The U.K. Had Better Stay In The EU And Retract From Fiscal Austerity

Includes: EWU
by: Lok Sang Ho

A recent of paper of mine shows that the U.K. was experiencing something very unique. Whereas most countries that I have tested have their elasticities of exports with respect to the exchange rate rising over the years, the U.K. was experiencing a rather dramatic decline. This means that exports were not as sensitive to changes in exchange rates as before. All of the other countries I have tested showed an increase. That would be natural, given increasing globalization. A rise in the elasticity of exports to the exchange rate means that a depreciation should have a greater stimulating effect on exports. In view of the keener competition that is a result of globalization, a depreciation of the currency will tend to have a quicker and larger effect on exports. The UK, on the other hand, seems to be the exception. Just as my estimates predicted, the U.K. had hardly benefited from the huge weakness of the pound sterling. In my paper I conjectured that this could be a result of the UK's not joining the eurozone.

I think the U.K. did the right thing not to join the eurozone. It is now enjoying lower interest rates than many eurozone countries, in large part because it has independent monetary policy. This had helped the U.K. tremendously. The fact that it is still so weak is largely a result of its extreme fiscal austerity measures.

In an early column here I had observed that America was on course tackling its deficit problem because it did not opt for extreme austerity. In the current fiscal year the federal deficit could fall to $642 billion, the smallest shortfall since 2008. This is just 4.0 percent of gross domestic product-less than half as large as the shortfall in 2009, when it stood at 10.1 percent of GDP.

The U.K. had everything in its favor for a strong recovery: low interest rates, a weak pound, and competitive tax rates. Yet its economy is weak, and the fiscal outlook pales in comparison with the U.S. The U.K. really should look at the history, and should take a lesson from the U.S. The economy quickly rebounded after the depreciation of the sterling in 1992. Why did it fail to repeat that success? What was different? Mervyn King had done the best he could. It is doubtful that the new Bank of England Chief from Canada will be able to work miracles. Severing ties from Europe at this time will only make things worse.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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