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Will Brexit make austerity worse?

Summary:
There seems to be some confusion among some on the left about the impact of Brexit. Statements like ‘Brexit will make austerity worse’ by Remainers are imprecise, so let me spell this out. Because of the controversy this generates I’m afraid this is going to be a rather dry, analytical post. But if you think government spending can somehow reverse the negative economic impacts of Brexit, this post is for you. Brexit will reduce UK trade relative to what it would be if we stayed in the EU. How much will depend on the type of Brexit. As I outlined here, it will not be possible to come near to replacing that trade through new trade deals. So less trade is a given. Less trade reduces GDP mainly because it reduces productivity. Trade allows specialisation. Instead of Honda cars being produced

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There seems to be some confusion among some on the left about the impact of Brexit. Statements like ‘Brexit will make austerity worse’ by Remainers are imprecise, so let me spell this out. Because of the controversy this generates I’m afraid this is going to be a rather dry, analytical post. But if you think government spending can somehow reverse the negative economic impacts of Brexit, this post is for you.

Brexit will reduce UK trade relative to what it would be if we stayed in the EU. How much will depend on the type of Brexit. As I outlined here, it will not be possible to come near to replacing that trade through new trade deals. So less trade is a given.

Less trade reduces GDP mainly because it reduces productivity. Trade allows specialisation. Instead of Honda cars being produced in each EU country they can be made in just one, which allows (in part because of what economists call economies of scale) the cars to be produced more efficiently. Trade also increases competition (you can buy many makes of car in the UK) which improves efficiency. Therefore if you restrict trade, you reduce productivity. Less productivity means less GDP. I discussed how much GDP could fall under May’s preferred trade arrangement here.

A reduction in productivity is a supply side decline in GDP. It is very different from a demand deficient recession of the kind we had after the GFC. In a demand deficit recession fiscal policy (more government spending or lower taxes) can be used to restore demand and therefore GDP, and must be used if interest rates are stuck at their lower bound. The tragedy of austerity from 2010 is that the opposite was done. The decline in GDP brought about by lower productivity following less trade cannot be tackled in that way.

When GDP falls, taxes fall. To keep the deficit constant, that requires a reduction in government spending. Brexit will reduce government spending compared to what it would be if we stayed in the EU. To that extent Brexit makes austerity worse. To say that those who point this out are advocating a continuation of the policy of 2010 austerity are wrong.

It is important to note that what I am doing here is comparing two states of the economy, and saying what the differences would be between those two states. This type of comparison confuses many people. I am not saying government spending is going to be lower than it is now - it almost certainly will not be. People say cannot we do something to mitigate the impact on GDP of Brexit? There are many things that can be done to improve GDP, like more public investment, but they could also be done if we stayed in the EU. If you think there is still spare capacity in the economy then GDP can be raised by fiscal or monetary policy, but that is equally true in or out of the EU.

Does government spending have to lower out of the EU compared to inside the EU? The answer is no, which is why statements like Brexit will make austerity worse are incomplete. You could keep government spending at the same level in and outside the EU. But that would raise the deficit, which requires higher taxes. So in that case Brexit would increase taxes. So a correct statement would be that Brexit either reduces government spending or raises taxes or some combination of the two.

At this point you get MMTers up in arms. The deficit does not matter for a country with its own currency and so on. Or even worse, that government spending determines taxes and not the other way around. This is a very good illustration of how misleading MMT rhetoric can be. To see why, go back to the case where government spending falls in proportion to GDP under Brexit, which means the deficit is unaffected by Brexit. Now suppose you increased government spending to the level it would have been without Brexit. That is an expansionary fiscal policy, which stimulates demand which raises inflation. The obvious way to reduce demand and inflation is to raise taxes so the deficit is back to its original level. It does not matter whether you need to keep the deficit unchanged because you have a fiscal rule, or you have fiscal policy stabilising the economy as MMT advocates, you get the same result.

Some MMT followers never admit they are wrong, so I got a lot of stuff about how you can use other measures to reduce inflation like credit controls. But you could use them if we stayed in the EU as well to allow higher government spending or less taxes. There is no obvious reason why leaving the EU makes such measure more effective.

The correct statement about the impact of Brexit on the public finances is that it means government spending will be lower or taxes higher or some combination of the two. Furthermore the overwhelming majority of economists think GDP will fall as a result of Brexit, and I have not come across an academic whose field is trade economics who thinks otherwise. If you think, as I do, that this government has reduced public spending way beyond the level that people want, and therefore you want to raise that spending, Brexit makes that more difficult.



Simon Wren-lewis
Professor of Economic Policy at the Blavatnik School of Government, Oxford University, and a fellow of Merton College. This blog is written for both economists and non-economists.

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