Will the vote for Brexit derail the UK economy? The Guardian newspaper yesterday contained a brief report here from two economists, both formerly members of the Bank of England’s interest rate-setting Monetary Policy Committee (MPC). Both of them focus on trends in domestic spending and consumption, driven mainly by wage growth and employment. Unemployment has apparently ticked up a little according to the latest figures. They conclude that economic growth will slow into 2017, and while one predicts that the UK will avoid recession, the other concludes with some gloomy speculation on an ‘oncoming Brexit tsunami’.
The pound has fallen sharply since the result of June’s referendum became apparent. Whatever else happens, I see this as a good thing, and necessary to help promote a long overdue rebalancing of the economy. As Roger Bootle writes here, the Brexit vote was the trigger for the pound’s devaluation, but not its deeper cause.
From the mid-1990s until the start of the 2008 crisis, the pound was arguably overvalued against the currencies of its main trading partners. This has contributed to a deteriorating current account balance. The latter reached a record level of 7% of GDP at the end of 2015. This overvaluation has made our exports less competitive, and imports cheaper. For the economy as a whole, this has raised the real incomes of consumers and boosted consumption, while reducing the incomes of producers and weakening production as a whole.
The difference between aggregate production and aggregate consumption is equal to aggregate saving. Savings are equal to investment for the world economy overall, but savings and investment can diverge for one economy, with the difference being exported or imported. For the UK as a whole, total net domestic private and public saving has been negative since 1982, which means the economy has been accumulating debt, equal to the sum of successive current account deficits over time. This can be seen in the government’s budget deficit and the smaller private financial deficit, equal to borrowing by firms and households.
Domestic borrowing in the private and public sectors is by definition equal to the current account deficit, or the level of foreign borrowing. The capital account is the flip side of the current account, so that our current account deficit means that we have been running a capital account surplus, or importing capital.
If UK capital imports are invested in productive assets that over time generate rising incomes that can service and ultimately pay down the stock of debt, then there may be little to worry about. But if the capital imports fail to generate sufficient returns by simply fueling financial asset price bubbles and excessive consumption, the stock of debt will at some point become unsustainable. This could in the worst case lead to a sudden loss of confidence by investors in the UK and potentially a financial crisis. At the very least a change in the valuation of the UK’s economic prospects by investors will produce a fall in capital imports, which will weaken the value of the currency, other things being equal.
While there has not been a financial crisis, we have seen a major fall in the pound. If this lower level is maintained, total domestic savings should increase relative to domestic investment. This will be reflected in a rise in production relative to consumption, which is the same thing. Exports should rise relative to imports, so while consumption will be squeezed, production will receive a boost, helping to reduce the current account deficit. While domestic savings will rise relative to investment, the latter should also rise as the increased production leads to rising demand for new capacity.
Even more significant than the trade balance is the deterioration in the UK’s net flow of investment income from abroad. This flow made a positive contribution to the current account in the early 2000s, but since 2012 has moved into negative territory. In part this change reflects the economic crisis in the eurozone and the poor returns on investment there. But the fall in the pound will raise the value of returns on investment from abroad valued in pounds, while the value of outflows of investment income will remain unchanged. Overall this will further contribute to reducing the current account deficit.
Note that these processes could take some time to play out. Given some UK exporters’ position in global value chains, the cost of their imported inputs will rise, so that they benefit less from greater demand for their products from abroad. Over a longer period, they might switch to domestic suppliers, a process which could be helped along by a supportive industrial policy from the government. The responsiveness (or elasticity in the jargon) of exporters with imported inputs to changes in their price will tend to be greater over time. This is why it is vital for the new lower level of the pound to be sustained. This will give producers of exports the confidence to invest for the long term and build new relationships with domestic suppliers.
This rebalancing of the economy clearly benefits some groups at the expense of others. But these changes are ultimately to be welcomed. The long period of currency overvaluation has benefited consumers at the expense of producers, particularly firms exporting manufactured goods and related services. The fall will do the opposite. A long-needed revival in manufacturing could raise the growth of productivity and output, slow or ideally reverse the UK’s overall accumulation of debt, support the revival of regions that have been left behind economically, and reduce inequality with the creation of more jobs in the middle of the income scale. This may require a more supportive package of policies which promote the expansion of manufacturing exports, domestic suppliers and related services, infrastructure and relevant skills.
The result of the Brexit vote was the trigger for the devaluation, but longer term economic trends created the conditions and arguably the necessity for it. This analysis admittedly ignores the longer term changes in trade relations that Brexit will bring about, as well as potential business uncertainty while negotiations are ongoing. But the new lower level of the pound, if sustained, could have major positive benefits for the UK economy as a whole.