Monday, 16 July 2018

The too high price of self-determination for Britain

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  • James Saft - June 2014

Self-determination for Britain in its relations with Europe may be priceless, not in the sense of being beyond value but simply just too expensive.

And don’t expect monetary policy to ride effectively to the rescue in the aftermath, as it did, at least somewhat, after the great financial crisis.

If Britain votes to leave the European Union in its June 23 vote, the pound could fall along with other asset values, dealing a sharp blow to the economy.

“In that scenario we would expect a material slowing in growth, a notable rise in inflation, a challenging trade-off,” Bank of England Governor Mark Carney said on Thursday after interest rates were left on hold.

“There’s a range of possible scenarios around those directions, which could possibly include a technical recession.”

Technical it might seem to Carney, but the worst of it is that such a recession, while self-induced, is the kind of old-fashioned almost emerging market variety characterized by a loss of confidence and asset sales by foreigners.

Carney was blunt, as he should be, about the limits of what his tools could do.

That’s because it would be not just a recession, but a recession of a particularly pernicious type which the monetary authorities would be singularly badly placed to counter.

Sterling could fall rapidly, hitting very few steps on the way, with a downdraft of 30% of its value over a year or so not out of the question. That would rapidly import inflation, sending it above the BOE’s 2% target all while employment and the economy slow.

“In this environment the Monetary Policy Committee would need to balance a rapid slowdown in economic activity against a sharp upward spike in inflation,” economists at Fathom Consulting wrote in a note to clients.

“Leaving policy on hold, or even cutting interest rates, would risk sending sterling even lower, and inflation even higher. Tightening policy would risk triggering a rapid correction in the UK housing market, compounding the slowdown in growth.”

Much would depend on how strong the reaction in sterling is, but Britain does run a persistently high current account deficit, one of those things that can go on merrily so long as overseas capital remains happy to provide finance.

Fire or ice?

Raise rates to support sterling and cap inflation and you kneecap Britain’s highly indebted household sector. Hit households, especially during a time when London’s position as a financial capital would come under, if not stress, then at least strain, and you could easily see house prices sell off.

While British banks are much better off than they were running into the last downturn in housing, both in their capital and funding positions, this still implies a level of risk best avoided if possible.

Leave rates where they are and you risk both sharper falls in sterling and, as inflation rises, the central bank’s own credibility.

None of this is to say that voting to leave the European Union has to work out to be a terrible idea and worse for the country, only that it is a move with upfront costs and risks which look considerable. There is a value to self-determination, and ultimately that is up to voters to decide.

In a year of unpredictable political battles, June’s vote is one more excellent reason for the Federal Reserve to sit on its hands. It would be a very brave Fed indeed which decided to pay attention to stronger data and risk destabilizing markets ahead of an event which might upset global financial markets. Once that is over the U.S. election gives it one more good reason to wait until December.

One other possibility is that Britain votes to remain in the EU, but that the process of examination does damage to its image with global capital anyway. Again, we return to the current account deficit, something investors now blithely ignore but which in the past has undermined many currencies. And that’s even before we consider the possibility that Britain is ready for a slowdown even without political risk as an amplifier.

British assets will reflect these risks, implying volatility and potentially sharp moves downward.

(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at

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