June 25, 2016
Neil Irwin had an Upshot piece trying to work through some of the fallout from the vote to leave the European Union. It is worth elaborating on a couple of the points in this piece.
First, Irwin seems to give financial markets undue credit in having a clue. He argues that the effects of the vote will be transmitted to the economy through financial markets. While this is largely true, financial markets are notoriously fickle. They often over-respond to events or even non-events, the most obvious being the 25 percent plunge in October of 1987 that wasn’t linked to anything in the world. This plunge also had only a very limited impact on the economy. For this reason, it doesn’t make much sense to project economic affects based on one day’s market movements.
Second, Irwin highlights the 8.0 percent plunge in the value of the pound against the dollar as something that is likely to have a substantial impact on the UK economy. This is true, but a little more background here is important.
The UK was running a trade deficit in the neighborhood of 5 percent of GDP (@ $900 billion in the U.S.). This deficit was being in large part fueled by an inflow of foreign money to buy UK real estate, leading to an enormous run-up in housing prices, especially in London. This was unsustainable. (Some folks may have heard about housing bubbles but apparently it was difficult in the UK in the pre-Brexit era to get information on such things.)
Anyhow, the correction for a large trade deficit is a drop in the value of the currency. If the UK had competent economic managers, they would have tried to engineer a drop in the value of their currency. They also would have tried to prevent the bubble from growing so large. The plunge in the pound may now bring about the necessary correction in the trade deficit. It may also stop and even reverse the inflow of foreign capital to buy real estate, thereby crashing the bubble.
If that happens, then the Brexit vote will have merely brought forward events that were inevitable. While Washington Post types will inevitably engage in a round of intense finger-wagging at the Brexit voters, the real problem here was the incompetent management of the UK economy by Prime Minister Cameron and the English Central Bank.
There is also a distributional effect that is worth noting. If the pound remains low, this hugely improves the situation of manufacturing workers in the UK, many of whom apparently supported Brexit. If the air goes out of the London real estate market and the UK financial industry takes a big hit, then the London elites will be much less wealthy in a post-Brexit economy. This would be an interesting outcome, even if it is not necessarily what the Brexit voters had in mind.
The final point is that Irwin notes the impact on inflation associated with the plunge in the pound and says that the Bank of England will have to decide whether to fight the inflation or boost the economy. While the plunge in the pound is certainly going to put upward pressure on prices, inflation in the UK had been under 1.0 percent, so some rise in the rate of inflation would be desired even from the standpoint of preserving its 2.0 percent target.
Furthermore, the serious concern about inflation is the risk of an ongoing acceleration. For this reason, it is common to ignore one-off events. This is why the Fed explicitly focuses on the core rate of inflation, ignoring the impact of one-time rises in food and energy prices. By this standard, the reasonable route for the central bank would be to ignore the immediate impact of the drop in the pound and only take action if it appears to be getting passed on in other prices, so that it is leading to an ongoing increase in the rate of inflation to rates that are unacceptable.
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