Why Are the Brits Ignoring the Cost of the Brexit Devaluation?

This article first appeared on the American Enterprise Institute site.

One has to be surprised at the economic illiteracy characterizing the current U.K. economic policy debate in the wake of the Brexit referendum.

Despite the fact that sterling has depreciated by more than 10 percent since that referendum and that it now shows every sign of falling further, the economic policy debate is not focusing on how to manage the likely inflationary fallout from that depreciation.

Rather, the debate seems to be focusing on how much more expansionary U.K. monetary and fiscal policy should be to limit the possibility of a slowdown in the U.K., economic recovery.

Two key points seem to be being missed in the current U.K. economic policy debate. The first is that the U.K. is a very open economy where total imports and exports account for some 60 percent of the country's GDP. As such, one would expect that the direct inflationary impact of every 10 percentage point decline in the pound could be to add at least 3 percentage points to U.K. inflation.

This means that were there to be a further 10 percent depreciation of the currency —as would seem to be a very real possibility in the event of a "hard" Brexit—sterling's depreciation could easily cause U.K. inflationary expectations to become unanchored.

The second point missed is that a large depreciation of the currency has the effect of shifting resources toward the external part of the economy. It does so as exports get a boost from a cheap currency and as imports become more costly in domestic currency terms since they are dominated in foreign currency.

In the context of the U.K.'s present record post-war external current account deficit of 7 percent of GDP, this in itself would be a welcome development.

However, if the U.K.'s external current account deficit is to be reduced from 7 percent of GDP to a more sustainable level of, say, 3 percent of GDP, room has to be made for this very large shift in resources to the external part of the economy to take place without generating inflation.

It is for these reasons that one has to be concerned that not only has the Bank of England cut interest rates in the wake of Brexit but it now seems to be committing itself to even more monetary policy loosening. It seems to be doing so irrespective of the risk that further monetary policy loosening might give occasion to yet another round of sterling depreciation.

Similarly, one has to be concerned that in advance of this year's autumn budget statement, the U.K. economic debate seems to be focusing on how much of a budgetary stimulus the U.K. economy needs to boost economic growth.

This would not be the first time in the U.K.'s economic history that a falling pound gave rise to inflation and poor economic performance for want of appropriate aggregate demand management policy.

This makes it all the more regrettable that the U.K. might now be well on its way to mishandling yet again the fallout from a large currency depreciation.

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.