A great deal of digital ink has been spilled in recent days on two topics of great interest in the aftermath of the Brexit vote: why the “Leavers” won and what will be the economic impact. The first has many answers; the second is largely unknowable.
The predictions about how, thanks to the Brexit vote, the economic end is near, are highly overwrought. We cannot accurately predict the economic impact of Brexit because there’s no precedent for it. While heightened uncertainty obviously isn’t a positive for investment, forecasting models work off of the past, and no country has ever left the EU. Also, the impact will be contingent on forthcoming negotiations over the terms of the divorce, and these discussions could take up to two years.
Don’t get me wrong: as you’ll see, I’m not at all suggesting complacency (and, ftr, mine would have been a strong “stay” vote). But do yourself a big favor and when someone goes on for too long about the economic impact of the Brexit, put on your headphones and listen to this (classical)…or this (jazz)…or this (blues). (In fact, forget about this mess for a few minutes and listen to these three either way; believe me, you’ll thank me).
Clearly, financial markets were surprised and roiled by the vote, but do not conflate financial markets with the real economy. Stocks took a hit on Friday and the British pound was hit hard, staging its biggest one-day drop on record and resulting in a 30-year low relative to the dollar. But while these are big, negative swings, markets go up and down all the time, and from what I can see, there’s no cascading Lehman story in here. Central banks are ready to intervene if needed, and I don’t see systemic financial losses that could lastingly undermine credit markets.
If the pound stays down, that has numerous “mechanical” impacts on the real economy. Since it makes imports to the UK more expensive—and imports are 30 percent of the UK’s GDP compared to about half that for the US—inflation there could go up. On the other hand, by making imports pricier and UK exports cheaper, this could help their growth by lowering their trade deficit, currently a hefty -5 percent of GDP. Also, these dynamics will likely lead central banks, including our Federal Reserve, to keep interest rates low for longer, which is a plus for growth but tough on those with fixed incomes. (There’s an irony there should rates also stay low in the UK, which they would if growth there takes a hit: pensioners who both supported the Brexit and depend on fixed incomes will be worse off.)
Beyond that, we’ll have to see. A lot depends on what happens in the forthcoming negotiations about UK access to EU markets, the extent to which multinationals with UK operations get spooked, and, extremely importantly, whether the UK/EU austerity fever breaks.
With the exception of austerity, the many reasons for the Brexit vote have been well covered. I’d stress:
–PM David Cameron’s reckless, opportunistic political gambit: calling for the referendum back in 2013 to assuage his far right Euro-skeptics in time for the upcoming election.
–Strong anti-immigration and anti-globalization sentiments. The unleashed xenophobia, surely linked to the refugee crisis, is to my thinking the worst part of all of this. Re globalization, UK voters (and probably US ones as well) finally had enough of elite economists and politicians lecturing them that if they only understood “comparative advantage” (the productivity-enhancing benefits of trade) and shut up about “factor price equalization” (the costs of trading with low-wage countries), they’d realize how great expanded trade has been for them.
–The stark polarization between the urban and economically dynamic parts of Britain (Remainers) and the rest (Leavers).
–Distrust of the EU given their mismanagement of the recession and the recovery, which oftentimes seemed wholly unresponsive to the people on the wrong side of their decisions, people that appeared to have little in the way of voice or democratic recourse.
A big part of this mismanagement was fiscal austerity, meaning instead of using fiscal policy to offset the impact of the Great Recession in weak EU economies, including the UK, Brussels and Germany insisted that government consolidate their public budgets, ensuring the recovery was extremely weak. Back in 2011, economist Jay Shambaugh wrote (for a Brookings paper): “The United Kingdom, which was not undergoing the same kind of stress in financial markets and thus arguably had more choice about whether to engage in austerity, nonetheless did so and today is also struggling with very weak growth and high unemployment.”
The figure below presents a simple way to show this (see data note for details). It plots changes in budget austerity against those in unemployment across the EU, 2009-13, the heart of the austerity years (each dot is the change in both variables for an EU country). The positive correlation is clear–that’s austerity poster child Greece in the upper right. The UK unemployment rate was 7.6 percent in both years, as their budget deficit fell almost 5 percentage points of GDP.
To a lesser degree, we did the same thing on this side of the pond, with similar, though scaled back, results. If you compare government spending at all levels (federal, state, and local) in this versus past cycles, the current expansion is a clear, negative outlier. No wonder we’re still trying to reach full employment and close output gaps 7 years into a recovery.
All that is backwards looking. Here’s my forward looking punchline. As I’ve stressed, the economic risks of Brexit are unknowable, but they could well be formidable. If they prove to be so, the UK government has a choice: let the people suffer as 52 percent of the voting electorate asked for this — a very EU-style reaction — or break the austerity fever and temporarily spend to offset the damage.
The idea that the country must suffer is not economics. It’s Old Testament morality, with a strong dash of hard-right, willful dysfunction to prove that government doesn’t work.
Not only that, but because dysfunctional governments have been persistently guilty of this fiscal malpractice, they too have played a role in bringing us Brexit, Trump, and this anti-globalization moment. To be clear, I’m not letting anyone off the hook for racist xenophobia, but when people are hurting because of reckless finance, imbalanced trade, or spiking immigrant flows, and government and institutional elites could help but choose not to, they too carry a large share of the blame.
Data note: The figure plots the change in unemployment (source: Eurostat) against that of the cyclically adjusted budget balance (source: IMF) for the following countries: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Netherlands, Portugal, Spain, Sweden, and the UK. The cyclically adjusted deficit means each country’s deficit is measured against its potential, as opposed to actual, GDP. This is the usual practice for such comparisons as it removes any distortions in measurements between countries based on depth of downturns and endogenous revenue and expenditure responses. That said, the figure for unadjusted balances shows the same pattern.