Will the results of Britain’s election lead to political instability?

As the United Kingdom’s own experience with earlier sterling crises amply attests, the last thing that a country not paying its way in the world needs is a period of political instability. Sadly, that is what seems to be in prospect for the United Kingdom as it goes to the polls on Thursday, May 7 in one of the closest election campaigns in living memory. The result of that election is all too likely to produce a weak coalition government about which there will be doubts either as to its ability to address the country’s still large macroeconomic imbalances or else its ability to keep the United Kingdom in Europe.

Over the past few years, the British economy has comfortably outperformed that of continental Europe. In particular, whereas the eurozone economy has yet to regain its pre-crisis 2008 peak, the U.K. economy has now surpassed that peak by around 3 percent. Similarly, whereas the eurozone’s unemployment rate remains stuck at 11.25 percent, that in the United Kingdom is now around 5.5 percent.

However, the U.K. economy remains characterized by twin deficits that make it very vulnerable to any change in foreign investor sentiment toward the country. At around 5.5 percent of gross domestic product (GDP), the U.K. has the largest budget deficit of the G-7 countries, while at over 5.5 percent of GDP the U.K. has its largest external current account deficit since 1948.

{mosads}The U.K.’s disturbingly large external current account deficit has not gone unnoticed by the Bank of England. Indeed, the bank’s financial policy committee has recently identified this deficit as the main risk to the country’s continued financial stability. It has also correctly noted that in a time of stress, the U.K.’s large current account deficit could cause financial markets to turn against the country’s economy.

Sadly, on the very eve of the U.K.’s election on Thursday, the electoral polls are suggesting that the U.K. could be in for a period of political instability that could put real pressure on the country’s currency. Polls show that the two main parties are now tied with only around one-third of the vote each. This makes it almost a certainty that the U.K. will have a weak coalition government that will not inspire confidence in either domestic or international investors. It is also very likely that the formation of a new government will take weeks to negotiate.

From a short-term perspective, a Labour Party victory would probably produce the worst result in terms of political and financial stability, since Labour would most likely have to rule with the consent of the more economically radical Scottish National Party. Such a result would raise doubts as to the U.K.’s commitment to stick to a path of medium-term budget deficit reduction and economic reform. It would also most likely raise anew questions as to whether the issue of Scottish independence has indeed been settled.

A Conservative Party victory would most likely give more comfort to both domestic and foreign investors as to British economic policy management. However, it would come at a longer–term cost in that it would fuel doubts about whether the U.K. will stay in Europe. One of Prime Minister David Cameron’s strongest policy commitments in this election has been that, if reelected, his government would hold an up-down referendum on Europe in 2017. By so doing, he has given hostages to fortune as to whether or not the U.K. might exit the European Union. This is bound to be a cause of ongoing market uncertainty.

The global economic significance of the U.K. election would seem to be that it is taking place at the very time that almost all of the world’s major economies are trying to weaken their currencies to boost exports. Both the European Central Bank and the Bank of Japan are engaged in full-bodied quantitative easing; the Bank of China is on the cusp of a major easing in monetary policy; and the Federal Reserve appears to be delaying the start of interest rate hikes due to fear of a stronger dollar. In such circumstances, a significant weakening in the pound sterling in the months ahead would provide grist to the mill of those who fear that the world is gradually drifting to a prolonged period of damaging currency warfare that could impair the proper functioning of the global economy.

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.