Amit Kara Brexit Modelling Minus Cover

Modelling the Economic Impact of Brexit

Here's the transcript of an interview with Amit Kara who is head of UK macroeconomic forecasting at the National Institute for Economic and Social Research. The reason why this is interesting is that it gives you an insight into why we build models, as well as insights into the possible impact of Brexit on the UK economy.

Why do we need models?

Ramin: So Amit so would you briefly introduce us into the concept of modeling and why we need models in the first place?

Amit: Hello Ramin great to see you after such a long time. So let me let me tell you about the Institute's macroeconomic model and what we use it for. So the National Institute runs and maintains this very large macroeconomic model called NIGEM. Now NIGEM is used by a number of central banks around the world and private sector organisations.

Now there are two main purposes for which we use NIGEM one is for bringing economic forecasts and the second and more important one I think, from my point of view at least, is to ask "what if?" type of questions.

All right so you know "what if Trump introduces tariffs or non-tariff barriers what impact will that have on the economy", "what happens if there's a sharp slowdown in China?", for example "what if this is a tax increase?". So these are the kind of stories that we can ask and answer with this model.

The model is useful because it provides a structure because the economy is very complex. The model tries to simplify those complexities by drawing the inter-linkages across different sectors.  So if you hurt or impact one particular sector it obviously has resonates across the entire economy and the model tries to capture those linkages.

So I think that's really the strength of the model: it forces you to think through these channels in a structural way

NIGEM Model

Thinking in a structured way

Ramin: For humans it's really hard to think through these kind of second-order effects isn't it so some people say that Brexit will be inflationary because it's going to reduce the pool of labour but there are going to be second-order effects on top of that so NIGEM lets you step beyond that into the second and third and fourth order effect

Amit: Right, absolutely I mean you know and even even the first-order effect I mean if you say to me Brexit is a inflationary for reason A we can input that reason a understand the full effects and we can all learn also understand for a different set of what kind of inflation effect will it have so you can actually quantify the size as well apart from understanding interlinkages.

Uncertainty

Ramin: Okay, so would you like to talk about the actual uncertainties that come into these models because I know there's been a massive massive push back in the UK from many politicians in fact Jacob Rees-Mogg being among the major detractors about modeling in general because some of the forecasts when we had the referendum were wildly inaccurate so people have lost faith in the ability of people to to actually forecast what the impact will be.

Amit: I mean a model is a model it's an approximation of the world the world is almost certainly different from an approximation and in that sense I think if but you know that said there are a number of sort of well-established linkages that have been proven time and time again and we rely on those to build our models.

Now in the context of Brexit what is important is I think there's two strands of sort of uncertainty one is well we don't know what the future relationship between the UK and the and the EU will be or will turn out to be. But I think there's another strand of uncertainty which relates to the impact of whatever that outcome is on the UK.

Now remember that UK is the first economy and the only economy to exit from the European Union. In fact, no major country has exited from a free trade area ever or certainly in recent decades. Now as I said I mean a model typically looks and tries to understand through precedence and because we don't have a precedence there's an unusual amount of uncertainty around our forecasts, our estimates of Brexit

Macroeconomic channels by which Brexit impacts the UK economy

NIESR Brexit Macroeconomic Channels Long Term

Ramin: Okay so maybe you could talk us through the actual channels by which Brexit is going to impact growth in the UK and indirectly it's going to affect markets because the people that watch this channel are interested in the market effects

Amit: Absolutely. Now here at NIESR we've used NIGEM to try and quantify the impact that Brexit will have on the UK economy both economic growth inflation public finances etc and we've identified you know around half a dozen channels through which Brexit could have an impact.

The Trade Channel

Our chief amongst these and the one that's probably discussed the most is the trade channel and I think you can you could think about the trade channel in two separate ways. One is the additional tariffs that will be imposed on UK goods by the EU and vice-versa should we fail to secure an agreement and we trade on WTO terms. So that's that's a tariff channel.

Non-Tariff Channels

The more important channel and, when I say important, I mean in terms the size of the shock to the to the economy is the non-tariff channels, so the non-tariff barriers. So for example, when you trade between the UK and the EU there are no customs borders there are no customs checks. Once a good is entered within the within the European Union area it can trade freely but once we're out of that area they will be there may be some kind of customs checks to assess, to check whether the goods are compliant with local regulations etc. So that's an additional channel.

Foreign Direct Investment

Other than that there's likely to be an impact on foreign direct investment in the UK because the UK is going to become a less attractive place to invest for the simple reason because there are trade barriers companies globally may not choose to locate in the UK if the main reason for for locating in the in the UK is access to the EU.

Ramin: There was an open letter, I believe, from the Japanese about the car manufacturing industry in the UK and what would happen if there were these trade frictions.

Amit: Absolutely I mean the supply chains within the auto sector are incredibly complex not just complex because of this just in time management of inventories they're also critical that you don't have delays at ports. I mean that is simply one of the key reasons why the UK needs to maintain frictionless trade with the EU. But there are others.

UK Fiscal Contribution to the EU

For example on the positive side there's there's the fiscal contribution that we make into the EU. So the UK makes a contribution of around half a percent of of national income on average each year so the net contribution is about 7, 8, 9 billion 10 billion pounds. It changes year by year but we'll stop making some of that contribution and to that extent we could divert that money into into the UK.

Migration

There are other channels. Another important one that's been discussed quite extensively is of course migration. As a member of the EU we allow free movement of labour. The UK is keen to stop that and be more selective in the type of lower workers that enter the UK economy. That's a huge unknown - and you know just to try and quantify that channel.

Productivity

We make a stab at another big unknown but important channel which is productivity. So the reason why productivity is important is ultimately our welfare depends on how productive we are as a nation. But we also know there's plenty of evidence and research that suggests that open economies tend to be more productive for the simple reason that we're able to choose the best skills and best resources and take advantage of all of our competitive strengths in an open economy versus a closed economy.

Again I mean the research on this front is not so compelling but all in all I think we generally believe that restricting trade will have a negative impact on productivity.

Uncertainty & Risk Premia

And I guess the other big unknown is, as as the word suggests, uncertainty. When you are sort of treading into unknown territory risk premia on assets goes up. So for the same stream of dividends you will simply pay less because you're going to impose some kind of risk.

Ramin: So for example for an equity if the equity risk premium goes up goes up then the price of the shares falls, right?

Amit: Absolutely, even though even if you expect the same performance for the company from the future so I think that's a big unknown and not just equity prices but you would expect that to occur with exchange rates you could expect that to occur on the bond yield on the sovereign bond yield on corporate bond yields etc and all these have then you know tend to hold back economic growth as well so so there are a number of channels that could through which Brexit could have an impact on the UK economy.

The Great British Trade Off Triangle

NIESR The Great Brexit Tradeoff Triangle

Ramin: So one of the beautiful slides that you've got in your presentation Amit is about this beautiful triangle which shows the great British trade off with our deal with Europe so what are the dimensions that matter and what compromises are we making for each of those dimensions? So perhaps you could talk about that triangle which will magically appear now as you speak...

Amit: I mean the negotiations are complex and they encompass many many different dimensions but what we've tried to do with this triangle is just distill the negotiations into three what we think are three key areas or certainly key areas from an economics point of view.

And the three areas are one access to the EU and of course the EU's access to the UK for both goods and services, so that's that the top corner of the of the triangle. On the left hand corner you have the fiscal contribution that the UK makes into the EU and then on the other on the right-hand side of the triangle you've got movement of labour.

But in our view these are the absolutely the three key areas of negotiation. So what the triangle tries to show is is the sort of trade-offs that we face in our negotiation and what is it that we want and what is it that you might offer us?

So you could think of the origin of the triangle as one where we're not members of the EU we're just another third country: so one where we do not trade, we do not have any special access into the EU market, one where we make no fiscal contribution into the EU and one where you don't have any agreement on movement of labour or free movement of labour.

Now the triangle as it stands now the outer triangle is the position of the UK currently where we have full access for what goods and services into the EU market we allow free movement of labour and we make a fiscal contribution of around half a percent of gross national income. So that's where we stand currently.

But the EU has struck a number of trading relationships with other third countries: South Korea, Canada, most recently Japan, Turkey, Switzerland, Norway etc.

So how did those deals compare with, say, the Chequers Deal or others? So we kind of try and show that in the context of these three dimensions.

The Swiss Deal

So let's start with for example the Swiss deal. Now the Swiss deal is primarily is more or less kind of restricted to goods trade so it's less ambitious compared with our current position of the EU which is for both goods and services. So it's it's not quite as big in terms of the triangle as the UK's current relationship with the EU. Again, Switzerland makes a fiscal contribution to the EU which is much smaller than the UK's contribution but it's there is still a contribution and similarly Switzerland allows a very high level of movement of labour between itself and the EU.

The Norway Deal

Okay now the EU also has a special relationship with Norway. Norway's part of the European Economic Area and as a member of the EEA Norway has a very high level of access to the EU market for both goods and services. So you can see it's pretty much as close as it can be as a full EU member in the triangle. Now in order to have that privilege of access the EU also allows almost full movement of labour. So again it's at the extreme end of of the triangle, and Norway makes a fiscal contribution as well.

Why the Chequers Deal is Unacceptable

Now what the UK is looking for in terms of Chequers is a quite an ambitious trading relationship for goods. It's relatively silent on movement of labour and it's completely silent on the fiscal contribution so you could almost think of the UK wanting to simply have access to the EU market, not really wanting to make any fiscal contribution and not allowing movement of labour. Now this is going to be unacceptable to the EU.

As you can see from these triangles there are trade-offs. The smaller the access that you have to the EU you either make a smaller fiscal contribution or you get some concessions in terms of movement of labour like the Canadian deal has.

So our sense is that the EU will simply not accept the Chequers or the white paper proposal. They will insist on some free movement of labour and a fiscal contribution. If the UK wants to have a more ambitious deal with both goods and services then I think it's almost certain that the UK is going to have to allow something close to Norway or Switzerland on free movement of labour.

Why Canada Plus Plus Plus is Unacceptable To the EU

Ramin: And could you comment briefly on on Canada because that's one of the ones which the Brexiteers I think in particular support?

Amit: Sure I mean the Canadian deal, at least in terms of access to the EU market, is quite similar to Switzerland so it's largely goods. Canada does not make a fiscal contribution into the EU which is something that's quite attractive to the to the Brexiteers. And movement of labour is extremely restricted which is another attractive feature of the Canadian deal.

Now in terms of the Brexiteers looking for a Canada plus plus plus it's essentially looking to have more access to the EU market for both goods and services and sort of an unfettered access which in my view not is not realistic for the simple reason that if the UK has this sort of exceptional access then it does beg the question then why other members of the EU and other countries who have reached trading relationships with the EU not getting a deal that's as good as the UK.

NIGEM Model Brexit Forecasts

NIESR White Paper Impacts

Ramin: Great, so those are the kind of principal axes by which we could classify the different trade deals. So now, moving on to the final step which is putting those assumptions into all those different scenarios into a model NIGEM and then working out what the consequences are could you briefly talk through what the consequences would be for growth?

Amit: sure now as I said I mean I think the first point to make is there's an enormous amount of uncertainty around these I mean even the white paper proposal is simply a proposal that's made out of you know I don't know half a dozen sides of an a4 it's not a full trading relationship so it's really our interpretation of that document so but I think I think the sort of broad gist of the of the proposals are reasonably clear so so what we've done in NIGEM is applied those half a dozen channels to each of these training relationships and what we have found is that if you did restrict create on WTO terms that would knock UK GDP growth quite substantially.

I mean I think that our chart shows that growth will be more than a percentage point lower the currency will depreciate and that'll raise inflation by more than a percentage point. This would imply that household real disposable income will be squeezed and over the longer term the UK will be poorer than in a situation where we remain members of the EU or in a situation where we reach a soft Brexit deal with the EU.

Our central forecast, by the way, is conditioned on a soft Brexit scenario. So what we mean by a soft Brexit scenario is one where the UK maintains a very high level of access for both goods and services into the EU economy and where financial markets function normally and there's no major dislocation in the financial markets.

Now you could easily think about scenarios where financial markets are dislocated. You could think of scenarios where that's one extreme. You could think of a scenario where we actually remain in the EU and there's a second referendum. So we're not thinking about extreme outcomes we're just thinking about an outcome where you have a soft and a solid trading relationship, probably something that looks like the one that the EU has with Norway. So that's our kind of central central scenario.

Under that scenario we see growth of around 1 and 3/4 of a percent over the medium-term. Inflation is more or less on target and so...

Double shock: Brexit and the Financial Crisis

Ramin: wait wait wait so one and three-quarters percent how would that compare with like you know long-term GDP growth in the UK if Brexit hadn't happened?

Amit: I think it could probably be marginally lower than a scenario where Brexit hadn't happened altogether. But maybe maybe another way to sort of think about this is what was the average before the financial crisis? Because there's been there's been a material slowdown in the economy since the financial crisis primarily because productivity has been weaker. And prior to the financial crisis the UK was probably growing by around a percentage point higher. So in the sort of two and a half to three percent region as opposed to the sort of one and a half to two percent region that we have in our soft Brexit scenario.

ONS Productivity Slowdown Post GFC

And I think that's important, because you're you're hitting the economy with two shocks: one is the financial crisis, the productivity impact of that crisis, and other reasons because of which productivity's been damaged, and then over and above that you're hitting with a Brexit shock which potentially has long-term consequences to it as well.

Hard Brexit Scenario

So in our hard Brexit scenario, this is one where the UK trades on WTO terms, we see growth materially slower dropping by around a percentage point. The main reason why growth drops in the short-term is because access to the EU market is blocked for both goods and services. Our underlying assumption here is that our exports to the EU will be something like 50% lower in the long run. And those are the kind of results that we've got from what they call gravity models where they've said that as a member of the EU trade with the EU has increased by 50%, something that wouldn't have happened if we were not members of the EU.

Now of course one of the criticisms of those studies is that just because trade increased by 50% as members of the EU it doesn't mean that if we exit that trade will fall by 50%, it might fall by less just because we've established some links with the EU or even circumvent these rules in some other ways. And to that extent the numbers that we present might be too high, but you know that's the best we have so far.

Sterling Strong As Bank of England Stands Back

GBPEUR 2016-2018

Ramin: Okay thanks Amit that's that's really interesting as an insight into the economic modeling of of Brexit. But what I'd love to talk about is the effect on sterling because I've done a Brexit video where I talked a lot about the asymmetry of the reaction from sterling to Brexit because we're already pretty much pricing in a hard Brexit now so if there's any good news we'll probably get a stronger rally in sterling then we get a downside if we actually get a hard Brexit. So what are your thoughts about that because I think your insight is based on central bank policy and it's a very interesting insight?

Amit: Sure so I think if you could go back to 2006 when we had the referendum result the inflation in the UK was significantly below the 2% target, there was still some spare capacity in the economy. And I think if you remember the PMIs and other indicators of growth collapsed on the news more or less. So the bank was comfortable with injecting stimulus into the economy to lift aggregate demand.

ONS UK unemployment rates (aged 16 years and over), seasonally adjusted

Now two years, two and a half years on unemployment is now down to four percent, there's very little spare capacity in the economy on conventional measures inflation is, well the latest print was 2.7 percent, which is well ahead of the target, and economic growth on the latest numbers of 0.7%.

ONS CPIH, OOH component and CPI 12-month rates for the last 10 years_ August 2008 to August 2018

So on our NIESR GDP tracker we think Q3 will be 0.7% and Q4 will be half a percent. In other words there's very little spare capacity in the economy and if we get a hard Brexit it's the view of the central bank that the productive capacity of the economy will be damaged. And given that the central bank's primary mandate is to hit the inflation target against a background where the productive capacity is falling there's very little room for manoeuvre.

In other words there's very little room to cut interest rates. So unless economic growth drops significantly I think the central bank will be hesitant to inject stimulus in the same way as it did in 2016.

Now if that is the case then I think sterling will remain supported. So in other words the downside on sterling will be fairly limited in that case, unless economic growth slows down very sharply and it remains weak for a long period of time. I think the stimulus from monetary policy will will be absent this time or certainly not in the same way as it was back in 2016.

Ramin: That's been really interesting thanks so much for your time Amit and thank you also to the National Institute for Economic and Social Research for for allowing you to spend the time with me and hopefully we can talk about this again once it actually happens.

Amit: Yes good to chat with you Ramin and let's be in touch.

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October 17, 2018
ramin

Investment coach, financial author and founder of PensionCraft. Ramin wants to share his knowledge of how to succeed in long-term investment by keeping fees low, understanding behavioural investment pitfalls, knowing how to read macroeconomic indicators and understanding and controlling risk.