The Bank’s stress tests rein­vent project fear by ac­ci­dent

The Observer - - Economics - Phillip In­man  @phillip­in­man

The case for stay­ing in­side the EU re­mains solid, but rein­ven­tions of project fear are wreck­ing the chances of ever per­suad­ing Leave vot­ers, pos­si­bly in a sec­ond ref­er­en­dum, that quit­ting the sin­gle mar­ket and cus­toms union would harm the econ­omy ir­re­vo­ca­bly.

That’s be­cause project fear – as first put for­ward by the Trea­sury be­fore the ref­er­en­dum vote and sup­ported by the likes of the In­ter­na­tional Mon­e­tary Fund – is full of al­most as many barmy as­sump­tions as are held true by Ja­cob Rees-Mogg and his Euro­pean Re­search Group (ERG).

Mark Car­ney, the Bank of Eng­land gover­nor, was drawn into the de­bate last week, af­ter he was forced to clar­ify claims that he had told Theresa May’s cab­i­net a “no deal” Brexit could be worse for the econ­omy than the 2008 fi­nan­cial cri­sis.

Car­ney re­jected this in­ter­pre­ta­tion of his re­marks, say­ing he had told min­is­ters about “stress test” sce­nar­ios de­signed to check the sta­bil­ity and dura­bil­ity of Bri­tain’s banks in a cri­sis. He said the worst case sce­nario, which showed house prices falling sharply in the next down­turn, did not amount to a pre­dic­tion by the Bank as to what would hap­pen should the UK leave with no deal.

De­spite his de­nials, how­ever, some sup­port­ers of the prime min­is­ter’s Che­quers deal have ar­gued that the Bank’s most pes­simistic out­look could in fact be trig­gered by a no-deal Brexit.

Car­ney is on solid ground when he ar­gues that the stress tests can­not be con­sid­ered a fore­cast: a fore­cast would con­tain a more plau­si­ble as­sump­tion of the Bank’s own ac­tions. In­stead, the tests sug­gest that, in the car­nage of a global fi­nan­cial melt­down, the Bank would in­crease in­ter­est rates to 4%.

If the Bank stuck to this rem­edy – even in the set­ting of a UK-only dis­as­ter rather than a global melt­down – the path to a ter­ri­ble out­come would start on the day it be­came clear that a no-deal exit was cer­tain.

Ris­ing in­fla­tion As no-deal be­came a re­al­ity, in­vestors would panic, trig­ger­ing a slump in the pound. In­ter­na­tional in­vestors are a ner­vous bunch and over a pe­riod of weeks ster­ling could fall fur­ther than it did fol­low­ing the Brexit vote, when it dropped by around 20% against the dol­lar and a lit­tle less against the euro. It’s pos­si­ble to ar­gue that a lower-val­ued cur­rency might help ex­ports in the long run. But in the short term Bri­tain would be forced to pay more for im­ports, fu­elling higher prices in the shops. On this most econ­o­mists agree. Higher in­ter­est rates So the first step in tack­ling in­fla­tion would be to re­strict con­sumers’ ac­cess to credit, ac­cord­ing to the stress tests. Higher in­ter­est rates would mean con­sumers had less buy­ing power. As a re­sult, shops and busi­nesses that im­port goods might have to ab­sorb the higher costs of im­ports rather than pass them on. Car­ney in­sists this is a pos­si­ble course of ac­tion. House price crash How­ever, any suc­cess in re­strict­ing prices rises would send tidal waves though the rest of the econ­omy, in­clud­ing a hous­ing panic as buy­ers found mort­gage loan rates soar­ing. In the stress tests, the Bank says a 25% to 35% fall in house prices across the coun­try is pos­si­ble, wip­ing hun­dreds of bil­lions off the value of UK prop­erty and the banks’ bal­ance sheets. Unem­ploy­ment hits dou­ble fig­ures Faced with ris­ing im­port costs and higher in­ter­est rates, busi­nesses would be forced to lay off work­ers. Some in­dus­tries would be es­pe­cially hard hit by the rise in in­ter­est rates, in­clud­ing the con­struc­tion in­dus­try and house­builders. The rip­ple ef­fects on other busi­nesses would send unem­ploy­ment above 10%, the Bank sug­gests in its bleak­est sce­nario.

De­pressed eco­nomic growth The Trea­sury’s in­de­pen­dent fore­caster, the Of­fice for Bud­get Re­spon­si­bil­ity, has es­ti­mated that last year 90% of the UK’s 1.8% GDP growth was the re­sult of house­hold spend­ing. So higher unem­ploy­ment would have the ef­fect of re­duc­ing house­hold spend­ing and there­fore GDP growth. A re­ces­sion is the likely re­sult.

Un­for­tu­nately, the Bank’s worst case sce­nario has a fa­mil­iar ring to it. It reads like the Trea­sury’s project fear fore­casts be­fore the Brexit vote, and rests on Car­ney and his pol­i­cy­mak­ers mak­ing the mis­take of tight­en­ing mon­e­tary pol­icy just as the com­mer­cial banks do the same and pri­vate busi­nesses and house­holds stop spend­ing.

That was not a mis­take the Bank made af­ter the 2008 fi­nan­cial crash, when its base rate was cut from 5% to 0.5% and over sub­se­quent years £375bn was pumped into the econ­omy. It was also not the cen­tral bank’s pol­icy re­sponse fol­low­ing the Brexit vote. Car­ney should be clear and say the Bank would al­ways loosen mon­e­tary pol­icy: then the project-fear-mon­gers would stop putting ris­ing in­ter­est rates in their sce­nario plan­ning, in­clud­ing the Bank of Eng­land.

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