The great Brexit devaluation mystery

A James Alexander post

Simon Wren-Lewis has an interesting post, Brexit harm denial and the exchange rate, where he discusses some popular notions about the great British devaluation after the Brexit vote.

I have already discussed it here and explained that part is a pessimistic reading of the future trade deals that the UK might strike. If you are pessimistic then fair enough. But this is not really about economics but futurology.

For a more optimistic, but very realistic understanding of the issues involved in trade deals Dr Richard North and his colleagues at EUReferendum have an excellent blog and series of monographs on Brexit, or Flexcit as they call it.

Wren-Lewis who, as far as I can tell, has never written a blog post on the economics of wealth creation out of the hundreds that he has posted, is not a great guide to the workings of the market – even if, to his credit, he is occasionally sympathetic to NGDP Targeting. Wealth creation is mysterious to him, a grubby business at best, full of overpaid CEOs, neoliberalism at worst. Perhaps it just happens by chance? According to him “99% of economics is about market failure” [in a reply on his blog to a comment of mine]: the modern dismal science epitomised, and his flirtations with Corbyn explained.

What caused the price change?

While it is utterly wrong to argue from a price change, it is very right to try and understand what caused the price change. Why did holders of Sterling sell? Political uncertainty was a factor, but that was relatively quickly sorted out and Sterling remains at the lows. Have other factors like US Dollar strength taken over, preventing a Sterling rally. Maybe.

Perhaps it was expectations that Mark Carney would dramatically ease monetary policy? In which case, the devaluation was not caused by Brexit but by the BoE’s expected stance. Although Carney had campaigned for Remain he made it clear he was ready to act if Remain lost. And he did act decisively, both on the day with interviews and somewhat grudgingly followed up with actions.

A relaxed monetary policy is quite a big step for a BoE that had been tightening all through 2015, if not quite a much as the US. In that sense, Brexit got Carney off the hook of having to make a more obvious u-turn. Carney had heavily overestimated UK economic strength during 2015 and early 2016 and was going to have ease in 2016 anyway.

Perhaps Sterling fell because market participants expected the UK economy to be smaller years ahead. Maybe, but it’s hard to see, practically speaking why they sold Sterling now on such an uncertain outcome, years ahead. Safe-haven buying of UK government bonds pushed down yields, which rather goes against this argument.

At the end of the day, the depreciation was only 10%, not that big in longer run historical contexts. Sterling fell 25% vs the US Dollar during both the 2008 financial crisis and after the ERM exit. It often moves on unexpected political news. The mild shock of a Tory victory in May 2015 drove it up 4%.

On Wren-Lewis’ specific four points:

  1. 1. “Depreciation has a good side, because it gives a boost to our exporters”

Well, he admits this is true. There will be a short term boost to exports thanks to the depreciation. And this will be good for the economy as the costs of Brexit, when it happens, will only come later. He says that “we are poorer because of Brexit”, but only because the markets expect us to be poorer and hence drove down the currency. He may be right in his interpretation, but those markets could turn out to be wrong about that piece of futurology. It is still very encouraging that Wren-Lewis recognises that market expectations can have real effects, just like market expectations about nominal growth.

He also claims that “markets believe Brexit will cause an economic downturn in the UK, implying lower levels of UK interest rates. (In this they have been proved correct).” One hates to disagree with such an eminent economist in his interpretations of market moves, but the Bank of England was very confident that Brexit would cause a rise in gilt yields due to fear about the UK economy and its credit rating. Remainers like Wren-Lewis and the BoE seem like they want to be right about the negative consequences of Brexit whatever gilt yields did.

What Wren-Lewis specifically fails to mention is the benefit to domestic demand of a depreciation, nicely expressed by Britmouse at Uneconomical back in January this year. Currency devaluation is a way of boosting AD, by forcing consumers to switch from overseas goods and services to domestic goods and services. This is the classic benefit of devaluation, not that it is good for exporters. The overall impact on the balance of trade is hard to tell given the inelasticity of much import demand. What tends to happen on a devaluation is that the value (in the devaluing currency) of both exports and imports rises, thus raising AD. If the devaluation was due to Carney’s expected reaction, then good.

  1. “Sterling was overvalued anyway”

While it is “ludicrous” to suggest that the problem of overvaluation, if it existed, was overcome by the Brexit devaluation, it isn’t ludicrous to suggest that devaluation will offset some of the pain. See 1.

3. “Sterling is only back to where it was …”

Wren-Lewis makes an obscure argument by analogy, something about having your basic pay cut but the boss promises it won’t be that bad as bonuses will be higher. The UK may be 10% poorer in $ terms but is it really relevant when Britons are paid in Sterling and wages in Sterling didn’t move at all. The UK is a massive holder of overseas investments, was the UK richer after the devaluation also?

And, yes, Sterling in Euro terms (the purple line) really only was “back to where it was”. In US Dollar terms (the blue line) it has been falling for a long while, mostly due to much more US monetary tightening versus the UK. To be fair, it does depend where one starts to draw the line, but then an argument about that issue doesn’t really lead very far as more and more “noise” enters the discussion.

JA Brexit Devaluation

  1. It is just a temporary problem before things become clearer”

Wren-Lewis now lays his cards on the table (I think) and assumes there will be a short term economic downturn until the UK accepts the single market and free movement, at which point “the economy then recovers, interest rates rise, and sterling appreciates”. Brexiteers can then be blamed “for all this uncertainty and the temporary damage”.

Again, Wren-Lewis engages in a lot of futurology. Who knows if there will be much of a significant economic downturn from Brexit. Were we due one anyway given the weak NGDP growth over the last 15 months? A fact that Wren-Lewis and other macro-economists have been awfully silent over.

Who is to say what “free movement” means once it is up for negotiation? Does it mean exactly what we have now, with full access to UK welfare benefits for all and any EU citizens who move to the UK? Once we have agreed the trade deal with the EU will the EU prevent us negotiating deals with third party countries and blocs that the EU has so signally failed to do itself? Would this be bad for the UK?

The answers to these questions and many more will inevitably colour the macro-economic outcome, but these are political questions and macro-economists (and the Bank of England) would do well to make clear their political judgements on these issues before sounding off with such certainty about the economic outcomes.

Brexit devaluation: Reasoning from a price change?

A James Alexander post

One of Scott Sumner’s great contributions to economics (blogging) has been his oft-repeated mantra of “not reasoning from a price change”. Probably its most familiar usage  is related to the oil price, although there are many, many more.

The oil price case

The 2014 collapse in oil prices was heralded by many financial types and economists as a great boon to wealth creation, a sort of hidden tax cut. What Scott tirelessly pointed out is that if the oil price drop was as a result of a drop in demand then the cut in price would not herald a rise in wealth, but was more a consequence of a fall in wealth.

While many thought the fall in price was related to supply it did also coincide with the great monetary tightening that followed on from the end of QE3 and the rise and rise of the USD further confirmed this thesis. There were no wild consumer celebrations of the oil price fall, things carried on pretty much as usual: the dull, low growth environment.

Similarly, earlier rises in the price of oil, often dramatic ones, should not have heralded real economy shocks as they are most often associated with an increase in demand. Real economy shocks have only been the consequence of oil price shocks when central banks have mistakenly decided that the short term CPI impacts are long term inflationary impacts – which they never are and never can be unless they are a trigger for excessive monetary tightening by those same central banks.

Sometimes the OPEC oil cartel has managed to raise prices dramatically, but economic crashes following such actions should only occur if monetary policy overreacts.

All in all, positive and negative oil price shocks are really just another instance of central banks being the real shockers, and not real shocks, just like Brexit. Bernanke himself wrote a paper in 1997 which concludes:

Substantively, our results suggest that an important part of the effect of oil price shocks on the economy results not from the change in oil prices, per se, but from the resulting tightening of monetary policy. This finding may help to explain the apparently large effects of oil price changes found by Hamilton and many others.

Currency devaluation not like any commodity price move

On Brexit I have been criticised for reasoning from a price change when celebrating the fall in the value of the pound. Surely it has fallen because of Brexit, and thus cannot also ameliorate the impact of Brexit?

Macroeconomists have struggled to make clear exactly the nature of the potential Brexit shock. Is it an Aggregate Supply or an Aggregate Demand shock? Or both?

Supply shock offset partly by devaluation

A “supply shock” is one that shifts the Aggregate Supply curve to the left, less is supplied at each and every price level along the curve. Such a shock would be inflationary as less output is available for the same amount of money around.

JA Brexit AS-AD Shocks_1

The tricky wrinkle is that the shock is, potentially, to the supplying of overseas markets only, not UK ones. Brexit is firstly a threat to UK exports. This would be expected to impact the currency not the UK economy per se. This shock would mean less GBP demand and the consequent drop in the currency.

The drop in the currency would then partially offset the impact as cheaper UK production would tempt other foreigners, even EU ones, to buy UK goods and services, shifting the AD curve to the right. How much so depends on the elasticity of overseas demand, an unknown, especially in advance.

JA Brexit AS-AD Shocks_2

The potential supply shock from Brexit will also depend on the deal with the EU and the deals with the RoW now negotiated independently of the EU. These are huge uncertainties but uncertainty is normal. Businesses live with it all the time.

The theory that the EU will want to “punish” the UK is interesting but self-interest will win out.  Assuming the worst case seems like scaremongering. This piece “Long Day’s Journey Into Night” by the Centre for European Reform being typical:

Economic developments in Britain since the referendum suggest that a recession is coming. And the politics of the negotiation with the EU suggest the country will suffer a prolonged period of weak economic growth … It is clearly in the EU’s interest to be inflexible. The EU wants the UK to understand the trade-off between single market access and free movement, and to come to a decision about what is more important to Britain. If people elsewhere in Europe see mounting economic problems in Britain, they might be less likely to support anti-EU parties, for example in France.

Many countries thrive outside the EU, why not the UK? Many countries inside the EU are in dire straits.The almost wide-eyed optimism that the EU is the best for the UK, or even many countries left in it, is sadly unimaginative.

This optimism could be envisaged as the AS curve shifting right in the short-term. In the longer run the AS curve is usually considered more vertical, so Brexit may not really alter the level of RGDP but would have raised the price level. Insofar as the EU was holding back UK productivity the AS curve may indeed shift to the right, lowering the price level and increasing RGDP.

JA Brexit AS-AD Shocks_3

Demand shock may occur too, entirely offset’able by monetary policy

The “pure” shock of Brexit was on UK politics. Spending decisions may well be put off. A surprise change in leadership of government is undoubtedly unsettling. Especially to non-Brits used to British stability. Part of the UK devaluation was this pure negative shock. And insofar as it was pure shock the impact will dissipate as politics settles down again, and the GBP will rally – as it has partly been doing so already.

It is even possible UK political economy will improve, and thus turn into a positive demand shock. Cameron was an average PM, more style than substance. More importantly, Osborne was over-focused on the deficit and under-focused on NGDP growth – even if he did recognise the worsening of the problem he did nothing about it. And the Labour Party may implode, which is usually good for UK economic confidence – though not always. The Blair years with Brown at the Treasury were mostly good ones for the UK economy.

The furious ignorance about monetary policy in this piece from the UK’s Centre for Policy Studies is quite encouraging – in that they fear a loosening of monetary policy from the new government:

Plans to relax the UK’s deficit reduction programme open up the risk of monetary policy

being used to deal with UK debt by inflation.

  • The UK has already been through unprecedentedly loose monetary policy with record low

interest rates for 83 consecutive months and a £375bn QE programme.

  • Risks of persistent loose monetary policy are clear. Asset price inflation, increasing

consumer debt, rising inflation and sustaining zombie firms are major risks.

  • Government borrowing costs have fallen since Brexit, but counter-intuitively costs to insure

against government defaults have increased. Additional risk of investor flight if holders of

0.38 per cent yielding debt may soon face a 2.5 to 3 per cent inflation environment (as

currently forecasted).

  • Abandonment of deficit targets, political instability and inappropriate monetary policy

response could lead to potential recession risk.

It is hard to know where to start putting these people right except to point out that low rates are a sign of tight monetary policy not loose or even ultra-loose, that 2.5-3.0% inflation is absolutely nothing to fear, and that only strong nominal growth can deal with “excessive” debt.


Sometimes it feels like the UK is sailing between the Scylla of EU wrath for requesting a divorce and the Charybdis of tight monetary policy. I expect that like with most divorce proceedings, even the sometimes bloody ones, life moves on sooner rather than later. And I hope that now Osborne has left the Treasury the blockages to a more flexible monetary policy will dissolve.

Brexit devaluation is monetary offset in action

A James Alexander post

I agree with Scott Sumner in his strong belief in the Efficient Market Hypothesis. The market is always right. But quite what it is “right” about is not always easy to tell. Sure, on central bank announcements the immediate market reaction is very telling. The market reaction is the policy, and this is not always what the central banks thinks is the policy.

The surprise Brexit vote did lead to some huge movements as markets opened on Friday 24th June and then more on Monday 27th after a weekend of follow-up news and reflection. But what were the markets signalling, especially the GBP devaluation and the large drops in the most domestically-oriented equities?

Scott Sumner wrote:

Brexit will reduce the foreign demand for British goods, services and assets. Since one needs pounds to buy British stuff, this reduces the value of the pound, as well as the quantity of exports. Think of it as a leftward shift in the demand for pounds, on an S&D diagram.

I am willing to admit less demand for pounds due to expected less FDI, as some global firms who based their EU businesses in the UK think of moving that production to inside the newly shrunk EU ex-UK. This is not a domestic demand shock directly as businesses would be choosing to produce less goods and services in the UK that were then exported.

Exports would also be expected to fall, further weakening demand for pounds, already weakened from less expected FDI.

The indirect effect is a demand shock for labour in the UK, that in turn reduces demand for goods and services within the UK.

UK workers are not less productive, there is just less demand for them. It is very hard to claim that the potentially lost UK export industries are more or less productive than average UK industry.

Other things being equal, less FDI, less exports and a potential, indirect, demand shock will shrink the size of the UK real economy. The drops of 10%-30% in some domestic-focused UK shares in particular sectors like commercial and residential real estate (British Land and Barret Developments), retail (Tesco and Marks & Spencer), banks (Lloyds Bank and Close Brothers) and media (Sky and ITV) illustrate this fear well.

However, care needs to be taken when looking at these sectors and judging the stock price falls. Property companies and banks are leveraged plays on the local economy, so that any local economy weakness gets magnified, sometimes greatly. Retail companies have been suffering from weak NGDP for years, as well as from the secular change to internet retailing, and so their equity prices may be particularly vulnerable to small changes in AD.

And care also needs to be taken not to assume the worst. Both the outcome of the negotiations with the EU and the eventual trade agreements with the Rest of the World will alter greatly these worst-case scenarios. In the absence of a government, fear and uncertainty get free reign but will dissipate over time, perhaps more quickly than many expected. if the latest news on Mrs May’s unopposed path to the top job is anything to go by.

Here comes the offset

But as Scott knows well a leftward shift in the demand curve for pounds is not like a shift in the demand curve for apples. A devaluation will lead to major monetary offset in the country experiencing the devaluation – even if these benefits are not immediately apparent – or understood by many commentators. The benefits will still accrue unless the devaluation is artificially prevented. So far the signs from the Bank of England are that it will be encouraged.

The current account may or may not improve following a devaluation as Chris Giles succinctly explained in the FT last week. He was echoing many macro experts. Unfortunately, Giles, like most economists and commentators who understand the subtleties of devaluation on trade deficits missed the bigger picture. The main benefit of a devaluation is something else.

In early 2014 in a discussion about Abenomics Scott re-posted a classic comment from the legendary Mark Sadowski. The punchline is very clear:

Devaluation improves a country’s trade balance only if the Marshall-Lerner condition on trade elasticities holds, and research shows that they’re not met in the majority of cases, either past or present:

That’s not to say that currency devaluation isn’t beneficial, of course it is, but the benefit flows primarily from increased domestic demand. 

Chris Giles does understand, and in fact warns in a follow-up  piece about higher inflation in the UK as a consequence of the devaluation and how it might hurt households:

In summary, Brexit has unleashed a different sort of currency depreciation, according to modern economics, one that is less likely to encourage domestic investment for exports, is more likely to raise inflation and will be more painful for hard-pressed families.

But it will drive up NGDP up, as domestic demand has to rise in nominal terms, and this, given wage and price stickiness, will drag up GDP in real terms too.

In fact, this rising nominal demand will be especially welcome in a UK economy starved  of nominal growth for the last 12 months. Something on which Giles and most of the UK macro-economic commentariat have been notably, not to say shamefully, silent.

Around the same time as the Sadowski re-post but on a different subject, Britmouse over at uneconomical also had an excellent post making a related point:

It is not that a[negative]productivity shock causes a rise in unemployment.  A productivity shock causes a tightening of monetary policy which causes a rise in unemployment.  

Brexit may cause a supply shock but there will only be a rise in unemployment if monetary policy is also tightened. If monetary policy is eased there will be moves within the economy from one job to another, but not an overall reduction in employment. That is the benefit of stable nominal growth, some people may experience low or no nominal wage growth but they will not be made unemployed.

Will the UK be poorer on leaving the EU? Maybe, but economies are quick to adjust as long as nominal growth is maintained at a suitable level. Unilateral free trade would also help as sagely proposed by the economists for Brexit.

Brexit-like political shocks are mere noise, central banks are the only real shockers

A James Alexander post

Brexit is an irrelevance. So say US equities. In fact, if US equities say anything, they seem to think Brexit is a good thing if it means the Fed holds off from rate rises for longer. Bring it on!

What US equities don’t like is US monetary tightening when there is no call for it. Two recent sell-offs in US equities illustrate well this point.

In late 2014 the Fed indicated QE really would come to an end. By mid-2015 they were strongly indicating that “normalization” of rates, rate hikes, would occur soon, probably in September. This stance set off a sequence of events including a rapid Chinese stock market sell-off from June that spread to US equities and RoW equities by August. It became so bad that by the time of the September FOMC meeting rate rises were off the table and calm had returned.

Rather stubbornly the FOMC felt its credibility was so on the line about “normalization” that it had to raise rates some time in 2015 so it orchestrated one for the December meeting. It was fairly well-telegraphed and markets reacted calmly in the immediate aftermath, and it was Christmas anyway and no-one really wants a year-end sell-off. But the economic data which had been turning down continued to do poorly and come early January, when a key member of the FOMC with enormous overconfidence predicted four more hikes in 2016, the equity markets took fright.

JA Brexit Irrelevance

Pretty quickly the Fed was back-pedalling and near-term rate hikes disappeared from the agenda by the late-January 2016 FOMC meeting, fully confirmed in the meeting in mid-March. Despite occasional harrumphing from FOMC members, regional ones in particular, and confusion around the outcome of the April FOMC meeting, there have been no more rate hikes.

Come late June and the UK Brexit vote, US stocks dipped but we have seen little of the earlier sell-offs. Maybe they are yet to come, though it will be hard to blame Brexit. US monetary policy is (nearly) everything, and the declines in market expectations of near-term rate hikes have, if anything, boosted US equities.

US bond markets are clearly far less sure. Longer term yields have fallen substantially, joining other quality bond markets in the march to zero yields and below. The longer term trends in NGDP are dull and likely to remain so with the Fed still biased to tighten.

To be fair, Brexit could have provided a much bigger shock. US NGDP growth is very low and in theory it shouldn’t take much of a shock to cause a rise in demand for money and the related reduction in spending and income. Perhaps the US Presidential election will cause it, or Putin playing games, or some incident in the South China Sea, or an Italian or German bank crisis. The surprise to many is just how resilient economies are to political shocks, or “regime uncertainty”.

What is certain is that the biggest shocks by far, and the ones that really stick, are monetary shocks caused by central banks mistakes.

Carney helps clear a mess he partly made

A James Alexander post

Mark Carney gave a speech at 4pm today that clearly eased monetary policy and raised NGDP growth expectations. Sterling immediately fell 1%, gilts rose 1% and stocks surged. What had he said that was so good?

Essentially this: The fall in Sterling would push up domestic inflation and not only was he OK with that but he also expected he would have to ease monetary policy even further.

Finally, as expected, sterling has depreciated sharply. For given foreign demand, this will mean support to net trade, though this may well be dampened by uncertainty around future trading relationships. A lower exchange rate will also entail higher prices for imported consumer goods, energy and capital goods, and consequently lower real incomes.

As the MPC said prior to the referendum, the combination of these influences on demand, supply and the exchange rate could lead to a materially lower path for growth and a notably higher path for inflation than set out in the May Inflation Report. In such circumstances, the MPC will face a trade-off between stabilising inflation on the one hand and avoiding undue volatility in output and employment on the other. The implications for monetary policy will depend on the relative magnitudes of these effects.

In my view, and I am not pre-judging the views of the other independent MPC members, the economic outlook has deteriorated and some monetary policy easing will likely be required over the summer. 

We have been consistently critical of Carney due to his instigating a crushing slowdown in NGDP growth during 2015. It has dragged down RGDP growth and made the UK vulnerable to shocks, like Brexit. To be fair, he is only one of many central bankers with the same mindset of inflation-phobia that blinds them to weak NGDP growth – and one shared by most mainstream economists and many financial types.

He didn’t help his credibility by taking sides in the referendum debate warning of potential long term damage to the economy. No one can predict with any confidence what the economic outcome will be given the huge unknown of the future political and trade relationships. These are political issues on which he was badly trespassing. 95% of economists reckoned an 8% loss of RGDP by 2030, roughly what the domestic FTSE 250 index fell. It’s an approximation that will depend on the politics.

The politics quickly became a huge mess, but is gradually being resolved. The FTSE 250 is recovering. A big help has been and will be the devaluation, a natural offset to economic damage from political uncertainty. Carney has now not only blessed the devaluation but vowed to protect it. So credit where credit is due.

That said, the bad old Carney was still evident earlier in the speech when he said this:

In May, the MPC judged that a sustainable return of inflation to the 2% target probably required a gradually rising path for Bank Rate over the next three years as growth picked up, jobs and wages increased and the drags from a stronger currency and lower commodity prices faded. 

To get inflation up he needs to tighten monetary policy? What? It still shows he is badly confused about his role even if he seems to be a good man in a crisis. The sad thing is that he is partly responsible for the crisis – a characteristic of far too many of today’s central bankers.

Brexit is noise in the bigger picture of monetary strangulation

A James Alexander/Marcus Nunes post

Independent of Brexit, the bigger issue remains that all three currency blocs – USD, Euro and British Pound – are seeing low NGDP growth, too low for comfort. Small real shocks like Brexit (let´s call them, à la Robert Higgs, actual and/or potential institutional discontinuities) cause market mayhem precisely because NGDP growth is too low and thus rather fragile and easily knocked lower.

Why is NGDP level and growth so low? Because central banks seem to like it that way. Their 2% inflation targets dominate their discourse and all their internal projections show them on course to meet their targets in two years’ time – and to hell with NGDP growth. The result is slow monetary strangulation; Brexit is mere noise in this bigger picture.

Nevertheless, given the nature of Brexit, that mixes Supply and Demand shocks, some clarification is in order.

  1. Brexit caused a (global) fall in velocity (AD shock). This requires an offsetting rise in money supply
  2. Brexit caused a (less global) fall in trend real growth (AS shock). Given that monetary policy is synonimous with interest rate policy, this requires a fall in interest rate (because the neutral rate has fallen), which at the ZLB is not forthcoming. In that case, a negative AS shock automatically turns into a negative AD shock.

Solution: Forget interest rate targeting and concentrate on nominal stability (NGDP-LT)


If the negative AS shock is permanent, for nominal stability to be maintained you require a lower trend growth in NGDP.


Permanent AS shocks tend to be rare!

Post-Brexit, what will Janet Yellen’s next excuse be?

A James Alexander post

Well the British have voted for Brexit. We shall see how it turns out.

Carney must not defend sterling

Market Monetarists must hope that Mark Carney doesn’t seek to defend the pound, but let currency weakness do it’s magic, monetarily offsetting any expected economic weakness. A drop in the pound is not like a drop in the price of a company after a profit warning that reflects a weaker future. Of course, a hit to potential economic growth will damage the value of the UK economy but the currency is a different issue. Currency reflects the monetary value of the economy not its real economic prospects.

Low or negative real economic growth but with even lower inflation tends to see currency appreciation, like in Japan or Switzerland. If there were expected to be 5% real growth and 5% inflation, other things being equal, the currency would not move.

If (as 95% of economists forecast) the UK leaving the EU were to result in 5% less real economic growth over time, or even a recession, then the central bank should ensure nominal growth stays at a level 5%. The pound could then fall up to 10%, other things being equal, ie ignoring what other currency blocs are doing. That would be the right thing for the central bank to allow and even facilitate. The currency drop would then automatically boost domestic demand offsetting the drop from “lost confidence” in the future, or whatever is supposed to happen to the UK outside the EU.

I suspect no such dramatic drop in real GDP as things change very slowly when it comes to international affairs, and businesses and consumers adjust their behaviour to fit the expected new environment. The UK government should focus on eliminating any supply side restraints on the economy and any potential tariffs that the EU may impose.

What the EU should do
Clearly the remaining EU members should be very careful about entering tariff wars given the modest nominal and real growth they currently enjoy. The Euro Area likewise. The Euro Area should move to a loose monetary policy by either abolishing the inflation ceiling or better still targeting nominal growth of 4-5%.

Draghi was recently asked in the European Parliament why he didn’t raise the inflation target. His reply betrayed a profound confusion about his current stance. His ECB projects 1.6% inflation two years away. De jure, his monetary stance is only neutral. De facto, market prices indicate much lower inflation two years out, thus the stance is actually very tight. Raising the inflation target or introducing nominal income growth targets would allow the market to expect no tightening if inflation were to go above 2%, thus easing policy as expectations for policy would be easier.

What will Yellen do next?
The more interesting question for the US is what excuse Janet Yellen might now have to come up with to explain away the consequences of the Fed’s tight monetary policy. She may think it is “highly accommodative” because rates are low and the Fed balance sheet bloated with QE securities. To be fair, very many economists and market commentators think likewise, making the same basic mistake. But Market Monetarists know better.

Monetary policy is judged by market expectations for nominal growth and these remain low. Current NGDP growth is low and both straight long duration government bonds and TIPs indicate very low inflation.

Yet the FOMC is indicating seven rate rises of 25bps over the next two and half years, with another three promised in the long run. Tight or what? Policy is tight because it is expected to be tight for the next two years. The result has been weakening nominal growth, weakening real growth, and low nominal wage growth. Real wage growth has supposedly been better but it certainly hasn’t felt like it – hence the rise and rise of populist politics.

The Brexit Consensus Bug (by Patrick Minford)

(Reprinted with permission)

In recent weeks there has been a relentless stream of output from modelling groups on the topic of Brexit- all of it negative. This has included long term and short term reports from not merely the Treasury but also CEP at LSE, PWC, Oxford Economics, the NIESR, the OECD and the IMF. All of these except the IMF have made available fairly good information about their methods and models. The Institute for Fiscal Studies (IFS) has usefully done a survey of this work- IFS, 2016. They note that apart from Economists for Brexit (EFB) and Open Europe, the consensus is that Brexit will reduce GDP relative to a base forecast both in the long term and the short term. EFB by contrast forecast a rise in GDP in both short and long run while Open Europe find a range, depending on post-Brexit policies from small negative to small positive in the long run (they do not look at the short term). The IFS table is shown below.

P Minford_Brexit

The  IFS look at these forecasts and note that the common element in the consensus outside EFB and Open Europe is that after Brexit under the WTO option the UK continues to maintain protectionist tariffs and other trade barriers against the rest of the world, including the EU.

By contrast EFB assumes unilateral free trade after leaving the EU. Open Europe considers a range of policies, which at the one extreme appear to involve more free market, free trade assumptions; we leave them on one side in what follows. The IFS comments that unilateral free trade is ‘unlikely’ to be politically feasible and in its subsequent calculations of the effects on the public finances takes the mean of the negative consensus.

At a conference on Friday May 27 in the NIESR all of these groups were represented apart from Open Europe and HM Treasury. The assumptions made by HM Treasury were in fact clarified by George Osborne to the Treasury Select Committee: after Brexit there would be general UK protection against the rest of the world, assumed to be in line with past experience of the countries before they entered the EU.

The groups who spoke at the NIESR conference confirmed that they had assumed UK protectionism after Brexit. The extent assumed differed according to the methods used. In fact, some groups used gravity equations (NIESR, CEP), others used Computable General Equilibrium (CGE) models (PWC, Oxford, OECD, also CEP in a new version). In one experiment CEP reported assuming that the UK reduced tariffs by 3% after Brexit, but this did not appear to correspond to the trade barriers the EU imposed on the UK after leaving, which had major effects on UK export trade; nor does it correspond to agricultural protection, which the OECD estimates at just under 20%.

By contrast EFB assumed that the EU trade barriers would be by 2030 around 10% on agriculture and manufacturing- EFB estimates are that recent protection levels are around twice that but it made the cautious assumption that due to international pressures that have gradually brought down trade barriers over the past two decades, protection rates would fall. EFB then assumed that on Brexit these barriers would be unilaterally abolished by the UK on its trade, so that import prices would fall to world levels in agriculture and manufacturing. Exporters of these products would also find their prices falling to world levels from preferentially higher levels. EFB used a standard CGE world trade model and this caused rising consumer living standards and a reallocation of output towards the unprotected service sector. As noted, this would include hi-tech manufacturing so that this transition would include the moving of manufacturing into this form.

Plainly there are other ways in which the various groups differed in their assumptions, including on migration and regulation.

These differences, as well as the differences in modelling methods, can account for detailed differences in the overall Brexit effect on long term output. However, these merely varied the effects on output around an overall negative mean. This negative mean appears to come from the assumption about the absence of UK unilateral free trade, much as indicated by the IFS.

Notice that by pursuing protectionism post-Brexit the UK would not only close down free trade with the EU regionally for its exporters, but fail to increase (or even reduce) free trade for its importers; thus this assumption actually moves away from free trade. All the modelling groups asserted that in their models moving towards free trade enhanced output; so the Brexit trade assumption would be expected, by reducing free trade, to reduce output. Plainly it does in all these models, regardless of their specification.

The question therefore that arises about the long-term consensus results of such a negative mean effect is whether it is reasonable to assume that unilateral free trade is indeed ‘politically infeasible’ and therefore to make this assumption the basis for forecasting.

First, suppose it was infeasible politically in the absence of full information about the consequences of different policies, on which people could form opinions and vote. Would it not be right for economists to cost such an option and provide information on it to the electorate? What the consensus modellers have done is simply to suppress this option and provide information only on the damaging Brexit WTO option.

Second, is unilateral free trade in fact politically infeasible? One major country, New Zealand, actually carried this policy out in the late 1980s- the Douglas reforms. Furthermore 92% of UK workers are employed outside the protected sectors of agriculture and manufacturing and would have a clear interest in lower consumer prices as well as a more efficient economy. It is often forgotten not only that protectionist policies are designed behind closed doors, without consulting or even informing voter-consumers, but that UK workers have been through substantial supply-side reforms in the past four decades; manufacturing employment has dropped from 35% of the workforce in 1970 to 8% today.

Many of those 92% have adjusted already to the same competition that would now be stronger post-Brexit. Given the choice of lower prices or continued protection they may well choose lower prices and opt to pursue policies designed to help manufacturing and agriculture adjust through higher productivity together with help for particular firms or subsectors on grounds of non-economic needs.

The policies involved could include lower energy costs and hi-tech infrastructure such as broadband and transport links. As the US has shown with steel there is scope for anti-dumping action as permitted by the WTO to deal with special situations.

Third, unilateral free trade would be a stimulus to our EU partners to negotiate sensible transitional arrangements for particular sectors such as the car industry. They will not be keen to subject EU car exporters, for example, to a large fall in UK car prices. It has always been envisaged by the Brexit side that there would be constructive negotiations on such matters. But if the UK simply goes to protection there is little incentive for the EU partners to negotiate since they will see the self-damage created and wait for the UK to change its mind.

In short the decision of the consensus to assume that the UK, instead of using Brexit as an opportunity to move to general free trade, pursues general protectionism which in effect reduces the extent of free trade, is important in obtaining its negative results for output. It is also hard to justify both ethically, in that information has been denied to voters and practically, in that unilateral free trade policies are not merely an optimal but also a natural choice for UK voters.

The short term forecasts

It remains to discuss the short-term forecasts made by these modellers. What emerged from the NIESR conference is that the method used by all modellers, with some minor variation, was to inject the long term effects on output productivity into a macro model for the short term and assume Rational Expectations (i.e. people understand the effects of new policies) to allow knowledge of these to affect consumers and firms’ short term spending decisions.

On top of this, modelling groups made a variety of ad hoc assumptions about the rise of ‘uncertainty’ (about post-Brexit policies)- on the rise in credit and other financial costs. Thus whether there would be a recession or not in the short term depended for these groups on a) the extent of the long term hit to productivity, and b) the extent of higher uncertainty.

Against this the EFB argue that uncertainty is a function of how quickly new post-Brexit policies are decided and explained. We can see no reason for delays in this under our WTO option since the decisions will in practice be entirely in UK hands; negotiations would be embarked on whose outcomes could easily be predicted and explained to the relevant industries. Under the WTO option control lies in UK hands. Thus policy uncertainty would be closed down. There is of course always some uncertainty in policy of all sorts; but it would not be out of the ordinary.

Thus it is that the EFB short term forecast is not at all dramatic. Output improves gradually towards the long run trade effect plus the regulative effect calculated separately. Other factors cut in, such as a falling exchange rate and rising competitiveness as workers trade rising living standards for some fall in real wages to boost employment.


In a previous report on the Treasury’s methods for estimating long and short term effects we set out a lengthy critique. We also made a similar critique of the CEP modelling approach. We favoured the use of CGE (structural) models. However we note that other groups have used CGE methods and get to some extent similarly negative results. What has emerged from considering all these approaches used by different modelling groups in the consensus is that they all assume post-Brexit the pursuit of protectionist policies on imports by the UK. This reduction in the scope of free trade predictably would damage UK output and productivity whatever methodology is used.

The key difference in EFB is the use of the unilateral free trade assumption under which Brexit is a move towards free trade. This not only gives a long-term boost to output but it also boosts the short term outlook by the standard route of expectations; with suitable policies it can be generally popular and beneficial across all sectors. It also enables the UK to be strong in negotiations and take control of its own policy environment independently of any actions by our EU neighbours. This in turn closes down short term ‘policy uncertainty’, avoiding the ad hoc rises in credit and other financial costs in the short term.

In short, the consensus has misrepresented the post-Brexit potential outlook quite seriously to UK voters in this referendum. It is the intention of EFB to bring this clearly to these voters’ attention.

Appendix on models and methods of the modelling groups:

The modellers whose results I review here have used a wide variety of modelling methods for both the short and long term.

By way of introduction EFB uses a CGE model of world trade under full competition with a 4x4x4 structure, four ‘countries’ (UK/rest EU/NAFTA/RestofWorld), four sectors (agriculture/manufacturing/services/nontraded), and four factors (land/capital/skilled labour/unskilled labour). This structure does rather well at accounting for long term trends in trade, employment and production (see Minford et al, 1997) in response to globalisation and technology shocks. For the short run EFB use the Liverpool Model supplemented by recent research on DSGE model behaviour- more details in EFB, 2016.

The long term modelling methods of each group fall into two types: gravity equations and CGE modelling.

Gravity equations are used by: HMT, NIESR (and in earlier versions CEP-LSE, but not in latest)

CGE models are used by: PWC, Oxford (GTAP), Open Europe (GTAP), OECD (GTAP for OECD Metro), more recently CEP(LSE) have developed a CGE model underlying their gravity equations- which appears to be the one they favour and show for their results in IFS.

EFB comments on gravity equations are critical: see Minford et al, 2015. Gravity models give large reactions as can be seen in IFS table for HMT and NIESR WTO+.

EFB comments on CGE models: in principle we support this approach but details of these models differ substantially and in particular the GTAP model is proprietary so that knowing what exactly is in which version is hard. In general these models embody reactions made quite ‘sticky’ by imperfect competition: this means that the size of their reactions is generally smaller than that of gravity models or the EFB CGE model which assumes full competition (this seems to us appropriate in a long run model).

Short run modelling by the groups also differ. Three groups- HMT, NIESR and OECD- take long run results and embed them in NIGEM (the NIESR’s macro multi-country model) as changes in long run productivity; they then run NIGEM under rational expectations while adding uncertainty premium effects on various credit and financial cost variables.  OECD drops rational expectations in favour of ‘backward-looking’ expectations whereby people slowly learn about the future from events; it argues this goes better with uncertainty effects. These short run uncertainty effects are fairly large in all these models.

LSE and PWC use the same CGE model but ‘dynamically’ for the short term. They too add uncertainty effects ad hoc into investment etc. Oxford Economics use their own short term macro model which is proprietary; they add uncertainty effects similarly to those using NIGEM.

It can be seen that there is a wide variety of both short term and long term modelling methods being used across these groups. As far as generalisation is possible, it would seem that all of them get quite similar uncertainty effects but this may well be because these effects are essentially ad hoc (i.e. we have no clear basis on which to impute them for any shock) and so they have sought to justify similar effects through a wide variety of ad hoc assumptions.

For long term results there seems to be a tendency for the CGE models these groups have used to give smaller effects than the gravity models used. This may be because CGE models under imperfect competition react rather modestly to shocks.

References to modelling group work- much of this work is recent and so written up in memos and informally on slides for presentations. Those interested in following up should address the institutions involved directly for details of all their modelling work.


Institute of Fiscal Studies, 2016, Brexit and the UK’s Finances. IFS Report 116, Institue of Fiscal Studies, London.

Minford, Patrick, Eric Nowell, and Jonathan Riley, 1997,’Trade, Technology and Labour Markets in the World Economy, 1970-90: A Computable General Equilibrium Analysis, The Journal of Development Studies, Vol. 34, No. 2 December 1997, pp.1-34.

Minford, Patrick, Gupta, S., Le, V.P.M., Mahambare, V., Xu, Y., 2015, ‘Should Britain leave the EU? An economic analysis of a troubled relationship’, second edition, Edward Elgar.

EFB publications- our forecasts for Brexit, our critique of the HMT reports, and our response to an LSE press release – can be found on

UK NGDP growth weakening. Blame it on Carney, not ‘Brexit’

A James Alexander post

The chickens continue to come home to roost for the Bank of England and its masters at the UK Treasury. The pathetic attempt of the a UK government minister to blame Brexit worries for the UK economic slowdown was truly breath-taking in its cheek. George Osborne recognises the problems caused by weak nominal growth but has failed persistently to show political leadership to do anything about, allowing the Bank of England to wallow in its hawkery about non-existent inflation threats.

Mark Carney tightened monetary policy throughout 2015, first by declaring that the next move in rates would be up and then in July confidently declaring that rate rises “will likely come into sharper relief around the turn of this year (2015)”. He has attempted to back pedal a few times since then over precise timing, but his tightening bias has been reiterated, most notably when he declared in February all members of his MPC believed the next move in rates would be up.

Ever since Carney sat on his laurels at the end of UK’s QE, and especially since his fatal Summer speechifying, UK nominal and real growth has been decelerating. We don’t have an Atlanta Fed-style “nowcast” for UK GDP but we can make a pretty good guess how badly things are turning out ahead of the release of 1Q16 data next week.

  • We already have Carney’s constant tightening bias.
  • We know the trend in NGDP is really poor.
  • This week we have seen retail sales growth slow (hitting the largest component of GDP) and the other side of the coin, personal income in the form of wage growth, also slow.

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Although quite volatile, the nominal wage growth figures had shown some encouraging trends up to 2Q15 until Carney put a dramatic stop to any real return to prosperity with his hawkishness.

It would be absurd to suggest that Brexit uncertainty is having no impact on the economy. It has hit the currency after all. But any currency weakness will actually work as nice countercyclical aid  to any potential economic damage from Brexit.

By far the biggest problem is the stance of UK monetary policy in the face of collapsing nominal growth. Carney follows most other central bankers and the economics consensus in believing that low interest rates mean easy money. Clearly, it cannot be true when actual (even if 4Q15 was revised up a bit) and expected nominal growth is so incredibly low.

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