In the post-war period, the United Kingdom has been no stranger to periodic sterling crises. Indeed, it experienced such virulent and damaging crises as recently as 1967, 1976 and 1992. However, this has not prevented Prime Minister David Cameron from risking yet another sterling crisis by calling a June 23 referendum on the issue of continued British membership in the European Union.
{mosads}At the best, Cameron’s decision will subject the country to four months of acute political and economic uncertainty in the run-up to the referendum. At the worst, in the event of a vote for “Brexit,” as Cameron himself acknowledges, it could lead to “seven years of uncertainty” that would damage jobs, investment and the financial services sector.
From an economic point of view, the timing of the Brexit referendum could hardly be worse. The United Kingdom is presently running close to its largest external current account deficit in the post-war period. As Bank of England Governor Mark Carney recently reminded us, this makes the United Kingdom uncomfortably dependent on the “kindness of strangers” to finance that deficit.
A further factor putting sterling at risk is the fact that the U.K. economic recovery now appears to be running out of steam while the British government is still intent on a budget-tightening path to improve the country’s public finances. This will makes it very difficult for the Bank of England to raise interest rates to defend the currency.
In the event of a vote in favor of Brexit, there can be little doubt that sterling would experience an acute and prolonged crisis. This is the case for at least three basic reasons. First, Brexit would usher in an 18-month period of economic and political uncertainty during which the United Kingdom would have to renegotiate its arrangements with the European Union. One would expect that Britain’s spurned European partners would not be inclined to make those negotiations easy for Britain or to soften the blow to the U.K. economy from Brexit.
The second reason is that the City of London would likely lose its luster and experience an exodus of foreign banks. In the event of Brexit, those banks would no longer enjoy unrestricted access to the European markets as they now do from their London bases. Third, and perhaps most importantly, is the likelihood that the very future of the United Kingdom would be thrown into question by a Brexit. At a minimum, one has to expect that Scotland will want to revisit its independence issue, especially if the United Kingdom were no longer to be a part of the European Union. One also must expect independence pressures to be fanned in Wales.
Hopefully, the referendum will deliver a vote against Brexit that would spare the United Kingdom from years of economic uncertainty. However, even in the event of a vote to stay in Europe, one cannot exclude the possibility of a run on sterling in the run-up to the June 23 referendum. This would be particularly the case if, as was the case in the recent Scottish independence referendum, it turns out to be a closely fought referendum. If the referendum looks to be close, one must expect that both companies and households would not want to subject themselves to the risk of very large losses on their sterling holdings that would occur if the electorate delivered a Brexit verdict.
Needless to add, the Brexit referendum has considerable implications for the global economy. It is the very last thing that an anemic European economy and a Europe already having to contend with a rise in political populism now needs. A plunge in sterling would also hardly be helpful to the global economy in that it would heighten the risk of a currency war in which a number of major central banks are already trying to gain competitive advantage by taking measures to deliberately weaken their currencies. We must hope that cooler and more sensible heads prevail in the forthcoming Brexit referendum and that the U.K. electorate votes to stay in Europe.
Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.