The UK vote on Brexit presents some fascinating political questions. Will Scotland now leave the United Kingdom? Will Northern Irish Catholics tolerate border controls with the Republic of Ireland? Let’s leave those aside and focus on the economic issues. Is Britain worse off leaving the EU?
There are good libertarian arguments for leaving the EU (too much regulation, too much money going to French farmers, pressure to harmonize tax rates) and for staying inside the EU (better access to the common market, free movement of people). How does this all balance out?
Markets are smarter than anyone, including me. Real individual decisions feed into markets, making them hyper-intelligent. So what happened with markets after Brexit won the vote?
- The pound fell: Against the US dollar, the UK pound fell almost 9%. Against the Euro, it fell 6%. The Euro also fell around 3% against the dollar. This suggests that the UK will be poorer after Brexit. But it also suggests that Europe will also be poorer.
- The Dow Jones Industrial Average & S&P 500 fell a little more than the FTSE 100: This is strange as it suggests a UK economy that will adjust better to Brexit than the United States. But not a whole lot better as the drops were all between 3%-4%.
- The CAC 40, DAX and FTSE MIB (Milano Italia Borsa) fell a lot more than the FTSE 100: While the FTSE 100 fell 3.15%, the CAC 40 fell 8.04%, the DAX 6.82% and the MIB by 12.48%. Could Italian business really be so affected by Brexit?
- The Nikkei fell a lot more than the FTSE 100: It fell 7.92%.
These markets seem to suggest that Britons will be poorer, but that the British economy will adjust better than the European economy. How can that be?
The drop in the pound is saying that, yes, the United Kingdom shot itself in the foot by leaving the European Union. Not only did it create a lot of uncertainty around whether it will be able to maintain free access to its largest market, but it also triggered an economic shock that is convulsing that same market.
But the Bank of England has been surprisingly adept at creating nominal GDP growth. Instead of letting nominal wages fall and unemployment rise, it has stoked inflation to clear employment markets. The Eurozone hasn’t been so lucky. So while the fall in the pound suggests a poorer United Kingdom, stock markets think that the Bank of England will react intelligently. British workers won’t be thrown out of their jobs to clear labor markets. Rather the BOE will stoke inflation to cut British wages in real terms, which will clear labor markets. The BOE will therefore not let the financial panic ruin economic growth. Any loss of wealth will only come from lost trade opportunities. Britain will be poorer, but it won’t feel like an economic collapse.
Because Brexit calls into question other countries’ commitment to Europe, and the Euro, attention will shift to ECB monetary policy. During and after the financial crisis, the ECB was extraordinarily poor at helping labor markets adjust via increased inflation rather than unemployment. The result has been economic collapse and depression in much of southern Europe, and even growing unrest in France. Instead of stable NGDP growth and higher inflation, the ECB has forced Europe onto the path of higher debt/GDP ratios and massive austerity.
Can Europe stay together with such a tight monetary policy? Brexit has brought back the fears that it cannot. The Milan exchange dropped 12.48% and the Spainish IBEX 35 dropped 12.35%. The Euro gaining against the Pound means Europe may not lose as much purchasing power, but the mechanism for adjustment will be much more painful for Europe’s periphery than the United Kingdom.
In summary, access to large markets is definitely good for your economy. But when a surprise decision like Brexit happens, triggering a potential financial panic, it’s far better to control your own monetary policy. So don’t be surprised if Britain gets poorer in real terms, but appears to do just fine while the European house burns down.