Commentary Type

Britain Is Becoming an Emerging Market


Breaking up is hard to do—especially after a 43-year marriage. Which is why the notion that the United Kingdom might engineer a “soft Brexit” from the European Union, the innocent hope of many investors and some Brits, was always a delusion. Instead, Britain’s plunging pound, which has swooned to a staggering 168-year low against a benchmark of other major currencies, is just a taste of the economic deterioration to come.

Instead of the pro-Brexit camp’s promise that the vote was a push for independence from European red tape, the drive for sovereignty has turned into a quixotic exercise in isolationism that shows few signs of ending well. In effect, the United Kingdom has abdicated its chief source of economic and political clout—its close association with the European Union, the world’s largest economy. In so doing, Britain may be on the way to looking more like an emerging market, where suddenly political risk, currency volatility, and uncertainty about the future are the new normal. And if you’re thinking that long-term investment and private spending might suffer as a result, you’re bloody well right.

Despite a raft of warnings, Brexiteers were quick to claim victory in the months following the momentous June referendum. “To me, Brexit is easy,” said a confident Nigel Farage, leader of the pro-Brexit UK Independence Party. Sure, the pound was falling a tad rapidly. But, hey, the economic data didn’t fall off a cliff, and the stock market even hit a new record. But that was the summer sun talking.

The arrival of autumn has brought the onset of reality. One leaked government report estimated the mere cost of the process at an eye-popping $22 billion. That’s substantially more than the United Kingdom’s yearly contribution to the EU budget, which was supposed to be a source of savings post-Brexit.

Meanwhile, it’s become clear that the stock market’s surge mostly reflected the pound’s depreciation. The reason late-summer markets had not started to fully price in a Brexit is that the new UK government, under conservative Prime Minister Theresa May, simply had decided to hold off on actually pulling the Brexit trigger by not invoking Article 50, the terms of the breakup. In other words, the first few months were like a period of separation when the divorce paperwork had yet to be filed.

Now that notice has arrived, things look a lot bleaker. The pound’s decline has started to look anything but orderly, with daily plunges compounded by a surprise “flash crash” that obliterated the currency momentarily but left a lasting scent of panic. This is quite typical of an emerging market, where currency swings tend to be much greater than in rich countries, in part because of the uncertainty generated by fractious, dysfunctional political systems. Worse yet, bond prices have been falling in the currency’s wake, pushing up expectations of inflation for all the wrong reasons—not because Brits expect the economy to boom and their wages to rise but rather because they expect a currency-driven loss of purchasing power. While it’s impossible to predict the pace at which Britain’s economic malaise and increasing isolation will progress—much still hinges on negotiations to come—it is feasible to determine the avenues through which the steady, gradual decay in British living standards is likely to take place.

First and most obviously, there’s the xenophobia underlying the push for a Brexit. The Conservative government’s anti-immigrant propaganda has surpassed the fears of many, most outrageously when it declared that companies should start publicly listing their foreign workers—a policy with dangerous echoes of nationalist totalitarianism. This is already putting a chill on economic activity and the sort of vibrancy that makes London and other major UK cities attractive cosmopolitan centers. The implications are widespread, affecting everything from potential investment by foreign companies, applications to British universities by top-tier foreign students, EU-wide funding for the arts and sciences—the list goes on and on.

This dissolution of the social fabric is compounded by a second major setback: Britain’s trade relations with the world.

In one fell swoop, long-lasting relationships have been undermined and thrown into disarray. Some early enthusiasm about potential bilateral trade deals has been dampened by the fact that non-EU countries want Britain’s continental relationship to be fully settled before entering into any new negotiations. For four decades, Britain’s trade relations were conducted with the European Union as a whole, so it’s impossible to disentangle the two until the United Kingdom has its own new rules of the road. Indeed, there’s so much uncertainty that the British government has had to go on a hiring spree for trade experts. I’m not sure that’s exactly what the Brexiteers had in mind when they said that leaving the European Union would be good for employment figures.

Then there’s the tumbling pound itself. The historically weak pound leaves the Bank of England in a very tight spot, since any effort to further cut already low interest rates would risk compounding the sell-off in sterling. Normally, a falling currency is a boon to manufacturing and exports, and, indeed, it may have a narrow short-term positive effect for the British economy. But given the waning strength of the country’s industrial sector, such a bump is likely to be marginal—and overwhelmed by the opposing, negative impact. Bank of England Governor Mark Carney, whose low-rate policies have been directly challenged by the May government, has said he would tolerate somewhat higher inflation for a time. But that is likely to become an unpopular strategy if inflation truly takes off.

And how can we forget Britain’s crowning jewel—its prized financial center? The so-called City of London, for all of its troubles and role in the financial crisis, is a major employer and driver of business activity both for the capital and the nation. Over the last four decades, the United Kingdom’s banking system has surged in size, with total assets climbing from about 100 percent of the country’s gross domestic product to a staggering 450 percent of GDP—too-big-to-fail on steroids. The large presence of banks in the economy has always been a major boost to other industries, including commercial and residential real estate, hotels, restaurants, and airlines. Some of that may be about to slip away as banks and other financial companies, including younger technology companies, rethink their British operations and investment. These are not empty threats. The benefits of having a London base came precisely from the free movement of people throughout the European Union. With that gone, and with it access to the European Single Market, the advantages begin to quickly evaporate. Cities like Paris; Frankfurt, Germany; and Dublin start to look competitive as potential alternatives.

Lastly, Brexit has thrown the very territorial integrity of the United Kingdom into question. Scotland is overwhelmingly pro-European Union, and the threat of another independence referendum looms. This only further ratchets up frightening levels of uncertainty, which nearly 90 percent of UK chief financial officers rank as abnormally high post-Brexit. There’s even the question of what might happen to Northern Ireland. “Robbed of EU financial support, with London less able to commit scarce fiscal funds to Northern Ireland, facing a land border once again with the rest of Ireland…a centrist majority for reunification on economic grounds might materialize,” argues Jacob Kirkegaard, senior fellow at the Peterson Institute for International Economics. “Catholic and Unionist voters who care about the Northern Irish economy may in time choose the perceived economic stability of a united Ireland over remaining in the UK.” How’s that for renewed sovereignty?

Most strikingly, the May government has actively chosen to alienate any initial attempts at European goodwill, already hard to come by, even though it has very little negotiating power under the circumstances. The pro-Brexit camp clearly advanced toward its cause without a plan and continues to fumble in developing one. It’s no wonder traders see an even steeper decline in the pound ahead, with a potential spike in inflation in its wake as import prices surge.

Sound familiar? It’s the sort of concern economists long reserved for the developing world.

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