As Britain looms to a no deal Brexit, more and more of the news will contain data that can be confusing, especially when talking about the economy. The Bank of England and how it operates can be puzzling with the multitude of terms they use – it can be rather daunting. I will be making this as simple as possible, explaining every small detail you will need. Indeed there was a lot I learnt along the way and this was one reason I wanted to do this article. So, we at POI are going to give you a crash course in what you need to know to understand what the news says, sound great at a dinner party, or even tell your Brexit-loving grandparents they’re wrong!
The headline: ‘The economy [shrank] 0.2% between April and June’ produced by the Bank of England and covered by the BBC has caught the United Kingdom’s attention – hence my decision to write this article this week. What does it mean that the economy shrank 0.2%? We will start looking at two important terms.
Easing you in with Quarters
Our first term is Quarter. Britain’s financial timetable is broken into 4 sections of the year. We call each 3-month period a Quarter, the first going from January 1st to March the 31st and so one. The Quarter we are looking at is the 2nd quarter, April to June, also known as Q2. If you are wondering why we have only found out about this dip in August, it is because it takes a long time to process all the data.
GDP (Gross Domestic Product) is also something that can confuse people. Most people have a basic grasp of its understanding, but don’t know the underlying meaning. The GDP generally means how wealthy and promising a country is at one moment in time.
The UK combines three methods to calculate their GDP; output measure which is ‘the total value of all goods and services produced by all sectors of the economy’, expenditure measure which is the ‘value of goods and services bought by households, government’ etc, and income measure which combines the total ‘value of the income generated mostly in terms of profits and wages’.
Therefore, when we look at an economy’s growth through GDP, it will be these three things added together, giving an overall idea of how the economy is doing. The more it is growing; the more money is being made. The more money being made, the more money available for investment and spending. More jobs are then created so on and so forth. Generally, a GDP growing is good thing.
The dreaded 0.2%
What does this dip mean for us? Well it is hard to tell. This 0.2% dip is based ‘mainly us[ing] the output measure’ the BBC reported. Why this dip has occurred is due to ‘manufacturer’s stockpiling ahead of Brexit’ and ‘a 5.2 percent contraction in transport equipment output’ as described by Trading Economics. Vehicle production has seen a massive reduction in recent months with factories such as ‘BMW, Honda and Jaguar Land Rover all scheduled downtime in their factories’ the Irish Times noted.
The key reason is stockpiling. To explain this easily to you I’m going to use an example close to my heart, Domino’s. ‘Domino’s Pizza Group has spent £7m stockpiling ingredients including tomato sauce in case a no-deal Brexit disrupts supplies’ according to the Guardian.
This also influences how we view the first quarter of the year. The UK had a GDP growth of 0.5% according to trading economics. This was much higher than anticipated due to stock piling. The UK had prepared to leave in March, which saw a rise in how our GDP was viewed through an expenditure measure. The build up for Brexit in March and October have both caused the GDP to fluctuate due to the stockpiling shrinking from 1st to 2nd Quarter and also companies are not producing the usual profits and output.
Inflation, GDP and you
I hope you are still following. We are getting there don’t worry. What you might be wondering now is what is the perfect amount of GDP growth? Isn’t 0.5% growth small or 0.2% decrease not that much? Well we need to introduce a new term now, inflation.
Inflation is a simple concept most people know. Inflation is measured in two things; increasing money supply and increasing price levels. If the government is printing lots of money, Sterling (the British Pound) will become less valuable. If the prices of food are also getting higher, sterling again loses value. If a delicious Bruno bar costs £1 in January, but rises to £1.10 in December, we have seen inflation rate of 10% as the Bruno bar is still the same product. Either the Sterling has gotten less valuable as the government have produced more currency, or the prices have been increased by the manufacturers. Either way this is called inflation.
What starts to develop between inflation and GDP is a ‘delicate dance’ as Investopedia beautifully describes. I really recommend Investopedia if you are confused in the future if we, at POI, don’t cover or explain that situation. Now let’s look at this dance, and what is the ideal pace to dance it and then we will be able to see how our economy is doing and what will happen to it – Brexit and beyond.
This is slow ballet, not a fast Cossack dance!
We want the GDP to grow and at a high rate of course. It is shown that an ‘annual GDP growth over 2.5% has caused a 0.5% drop in unemployment for every percentage point over 2.5%’. However, this is where we get a system of checks and balances. The fine margins can have major effects.
A high GDP would eventually lead to 0% unemployment. However, as amazing as this sounds, it can have major effects.
With everyone being employed, supply remains the same but demand increases rapidly. This is called ‘aggregate demand’. Demand increases with more cash available for average citizen, but the supply doesn’t increase, causing prices to rocket up. Inflation then rises as production has remained the same, but the price has increased therefore making Sterling less valuable.
Prices will rise due to wages. Wages rise because of a lack of labour market, which again is a good thing, but there is no competition to keep wages down. As it becomes more expensive to make products, owners must increase the product price to make a profit. This causes inflation to rise rapidly and then cause hyperinflation. Hyperinflation crippled countries such as Germany and Zimbabwe. The currency becomes worthless internationally and food prices can increase astronomically. Wages can’t increase as quickly and the country’s economy is destroyed as people can no longer afford basic goods.
To explain this simply, if the GDP is an engine and it is being overworked it will become overheated. This overheating is inflation. GDP growth will automatically affect inflation, however high inflation can be disastrous for a country. Therefore, ideally a government wants to keep inflation at around ‘1-2%’ and the GDP from ‘0-3.5%’.
The Government can control inflation itself, but this is not important for us today, so we will now continue to look back at GDP.
Recession. Really, more terms?
I know that bit probably hurt. If you are still reading this well done, I commend you. We have a way to go but believe me it gets a lot easier. We will be finished soon and then you can show off your new working knowledge of basic economics.
We looked at why it is bad for GDP to rise too quickly, now let’s look at the easy side; why it is bad for an economy to shrink. If a country has one negative quarter it usually isn’t that bad. Even with one bad quarter, over the full year you can still see a growth in the yearly GDP, and therefore the economy is stable.
When an economy shrinks over two quarters in a row this is called a recession. This is when real chaos can start.
A recession can be caused by two things. The first is real life effects on the economy. If a country selling lots of oil breaks down due to a Civil War, the valuable asset of oil can rise sharply in price. For example, oil prices rose sharply during the invasion of Iraq.
The other cause is financial factors. If the economy is doing well, investors invest more. As they grow more confident due to their returns they start to invest into riskier ventures. As investment increases, so does the amount of money at risk. If the market turns slightly, all will be affected. This is what happened to the 2008 sub-prime mortgage crisis when all the risky investments containing sub-prime mortgage bonds turned to nothing, causing a massive recession.
If a recession gets too bad, it can cause a depression. A recession becomes a depression when the ‘GDP declines in excess of 10%’.
‘Yes, a recession is bad I know that…Why? … Umm’
So, what are the effects of a recession, or the shrinking of an economy, and why does that happen. When a GDP is shrinking, businesses spend less, they make make less products and people usually buy fewer products than they usually would. This can also be massively affected and hurt by increasing inflation.
When all these things are happening, a company is effectively shrinking itself. When it’s profits decrease from their usual amount due to making less products or due to no one buying their products, a company must take action to ensure it doesn’t go into debt and collapse. To avoid this, they make people redundant to stay afloat.
A company may also try to avoid redundancy and cut their quality of goods to make them cheaper. This can have drastic effects on the company’s reputation, pushing it further towards breaking point. The consumer also suffers as worse products will then be on the market.
An investor may no longer believe in a company when it sees it in decline. It will either take steps to fire management or sell their shares to another investor. This can sometimes act as the kiss of death for a company.
Another factor is consumer confidence. Not only are products getting worse, but companies can no longer afford advertising. Brand awareness decreases and consumers lose confidence and motivation to purchase goods. Consumer confidence will drop, again having an effect on companies profits and GDP growth.
For all these reasons, especially high unemployment, avoiding recession is so important, and why that 0.2% shrink can be scary.
Economy under Brexit
Congratulations! You are so close. If you are still reading this, I am impressed that you stuck with this. You can now gain your reward…. Kind of.
What can we expect in the future months under Brexit? Well for this we need to look at the Bank of England’s prediction. So much is undecided at the moment it can be hard to tell, but this is what we can predict to the best of our knowledge.
At the moment the Bank of England is predicting a 1.3% annual GDP growth, down from their 1.5% over 2019 at the start of the year – this is why most economist are not too worried at the moment. Now you may hear Nigel Farage screaming ‘Hooray’, ‘golly good show’ and run off to get his German passport. But it is nowhere near this simple, and we now get to the bread and butter to help you tell a Brexiteer why they are wrong.
The Bank of England has followed four potential path predictions; remain in the EU during the referendum (1), deciding to stay in the EU now (2), coming out the EU with a close relationship varying from a close to a distant (3), and No Deal Brexit varying from a disruptive to disorderly exit (4). We compare the latter with the first two predictions, using GDP (Chart A) and Inflation (chart B).
To explain why remaining in the EU in 2016 straight after the referendum (1) and now (2) and why the latter is worse than it would of been is easy to explain. We have seen the effect of pre-Brexit, as foreign and domestic investors cannot invest and grow at usual rate due to the worrying future of Brexit and the pound crashing (seeing mass inflation) after the referendum. So, we now look at the prediction under the ‘November 2018 inflation report’ (2) which is much weaker than the Bank of England reported we would have seen if Britain had voted to remain in the EU.
The first scenario is an ‘economic partnership under the withdrawal agreement’ (3). It is not too bad a prediction, but not great either. It is more disappointing. Compared to remaining In the EU in 2016 (1), we will see ‘between 1.25% and 3.75% lower’ GDP. Compared to the November 2018 inflation report we will see a ‘1.75% higher [GDP] in the Close scenario, and 0.75% lower in the Less Close scenario’. Inflation with a deal looks promising, due to Sterling increasing in value after remaining within the EU’s trading agreement.
For a No Deal Brexit, predictions are even worse. Compared to remain in the EU (1) we will see an immediate slump, decreasing our GDP by ‘7.75% and 10.5%’. Compared to the November 2018 inflation report (2) we will see the GDP be ‘4.75% and 7.75% lower’. Inflation with a No Deal Brexit is even worse, rising ‘between 4.25 and 6.5%’.
This slump is due to tariffs adding a minimum of 10% tax to imported and exported products which we, the consumer, pay on imported goods. That is a minimum! Lamb tariffs will be at 40% before all deals with counties around the world are sorted, which will most likely be worse than we currently have through the EU and will take years to agree. A straight up lie told by the Brexit campaign is that we don’t have a trading agreement with New Zealand, China, America. We do! It is done through the EU. We trade as a powerful block, meaning tariffs for our exports are virtually 0! How can Brexit improve this especially when we are standing alone?
‘The EU Single Market has substantially reduced trade costs between its members and other countries by removing tariffs on goods trade within the EU, reducing non-tariff barriers to trade within the EU, and providing access to markets beyond the EU through common Free Trade Agreements (FTAs) with third countries’ as reported by the Bank of England. Without this benefit, our country will suffer.
That is all we have to say. We have only scratched the surface. We will be going deeper into many different confusing issues to help you in the future. Well done on reading it all. It was challenging I know; I have read this a few times and there is a lot to learn and understand. I hope you enjoyed the article and have more of an idea of how the economy basically works, and how Brexit will screw us over!
Written by Max Anderson