Thursday’s Brexit vote wasn’t a “Lehman moment”, as some have feared. Instead, it was a growth moment. And that may be the greater threat. If policymakers respond effectively, the benefits could be substantial: a stronger global economy, and an ebbing of the political and economic forces now pressuring UK and European policymakers. Conversely, failure to address the growth risks could cause broader and deeper global economic contagion.
In the immediate aftermath of Thursday’s vote, there were significant concerns that Brexit would generate a market reaction similar to what we saw following the fall of Lehman Brothers in August 2008. Market moves in the immediate aftermath of the vote wiped around $3 trillion off of global equity markets, mostly in the industrial world. Indeed, foreign exchange markets (and some equity markets) saw larger moves than after Lehman’s collapse, before finding a degree of stability today. Yet, by all accounts, markets moved smoothly and cleared, there were few reports of payment and settlement issues, and little evidence of financial distress affecting counterparties. No doubt, news may emerge in coming days of large loses taken by some over-leveraged investors, and periods of intense volatility are more likely than not. So we should see today’s bounce as a temporary calm, not the end of the storm. But, if we define a Lehman moment as a comprehensive breakdown in trust in markets, a collapse in creditworthiness and confidence that cascades through financial markets as we saw in 2008, then Brexit is a crisis averted.
Central banks deserve a great deal of credit on this score. According to reports, the major central banks, led by the Bank of England, had been war-gaming a Brexit vote for several weeks, talking to market participants, and stress testing banks and markets. BoE head Mark Carney had his version of ‘whatever it takes’ remarks early on Friday, and provided ample liquidity to markets (in both pounds and sterling). The Federal Reserve, European Central Bank, and other central banks made statements of support.
The broader concern for markets, and for policymakers, is growth. For the United Kingdom, which before the vote was expected to grow on the order of 2 percent, the shock will be severe, perhaps on the order of 2-3 percent over the next 18 months. Some market analysts are predicting an outright recession given the substantial political and economic uncertainty that has been created and its likely effect on investment and consumer demand. The exchange rate depreciation will over time provide a powerful offsetting boost, as will expected rate cuts from the Bank of England, but will take time to be felt. First and foremost, this is a UK shock.
The more difficult question is the extent of contagion to the rest of the world. The sharp rise in the yen has intensified concerns about Japanese growth, and put pressure both on the Bank of Japan and the government to introduce additional stimulative measures. But looking beyond the immediate cyclical considerations, Europe poses the more significant concern, given the weak state of the region’s economy (and a population increasingly frustrated with their economic prospects). As in the United Kingdom, uncertainty about post-Brexit relations is likely to weigh powerfully on investment. Relatedly, it is not surprising that European bank stocks fell sharply after the vote, given a continental banking system struggling with the legacy of the crisis and weak profitability. Lower interest rates will not help on that latter score. The ECB can ensure adequate liquidity to troubled banks, but can’t make them lend. If Europe wants above-trend growth in this environment, fiscal policy will need to do more. My colleague Sebastian Mallaby has a sensible set of recommendations, starting with a German tax cut, but his proposals seem politically quite challenging. Failure to act may not lead to an immediate economic crisis, but a weaker European economy makes the politics of preserving the European Union all the more treacherous.
The dog that hasn’t yet barked is the emerging markets, which have held up well in recent days. In part, this reflects that commodity prices and Chinese growth, the two most important drivers of EM prospects, have strengthened in recent months and, at least compared to the start of the year, there was a buffer to absorb this most recent shock. Also, many emerging market investors pulled back on risk before the vote. Tax measures in some countries (e.g., South Korea and Indonesia) have boosted confidence. Perhaps most importantly, the decline in interest rates in the United States, and the associated decline in expectations that the Federal Reserve would hike rates, matters a great deal for these markets. Still, if doubts about any of these supports were to arise, particularly Chinese growth, then a European regional shock could become global quickly.
Finally, in the United States, most analysts (and the market more generally) now expect the Fed to delay a tightening till the end of the year, if not cut interest rates. The prospect of a significant strengthening of the dollar will cause a drag on growth, but given normal lags the brunt of any dollar move will not be felt on the economy till 2017. Unfortunately, the political consequences of a dollar spike on the election campaign is far more uncertain, and potentially more immediate. Those who believe that the populist anger we saw in the UK will be mirrored in the U.S. elections will see opportunity here. This may be the most worrisome source of contagion from Brexit.