UK: EU Referendum - Some Thoughts

Pretty much everyone agrees that the UK's referendum has put us into a world of uncertainty and elevated risk. For once the use of the term "Earthquake" in the headlines was not hyperbole.

Saying that things are "uncertain" is obvious but not very helpful.  Quite naturally theories, speculation and forecasts multiply.

Some argue that since the referendum vote was only advisory, 70% of MPs favour Remain and some Leave voters seem to be suffering buyers' remorse, the UK will never leave the EU. Others think that the EU will seek to minimise uncertainty and send a message to other Brexit-inclined movements in Europe by hustling the UK out as quickly as possible.

There are plenty more theories, most of which, like the bookies odds and the opinion polls before the referendum, will probably prove wrong. What follows therefore aims to be rather less speculative.

As a shock Brexit has some elements in common with the failure of Lehman Brothers in 2008. That was an economic shock, one which threatened the solvency of the banking system and triggered a credit crunch. Brexit is a political shock. Its impact on the economy is more indirect, at least in the short term, and come via financial markets and the knock on effects on business and consumer confidence.

Friday saw a flight from riskier assets, such as sterling and equities, to safer assets such as gold, government bonds, the yen and the dollar. If sustained, declining financial market risk appetite tends to feed through to weaker risk appetite in the corporate sector. Companies react by battening down hatches, paring investment and sharpening their focus on cost control.

Foreign investors may also take fright and hold back on investing in the UK. Since the UK needs overseas capital to cover our current account deficit, the result of such a buyers' strike would be a further weakening of the pound.

To generate a full-blown recession consumers, who account for two-thirds of GDP, would need to stop consuming, as they did in 2009-10. The worry is that a toxic combination of uncertainty and a squeeze on spending power from high inflation and weaker earnings does just that.

If Friday's sell-off in equities and sterling was a prelude for worse to come this week the risk of greater economic damage mounts.

One of the lessons from history, including the 9/11 attacks, the UK's ejection from the Exchange Rate Mechanism and Lehman's failure, is that shocks which threaten growth prompt a countervailing policy response. The authorities don't sit on their hands and do nothing.

Today the most useful response would be for the government to signal the direction of travel for the UK in its negotiations with the EU. In markets and business as in life, intent matters. With the Prime Minister stepping down in October and the current Labour leadership under pressure, the two main parties are not well placed to offer leadership. Nonetheless, the government could work with the other parties and the likely contenders for the Party leadership to develop a set of principles for a post-EU settlement. Sajid Javid, the Business Secretary, gave some indications of his preferences in a short article in yesterday's Sunday Times. In it he emphasised the need for the UK to remain an open, trading economy and to involve all shades of business opinion, whether they favoured Remain or Leave, in fashioning the post-EU settlement.

The usual policy levers could also be pulled. The Bank of England could undertake more Quantitative Easing, stepping up the volume of and the range of assets purchased to boost liquidity and asset prices and drive down long-term interest rates. Agreed, inflation may head higher as a weaker pound pushes up import prices. But as a one-off phenomenon in an economy facing great uncertainties, such a temporary inflation would not justify interest rate rises. 

Fiscal policy may need to play a role too. The Chancellor has previously suggested Brexit would lead to an austerity budget in order to balance the books. That would dent growth and might well be politically unviable given opposition from many MPs. In today's exceptional circumstances the government could put deficit reduction on the back burner and use public spending and tax cuts to bolster growth. Such an approach has particular appeal to those who believe that monetary policy is a spent force.

Last Thursday's vote is as much a shock for the EU as the UK. The sharp decline in Continental European equity markets on Friday testifies to concerns about the knock on effects. A British exit from the EU would represent the greatest political setback to the EU in its 65-year history. This comes at a time when the EU is coping with a migration crisis and is trying to strengthen the euro area against future shocks. After a period of rapid economic and political integration in the '90s and '00s, Europe is seeing slower, more divergent growth and a loss of political momentum.

More extreme, anti-establishment political parties such as the Freedom Party in Austria, the Five Star Movement in Italy, the Front National in France and the Freedom Party in the Netherlands are gaining ground. The immediate concern is the risk of a domino effect as eurosceptic parties elsewhere in the EU demand their own referenda. Recent research conducted by Deloitte and the German employers' organisation BDI found that 66% of German businesses believe a British exit would lead to further such votes in the EU.

A complicating factor for any UK negotiations with the EU is a series of national elections, most crucially in the Netherlands (March 2017), France (April to May 2017) and Germany (August to October 2017). It is possible that Europe's de facto leaders, Angela Merkel and Francois Hollande, will leave office in 2017.

The UK's departure from the EU also raises questions about the future direction of the trade bloc. Without the UK, the EU loses a significant supporter of free trade and free-market policies. Analysis by the Open Europe think tank suggests that the UK's exit from the EU will tilt the balance of power in the EU under Qualified Majority Voting significantly towards a more protectionist, less free-market, approach.

Faced with the risk of further secessions across Europe, and seeking to avoid political drift, EU leaders may seek to 'double-down' on ever closer union. Press reports have suggested that European leaders have already been drawing up plans for a future union without the UK, developing a so-called "Plan B" focused on closer security and defence cooperation.

Yet the integration that the EU sees as being needed to strengthen the European project could run into resistance from national electorates. The Pew Research Center recently reported a decline in support for the EU across ten major member states. The research also found that those European voters who favoured the transfer of powers from nations to the EU were outnumbered, two to one, by those who wanted to see powers returned from the EU to national governments.  

At times of great uncertainty marginal new information, both important and trivial, is subject to great scrutiny. Dramatic, but unrepresentative or erratic events, are sometimes given more significance than they deserve. Fundamentals can get drowned out in a torrent of speculation and news flow.

And in terms of the fundamentals, measured in terms of international measures of competitiveness, the UK looks in decent shape. The World Bank, the World Economic Forum and the Heritage Foundation rank the UK in the top tier of their league tables of competitiveness, up there with countries like the Netherlands, Denmark and Australia. This ranking speaks of a flexibility and resilience which will be vital to the UK as it navigates what lies ahead.