The UK has been no stranger to wrenching sterling crises in the post-war period. Indeed, it experienced such turmoil in 1967, 1976, and 1992. This makes it all the more difficult to understand the current complacency in British academic and policy-making circles surrounding the likely fallout from a ‘hard’ Brexit – particularly as the UK vote, and developments flowing from it, come at a time when the UK is suffering from acute external vulnerabilities heightening the chances of yet another sterling crisis.
An indication of the UK’s external vulnerability is its gaping external current account deficit, now running at a staggering 6% of GDP – the largest deficit the country has seen in the post-war period. As Mark Carney, the Bank of England governor, has put it, the deficit’s size makes the UK uncomfortably dependent on the kindness of strangers for its financing.
An important risk that a hard Brexit poses is that foreigners may be less inclined to continue financing such a large deficit. An early indication of this likely reluctance was seen in the more than 10% drop in sterling immediately following the UK vote in June. It has also been seen in sterling’s renewed slide over the past few weeks as the market’s perception of the likelihood of a ‘hard’ Brexit has increased.
There would seem to be at least two reasons to believe that market fears about the consequences of a hard Brexit for continued large capital flows to the UK are not misplaced. The first is that, were the UK no longer to have ready access to Europe’s single market for its exports, it would lose its attractiveness as a location for foreign companies’ European investments. This was precisely the point that the Japanese government made at a recent G20 meeting – when it publicly warned its UK counterparts of the likelihood that Japanese companies would relocate out of the UK in the event of a hard Brexit.
The second reason is that a hard Brexit would almost certainly result in the loss of the ‘financial passport’ that City of London financial institutions now enjoy for accessing the European market. A Financial Conduct Authority report in September suggested that as many as 5,500 UK financial firms could be affected by such a loss of passport rights. Meanwhile, major international banks including JP Morgan Chase and Goldman Sachs are warning that, if the City loses its financial passport, they will need to conduct at least part of their European operations from outside the UK.
A key point that those in favour of a hard Brexit overlook is that a rapid drying up of foreign capital flows to the UK would have dire consequences for domestic living standards. A further currency dip would raise import costs and increase inflation. Furthermore, domestic economic policy would be likely to need to be tightened – both to contain inflation and to make room for a large narrowing in the external current account deficit that foreigners would no longer be prepared to finance. UK households would be forced to reduce their consumption levels painfully, while businesses would be forced to cut back on their investment plans, to the detriment of future UK growth prospects.
In 1967, immediately after sterling’s 14% devaluation, Harold Wilson, the British prime minister, famously assured voters that nothing much had happened to the ‘pound in your pocket’. One has to wonder whether those UK cabinet ministers who favour a hard Brexit – now seemingly gaining the ascendancy in Theresa May’s cabinet – are not repeating Wilson’s mistake of minimising the economic damage a further sharp fall in the pound might wreak. The UK’s own painful experience with sterling crises underlines how economically destructive such turmoil can be.
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.