The United Kingdom voted to no longer be a member of the European Union. With its announced exit comes the biggest currency shock to the British sterling since the Great Recession. The world economy is now particularly risk averse and is awaiting deeper signs of what's to come.
The sterling's drop is calculated relative to other currencies--this is called the nominal exchange rate. Nominal exchange rates determine how much a single unit of a domestic currency is worth in a foreign currency. On the other hands, real exchange rates compare the purchasing power for goods of two currencies. In the UK's case, the real exchange rate and the nominal exchange rate will both likely fall together.
A lower real exchange rate means that a country can get fewer foreign goods for the same number of local goods. The British consumer can already witness this with more expensive imported goods. When a country imports goods, it enters a currency exchange market to buy foreign currency that could then be used to buy foreign goods. A falling British pound will yield less foreign currency then normal and therefore, fewer foreign goods.
Just as Brexit weakens the sterling, it strengthens the dollar. This effect is triggered by investors who perceive the US dollar as a safe asset to hold their income during these uncertain times. While the resulting strong dollar is good for imports into the United States, it is bad for exports. Just as importing goods can be equated to demanding foreign currency, exporting goods can be equated to selling domestic currency. Stronger dollars cause exported goods to become more expensive because other countries can buy fewer dollars at the currency exchange markets.
Even with the strong dollar in America, consumer spending is lower. Americans feel safer leaving their dollars in the bank than investing them into the economy. To dissuade this behavior, the Federal reserve may have to step in.
In December, the US Federal Reserve announced that it anticipated raising interest rates four times this year. The interest rate the Fed controls is called the Federal Funds Rate. It is the rate at which banks lend to each other to help meet reserve requirements. The rate is also a good indication of the interest rate that is passed on to consumers. If Americans become more cautious with spending, the Fed will disincentivize saving. It can do this by cancelling its plans of raising the Federal Funds Rate.
Beyond currency shocks, experts like Nobel laureate Paul Krugman believe that the most significant impact of Brexit will be in the political sphere. To better understand the possible ramifications of leaving the European Union, it is helpful to revisit the history of the European Union.
The first seed of the modern European Union was planted after World War II, with the Treaty of Paris. The treaty created the European Coal and Steel Community (ECSC), a supranational organization that supervised the steel and coal production of countries like Germany and France in war-torn Europe. By removing the main factors of weapon production from any one national body, it served as a deterrent to additional European wars. The treaty also removed trade barriers for steel and coal between member countries to further intertwine European economies. Interestingly, the United Kingdom refused to join the ECSC.
Nevertheless, the United Kingdom did eventually agree to be a part of the European Economic Community (EEC), a coalition of states that was created in 1957 by the Treaty of Rome. The ECC attempted to further unify the economies of Europe by allowing the free movement of people, capital, and goods across the borders of member countries.
In 1992, the Maastricht Treaty created fiscal guidelines for countries wishing to remain in the modern European Union. Eligible countries had to join the European Exchange Rate Mechanism (ERM), a system created in preparation for the Euro. The ERM created lower and upper limits for currency valuations of countries in the EU. It was intended to reduce currency variability and ultimately to smoothen the transition to the Euro.
Later that year, on a day now known as Black Wednesday, the UK was forced to withdraw from the ERM. The pound had plunged below the agreed upon lower-limit. Since then, Britain was granted an opt-out from the ERM.
In 1999, the European Union created a the euro as a common currency that could be used in any of its member nations. With the euro, citizens could seamlessly travel through the EU and participate in any market. Even so, polls have shown that UK citizens are overwhelmingly against adopting the Euro. Similar stances may have triggered Brexit.
The chief initial purpose of the European Union was to provide political unity for the continent. With the UK leaving, there may be negative political reactions from other EU nations. The UK was never as integrated with the EU as other member nations were from the very beginning. But, Britain is economically reliant on the European Union, and that will not change in the near future.
Works Cited
The Economist. "Financial Institutions Weigh Their Options after Brexit." The Economist. The Economist Newspaper, 26 June 2016. Web.
The Economist. "A Tragic Split." The Economist. The Economist Newspaper, 25 June 2016. Web.
The So-called Brexit Has Wide Implications for the U.S. Economy. "How Brexit Impacts the U.S. Economy." CNNMoney. Cable News Network, Web.