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Brexit silver lining

28 June 2016 By Edward Chancellor

Britain’s referendum on EU membership has left the country divided and bitter. Defeated supporters of staying in believe that those who voted the other way are ignorant and that they will come to regret the material consequences of their decision. Perhaps John Bull has better economic sense than he’s credited with.

The majority of voters, ignoring shrill warnings from the UK government and sundry other official bodies, signaled their dissatisfaction with the status quo. They embraced economic uncertainty because they didn’t see they had much to lose. As it turns out, the market turmoil unleashed by the decision to exit the EU creates the possibility of putting the UK economy on a sounder footing.

Immigration is something of a red herring as an explanation for the British public’s discontent. When the economy is growing at a healthy clip and living standards are improving, migrants are generally welcome. The real problem afflicting the UK is that incomes have stagnated for years. Households struggle under the burden of excess debt. Housing is seen as increasingly unaffordable. Although Britain’s private wealth is at record levels, the gains have been unequally distributed both geographically and amongst the population.

Weak household income growth reflects Britain’s miserable productivity record over recent years. The best explanation for this is that during the era of ultra-low interest rates the UK has morphed into a bubble economy. That’s the type of economy which generates profits (and taxes) from shuffling around pieces of paper, but little by way of genuine value added. It is characterized by inflated asset prices, low rates of saving, the misallocation of capital, an overly large financial sector and often by increasing levels of foreign indebtedness.

Contemporary Britain ticks all these boxes. Low interest rates have pushed up house prices – London’s are now among the most expensive globally. Since (some of) the public enjoys vast paper wealth, it doesn’t bother to squirrel much away. The UK household savings rate, at around 4 percent of GDP, is lower than it’s been for more than half a century. Low savings have been accompanied by weak investment.

Interest rates at close to zero set an inadequate hurdle for returns on capital. As a result, the economy’s powers of creative destruction have been sapped and resources have been sucked into areas with low productivity, such as construction and domestic services, and away from the manufacturing and traded-goods sectors.

The financial industry is bloated, occupying a greater share of output than ever before. The total assets of the UK financial system are around 12 times the size of the economy – more than twice the level of the United States, according to the Bank of England. The spendthrift Brits have become dependent on foreign capital. A string of massive current-account deficits – a sign that Britain has been consuming more than it produces – has pushed the UK’s net foreign liabilities to a record 25 percent of GDP.

Britain’s bubble has resulted in disappointing productivity and wage growth. None of this bothers Londoners much since they have enjoyed the greatest increases in house prices and their incomes are boosted by the outsized financial sector – half of whose revenues are generated by the City. That probably explains why the capital voted to remain. But the rest of the country had less of an interest in maintaining the status quo.

The Brexit vote has been accompanied by a sharp fall in the British pound, rising financial-market volatility and the downgrading of the nation’s credit by the rating agencies. On the stock exchange, the weak performance of UK homebuilders suggests that the British housing boom, already threatened by overbuilding in the luxury segment, may be about to burst.

The conventional wisdom is that this is unmitigated bad news. In the long run, however, these developments should be welcomed. As sterling falls and currency volatility rises, foreigners will become reluctant to fund the current-account deficit. As a result, savings will have to rise. A cheaper currency means that exports are more competitive. In theory, this means resources will be diverted away from construction towards the traded-goods sector. A higher cost of capital should improve the allocation of capital. In time, this should allow interest rates to normalize.

As the bubble deflates, Britain will become more productive, paving the way for faster income growth. Of course, there will be losers. The financial sector will probably shrink. There may be fewer opportunities to get rich quick from a career in banking. London house prices will likely decline relative to the rest of the country. But there’s an upside. The City won’t act as such a brain drain depriving other more genuinely productive sectors of talent. Cheaper house prices mean more affordable homes.

This change will undoubtedly inflict pain. In the long run, however, there will be more winners than losers. The country should eventually end up richer and disparities of wealth will be less extreme. John Bull probably didn’t clearly envisage such an outcome when he marked his ballot paper, but in his bones he may have sensed that change was both necessary and long overdue.


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