Why hasn’t the Brexit vote slowed the UK economy?
Macroeconomics under attack after another awkward forecasting failure
Last week, when figures revealed that the UK economy grew at a very respectable 0.6% in the final quarter of last year, officials at the Bank of England and Treasury (the UK’s finance ministry) were left a little red-faced. The cause? Before the UK’s decision to leave the EU, they had predicted it would cause a dramatic slowdown and probable recession. But nothing of the kind has happened. For two quarters the economy has grown at 0.6% and now the Bank of England has raised its growth forecast for 2017 to 2%, from 1.4% in November and just 0.8% last August. This has prompted discussion among economists about the surprising strength of the UK economy, as well as some trenchant criticism of the discipline of macroeconomics.
The government’s grim forecasts were issued shortly before the UK’s referendum vote on EU membership, in a document entitled “HM Treasury Analysis: the immediate economic impact of leaving the EU.” It said that the uncertainty created by the vote would prompt falls in investment by firms and spending by consumers, pushing the economy into recession. The Bank of England agreed. There were some important differences in their tone. While the Treasury document said households and firms “would” reduce spending, the Bank of England, more cautiously, said “could”, but the overall prediction was clear. Yet then, rather than tightening their belts British households went on a spending spree and growth held steady.
Such forecasting failures are hardly new. But this one is particularly awkward, as it emanated not from an obscure think tank or pressure group, but from the epicentre of official economics in Britain. These were the product of months of extensive modelling and analysis. So the Brexit mistake, at the very least raises a question mark about both the economic models and the judgement of the officials and politicians who made use of them. What exactly went wrong?
Traditional economic theory has it that uncertainty causes firms to postpone investment decisions and households to save more, in anticipation of an unknown future, causing the economy to contract. This idea has been supported by empirical studies of the 2008/9 recession (see for instance this and this). But Scott Sumner (of George Mason University) thinks that Brexit has effectively disproved that theory. Warning that “macroeconomics is a deeply flawed field” because you can’t do normally do controlled experiments he thinks that Brexit vote was closest we get to such an experiment:
“In the field of macroeconomics it is very unusual to see an almost perfect test of the “uncertainty theory of business cycles”. I certainly never expected to see such a nice natural experiment. Now that it is over, we can remove one suspect from the list of possible causes of business cycles…”
In other words, if the rise in uncertainty hasn’t slowed the economy down, then the theory is wrong.
Tyler Cowen (also of George Mason University) disagrees. He doesn’t think Brexit is a good example of the kind of uncertainty economists include in their models. In any case, he argues that the main immediate impact has been the depreciation of sterling (by about 15% against the US dollar) which will lower purchasing power and consumers’ wealth. But those effects will take some time to feed through. As he puts it:
“Now fast forward to Brexit…the shock “attacked” the UK economy in the form of an immediate exchange rate depreciation. That is a hit to wealth, concentrated on import purchases, though with a good deal of smoothing over time, because import purchases are themselves spread out.”
Simon Wren-Lewis, of Oxford University, has a different take. He rejects Sumner’s idea that the unexpectedly strong growth is a challenge to macroeconomic theory. He argues that it’s mostly due to an unexpected fall in the personal savings rate and the depreciation of sterling. He also attributes the higher growth to the cut in interest rates and extra bout of quantitative easing introduced by the Bank of England in August 2016 – which were specifically aimed at mitigating the shock of Brexit. (The Bank of England’s forecasts prior to Brexit assumed that interest rates and quantitative easing would remain unchanged.)
Nevertheless, the unexpected strength of the UK economy has spilled over into a wider debate about the status of the economics profession. Even Andy Haldane, the Bank of England’s Chief Economist, has admitted that economic forecasting is “in crisis”, although he still expects an Brexit-induced economic slowdown, round the corner.
Kwasi Kwarteng, a Conservative MP and supporter of the Leave campaign, is much more scathing. Arguing that economics is flawed because you can’t use mathematics to understand the complexities of human behaviour, he says:
“Human behaviour is notoriously difficult to predict. Newton’s laws of motion cannot be applied to the propensity of human beings to save or spend. The great economist John Maynard Keynes, in his wisdom, spoke of ‘animal spirits’ to describe the psychology of business, investors and consumers. You cannot construct a mathematical model for ‘animal spirits’.”
He goes further to suggest that the predictions of economic calamity were the result of “group-think” or political bias. John Lanchester, a writer who has taken a big interest in capitalism and the City in recent years, also puts the boot in. He catalogues multiple problems in macroeconomics, including the neglect of financial markets and the assumption of rational decision-making. He argues that the original purpose of macroeconomics was to prevent economic depressions, and it hasn’t even managed that.
It is perhaps a little unfair that macroeconomists, unlike almost any other social scientists, are called-upon to make forecasts and then be judged by their accuracy. But if the authorities are to make sensible decisions about fiscal and monetary policy, forecasting is unavoidable. Given this, economists could respond to the unexpected outcome of the Brexit vote in two main ways.
One is to take refuge: deny that it was a real forecast, claim that special considerations apply, perhaps including unexpected external events. That way, tempting though it might be, lies irrelevance.
The second is to admit that it went wrong and try to learn why. This involves taking responsibility, investigating the assumptions and theories behind models. This route is painful and inconvenient, but the only reliable route for a reinvigoration of the discipline, as a Bloomberg editorial argues. In this case that would involve asking: why might households increase their spending after they voted to leave the EU? Both drowning sorrows and celebrating victories involves extra spending, but they aren’t the stuff of economic theory – yet.
Edited by Bill Emmott