Rough sailing ahead for UK economy

At a time of rising US-China trade tensions and a marked slowdown in the European economy, the last thing that the world economy now needs is a deepening in the UK’s Brexit crisis. Yet it is difficult to see how the UK economic and political situation will not worsen meaningfully as the world’s fifth largest economy approaches its October 31 Brexit deadline.

The primary reason for heightened concern about the UK’s immediate economic and political outlook is Nigel Farage’s Brexit Party’s strong showing in last month’s UK European parliamentary election. The corresponding implosion of the ruling Conservative Party, which suffered its worst electoral defeat in more than 150 years, leaves the Conservative Party with little alternative but to choose a hardline Brexiter like Boris Johnson to replace Theresa May as prime minister. The Conservative Party’s very survival would dictate that it does so.

As if to underline the rising risks that the UK will soon crash out of Europe, Boris Johnson, the odds on favorite to become the UK’s next prime minister, has indicated emphatically his commitment to have the UK leave Europe on October 31 with or without a deal. It also does not help matters that the Europeans are showing little inclination to renegotiate the Brexit deal that they negotiated with Theresa May nor that the UK parliament does not have the necessary time to agree to a new Brexit deal before October 31.

The economic damage to the UK economy from a hard Brexit is not to be underestimated. According to the Bank of England and the IMF such a worst case scenario would almost certainly precipitate a deep economic recession with UK GDP likely to decline by more than 5%. It would do so as supply chains would be seriously disrupted and as investors would choose to relocate their operations out of the UK and towards the continent.

At this stage, the only real way that a hard-Brexit can be avoided would be for parliament to engineer a successful no-confidence vote in the government before October 31. That would give the Europeans a credible excuse to make yet another extension to their Brexit deadline and to thereby avoid a hard Brexit that is neither in the UK nor Europe’s economic interest. They could do so on the grounds that a new general election would give the UK public the chance to reconsider whether or not they really wanted to leave Europe.

The chances of a successful no-confidence vote before October 31 would not appear to be high. This is particularly the case since it would require many members of parliament to be prepared to accept the high likelihood that they would lose their seats to members of the surging Brexit Party.

Even if there were to be a successful no-confidence vote it would not be without serious adverse economic consequences. This would seem to be particularly the case because investor’s confidence would be seriously shaken by the prospect of a minority government that could be led by a very market-unfriendly Jeremy Corbyn.

The net upshot is that rough sailing seems to lie ahead for the UK economy under any plausible scenario. In the worst case and more probable scenario, the UK could crash out of Europe on October 31 and see the world’s fifth largest economy take a serious hit. In the best case and less probable scenario, the UK economy would languish for a prolonged period of time in an environment of heightened domestic political uncertainty.

Judging by the relative calm in the UK currency market, investors seem to be sanguine about the UK’s immediate economic and political outlook. One has to hope that global economic policymakers do not share the market’s sanguine view of the UK’s immediate economic and political prospects and that they are making contingency plans for a hard Brexit on October 31.

Desmond Lachman joined AEI after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney. He previously served as deputy director in the International Monetary Fund’s (IMF) Policy Development and Review Department and was active in staff formulation of IMF policies. Mr. Lachman has written extensively on the global economic crisis, the U.S. housing market bust, the U.S. dollar, and the strains in the euro area. At AEI, Mr. Lachman is focused on the global macroeconomy, global currency issues, and the multilateral lending agencies.