The UK economy needs to rebalance, but is leaving the EU the way to do it? Amidst all the highly emotive but often vacuous campaigning on both sides of the EU referendum debate, the financial markets have become quite unsettled as the polls have swung towards the Brexiteers, who favour leaving. The pound has depreciated by about 9% since last November. If the UK does vote to leave the EU, further falls in the markets, possibly sharp, might occur as capital outflows are triggered due to the sheer economic and political uncertainties involved. And business does not like uncertainty, as Alan Sugar, a Labour peer famous for Amstrad computers and The Apprentice among other exploits, made clear in a recent ‘Remain’ campaign television broadcast.
Keynes himself, and many of the post-Keynesians who have remained faithful to his more revolutionary ideas, emphasised the power of uncertainty over the future faced by entrepreneurs making decisions on investment. In particular, the short-termism and speculative nature of the financial markets were, he felt, often a drag on long-term investment in productive assets. A vote to leave the EU would bring some inevitable instability and quite possibly a weakening of investment. This could last for a many years, as trade agreements are renegotiated.
Having said all that, further falls in the pound would help to rebalance the UK economy away from an over-reliance on private and public sector debt accumulation. The current account deficit is currently 7% of GDP. If a lower pound could somehow be maintained for some time, which is of course not inevitable, this could boost net exports and begin to reduce this deficit.
A country’s current account is the rate of international lending or borrowing, and is reflected in net domestic saving or investment, or the total of government and private (household and business) lending or borrowing. At the moment the large current account deficit has its counterpart in the accumulation of domestic debt by both government and the private sector. A move towards a current account balance requires some combination of an improvement in external competitiveness and an increase in the demand for net exports. A depreciation of the pound and a faster growth in domestic demand from our trading partners are the keys to economic rebalancing. The effects on output from changes in the value of a currency can take some time to work, and a depreciation can even worsen the current account deficit in the short term, the so-called ‘J-curve‘ effect.
If the UK current account were to move towards balance as a result of rising net exports due to a depreciation of the pound, rather than a slowdown in growth reducing imports (not the kind of rebalancing that the economy needs), this would automatically reduce the rate of accumulation of domestic debt. How this is allocated between the public and private sectors, and within the latter, between households and firms, is hard to predict, but it would move the economy onto a more sustainable growth path, in the absence of external shocks.
If the government wants to rapidly reduce both private and public sector debt ratios as a proportion of GDP at the same time, then this can only be done on the basis of a much smaller current account deficit, or preferably a surplus. Exports of goods and services need to grow more rapidly relative to imports, and net investment income from abroad needs to recover. A much stronger recovery in domestic demand in the Eurozone and the EU more broadly would be a great help. Industrial and technology policies to promote greater competitiveness in exporting sectors could also play a role, although these are more of a long term solution.
So if Brexit leads to a fall in the pound, that could be a good thing, right? Unfortunately, there are other economic factors to take into account which could offset the benefits. Ideally, the pound would fall gradually. If it fell too sharply, this might fuel inflation as import prices rise rapidly. It might also lead to a fall in bond prices and a spike in interest rates, affecting the debt burdens of firms and households and tipping the economy into recession as spending on investment and consumption is reduced. Of course the Bank of England could respond with more Quantitative Easing to try to put downward pressure on interest rates. But there remains the possibility of instability and crisis in the short term, and possibly further ahead. Uncertainty could reduce the volume of trade and foreign direct investment, and such trends would have a negative effect on growth for some time.
The UK needs a devaluation of the pound and a recovery in its export markets, yes, but Brexit would be a rather clumsy way to proceed.