INSIGHTS: BREXIT – THE BIGGEST GLOBAL MONETARY SHOCK SINCE 2008
By Guest Columnist David Beckworth:
Associate Professor of Economics at Western Kentucky University, a visiting scholar at the Mercatus Center-George Mason University, and a former economist at the U.S. Department of Treasury. Reprinted with permission.
Scott Sumner is right. Brexit is the biggest global monetary shock since 2008. This could be the tipping point that turns the existing global slowdown of 2016 into a global recession. Here is why.
First, Brexit is adding further strength to an already overvalued dollar. The trade weighted dollar had appreciated roughly 25 percent between mid-2015 and early-2016. That is a very sharp increase in so short a time. It has come down some, but not much as seen in the figure below (red line):
The figure also shows that this sudden increase in the dollar is closely tied to the policy divergence between the Fed and the ECB (blue line). That is, as the Fed began talking up interest rate hikes in mid-2014 the ECB was talking up the easing of monetary policy. The rise in the blue line shows this policy divergence1
Brexit is now adding fuel to this dollar fire. The dollar has appreciated almost 4 percent since the Brexit fate became clear last evening, as seen in the figure below.
Why does a strengthening dollar matter? There are two reasons. First, over 40 percent of the world economy ties its currency to the dollar in some form. This can be seen in the figure below. That means when the dollar strengthens, these currencies strengthen too. This is the curse of the so called ‘dollar block’ countries–they import their monetary policy from abroad. Via this channel, Brexit has just further tightened monetary conditions in all these countries. This added pressure makes it likely China will be forced to devalue soon. And we saw how well that went last time it was tried.
The second reason the rising dollar matters is the rapid growth of what the BIS calls the ‘parallel dollar system’. This is a system of dollar loans and dollar debt securities that has emerged outside the United States. This dollar credit to and from non-U.S. residents has tripled since 2000, while non-resident Euro and Yen financing has remained relatively stable. In fact, the dollar’s share of this non-resident credit growth has increased from 62% to 75% according to BIS data. This means there is a lot of dollar-denominated debt outside the United States that is very vulnerable to dollar shocks. Brexit just increased the real debt burden of these borrowers.
So between tightening monetary conditions for the dollar bloc countries and increasing real debt burdens for all the non-resident issuers of dollar debt, the global economy has been hit with a large dollar shock. Put more crudely, the strong dollar noose that has been choking emerging economies since mid-2014 has now been complemented by the opening of trap door on the gallows via Brexit. This makes the strangulation of global economy complete.
A second reason Brexit might be pushing the global economy into a global recession is that it hastening the the frantic race to bottom on safe yields. As I noted in a recent post, yields on safe assets around the world have been going down since the demand for safe assets remain unmet. Given global capital markets this also means there is a race to the bottom on safe yields as noted by Caballero, Fahri, and Gourinchas (2016) :
In the open economy, the scarcity of safe assets spreads from one country to the other via the capital account. Net safe asset producers export these assets to net safe asset absorbers until interest rates are equalized across countries. As the global scarcity of safe assets intensifies, interest rates drop and capital flows increase to restore equilibrium in global and local safe asset markets. Once the ZLB is reached, output becomes the adjustment variable again.
Brexit massively intensified this race to the bottom as seen in the the 10-year yield below. Incredibly, the yield fell from 1.74 to 1.43 this evening! Brexit, in other words, just jolted the demand for safe, liquid assets in a major way.
This frantic race to the bottom of safe yields will eventually run up against the effective lower bound (ELB). When that happens something else will have to adjust. And that something is output, as noted by Caballero, Fahri, and Gourinchas (2016).
So there you have it. The world has been hit with a massive global monetary shock. And via dollar bloc countries, the parallel dollar system, and the shortage of safe asset problem this monetary shock may be what pushes an already slowing global economy into a global recession.
Will central bankers and finance ministries be ready for it? I hope so.
ON THE ECONOMY: GOD SAVE THE QUEEN
By John Dunham:
Managing Partner, John Dunham & Associates
God save the queen, she ain’t no human being. There is no future, in England’s dreaming. Don’t be told what you want. Don’t be told what you need. There’s no future, no future, no future for you. God save the queen – we mean it man – we love our queen. So the Sex Pistols finally made the Monthly Manifesto. God Save the Queen was a song released by the British punk rock band the Sex Pistols during Queen Elizabeth II’s Silver Jubilee in 1977. It was released both as a single and on the Band’s sole album, Never Mind the Bollocks, Here’s the Sex Pistols. It is a commentary on the division between the working classes and the government, and serves as a great introduction to this discussion of the recent vote by the people of the United Kingdom to leave the European Union.
We recently published a blog on the politics of Brexit (Rule Britannia) which examined many of the reasons why the British people voted to leave the EU. The campaign led to some of the most amazing demagoguery that I have seen in a long time. For example, soon to be former British Prime Minister David Cameron suggested that Brexit could lead to World War III, stating, “The serried rows of white headstones in lovingly tended Commonwealth war cemeteries stand as silent testament to the price that this country has paid to help restore peace and order in Europe … can we be so sure that peace and stability on our continent are assured beyond any shadow of doubt?” Not to be outdone, former London mayor Ken Livingstone was quoted as saying, “I would personally start thinking about emigrating to somewhere the economy is not going to collapse,” while the European Council President Donald Tusk went as far as to state, “As a historian I fear that Brexit could be the beginning of the destruction of not only the EU but also of western political civilization in its entirety.”
On the pro Brexit side, another former London mayor Boris Johnson compared the EU to the Nazis in stating, “Napoleon, Hitler, various people tried this out, and it ends tragically … the EU is an attempt to do this by different methods.”
Wow! Just like that, the people of Britain voted to destroy their economy, start World War III and do battle with the specter of Hitler all in one afternoon.
A lot of people (including our guest columnist) have claimed that this decision will have dire economic consequences; however, most of these consequences are short term at best and reflect the fact that many financial traders were betting on a Remain vote. They will have to wind down their bets, selling overvalued stocks for net importers, capitalizing short sales on exporters, and reversing any bets that were long on the pound. While this may lead to some short term volatility in financial markets, it is no different than a gambler rolling a seven in craps, and losing all of his chips. The gambler may lose, but those who bet on Any 7 will win.
Any real implications of the Brexit vote will depend on how the British and the EU negotiate their divorce, but in general any implications depend on how Brexit changes patterns of trade, investment, and labor markets.
Let’s start with trade because this is likely where a departure from the European Union will have the greatest effect on both Britain and the World Economy. First economic growth and trade are correlated, so GDP rises with trade. While correlation does not imply causality, economists from the Physiocrats to today have shown why more trade leads to a better economy so let’s take this as a given. Trade between the UK and the world accounts for just 4.5 percent of total world trade, and less than half of that is with the EU. If trade negotiations between Europe and Britain get totally bollixed up, the worst case scenario is that overall tariffs between the UK and the continent would be about 8.8 percent which represents what is called Most-Favored Nation status by the World Trade Organization. So after doing the math, worst case scenario is that tariffs of about $35 billion are imposed on British goods. Since trade accounts for about a third of world economic growth, this would be about a $10 billion hit assuming an extraordinarily high one-to-one reduction between trade and tariffs. Since the British economy is about $3 trillion in size, the worst case is a loss of 30 basis points (0.3 percent) in economic activity due to a reduction in trade. Taken across the world economy the loss is at most about one-one hundredth of one percent.
So the British economy may be slightly smaller due to a reduction in trade, but if the doomsayers are correct, and the British pound falls dramatically in value, chances are that these lower prices would make up for the tariffs. But would the pound necessarily fall in value? First, the UK is not a Eurozone country, so the Brexit decision should not really impact overall demand for pounds and euros as currency. Rather they would reflect changes in investment decisions as traders might find the pound to be less secure relative to the euro. Let’s examine the situation. Following the Brexit vote, the value of sterling relative to the Euro fell by a whopping 7.7 percent. This is a huge change in currency markets and obviously left those traders who were long on the pound quite poorer (of course those who shorted sterling are quite happy). But at an exchange rate of 1.2 pounds per euro, sterling is still trading well within its 10 year band, and is actually above the rate it was trading at just two years ago. Obviously the Brexit decision has not impacted the British currency outside of what might be considered to be normal trading fluctuations.
Even so, the weaker pound may lead to some increases in inflation in Britain as the country is a net importer; however, with inflation running at … well roughly zero … this should not be a huge cause for concern either.
One thing that pundits have suggested is that Brexit will lead to tremendous reductions in investment in Britain as there will be a lot of uncertainty. Since I have suggested that uncertainty is one reason why investment in the United States has been so tepid over the past 8 years it is hard to disagree with this; however, investment levels in Britain have generally been falling ever since the country joined the EU in 1973. This suggests that there are a lot of other factors that impact capital investment, and maybe, just maybe, the Leave camp was right in suggesting that the heavy hand of regulation from Brussels may have had an impact. This is a complicated analysis to undertake, but as I said in my blog post, it is difficult to think that any extra layer of government – particularly a layer with no other purpose than to write rules – would do much to make life better for anyone. So I call bollocks on this claim – at least once negotiations are complete, and a lack of investment is already going to happen since Europe and the United States are both on their way to recession.
Labor markets are the one place where there could be some ramifications from a break between the UK and the EU. Over the past few years, there has been a tremendous shift in the way that workers, particularly higher skilled workers, across the EU have found jobs. Financial wizards from Germany can easily work in the City, fashion models from Spain can work in hotels in London, and engineers from Nottingham can find work in Bremen. Considering how sclerotic Europe’s labor markets are this is a very good thing. In many cases it is the only way that younger people from places like Spain or France can even find meaningful work. It also explains to a large extent why younger people favored “Remain,” since they are more likely to have friends who have been helped by free movement of labor. The impact of Brexit on labor markets is difficult to predict because in reality integration favors the Continent over the UK. Just look at the number of refugees trying to get through the Chunnel as evidence to the fact that it is easier to find work in Britain. One would think that the UK could use this advantage in negotiations for lower trade barriers, and in effect eliminate much of the negative impact of Brexit – but this is up to politicians not economists to figure out.
After looking at the evidence and examining the real economics (not the financial economics) I have to agree with the Sex Pistols when they say Don’t be told what you want. Don’t be told what you need. Once the financial markets settle out, and once an amicable divorce settlement is in place, I think Never Mind the Bollocks pretty much says it all when it comes to Brexit.
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