The Arithmetic of Brexit

The United Kingdom voted last week to separate from the European Union. The decision has already had significant implications for the U.K. economy, and things could get worse from here.

In this clip from the Industry Focus: Financials podcast, The Motley Fool's Gaby Lapera and John Maxfield dig into what these implications are likely to be, focusing in particular on the potential impact on the country's GDP.

A full transcript follows the video.

This podcast was recorded on June 27, 2016.

John Maxfield: This is something we've talked about in the past, Gaby. If you look at how you grow an economy, it's actually a really simple equation. Economic growth comes from changes in capital, changes in labor, and changes in productivity. Those three things. If you increase one, you hold the other two equal, you're going to increase your economic growth. If you decrease one holding the other equal, you're going to decrease economic growth. Let's just break that down and look at what a Brexit, if they go through on this, what a Brexit will do to those components.

Let's first start with capital. To your point, what is Britain's economy predicated on? Is it predicated on manufacturing and exports? No, right? If you've ever been to the United Kingdom, you know how ridiculously expensive it is there. That means that labor there must be really expensive, which means that on a global manufacturing basis, it's not going to be able to compete against your Chinas, your Vietnams, your Philippines, right? What is its economy predicated on? It's predicated on its financial sector.

London is one of the financial centers in the entire world. In fact, if you look there's an index that traces what are the biggest financial centers in the world, and London and New York are tied. You say, why is London such an important financial center? One of the reasons is that the pound is a reserve currency for all of these different countries in the world. You have your central banks, your sovereign wealth funds holding pounds, dollars, euros, and Japanese yen in order to help them smooth out the fluctuations in their own currencies. The reason they hold those four currencies, in particular, in reserve, is because they have the deepest financial markets and because those currencies are the most stable in the entire world. 

If you look at what's happened since the Brexit vote last Thursday, the pound has dropped something like 11% or 12%, which it is now at its lowest point in 30 years. We are just at the beginning of this. It's impossible to say if it will go up or down from here, but it very realistically could do both and it very realistically could go down. Right?

Gaby Lapera: Yeah. Right now, right at this very instant, the British pound equals $1.32, which is insane.

Maxfield: Right.

Lapera: I can't remember the last time it was that low, probably because the last time it was that low was before I was born, which is insane. This is part of the reason that the Brexit coverage has been so obsessed with what was going on with the pound.

Maxfield: Right. Then you think, how does this factor into that equation for growing your GDP, which just to be clear, there is no doubt that growing your economy is a very important thing. That's a very important thing. 

What happens when if its currency were to go into this period where it loses a ton of value and fluctuates a lot more, there is going to be less incentive to hold it as a reserve currency. If other countries do not hold it as a reserve currency, they're going to pull their money out of that economy and that leads to a loss of capital. Again, GDP is a function of capital, labor, and productivity. If you decrease capital, you're going to decrease economic growth. Okay?

The other piece that we have going on here is your labor. One of the big reasons that Brexit was supported was because there's this fear about too many immigrants flooding into the country. Immigrants flooding into a country as a general rule will actually increase your economic output because you're boosting labor. If they were to kick out all these immigrants that have come from all these different European countries and all over the world into the United Kingdom under these open border policies, you are going to decrease your labor, which will necessarily decrease your GDP. On top of that, if you institute more stringent immigration standards, it will slow the flood of immigrants into a trickle, that will then further throttle your GDP growth. 

The big thing for the United Kingdom is that, yes, we all understand that everybody's having issues right now in the world as a result of the layover from the financial crisis. By voting to separate yourself from the European Union, you are almost necessarily condemning your country to a decrease in economic output.