The UK increasingly looks like an economic basket case. Global financial markets are losing faith in it. Since the beginning of May, sterling is down nearly 8pc against both the euro and the dollar. This latest drop extends the already large depreciation since the 2016 EU referendum.
On a trade-weighted basis, sterling is down 20pc since late 2015. The drop in the exchange rate reflects markets’ downgraded view of the UK’s long-run prospects.
Recent economic trends support this view. Weighed down by uncertainty, productivity-enhancing business investment has stagnated for the past three years. Thanks to the jump in import prices due to the weaker currency, UK households are poorer in real terms. Looking ahead, things could get worse still.
In an attempt to sort out Brexit, the new Prime Minister Boris Johnson is playing a game of chicken with the EU and pro-EU Conservatives. He wants to renegotiate the Brexit Withdrawal Agreement – mainly the contentious “Irish backstop” – that Parliament has three times rejected.
But Johnson has just a one-seat working majority in the House of Commons. The EU may be inclined to stick to its guns and refuse him, in the hope that Parliament would block a hard Brexit.
Politics is inherently unpredictable. An orderly Brexit, a hard Brexit or a further extension, probably plus a snap election, all seem possible.
The outcome of this game could decide the future UK-EU relationship and will have a large bearing on future UK domestic economic policy. It is the economic equivalent of spinning the wheel of fortune.
In the best case Brexit scenario, Johnson would manage to renegotiate a new Brexit agreement with the EU, Parliament would back it and the UK would leave the EU in an orderly fashion on October 31. Even then, the economic risks would not end.
On the campaign trail for leadership of the Conservative Party, Johnson promised cuts to income tax and national insurance plus increased spending on major infrastructure projects such as 5G. On top of his commitment to increase spending on police and the NHS, it all sounds very expensive.
Reversing the fiscal consolidation of the last decade would carry serious risks, even in an orderly Brexit scenario that avoided the short-term shock of no deal.
A large demand-side stimulus would lift growth for a few years. However, it would also add to inflationary pressures and amplify existing long-run fiscal challenges linked to rising health costs and an ageing population. The Office for Budget Responsibility’s most recent forecasts suggest that the UK’s long-run fiscal outlook is already unsustainable. It projects that, by the 2060s, debt as a percentage of GDP will rise above 250pc.
A decade of fiscal prudence has reduced public sector net borrowing from a peacetime high of 9.9pc of GDP in 2009 to 1.1pc in 2018. Johnson’s spending promises could easily take the fiscal deficit to 2.5pc of GDP and perhaps higher in the case of a hard Brexit. By comparison, borrowing during the most profligate Gordon Brown years – 2002 to 2007 – averaged 2.9pc.
In the event of a genuine economic crisis, the UK would not be left with much fiscal headroom (again). In the long run, higher taxes to pay for the splurge now would lower growth. Slow growth over the last decade was partly a result of the need to balance the excesses of the Labour years.
A cynic would say that Johnson’s tax and spending plans are more about politics than economics. What does the Prime Minister really have in mind? Fixing the productivity crisis or boosting his support in the polls in case of snap elections? His plans could easily backfire.
A large fiscal stimulus would be unwise in a hard Brexit scenario. The sudden introduction of borders for people, goods, services and data would throttle the supply side of the economy. Reacting to that by raising demand would merely exacerbate the existing inflation problem that would surely arise from a further drop in the pound. Such a policy would be wasteful and costly to the taxpayer.
If Parliament triggers snap elections to try to prevent a hard Brexit – although it is not clear that this could easily be achieved – the risks to the domestic economy could be higher still. In a worst-case scenario, a snap election could end with a Labour-led coalition fronted by Jeremy Corbyn and John McDonnell.
Imagine what that would mean... increased taxation and regulation, the nationalisation of key industries, no more Bank of England independence, capital controls perhaps? That is a big risk to take to try to stop a hard Brexit.
After all, in the long run, domestic policies matter far more to an economy’s prosperity than trade policy. An economy facing excessive regulation and poor fiscal discipline could not prosper even within the most frictionless trading regime.
The current Italian economy, France before Macron’s reforms, Germany before the 2004 Schröder agenda, and pre-Thatcher Britain all serve as examples of how economies suffer when domestic policy goes wrong.
The UK faces long-term risks on all fronts: a no-deal Brexit that would raise barriers to trade between the UK and its biggest market; reckless fiscal policies that would raise the long-term debt burden; and the threat of a far-Left government whose policies would throttle the private sector. Is it any wonder that financial markets are spooked?
The UK has voted to leave the EU. It has a chance to forge a new path and reconfigure its place in the world. It does not enjoy the economic might that comes with size, as the US, China and the EU do. As a very minimum, to be taken seriously outside the EU, it has to pursue policies that adhere to sound economic principles. The likelihood of heading in that direction soon does not seem high.
If the UK is not careful, it could become the sick man of Europe again. And, if it manages to get through all of this mostly unscathed, historians will surely look back and say: “That was a close one.”
Kallum Pickering is the senior economist at Berenberg