Brexit and the Unforecastability of Demand-Side Recessions

Simon Wren-Lewis claims the Brexit slowdown is about to begin because its negative effect on the economy is no longer masked by unusually strong consumption. Hence, GDP is going to take a hit.

The thing is: all the effects the Brexit vote could conceivably have in the short-run pertain to aggregate demand (AD). Since AD is controlled by the BoE, there is no reason to assume that Brexit will have any short-run consequences on GDP – as I already pointed out immediately after the Brexit vote.

One may argue that at the Zero Lower Bound (ZLB) and under strict inflation targeting, the central bank might lose this control. But since monetary policy in the UK is not even at the ZLB, this theoretical possibility does not apply in the case of post-Brexit Britain.

In general, if the central bank is doing its job properly, any slow-down or reduction of GDP caused by demand-shocks is impossible to predict ahead of time.

Why has this basic fact been ignored by so many economists in the case of Brexit?

Well, most of the economists who have been predicting a negative effect of Brexit on GDP in the short-run believe that Brexit will have a negative effect on the long-run supply side of the British economy. Whether the long-run effect of Brexit will be negative or positive is debatable but taking a pessimistic view is certainly not inherently flawed.

Since economists are human and few humans are immune to the passions involved in political arguments, I guess that, being of the conviction that the long-run effects of Brexit will be negative, these economists have been tempted to loosen their intellectual standards and to sex up their arguments by making gloomy predictions about the short-run as well.

That so many economists have been making these predictions may make them seem respectable. It doesn’t make them well-reasoned or correct.


The Inexact Science of Economics – and Brexit

Some argue that economics is not a science because it is not able to prove  theories ‘beyond doubt’ the same way as the hard sciences can. Or put another way: most economic theories cannot be disproved in the same way that Popper thought scientific theories could be disproved.

Simon Wren-Lewis objects, defining economics as an inexact science, but science nevertheless. He concedes that in economics no single experiment or regression can kill a theory but points out that economists “[…] have accumulations of evidence that confirm the applicability of some theories and reject the applicability of others. Economists’ views about what models are applicable change as this evidence accumulates.”

I find the term inexact science very fitting and basically agree with Wren-Lewis’ remarks on the topic. But then he ruins it in the last paragraph of the post:

This is why economists views about the (negative – ed) long term impact of Brexit should be treated as knowledge rather than just an opinion. Here knowledge is shorthand for the accumulation of evidence consistent with plausible theory. Sometimes the theories are common sense, like making trade more difficult will reduce trade. Estimates of the size of trade reduction based on evidence are uncertain, but they are better than estimates based on wishful thinking. Empirical gravity equations consistently show that geography still matters a lot in determining how much is traded. Finally there is clear evidence that trade is positively associated with productivity growth. To say that all this has no more worth than some politicians opinion is ultimately to degrade evidence and the science which interprets it.

Not so fast. Economists indeed know that making trade with EU countries more difficult, which Brexit undoubtedly will, will have a negative effect on British incomes. However, the EU is not only a free trade area but also (and arguably more importantly) a political union, producing a large amount of legislation each year.

For example, banking regulation is basically completely defined at the EU level, with national discretion restricted to a couple of unimportant parameters and risk-weights.

That is, Brexit will also have an effect on the laws and regulations under which the UK economy is going to operate. Will this legislative effect of Brexit be positive or negative for British incomes? As I said before, nobody can know for sure.

However, EU legislation certainly has room for improvement (to put it politely) and, in general, smaller political entities tend to be governed better than larger ones. Hence, the legislative effect on British incomes may well be positive. Furthermore, the legislative effect of Brexit might not only be positive but also strong enough to more than offset the negative effect of making trade with EU countries more difficult.

In short, the net effect of Brexit on British incomes may well be positive.

The undue certainty with which many economists have made their predictions on the economic consequences of Brexit is based on ignoring its legislative effect. This effect is, of course, more difficult to measure and to predict than the effect of restrictions to free trade with EU countries. That doesn’t mean it’s not important.

Brexit – the long run vs. the short run

There are forecasts that Brexit will precipitate a British recession or at least a significant slowdown of economic growth in the short run.

As Paul Krugman argues here and here, the assumption that the Brexit will be a major negative shock to aggregate demand does not follow from standard macroeconomic theory. Hence, according to Krugman, there is no good reason to expect a UK recession.

I agree with Paul Krugman. There is no strong reason to believe that Brexit will be a major negative shock to aggregate demand. And even if a negative shock to aggregate demand were to occur (for example, because of self-fulfilling negative expectations, i.e. firms believe there will be a recession so they reduce investment which then leads to reduced aggregate demand), monetary policy (maybe even combined with fiscal policy) could offset this negative effect by keeping nominal spending stable.

Of course, Brexit will have an effect on the British economy, namely on the long-run supply side of the economy. Krugman argues that this effect will be negative:

Brexit will almost certainly have an adverse effect on British trade; even if the UK ends up with a Norway-type agreement with the EU, the loss of guaranteed access to the EU market will affect firms’ decisions about investments, and inhibit trade flows.

This reduction in trade relative to what would otherwise happen will, in turn, make the British economy less productive and poorer than it would otherwise have been.

Ceteris paribus, i.e. given all other trade arrangements between Britain and the rest of the world and given the current regulatory framework  in the UK (which is, to a large extent, determined by the EU), Krugman is of course right.

But why would everything else stay equal?

By leaving the EU, Britain will be free to adopt a unilateral free trade policy. Many Brexiteers favour this approach and one can only hope that they will prevail.

Britain would benefit from dispensing with barriers to trade even if other countries did not do the same. It would of course be desirable if other countries also removed their barriers to trade: in this case the gains from trade would be even higher. But moving to free trade unilaterally is the optimal policy for Britain independent of whether or not trade barriers in other countries continue to exist.

Furthermore, Brexit makes it possible for Britain to embark on a new approach to, say, financial regulation. In the UK, there was virtually no government regulation of banking until 1979. Instead, the behavior of banks was subject to tight private regulation. The private regulatory framework for banking was then substituted by government regulation in the 1980s.

This approach has not been a success. Brexit gives Britain the opportunity to return to the principles that served financial markets so well before the 1980s.

Will Britain use the opportunities presented by Brexit – or will Britain’s approach to trade and regulations be more restrictive and intrusive than before?

I don’t know for sure. Nobody knows for sure.

But on the whole I am slightly optimistic. In general, smaller political entities are governed better than larger ones. And many Brexiteers have a fairly libertarian world-view.

The most important effect of Brexit may not (directly) pertain to Britain anyway but to the rest of Europe and the world. Brexit may constitute the beginning of the end of the EU, which – by imposing a large, bureaucratic, uniform governance structure on a diverse continent – is basically the opposite of competitive governance.

Let us hope that, in hindsight, Brexit indeed turns out to be the beginning of a trend towards local autonomy and governance diversity. It would be the best possible outcome.