Photo: AFP
Photo: AFP

UK Prime Minister Teresa May held on to her job despite the resignation of several members of her cabinet in protest at the draft Brexit deal with the European Community, including Brexit Minister Dominic Raab. She probably will face down a rebellion by the Brexiteer wing of the Conservative Party led by former Foreign Secretary Boris Johnson.

May needs to keep the support of more than 85% of the 315 Conservative Members of Parliament in order to prevent a vote of no confidence. In that case, rebel Tories would vote along with the Labour Party to bring down the government, effectively pushing May out of office. That might turn out to be an act of political suicide, leading to the election of a Labour government headed by Labour leader Jeremy Corbyn, who stands well to the left of his Labour predecessors.

That could be the least of Britain’s problems in the case of a “hard Brexit,” a departure from the European Union without a deal. Britain’s fundamentals are in many respects worse than those of Italy, and a flight of capital from the UK might cause severe financial disruptions.

Britain’s debt burden is as large as that of Italy, the sick man of Europe and the subject of perpetual market worry about systemic risk.

Britain’s total debt-to-GDP ratio is higher than Italy’s, according to the Bank for International Settlements:

Total debt as % of GDP

Government debt is a higher proportion of GDP in Italy than in the UK:

Credit to govt as % of GDP

But household debt is much lower. That is important because households are less able to adjust to market stress than governments. UK mortgage debt, for the most part, entails floating interest rates, which means that any substantial rise in interest rates due to capital outflow would put severe strains on household balance sheets.

Household debt as % of GDP

Debt of nonfinancial companies is roughly equal in the two countries:

Nonfinancial debt as % of GDP

But the critical difference between the two economies is the current account. Italy has a surplus of exports of goods and services amounting to almost 3% of GDP, while the UK has a deficit equal to 3.5% of GDP. A country in financial trouble that does not have to borrow from abroad can always lend money to itself; a country in financial trouble with a deficit has to persuade foreigners to keep lending to it.

UK vs Italy CA as % of GDP

Britain’s only real economic advantage is in financial services – banking, insurance, clearing, asset management and legal. A hard Brexit would force financial institutions to move operations out of London to Paris, Frankfurt or Dublin, destroying Britain’s most important source of revenues. Foreign money would likely flee the country, forcing Britain to raise interest rates sharply, with dire consequences for households in particular.

A hard Brexit would be a leap off a cliff, and virtually the entire UK business community has warned against it. The British have real and palpable grievances against the European bureaucracy in Brussels, but their rancor against the overbearing EC bureaucracy is not intense enough to provoke them into self-harm.

That’s why Prime Minister May’s compromise approach is likely to succeed.

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