Why Brexit is grim news for the world economy

Uncertainty abounds. Expect a global chilling effect on investment

Jun 24th 2016, http://www.economist.com/news/finance-and-economics/21701292-uncertainty-abounds-expect-global-chilling-effect-investment-why-brexit?fsrc=scn/tw/te/pe/ed/whybrexitisgrimnewsfortheworldeconomy

NIGEL FARAGE, the leader of the UK Independence Party, told elated supporters that June 23rd should go down as Britain’s Independence Day. The reaction in financial markets to Britain’s vote to leave the European Union was rather less euphoric. During the Asian trading day, the pound plunged against the dollar by over 10% to $1.32, a 30-year low. It fell far harder against the yen, a frequent bolthole for the anxious. Investors have started to flock to the safety of US Treasuries. As Europe’s markets opened, the main stock indices followed the lead set overnight in Asia and fell by around 10%.

Investors hate uncertainty and the result of the referendum gives rise to a surfeit of it. But the falls in Asia’s equity markets are also in large part an early judgment about the impact on the world economy. Of course, markets often overreact. Britain accounts for just 3.9% of the world’s output; it is not big enough to make the global economic weather in the way America or China can. Then again, America’s economy has been sluggish of late and there are grave worries about China’s ability to escape the shadow of its mountainous debts. Britain’s economy looms large in Europe, where it is a reliable consumer in an otherwise high-saving continent. And any disruption to European growth is particularly unwelcome now.

The Bank of England said this morning: “We are well prepared for this.” It may cut its main interest rate from its present level, of 0.5%. It may even revive its quantitative-easing programme, buying bonds with freshly minted electronic money. A recession in Britain nevertheless seems likely. Corporate investment will be hurt by uncertainty about future access to both the single market and to other places where Britain has piggybacked on trade deals negotiated by the EU. In unsettled times, businesses defer whatever spending they can.

The same is true for consumers. The majority who voted to leave the EU may think that forecasts of recession in the event of a Brexit vote were a tactic to scare voters. If so, they are unlikely to curb their spending overnight. But as the bleak consequences for the economy become clearer, spending on big-ticket items is likely to slump. The collapsing pound will drive up inflation up, crimping real incomes. Some jobs will go. Hours worked and wage growth will fall. And Britain is big enough for a recession there to have a meaningful effect on Europe’s economy. As a rule of thumb, whatever the reduction in Britain’s GDP growth, Europe’s economy will suffer a drop of about half as much.

Brexit will hurt the world economy in other ways. A big concern is the extent to which a retreat from financial risk will disturb the existing fault lines in the world economy, notably in China and southern Europe. Italy has a referendum of its own (on constitutional change) in October. Matteo Renzi, Italy’s reform-minded prime minister, says he will resign if the result goes against him. The Brexit vote scarcely helps his chances. A widening of bond spreads in southern Europe seems likely in the run-up to the poll. The European Central Bank can intervene to swamp the symptoms of anxiety by buying bonds, but it can’t do much more to cure the underlying problem of weak growth.

It is trickier to draw a line from Brexit to China. A weaker European economy will certainly hurt Chinese exports. Perhaps a bigger risk is a renewed bout of dollar strength, as Europe’s currencies weaken, which might in turn put renewed downward pressure on the yuan.

Even if some investors have short horizons, tumbling stockmarkets reflect some long-term worries. If Britain, long a champion of free trade, can vote to revoke a regional trade deal, how much faith can businesses worldwide put in other international economic agreements? An EU shorn of Britain’s deregulating influence is a troubling portent for the liberal world order. Nationalist, populist and protectionist forces in other countries will be greatly encouraged by Brexit. The WTO recently gave warning that protectionist trade measures in the G20 are multiplying at their fastest rate since 2008. In such circumstances, it would be surprising if the Brexit vote did not have some chilling effect on investment worldwide. It makes curbs on migration of workers a little more likely, which will be costly for businesses. And if Europe exports some of its misery to Asia and America through weaker currencies, it may increase pressure for restrictions on capital flows, too.

A lot depends on the kind of trade deal Britain can negotiate with the EU and how quickly. If Britain gets a quick deal with no big reductions in its access to the single market, the grimmer scenarios for the world economy may not come to pass. But markets do not seem to be counting on it.