The paradox of uncertainty

A certain level of uncertainty is part of life, and insurance (both private and public) and precautionary savings help manage this so that we can go about our lives unabated. At times, however, uncertainty increases well beyond these levels, often driven by political events. Faced with such uncertainty shocks, business managers will often freeze new investment and hiring decisions, while consumers delay spending on big ticket items such as cars or the purchase of a new home. Investors, in turn, may opt to reallocate their portfolios towards safer asset classes, such as triple-A rated government bonds. At the micro level, each of these behaviours make perfect sense. At the macro level, however, these combined behaviours will weigh on economic growth and can result in a self-fulfilling negative spiral.

Brexit offers an interesting case study as to how these mechanisms can play out in practice. It is now just over two years since the British electorate voted by referendum to leave the European Union. While few observers doubt that the United Kingdom will formally leave the European Union on 29 March 2019 at the stroke of midnight, significant uncertainty remains with regards to the transition period and the future relationship that the United Kingdom will enjoy with the European Union, and not least with respect to trade. There can be little doubt that this uncertainty is costly, as testified by the many calls for speedy progress on the Brexit talks from both business managers and trade unions.

Gauging just how much of a toll the Brexit uncertainty has already taken on the British economy is no easy feat. Just looking at the numbers, it is clear that the sharp depreciation of Sterling that followed in the wake of the referendum has already taken a toll on household spending power by lifting imported inflation. Moreover, there is evidence to suggest that overall growth may have been further hindered by Brexit uncertainty. Taking the consensus outlook for 2018 of economists surveyed by Bloomberg, this stood at 2.2% just before the referendum and now stands at just 1.4%. In contrast, the 2018 forecast for the euro area has been lifted from 1.6% to 2.3% over the same period. While it is debatable just how much of the divergence can be blamed on Brexit uncertainty, there is little doubt that Brexit is weighing down UK growth.

Michala Marcussen, Societe Generale’s Group Chief Economist

Michala Marcussen, Societe Generale’s Group Chief Economist

President Trump would be well to consider the mechanics of the Brexit uncertainty as he pursues his trade policy. A simple back of the envelope calculation finds that the latest tariff announcements from Trump of 25% on $50bn of US imports from China will add around 0.4 percentage points to US import prices. If the amount concerned by the 25% tariff increases to $250bn as threatened by President Trump, then import prices would mechanically go up by 2.0 percentage points, all else being equal. Even then, this would still have only a modest impact on the spending power of US households. Adding retaliatory measures increases the impact, but the real damage could come from uncertainty if US companies decide to slow investment and hiring plans. The next Beige Book due for release by the Federal Reserve on 18 July will offer important clues as the uncertainty channels. Moreover, should financial markets become more worried about these threats, more negative effects could result.

Back in Europe, the threat of trade wars, Brexit uncertainty and concerns over the political situation in both Italy and Germany is beginning to weigh on business confidence. And, in the case of Italy, government bond yields have increased factoring in higher risk. So far, this remains manageable and confidence indicators for the euro area still remain in expansion territory. History teaches, however, that while economies can bounce back quickly from short-lived uncertainty spikes, prolonged periods of heightened uncertainty can prove very costly and ultimately become the cause of an economic slowdown. Such is the paradox of uncertainty.