound sterling; falls in share prices across the major stock exchanges of the world. UK bank shares have particularly been hit, which, in part, reflects an expectation that UK banks will lose their regulatory protections to serve EU customers. However, as Simon Wren Lewis points out the media frenzy surrounding volatility in the financial markets may sound like a major financial crisis but “it is almost certainly not that.”

Brexit has led to a significant rise in uncertainty about its impact on the real economy in the UK and elsewhere. Hence, the large flow of funds into long-term government bonds serving to depress yields. But note that confidence in the UK government has not evaporated because the yield on UK 10-year Gilts have fallen below 1 per cent for the first time. Moreover some of the financial market volatility is due to Brexit being unanticipated by the markets, which has led to more extreme movements in process than would otherwise have been the case. Volatility will diminish soon but it may take some time for sterling and share prices to find a new equilibrium because of the continuing uncertainty about the trading relations that will emerge once the Article 50 negotiations and bilateral trade arrangements with non-EU countries have been negotiated.

The significance of higher and continuing levels of uncertainty as a result of Brexit for the real economy is that risk premiums will rise. So, the exchange value of sterling will be lower in the long-run and  the cost of borrowing to households, companies and government will be higher. Although, UK government debt may persist as a safe haven if political stability is restored within the UK and in view of the UK’s ability to print its own money and borrow in its own currency there may be little rise in the cost of borrowing for the UK government.

The effect of increased risk premia, and increased cost of borrowing will, therefore, serve to lower household demand and fixed investment in Scotland and in the UK depressing aggregate demand. Demand will also fall because real wages and incomes are lower due to higher import prices following the large fall in the value of sterling. Uncertainty will also lead to planned investment projects being delayed, or even abandoned altogether. In addition, any slowing of economic activity will lower government tax revenues and push up government spending as the automatic stabiliser of increased social security payments, such as unemployment benefit, kicks in. Austerity could intensify if the UK government seeks to maintain its current fiscal targets. Moreover, a weakening of the housing market along with a possible lower levels of shares and other asset prices will depress household wealth holdings, which would serve to depress spending and output further.

For these reasons the short-term effect of Brexit should be to depress aggregate demand in Scotland and the UK. However, these effects will occur progressively while as we have seen the fall in sterling is immediate. The large fall in sterling will boost the competitiveness of Scottish exporters, although as costs rise this will disappear in the medium to long term. The rise in export competitiveness will boost the demand for exports and serve to some extent to counterbalance the short-term Brexit factors that depress aggregate demand. Moreover, there could be a further loosening of monetary policy if the Bank of England privileges demand and output maintenance above inflation – due to the effect of higher import prices – stabilisation.

The upshot of this is that the effect of Brexit on demand and GDP growth in 2016 is likely to be negative but small.

The short-term negative effects will strengthen in 2017 and possibly 2018, with the result that we should expect to see a sizeable slowing in growth compared with pre-Brexit forecasts over the next two years. A recession running for longer than two quarters is a distinct possibility.

Medium to Long-Term Effects

These effects are largely the consequence of the new trading relationship that will emerge after the formal Brexit progress is complete. There was a high probability that output and growth in the Scottish economy would be permanently damaged compared to the situation if Britain had remained in the EU.

First, the likelihood would be that the new trading relationship would be less favourable than in the EU. A key study by the Centre of Economic Policy (CEP) at the London School of Economics, estimated that even if a post-Brexit UK secured a free trade agreement with the EU, the effect on GDP through the loss of trade creation benefits is modeled to be around 2.2%. However, once the estimated dynamic losses of Brexit on productivity growth through reduced competition and reduced technological innovation linked to lower FDI inflows and reduced financial integration, CEP’s estimates of loss to GDP rises from 2.2% to 9.5%.

Secondly, this is an area where I fear that Scotland will suffer especially. Labour productivity is currently around 2.5% below the UK and academic estimates put overall productivity around 10% or more below the UK. Moreover, the weaker productivity position in Scotland is bolstered by success in attracting inward investment better than almost anywhere else in the UK. Not only would actual and potential Scottish exporters have to overcome their weaker competitive position due to lower productivity they would also have to face the additional hurdle of less favourable trading arrangements and the attendant loss of productivity enhancing inward investment, which has been key to the Scottish economy. The NIESR draw on the academic literature to estimate a decrease in foreign direct investment inflows to the UK of -24%. Given our past successes the loss to Scotland could be even greater.

So there is much to worry about concerning the future growth of the Scottish economy once Brexit is complete. It is quite understandable that these and other concerns have led to demands for a second referendum on Scottish independence from the UK. But as the data below suggest breaking the UK union might be more costly than leaving the EU Single Market.

Memorandum on trade and corporate links to EU and Rest of UK

On Scotland’s trade, the latest data is for 2014 published in Export Statistics Scotland 2014 (formerly the Global Connections Survey) in January of this year. This shows that the Single Market is much less important to Scotland than exports to Rest of UK. Exports to RUK are £48.5bn (64% of total) to the EU they are £11.6bn (15%) and to Rest of World £15.2bn (20%) and about 1% is unallocated.

I have no estimates of the total number of jobs linked to this trade but their share should be broadly pro-rata to the export sales shares. The Scottish Government’s Boosting the Economy web page cites “Over 300,000 Scottish jobs were estimated by the Centre for Economic and Business Research to be directly and indirectly associated with exports to the EU in 2011” and this is similar to the 250,000 jobs cited by the pro- Europe campaign. But even if this figure is correct the jobs directly and indirectly associated with exports to rest of UK should be more than 4 times greater.

On jobs linked to ownership of companies based in Scotland, using Scottish Government data principally from Businesses in Scotland 2015 and from the Boosting our Economy page in the Benefits of EU membership section I roughly estimate the following job breakdowns:

Total private sector employment in 2015: 2,158,000 (100%)

Jobs in Scottish owned enterprises:          1,422,000 (65.9%)

Jobs in Rest of UK owned enterprises:         377,000 (17.5%)

Jobs in Rest of world owned enterprises:     358,000 (16.6%)
Of which – EU owned     150,000 ( 7.0%)