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Damaging uncertainty

Policy uncertainty can do long-lasting damage to productivity and hence to future growth
Damaging uncertainty

Next week’s purchasing managers’ surveys are likely to report that both manufacturing and construction activity are weak. One reason for this, of course, is that uncertainty about Brexit is causing companies to delay investing in both new capital and in export efforts. The University of Tubingen’s Gernot Müller and colleagues estimate that by 2020 this uncertainty will result in the UK economy being 4 per cent smaller than it would otherwise be.

It’s not just output that’s suffering from Brexit uncertainty. It’s possible too that productivity is as well. One reason for this is that companies don’t immediately lay off staff when demand falters, but instead get them to do other jobs such as non-essential maintenance and repairs. The UK’s factories might not be very productive, but they are nice and clean.

There are other channels whereby uncertainty reduces productivity. One is that it causes companies to delay investing in labour-saving technology until they can be more confident that there’ll be enough demand to justify the outlay. There’s no oddity in employment increasing at a time of uncertainty. Faced with such uncertainty companies prefer to hire labour, which they can cut in a downturn, rather than be lumbered with expensive capital equipment.

Secondly, uncertainty deters companies from entering new markets or expanding if they are in them. This reduces competition, which means that incumbents have less incentive to increase efficiency. Smaller companies are especially hit by uncertainty as they have fewer ways of coping with bad times. It’s no accident that their borrowing has flatlined in recent months.

Thirdly, it is exporters who are being especially hard hit by Brexit uncertainty and it is these who tend to be more efficient than the average company. Brute maths, says Stanford University’s Nick Bloom, means that this depresses productivity.

You might object that these are all temporary effects, and that we could see investment boom once uncertainty is resolved as companies finally implement plans they’ve put on ice.

Don’t bet on it. For one thing, the uncertainty might be resolved by the worst possible outcome actually materialising. And for another, even if a smoothish Brexit is achieved, there’ll still be months of wrangling about the UK’s future trading arrangements with the EU.

But there’s something else. Uncertainty can have long-lasting effects. For example, memories of the Great Depression in the 1930s suppressed share prices and wage demands in the 1950s; people who spend their formative years in recessions own fewer equities than others even decades later; and memories of the withdrawal of credit lines in 2008-09 are making some companies reluctant to borrow even now. It’s possible therefore that the memory of today’s uncertainty will depress animal spirits for years to come, as potential entrepreneurs remember that the state is not always their friend.

One big fact supports these hypotheses. It is that economic policy uncertainty (as measured by Professor Bloom and colleagues) is strongly positively correlated with the dividend yield on the All-Share index and negatively correlated with 10-year index-linked yields: the correlations are 0.42 and minus 0.51, respectively, since data began in 1998. This is consistent with financial markets believing that uncertainty reduces future growth.

Margaret Thatcher and Gordon Brown disagreed about a lot, but they agreed on one big thing – that businesses need a stable policy framework if they are to invest and grow. They were right.