Uncertainty, volatility and structural challenges – welcome to a post-Brexit World!


Julia Darby, Department of Economics, University of Strathclyde


Tomorrow we will obtain an indication of the strength of the Scottish economy with GDP data for Q1 2016 published alongside jobs data for the period up to May. They are likely to show that the Scottish economy remains fragile, driven largely by the on-going challenges in the North Sea.

In the period immediately prior to the EU referendum however, there had been some tentative signs of an improved outlook within parts of the economy. Businesses had reported more positive expectations for the 2nd half of 2016.

The shock decision by the UK electorate, to vote in favour of leaving the EU, has turned all of this on its head.

Prospects for 2016, 2017 and 2018 now look much more challenging.

Our Forecasts

The Fraser are preparing revised forecasts up to 2018 for publication in the coming weeks.

This is no trivial task. The referendum outcome took many people by surprise – including the UK Government  – and the uncertainty that has followed make economic predictions, like business planning, particularly difficult.

A necessary step in assessing the impact of the referendum on Scotland over the coming months is to unpick the influences of uncertainty and financial market volatility from the longer term structural challenges which will gradually take hold. All three will influence economic performance over the next few months and years – often at the same time, and, on certain occasions, in opposite directions!

Structural Challenges

These factors are perhaps the easiest to identify – although also the most controversial. Most independent economists predict that, in the long-run, the decision to leave the EU will damage trade, investment and productivity as Scotland becomes less integrated with its largest international trading partner.

However, businesses cannot adjust their plans overnight. And for the time being Scotland currently remains within the EU, so in terms of trade, regulation and free movement nothing has changed thus far.

But it will only be a matter of time before expectations of reduced integration feed through to day-to-day business decisions. As Scotland transitions to the new ‘steady-state’ of life outside the EU, growth will be lower than it otherwise would have been.

The lower exchange rate may help dampen some of these effects by boosting exports. However, the lower value of the pound will also reduce the purchasing power of households in Scotland as imports – particularly food and fuel – become more expensive. Moreover, many Scottish exporters don’t compete solely on price, but on quality and customer service, making any exchange rate boost to competitiveness less powerful than it perhaps once was.

Uncertainty

Much more likely to dominate the growth trajectory in the short to medium term will be the effects of uncertainty and financial volatility.

Uncertainty comes from the fear of the unknown and the need to reassess plans based on a particular ‘view of the world’ which is now no longer correct.

Macroeconomic uncertainty is common, but when it does occur it can act as a significant headwind to growth.

On the plus side, more often than not, once the uncertainty is resolved the macroeconomic impacts turn out to be largely transitory. Decisions that have been postponed can be adjusted and implemented at some point in the future. However, the longer uncertainty continues (and particularly if limited to one particular country or region) the more damaging it can be. Projects become more likely to be cancelled rather than simply delayed. Sustained uncertainty also pushes up risk premiums which reduces investment and household spending.

For businesses, consumers, EU workers in Scotland and Scottish workers elsewhere in the EU, the current economic uncertainties are exacerbated by policy uncertainty. Policy uncertainty is arguably much more damaging. As the chart highlights, policy uncertainty spiked at the time of the referendum – source: Scott Baker, Nick Bloom and Steven Davis, http://www.policyuncertainty.com.

In the event of a remain outcome, we would have expected the pre-referendum uncertainty to diminish fairly quickly, as the case following the Scottish independence referendum.

Uncertainty

The reality is that there is unlikely to be clarity on the eventual post Brexit policy landscape for some time, meaning that that the full nature and extent of the adjustments required to move to the ‘new normal’ remain unclear.

This will act as a drag on growth.

Financial Volatility

If this wasn’t challenging enough, financial volatility, distinct from uncertainty, will also play a significant role.

In recent weeks, we’ve seen expectations adjust: first to the referendum result and then to plethora of ‘news’ items – the outlook for monetary and fiscal policy; the short-lived Conservative leadership contest; the announcement of a new PM and Cabinet; the prospects for a second Scottish independence referendum; and the reaction of EU politicians to the referendum outcome. All of this has been captured in large swings in financial markets.

This is an unavoidable feature of the modern global economy. Markets will continue to extract signals from every move that might improve/detract from the clarity on next steps and the evolving nature of any UK-EU deal.

The process is likely to continue for a number of years. Years of negotiation followed by a further period of unwinding economic and policy arrangements with the undoubted controversies, political difficulties, progress, setbacks etc. all being played out on an hourly basis will mean that volatility will be a feature we will have to live with for some considerable amount of time.

Given this, exchange rates and stock prices are likely to deviate substantially from ‘fundamentals’, sometimes for significant periods This instability will itself act as a further drag on Scottish and UK growth. It implies a less productive use of resources – at the macro level – than would otherwise have been the case.

So what can be done?

To an extent, the issues outlined above are largely a direct consequence of the decision to leave the EU. Only once this full process is complete will the issues of uncertainty and financial volatility finally dissipate.

But there are still things that can be done in the meantime.

Firstly, on the structural adjustment challenge, the key risk to the post-Brexit Scottish and UK economies will be the shock to productivity. And here, Scotland and the UK have both lagged behind competitors for years. The UK and Scottish Governments must re-double their efforts to tackle our poor productivity performance, and not just through a race to the bottom in regulation, but with genuine reform. At the top of  key business organisations’ list of issues for both Governments to address are i) unequivocal reaffirmation of the long-term residence rights of EU citizens currently working in the UK; and ii) action to progress long-planned infrastructure projects . Without clear action in these areas, productivity will weaken further.

Secondly, the UK Government has to set out its clear intentions and realistic objectives for negotiating with the EU. At the same time, the approach it will take to the negotiations – constructive or confrontational – needs to be decided. If businesses and investors can be reassured that the process to negotiate the UK’s exit from the EU will be done in a way which will seek to maintain close economic linkages, then this will help reduce uncertainty and financial market volatility.

Thirdly, the Scottish Government will also be required to set out its long-term plan for the constitution. If negotiations with the UK on Scotland’s place in the EU do not go well, then the sooner the government sets out its plans for a possible second referendum, or otherwise, the better. On domestic policy – as Graeme Roy and Andrew Goudie have argued – there is also the need for the Scottish Government to review the delivery of its economic strategy in a post-Brexit world.

Even then, uncertainty, volatility and structural change will be a feature of the Scottish economy for a considerable period of time. It’s something we’ll also have to get used to – particularly economic forecasters!