It is not too early to raise serious questions about the wisdom of British electorate’s vote to leave the European Union (commonly referred to as “Brexit”).
{mosads}Indeed, in the four months since that vote, there have been a number of developments that suggest that the Brexit vote will have put the U.K. on the most difficult of economic paths. Those developments also make it all too likely that the claims of Brexit proponents of a rosier economic future for the U.K. outside of Europe will not be realized.
Among the clearer developments that suggest that the U.K. economy is now in for some tough sledding has been the plunge in sterling. Since the June 23 vote, sterling has now declined by around 18 percent, with little sign that the fall is anywhere near an end.
The sterling depreciation that has already taken place is approaching that which occurred in the wake of the 2008 Lehman Brothers financial crisis and of the 1992 European Exchange Rate Mechanism crisis. It also very much exceeds the infamous 14 percent “pound in your pocket” devaluation of then-Prime Minister Harold Wilson in 1967.
There are at least three reasons to think that sterling will continue its decline in the months ahead. The first is that it appears that Prime Minister Theresa May has opted for a “hard” Brexit. That will almost certainly make it difficult for the U.K. to continue attracting external capital to fund its record external current account deficit, which currently amounts to as much as 6 percent of gross domestic product (GDP).
In an environment of uncertainty as to the U.K.’s future relationship with Europe, which will at best be settled only after two years of tortuous negotiations, foreign investors will be loath to locate in the U.K. their investments aimed at the European single market.
Similarly, with financial firms in the City of London likely to lose their financial passport to Europe, one has to expect that these firms will relocate at least part of their operations in Dublin, Frankfurt or Paris.
A second reason for expecting a further sterling decline is that U.S. monetary policy is likely to become increasingly out of sync with that in the U.K. At a time when the Federal Reserve must be expected to resume raising interest rates, the Bank of England has signaled that it will further loosen U.K. monetary policy in an effort to support a flagging British economy. Higher interest rates in the U.S. than those in the U.K. will make it relatively more attractive for investors to hold U.S. assets rather than those in the U.K.
Yet a third reason for expecting further sterling weakness are the increasing signs that it will be very difficult for the U.K. to negotiate a customized exit arrangement with Europe. As if to underline this point, a European geographic entity as small as Wallonia has very recently managed to block an EU trade agreement with Canada that took more than five years to negotiate.
This must make one think that if a simple trade agreement with Canada could be blocked by Wallonia, which is merely a part of small Belgium, would it not seem very likely that at least one of the other 27 EU member countries will succeed in blocking the very much more complex and consequential exit arrangement that is likely to be negotiated for the U.K.
The U.K.’s own past experience with sharp falls in sterling would inform us that Britain could now very well be in for a prolonged period of stagflation. According to the Bank of England’s own estimates, a 20 percent sterling decline would have the affect of raising the U.K.’s price level by almost 6 percent.
In this context, it is hardly encouraging that U.K. inflationary expectations are already becoming unanchored as suggested by the fact that the British bond market now expects that inflation over the next five years will be around 3.5 percent. That would be well above the Bank of England’s 2 percent inflation target.
An equally important development that would suggest that the U.K.’s economic future outside of Europe might not be as bright as Brexit supporters would like us to believe is the direction in which May’s government is now taking the country.
The Brexiteers had hoped that, free of the shackles of Europe, the U.K. would move in the direction of a free-market economy with less regulation and less government intervention than is characteristic in Europe. Yet, rather than moving in that direction, May seems to be moving in the direction of Tony Blair, a former Labor Party prime minister.
This is indicated by her attacks on large corporations, her backing away from the disciplined fiscal policy of George Osborne, and by her emphasizing that the U.K. economy must become more inclusive.
Sadly, it would seem too much to expect that, politically, Prime Minister May can make an abrupt U-turn and keep the U.K. in Europe. However, one can still hope that at least she might soften her tough position on immigration and regaining sovereignty that might allow the U.K. to avoid the economic hazards of a hard Brexit.
Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.
The views expressed by contributors are their own and not the views of The Hill.