We have seen many economic and market prognostications about the impact of the Brexit vote. Our view is that the immediate financial market reaction was more emotional than rational. It is important to keep this referendum in perspective. Few probably remember what happened to financial markets on September 16, 1992 (The day Britain withdrew from the European Exchange Rate Mechanism (ERM)) or August 15, 1971 (The day the U.S. abandoned $/Gold convertibility), both of which triggered greater economic shocks then Brexit ever will. How many experts today would argue those were poor economic decisions? Nevertheless, Brexit does magnify significant macro-economic and geo-political concerns, including knock-on political uncertainty.
Brexit did not occur in an economic vacuum. The aftermath of the Global Financial Crisis has produced an environment of anemic growth and persistent deflationary pressure. Nearly every major economy has experienced slowing growth, mounting debt issues, and an ineffective response to both fiscal and monetary stimulus. There are many reasons for these policy failures, but perhaps the most significant reason for the economic stagnation is the policy not tried—concerted commitment to pro-growth regulatory and tax reform. In fact, the policies being pursued in most of the developed world run in the opposite direction—more regulation and more government interference into the conduct of commerce. Countries have been too reliant on monetary stimulus and have underutilized necessary fiscal and structural reform.
Immediate Economic Impact of Brexit
It is clear that neither the “Leavers” nor the “Remainers” had any plan in place to manage the political process of Brexit. This exacerbated both the political and economic uncertainty that will magnify Brexit’s short-term economic impact. Britain will bear the lion’s share of the economic cost of that uncertainty. More than 50% of Britain’s trade of goods and services is with EU nations. Moreover, many major non-EU countries, including the U.S., China, and Japan, use Britain as a services and manufacturing hub for the EU. At a minimum, we would expect a pause in capital investment in the UK. The longer the political uncertainty, the longer the pause and the larger the economic hit. While we do not share the dire 3.5% GDP negative impact projected by “Remainers,” we do anticipate a GDP contraction that pushes Britain into recession. Its length and depth ultimately will depend on the timing and substance of the eventual political solution.
The major candidates to replace Prime Minister Cameron such as Michael Gove and Theresa May have an Atlanticist worldview and are strong defenders of free trade. That being said, if Brexit foreshadows increasing voter opposition to international trade, Brexit could produce a prolonged contraction in the global economy.
Brexit will likely exacerbate the already fragile condition of many European banks. Eurozone leaders have not fully resolved the issues confronting the weaker Eurozone economies exposed by the Greek crisis—Portugal, Spain, and Italy in particular. Italian banks appear to present the most immediate danger ($408 billion in past due loans, 17% of total). Italian PM Renzi has publically defied Merkel's admonitions that bending the bailout rules is not an option
Currency readjustment is another impact of the Brexit vote. Relative to the U.S. Dollar, the British Pound has dropped 11%, the Japanese Yen has rallied 3.5%, the Euro has dropped 2.2%, and the Chinese Yuan has dropped 1.2%. Many emerging markets have seen appreciation versus the Dollar since Brexit. The rapid decline in the Pound to a level last plumbed briefly in the mid-1980s should lead to an increased flow of tourism to the UK and a slight improvement in the price competitiveness of other British exports. This process will mitigate some of the recessionary impact of Brexit but only over an extended period of time.
The currency volatility initiated by Brexit bears monitoring. As witnessed during the Asian Financial Crisis in 1997, currency dislocation of even small economies can have broad implications especially when coupled with weak banking institutions. The impact has already undermined Japan’s monetary policy and put further pressure on the BOJ and the Abe government. Japan has now proven that aggressive monetary policy supported by profligate fiscal policy is no recipe for reaccelerating growth absent real pro-growth regulatory reform. The failure to conclude a successful TPP has further undermined the probability that the Abe government can muster the political will to adopt important structural reform within the Japanese economy.
It is interesting to note that the sharp rally in many commodities, especially gold, and in the equity and bond markets of commodity export economies that followed Brexit may be a harbinger that long sought inflation is finally on the horizon. Could Brexit have achieved in one vote what the major Central Banks have unsuccessfully sought to produce with 8 years of unprecedented easing? Will the Central Banks like the results?
- During the initial signaling stage between the UK and the EU, the best approach for the U.S. is to reassure both the UK and the EU that the U.S. will remain a strong partner to both as the respective parties each determine how to proceed with Brexit. While President Obama has already undermined this neutrality with his comments about putting the UK to the back of the line on trade deals, many in the “Leave” camp believe Obama made his comments only after strong pressure from Prime Minister Cameron.
- The U.S. should make it clear that clarity on how this process will unfold is critical to the global economy. While financial markets have calmed down since the initial reaction, continued uncertainty regarding the Brexit process will likely instigate renewed volatility globally.
- We support the U.S. congressional effort to initiate Free Trade Agreement negotiations with Britain post-Brexit, and believe it will help balance the comments made by Obama during the Brexit campaign. It is important, however, that this effort is not perceived as rewarding the UK for departing the EU. The message we need to send is that we are willing to work with all our partners, but while none are at the back of the line, none are at the front either.
- UK leaving the EU will reopen independence debates in Scotland and Northern Ireland. The economic cost to both could be high. Scotland was already fragile when they last considered separation. At that point in time, oil, a critical revenue source for Scotland, traded at $100+ per barrel. At $50 per barrel, those revenues have been cut in half. The economic consequences of Brexit for Northern Ireland are much larger, and Brexit could reopen old wounds. The line between Northern Ireland and Ireland is the only land border between the UK and EU, and the re-establishment of a militarized border control through which thousands of people commute each day will undermine the economic recovery that Northern Ireland has experienced over the past 20 years.
- Policymakers need to understand that Brexit will likely exacerbate Polish uncertainty about their strategic importance to the United States, a problem compounded by the current erratic Polish leadership. While much attention to the impact that migration flows had on the Brexit results, few in the United States realize that Polish immigrants were causing much more economic and political concern than migrant flows from the Middle East. Moreover, Poland, which after Brexit will become the second (slightly smaller than Sweden) largest non-Eurozone EU economy, has often cited Britain as proof that lack of membership in the Eurozone does not diminish its commitment to the European Union. Coupled with the anxiety created by the situation in Ukraine and perceived NATO weakness, Poland will need increased diplomatic attention as Brexit unfolds.
- The U.S. should use Brexit as a wakeup call that imposing laws and regulations lacking broad popular consent will over the long-term damage productivity and political cohesion. In fact, nearly every major global economy, including the United States, needs to realize that market-oriented political reforms are critical to reversing the current sub-par global economic trajectory. The existing status quo of myopically relying on monetary policy is simply failing. Perhaps Chancellor of the Exchequer Osborne’s tax proposal is a first step in the right direction.