UK: How a Development Economist Sees It

Before the Brexit vote rolled around, the UK economy and polity stood out for one very surprising fact: It exhibited features that could be found at the end of various boom episodes in emerging market countries.

The distortions triggered by the boom centered around London and some satellite services, with high-paying jobs in the financial sector and attracting some smart cosmopolitan crowd (and much low skilled labor).

Meanwhile, an overvalued exchange rate for the British pound burdened manufactures’ profits and wage levels, which had a very direct impact on people with only basic skills.

What’s there to be proud of about the UK, pre-Brexit? There was neither external nor internal balance. The current account of the balance of payments stood at 7% of GDP.

Productivity growth has been absent for long and ranks below the level obtained by its European peers.

In addition, the UK public sector has been reduced to the bones in various areas, so there has been little room to compensate the poor for unfavorable market outcomes.

A glitzy house of horrors – for the people

Meanwhile, super-rich foreigners are able to launder their money by investing in London’s real estate. The price increases they triggered ultimately came to the detriment of young families trying to establish an existence in the British capital.

The role of the City may be unrivalled as the financial center of Europe, not least thanks to becoming a magnet for speculative property flows from Russia, China and the Middle East.

As for the rest of the country, regional imbalances between the prosperous South and the rest of the UK have deepened. And compared to other developed countries, the UK has a very unequal distribution of income. Out of the 30 OECD countries, the UK is the sixth most unequal.

What needs to be done?

To a development economist, the macroeconomic policy needs for Britain seem fairly obvious. Brexit addresses these needs only very tangentially.

The crux of the issue for the UK thus is not leaving the EU, especially as the UK did not suffer from the Euro straightjacket.

What is needed in the UK is a rebalancing toward more regional and personal equity, the creation of pro-poor growth and jobs, implying the need to tame the City plus its satellites.

As well, a more competitive exchange rate, infant industry support and a public sector, reborn and rebalanced, are essential to any strategy to bring the UK back on a sustainable development path.

Where does the British pound stand?

Well, today the British pound stands 20% lower as measured by the BIS real effective exchange rate index. And parts of the financial industry threaten to move elsewhere.

Whether you love it or hate it, there is no denying that both of these developments are a result of Brexit.

Paint it black: Most of the observers who did not see Brexit coming now deny that anything good can come out of the “pounded British pound.” They were and are uniform in their warning that Brexit would cause a sharp recession.

In my mind, they make two statements that simply don’t add up:

1. Elasticity Pessimism

Many people seem to believe that real exchange rates don’t matter for adjustment — that is, that external and internal devaluation (downward adjustment of non-tradables and wages relative to trading partners) don’t help alleviate imbalances as trade and resource flows fail to respond.

The Center for European Reform, a privately sponsored think tank that gets more media attention than the quality of its opinion-heavy output might suggest, is just one example.

The notion of “elasticity pessimism” that was popular post World War II, but has been largely refuted by considerable evidence of emerging countries.

Those countries did succeed with crowding in foreign demand by sustained real exchange rate devaluation. To be sure, a short-term flash crash will not provide the incentives and signals that a sustained real devaluation will confer.

2. Devaluation makes Britain poorer

It is often argued that a cheaper pound makes Britain poorer. The Economist, not seldom on the wrong side of history (remember Africa – A Failed Continent?), titled recently: “Brexit is making Britons poorer, and meaner.”

Iinternational trade theory has taught us that a devaluation makes a country poorer if that devaluation leads to a deterioration of its terms of trade.

Moreover, trade diversion effects of leaving the EU can outweigh trade creation effects, as the UK economy redirects its focus toward global markets.

According to Fritz Machlup´s definitive 1956 study, there is a “strong presumption that the devaluation of an overvalued currency leads to better resource allocation.” This mirrors the UK case, so that an improvement of UK’s terms of trade should not be excluded.

3. The finance “curse”

In many poor countries, resource dependence generated slower growth, reduced economic diversity and it also produced economic instability, inequality, conflict, rent-seeking and corruption.

The term “Dutch Disease” indicates that the risk of low growth due to resource dependence can apply to rich countries as well. The term describes the decline of the manufacturing sector in the Netherlands after the discovery of large gas fields in 1959.

As regards the UK, the “Finance Curse” produces similar effects, often for similar reasons. Beyond a certain point, a growing financial sector can do more harm than good.

Before the Brexit vote, the Tax Justice Network had released a very readable pamphlet, entitled “The Finance Curse: Britain and the World Economy.” Its conclusions might silence those who are determined to paint the outcome of Brexit black.

After all, a more competitive British pound and a reduced size of the country’s finance sector are definitely two things worth striving for.

As the report argued: “Downsized finance itself will provide the basis for such a transformation with, for instance, finance losing its virtual monopoly on UK talent.”

Why then not paint it rose?

The pound’s fall and the withdrawal of banks from the City could well be a blessing in disguise. Maybe, just maybe, Britain is at the first stage of a sustainable development upswing.