Hard realities for a hard Brexit
Harsh economic truths lie beneath legal ambiguities
by Danae Kyriakopoulou
Thu 20 Oct 2016
A hint by a UK government lawyer this week that a final deal with Brussels on the UK's departure from the European Union would require parliamentary approval was enough to rally the pound to $1.23. But the hard reality is that, once invoked by March 2017, Article 50 will be irreversible. A vote in 2019 would come too late to refuse to ratify it.
This leaves Prime Minister Theresa May in full control of choosing the coordinates on the free movement-free trade nexus that will define the UK’s path towards Brexit. European leaders have asserted that the two cannot be separated, effectively ruling out à la carte membership. In a political environment characterised by election threats from eurosceptic movements in France and Germany next year, this cannot be dismissed lightly.
There are three possible scenarios for the UK: 'hard Brexit' from the single market; 'soft Brexit', in the form of a European Economic Area/European Free Trade Area-type arrangement; and – very unlikely but still possible – ‘Bremain’. The markets have already given their verdict on the prospect of a hard Brexit. Following remarks by May to the Conservative party conference this month, sterling slid to $1.21 and inflation expectations rose to 3.5%.
While some see the pound's drop as a potential blessing for exporters, empirical evidence from past episodes of devaluation implies a low elasticity of demand for UK exports. The impact on the economy of rising import prices will be felt quickly and severely, particularly by lower-income households. Coupled with a hit to investment from persistent policy uncertainty, higher prices could push the UK into a dangerous stagflation trap and put the Bank of England in an untenable position. Raising rates would be undesirable in the face of slowing growth or recession.
The risks from higher rates are even greater when looking at the UK’s household debt position. At 87.4% of GDP, it is higher than that of Greece, Italy, or Ireland, according to the Bank for International Settlements. The Office for Budget Responsibility projects household debt to income at 164% by 2025. Any rise in rates would make UK households even more vulnerable.
But an expansionary path for monetary policy carries risks too. The undesirable side effects of ‘too low for too long’ policies are setting off alarm bells across the globe, as several articles in the October edition of OMFIF’s Bulletin attest. May says, 'While monetary policy provided the necessary emergency medicine after the financial crash, there have been some bad side effects.' Low long-term gilt yields are putting pressure on the UK’s rising pension deficit.
With monetary stimulus off the table, the burden would fall on fiscal measures to cushion a potential economic slowdown. May has repeatedly referred to a supportive fiscal environment, particularly regarding infrastructure spending. This would be a welcome change: the UK has chronically underinvested in its infrastructure for decades, resulting in a lower quality of overall infrastructure than its G7 peers, even lower than several developing economies, according to the World Economic Forum.
While desirable, higher spending on infrastructure will be hard to afford. At 4.4% of GDP, the UK's fiscal deficit was the third largest among EU countries in 2015, higher than the G20 average. And while George Osborne, the former chancellor of the exchequer, abandoned his plans for a return to fiscal surplus by the end of the decade shortly after Brexit, any plans for a substantial change of course in Philip Hammond’s first autumn statement next month could be jeopardised by a shock to the gilt market should fears of a hard Brexit resurface.
Danae Kyriakopoulou is Head of Research at OMFIF.
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