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The current uncertainty could affect the economy for nearly two years

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The recent dramatic events that led to the resignation of the UK prime minister, Boris Johnson, on July 7 2022 raise the issue of how politics — and economic policy uncertainty — more specifically affects the UK economy. . The answer, of course, is it does, and sometimes up to two years.

News of Johnson’s resignation produced a small rally in sterling, which was limited by expectations of his departure after a flood of ministerial resignations in earlier days. The possibility of a recession in the UK has likely had more of an impact on the pound recently, but an upward mark on political uncertainty following days of speculation if Johnson will resign seems to have strengthened sterling. This certainty, of course, is short -lived because we will have to wait for the result of a Conservative Party leadership contest.

Any major political change like this will also create uncertainty in economic policy. This can be measured by monitoring the discussion of such uncertainty in newspapers, as well as surveys by economic forecasters, for example. Recent research I conducted with Michael Ellington and Marcin Michalski, also from the University of Liverpool, uses such data from the Economic Policy Uncertainty research project to show that growing uncertainty about economic policy of the UK could hurt GDP growth for up to 12 months. It could also flow into UK financial markets — in the form of higher long -term borrowing costs and increased volatility in UK bonds, foreign exchange and stock markets — in as little as 20 months.

Such unfavorable developments will continue to cause the UK economy to contract — unless, of course, economic policy uncertainty recedes. For now, the hope is that Johnson’s resignation, followed by a relatively quick appointment of a new prime minister, will go in some way toward providing political and economic stability.

But since a quick new appointment isn’t likely, it’s worth looking at exactly how — and how much — continued uncertainty could affect economic indicators like the value of the pound.

Here are three charts that provide some insight:

1. The effect of uncertainty on sterling

Sterling reflects investor confidence in the UK economy. Rising economic uncertainty should push the pound down. The recent increase in economic policy uncertainty following the turbulent events associated with the end of Johnson’s premiership is actually very mild compared to events like the 2016 Brexit referendum or the start of the COVID pandemic in March 2020.

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

UK political resignations: Current uncertainty could affect the economy for almost two years

Sterling against the US dollar against economic policy uncertainty. Credits: Bank of England

In fact, the most recent fall in the value of sterling (which was 13% weaker against the dollar in July 2022 compared to 12 months ago, and 10.5% less than the two -year average) is more likely to be related to concerns. about the weakness of the UK economy. According to the OECD, UK growth is set to be the worst in the G20 in 2023, apart from Russia. The prospect of the UK entering a recession, as recently forecast by Bank of England policymakers, has become a stronger force in sterling than uncertainty.

2. The impact of some certainty on business investment in the UK

Uncertainty in economic policy also affects business investments in the UK — or the amount of money investors are willing to put into the UK economy. Not surprisingly, the greater uncertainty in economic policy makes business less willing to invest in the UK (see chart 3) until the cloud of uncertainty disappears.

But even if some indication of future plans is given by the government, it does not always provide balance. For example, the exchequer’s newly appointed chancellor, Nadhim Zahawi, wants to start the UK economy by reviewing the planned corporate tax increase from 19% to 25%. The theory is that scrapping the planned increase will encourage business investment in the UK, which will ultimately increase UK GDP growth.

UK political resignations: Current uncertainty could affect the economy for almost two years

UK business investment growth and corporate tax rate (UK minus OECD average rate). Credits: Office of National Statistics, OECD

At 19%, however, the UK corporate tax rate is four points lower than the corporate tax rate in other OECD countries. The chart below shows that business investment growth is not very much connected to the average corporate tax rate in OECD countries (shown as the difference in the UK rate in the chart, which is related to -0.15). The prospect of reversing the planned UK corporate tax rate increase will not have a significant impact on business investments in the UK, therefore. In addition to the lower corporate tax rate in the UK, it shows that business investment decisions are only weakly linked to tax policy.

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

The following chart, however, shows business investment growth and economic policy uncertainty are more likely to move in line with each other (in a correlation of -0.36). In other words, economic policy uncertainty actually has a stronger impact on business investments than the proposed changes to UK corporate tax policy.

It is also noteworthy that the UK Office for Budgetary Responsibility has warned about the deteriorating outlook on UK public finances, weakening the new chancellor’s hopes for tax cuts as it will add to deteriorating public finances.

UK political resignations: Current uncertainty could affect the economy for almost two years

Growth of business investment in the UK versus economic policy uncertainty. Credits: Office of National Statistics

Johnson’s resignation should lead to more normal functioning of the UK government, 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 impact on the economy for up to two years. Given the current outlook for the UK economy, we need all the assurance we can get.

Companies have changed their global supply chains in profound ways due to Brexit, US-China trade war and COVID

Additional information:
Michael Ellington et al, Of votes and viruses: the UK economy and economic policy uncertainty, The European Journal of Finance (2022). DOI: 10.1080/1351847X.2022.2083978

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