The Sick Man of Europe

Summary

• UK relative economic performance has been very weak since the 2016 Brexit vote.
• Brexit’s arrival is unlikely to reverse this trend, despite the goods trade agreement.
• The UK service sector is exposed to post-Brexit dislocation; investment will remain weak.
• Expansionary policy has helped, but public debt has hit 100% of GDP; inflation is a way out.

Turkey (the Ottoman Empire) became known as ‘the sick man of Europe’ in the later 19^th century. Its global political influence faded, its financial position weakened, and its political elite remained stuck romanticizing their past. The UK’s relative performance since the 2016 Brexit vote positions it to carry this moniker for the foreseeable future (Chart 1). Since 2016, UK growth has underperformed non-UK DM growth by 7.25 percentage points (thanks to dreadful performance in 2020; the cumulative gap had been 1.5 percentage points before).

Financial market participants face a key judgment call. Does the UK’s recent awful relative performance reflect a one-off adjustment to the Brexit disruption? An optimistic view would be that UK assets are now cheap and will flourish as the economy settles down to a post-Brexit world of free trade (Chart 2).

I am more pessimistic. The UK has had a growth and productivity problem for a decade. Brexit will worsen that in several ways. Another phase of sluggish growth would raise financial and political risks. Economic policy is already at an extreme, and government debt is high. The external position has been a problem for most of the past century; Brexit will have made it no easier. The Bank of England will quite possibly experiment with a move to negative rates in 2021, which could further overheat an already extended housing market. The current populist government has shown unusually poor administrative capabilities. The union of the UK itself could be at risk in coming years.

A Lost Decade for Living Standards in the Books

The UK economy has performed very poorly since the global financial crisis in 2008. UK productivity growth (as measured by GDP per hour worked) slowed from an average rate that was at the higher end of the DM average from 1970 until then to one that was firmly below after 2010 (Chart 3). The source of this slump has been the decline in the growth rate of the productivity residual: that part of GDP growth that labour and capital inputs and capital productivity cannot explain (Chart 4). After 2010, the UK lost its organizational mojo.

This breakdown came in two phases. I think the aggressive regulatory policy reaction to the banking sector excesses leading up to 2008 caused the first phase. The UK stands out as being overly permissive in the decade up to 2008 and overly restrictive in the half-decade after. By 2014, these drags were largely played out. The second phase was after 2016, once the pro-Brexit vote signalled a need for significant economic dislocation and adjustment in the years ahead. Brexit supporters derided the Remain campaign as alarmist on growth, calling it ‘Project Fear’. Instead of a quick slump, the Brexit vote led to a corrosive reduction in the growth of relative UK living standards.

As a member of the EU (formerly European Community, or EC) since 1973, the UK had integrated itself into the broader European economy with remarkable success. The UK (under Prime Minister Thatcher) had been the leading voice in both the growth of the single market and the integration of the former Communist countries of Central Europe into the EU. The result was that the UK benefitted from an infusion of skilled labour and entrepreneurial talent from the Continent, especially in sectors (most notably finance) where it had a comparative advantage (Chart 5). With no commitment to join the euro, it nonetheless became the centre of euro financial markets. From the mid-1980s, the UK enjoyed much of the upside of EU membership without suffering from its key downside.

An alternative reality could have played out after 1975 if the UK had voted against continued EC membership in its first referendum. This would have involved the UK becoming less integrated with Europe and so (by definition) either more closed or more integrated with the rest of the world. This is the alternative reality that most Brexiteers envisage moving towards. However attractive this might be as a long-run state, there have been (and will continue to be) significant adjustment costs in moving to these new trading arrangements. Moreover, the fall in global support for multilateral free trade makes the UK’s decision to leave its trading block poorly timed.

A Focus on Fish, but Not the Fish and Chip Shop

December’s last-minute trade agreement between the UK and the EU meant avoiding the worst-case scenario of tariffs and quotas being imposed on bilateral goods trade. The agreement means that goods trade can continue without tariffs or quotas, although not without a significant increase in red tape and paperwork (despite digitalization).

The geographic pattern of UK exports highlights how integrated into the EU it has become through its membership period. The share of goods exports the EU accounts for has risen from about a quarter of the total in 1972 to about half in 2019 (Chart 6). An important reason for this is that the EU has enlarged from six countries in 1972 to 28 in 2019. The UK has therefore now jumped out of a much larger economic unit. Time will tell how damaging goods trade frictions will be to UK activity. The government’s hope is that it can replace trade access that it had as part of the EU with newly negotiated bilateral agreements with other countries around the world. My reckoning would be that it will take many years (and much good fortune) for the UK to replicate the bilateral market access that it had until 2019.

The trade problem runs deeper than this, however. The UK has a comparative advantage in services trade. It runs goods trade deficits with both the EU and rest of the world and surpluses in services with both regions (Chart 7). The post-Brexit services trade regime has yet to be determined (especially for financial services). The Johnson government instead focused on a sector (fishing) accounting for less than 1% of GDP. They reached a free trade agreement in goods trade where the UK lacks comparative advantage with the EU. But they left services (80% of GDP) to worry about later. This approach (combined with awful management of the Covid-19 crisis, resulting in a far larger growth hit than for other countries) inspires no confidence in the capability of a government whose term has over three years to run.

A Difficult Investment Climate

Consider an optimistic scenario: Brexit disruptions are either largely in the past or can be smoothed over as the new border regime is established. Even then, there is an additional significant concern about what Brexit will do to trend UK growth in the new steady state. Total factor productivity growth is unlikely to pick up magically in a dislocated post-Brexit economy given ‘stranded’ fixed assets: factories built to service the single market and offices to house financial services firms shrinking their UK footprint.

The combination of capital spending and labour force growth will shape the medium-term growth outlook. UK business fixed investment has been weak since 2016 (a development that Covid-19 intensified). In 2020Q3, it was 10.3% below 2016Q2. By comparison, US business investment rose by 9.9% over this timeframe. Even more concerning, there has been a slump in direct investment inflows since 2016 (Chart 8). Non-EU based companies (e.g., Japanese auto companies) had viewed the UK as an ideal base to access the single market. Unsurprisingly, Brexit appears to have changed that calculus.

The impact of Brexit on the UK labour supply has been more complicated. The UK population is projected to grow by 0.5% per year through 2024 and by 0.4% per year in the following five years. Inward net migration is an important source of this growth. Since 2016, a decline in net migration from the EU has been made up by migration from elsewhere (especially South Asia). The government has also expressed an interest in attracting migrants from Hong Kong (something that it was reluctant to do in the 1980s, to the longer-run benefit of Australia and Canada).

A Public Debt Problem Ahead

I expect post-Brexit UK growth will be quite weak over the next five years, once the 2021-22 bounce back from the Covid-19 slump has played out. As noted earlier, new dislocations resulting from a Scottish independence vote cannot be ruled out. By contrast, Irish unification could well end up being a win-win for both the UK and Ireland.

Sluggish growth would raise the risk of a public debt problem. UK public debt has jumped from 35% of GDP in 2007 to 100% of GDP in 2020 (Chart 10). Although this is nowhere close to peak levels seen in wartime (1820, 1918 and 1946), the pace of increase has been very rapid in recent years. An (unpopular) austerity program after 2010 merely helped stabilize the debt/GDP ratio. The UK is rated AA- by Fitch and Moody’s (and one notch higher by S&P). This puts it on a par with Belgium and the Czech Republic.

Financing high deficits in recent quarters has been unproblematic as net gilt purchases under the Bank of England quantitative easing program have more than offset net issuance. Moreover, aggressive monetary easing has been such that ex-post real interest rates have been significantly negative, helping limit the growth in the debt/GDP ratio from large primary deficits.

The UK remains more prone to inflation than most other DM countries (Chart 11). Since 2010, it has hit its 2% inflation target perfectly (on average). Higher nominal growth would be the obvious way to arrest (and reverse) the rise in the debt/GDP ratio. This was the path followed from 1946 to 1990.