18 June 2016

VoxEU: The pound and the macroeconomic effects of Brexit

A depreciation of the pound following a vote to leave the EU could well generate an export boom, but this would not compensate for the damage to UK's internal demand and to its ability to access external financing of its deficits. This would put the UK's low-risk status in jeopardy.

Ahead of the EU referendum in the UK, the pound has been falling markedly. The high volatility and relative weakness of the pound may not come to an end on June 23. If the UK opts to leave the EU, persistent uncertainty over what Brexit actually means is likely to produce much more of the same for quite a long time.

A prolonged period of uncertainty would be unavoidable, because there are many areas in which the EU and the UK are strictly interrelated (trade, finance, energy, environment, border security, defence, and so on). As policymakers try to sort out the post-Brexit regime, many tables would have to be re-opened at once, both multilaterally and bilaterally. Every table would create opportunities for disagreement and numerous unexpected issues may arise. Every issue would create policy conflict and political games, resulting in delays and amplifying uncertainty about the final outcome.

While some studies warn against the costs and risks of a currency ‘collapse’ in this environment, many observers are more optimistic and stress a potential benefit for the UK. [...] 

Based on related work (Corsetti et al. 2016), we argue that things are not that simple. A hike in country risk can hardly be welcomed as a good thing. As the periphery of the Eurozone has amply demonstrated, country risk means that the government, firms and households in a country suffer from deteriorating borrowing conditions. While net exports expand, internal demand suffers. Fiscal policy becomes more costly and politically difficult to resort to, as markets may show little or no tolerance for widening deficits. [...]

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