It remains to be seen whether Britain’s impending departure from the European Union will be “hard” or “soft.” Either way, it is time to start thinking about the post-Brexit economic environment. It will take sustained and concentrated efforts by the British government to begin shaping policy to mitigate the paralysis that has damped the economy.
A Brexit “uncertainty tax” has hung like the sword of Damocles over the UK economy for the past three years with little clarity around the direction of policy linked to the type of exit from the European union the country will take. Consequently, policy makers will need to acknowledge the supply shock that is coming as the economy exits the EU.
The separation of the domestic economy from continental supply chains will likely be painful and the optimal policy should probably target a reduction in tariffs, incentives to bolster outlays on capital expenditures and a reduction in rates by the Bank of England.
The government’s plan to reduce tariffs by 80 percent is a good start, but will likely prove insufficient. Where possible, tariffs should be cut to 100 percent to boost exports in line with what will likely be a deprecation in sterling against both the euro and the U.S. dollar.
While supporters of the status quo may claim that free trade agreements will be quickly put in place and so there is little reason to support robust and sustained action, the reality is that it may take years before a new U.K. relationship with the EU or United States can be negotiated.
In the final quarter of 2018, business investment declined 3.7 percent. If the status quo holds, there is no incentive for firms to unlock pent-up demand for outlays on new software, equipment and intellectual property. Those investments will be required to bolster the backbone of the services economy, which will be needed to supplant lost domestic manufacturing capacity that will follow in the wake of Brexit.
Meanwhile, write-offs and consolidation are coming to domestic manufacturing operations enmeshed in European supply chains. The fracturing of those economic ecosystems requires strong and sustained measures to cushion the blow following the de-linking from the EU.
Finally, the Bank of England should alter the balance of risks to the economy and begin to shape expectations for a rate cut. The BOE should prepare to bring the nominal policy rate down to zero from 0.75 percent in an effective and orderly manner by the end of this year with the ultimate goal of pushing the real rate of interest further negative from its current minus 1.15 percent rate.
The hit to the economy will almost certainly result in a weaker inflation trend over the medium term, thus mitigating the potential for an inflationary shock. Despite the fog of Brexit uncertainty, or perhaps because of it, the BoE will likely see the need to act to stabilize the economy; monetary and fiscal authorities can worry about inflation once the need for stabilization policies has passed.
