What does robust UK gdp growth show?

Scott Sumner has a very good post on that question, noting that UK gdp growth has been robust and suggesting this refutes uncertainty-based theories of the business cycle.  I see the matter somewhat differently, however.  In standard real business cycle theory, a’la Long and Plosser, a business cycle is defined in terms of comovement and persistence.  The real business cycle “victim” can either take a direct hit to wealth, or by various processes of smoothing and substitution, spread the hit out across various sectors and over time, thereby generating comovement and persistence and thus what we call a cycle.  Taking the direct, concentrated hit isn’t a “cycle” but it still is very painful, in most simple versions of the model it is more painful than doing the smoothing.

Now fast forward to Brexit.  There is no representative agent, and the shock “attacked” the UK economy in the form of an immediate exchange rate depreciation.  That is a hit to wealth, concentrated on import purchases, though with a good deal of smoothing over time, because import purchases are themselves spread out.  Presumably British consumers would prefer the price increases to be more evenly distributed, and not just over imports, but it is easy enough to cite reasons why, in heterogeneous agent models, that won’t happen so easily.  Of course over time, some of this smoothing will occur, as the Brits reallocate domestic production to substitute for the now more-expensive foreign goods, pulling resources away from a broader variety of sectors.

None of this refutes real business cycle theory once you see that the non-cyclical immediate “hit” to wealth is an ever-present option.  The results don’t look like a “cycle,” but they very much fit the overall framework.  But the result is a mix of a super-rapid wealth adjustment, and a super-slow motion series of taxes on imports; I think Scott is a little too distracted by not seeing cyclical action at the usual intermediate frequency.

A while ago I estimated the costs of this “hit” at 5,625 pounds per capita, though since then the British pound has fallen even further, thereby raising those costs.

As for the uncertainty theories, I’m not sure the Brexit story is a good case study for them.  At first I was uncertain as to whether it really would happen, but not very much any more.  It doesn’t seem the market was ever that uncertain about the final results.  A known but surprise event came, and the market knocked down British wealth, mostly bypassing the cycle.

The key point here is that the cycle is an artifact, not something that absolutely has to happen.  The negative wealth effect is a more fundamental category, and we absolutely have seen one of those in Great Britain.

The puzzle here — and it is a very real one — is why economies sometimes get immediate hits to wealth, and no cycle, and other times they have to go through the wringer with an ongoing process of temporal decay.  The answer lies in part with Britain’s nature as an open economy, and the total lack of stickiness in the exchange rate price, but I think there is also more to it than that…


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