Brexit: the Immediate Risks
By Olivier Vardakoulias / neweconomics.org
Jun 24, 2016

We all have our view on the long-term prospects associated with an exit from the EU. 

But as foretold by virtually all economists, the dramatic, immediate consequences of a vote to leave the EU are already being felt. The value of the British Pound is currently plummeting, stock markets are in freefall and no doubt a sizeable outflow of capital is underway. This isn’t “black Wednesday” (when the UK exited the European Exchange Rate Mechanism in 1992): it’s much uglier – and this was predicted and predictable.

What we’re currently seeing is only the beginning of a period of instability – so what does this mean for our economy, which has barely recovered from the financial shock on 2008, in the short-term? Here are some of the impacts:

How will UK households be affected?

First the important depreciation of the British Pound, which is currently underway, means that UK households will suffer – particularly the poorest ones.

A strong currency depreciation renders imported goods more expensive – relative to domestic goods and domestic wages. In theory people can switch their consumption away from imported goods (e.g. imported foodstuff) towards domestically produced ones. But this assumes that an economy is able to substitute imported goods with domestic production quickly and easily.

This is currently not the case for the British economy, which has a record-high trade deficit (particularly in manufacturing trade) and is running to the limits of its potential production. The consequence is simple: there will be inflation and people will have to spend more on the items they consume – losing purchasing power and cutting down on their expenditures in the process.

The Brexiteers’ idea that the economy will magically adjust overnight, and start producing the products that it hasn’t been for decades was always a mirage. 

Altogether, this will contract economic activity and increase unemployment. 

What does Brexit mean for the financial system?

While the big medium-term risk is a drive towards further financial deregulation, there are sizeable short-term risks too.

The UK’s financial system is extremely exposed to the rest of the world, having a massive external debt. It is also heavily reliant on the inflow of capital from abroad. A heavy depreciation of the British Pound isn’t just likely to shrink the turnover of the City: it may also lead to a new financial crisis in the UK and elsewhere.

Although scarce public information is available, there is a suspicion that massive maturity and currency mismatches exist between the assets and liabilities of UK financial institutions. While the former are easier to deal with through injections of cash by the Bank of England, the latter are not.

In a scenario where currency mismatches are large, the Bank of England is likely to find itself in a cul-de-sac.

If the British Pound continues falling along with ongoing capital outflows, and the Bank of England doesn’t act to stop that – for example by increasing interest rates – then inflation through the increase of imported goods prices will hit household pockets disproportionally. As a result consumption will decline, leading to a recession, which would in turn, potentially increase non-performing loans and mortgages – eventually making the banking sector even more vulnerable.

But if the Bank of England does eventually increase interest rates – after a foretold easing of monetary policy – to stabilise the value of the British pound, it will also risk a recession while increasing household defaults on loans and mortgages. And this will eventually put the health of the banking sector at risk through another route.

In either case, as in 2008, all of us will pay the price for the UK’s disproportionate reliance on an oversized financial sector. And European banks, heavily exposed to the UK market and sterling, will be hit too.

How will the rest of the EU be affected?

There will also be consequences for the rest of the EU – whose post-crisis economies, for many, are in a deplorable condition. Virtually all European stock markets are currently in freefall.

The UK has been running a massive trade deficit, and is in effect, along with the US, the global "consumer of last resort" – including for the EU.

Most Eurozone countries are trying to export their way out of the crisis following the crushing of internal demand (consumption). So, a strong depreciation of the British Pound – which will reduce UK’s consumption – is very bad news. Britain is indeed the third destination for Germany’s exports and represents 10% of the Eurozone’s total exports.

And in a global context characterized by mercantilism and recessions in emerging markets, the idea that the Eurozone can simply replace the lost exports to the UK with exports to the rest of the world is nonsensical.

Many European economies are likely to suffer considerably – with the possibility of unemployment increasing in countries which can barely afford this additional hit already, including Spain, Italy and France.  

Stopping the doom loop and planning for the future

There are immediate things we can do.

  1. Get to the negotiation table with the EU as soon as possible – without waiting for Conservative party to elect its new leader. For many households, the cost of uncertainty is simply too high: it will translate into a loss of income and higher unemployment. And the doom loop may not stop unless there is a sense of what a future agreement with the EU looks like.
  2. We need to take immediate action to protect households from the shock of Brexit. Now is the time for the State to fulfil its role by increasing redistribution towards vulnerable households, and draw a line on austerity: at difficult time, the State is ultimately responsible for kick-starting investment, securing full employment, and providing essential public services, like health.

Along with short-term measures we also need to actively plan for a new economic model. At the very minimum, this new model should involve an active industrial policy targeted towards new technologies and clean energy; more financial regulation; and a drastic reduction of inequalities by enhancing labour rights, increasing real wages and more income redistribution. 

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Brexit: the Immediate Risks