Brexit is not just a risk to Britain, EU — it could hurt US, too

It is tempting to think, as does the Trump administration, of Brexit as a problem besetting a small, faraway island economy of little economic consequence to the United States.

However, that could prove to be a very costly miscalculation.

Should the United Kingdom crash out of Europe in a disorderly way, or should it be forced into a divisive early general election as a result of Brexit, not only would the U.K.’s economy be dealt a severe blow, so, too, would that of an already troubled European economy. That, in turn, is almost certain to further roil global financial markets in a manner that would have the potential to derail both the global and the U.S. economic recoveries.

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Sadly, British Prime Minister Theresa MayTheresa Mary MayUK's May resigns after Brexit failures The Hill's Morning Report — After contentious week, Trump heads for Japan Another UK Cabinet secretary resigns over Brexit MORE’s increasing loss of control over her own Conservative Party, as evidenced by this week’s backbencher revolt and by her subsequent unconvincing victory in a confidence vote, heightens the chances that the U.K. is heading toward one of two adverse economic scenarios. 

The worst-case scenario is that the U.K. would crash out of Europe without a deal on March 29, 2019, when the two-year Brexit negotiating period under Article 50 of the Lisbon Treaty expires. As the Bank of England and the U.K. Treasury keep reminding us, such a disorderly eventuality would almost certainly seriously disrupt U.K. trade flows, cause the pound to plummet, and greatly undermine investor confidence. That, in turn, must be expected to plunge the U.K. into a serious economic recession.

The less adverse scenario would be that Mrs. May would be forced to call an early general election as a prelude to creating the conditions for a second Brexit referendum. That scenario, too, would have adverse, albeit less severe, consequences for the U.K. economy, in that it would all too likely usher in a prolonged period of political uncertainty. It would do so not least by opening up the possibility of the market’s nightmare scenario that a far-left Jeremy Corbyn government would come to power.

Before dismissing a serious U.K. economic setback or a further plunge in the pound as non-events for the U.S. economy, recall that the U.K. is Europe’s second largest and the world’s fifth largest economy. It also might be recalled that the U.K. is the largest destination for U.S. foreign investment and that U.S. companies employ as many as 1.4 million Britons.

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An even more serious reason why the U.S. should be concerned about the U.K.’s present Brexit travails is that they are occurring at a highly inopportune time in the global credit cycle, and they are not occurring in isolation.

After many years of very easy money, global liquidity conditions are tightening as the U.S. Federal Reserve raises interest rates and as the European Central Bank puts an end to its bond-buying program. Meanwhile the European economy is now beset by a whole host of largely politically generated economic problems. The French economy is being hit by social disruptions from the Yellow-Vest Movement, Italian economic confidence is being battered by its populist government’s deficit-busting budget confrontation with the European Commission, and the German economy is having to cope with Angela Merkel’s waning political star as well as with the prospect of increased U.S. automobile import tariffs. 

Especially at a time when the U.S. is engaged in a trade war with China, and following a prolonged period during which global credit has been seriously mispriced, one must expect that renewed weakness in the U.K. and European economies could seriously roil global financial markets.

All of this would suggest that rather than take pleasure in Europe’s current economic misfortunes, the Trump administration might consider that those misfortunes could reach our shores. They could do so in much the same way as, in 2008, our Lehman-related economic problems reached European shores.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the Chief Emerging Market Economic Strategist at Salomon Smith Barney.