Britain’s Chancellor George Osborne tried to calm tumultuous seas on Monday morning as markets struggled to understand the implications of the vote for the UK to leave the European Union. It’s unlikely it will be the last time. The truth is that Britain is now in the preamble of a deep recession, and a political “perfect storm” that is driving the economy into a negative spiral that must be stopped. The sooner the better.
Why do we say that? First, all known engines of growth in the British economy – finance, services, construction and manufacturing – have stalled. They are unlikely to reignite even at a lower level of activity until some clarity about the future of Britain’s position in the world is achieved.
Most optimistic scenarios suggest this will take about three years but it is likely to take even longer. Britain is now a far less attractive place for foreign investment. This is reflected in the lower value of the pound, and in the sharp decline in the value of the shares of construction companies. The housing market has also stalled. The prospect of much construction in the next year or two is very low, and that will affect all the sectors that service the industry, from kitchen makers to lawyers to removals firms.
Second, the other major engine of growth, the City of London, is in danger of losing its highly valued passporting arrangement which allows institutions to provide services from one EU state to another. As a result, banks are reportedly preparing to move some of their operations to continental Europe. Thousands of jobs are under threat. Suggestions that the City might thrive as an offshore financial centre are misguided. The tide has turned, and a UK torn from the EU will be in a much weaker position to withstand global pressure against tax havens from the US, OECD, and the IMF among others.
Third, some people argue that the lower pound will drive export growth. But large exporters, such as UK-based car makers, are unsure about their core export markets in the EU, and that is true of small exporters too.
In short, Britain is in limbo. It is not a signatory to the World Trade Organisation (WTO) and cannot move ahead with negotiations on that front before a deal with the EU and certainly not before it has a new government. US president Barack Obama has warned that the UK will be at the “back of the queue” in its trade negotiations.
Any investment in export-oriented manufacturing and services right now therefore represents a huge leap of faith on the part of the investor. They will need to convince banks, most of which have lost considerable market capitalisation, to back them. The uncertainty facing investors is amplified by fears the “UK market” may shrink with a possible secession of Scotland.
It is hard to find viable engines of growth. The UK tech scene is highly sensitive to changes in its environment, and particularly to financial services fragility. Another major export sector – the UK education sector – is facing turmoil. The weaker pound and more affordable housing might make our universities cheaper for overseas students, but more worrying is the impact of likely new visa requirements for EU students considering a three-year stay. EU education funding is now also in doubt.The weaker pound may bring more tourists into the UK but the impact is likely to be seasonal, uneven and outweighed by losses in other sectors. The next few months' data will be crucial for estimating the extent of Britain’s downward spiral. Shrinking economic activity will result in lower tax receipts and higher borrowing at a time when Britain’s sovereign rating is likely to be downgraded. Deficits will grow.
In the financial markets, excessive volatility is the largest near term risk, but it is not the only one. It will take time for the weaker pound and the deteriorating quality of collateral to work their way through the balance sheets. In the process, it will affect not only UK banks and the corporate sector, but also many overseas banks operating in the UK and banks operating in Europe. The balance sheet adjustments will increase margin calls (demands by brokers that an investor puts up further cash to cover possible losses). This will eat into cash reserves and could trigger the collapse of weaker companies.
In the medium term and beyond, pension funds may seek riskier assets in the search for returns which pay for people’s retirement, a move that over time may prove detrimental. And the nuts and bolts of the financial market – the repo market that secures day-to-day funding for banks, and the clearing houses which manage the flow of transactions – will be tested by volatility, by those margin calls, and by the prospect of assets and investment moving elsewhere.
New problemsMany have suggested that this is not a Lehman moment. We agree, but only because it may be much worse than Lehman, at least for the UK. Back in 2007-2009, a large public sector and continued investment in the public services sustained the aggregate demand in the economy and softened the recession, as did the eventual decision by the Bank of England to reduce interest rates. It was the young generation, the 16-25 year olds, who bore the brunt of the crisis at that time.
Cash rich emerging market investors helped the corporate sector and banks with their appetite for British assets. Back then, Britain was a global going concern whose power was amplified through its European status. Now, the Bank of England cannot reduce interest rates much further, the effect of tax cuts is marginal in a recession, and the public sector has been weakened by years of austerity – as have people’s savings. With a major element of its competitive advantage – being part of the EU – gone, it is unclear what the UK is as a going concern, a situation which can only be resolved once the political map for post-Brexit future is agreed upon.
That does not appear feasible. The Brexiters never came with any concrete plan for the future. They dismissed the expert opinion in the name of the greatness of the British state and stoicism of its people. The demands of the Brexit vote are so contradictory that no political agenda can possibly fulfil them. The Leave vote contained multitudes: a protest and revenge vote against austerity, against elites, immigrants, markets and globalization. In a dramatic but ironic twist, Brexit has granted more power to right-wing elites that favour free market solutions – forces that never protect those parts of society that are most disadvantaged by market competition, deregulation and freedom of trade.
The solution lies in a critical but honest revisiting of the referendum outcome. Barring a technical solution (a mooted veto by the Scottish parliament), this can take two routes. One (longer) is economic: as negotiations with the EU hit hurdles, the unravelling economy will generate the political need to stop the crisis. Another route is political: the referendum was won on the assumption that the experts had got it wrong and Britain would emerge much stronger as a result. Truly courageous political leadership would now concede that it was never in the British public’s interest to wreck the economy and break the union.