The Bank of England is expected to announce on Thursday measures to stimulate the UK economy following signs that there will be a significant economic downturn following the vote for Brexit. The Bank may cut interest rates, inject another dose of quantitative easing or conjure up something new to give the economy a monetary boost.
Although some have dubbed this “Super Thursday”, it cannot hope to be anything of the sort. The Bank only has tools to help ameliorate the immediate damaging impact of the Brexit vote. It can do little to address the underlying structural problems of the UK economy; structural problems that are likely to deepen unless the government makes a U-turn and uses fiscal policy as a means to stimulate long-term economic growth.
The impact of the Brexit vote will be revealed over many years. The immediate evidence is patchy but the initial signs are that the economy is slowing down. The Purchasing Managers’ Index, which is a lead indicator of GDP, shows that the UK economy suffered a significant deterioration following the Brexit vote.
Sterling has weakened and this was expected to stimulate manufacturing exports. But the immediate evidence suggests that even manufacturing activity is slowing down. The Bank is also expected to revise downwards its growth forecast for the UK economy – not simply because of its macroeconomic model but also, as the Financial Times reported on July 19, because some of its economists have been talking to businesses and finding out the story from the horse’s mouth.
The Bank, assuming the mantle of the “muscular” interventionist, is expected to introduce further monetary stimulus to help business confidence and encourage spending. This should help to reduce the depth of the emerging downturn and it will assuage markets that at least there has been some response to deal with the impact of the Brexit vote.
But there is little evidence that monetary stimulus alone will address the long-term weaknesses of the UK economy. There are two major limitations of excessive reliance on monetary policy to manage the economy.
First, it does little to expand the capacity of the economy by stimulating new investment. Second, it increases the inequality of wealth: the big gainers are those who own assets which are propped up by the monetary stimulus such as housing, bonds and shares. Very low interest rates have increased demand, but this demand has served to increase the prices of existing assets – such as the cost of housing. It has had little impact on the creation of new assets, such as house building and corporate investment and expansion.
The Big Problem
One of the major long-term problems facing the UK economy is stagnant productivity, the prime determinant of future prosperity and income growth. There are a number of drivers of productivity including investment in capacity, investment in education and the creation of new ideas. Monetary stimulus can do little to stimulate these.
Low interest rates may stimulate private sector investment in normal times, but such investment is discouraged by economic and financial uncertainty. An active fiscal policy is required to address the productivity problem, including state investment in infrastructure, housing and education.
And the productivity problem is likely to get worse in the long-term as the UK wrestles with its post-Brexit legacy. First, the UK will find it more difficult to trade with both Europe and the rest of the world. This will lead to a widening of the UK’s trade deficit or a permanently lower exchange rate – or possibly a combination of both. Second, the level of foreign direct investment into the UK economy is likely to fall as foreign firms remain in, or move into countries within the EU single market.
Third, there will be serious disruptions to the UK’s innovation system. Universities are one of the strong aspects of the UK system, but their ability to attract funding and world-class researchers will be hindered when (or if) the UK leaves the single market. Furthermore, much business research and development in the UK is carried out by overseas firms, which may fall if such firms move or expand abroad.
A New Industrial Policy?
The Brexit vote has led to a new government and a new opportunity to recast economic policy. The new Prime Minister has indicated her support for industrial policy and she has established a new Department for Business, Energy and Industrial Strategy. But we have been here before and the rhetoric and rebranding has often not been followed by action.
The decisions of the Bank of England that will be announced on Thursday may be mildly useful, but they can’t hope to be much more than that. They can do little to alter the long-term direction of the economy. The key issue is whether the new government acknowledges the important role for the state in driving long-term growth and re-orientates fiscal policy towards increasing public investment in infrastructure, education and innovation.