Brexit: What Cometh Now?

Away from the specter of the implosion of the British political establishment that has kept the media occupied, economists are busy speculating what happens next to the economy.

True to the lament of the profession, economists have not one, but three radially opposite answers.

One camp believes that as the UK retreats within its domestic borders, there will be a flight of capital to larger safe-haven economies, driving down the British sterling, and thereby increasing the cost of imports. The rising prices of energy, food and clothing will invariably contribute to a higher inflation rate. In this scenario, the Bank of England will respond by raising interest rate to combat inflation. Investors may also lose appetite for UK government bonds, driving up the yield on short-term UK government debt. In this scenario, aggressive purchase of government debt by the Bank of England will lead to market distortions driving the sterling even lower. So, the only realistic choice for the Bank is to increase its rates. Sounds fair enough? Then hear what the other camp has to say.

The EU is the largest export market for the UK. Naturally, the EU is determined to exact a price for British withdrawal. Some trade barrier, whether in the form of tariffs or regulations, will complicate the ease of conducting business. The lower demand for British goods will cause British exporters to shed jobs, leading to economic contraction. This leaves the Bank of England with no choice but to increase the money supply by reducing interest rates. Mark Carney, Governor of Bank of England has expressed this view numerous times. Coming from the Governor, this may appear to be the consensus view, but there is also a third argument.

The UK will simultaneously experience higher inflation due to the rising cost of imports, and contraction in the economy because of job losses. In this case, what can the Bank of England do? For the answer, let us examine recent history.

In the 1970s, the US suffered a long bout of economic stagnation when the real economy was not growing yet inflation was stubbornly high. This was dubbed as "stagflation." Stagflation debunked Keynesian theory that only greater demand leads to inflation, therefore, inflation is an indicator of economic expansion. Milton Friedman of the University of Chicago had a different explanation. Friedman believed inflation to be a necessary result of increased money supply. He advocated raising interest rates to fight inflation. In 1979, Chairman of the Fed Paul Volcker put this theory to test. Within two years, the US inflation rate became tame, but the economy dove into recession.

If the Bank of England follows Milton Friedman's prescription, they will raise the interest rate, plopping up the value of pound. However, this scenario will also drive the UK into an even deeper recession. Tax receipts will fall short. The government will have to slash budgets. Where will these cuts fall? The last thing that the politicians would want to do is to cut welfare programs which have some stimulative impact on the economy. My suspicion is that the budget cuts will affect military spending disproportionately. As a result, the UK will lose its clout in NATO and the country will retreat further within its walls.

Which of these three economic scenarios is most likely? The answer may likely be all of the above. In the short-term after Brexit, interest rate cuts will be necessary to maintain market liquidity--to keep markets from seizing up. It may even head to negative territory. This will have a negative impact on the sterling; invite inflation in food, clothing and energy prices, and, make the latest "sick man of Europe" even sicker. This is likely to bring the Bank of England under withering criticism for its policies and will reverse course which will drive UK deep into recession before it finds a new point of stability. Indeed, complex questions seldom have simple answers. Is three enough?