Daily Times

On Monday, Her Majesty’s Treasury released a report claiming that a “Leave” vote in the June 23rd referendum on whether the United Kingdom should leave the European Union would plunge the British economy, which has been growing modestly for the past couple of years, into a slump. The report says that, in the event of “Brexit,” the unemployment rate would jump, while G.D.P., house prices, the stock market, and the value of the pound sterling would all be hit hard. To emphasize this message, the Treasury posted a big headline on the home page of its Web site: “UK economy would fall into RECESSION if Britain leaves the EU.” In case the message wasn’t clear, the word “RECESSION” was printed in red, with cracks in the letters.

What Treasury mandarins of the old school thought of this, I have no idea: they dealt in understatement and sangfroid. But, with the direction of the country at stake, not to mention the political fates of Prime Minister David Cameron and the Chancellor of the Exchequer, George Osborne, the government is doing all that it can to raise fears about the consequences of a decision to quit the E.U. Appearing alongside Osborne at a home-improvement store in Eastleigh, Hampshire, Cameron described Brexit as the “self-destruct option,” adding, “It’s about you, about your money and your life. The stakes couldn’t be higher; the risks couldn’t be greater.”

No sooner had the Treasury report been released than leaders of the Leave campaign tried to discredit it. Campaigning in York, Boris Johnson, the former mayor of London, denounced it as propaganda. Nigel Lawson, who was Chancellor under Margaret Thatcher, claimed that the Treasury officials who prepared it had been “made to prostitute themselves in the cause of a political campaign.”

More damagingly, the report was also criticized by some less partisan sources. Oxford Economics, a respected consultancy, said that the Treasury’s central forecast-that G.D.P. would fall 3.6 per cent in the case of a decision to quit the E.U.-was “a worst-case scenario,” and almost three times as large as its own estimate. Katie Allen, an economics reporter for the Guardian, highlighted the Treasury forecast’s unrealistic assumption that monetary and fiscal policy wouldn’t change after a Leave vote. And Nicola Sturgeon, the pro-E.U. first minister of Scotland, recalled the 2014 referendum in which Scots voted not to become an independent country, saying that the build-up to that vote showed how “that kind of fear-based campaigning starts to insult people’s intelligence and can start to have a negative effect.”

Each of these criticisms has some force, particularly the last one. With just over four weeks until the referendum, the “Remain” side is retaining a steady lead in opinion polls-seven percentage points in the poll of polls in Financial Times-and British bookies are offering odds of around 4:1 on a Leave vote, against 1:6 for remaining. The last thing the government needs, at a point when it appears to be winning the debate, is to have its credibility called into question.

But despite the critiques, the central argument that the Treasury report makes is a sound one. Britain has been a member of the E.U. for more than forty years, and a decision to go it alone would create a period of economic uncertainty for businesses and households, which could in turn have a negative impact on spending. Whether this negative shock would be sufficient to cause an economy that grew at a rate of 2.2. per cent last year to fall into recession can be debated-a lot would depend, as the Guardian’s Allen pointed out, on the policy response. But the effect would be considerable.

Consider what might happen if the Leave side did prevail. Right now, the financial markets are expecting the opposite outcome, and that belief is reflected in asset prices. If the referendum result is a surprise, the stock market, the bond market, and the pound sterling would all fall simultaneously. Quite conceivably, the tremors would spread to other markets around the world. And, if investors interpreted the British decision as a precursor to a broader breakup of the E.U., this contagion could be quite serious.

At the same time, there would be a political crisis in the U.K. Cameron, who has staked his reputation on obtaining a Remain vote, would almost certainly either resign or announce his intention to do so. The Conservative Party would have to select a new leader, who would succeed Cameron as Prime Minister. Even if this process could be carried out expeditiously, there would be calls for another general election. (The last one took place a year ago.)

Meanwhile, the British government-whoever was leading it-would have to start negotiating the mechanics of the withdrawal, which would be complicated. Under Article 50 of the Treaty on European Union, a member state that wants to leave has to reach a formal agreement with the European Council, which comprises the heads of state of all E.U. members, along with the presidents of the Council and the European Commission. Once such a deal had been finalized, the European Council would have to approve it by a qualified majority.

That would only be the beginning of the transition process. To secure market access for all the goods and services that it exports, Britain would have to reach new trade agreements with the E.U. and many other countries, including the United States. (In April, President Obama, in an effort to strengthen the Remain campaign, said that Britain would be at “the back of the queue” for such a deal.) Plus, because E.U. rules would no longer apply to Britain, the country would have to overhaul its legal and regulatory systems in many areas.

These processes, the Treasury report says, “would be complicated in their own right, but conducting them all at the same time, on any terms that would be acceptable to the UK and within the specified two-year period for leaving the EU would almost certainly be impossible. If these processes were more protracted, the uncertainty would be larger.”

How can the likely impact of this uncertainty on the economy be quantified? One defensible argument is that it can’t be, or not convincingly. A vote to withdraw would place Britain in an unprecedented situation, and it is very hard to predict how businesses, households, and policy makers would react. Initially, economic confidence would almost certainly take a hit, and precautionary saving would increase. Beyond that, we can’t say very much.

But, rather than throw their hands up, the Treasury forecasters adopted an approach pioneered by Nicholas Bloom, a British economist who is now at Stanford. This method involves using various data sources (such as surveys of businesses and employees, and measures of financial volatility) to construct a numerical index of uncertainty; running a statistical regression to gauge how changes in uncertainty affect consumption and capital spending; and, finally, plugging these findings into a macroeconomic model that spits out forecasts for G.D.P. growth, unemployment, and other important variables.

In carrying out such an analysis, a key issue is how far the uncertainty index would rise in response to a Leave vote. The paper examines two possibilities: a “shock” scenario, in which the index jumps by one standard deviation (and G.D.P. falls by 3.6 per cent over two years), and a “severe shock” scenario, in which the uncertainty index jumps by one and a half standard deviations (and G.D.P. falls by six per cent over two years). Compared to previous periods during which uncertainty has risen sharply, these assumptions don’t seem unreasonable. During the financial crisis of 2007-2009, for example, the uncertainty index rose by about five standard deviations; in the recession of the early nineteen-nineties, it jumped by 3.5 standard deviations. Courtesy – The New Yorker