Deloitte-uk-money-piled-up

With Brexit uncertainty undimmed we start this week’s Briefing with a short recap on the economics of leaving the EU.

The consensus among economists is that the UK will grow by 1.3% this year and 1.5% next year. With activity slowing across the world, particularly in the euro area, and the UK scheduled to leave the EU, growth at these rates looks pretty respectable. Given the uncertainties facing the UK it’s perhaps surprising that its economy is expected to outpace Italy’s or Germany’s this year.

This fairly cheery outlook for the UK comes with a major caveat. Most forecasts are predicated on the UK leaving the EU in an orderly, managed fashion. In the event of an abrupt departure without a deal UK growth forecasts would almost certainly plummet. Leaving the EU without a deal would, according to the OECD and the National Institute of Economic and Social Research, leave the UK growing by around 0.4% this year and next.

Such forecasts are speculative, but reflect concerns that disruption to trade and supply chains, along with sterling weakness, rising import costs and uncertainty, would dampen growth.

Betting odds offer one way of thinking about the probability of different Brexit options. At the time of writing, the odds from bookmaker Paddy Power imply a 36% chance of Mrs May’s deal being passed by the House of Commons at the third attempt, a 17% chance of the UK exiting without a deal before 1 April and a 29% chance of another referendum happening before the end of this year.

We now turn to the main subject of this week’s briefing, the way in which deep recessions can depress growth for years to come.

In the ten years since the financial crisis Western growth has run at much lower rates than in the two decades before the crisis. In the G7 group of major industrialised nations the growth rate has fallen by a quarter since 2008-09. For G7 nations it means a cumulative loss of 6% of GDP over ten years.

There are lots of theories as to what has gone wrong, but no consensus. One factor which gets little attention is how deep recessions can have lasting effects on an individual’s behaviour and prospects.

There is a large body of literature showing that trauma can led to a sustained decline in the risk tolerance of individuals. US research shows numerous examples of such so-called scarring effects.

Researchers in California examined the business strategies of US CEOs who grew up during the Great Depression of the 1920s and 1930s. As CEOs these individuals displayed greater caution than peers who had not experienced the Great Depression, relying more heavily on internal financing and making less use of debt.

In a similar vein, researchers at MIT and Cornell looked at individuals who started their careers during a recession and served as CEOs in the 1990s and 2000s. Again, recession-generation CEOs exhibited greater caution than their peers. Cost control was ranked as a higher priority for this group while investment, R&D and taking on debt were less important.

The tendency in recent years for corporates to run high cash balances may well reflect a similar post-crisis mood of caution.

The labour market provides another example of scarring effects. For young people a spell of unemployment, or even entering work in a recession, can have lasting effects on pay.

Researchers in North Carolina found that being unemployed at the age of 21 depressed wages for at least ten years relative to those who not been unemployed at this age. According to a Yale study, those entering the labour force at a time of recession, even if they find employment, are also likely to see enduring depressed earnings.

This seems to have been the case in the UK since the financial crisis. For younger workers the upward trajectory of earnings, from one generation to the next, has ground to a halt. Data from the Resolution Foundation show that median real pay for 30–year-olds was lower in 2017 than it was 15 years earlier.

Recessions raise risk aversion and people tend to stick with their current job. As a result they miss out on the step changes in pay that tend to accompany job changes. (Resolution Foundation data for the UK show that moving jobs is associated with a pay rise of 7.3% compared to a 2.5% increase for those staying put.) This is a particular issue for younger workers; most of the increase in a person’s salary occur in the first 15 years of work. Less job-switching at this stage of a career can have a significant impact on subsequent earnings.

The lesson from history is that recessions, especially deep ones, cast long shadows.

PS: Following our briefing on Germany last week, more worrying data has emerged for Germany. The influential Ifo institute cut its forecast for German growth in 2019 from 1.1% to 0.6%. This would be the lowest growth since 2013.