Brexit is clearly a first order political shock within Britain itself, perhaps ranking just behind the miners’ strikes in the 1970s and 1980s as the most disruptive shock since the Second World War. Over that entire period, it is only the second purely British event that could have a global economic impact, the first being the Suez War in 1956.
We have seen a lawful rebellion against the urban political elite, which has stood for globalisation, low taxation, free markets, free trade and European political integration. The eventual global effects will depend on whether this remains a peculiarly British political upheaval – after all, the European issue has always had a special capacity to disrupt the political order within these shores – or whether it is the start of a European, even a global, political trend.
The drop of 3.5 per cent in the S&P 500 on Friday – an event that happens only three times a year on average – suggests that there are genuine global concerns about the consequences of Britain’s decision. If there is political contagion to other EU members, then the global economic effects could start to get serious, because the shock is coming when the world economy is fairly weak, and when monetary policy options to stimulate activity are apparently limited. But wise policy within the EU can stop that happening.
The initial, direct impact of Brexit on global demand depends on the damage done to investment and consumer demand within the UK economy. The pre-referendum studies on this question generally showed that the UK would flirt with recession over the next few quarters, despite a monetary easing by the Bank of England (with zero interest rates by August), and a sizable devaluation of sterling.
Because the uncertainty effects on private demand will happen immediately, while the policy support will operate over a two year horizon, many forecasters warn that UK output could be 2-3 per cent lower than it otherwise would have been by 2018. We can hope that this is too pessimistic, but it is what the Bank of England will probably assume, given the econometric studies they have published on uncertainty shocks.
The direct impact of this UK shock through trade with the rest of the world is not very large. Exports to the UK account for only 2-3 per cent of GDP in Germany and France, and around 0.5 per cent of GDP in the US, Japan and China. The loss of trade with the UK is therefore an almost irrelevant event for other large economies, especially those outside Europe. Why, then, are the markets concerned?
The growing literature on the impact of uncertainty shocks on economic activity suggests that there are three different ways in which policy or political uncertainty can impact aggregate demand. The three categories are the following:
- Stress in the financial sector as banks find it harder to raise new liquidity to finance the assets on their balance sheets, and are forced to cut loans and ditch longer term assets into a declining market. This channel was frequently ignored prior to the Lehman shock in 2008, but it is now front and centre as far as the central banks are concerned. There have been no signs so far that this is happening. The G7 central banks have injected liquidity, and provided dollar swap lines that should prevent an acute dollar shortage from developing. And the banks are much better capitalised than they were in 2008. Still, the Bank of England and ECB are clearly very worried that problems could arise here.
- Turmoil in other financial markets, including equity, credit and weaker government bond markets. This occurs because markets are forward looking, and react today to events that they fear might happen tomorrow. Risk premiums rise, so asset prices fall for any given level of risk free interest rates. Sentiment matters here, and this can exacerbate the early impact of the uncertainty shock. We have clearly seen this channel operating in recent days, notably in the equity markets in the EU, which have fallen by 8.5 per cent this month. Fortunately, the ability of the ECB to purchase government debt in peripheral sovereign debt markets has prevented turmoil inside the euro area, which is a major difference compared to the 2011/12 euro crisis.
- Reductions in corporate and consumer spending as private entities become less certain about the path for output and employment in the years ahead. In the past, these real economy, Keynesian-type channels have focused on reductions in central expectations for economic variables, but now it is recognised that greater uncertainty about any given central forecast can also have damaging effects. It seems clear that increased political risk in the EU must be having this effect today, but it is hard to measure how large or persistent it might be.
So far, the consensus of global economists is that none of these channels will operate forcibly, so the overall impact of the Brexit uncertainty shock will be large for the UK, fairly small for the remainder of the EU, and negligible for the US and Asia. For example, some major investment banks have this weekend been reducing their 2017 real GDP forecasts by about 2 per cent for the UK, by 0.5 per cent for the EU, and by only 0.2 per cent for the global economy.
This relatively optimistic case is based on an assumption that the UK’s political mood will not spread more widely in the EU. But political firestorms have an unnerving tendency to spread across borders. In that event, with the global economy already vulnerable, the market consequences would obviously become more profound. Here are some early conjectures about the pessimistic case.
- It is easy to see that the dollar would probably rise, causing problems for the Chinese currency regime.
- The Federal Reserve would then be on hold for a long while.
- The yen might also rise sharply. With Japan out of monetary ammunition, the focus there would shift even further towards fiscal policy.
- Within the EU, the ECB probably still has some scope to act if needed, but there will be enormous political pressure to step back from the German insistence on fiscal austerity as the migrant shock is absorbed.
- In the UK, the “punishment budget” has now been forgotten, and the new Conservative prime minister is likely to postpone the balancing of the budget for at least a full Parliament after this one.
- So the thrust of global policy support may shift from the central banks to the fiscal authorities.
- Perhaps the greatest unknown of all is how the US fits into this picture. Is the US a safe haven from this foreign uncertainty, or is the candidacy of Donald Trump a symptom of similar populist political forces operating there? If he wins, American fiscal policy would probably also be eased considerably. Many other aspects of macro economic policy would, however, become very unpredictable.
This is not, in my view, the base case. But, if uncertainty is the enemy of markets and economic growth, investors will be risk averse until the political reaction in the EU is substantially clarified.