Would a no-deal Brexit cause a recession?

A “do or die” Brexit would dramatically increase the likelihood of an economic downturn – but its severity would depend on how the government responded.

By Arno Hantzsche and Garry Young

A pedestrian walks past a boarded-up shop in Sunderland in north east England on March 16, 2019. - The former shipbuilding city in northeast England, where the Nissan carmaker plant is now the lifeblood, played a starring role in Britain's seismic decision to leave the European Union. The city's 61 percent vote in favour of leaving in the 2016 referendum signalled early on where the nation was heading on the night of June 23, 2016 and celebrations at the count were beamed worldwide. (Photo by ANDY BUCHANAN / AFP) (Photo credit should read ANDY BUCHANAN/AFP/Getty Images)

Advocates of a hard Brexit often point to World Trade Organisation rules as an alternative to the UK’s current trading terms with the European single market. Though optimists suggest “no-deal WTO” is a viable path, the reality is that no deal would make trading goods and services costlier, and in some instances impossible.

A weakening global economy and high levels of uncertainty mean the UK’s economic activity is already lagging. According to early estimates by the National Institute of Economic and Social Research, economic output likely contracted in the second quarter of this year, putting the chance of a recession at around one in four. With weak underlying growth, a no-deal Brexit could further contract the UK’s enervated economy.

In the days following a no-deal Brexit, it’s reasonable to expect consumer confidence will slide and investment stall. The value of Sterling has plummeted as the chances of a no-deal Brexit have risen – an early indicator of the future downturn that could lie in store. Though a depreciation of the pound would make British exports competitive abroad, it would also raise the price of imported inputs, contributing to a sharp increase in consumer price inflation and reducing the living standards of people in Britain.

The severity of a downturn following a no-deal Brexit would depend first on how well the government and individual firms and households have prepared. Though contingency measures and government support could help alleviate disruption, their effects would be slight in the face of new EU tariffs and trade regulation. With two Brexit deadlines already elapsed, there’s also a risk that firms and households have become complacent about the importance of preparation.

Second, the severity of a downturn will also depend on how the government uses its monetary and fiscal levers. The government’s pledges to increase public spending and lower corporate and income taxes will affect the distribution of national income, mostly to the benefit of high earners, but will have little effect on the size of the economy as a whole. Instead, such spending measures could simply add to inflationary pressure, leaving less room for monetary policy while adding to public borrowing. Tax and spending policies should instead focus on the provision of support to industries and regions most severely affected by disruptions to UK-EU trade.

After the dust has settled, a no-deal Brexit is likely to change the future structure of the UK economy in a way not dissimilar to the decline of industrial manufacturing in the 1980s, or periods of rapid globalisation since the 1990s. There will be winners and losers. Labour market policies that allow people to retrain can go some of the way to smoothing this period of adjustment.

The main responsibility for buffering the economy against a no-deal shock should fall to monetary policy. A bank rate cut from 0.75 per cent to 0.25 per cent, accompanied by further quantitative easing, could ensure that a no-deal recession remains short-lived. However, such a move would only be possible if inflation expectations remain close to the 2 per cent target, allowing the Bank of England to ignore above-target rates of inflation for a limited period.

Whatever its political rationale, there is no doubt that no deal would be a costly blow to the UK’s already enfeebled economy.

Arno Hantzsche is senior economist at the National Institute of Economic and Social Research and Garry Young is director of macroeconomic modelling and forecasting at the National Institute of Economic and Social Research.