Tax Analysts Blog

The Pound Is Going to the Dogs

Posted on Oct 7, 2016

On June 23 British voters decided to leave the European Union. For the better part of the following week, turmoil reigned in the U.K. political system. Prime Minister David Cameron abruptly – and appropriately – resigned. Curiously, the leaders of the victorious Leave campaign – including UKIP head Nigel Farage and putative Cameron successor Boris Johnson – followed him to the exits. All three have since left public life – normal for the loser, bizarre for the winners.

The financial markets reacted predictably, as they always do when actual events conflict with the consensus of the pundit class. Stock markets around the world fell precipitously, then rebounded nearly as fast, after dire predictions of economic calamity faded into the dull monotony of waiting for something to happen. The markets are still waiting.

As the country braced for the potentially radical consequences of the changes the electorate had demanded, the Conservatives elected the country’s second female prime minister. Even though Theresa May, a “quiet” Remain supporter, assumed office with a firm hand, she has taken a “go very slow” approach to Brexit, promising not to begin the formal process to exit the EU until next year, probably not until March. Despite the sword of Damocles hanging over the country, the U.K. appears to have returned to normal.

That normalcy exists, however, only on the surface. I recently spoke with a number of British tax experts at the 70th annual Congress of the International Fiscal Association, the world’s largest organization of tax professionals. They shared the view that the sense of calm emanating from Britain masks a growing anxiety about the future. After all, they explained, given the state of the Brexit effort, it makes no sense for anyone to make a long-term investment in the U.K. No prudent business would invest millions of pounds building a facility or locating a company in Britain without a strong indication that it would have access to the European single market after a Brexit.

But if government pronouncements are any indication, it is unlikely that Britain will retain that access. May recently declared that she had no interest in negotiating a Norwegian-style arrangement with the EU. Such a deal, in which the U.K. would have access to the single market in exchange for accepting free movement of individuals across national borders, would contradict the principal reason the voters wanted out in the first place. She knows who pays her salary.

As, one by one, businesses decide not to commit capital to the U.K., the pace of economic activity is slowing. And the government’s promise to cut the U.K. corporate tax rate from 20 percent to 17 percent post-Brexit cannot possibly stem the flow of capital away from the U.K. After all, if a British business lacks free access to the European single market, the tax rate it will pay on profits it may never earn may be the least of its concerns.

Which brings us to the once-mighty pound. Shortly after the Brexit vote commentators remarked on the strength of the pound in the face of adversity. As it dropped to $1.35 and then to $1.30, pundits assured a leery public that the pound would never reach $1.25. As of this writing, however, it has slipped to $1.26, and continues to trend downward. The pro-Brexit voters would do well to temper their unbridled optimism over the future, as the pound slowly goes to the dogs.

Read Comments (9)

Edmund DantesOct 6, 2016

As Europe continues to unravel, free access to its markets may become less and less important.

Brexit was a triumph of democracy, a victory of the people over the elites, over their "betters." The elites are being challenged all over the world, mostly because they have made such an incredible hash of things.

Mike55Oct 7, 2016

Every major analyst has now improved their post-Brexit forecasts for the UK economy, in some cases by over 50%!* Before the thinking was 1.2% growth in 2017, followed by .5% in 2018, but now people are thinking more along the lines of 1.9% in 2017 and .7% in 2018. That is a rather astounding turn of events, giving the Brexiters (or whatever it is they're called) cause for a bit of swagger.

You are of course 100% correct though: the UK economy is going to suffer a severe recession over the next 2-3 years (albeit a far less severe than initially expected). 1.9% growth might be considered solid for the typical EU country, but it's a recession by UK standards. And .7% growth may be the norm towards the bottom of the EU, but in the UK it's approaching depression level. After that, no one really knows what will happen. The UK will clearly bounce back, but no one knows what exactly it will bounce back to.

For what it's worth, my own perspective is that the UK is trading a large amount of short term pain for less overall pain in the long run. In other words, they are ripping off the band aid quickly. The EU has been headed down a steady path of ever strengthening economic ties and homogeneity amongst its members for a long time, but that's a bad thing if you're the UK, since the UK economy is far stronger than the EU as a whole. The Brexit means that the UK has given itself a chance to stabilize at something along the same lines as Australia's economy, rather than being inexorably dragged down towards its fellow EU members. Becoming Australia might not be ideal from a UK economic perspective, but it's a heck of a lot better than becoming France. I guess we'll see.

*The reason is that consumption hasn't dropped at all... whether out of patriotism or foolishness, UK consumers are still out there spending their cash, propping up the UK economy. Some economists had anticipated consumption might not dip by quite as much as it would in a normal period of economic contraction due to the uniqueness of the Brexit situation, but no one predicted this.

Christopher FranksOct 8, 2016

Would Mr Gibson think it acceptable for duly-enacted US statutes to be quashed by a non-US judicial body, and for the US Supreme Court to be subordinate to that same non-US judicial body? If the answer is Yes, then he is perfectly entitled to patronise those simple-minded Brits who so myopically voted to restore the national independence that their ancestors fought for centuries to preserve.

One further question. If, as Mr Gibson states, Boris Johnson has left public life, who's that blonde-haired chap with a colourful turn of phrase who is now the UK's Foreign Secretary?

JusticeTwoOct 11, 2016

Two points in response to the various comments:
1. If the U.S. had signed a treaty agreeing to all the things listed in Mr. Franks' comment (as the U.K. did), then I would expect our country to abide by its commitment. In fact, Congress lacks the power to enact laws that violate our treaty obligations. The U.K. certainly has the authority to leave the EU if it believes the negatives of remaining in the union outweigh the positives. But that decision, as with the decision to join the EU in the first place, has consequences. Regardless of how one views the wisdom of the voters' decision to leave the EU, it is the market (not the so-called elites) that will impose some of the consequences). The decline of the Pound, post-Brexit-vote, to less than $1.25 reflects one such consequence.
2. Yes -- Boris Johnson is back in government. But for a man who renounced his U.S. citizenship to position himself to become PM after he helped engineer the successful Leave campaign, serving as Home Secretary in a May government may make him feel like he has, indeed, left public life.

Mike55Oct 11, 2016

Why are you so focused on the decline of the Pound? In isolation that's a non-traditional measure of a country's fiscal strength and viability; a weakening currency is indeed sometimes a secondary consequence of a declining economy, but the correlation is far from perfect, and there are numerous other variables (e.g., relative interest rates/expectations have a huge impact on F/X). That said I'm a tax professional, not an economist, so I hope you take this question as genuine curiosity as opposed to being rhetorical.

As for Johnson..... wasn't the story that Gove pulled off a coup within the Brexit political faction that destroyed any chance Johnson had of becoming the PM? Here in the U.S. I'm admittedly a bit removed from all this, but I do recall something about Johnson either refusing to guarantee appointments, or promising appointments to the wrong people, or something along those lines, thereby creating a weakness Gove successfully exploited to sink Johnson's chances of becoming PM. Hopefully a UK reader can offer a bit more insight/detail, but I my recollection is that Johnson did not "walk away" voluntarily.

Christopher FranksOct 13, 2016

Did I say that leaving the EU would have no consequences for the UK? Of course, it will have consequences - many of them, no doubt, unforeseen, unintended and uncomfortable. That always follows from really big decisions. The consequences will take years, perhaps even decades, to work through, and in the meantime the UK will be in for a bumpy ride. I was perfectly aware of that when I cast my vote in the referendum. But I voted leave because the legislative and judicial independence of my country mattered more to me than anything else. I find it truly bewildering that citizens of the United States, of all countries, apparently find that so difficult to comprehend.

Edmund DantesOct 11, 2016

Per a recent WSJ article, the decline in the pound has been a good thing for Britain, it has insulated it from many of the dire economic consequences predicted by the Remain movement. Spikes in unemployment, crashes in consumption and economic contraction have been avoided. Devaluation of the pound provided a cushion for Britain that Greece could not have, as it was chained to the Euro.

JusticeTwoOct 13, 2016

If the pound had risen by 10% against the dollar after the Brexit vote, commentators would cite that as evidence of the robustness of the British economy, and further evidence of the wisdom of voters who supported Brexit. But now that the pound has dropped by 10%, the value of a currency that was at one point more than double the price of the dollar is irrelevant?

The basic point remains: No prudent business person will invest substantial capital in the UK without knowing the shape of the relationship between the U.K. and the EU single market post-Brexit. And the longer the May government waits to invoke Article 50, the longer that uncertainty will persist.

Mike55Oct 17, 2016

"If the pound had risen by 10% against the dollar after the Brexit vote, commentators would cite that as evidence of the robustness of the British economy, and further evidence of the wisdom of voters who supported Brexit."

Of course some would. Or, barring a strong GPB, commentators with a right leaning agenda would find some other meaningless-in-a-vacuum indicator of UK financial success to exploit in order to push their agenda. But why do two wrongs make a right?

All unbiased economic analysis points to the following: (1) the UK economy will suffer a meaningful contraction due to the Brexit vote, but (2) that contraction will be significantly less severe than anti-Brexiters had predicted. It's difficult to understand why the anti-Brexit crowd is taking a victory lap on this basis.

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