Mark Carney, the outgoing governor of the Bank of England, remarked in August that “entrenched uncertainty” about Brexit may be exerting a pervasive depressing effect on the UK economy. Instead of temporarily flaring up from time to time, and then disappearing, this form of uncertainty does not automatically disappear when harmful policy developments are reversed.
Instead, there may have been a fundamental change: investors and corporations have become inured to the possibility that the process of disengagement, or subsequent re-engagement, with the EU may take years or decades to complete. The topic may not simply disappear from our radar screens on October 31.
The role of policy uncertainty in damaging growth rates in many economies is now well recognised by economists. Because of the importance of the Brexit shock in the UK, the BoE has probably done more work on uncertainty than any other central bank.
This work (see box below) has established beyond reasonable doubt that Britain has experienced a large and pervasive uncertainty shock, not just a brief hiatus in confidence, and that this has reduced investment and long-term productivity in the economy.
Now, with the electorate deeply divided over Brexit, it is difficult to see how any feasible grouping of UK politicians can dispel this uncertainty entirely. If a compromise along the lines of former prime minister Theresa May’s deal is approved by parliament in the coming month, near-term risks and market volatility would decline. But entrenched uncertainty about the shape of Britain’s relationship with its largest trading partners could remain.
If this phenomenon were confined to a medium-sized economy like the UK, the global effects would be negligible. However, as Mr Carney argued in his important “sea change” speech in July, there are mounting concerns that a similar shock is occurring in global trade policy.
What started with an outbreak of tit-for-tat tariff increases between the US and China in 2018 may be
developing into a much more profound rupture in their bilateral economic relationship.
In the course of this escalation, US president Donald Trump has used threats about tariffs to affect very different areas of policy, including immigration, China’s industrial policy and technology transfers. He has even raised the possibility of using the Emergency Economic Powers Act of 1977 to forbid the engagement of US companies with China.
Mr Trump has also said repeatedly that he might withdraw the US from the World Trade Organization, a move that would eliminate the most-favoured nation clause, which requires the US to treat all WTO members equally when imposing import tariffs.
Contemplating such a drastic step only makes sense if it is intended as a prelude to the imposition of
discriminatory tariffs on imports from specific countries. It is not clear whether the president has the legal authority to undertake such action without congressional approval, but in the meantime his refusal to approve appointments to the appellate panel of the WTO may cripple the effectiveness of the enforcement apparatus that underpins world trade.
It would be scarcely surprising if these actions and threats have led investors and companies to ask whether they can rely on the rules-based global trade system that has been in place for decades. Also, now that an American president has shown he can take aggressive action to impose tariffs without restraint from Congress, companies in both the US and China are unlikely to forget this risk when planning the location of long-term investment projects.
Evidence from the UK and elsewhere (as highlighted by BoE deputy governor Ben Broadbent and Monetary Policy Committee member Michael Saunders) suggests that such entrenched uncertainty about public policy leads companies to demand an additional risk premium when assessing the likely returns on capital investment. This can lead to lower investment, a reduced capital/labour ratio in the economy and consequently lower productivity. These effects may emerge many years after the immediate cause of the uncertainty has apparently disappeared.
Has anything similar happened before? It certainly has. The collapse of the global financial system in 2008 led to deeply embedded risk premiums in the financial system and was followed by large increases in corporate cash balances and lower productive investment.
The global trade shock may be much smaller, but just as persistent.
The Bank of England has suggested that business investment in the UK is 6 per cent to 14 per cent lower than it would have been without Brexit uncertainties, especially those over the long-term effects of Brexit on trading relationships. Relative to previous economic cycles, the UK investment shortfall looks even larger.
The BoE’s research also shows that global policy uncertainty has risen markedly since 2017. As the trade wars have broadened in scope, this higher level of global uncertainty may be very difficult to reverse. The central bank says this could reduce the level of US and China gross domestic product by 1.8 percentage points within a three-year period — much more than previously thought.
Global capital investment surged in 2016-17, when annualised growth temporarily touched 8 per cent (according to JPMorgan’s extremely useful capex nowcaster). However, as trade uncertainty has become more pronounced in 2018-19, the growth rate in global capex has collapsed, and has now stabilised around zero.