I am very hesitant to discuss something that confuses Paul Krugman. Very hesitant.
There is a great paper by Ricardo Hausmann and Dani Rodrik from 2003: “Economic Development as Self-Discovery.” The basic story is that it really isn’t just what it is that poor countries are best at producing. Are Salvadoreans really making the most of the country’s endowments of human capital and raw materials? Probably not ... but what then should they be doing? That isn’t clear either. Figuring out what industries a country is best at doing is very hard. Moreover, the first people who figure out what a country is best at won’t reap all the benefits: others will imitate their business models and pile in. That reduces their incentive to figure out those business models in the first place. Of course, you could try granting monopolies or some such — a nation-wide version of a patent — but then you have the problem of picking which industries to back. If you back all of them, then investment will flow into monopolies that turn out to be bad bets as well as ones that are good ... and you saddle your countries with lots of, well, monopolies.
Sticky! But what does this have to do with the idea that Brexit will cause a recession followed by slow growth? Well, Prof. Krugman gives the following example:
Let’s be slightly spuriously concrete. Suppose you think Brexit might have seriously adverse effects on service exports from the City of London. This would mean that investment in, say, London office buildings would become a bad idea. On the other hand, it would also mean a weaker pound, making investment in industrial properties in the north of England more attractive. But you don’t know how big either effect might be. So both kinds of investment are put on hold, pending clarification.
OK, that’s a coherent story, and it could lead to a recession next year.
At some point, however, this situation clarifies. Either we see financial business exiting London, and it becomes clear that a weak pound is here to stay, or the charms of Paris and Frankfurt turn out to be overstated, and London goes back to what it was. Either way, the pent-up investment spending that was put on hold should come back. This doesn’t just mean that the hit to growth is temporary: there should also be a bounce-back, a period of above-normal growth as the delayed investment kicks in.
That makes sense! But there is another way to think about the problem. You believe that Brexit might have seriously adverse effects on service exports from the City of London. This means that investment in, say, London office buildings would become a bad idea. On the other hand, it would also mean a weaker pound, making investment in ... uh ... well ... by gosh, just what is Britain going to become better at exporting? Manufactures from the north of England? Maybe. Wind power from offshore Scotland? Could be. Videogames written up in London exurbs? Possible. Music and are from London? Hmm! Or maybe the U.K. could build giant spaceships, like this one I saw off in the distance in Birmingham back in ‘12?
The problem is that you have no idea what the best thing to invest in is, if finance does not pan out. You know that Brexit means finance is not the future, but you have no idea what the future is. And failure certainly is an option, as the slow growth of many many countries in many many time periods tells us.
So right now, investment goes on hold, which triggers a recession. (If that is indeed what is happening.) If Prime Minister May somehow stops Brexit, “or the charms of Paris and Frankfurt turn out to be overstated,” then investment roars back into finance!
But if she does not, well, uh ... it slowly trickles back as Britain undertakes that long slow process of self-discovery. There is no countervailing boom once the policy uncertainty is resolved.* Just a slow recovery followed by slow growth.
Somehow I suspect that there must be a giant hole in this logic.
* Right now Britain has no better than NTR with any place in the world. A Britain that goes on to jump into a customs union with the United States is going to look very different from one that signs an bunch of FTAs with Latin America. No, the first option is not likely ... but policy uncertainty does not go away once you know what Brexit looks like. That, however, is orthogonal to the main point.