After the Brexit referendum, the pound fell and so did economic growth. But although the primary mechanism by which Brexit will affect the UK economy is trade, growth in the non-tradeable sector actually fell by much more than in the tradeable sector.
The former refers to aspects of economic activity which can realistically only be consumed inside a given country, like healthcare, food provision, and construction; while the latter refers to goods or services which could feasibly be exported (such as manufactured goods, or agricultural production).
In a recent research paper we show that if Brexit affects expectations about future productivity growth in the traded sector, we can explain this somewhat counterintuitive short-run impact.
The macroeconomic adjustments to the Brexit vote
Figure 1 shows successive IMF forecasts for UK GDP growth before and after the Brexit referendum. Similar patterns hold for other economic forecasters.
What is behind this slowdown? To characterize the macroeconomic adjustments of the UK in more detail, we have built a novel UK macroeconomic data set for the UK tradeable and non-tradeable sectors.
Figure 2 decomposes economic activity into tradeable and non-tradeable gross value added. While the two sectors show a parallel trend prior to the referendum, there is a sharp break in the growth rate of the non-tradeable sector afterwards.
This is perhaps surprising, as Brexit is expected to primarily affect the tradeable sector of the UK.
Figure 3 reveals that the different patterns in tradeable and non-tradeable activity are the flipside of a change in relative prices. The figure presents the relative price of non-tradeable to tradeable output together with the real effective exchange rate.
According to basic economic theory, these are closely related concepts. It is evident that the UK real exchange rate depreciates sharply following the referendum, meaning that non-tradeables goods and services have become relatively cheaper than tradeable ones.
While in the period following the June 2016 referendum, no specific policies related to Brexit had actually been implemented yet, the relatively higher price of tradeable goods and services has provided a temporary ‘sweet spot’ for producers in the tradeable sector.
A simple economic interpretation: negative news about productivity in the tradeable sector
The specific consequences of Brexit are likely to result in a slowdown of productivity growth in the tradeable sector: increased trade barriers, reduced capital flows and impediments to labor mobility can all be linked to reduced productivity of tradeable goods and services.
So why did tradeables actually do better after the Brexit vote? Our model provides a simple and intuitive formal framework to explain this.
We simulate of how firms and households respond to news about future productivity in the tradeable sector. The macroeconomic dynamics triggered by news about a disruption in the tradeable sector are consistent with the broad patterns in the data following the referendum.
The intuition behind this insight is that in the long-run, relative prices are determined by the relative efficiency in producing different goods and services. This implies that slower productivity growth in tradeables will make their prices go up.
Furthermore, when firms and households learn about future changes to productivity growth, they change their behaviour immediately
So what happened at the time of the Brexit referendum? Productivity didn’t change, but firms and households learned that it was likely to grow more slowly in the future, and so the exchange rate fell.
This was good news for the tradeable sector – in the short term – because it made UK firms more competitive at home and abroad, even though it’s bad news in the long run. By contrast, since overall the fall in the exchange rate makes UK consumers poorer, non-tradeables suffered.
So the tradeable sector performed relatively well, not in spite of the Brexit vote, but because of it. Over the long run – as the actual effects of Brexit materialize – these relative impacts will reverse.
By Thomas Drechsel, assistant professor, University of Maryland