Posted by on June 26, 2016

I think that the key takeaway from the Brexit vote is that it is further proof that the public is in an ugly mood.  Brexit therefore falls in the same category as support for Donald Trump or Bernie Sanders, or for the National Front in France, Podemos in Spain or the Five Star Movement in Italy.  All of these are signs of a deep dissatisfaction and distrust.  The fact that this has arrived in the UK, a land of normally dispassionate pragmatism, is a worrying indication of just how deep the malaise is.

As I have said before, the economic argument for Brexit was weak, particularly if you consider the low likelihood of the UK fully exploiting its new-found economic freedom.  But at the end of the day, a headline in The Wall Street Journal had it right: “It’s Not the Economy, Stupid.”  The winning arguments were basic appeals to tribal instincts, such as the rejection of outsiders (immigrants) and the overthrow of foreign rulers (Brussels).[1]  This is certainly not unique to Brexit; Donald Trump tweeted his approval with “people want their country back.”

The vote was also largely anti-intellectual.  As Michael Gove, one of the leaders of the Leave campaign, said “people in this country have had enough of experts.”  This is another characteristic that has international parallels.  There are very good reasons why people should be wary of experts telling them what to do, but the objection should be against the compulsion and not expertise per se.  Among other things, expertise will be required if we want to find answers.  Like Trump, the leaders of the Leave campaign were much better at identifying problems than offering viable solutions.

My oft-repeated prediction that Remain would win was based on the assumption that, at the end of the day, the “devil you know” would prevail over an alternative that the Leave campaign kept deliberately opaque.  It is a measure of how dissatisfied the English voters are with the status quo that they are willing to take a leap into the unknown.  This is another pattern that resonates internationally.  The Trump promise to “Make America Great Again” is equally content-free.

But above all, the strongest trans-Atlantic parallel is the theme of “stickin’ it to the man.”  More and more, voting is an opportunity to display anger and rebellion, rather than a mechanism for policy choice.  This kind of nihilism has often ended badly in the past.  Ask a German.

Ripples

The big question facing Europe now is what effect this will have on other countries, many of which (according to a recent Pew Research poll) are even more euroskeptic than the British (Greece and France) or are equally so (Netherlands, Germany and Spain).

As I have pointed out before, if the British, who have by far the best deal in the EU (avoiding both the financial troubles of the Eurozone and the refugee troubles of the Schengen passport-free zone), want out, then what does this say about the rest of Europe?  I have many friends from these more “oppressed” parts of Europe who have been rooting for the English to start the ball rolling.

Right on cue, populist parties in France, the Netherlands and Italy have called for referendums in their countries.  It will be fascinating to watch the contortions of the European political class as it rationalizes denying more citizens their day at the polls.  Because in the absence of pitchforks and barricades in the streets, there is no way that the leaders of other countries will dare to take this issue to the voters.[2]

But there will be a lot of proxy votes.  Beginning with Spain this weekend, where a new national election is being held.  We haven’t been keeping up with Spain, but it is one of the many fault lines running through Europe, even though its economy is now growing much faster than the average.  Spain held an inconclusive national election last December and has failed to form a new government since then.  At the moment, it appears that Sunday will also be an unsatisfying draw.

The team to watch out for is Unidos Podemos, the electoral coalition formed between Podemos and several other left-wing parties.  They are an example of left-wing euroskepticism, which blames the EU for globalization and austerity.  It is a measure of the ineptitude (or misfortune) of the EU that it has managed to make enemies on both the Left (which accuses it of neo-liberalism) and the Right (which blames it for overreach).

If you are counting, here are some of the other fault lines in Europe:

  • Italy is a mess.  The economy is still 9% smaller than its pre-crisis peak and, at its current anaemic rate of growth, will take another 7 to 9 years to catch up.  The Five Star Movement, started by a comedian in what was initially thought to be another example of Italy’s love of political farce[3], has just won 19 of the 20 mayoral elections it contested, including in Rome and Turin.  Five Star is deeply skeptical of the EU, as is the Northern League, with which it is allied.  Matteo Renzi, the Prime Minister, is trying to change the constitution in order to make it easier to pass reforming legislation.  This requires a referendum, scheduled for November.  If it fails, as current polls predict, then Renzi has said he will step down; there is no obvious replacement.  (Remember: Italy has the third largest government bond market, and one of the heaviest debt/GDP ratios, in the world.  It is too big to bail.)
  • Portugal is heavily over-indebted, has negligible growth, and has recently elected a very left-wing government that is at loggerheads with the EU over budget deficits.
  • Finland is making the running for being the new “sick man of Europe.”  Booming Sweden is outside of the Eurozone, while Finland is in it.  The Finnish voters have noticed.
  • Greece is, well, Greece.  It is still bankrupt, ungovernable and corrupt.  Enough said.
  • Francois Hollande in France is setting records for unpopularity in the polls.  His recent timid attempts at labor-market reform are being resisted with demonstrations and strikes.  The National Front, a nativist, euroskeptic and anti-markets party, is consistently polling in the range of 25-35% for the national elections in 2017.
  • Poland, Hungary, and the Czech and Slovak Republics are increasingly restive with the EU; each one has refused to participate in the plan to share out refugees which currently find themselves in Germany.  At least two of these countries, Poland and Hungary, have governments with strong authoritarian leanings and are in a continuous battle with the EU.

And the list could go on.  Even Chancellor Merkel in Germany, until recently unassailable, has been winged.  A good case can be made that she bears a lot of responsibility for Brexit due to her handling of the refugee crisis.  Now Germany finds itself alone in the EU with France, which is not where it wants to be.

Scottish Independence

As I have mentioned before, the Scots are much more pro-EU than the rest of the UK and don’t like their membership being determined by southerners.  On Thursday, they voted 62% to 38% in favor of Remain.  Nicola Sturgeon, The First Minister of Scotland and the leader of the Scottish National Party, wasted no time in raising the issue of a second vote for Scottish independence.  She claims to be preparing legislation for another referendum.

Although political prediction is proving to be a mug’s game these days, there is one good reason to believe that this attempt at independence would be no more successful than the first one.  At the time of the first vote, Brent crude oil stood at $97.70 a barrel.  On Friday, it closed at slightly less than half of that amount, after trading as low as the $20s.  The Scots’ dreams of becoming Norway on the River Clyde, never very plausible, are even harder to hold now.  However…it’s not the economy, stupid.

Remember, if Scotland goes, then Catalonia in Spain will certainly give it a try.

Foreign Direct Investment and Brexit

One area that was probably insufficiently discussed in the Brexit debate was the impact of a departure on foreign direct investment (FDI).

I have worked for many foreign companies headquartered in the UK.  They have been attracted to England on a relative basis: taxes are relatively low, regulation is relatively light, the workforce is relatively productive and flexible, and the country speaks relatively good English.  But they have also been attracted by access to the EU.  The UK has been the relatively attractive beachhead for Europe.

The UK has just taken away a major motivation for foreign companies to set up shop here.  Before, a UK presence gave them ready access to a market of 508 million people.  Now, that shrinks to 65 million.  The Leave campaign would say that this is more than counter-balanced by the easier access to the rest of the world that the UK will now be able to arrange, but the reality that no one would choose the UK to supply the world.  The UK’s relative attractiveness is only in a European context.  On the world stage, it doesn’t have that much to offer.

This is a major problem for the UK for two reasons.  The first is that much of the dynamism of the UK economy is driven by FDI.  I was a student in London in 1979 when it was a dull, grey and depressed country that had only recently emerged from IMF stewardship – the Greece of its day, but with shitty food and no sun.  Much of its current success in everything from financial services to car manufacturing has been driven by foreign-owned companies.  Although there was a good deal of John Bull swagger in the Leave camp, the reality is that the natives have not produced an economic powerhouse since at least World War I.

This issue is particularly pressing for London.  London has benefitted tremendously from being the de facto capital of Europe.  It is possible that it has now established enough critical mass to retain that status, and certainly the competition for the title is weak[4], but it is hard to be the capital of a political entity to which you do not belong.

The second reason is more mundane, but potentially faster acting.  The UK has a significant balance of payments problem, equal to about 5% of GDP.  Brexit will make this problem worse in a bunch of ways.  First, the deficit is reduced by a large surplus from the export of services, which is precisely the area most likely to be affected by an EU departure.  Second, the deficit is most reliably financed by the long-term capital inflows of FDI, which should weaken for the reason discussed above.  Third, the deficit is also financed by short-term capital inflows, which will undoubtedly be hit by the uncertainty arising from Brexit.

In recent history, the UK has tended to have one currency crisis per decade.  I am not predicting this to happen now, but the odds certainly just went up.

Brexit and the UK, European and US Economies

There is one pretty predictable outcome from the vote: big economic decisions are going to be put on hold.  Until there is greater clarity on this brave new world, companies will be reluctant to invest and hire.  Like many places in the world, the UK economy has already been slowing.  With Brexit, I think that it is a near certainty that the UK will dip into recession in the next 12 months.

The vote will also produce weakening on the Continent, although in a somewhat reduced form.  For the reasons cited above, the political uncertainty in Europe will be highly elevated for the next 12-24 months and this will negatively affect economic activity.  This is particularly unwelcome given the tenuous nature of the European recovery.

In normal times, Brexit would be a non-event for the US economy.  But we are not living in normal times.  As I have indicated before, I think that the US economy is weak.  The recent very disappointing payroll figures are finally starting to confirm what other numbers have been showing for a while.  I am on record as giving a 50-75% chance of a US recession this year.  My timing may be off by three to six months, but I am very comfortable with the probability.

In general, Brexit could not have come at a worse time.  If Brexit is followed by some combination of Grexit, Departugal, Italeave, Czechout, Oustria, Finish, Slovakout and Byegium, leaving only Germaining[5], then things could become very interesting.

The Markets for Risk Assets

Although the purpose of this blog is not to provide investment advice, I have hidden my belief that risk assets – stocks, high yield bonds, emerging markets, many areas of real estate, etc. – are over-priced.  This is true by comparison to almost all historical benchmarks.  But this is doubly true when one considers the economic and political environment.

Around the world, we are pursuing economic policies that have no historical precedents and they seem not to be working.  In addition, political risks are rife, as the vote for Brexit has just sharply reminded us.

As a measure of the topsy-turvy world we currently have, the Japanese yen appreciated after the Brexit vote on the back of a “safe haven” bid.  There is no way that a rapidly aging retirement colony with a 20-year recession and massive debts should ever be a safe haven in any kind of healthy world.

The skies are thick with flocks of black swans awaiting.  This should demand a large risk premium in the pricing of assets, whereas we appear to have the opposite.  This conflict will have to be resolved one day, either through a sharp fall in the price of risk assets or a sharp improvement in the condition of the world.  I can’t imagine why anyone would bet on the latter.

 All Change

 As widely expected, Conservative Party leader David Cameron, who led the Remain campaign, resigned as Prime Minister after the Brexit vote became official.  The Onion aptly marked his departure with an article entitled “Americans Confused By System Of Government In Which Leader Would Resign After Making Terrible Decision.”

As the leader of the victorious Leave campaign, Boris Johnson, the popular ex-mayor of London, is the odds-on favorite to follow Cameron.  But he will not be unopposed.  Johnson has a huge amount of personal and political baggage.  Also, as anyone who watches Game of Thrones knows, regicides are not generally well regarded.  One thing for sure, though, if Johnson and Trump gain the leadership of their respective countries, G8 meetings will never be the same again.

Factions in the Labour Party are attempting to make sure that Cameron is not the only casualty of the Brexit vote.  The leader of the Labour Party, Jeremy Corbyn, is under fire for his soporific performance in support of Remain.  Although Labour is pro-EU, Corbyn has long been a skeptic and many of his colleagues are now accusing him of deliberately undercutting the campaign.  Corbyn has responded by sacking one of his sharpest critics, which has led to the resignation of half of the party leadership.

Corbyn has the leadership due to a populist revolt within the Labour Party, which the party mandarins are trying to reverse.  If Bernie Sanders had been a bit more successful, we would be watching the same fight in the Democratic Party.

Inter-Generational Conflicts

I have written at length (see here and here) about the subject of inter-generational conflicts in things like medical insurance, government debt, pensions, housing and the labor market.  I have also noted that the young are being consistently short-changed by an older generation that has the time and inclination to vote.

The same dynamic was on display in the Brexit vote.  Based on exit polls, the youngest group (18 to 24 years old) voted 75% to 25% to Remain.  The Remain percentage then fell monotonically with age, ending up with 39% in the oldest group (65+ years).

The irony of this, of course, is that the young will have to live with the consequences of the votes of the old.  Democracy is a wonder to behold.

The (Unlikely) Silver Lining

There is, of course, a potential silver lining in all of this.  It should be a huge wake-up call that there is very limited support for the supranational integration so beloved of European political leaders and the EU bureaucracy.  This blog has already favorably quoted a tweet from Donald Tusk, the former Prime Minister of Poland and current head of the European Council, which shows that he gets the joke.  Conversely, I think that we can reliably predict that Jean-Claude Juncker, the EU Commission President[6] and all-around arrogant buffoon, will take his usual approach of “the beatings will continue until morale improves.”

The key question is what the reactions of Hollande in France and Merkel in Germany will be.  Will they take this as an opportunity to roll back the centralizing tendencies of the EU and point it in the direction of the customs union that it should have always remained?[7]   Or will they conclude, despite all logic and evidence, that the Brexit crisis, following hard on the heels of the Euro and refugee crises, prove that tighter integration is required?  Or will they choose the default path of announcing big things, making small changes and hoping to muddle through?

If Brexit precipitates a fundamental re-thinking of the EU, then the Brits will have fallen on their sword nobly.  My fundamental pessimism about politics and politicians tells me, however, that their sacrifice will be in vain.

Roger Barris

Weybridge, United Kingdom

I Wish That I Had Said That (And Sometimes Not)…

“We will never be able to fix a rigged system by counting on the same people who rigged it in the first place,” by Donald Trump, referring to Hillary Clinton and appealing to the supporters of Bernie Sanders.  As is so often the case with Trump, the medium conflicts with the message.  Trump has spent much of his campaign claiming that only a crony-capitalist poacher like him can be an effective game warden.  Now he denies this logic.

 

[1] The libertarian blogosphere has almost universally applauded the vote, seeing it as a rejection of overbearing government and a celebration of liberty and free markets.  I think that this is almost certainly wishful thinking, just as some libertarians have misjudged the support for Trump.  The supporters of both Brexit and Trump do not include many free-marketers.  Both movements reject rule by the “other,” not rule in general.

[2] With the possible exception of the Nordic countries (Sweden and Finland), where they actually believe in democracy.

[3] In addition to the incomparable Silvio Berlusconi – well, no longer incomparable after the appearance of Donald Trump – Italy has previously elected porn stars and strippers to parliament.

[4] Frankfurt is way too boring.  Paris is way too French.

[5] Thanks to my friend Zeynep for this witticism.

[6] Broadly speaking, Tusk represents the grouping of the leaders of the EU countries when they get together to decide major policies.  Juncker represents the permanent EU bureaucracy in Brussels.  I think that makes Tusk more important than Juncker, but don’t ask me for details.  It was a standard line of the Leave campaign that no one really understands the EU structure and this is right.

[7] Careful readers of this blog may wonder if my reaction to Brexit is consistent with my general preference for decentralized government, as described here and here.  I am unambiguously in favor of decentralization when it has no implications for the size of the free-trade area, such as it would have in the US.  However, when decentralization affects the size of the free-trade area, then it is not possible to make general conclusions.  Conversely, those who claim that a large free-trade area requires centralization to set common rules, simply do not understand how trade works.

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