More than deregulation is required

One of my more astute colleagues, who is an ardent Remainer, recently played devil’s advocate by asking whether the UK was likely to gain anything by diverging from the EU’s regulatory regime. After all, regulation represents a business friction which raises costs and lowers output. This is an interesting question which goes to the heart of the economics of leaving the EU and it is worth setting out some of the issues in detail. 

The first point is that the UK is already one of the least regulated economies in Europe, with OECD data showing that it has one of the least regulated product markets and the most deregulated labour market  in the EU. The corollary is that the bang for the buck from additional deregulation would be limited. There are some who believe that legislation such as the Working Time Directive is a hindrance but I am not sure that the majority of workers would necessarily be in agreement, since it guarantees them the right to benefits such as paid holidays. In any case, measures to increase labour input do nothing to resolve one of the economy’s bigger long-term challenges of low productivity. Working longer hours allows you to produce more but does not raise output per hour.

One of the features of the forecast in the BoE’s Monetary Policy Report, released on Thursday, was the downgrade to the medium-term rate of potential growth. When the exercise was last conducted a year ago, the Bank estimated it at 1.4% but it is now put at 1.1%. Compare this with the period 1998 to 2007 when the economy was estimated to have a potential growth rate of 2.9% (my own estimates are shown in the chart below). The underlying reason for this downgrade is the rate of productivity growth which has slowed from a rate of 2.2% in the decade prior to the crash of 2008 to just 0.5% subsequently. It is notable that for many years the BoE assumed that productivity growth would recover, if not to pre-crash levels at least to something higher than of late. This time, however, it has thrown in the towel and acknowledged that a recovery is unlikely in the near-term. This partly reflects cyclical factors, with some evidence of labour hoarding, but structural factors also play an important role. Brexit is expected to compound the difficulties, with trade frictions likely to weigh on productivity, and even though a modest recovery is expected over the next 2-3 years, the economy’s speed limit is not expected to recover very far which calls into question Sajid Javid’s ambition to restore UK growth rates to “between 2.7 and 2.8 per cent a year”.

Regulatory changes are thus going to have little impact on the UK growth rate unless there is a game-changing boost to productivity growth as a result. One possible way for this to happen might be through a surge in foreign investment which significantly boosts the capital stock. If, for example, there is a huge increase in Chinese or US manufacturing capacity in the UK, it could benefit from productive FDI in a similar fashion to Ireland which has been supported by the actions of US multinationals over the last three decades. It’s not totally impossible now that China is the UK’s “new best mate” following the decision to allow Huawei a role in building the 5G network, but I wouldn’t hold my breath. 

Nor should we expect the UK to derive the same apparent deregulation boost that it enjoyed in the 1980s during Thatcher’s term of office. For one thing, the idea that the recovery in the UK’s performance was all down to deregulation is bit of a myth. It also owed a lot to the reallocation of economic resources that came about as a result of the decision to stop providing subsidies to heavy industry. When people think of 1980s deregulation they think of the privatisation programme that reduced the size of the state. But the evidence that it actually improved the economy’s performance is limited: Some things worked, some things didn’t. Admittedly the 1980s Tory administration did break the stranglehold of trade unions which did ultimately help to improve productivity. One industry that did benefit from deregulation was financial services with the Big Bang of 1986 helping to revitalise London as a global financial centre. However, one of the downsides of the reforms of the 1980s is that it was associated with a significant widening of income inequality (chart below) with the excesses in the City of London standing as a metaphor.

Furthermore, in contrast to the situation today, growth in the 1980s was helped by the last of the baby boomers entering the labour force which was a major contributory factor in helping to boost the labour contribution to growth and enabling a potential growth rate which averaged around 2.8% throughout the decade. Then of course, the economy was sheltered by the advent of North Sea oil output which provided a windfall gain to the government. And whatever else people may think about Thatcher’s economic policy, she did recognise the importance of the EU as a market for British exports and was one of the prime movers behind the creation of the single market.

The position today is much less favourable. You simply cannot deregulate your way to prosperity, particularly in a world where the Chinese can produce everything on a bigger scale and more cheaply. There are greater headwinds from demographics as the population ages and the economic speed limit is correspondingly reduced. Consequently the lessons from the 1980s are not a blueprint for the post-Brexit economy. What will mitigate the economic damage are as close relationships as possible with the UK’s main trading partners but the recent rhetoric from the government does not sound very promising in this regard. The old saying that empty vessels make most noise is a phrase we should bear in mind when we listen to the British government issue its “demands”. Its hand became a lot weaker on Friday night and if ministers have not recognised it yet, they soon will.