Fed Should Note Brexit’s Unintended Consequences

Major economic and political events in a country the United Kingdom’s size all too frequently have unintended consequences that ripple through the rest of the global economy. Sadly, the recent Brexit referendum will all too likely prove to be no exception to that rule. This is to be deeply regretted. For not only did that referendum take place at an inauspicious time for the UK economy, it also occurred at a highly inauspicious time for the rest of the global economy.

In the immediate aftermath of the Brexit vote, sterling has already depreciated by more than 12 percent with little sign of its steep decline stopping anytime soon. At the same time, the UK property market has been shaken as investors have sought to withdraw their money from property market funds while consumer confidence has plummeted at a disturbing rate. These developments have occurred in an atmosphere of unusually heightened investor uncertainty.

Present UK investor uncertainty appears to have multiple causes. These include questions as to how soon the UK’s political disarray will be settled and whether Scotland will choose to have a second independence referendum. They have also included fundamental questions as to what might be the UK’s future trade relations with Europe and how large a part of the UK’s financial industry might relocate to Dublin, Frankfurt, and Paris.

There are all too many reasons to fear that UK political and economic uncertainty will not dissipate anytime soon. After all, the UK government has not yet triggered Article 50 of the Lisbon Treaty to start negotiations with the UK’s European partners.  When it is triggered, those contentious negotiations are bound to drag on for at least two years. This is particularly concerning since at present the UK is running a gaping external current account deficit, which is the largest such deficit in the post-war period. Should prolonged uncertainty give rise to sustained capital outflows, the UK could very well have a full-blown sterling-crisis.

At this very delicate stage in the global economic cycle, the last thing that we need is an external shock from the UK that might expose the major fault lines in today’s world economy. Yet that is precisely what a deepening in the UK’s economic and political crisis could do. It might do so as it unsettles global financial markets, as it gives rise to a further strengthening in the US dollar, and as it gives encouragement to populist movements in Europe to demand European exit referendums for their own countries.

Among the more worrisome of the global fault lines that might be exposed by Brexit is Italy, the Eurozone’s third largest economy. What makes Italy particularly vulnerable to an external shock is its excessively high level of public debt, a highly sclerotic economy, and a banking system that has 360 billion Euros in non-performing loans.

Further complicating matters, the Brexit referendum has put wind in the sails of Italy’s populist Five Star Party, which is in favor of Italy exiting the Euro and which is now Italy’s most popular political party. This raises the real risk that the Five Star Party, together with the other opposition parties, might seek to bring down Matteo Renzi’s government by defeating him in Italy’s scheduled October referendum on constitutional reform. Were that to occur, we should brace ourselves for another chapter in Europe’s sovereign debt crisis.

Yet another troubling way in which the Brexit referendum could have unintended global consequences is through the exchange rate movements that it is provoking. Following the Brexit referendum, there has been a global flight to safety that has seen a sharp appreciation of the Japanese yen and of the US dollar. A stronger Japanese yen is the last thing that the Japanese economy now needs as it struggles with a faltering economy and with the specter of another bout with deflation.

Any further strengthening of the US dollar as a result of the Brexit referendum risks inducing China to again depreciate its currency as it seeks to maintain a competitive advantage. Any such depreciation could prove to be highly damaging to US-Chinese relations particularly in a US presidential year where the issue of globalization is very much in focus. It could also prove destabilizing to the Chinese economy itself should it precipitate capital outflows from China in much the same way as occurred after the August 2015 renminbi devaluation. This is especially the case at a time that China is facing the bursting of its own credit bubble.

It is to be hoped that when the Federal Reserve assesses the fallout from the Brexit referendum it will not confine itself to looking at the effect of that referendum on the UK economy alone. If it also considers the likely global consequences of the Brexit vote, it will not be in a hurry to further complicate matters for the global economy by prematurely raising interest rates.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

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