Monday, 24 October 2016

Brexit, a Development Opportunity

Pre Brexit, the UK economy and polity had features that could be found at the end of various boom episodes in emerging countries. The boom distortion centered around London´s City and some satellite services, with highly paid jobs in the financial sector and attracting some smart cosmopolitan crowd (and much low skilled labour). An overvalued exchange rate had burdened manufactures profits and wages, the periphery and people with only basic skills. According to Ashoka Mody, "the pound had been driven up to nose-bleed levels from 2011 to 2015 by global property speculators and the banking elites acting in destructive synergy, causing serious damage to Britain’s manufacturing base and long-term competitiveness". Britain was suffering a variant of the ‘Dutch Disease’, although in this case the problem was over-reliance on finance rather than commodities. (The Telegraph, 10/10/2016)

In James Meade´s country, there was neither external nor internal balance. The current account of the balance of payments stood at 7% of GDP. Productivity growth was absent since long and below the level obtained by European peers. The public sector had been reduced to the bones in various areas, so there was little room to compensate the poor for unfavorable market outcomes. Meanwhile, super rich foreigners could launder money by investing in London´s real estate that saw ever rising  prices to the detriment of young families. The role of the City as the unrivalled financial centre of Europe made it a magnet for speculative property flows from Russia, China, the Mid-East. Regional imbalances between the prosperous South and the rest of the UK deepened. 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, and within this data set it is the third most unequal in Europe, according to the UK Equality Trust.

 Nonetheless, the outcome of the referendum - a small but significant majority voted for leaving the EU - surprised most observers who had lost touch with the UK outside London. The EU had been badmouthed since long in the UK, notably by the evil Murdoch press. It provided to insular minds a welcome scapegoat for all the ills that had plagued the UK since long.

To a development economist, the macroeconomic policy needs for Britain seemed fairly obvious. It was not about leaving the EU, especially as the UK did not suffer from the Euro straightjacket. What was needed, however, was 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. A more competitive exchange rate, infant industry support and a public sector - reborn and rebalanced - were essential to any strategy to bring the UK back on a sustainable development path. Well, today the British pound stands 20% lower as measured by the BIS real effective exchange rate index. Amd parts of the financial industry threatens to move elsewhere...

Paint it black: Most of the selfreferential 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. That recession has still to materialize (as has Brexit). In my mind, they make two loose statements:

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 nontradables 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. Elasticity pessimism that was popular post WW II but has been largely refuted by considerable evidence of emerging countries that succeeded to crowd 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.

Devaluation makes Britain poorer. It is often argued that a cheaper pound makes Britain poorer. The Economist, not seldom on the wrong site of history (remember Africa - A Failed Continent?), titled recently: "Brexit is making Britons poorer, and meaner". But international trade theory has learnt us that a devaluation only makes a country poorer if it leads to a deterioration of its terms of trade. According to Fritz Machlup´s definite Kyklos (1956) study, … there is a "strong presumption that devaluation of overvalued currency lead to better resource allocation". This mirrors the UK case so that an improvement of UK´s terms of trade should not be excluded. But even if the terms of trade worsen as a result of devaluation, it does not follow that income is hit. Machlup: "The contention that a deterioration of the net terms of trade will normally cause a reduction of the real national income and a worsening of the balance of trade by equal amounts must surely be rejected."

In many poor countries, resource dependence generated slower growth, reduced economic diversity, and produced economic instability, inequality, conflict, rent-seeking and corruption. The Finance Curse produces similarly effects, often for similar reasons. Beyond a point, a growing financial sector can do more harm than good. The Tax Justice Network had, before Brexit, released a very readable pamphlet, entitled "The Finance Curse: Britain and the World Economy". Its conclusions might silence the black painters of the outcome of Brexit, a more competitive pound and a reduced finance sector:

" The financial services sector should be downsized. Macroeconomic policy should be conducted in the interests of a broader set of objectives and constituency. In turn, industrial policy should explicitly target diversification and the spatial diffusion of economic activity. Downsized finance itself will provide the basis for such a transformation with, for instance, finance losing its virtual monopoly on UK talent."

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.

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