The UK economy has recovered more strongly and more quickly from the financial crisis, and generally has been doing better than the eurozone. While some external factors worked in the UK’s favour – it was not as badly affected as some peripheral euro economies by the global financial crisis – both the magnitude of its growth and the consistently slow growth seen across the eurozone suggest that the UK’s comparative success has deeper causes.
In this paper, we have argued that the primary cause of this divergence was the UK’s more aggressive macroeconomic policy stance at an early stage in the crisis, and more rapid intervention by the government in the financial sector. This helped to kick-start the recovery and enabled it to reach the necessary ‘escape velocity’ for self-sustained, demand-led growth. Moreover, a flexible labour market allowed employers to both shed jobs quickly and hire workers quickly once confidence returned. Eurozone economies have less flexible labour markets – and those that have reformed their labour markets most effectively are now more successful than those that have not – and rely more heavily on capital formation to drive GDP growth. In these economies, households, firms and governments draw down on their savings in times of low economic growth, which dampens consumption- and investment-led growth. Labour market inflexibility also means that workers who lose their jobs are more likely to remain outside the labour pool for longer, thus saving and consuming less.
This ties in with evidence that slower post-crisis growth in consumption in the eurozone can be attributed to the lag in recovery in employment. If a large percentage of the population is out of work, those people are less likely to make significant spending decisions. Countries such as Germany and the UK, which are back to their pre-crisis levels of household spending,23 have benefited from a faster rebound in consumption than countries such as Italy and Spain with high unemployment.24 The prevalence of high levels of long-term and very long-term unemployment, especially in Spain and Italy,25 will exacerbate the problem of weak consumption if labour markets cannot reintegrate the jobless.
This is not to say that the UK model is without flaws. Despite having deleveraged throughout the crisis, the UK remains significantly leveraged, especially at the household level, and its public sector has taken on a large portion of debt. High indebtedness will limit the country’s ability to maintain consumption-led growth indefinitely unless foreign investors are willing to finance the current-account deficit on favourable terms. In addition, the UK’s lack of worker productivity growth, which has been mitigated by inflows of foreign workers and the drop in the real unit labour cost, will undermine competitiveness and so GDP growth unless the exchange rate stays low or depreciates further.
As the UK government is considering all the possible options that arise from the decision to leave the EU, these findings need to be factored in. The key question is whether the current model, which relies on attracting and absorbing high levels of foreign capital and labour, will be sustainable in the event of a new relationship with the EU that reduces market openness and integration.
The sustainability of the UK model post-Brexit relies on both economic and political dimensions. In terms of the former, it is critical to maintain the confidence of international investors. A more constraining relationship with the EU and limited access to Europe’s single market would affect investors’ confidence. If the UK becomes less attractive as an investment destination, and stricter immigration policy causes the labour force to shrink, then it may find it difficult to attract the quantity of foreign capital and labour necessary to keep a domestic demand-driven economy dependent on foreign capital and labour in balance. If net FDI and other capital inflows to the UK shrink, then the impact on the sterling exchange rate will be even more severe than has so far become apparent in the aftermath of the Brexit vote. On the one hand this would help reduce the current-account deficit and cushion the adverse impact of Brexit on real GDP growth via the export channel. On the other hand, this would be accompanied by deleveraging and a slowdown in domestic demand.
Stalling (or reversing) labour inflows, meanwhile, could produce a fall in potential output and employment, which in turn would feed into weaker household consumption. If the UK were to partially lose access to the EU’s internal market – which would be particularly damaging for its financial services industry – this would have a negative impact on potential output and jobs.
This brings us to the political dimension: how much EU internal market access will the UK be willing to sacrifice, and in return for what degree of control over immigration? The Brexit vote reflects the disparity between the ‘winners’ and ‘losers’ from globalization inside the UK. The ‘losers’ expect the political establishment to offer more ‘protection’ against globalization, notably by restricting immigration. If the leadership doesn’t deliver on that desire, a political backlash could ensue. At worst, the UK economy could fall prey to protectionism and would suffer as a result. Obviously the UK leadership will want to avoid this, but it finds itself between a rock and a hard place. A lot of political talent will be needed to navigate past this.
23 Office for National Statistics (2016), ‘Household spending’, https://www.ons.gov.uk/ (accessed 6 Oct. 2016); and Federal Statistical Office, Germany (2016), ‘Final Consumption Expenditure’, https://www.destatis.de/EN/Homepage.html (accessed 6 Oct. 2016).
24 OECD.Stat (2016), ‘Gross domestic product (GDP)’, https://stats.oecd.org/index.aspx?queryid=60702 (accessed 6 Oct. 2016).
25 Eurostat (2016), ‘Unemployment by duration’, http://ec.europa.eu/eurostat/ (accessed 6 Oct. 2016).