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The Brexit vote impact: What does the uncertainty mean for the economy?

Press Release of August 10, 2016

DIW Berlin study shows that Brexit vote-related uncertainty will do considerable damage to the European and German economies in a way that will be noticeable even two years from now – since the German economy is primarily affected by sinking business investment, policy should be more oriented toward promoting investment

Uncertainty plays a major role in the economy overall – but what are the consequences when financial markets, businesses, and consumers are affected all at once, as in the case of the recent Brexit vote? The German Institute for Economic Research (DIW Berlin) sought to answer this question by isolating the effects of the Brexit vote-related uncertainty shock using a counterfactual analysis. (The authors emphasize that the study should not be considered an economic forecast.) The result: even after several months, the impact of the unexpected Brexit vote outcome will still be noticeable in GDP, unemployment, and the consumer price index. According to the model calculation, euro area GDP will be roughly 0.2 percent lower eight months from now. Due to its openness and dependence on trade, the German economy will be even more strongly affected: in this case, GDP will be 0.4 percent lower. The consensus among the experts: “Even after two years, GDP will still be below the level that would have been in a no-shock scenario.” 

DIW macroeconomists Malte Rieth, Claus Michelson, and Michele Piffer focused solely on the uncertainty shock that resulted from the Brexit vote on June 23. “We wanted to accurately quantify this single aspect,” said Rieth. “To that end, we held all other factors affecting the German and euro area economies constant.” To measure the uncertainty, the economists examined the respective volatility indices for the EURO STOXX 50 and the German stock index (DAX). Both indices spiked on the morning following the Brexit vote.

The decline in German economic performance will be primarily due to a drop in investment activity, which could amount to one percent. “The German economy is suffering more from the uncertainty than is the euro area as a whole: our manufacturing sector is very export-oriented and will feel the direct effects of the weaker demand from the UK,” explains Rieth. 

Machinery investment experiences strongest decline

The shock will also have lasting effects on investment across the euro area as a whole: within a year, investment will drop by 0.7 percent, with the lowest point being reached after six to tenth months in most countries. In the case of German investment, the reaction will be slower but stronger: the negative impact will only be fully felt after one year. Machinery investment will be affected the most, but businesses will also be investing significantly less in metal products and electronics. The uncertainty will have little impact on construction investment and R&D, however, since these projects are longer-term and thus less responsive to increases in uncertainty.

The uncertainty will affect other aspects of the economy as well: “The unemployment rate won’t be dramatically affected, but it will be noticeably higher than it would have been in a no-Brexit scenario. Similarly, consumer price development will continue to be weak as a result of the Brexit vote,” said Rieth. “Given the already low inflation, this is particularly troubling.”

To reduce economic insecurity for businesses, the future relationship between Britain and the EU should be clarified as soon as possible. According to the study’s authors, policy should be designed to directly promote business investment, as suggested by the Experts Commission in their 2015 proposal for strengthening investment in Germany. In addition, the government must invest more, since this is an important condition for increasing private investment.