Brexit and Britain’s dutch disease

The pound is up on the back of Theresa May agreeing to opposition demands for “a full and transparent” Brexit debate in parliament before activating Article 50.

But even if it wasn’t, would it really be that bad for the British economy? Let’s pause for some perspective maybe?

BoE governor Mervyn King outlined the case for why a weaker pound shouldn’t be seen as the end of the world two days ago. Ambrose Evans-Pritchard meanwhile cited Ashoka Mody, the IMF’s former deputy-director for Europe arguing that the strong pound is largely the by-product of the City’s position as an unrivalled financial centre which draws continuous speculative inflows from abroad, which can then be leveraged up through global banks in London.

If the real British economy ends up being crowded out because of the City effect, it’s fair to hypothesise there’s been a not insignificant Dutch disease effect across the nation. The only difference is that instead of the economy being geared up to overly produce commodities — without necessarily any back-up plan for what happens once the resources run out — it ends up being geared for financial service provision. That’s fine until you realise there’s no reason for why financial services have to be geographically exclusive. Or when you realise they don’t always create a net positive value effect in the aggregate, and can be quite zero sum.

Mody’s comments from the Evans-Pritchard’s piece hone in on the problem:

“It was essentially a bank-property nexus, and the rest of the economy was left to suffer. It is stunning that just 1.4pc of all loans were going to the manufacturing sector,” he said.

“Britain was borrowing 5pc to 6pc of GDP a year to buy imports and live beyond its means. The strong pound was great if you wanted to buy a Mercedes Benz of take a holiday in Spain, but the prosperity was an illusion, borrowed from the future,” he said.

If what’s good for the City is good for London but not necessarily for the rest of Britain, there’s a reasonable argument to be made that a loss of financial services could result in a healthy rebalancing.

As Paul Krugman noted on Tuesday, what’s bad for financial services may even end up being unexpectedly good for the rest of Britain as a whole.

Pre-Brexit, Britain was obviously experiencing a version of the so-called Dutch disease. In its traditional form, this referred to the way natural resource exports crowd out manufacturing by keeping the currency strong. In the UK case, the City’s financial exports play the same role. So their weakening helps British manufacturing – and, maybe, the incomes of people who live far from the City and still depend directly or indirectly on manufacturing for their incomes. It’s not completely incidental that these were the parts of England (not Scotland!) that voted for Brexit.

Is there a policy moral here? Basically it is that a weaker pound shouldn’t be viewed as an additional cost from Brexit, it’s just part of the adjustment. And it would be a big mistake to prop up the pound: old notions of an equilibrium exchange rate no longer apply.

In a world haunted by deflation and currency wars, it seems irrational to be panicking about a revaluation of the pound — which some might say was a long time coming anyway.

Related links:
Fintech and banking risk; cognitive dissonance de semaine – FT Alphaville
The pound and the fury – Economist Ryan Avent