Macroeconomics

The great British economic rollercoaster (and how to derail it)

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Source: Credit Suisse & Business Insider

The two main challenges facing the UK economy at the start of 2017 are the much trumped-up uncertainties of Brexit and the imminent interest-rate divergence across the rich world. The intricacies and complexities of the Brexit process have the potential to upend quite a few givens in the well-oiled machine of the British economy and create many uncertainties as to the role of the United Kingdom in the wider European and world economies. The main talking points have been waning investor confidence, threatened export potential (somewhat alleviated by the commitment of behemoths Nissan and Google to expanding their activities in the UK), and the value of the British pound.

Bank angles and centrifugal forces

A dilemma that the Bank of England, which has been a favourite punching bag for populists and political opportunists of all kinds and political spectra might have to face in the coming months is whether to increase its base interest rate to defend the pound and prevent inflation at the price of pushing the economy towards recession, or to keep rates low and let inflation run its course and even cross the hallowed 2% per annum.  For now, the indications given by Mark Carney is that the Bank is not ready to endanger the carefully nurtured recovery of the British economy in the name pushing down inflation, whose stubborn bottom-scratching has been the main source of headaches for central bankers in the past decade.

Whilst China was considered the main risk for the world economy at the beginning of 2016, as its slowing economy and bubbly property markets were causing concerns of an imminent meltdown, investors have largely been assuaged that the Chinese government still has the capacity and the willingness to defend the status quo. Major risks have thus shifted from emerging markets to the big Trumpian and Brexitarian question marks in the West. The dangers lingering in the background are the French, German, and Italian elections looming in 2017, which in a worst-case scenario can see Italy and France staging a referendum to leave the Eurozone, which could spell its collapse, with tectonic consequences for European economies. They, just like Britain, will find out that tying the knot is much easier than untying it.

The rich are getting richer and the rich are getting poorer

The second main challenge is related to the divergence in the recovery dynamics of rich-world economies in the aftermath of the Great Recession. The US economy, thanks in part to the decisive actions of the Obama administration and the monetary weight-lifting of the Federal Reserve, has performed well, created jobs, and exhibited rude growth rates in the interval of 2% to 3% per annum. This has warranted the recent decision of the Federal Reserve to restart the gradual process of monetary tightening, begun at the end of 2015 but delayed by perceived market turmoil.  Whilst the UK had for some time been exhibiting similar robustness, Brexit has the potential to jeopardise that and lay bare structural weaknesses such as the abysmal growth of productivity in recent years and high private-sector indebtedness. The Eurozone and Japan, the traditional anaemic patients, have forced their central banks to stay the course of low-interest rates and experiment with unprecedented instruments designed to lift demand out of its almost chronic torpor.

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Source: The Brookings Institute

This divergence in recovery trends might cause instability in the global financial system as the dollar strengthens against other currencies despite the substantial current account deficit of the US. In those conditions, the role of the Bank of England, the European Central Bank, and the Bank of Japan might be constrained by the requirement to protect their ward economies against inflation without knocking out the still fragile patient into a new recession. The compromise between preventing another slump and keeping prices at bay will be finer than ever.