Brexit’s ‘Project Fear’ Has Just Become Reality

(Bloomberg Opinion) -- When Britain voted to leave the EU in June 2016, most economists expected the country’s economy to decelerate sharply. The slowdown has finally arrived.

The sudden drop in economic activity at the end of 2018 raises the stakes for the British political class, which has been dithering over the future relationship with the EU as the U.K. enjoyed a relatively benign economic outlook. It also raises questions for the Bank of England, which has been pretty sanguine about the country’s future, before making a screeching U-turn last week.

The economy expanded by 0.2 percent in the last quarter of last year, just below expectations. But it contracted by 0.4 percent in December. While this might just be a blip, it may also be a sign that the worst is yet to come.

The breakdown of the overall figure is equally troubling. Business investment — which is highly vulnerable to uncertainty — was 3.7 percent lower than a year earlier, the fourth quarterly decline in a row. And while the country’s dominant services sector held up, industrial production and manufacturing both contracted. These are exactly the sectors one would expect to suffer most in the event of possible disruptions to trade and supply chains.

Britain’s deceleration supports the position of most economists, who’ve been warning about Brexit fallout since the referendum campaign. It is fair to say that this wasn’t immediately evident after the vote, when the Bank of England, the International Monetary Fund and others were too pessimistic. Corporate leaders didn’t behave like the hyper-rational agents who populate the economics textbooks. Many waited to see whether the Brexit fog would lift quickly, and continued with business as usual. As the deadline of March 29 fast approaches, and the chances of reversing Brexit diminish, fewer want to take any risks. The doom-saying economists were wrong on the timing, but probably not on the substance of their predictions.

Britain’s slowing economy should hopefully rouse Theresa May’s Conservative government and the opposition Labour Party. A month and a half from Brexit day, we still don’t know what the U.K. parliament wants. May’s deal with the EU, which would trigger a soft transition and give businesses more time to adjust, was comprehensively beaten in Westminster. There’s nascent optimism that a version of her deal will be dragged over the line, but it all depends on extracting concessions from Brussels, winning over hardline Brexiter Conservative lawmakers and working with an opposition led by the hard left. If any of that fails, we’re looking at the possibility of a departure without a deal. No wonder companies are running scared.

So far, Britain’s politicians have had the luxury of being able to fiddle without London burning. True, sterling has dropped sharply. But the U.K. hasn’t suffered from the traumatic outflows that put other countries such as Greece and Italy on the spot when they were negotiating with Brussels. A sharply slowing economy would remind the British political elite what is really at stake.

The Bank of England’s technocrats need to wake up too. After predicting a possible recession should Britain vote to leave the EU, the Bank adopted a more upbeat stance. In August last year, it raised rates to 0.75 percent as it warned that the economy was reaching its “speed limit,” and planned more hikes. Last week, governor Mark Carney was much gloomier about the outlook again. The Bank’s central forecasts show that Britain will avoid a recession in the first six months of the year, but there’s a one in four chance of one happening. Most worrying, this prediction holds even if there’s an orderly Brexit. With a “no deal” departure, the outlook would be worse still.

One wonders why the Bank lifted rates in the first place, when the uncertainty around Brexit was so evident. True, wages have been rising at a decent clip, but inflation is only above the Bank’s 2 percent target because of energy prices, and is likely to drop further. Of course, there’s no guarantee that the Bank will have to slash rates in the event of a no-deal Brexit, since it may be forced to deal with capital flight. But that rate hike, and the upbeat talk, now look premature.

Still, the Bank’s responsibilities are insignificant when compared to those of the politicians — and the boosters of Brexit in particular. The cost is becoming clearer for Britain. Just how high that will be depends on the choices of elected officials over the next few weeks.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Ferdinando Giugliano writes columns and editorials on European economics for Bloomberg Opinion. He is also an economics columnist for La Repubblica and was a member of the editorial board of the Financial Times.

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