Brexit woes & the UK economy: Which policies to damage control?

#Brexit Facts

­Brexit implies heavy consequences for the UK economy at least in the short and medium term. For the moment, I will stop dwelling on the reasons why Brexit is economic suicide and discuss policy actions to mitigate its adverse impacts.

Let’s have a quick look at the state of the UK economy, exactly a year after the Brexit vote:

• Low growth & high inflation: The UK economic growth slowed down in 2017 amid high uncertainty of Brexit negotiations, low investment and consumption spending. Inflation stood at 2.9% in May 2017, well above the 2% policy target of the Bank of England. High inflation was mainly driven by rising import prices (e.g. raw materials, energy, food) as a result of pound depreciation. Rising inflation had the consequence of decreasing the real earnings of the UK households.
• High consumer debt: As a response to a stricter regulation of mortgage lending, the UK credit institutions  have been expanding their unsecured loans in 2017 . Thus, credit card lending and car finance grew at pre-crisis levels. More worryingly, the UK household saving rates declined to historically low levels in 2017. Precautionary savings serve as a cash cushion for households during ‘bad times’. Put differently, high debt and low savings make the UK consumers more vulnerable to economic/financial shocks during these uncertain times.

Brexit constitutes a major challenge for the UK policy makers. Since the economic crisis in 2008, the Bank of England has followed an accommodative policy stance (low interest rates + Quantitative Easing) to support economic growth. However, almost a decade of historically-low interest rates and unconventional monetary policy measures have rather contributed to building-up debt, both public and private, and asset-price bubbles in certain sectors. All in all, without the support of the economic policy (which was rather stuck in austerity), loose monetary policy was not enough to create the necessary conditions for a truly self-sustaining economic recovery.

The Bank of England’s next interest rate decision is scheduled on August 3rd. In a context of rising inflation and slowing growth, the Bank is facing an uncomfortable decision. The members of the Monetary Policy Committee expressed mixed opinions on whatever or not to start raising policy interest rates already.

Clearly, increasing inflationary pressures should be not ignored for long time to prevent the de-anchoring of long-term inflation expectations. In this sense, an interest rate hike could support the exchange rate of the pound and put the break on rising import prices. However, considering the ongoing fragility of the UK economy, raising interest rates ‘too soon’ may have disastrous consequences in terms of economic growth and household debt sustainability. For instance, high interest rates may further depress internal demand (investment and consumption) by making bank credit ‘too expensive’. Furthermore, most mortgage loans in the UK are contracted at variable or short-term fixed rates. Therefore, even a small rise of interest rates could make monthly mortgage payments more expensive, putting household budgets under increased pressure.

To my opinion, an interest rate rise already in August might be ‘too early’ in an environment of “anaemic” wage growth and Brexit uncertainty. Therefore, I believe, macroprudential measures could be more effective in tightening credit growth without endangering the economy. For instance, on 27 June, the Bank of England introduced higher capital requirements for major credit institutions. In other words, banks will have to put more capital aside for new lending. This was a good step in the right direction, in order to tame consumer credit growth without putting ‘debt sustainability’ under stress.

Of course, monetary policy cannot tackle all alone  the Brexit woes of the UK economy. The UK needs a good ‘policy-mix’ of gradual and timely monetary tightening together with fiscal expansion in the form of public investment in productivity-enhancing infrastructure. Since decades, the UK lacks a coherent and long-term strategic vision in infrastructure investment. Compared to the peer economies, the UK is ‘singled out’ because of its poor infrastructure in transport, telecoms and energy sectors. More importantly, the infrastructure deficit of the UK is detrimental to growth and largely explains the poor productivity of the UK industry.

The UK public debt is currently at historically high levels and the country has almost no fiscal space to introduce expansive fiscal policies. Obviously, addressing the UK’s deficit in infrastructure requires private-sector capital and expertise to complement public policies, which have failed so far.

I hope you found this article helpful. Please leave me a comment for your feedback and questions.