Abstract
Conventional estimates suggest that the 2007–2009 financial crisis reduced UK potential output by 3.8–7.5% of GDP. This implied a need for fiscal tightening as the structural budget deficit had increased considerably. The austerity that followed led to the rise of UKIP, the EU referendum and the vote for Brexit. Brexit will reduce potential output by somewhere between 3.9 and 8.7% of GDP. Thus, it can be argued that the total fall in UK potential output due to the banking crisis is between 7.7 and 16.2% of GDP—approximately double the conventional estimate.
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Notes
See, for example, OECD (2012) which gives projections for post-crisis growth in OECD economies. The assumption explicitly stated was that the crisis would reduce the level of potential output by 2.5% on average but have no effect on the post-crisis trend rate of growth.
It should be noted that these are comparisons based on a zero output gap in each case. These do not include the actual GDP losses which accrue during the post-crisis recession before the output gap is closed.
In a companion paper, it is reported that trend productivity growth estimated using an HP-filter method was only 0.7% in 2007 compared with 2.1% in 2000 (Ollivaud et al. 2016). Discussions of the ‘productivity puzzle’, for example, by ONS (2018), typically measure the shortfall in actual labour productivity compared with an assumption that pre-crisis trend productivity growth was around 2% per year. In any case, the levels adjustment in potential output may be a contributing factor to this puzzle but is far from a complete explanation.
The Institute for Fiscal Studies is a highly respected think tank which produces an authoritative analysis of the UK fiscal situation every year in its ‘Green Budget’.
Table 3 shows that the 20 districts most affected by cuts in tax credits generally gave big support to Leave—more than 60% vote shares in 15 of the 20. Tax credits are a benefit that matters a lot to areas with weak socio-economic fundamentals. This illustrates Fetzer’s argument.
The authors conjecture that the swing back to Remain may be stimulated by increased awareness of possible negative consequences of Brexit.
These are the assumptions made by the vast majority of studies. Erken et al. (2018) argue that Brexit would reduce the rate of growth (rather than the level) of GDP by 0.8% per year and thus have a much bigger long-run impact. Minford (2015) predicts a positive impact on GDP largely because Brexit will mean escaping onerous future regulation which would lower GDP substantially if the UK stayed in. I disregard both these estimates.
Emmerson et al. (2016) estimated that a decline of 1% in GDP due to Brexit would increase new public sector borrowing by 0.7% of GDP and that a reduction of 0.6% in GDP would approximately cancel out the improvement in the public finances from ending the UK’s net budgetary contribution. So, the net effect of ‘hard Brexit’ would be (8.7 − 0.6) × 0.7 = 5.67% of GDP.
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Acknowledgements
I am grateful to Nauro Campos and two anonymous referees for comments which significantly improved an earlier draft of this paper. I have also benefited from helpful discussions with Sascha Becker, Graham Hacche and Marcus Miller. I am responsible for any errors or omissions.
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Crafts, N. The Fall in Potential Output due to the Financial Crisis: A Much Bigger Estimate for the UK. Comp Econ Stud 61, 625–635 (2019). https://doi.org/10.1057/s41294-019-00094-z
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DOI: https://doi.org/10.1057/s41294-019-00094-z