2 Brexit Scenarios. Or, Why The Current Account Could Matter.

Another day, another solid bit of work from the Treasury that risks being undermined by being politicised.

The combination of that rather unsubtle website front page and the fact that yesterday’s document omitted one potentially less damaging scenario both risk undermining what was otherwise a very useful bit of analysis.

For what it’s worth — and after day’s reflection — I think there are broadly two plausible scenarios for the short term impact f a leave vote next month. One of which is manageable and one of which would be very painful indeed.

Just to be clear — I’m talking here about the short term impact of a vote to leave, the effect on the macroeconomy over the following two years or so.

In the longer run the picture is less clear, we just don’t know what kind of trading arrangements the UK will end up with or how open it will be to immigration. That said there is a reason that some 280 economists (including myself) have signed a letter warning that the impact of leaving is likely to leave the UK economy less well off. The balance of probabilities is that the UK economy post-Brexit would less open and that productivity growth would be slower.

Turning to the short run though: in as much as anything can be called “likely” in macroeconomics a Leave vote would likely the economy directly in two distinct ways both driven by a rise in uncertainty.

The first is through a slowing or a fall in corporate investment. As firms waited to see exactly what kind of arrangements the UK ended up with they would likely cut back their spending — either postponing it or cancelling it. In fact this seems to be happening already.

That slowdown in business spending and hiring would hit the economy directly.

It’s also very possible that consumers would tighten their belts, choosing to increase their savings and cut back on spending whilst the outlook was unclear.

Add those effects together and the UK would face an immediate slowdown in demand that would slow the economy.

All this would likely to be magnified by a rise in banks’ funding costs which would be passed on to consumers pushing up borrowing rates for households and businesses.

But this should be a manageable slowdown. Perhaps the biggest weakness of the Treasury document is that it assumes no fiscal policy response (other than allowing the automatic stabilisers (the impact of lower tax revenues and higher social security spending) to operate) and no further policy easing from the Bank of England.

But faced with a slowing economy, the Bank could well choose to ease policy (indeed negative interest rates wouldn’t be out of the picture) further or the Treasury could choose to delay sending cuts.

Policymakers’ toolkits aren’t empty, they haven’t run out of ammo and a fiscal/monetary response could offset some of the slowdown in demand.

But this relatively manageable scenario (and the key word here is relative — it still wouldn’t be pleasant) ignores the elephant in the room. The UK’s large current account deficit (see lots of previous posts). The fact that in the last quarter of 2015 the UK borrowed 7% of GDP from the rest of the world.

The current account deficit is at its highest level in decades and as the Governor of the Bank has put it, we are “reliant on the kindness of strangers”.

I usually worry about the current account deficit as representing a sign of a fundamental imbalance in the UK economy rather than as a direct risk in and of itself. The idea that a developed economy could be subject to an emerging market style sudden stop in capital flows still feels outlandish, Still, until a few years ago the idea that a developed market would mess around with political risk on a merging market scale also felt pretty distant.

It’s easy to worry about the current account deficit but sometimes hard to see a catalyst that would turn a vulnerability into an actual problem.

The risk scenario has always been there. 18 months ago I wrote about the interaction of a large current account deficit and still high household debt levels could put the Bank in a terrible position if foreign investors ever decided to re-assess the risk that lending to the UK posed.

Their reaction is to start sell sterling and push down the value of the pound. A moderate downwards move in sterling could prove helpful — it might make UK exports more competitive and help reduce the trade deficit and it could help push up inflation, which is currently below the Bank of England’s target. Sterling was devalued hugely between 2008 and 2009 in a move that was quietly welcomed by UK policymakers.
But the extreme scenario goes further, it sees disorderly sell off in sterling and sterling assets as international investors begin to dump anything connected to the UK. Assets prices fall and sterling depreciates quickly pushing up inflation to well ahead of the Bank of England’s target.
The usual policy response to this would be to hike interest rates — that would make holding sterling more attractive and push down domestic demand (hopefully crimping imports).
And this is where the interaction of the ‘other deficit’ and the ‘other debt’ comes into play. Because hiking interest rates rapidly when household debt is so high would have serious consequences for people’s ability to meet their obligations.
That nightmare scenario isn’t, as I’ve said, the central view of many. But it does highlight the kind of problems that the interaction of high household debt and a large current account deficit can bring.

The real worry is that after a vote to leave, foreign investors re-assess the risk of lending to the UK and decide to cut back.

The UK would face slowing investment, rising inflation, rising borrowing costs for firms, households, banks and possibly the government itself whilst asset prices fell sharply. Meanwhile the Bank would be a less strong position to offer policy support and it isn’t entirely implausible that the long waited bond vigilantes would arrive, worry about lending to the UK government and push up government borrowing costs too. The fiscal space to provide support could fall.

I simply don’t know how far the “kindness of strangers” would stretch after a vote to Brexit.

It’s possible they would shrug it off and the fall in private UK demand could be offset by policy. But it’s also possible that the kindness would drove up and the UK would take a much bigger economic hit.

Perhaps the one immediate upside, in terms of the economics, to a leave vote would a chance to answer an old question: do current account deficits matter for developed countries?