A More Prosperous United Kingdom?

Brexit supporters are now looking forward to a more prosperous future for the United Kingdom outside of Europe. Their hopes, however, rest on two highly questionable premises. The first is that the short-term economic and political costs of exiting Europe will be very much smaller than the long-term gains to be derived from being outside of Europe. The second is that the UK will now be in a political position to free itself from excessive European regulation and to undertake those economic reforms that might place the country on a faster economic growth path.

Developments in the immediate aftermath of the Brexit vote should be concentrating minds as to how costly the UK’s exit from Europe is likely to be. In the space of just two days, sterling declined by around 11 percent making it by far the largest such two-day decline in the currency’s history. Meanwhile, domestic and global equity markets became unhinged with around $3 trillion wiped off global equity valuations, while populist leaders in France, Italy, and the Netherlands argued that their countries too should hold exit referendums.

Equally troubling, the referendum has turned UK politics upside down. Prime Minister David Cameron was forced to resign, opening the way for a bitter Conservative Party leadership fight over the next two months. At the same time, the opposition Labor Party was thrown into disarray by a leadership challenge to Jeremy Corbyn. Meanwhile Nicola Sturgeon, the leader of the Scottish National Party, has given notice that a second Scottish independence referendum is very much on the table. She has also intimated that Scotland could precipitate a UK constitutional crisis by refusing to approve any decision by the UK parliament to formally begin the divorce negotiations with Europe.

Political turmoil is the last thing that the UK needs at a time that it will be negotiating its future relationship with Europe. These negotiations, which will take at least two years, are already seriously undermining household and investment confidence in the UK economy as they raise basic questions about the UK’s future European relationship. There is also the risk that political uncertainty will only accelerate the London-based banks’ efforts already underway to relocate parts of their operations to Dublin, Frankfurt, and Paris in anticipation of their losing their European financial passports.

All of this uncertainty has to be highly concerning since it is occurring at a time that the UK is running an external current account deficit of 7 percent of GDP, which is the highest such deficit in the post-war period. The financing of that deficit requires that capital continue to flow into the country in very substantial amounts. This makes it all too likely that we are only at the start of a prolonged period of considerable sterling weakness.

If there would be a further major decline in sterling, there is every prospect that the UK would experience a deep economic recession as it has done on the occasion of previous sterling crises. It is also all too likely that sterling weakness would further unhinge global financial markets. That would constitute yet another headwind for the UK and global economic recoveries and it would put further wind in the sails of European populist parties.

Brexit supporters are certainly right to think that, freed from its European shackles, the UK would have the potential to deregulate its economy and to unleash its entrepreneurial and innovative spirit. However, the crucial point that they seem to be overlooking is that one requires the right domestic political conditions to be in place in order to successfully pursue policies of economic liberalization and reform.

The one thing that we should have learnt from recent European and US experience is that difficult economic conditions all too often give rise to political forces that are inimical to sensible economic policies and to economic reform. Sadly, the likelihood of a drawn-out UK economic recession greatly minimizes the chances that supportive political conditions will prevail. In which case, those who got their way with Brexit are likely to experience deep buyer’s remorse since the UK will have suffered the costs of Brexit without having reaped the long-run benefits. It will also have had UK politics upended for a long time to come.

Desmond 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.

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