the current uncertainty could affect the economy for almost two years

The recent dramatic events leading to the resignation of UK Prime Minister Boris Johnson on July 7, 2022 raise the question of how politics – and more specifically economic policy uncertainty – affects the UK economy. The answer, of course, is that it is, and sometimes for as long as two years.

News of Johnson’s resignation produced a small rally in sterling, which was limited by expectations of his exit after a flood of ministerial resignations in the previous days. The likelihood of a recession in the UK has probably had more of an impact on the pound recently, but a rise in political certainty after days of speculation over Johnson’s resignation appears to have boosted the pound. This certainty will of course be short-lived since we now have to wait for the result of a race for the leadership of the Conservative Party.

Any major policy shift like this will also create uncertainty around economic policy. This can be measured by following discussions of this uncertainty in newspapers, as well as surveys of economic forecasters, for example. Recent research I conducted with Michael Ellington and Marcin Michalski, also from the University of Liverpool, uses this data from the Economic Policy Uncertainty research project to show that growing uncertainty about UK economic policy can hurt growth of GDP up to 12 months. It may also ripple through UK financial markets – in the form of higher long-term borrowing costs and increased volatility in UK bond, currency and equity markets – for 20 months.

These unwelcome developments will continue to cause the UK economy to contract – unless, of course, economic policy uncertainty eases. For now, it is hoped that Johnson’s resignation, followed by the fairly quick appointment of a new prime minister, will go some way to ensuring political and economic stability.

But since a quick reappointment is unlikely, it’s worth considering exactly how – and to what extent – the lingering uncertainty might affect economic indicators such as the value of the pound.

Here are three graphs that provide some information:

1. The impact of uncertainty on the pound sterling

The pound sterling reflects investor confidence in the UK economy. Growing economic uncertainty is expected to push the pound lower. The recent surge in economic policy uncertainty following the chaotic events surrounding the end of Johnson’s term is actually very subdued compared to events like the 2016 Brexit referendum or the start of the pandemic. of COVID in March 2020.

The chart below compares economic policy uncertainty (in red) with the value of the British pound against the US dollar, showing that the correlation is limited. Correlation is measured as a range of 1.0 to -1.0 (with zero, the midpoint, meaning there is no correlation). This lack of strong correlation holds for both the 12-month growth rate of the pound against the dollar (in blue with a correlation of -0.18), as well as the two-year moving average (in gray with a correlation of -0.22). In other words, economic policy uncertainty affects the pound, but it only accounts for a small part of any change in its value.

British pound against US dollar versus economic policy uncertainty.
Bank of England, www.policyuncertainty.com/uk_monthly.html

Indeed, the most recent drop in the value of the British pound (which was 13% weaker against the dollar in July 2022 compared to 12 months ago, and 10.5% lower than the two-year average) is more likely related to concerns about the weakness of the UK economy. According to the OECD, British growth is expected to be the worst in the G20 in 2023, with the exception of Russia. The prospect of the UK entering recession, as recently predicted by policymakers at the Bank of England, has been a far more powerful force for the pound than uncertainty.

2. The impact of certainty on UK business investment

Economic policy uncertainty is also affecting UK business investment – ​​or the amount of money investors are willing to pour into the UK economy. Unsurprisingly, greater economic policy uncertainty is making UK businesses less willing to invest (see Chart 3) until the fog of uncertainty is lifted.

But even when the government gives hints about future plans, it doesn’t always tip the scales. For example, the new Chancellor of the Exchequer, Nadhim Zahawi, wants to revive the British economy by revising the planned increase in corporation tax from 19% to 25%. The theory is that removing the planned increase will encourage UK business investment, which will ultimately boost UK GDP growth.

At 19%, however, the UK corporate tax rate is already four percentage points lower than the corporate tax rate of other OECD countries. The graph below shows that the growth of business investment is not strongly related to the average corporate tax rate in OECD countries (indicated by the difference with the UK rate in the graph, correlated to -0.15). The prospect of canceling the planned increase in the UK corporate tax rate will therefore not have a major impact on UK business investment. Apart from the fact that the UK corporate tax rate is already lower, this shows that corporate investment decisions are only weakly linked to tax policy.

Line chart
UK business investment growth and corporate tax rates (UK minus OECD average rate)
Office for National Statistics, OECD

3. The impact of economic policy uncertainty in relation to potential tax changes in the UK

However, the following chart shows that business investment growth and economic policy uncertainty are more likely to move together (with a correlation of -0.36). In other words, economic policy uncertainty actually has a more powerful effect on business investment than proposed changes in UK corporate tax policy.

It should also be noted that the UK Office for Budget Responsibility has warned of a worsening outlook for UK public finances, undermining the new chancellor’s hopes of a tax cut, as it would contribute to the deterioration of finances public.

UK business investment growth versus economic policy uncertainty.
Office for National Statistics, www.policyuncertainty.com/uk_monthly.html, Author provided

Johnson’s resignation should lead to a more normal functioning of government in the UK, paving the way for less uncertainty in economic policy. This is clearly a good thing. As my research in this area shows, uncertainty can have an economic effect of up to two years. Given the current outlook for the UK economy, we need as much certainty as possible.

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