Last Thursday, in voting in favor of Brexit, the United Kingdom electorate voted with its heart rather than its head. Instead of heeding the consensus of economists and policymakers about the likely dire economic consequences from a decision to leave Europe, it chose to be swayed by concerns over continued high immigration and a purported further loss in sovereignty that remaining in Europe would have entailed. Sadly, the fallout from this decision is likely to be long felt not only in the United Kingdom but well beyond that country’s borders.
The reason for fearing a particularly adverse economic fallout from the Brexit vote is that the referendum took place at a highly inauspicious time for the UK, the world’s fifth largest economy. Indeed, it occurred at a time when the UK had an external current account deficit of seven percent of GDP, which is the largest such deficit in the UK’s post-war history. It also occurred at a time when the UK banking system had grown to be among the largest in the world relative to the UK’s GDP.
Financing a very large current account deficit and maintaining the UK’s large foreign deposit base in its banks will depend crucially on maintaining domestic and foreign investor confidence in the economy. Yet the Brexit vote is bound to result in considerable economic uncertainty for a number of years as the new terms for the UK’s complex trade relations with Europe are negotiated. This is particularly the case considering that the UK’s European partners will have little incentive to give it favorable terms for fear of encouraging other members of the European Union to emulate the UK and head for the door.
A further factor that will likely cause capital to leave the UK in the wake of the Brexit vote is the all too likely relocation of large parts of the all-important UK financial system to Europe. This will occur since banks based in London will now lose the “financial passport” that they currently enjoy, which allows them to operate freely in Europe without being subject to additional European regulation.
The likely bitter Conservative Party leadership contest after the fall of David Cameron and the likely calls for a new referendum on Scottish independence in the wake of a Brexit vote will hardly help calm investors’ nerves about the UK’s future economic and political direction.
An important way in which the Brexit vote will ripple beyond the UK will be through an abrupt and steep decline in sterling as the UK struggles to finance its gaping current account deficit. This is bound to unsettle global financial markets, particularly at a time when other central banks like the European Central Bank and the Bank of Japan are trying to cheapen their currencies.
A further way in which the Brexit vote could unsettle global financial markets will be through the impact that such a vote will now have on the populist tide all too evident across Europe. A recent Pew Survey of European attitudes underlined that tide; it found that barely 50 percent of Europeans now think the European project is a good idea. One now has to expect calls for similar referendums in countries like France, Italy, and the Netherlands. Such referendums are bound to undermine investor confidence and rekindle the European sovereign debt crisis.
It would be a big mistake to think that economic and political difficulties will be confined to the United Kingdom and Europe. Rather, one must expect that, much in the same way as global financial markets were unsettled in the wake of the 2008 U.S. Lehman crisis, so too will they now be unsettled by troubles in the UK and Europe. It will also not help calm U.S. markets to have an example in the run up to the U.S. November elections of how successful an anti-immigrant and populist election campaign can be.
