The Treasury says a vote to leave the EU would tip Britain’s economy into recession, causing at least 500,000 people to lose their jobs, reducing wages and lowering house prices. It expects three channels will hit growth: a “transition effect”, in which households tighten their belts in anticipation of being poorer in the long term; an “uncertainty effect” limiting business investment and consumption; and a “financial conditions” effect from turmoil in markets.
This is the government’s second analysis of a British exit from the EU and covers the immediate impact. The first paper concluded that in the long term — about 15 years hence — the economy would be 6.2 per cent smaller than current projections, the equivalent of £4,300 for every household.
Are the latest Treasury figures plausible?
Yes. Saying the economy would face the risks of a recession after a vote to leave the EU is in line with predictions made by the Bank of England, the International Monetary Fund and even many economists who support the Leave campaign, such as Gerard Lyons. The recession in the main “shock” scenario is small — a 0.1 per cent quarterly contraction for four quarters — far smaller than the 2008 financial crisis and the early 1990s recession. These figures are not outlandish and many would say they are cautious. The “severe shock” scenario is on a par with the 1990s recession.
Are the Treasury’s methods convincing?
No. There appears to be a lot of reverse engineering going on. Politics required lost jobs, a recession and lower house prices and officials chose methods that delivered that outcome — just.
All parts of the analysis are open to criticism and the Treasury’s reluctance to talk about margins of error or what are the real driving forces behind the results speaks volumes.
Dave Ramsden, chief economist at the Treasury and lead official on this report, has recently written about how the independent Office for Budget Responsibility “has ended the perception of bias associated with the forecasts that were previously produced by the Treasury”. This report will not escape a perception of bias.
Should we believe the “transition effect”?
Last month the Treasury published analysis suggesting UK households would be poorer in the long run if Britain leaves the EU. Assuming individuals anticipate this, they will immediately cut back on their consumption and raise their saving rate.
This transition effect is circular: Treasury prophesies of long-run economic gloom cause the short-term recession. If instead households believed the UK economy would be wealthier as a result of Brexit, this effect could be reversed.
What about uncertainty?
Everyone accepts there would be a significant period of uncertainty following a vote to leave the EU. It is unclear what policies the government would pursue, including the trading relationships we would have with other countries.
The Treasury sought to measure the link between numerical estimates of uncertainty and economic growth in the past. The technique it employed is not perfect but has been used by other reputable economists and institutions. Similar analysis by the Bank of England concluded that extreme uncertainty could reduce the level of gross domestic product by 0.8 per cent and the effect could persist for at least four years. If the Treasury followed the BoE’s technique, this would suggest the uncertainty effect only accounts for a small part of the estimated 3.6 per cent hit to GDP.
Will financial markets sink the economy?
The Treasury thinks the immediate impact of a vote to leave the EU would weigh on financial markets and it assumes borrowing costs would rise. The risk premium on equities is also assumed to go up, hitting share prices. Meanwhile, the value of sterling would fall.
The Treasury bases its estimate of the size of these effects on past experience. However, the document provides very few numbers on how these financial market variables have evolved in the past and no detail on how important this assumed tightening of financial conditions is for growth in the economy.
Surely the Bank of England would ride to the rescue?
Possibly. But another questionable element of the Treasury analysis is that it assumes no monetary or fiscal policy response. If the BoE cut interest rates and restarted quantitative easing, it could mitigate some of the negative effects, but it has cautioned that if a sterling fall raised expectations of inflation or if the economy’s capacity to supply goods and services was hit, it might not be able to act. Likewise, the government might respond to a downturn with spending increases or spending cuts.
Given these complications, the assumption of “no change in policy” is reasonable as a reflection of the choices available, but it is not reasonable as a prediction of the future, which is how David Cameron and George Osborne characterised the work.
So should I take any notice of this report?
A vote to quit the EU would almost certainly be a nasty economic shock, so you should not dismiss the conclusions — but you should remain very sceptical about the report’s details. Charlie Bean, the highly respected former deputy governor of the BoE, alludes to this in his assessment that “there are many uncertainties” but the estimates are still “reasonable”.
Put bluntly, the Treasury has made up the numbers but not exaggerated wildly.
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