Recent Posts

Sunday, June 26, 2016

Brexit - A Cautious Panic

For those of us outside the United Kingdom, the "Leave" victory in the referendum is not enough to cause worries about the real economy. We have entered the thin summer market period, so some form of financial turbulence is likely, but until some defaults occur it is not going to matter for non-levered investors. For the U.K., the most likely outcome is going to be an extremely long period of technical negotiations, which will eventually be pushed out of the news cycle by news about the Royal Family and football.

Financial Markets - Thin Summer Markets Await

The timing of the referendum could not have been worse. Senior financiers and European fonctionnaires are about to go on vacation. With junior personnel manning trading desks, there is always the possibility for shenanigans.

However, it has to be kept in mind that nobody sensible lends against equity collateral (without a massive haircut). Gyrations in the equity market are greatly exciting for investors and employees of hedge funds, but they do not matter for the rest of us. The only way financial market volatility is going to translate into damage for the real economy is for a wave of defaults to hit. I am not ruling out the possibility, but it is unclear to me which entities are supposed to default on this news.

At the end of the day, investor portfolios are presumably less illiquid than they were in 2007. Nobody really wants to own Treasury bonds at sub-2% yields as a long-term investment. There is plenty of capacity for investors to rebalance into equities from bonds.

This event provides yet another excuse for the Fed to remain on the sidelines. At this point, it looks like the earliest possible hike would be in December. Conversely, since the policy rate is so close to zero to begin with, we will need evidence of a crisis for a rate cut (and random unconventional policies) to be put into play. As for those people who thought that a weaker pound would raise gilt yields, they were wrong once again (for about the thousandth time in a row).

Impact On The U.K. And The E.U.

Although I have seen grumblings about thuggish Continental politicians wanting to make an example of the U.K. in order to keep other countries in line, such a step is not necessary. As Greece found out, being a member of the euro represents such a loss of sovereignty that eurozone countries have no choice but to follow the dictates of the EU. The U.K. never gave up the pound, and so it was always going to have an easier time to disentangle itself.

Although it might be possible to rupture some parts of the relationship with the EU easily, it seems very unlikely that the entire corpus of EU law can be jettisoned quickly. A total rapid rupture would be disastrous for the U.K. economy, but it would have a similar effect on the rest of the EU. Meanwhile, the euro is strangling growth, and European banking systems are shaky. The U.K. would be more likely to recover from the rupture than Continental Europe, and one hopes that Continental policymakers are not delusional about this reality.

The EU can wring some short-term concessions out of the U.K. (for example, continuing to contribute to the EU budget) while the existing body of law is grandfathered, and extrication is negotiated.

Although this scenario implies that there is no economic catastrophe, it would put into question some long-term investment plans. The media will be filled with stories about "Corporation X pulls out of UK investment plan because of Brexit," but at the same time, other corporations might invest because they want to keep their foot in the door of the vibrant U.K. market. Sure, there will be a net negative economic impact, but that is not saying much. The action of fiscal policy and monetary policy will act to attenuate any shock, and so the net effect will be much smaller than static analysis would suggest. As others have pointed, the idiotic austerity policies pursued after the Financial Crisis had a greater negative impact on U.K. growth than any plausible Brexit forecast.

UPDATE: This article may be too complacent from the perspective of effects on Continental European politics. One reasonable fear is that this vote will trigger calls for leaving the EU (and the euro) by other countries. Such an event was not a scenario that I had in mind when writing this. Instead, I view euro breakup as a different risk scenario, one that will always exist. I believe that the euro is ultimately doomed, but I am unsure that this referendum result will be the catalyst. There are plenty of recent precedents of election results being ignored by the EU, so it does not seem to matter whether hooligans are demonstrating in favour of referenda elsewhere. The real risk to the euro is when an established party decides to ride the tiger of nationalism, breaking away from the pro-EU elite consensus. (This is essentially what happened in the United Kingdom, but euroskeptics had always been a force within the Conservative Party, so there was much less resistance to calling a referendum.) As the Greeks found out, the EU has the ability to pulverise a euro member's banking system, making middle class support of an anti-EU stance very awkward.

(c) Brian Romanchuk 2016


  1. The sharp drop in the exchange rates vs the pound provides both opportunity and challenge for international lenders. I offer the following possible scenario:

    A private British businessman borrows from British banks to buy British made cars to be sold in Germany . This plan is approved and completed, but the loan is not yet repaid. Interim result: British businessman owes British debt (pounds) fully covered by German euros.

    Continuing the scenario, a private German businessman follows the identical script in every aspect. The only difference is the place of residence between the two businessmen.

    Now we introduce a situational change: the value of the pound suffers a dramatic change in value. What will be the resulting effects?

    I can see that the two businessmen have a diverse new situation, one having a windfall and the other a major loss of capital. The winner would like to cement the gain by paying off the loan, the loser would be under pressure from the bank to repay the bank loan.

    Now comes my puzzle: Where does the money (needed for both parties to perform) come from?

    1. In general, businesses hedge their currency exposure if it is material. If a business cannot survive currency fluctuations, they would have been culled a long time ago. Where you see problems typically is in when there is a currency peg of some sort, and businesses get overconfident and run currency risk.

      As for your puzzle, the EUR and GBP currency areas have circular flows. Whether or not entities export and trade in other currencies do not affect those flows.

  2. Brian,

    I suspect you are perhaps too sanguine about the likely fiscal/monetary response from the government should recession ensue. If they followed up the financial crisis with austerity, I'm sure that more of the same could quite easily follow any brexit recession. Osborne appears to have done his level best to take a hatchet to the automatic stabilisers, so this should be a relatively illuminating test of our partially-reformed tax and benefits system.

    1. The tightening was done after the worst was past, and complacency set in. If the data heads south, and the shares in the Tory's portfolios are tanking, they will probably become "Keynesians of convenience," like during the worst of the Financial Crisis. Sure, human stupidity is impressive, but politicians have an instinct for political survival.

      I am less confident in the euro zone doing the right thing. Whether this shock blows up the euro zone remains to be seen; there is no reason it should, but the foundation of the euro is weak and tottering.

  3. See here for potentially ugly effects:

    1. My previous article linked to an older article on UK inflation. Although there was an exchange rate effect, by my guesstimation would still be counteracted by a VAT cut (assuming a sensible government). Certainly small when compared to pre-1990s inflation.


Note: Posts are manually moderated, with a varying delay. Some disappear.

The comment section here is largely dead. My Substack or Twitter are better places to have a conversation.

Given that this is largely a backup way to reach me, I am going to reject posts that annoy me. Please post lengthy essays elsewhere.