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Markets do actually solve problems – yea, even Brexit

Summary:
This is not to take a view upon the merits of Brexit itself - opinion here as elsewhere is divided on that. Rather, it is to point out that if there are economic problems either way, markets will indeed solve those economic problems. That being what markets do, adjust to any new reality which affects markets:Toward a sterling crisisThat’s a rather odd thing to be worrying about really. We have a floating exchange rate these days. We are not trying to tie the value of sterling into any other economic number. The price is just what it is, the price. So how can we have a crisis? Those belong to the days of fixed exchange rates, when we would try to enforce a particular value, even as other economic policy forced a divergence from it.In highlighting the economic cost of the United Kingdom

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This is not to take a view upon the merits of Brexit itself - opinion here as elsewhere is divided on that. Rather, it is to point out that if there are economic problems either way, markets will indeed solve those economic problems. That being what markets do, adjust to any new reality which affects markets:

Toward a sterling crisis

That’s a rather odd thing to be worrying about really. We have a floating exchange rate these days. We are not trying to tie the value of sterling into any other economic number. The price is just what it is, the price. So how can we have a crisis? Those belong to the days of fixed exchange rates, when we would try to enforce a particular value, even as other economic policy forced a divergence from it.

In highlighting the economic cost of the United Kingdom crashing out of Europe without a Brexit deal, Mark Carney, the Governor of the Bank of England, famously cautioned that the country was overly dependent upon the kindness of strangers to finance it. By this he meant that the UK’s financial and economic stability depends very importantly on foreigners being willing to continue financing the UK’s large external current account deficit, which now amounts to as much as 4.5% of GDP.

Remember the most basic thing about the balance of payments - the payments do balance. This is wrong in exact detail but good enough. Any trade deficit will be balanced by a capital account surplus. That’s what is meant there by foreigners financing our trade deficit. That causality operates the other way is true - it is the difference between domestic savings and domestic investment which produces the trade deficit.

But no matter. Payments always balance. So, if foreigners decide they’d prefer not to invest in the UK then that trade deficit will shrink. How? Because foreigners exchanging their funny money for good solid pounds sterling to then buy stuff in Britain raises the exchange rate of sterling. If they fail to do this then the exchange rate falls. A lower value of sterling in funny money means that we will buy fewer imports, foreigners will buy more of what we produce. The deficit - after increasing as a result of the J-Curve where it takes time for volumes to catch up with prices - decreases. For the balance of payments balances.

Given that we’ve got a floating exchange rate we cannot actually have a sterling crisis. We just sit here and watch markets and their prices take the strain.

Oh, sure, we might not like those new prices but that’s not a crisis.

And what has happened? Well, when the Brexit vote came in sterling fell - markets are forward looking. And every time it looks like a hard Brexit is getting closer sterling falls, every time some deal that results in single market access, or customs union , or a trade deal, looks more likely then sterling rises. That is, we’ve got that real time and forward looking adjustment mechanism working every moment the markets are open. We’re not even going to get to a crisis point because the adjustment will already have happened.

There are many things we can ponder concerning Brexit and everyone’s entitled to their own views on the desirability of near all of them. But as long as we do indeed have a floating exchange rate a sterling crisis just isn’t one of those things we’ve got to worry about.

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Tim Worstall
Tim Worstall is a British-born writer and Senior Fellow of the Adam Smith Institute. Worstall is a regular contributor to Forbes and the Register. He has also written for the Guardian, the New York Times, PandoDaily, the Daily Telegraph blogs, the Times, and The Wall Street Journal. In 2010 his blog was listed as one of the top 100 UK political blogs by Total Politics.

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