Gazing into the distance

The result of the EU referendum was a considerable shock - not just to the UK, but to the EU and indeed to the whole world. Just how big a shock it was is evident from the fact that the OECD has suspended its forecasts until September. It usually only does this for "significant unforeseen or unexpected events", such as a major earthquake or a tsunami. Brexit is a shock to the global economy of a similar order. And it has permanently changed the world. Whatever the future holds, we can be pretty sure that it will be very different from the dominant paradigm of the last forty years.

The vote was highly disruptive. It created chaos in the UK, anger and confusion in the EU, and puzzlement and concern further afield. But as the fog clears, markets return to some kind of normality and a new UK government takes the reins, we can perhaps begin to discern what the future might hold.

To everyone's relief, the UK's banking sector appears resilient: bank share prices have fallen, but there have been no bank runs, market freezes or liquidity crises, and banks are continuing to lend. If only the same could be said of the European banks. The Brexit shock highlighted the weakness of Italian banks in particular, but the truth is that the entire European banking sector is under-capitalised, highly risky and stuffed with bad assets. On the day of the EU referendum, Deutsche Bank failed the Federal Reserve's stress tests for a second time, and the Spanish bank Santander for the third time. The EU's abject failure to deal adequately with its banks was brought into sharp focus. By comparison, the UK's banks looked - and still look - rather good.

However, the UK's property market does not look so good. Open-ended property funds suffered severe liquidity crises and were forced to cease redemptions: additionally, both open-ended and closed property funds slashed their valuations. Construction has already suffered a sharp downturn and it seems likely there will be more pain to come. We should expect a price correction in commercial real estate and high-end residential property, especially in London: it is possible that price falls may trickle down to ordinary residential property too. Falling property prices nearly always presage a recession. 

There is also growing evidence of a significant hit to the real economy. Businesses are delaying or cancelling investment decisions, cutting production and in some cases considering moving headquarters and/or operations elsewhere. Of course, this might be a response to the chaos of the last couple of weeks. But if these effects are sustained, we should expect there to be negative consequences for wages and employment. 

Currently, the indications are that the UK will suffer possibly quite a nasty downturn. The gilt yield curve is inverted at the 2-year point, which suggests that markets are expecting a recession within the next two years:

Because of this, the Bank of England has already relieved banks of the requirement to build up countercyclical buffers, and is widely expected to cut interest rates and perhaps do more QE to support the economy. But as this is primarily a supply-side shock, monetary policy won't be enough. Indeed, in the absence of fiscal support, the unfortunate distributional consequences of unconventional monetary policy could even make matters worse. In the aftermath of a vote driven to a considerable extent by anger against what is perceived as a rich metropolitan elite, the last thing the UK needs is a policy response that increases inequality. 

I am relieved that key government figures have already indicated that tough fiscal targets will no longer apply. Trying to close the deficit now would be folly. Quite apart from the fact that tax revenues are likely to disappoint and benefits bills to rise, the economy will need fiscal support. A cut in VAT would be sensible to support demand, coupled with a substantial programme of investment spending. There is no reason to be shy about this. The new Chancellor, whoever it is, will no longer have the European Commission breathing down his or her neck. Gilt yields are low and falling. And the Bank of England can be relied upon to support gilt prices. This is a heaven-sent opportunity to invest in infrastructure, R&D, innovation, education and housing. 

Once the path and timetable for Brexit are clear, changes are likely to intensify in the run-up to leaving the EU. Those who no longer see their future in the UK will leave: but we may see others arriving, perhaps attracted by the UK's global outlook. It depends how we play it, of course: if we make life very hard for immigrants or foreign businesses, new ventures may be slow to appear. The new government will need to think about what businesses it wishes to attract for the future, and how to attract them.

To me, the present situation looks a lot like the preparation for the handover of Hong Kong to China in 1997. In 1996, while working for a major global bank, I was involved in a project to transfer trading books from Hong Kong to London. Like many international businesses, we feared that Hong Kong would lose access to international markets once it returned to China, so we wanted to get our business out of there. We were by no means the only business planning to leave. Many people, too, did their best to leave: those with British passports came to the UK, while others went to Singapore. There was a general atmosphere of worry during the five years between the terms of the handover being agreed and the actual return of Hong Kong to China. And it had a dampening effect on Hong Kong's economy.  

But we were wrong. Leaving the UK did not end Hong Kong's access to international markets. Nor did it result in the imposition of a repressive Chinese regime, as many feared. In fact, Hong Kong has become both the gateway to the largest market in the world and one of the world's great financial centres in its own right. It remains a lively, cosmopolitan, multi-cultural place. And many of those who left out of fear before 1997 have returned, attracted by Hong Kong's vibrant economy and its key role in the South East Asian marketplace. 

Of course, the UK is very different from Hong Kong, and it is leaving rather than joining a major trading bloc. It all could go horribly wrong: the UK could lose large parts of its financial services industry and be unable to develop other industries to compensate. Rather than a vibrant future, it could face years of stagnation and decline. There are no guarantees. But it is entirely possible that, like Hong Kong, once the UK has completely cut the ties, investment could return and the economy start to grow again. 

Whatever happens, though, the UK will change fundamentally. I do not know what the UK will look like in thirty years' time. But I am certain it will be little like today. Those who voted for Brexit in the hope of preserving their idea of Britain, preventing "their" culture from being diluted by foreign influences, are in my view doomed to be disappointed. When the UK leaves the EU and faces the world, it will place itself at the mercy of the world, and the world will make of it whatever it chooses. Short of imposing North Korea-style autarky, UK will have little control over this process. "Take back control" is in fact relinquishing control and stepping into the unknown. 

Not for a long time has the future been so uncertain. In the short-term, there will be pain. But in the longer-term, the future could be exciting. I did not vote for this, but this is what my compatriots chose, and I accept their decision. So this is what we - collectively - have chosen. Now we must embrace it, fully. For only by committing to our post-Brexit world can we have any hope of making it work. While we hanker after the past, and try to find ways of hanging on to it, we remain condemned to a stagnant future. Risk is life. Let's take some risk. 

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  1. Perhaps you will be disappointed. We are through a while of uncertitude, that can be well finish with the beginning of the new May's government, which has been well received by the markets. I don't see the reason why GB cannot live out of an Europe not so efficient in so many points. All we are seeing now will not necessary be permanent.

  2. Interesting piece, but like Ashok Mody recently, I fear you're trying too hard to be fair to the Leave side.

    The key issue here is that smaller economies thrive through their links with bigger ones. HK & Singapore in Asia, Canada wrt USA. There has been no plausible argument about which economy we could be linked with where we would have competitive advantage. It's noticeable that location is a key advantage. The one we did have was Europe, but we are shutting that down.

    There's a very good chance that what happens to the UK is what happened to e.g. South Yorkshire. The main industry hits turmoil and economic activity declines, never to return to the previous level.

    1. I'm with Metatone entirely on this one. Moreover, there's a reason it's called risk.

    2. Once The time pass, we'll never be sure what had be the alternative history. I tend it think that there will be a short term shock, but at long term "we all will be death"

  3. There's always the chance the UK cld Rejoin in 10-20 years

  4. Imagine the year 2018 and a conversation between a UK Trade Minister and Mr Bigshot from GiantCorp who does want to build a 700+ hectare plant in say Norfolk. Something like Tesla's battery factory but bigger and better. Employment for 30,000 plus support. The offer is time limited and requires the provision of land, roads, an airstrip, open immigration of scientists and the relocation of a couple of towns to make room for power plant, worker dormitories, worker city, research facilities and fairly dangerous test facilities. Value to economy say £200+ billion over the succeeding 15 years.

    Does anyone imagine HMG is anything like ready for the changes needed to make the UK open to such big-scale investment? Or will we be stuck with the endless dithering we are famous for. Pressed flowers and potpourri yes, new industry very unlikely.

    We shall see, but my money is on an ignominious return to the the EU in 10 to 20 years with King Charles' or King William's head on the Brit Euro note.

  5. Educational question:

    Do you know the reasons why the Deutsche Bank share price would go down after the Brexit vote?

    George Soros was reported to have shorted Deutsche Bank before Brexit. The amount was reported to be $100m. He was also reported to be long the pound. (Maybe he had some pounds in his pocket. He made a bundle with a capital B shorting the pound on the exit from the peg with Germany.)

    Deutsche Bank's share price value dropped nearly 30% top to bottom from before and after brexit. (24% technically but 30% actually.) $17 to $13, (17/13-1)*100 means it has to gain 30% to make up for the loss from going long or profit from a short.

    Also, in particular, what reasons could Brexit be bad for foreign bank shares or trigger stock price falls for German banks, Italian banks (worse), or (more worse) Greek banks? ? I think this is a short term question as the move was quick and event based and it is for short speculation not long investment.

    I noticed many of the Italian banks are rebounding quickly since about July 7th to July 12.


    An Italian bank, others can be clicked in the related companies list:

    1. I'd short Deutsche. It's desperately short of capital, hasn't got any decent businesses and its management doesn't have a coherent strategy. And its balance sheet is stuffed full of capital-hungry derivatives. It's a bad investment.

      (Disclaimer: I don't give investment advice)

      Any shock to the EU is dangerous to its banks, because they are all so risky. Brexit was a shock. Therefore it was dangerous to EU banks. They bounced back because actually Brexit is not that big a deal for them, since UK is not a member of the Euro. However, we will replay this scene every time there is some adverse shock to the EU. Next up, Renzi's referendum in Oct/Nov - which is potentially a FAR bigger deal than Brexit for Italian banks. Brexit wobbled them, but a big shock in the Italian referendum would kill them - and Deutsche would go down with them.

      In my view you have the precedence reversed, by the way. Greek banks (bad), Italian banks (worse), German banks (meltdown). No accident that Deutsche Bank's chief economist is now calling for EU to bail out all its banks.

  6. I cannot see any return to the EU in its current state, the recent referendum has been building for a number of years just as it does now in other countries, the UK has always been one of the more Eurosceptic members.

    The EU needs drastic changes but what are the chances of that happening? There is however every chance that another country will leave in due course.

    I am quite hopeful for the future, I voted leave for the UK to have greater freedom in its choices such as law making and trade deals amongst other things, immigration wasn't an issue for me, I welcome it with some controls. Britain seems to be at its best when our backs are to the wall and we are an outward looking nation, I do expect the UK to build new alliances that were somewhat difficult to do while in the EU.

    I also voted leave in the vain hope that a Brexit will be the beginning of the end of the EU, it's countries and peoples deserve far better.

  7. I found the sentiments in your concluding paragraph admirable.

  8. Ireland proves in a dramatic fashion shift B inflation.

    Gdp is total prices in the economy.

    Net national income is total income.

    GDP is rising explosively in Ireland.

    National income is rising slowly

    Foreclosed property / seized collateral is the driver of inflation in Ireland.

    Not the money supply which has been stagnant for nearly 10 years

  9. Ireland proves in a dramatic fashion shift B inflation.

    Gdp is total prices in the economy.

    Net national income is total income.

    GDP is rising explosively in Ireland.

    National income is rising slowly

    Foreclosed property / seized collateral is the driver of inflation in Ireland.

    Not the money supply which has been stagnant for nearly 10 years

  10. The economic rules of robotic manufacturing:

    Once built, a robotic gizmo making tool has rules of improving economic performance. There are sequential steps, each of which offers diminishing economic improvements.

    1. Work the robot longer hours, with 24 hours being the limit.

    2. Work the robot faster, with limits of practical design.

    3. Build more robots, with limits of material supply and profitable sale of output.

    How does this fit into a discussion of brexit? The UK has decided, in a world increasingly supplied using robotic tools, to make it's own trade rules. It wants to directly compete with all the other world nations that have their own central banks.

    Increased competition is deflationary.

  11. In his economic blog Seamus Coffey makes the point that the depreciation was added by foregin owned / based companies.

    But this misses the point.
    As far as I am aware these remain national accounts.
    The assets are based on the island.
    They therefore indicate how rotten the domestic economy is

    He also makes the point that aircraft leasing is a minor component of total.

    My guess is it is decaying foregin owned Irish property.

    My own direct experience of the real economy points in that direction.
    A hotel near me in a former prime location on the SW coast of Ireland has been empty for 2 years now.
    It relied on domestic rather then foregin tourism.
    The local economy had been kept somewhat afloat by foregin exchange but is now very very quiet this July after the Sterling fall.

    What's striking about the economy in a usury dependent system is its total lack of redundancy.

  12. Dear Frances, You need to look more closely at the 2008 collapse.

    Are we now at a point in Western economies where economic expansion is being throttled by energy prices increasing beyond the ability of an economy to generate returns sufficient to pay for excess energy?
    Is this a peak oil situation where the production cost of extra energy is beyond the ability of our economies to pay the excess?
    If so, is this the seed of the 2008 collapse in that money left economic activity and went seeking returns in speculative asset price bubbles?
    Is this expansion and collapse the new normal and will it create another credit recession?
    Are Govt interest rates now the better indicator of economic activity? Are their negative nature an indication that a lot of money is being parked for the foreseeable future?
    Is there a way out of this?
    Energy is required to fuel growth but there are no high yielding energy sources to replace oil. And oil is now becoming exponentially expensive to meet increased demand. The price of economic growth could be said to be now permanently higher than the returns on economic growth.

    Brexit, in this case, could be said to be a populist reaction to the above but a fatal one for the British economy as every market must be exploited to the full to at least break or to in the worst case usher in an economy that is going to survive at a lower energy threshold.

    2008 was not caused by speculation. It was caused by there being no alternative for money but to speculate. Returns in the real economies forced money elsewhere.

    This is the real problem. The rest is micro economic neurotics. The macro problem for the world is existential with regard to the true fuel of growth. This is where all politics and economics will find understanding.

    As an aside, the fuel for growth is going to heat up the middle of the world and force emigrants to move north which will increase the norths demand for oil and gas. There is a horrific catch 22 underway and most have blinkers on.

    Every economist must work to provide understanding before politics is destroyed by populist demagogues who bewitch people with utterly destructive crie de coeurs.


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