This post concludes that UK real income and investment would have been 4% and 6% larger respectively had it not been for the shock of the Brexit referendum result.
[...]While this post has something to say about Brexit, one can also take it as relevant for an assessment of the importance of expectations for economic developments. Indeed, the ‘leave’ vote in the Brexit referendum has only changed expectations and not, directly, any hard economic variable. If we detect possible consequences, these must be due to the fact that expectations have changed.
And, of course, we have to recognise that it is not easy to be precise about the change of expectations, since these reflect the weighted average, with unknown weights, of three possible outcomes, each with uncertain consequences: Brexit without a deal, Brexit with a deal, and no Brexit.
So we are possibly seeing the effects of a composite change of expectations: if expectations were more precise, the consequences would be themselves clearer. The issue of the composite nature of Brexit expectations is taken up again at the end of this post.
It seems clear, however, that expectations have indeed changed. The best place to look for evidence is in the foreign exchange market: unlike macroeconomic variables, the exchange rate can jump when expectations change and, in fact, it did jump on the occasion of the referendum. [...]
The interpretation I offer of this development is that the expectation shock delivered by the Brexit referendum result had a lagged and protracted effect on real growth, consistent with the fact that real variables are characterised by a lot of inertia. [...]
To give more sense to what the lower growth of the UK economy post-referendum means, I have carried out a back-of-the-envelope calculation of how much less, in cumulative terms, real GDP has grown, since the fourth quarter of 2016, with respect to the pre-referendum pace.
In the four years before the referendum, the UK economy was growing by some 1.2% more than the euro area on average every year. If this differential had remained constant, given that more than two years have passed since the referendum and given the growth in the euro area in this period, the UK economy would now be some 4% larger than its real current size. [...]
If the ratio between the investment in the UK and that in the euro area had remained at the same level as in the four years before the referendum, investment in the UK would have been some 6% higher than it actually has been. This does not prove, but is consistent with, a causal chain from the referendum result to expectations; from those, then, to investment; and finally to aggregate demand and, thus, real income. [...]
In conclusion, the behaviour of growth, investment and inflation in the UK relative to the euro area economy, which is by far its largest trading partner, is consistent with an expectation shock delivered by the result of the Brexit referendum. This has likely caused cumulative lower growth by some 4% while investment would have been some 6% higher. Inflation in the UK came down and is now similar to that in the euro area.
These possible macro-economic effects, while significant, are not dramatic – but they are just, as the title of this post says, the shadow of Brexit working through expectations.
In addition, as mentioned at the beginning of this post, Brexit expectations are the weighted average of three very different events: Brexit with no deal, Brexit with a deal, and no Brexit. There is no objective measure either of the probabilities to be attached to the three events or of their economic consequences. Audacity is needed to build on such frail basis. Still, it may be illustrative to carry out some quantitative, yet arbitrary, exercise to extrapolate, from what has happened so far, the possible consequences of a revelation of one or other of the Brexit outcomes. [...]
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