The Bank’s stress tests reinvent project fear by accident
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.