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Analysis
Brexit's fiscal hangover

Brexit's fiscal hangover

Autumn statement highlights vote’s damage to public finances

by Danae Kyriakopoulou

Thu 24 Nov 2016

As many had feared and warned ahead of Britain’s 23 June European Union membership referendum, the Brexit vote has significantly worsened the UK’s medium-term economic outlook. This is now confirmed by the independent Office for Budget Responsibility. The OBR’s downward forecast revisions of the UK’s pace of economic growth and a worsening outlook for public finances have provided a sober backdrop for Chancellor Philip Hammond’s debut autumn statement.

Brexit means that the pace of GDP expansion will slow despite the expansionary fiscal policy stance presented in the autumn statement, and also in spite of the presently benign monetary policy backdrop which still feeds into the OBR’s assumptions when preparing the economic outlook. With interest rates widely expected to rise in response to higher inflation, GDP growth could fall further. In itself, the chancellor’s plan to abandon former Chancellor George Osborne’s commitment to return the public finances to surplus by 2020 is good news, and one that Osborne himself had promised in the wake of Brexit. The rise in borrowing will enable the government to spend more on much-needed infrastructure. The newly created National Productivity Investment Fund will include £3.3bn additional spending on both traditional forms of infrastructure such as roads, but also on digital infrastructure. Osborne’s strategy for a ‘march of the makers’ has rightly been replaced by a ‘march of the coders’, with the chancellor rightly resisting directing support to failing industries that have been hurt by globalisation and instead focusing on the growth industries of the future.

Much like Donald Trump’s grand infrastructure plan, the overall shift to fiscal policy and focus on infrastructure outlined in the autumn statement is much needed. The UK has been underinvesting in its infrastructure for decades, creating a huge infrastructure deficit that the National Infrastructure Commission estimates at £483bn and which independent estimates place much higher. Similarly to the US, however, the government’s veer towards fiscal expansion risks destabilising the gilts market. Yields on 10-year gilts jumped from 1.39% to 1.45% during Hammond’s statement.

And unlike the US, the UK faces the additional negative impact from Brexit. According to the OBR’s analysis, only a very small share of the worsening in the UK’s public finances is accounted for by the UK’s new growth policies. The OBR’s underlying analysis suggests that around half of the rise in public sector net borrowing compared with the March forecasts (which ranges from £12.7bn in 2016-17 to £31.8bn in 2020-21) can be attributed to Brexit, with a fifth due to non-Brexit forecast changes and a further fifth attributable to the effect of government’s decisions in the autumn statement. This rise, in combination with declining tax revenues due to slower growth, will raise the overall size of the debt by £220bn to reach just under £2tn by 2021. And with the decline in sterling, the UK’s contribution to the EU budget (which is priced in euros) has actually gone up, putting further strain on the public finances. So much for Brexit creating fiscal room to spend £350m a week on the NHS.

Brexit’s impact on the UK’s public finances as forecast by the OBR, however, rests on some important assumptions. In particular, the forecasts assume that the UK leaves the EU in April 2019, two years after the prime minister has stated that Article 50 will be invoked. Any complication involving the role of parliament and the legal battles would impact these forecasts. Elevated uncertainty could mean that the cost to the economy is even higher. Forecasts further assume that the negotiation of new trading agreements with the EU and others slows the pace of import and export growth for the next ten years. This has been calibrated on external studies with different trading regimes, but could be criticised as too pessimistic by those Brexiteers who supported the UK’s exit from the EU with the hope that this would open the door for a move to faster-growing export markets and consequently faster export growth – perhaps not immediately but certainly within the next decade.

Finally, the OBR’s forecasts assume that the UK adopts a tighter migration scheme than what is currently in place, but not sufficiently tight to reduce migration to the tens of thousands. As was proven by the previous government’s inability to control migration flows – not just from the EU but also from the rest of the world – this seems an unrealistic assumption.  Interestingly though, the OBR admitted that it has ‘been given no information regarding the Government’s goals or expectations for the negotiations that is not already in the public domain’. This means that the economic outlook could change significantly – for better or for worse – from what has currently been predicted by the OBR.

While increased spending, both on traffic jams and ‘Jams’ (Whitehall’s term for families who are ‘just about managing’), is a welcome shift from Osborne’s austerity, the associated deterioration of the public finances makes the UK less well prepared to weather the next downturn.

Beneath the cheering tone from the Tory side of the House of Commons, Project Fear has turned into Project Reality. It is no wonder that Hammond does not want to have to carry out another autumn statement and has decided to abolish it.

Danae Kyriakopoulou is Head of Research at OMFIF.

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