Brexit is not about Britain
By Scott Sumner
I’m seeing a lot of confusion about the implications of Brexit. Here are two common misconceptions:
1. Some people see it as a real shock, whereas it’s primarily a monetary shock.
2. Some see it affecting Britain’s economy by disrupting trade, whereas it actually hurts the eurozone more, by depressing expected NGDP growth. The real effects are often overstated; Norway and Switzerland do fine outside the EU.
In some respects, this is quite similar to the British decision to leave the gold standard in September 1931. That decision also hurt the continent of Europe more than Britain (indeed in that case it actually helped Britain.)
This time around the UK was probably hurt somewhat; British stocks are down around 4% as I write. But French and German stocks are down 7% to 8%. The markets in southern Europe are down 10% to 15%. Brexit’s most powerful effect is to make the eurozone crisis worse, by increasing doubts as to whether the eurozone will stay together. By analogy, the 1931 UK decision to leave gold made things worse for the rest of the gold standard, indeed a surge of public and private gold hoarding over the next few months drove global commodity prices sharply lower.
To understand the effects of Brexit, it’s best to forget about the UK and look at market reactions around the world:
1. Plunging stock prices
2. Plunging bond yields
3. Plunging commodity prices
This is how global markets react when NGDP expectations fall. In contrast, negative real shocks are inflationary.
I don’t want to overstate things; the level of equity prices in the US is still quite high—and thus the markets currently do not seem to be forecasting a recession. If the central banks react in the correct way then it’s possible that markets will recover. But at the moment, expectations of global nominal growth have clearly declined somewhat.
Several people asked me why this is a monetary shock and not a real shock. First of all, it clearly is a bit of a real shock for the UK economy, but even there it’s also partly monetary. But at the global level (which is far more important) it’s almost entirely a monetary shock. Here’s how the two differ:
1. A real shock is a shock that would depress RGDP even if monetary policy maintained stable NGDP growth expectations.
2. A monetary shock only depresses RGDP because of a decline in NGDP (and/or inflation) expectations.
I think people get confused over two points:
1. Many people wrongly think of monetary shocks in terms of interest rates. Since interest rates fell sharply, these “IS-LM” people don’t see how monetary conditions could have tightened. These ISLMic people are often referred to as Keynesians.
2. Old monetarists are also confused, as they focus on the supply of money, which did not decline today. But an increase in the demand for money is every bit as contractionary as a decline in the supply of money; indeed monetary models are completely symmetric in that respect
The most interesting market reaction occurred in the fed funds futures market, where rates fell sharply. The markets now forecast ultra-low interest rates in America, as far as the eye can see. This suggests that the Fed needs to undertake a radical regime change. Unfortunately, central banks are conservative institutions, and thus they’ll have to be dragged kicking and screaming into this new reality. I fear that the economics profession as a whole will misdiagnose the nature of the monetary problem, just as they did in the 1930s, and in 2008. The single most useful reform at this moment would be a global shift toward level targeting.
I frequently point out that the economics profession, which is still stuck in the Stone Age, has not even taken the basic step of creating a highly liquid NGDP futures market. Last night would have been a great time to have had such a market, but alas we do not have one. With a highly liquid NGDP futures market we could actually watch monetary policy change in real time.
There are also some odd political aspects to Brexit. Three in four young voters wanted to remain. They will have to live with the consequences. There is a sense in which the older UK voters stabbed their children in the back (Yes, that’s a bit melodramatic, but there’s a grain of truth.) When the older voters die off, will Britain rejoin the EU, or will the young get more nationalistic as they age? BTW, there are some very good arguments in favor of Brexit; I’m just discussing the psychology of the vote here.
Of course this is good news for Trump, as it suggests a groundswell of nationalism. It’s also good news (for Trump) in the sense that the Brexit vote was greater than predicted by either polls or betting markets. I think at some level Brexit voters understood that their decision was destructive (even if justified in the long run) and hence they were more reluctant to reveal this “politically incorrect’ view to pollsters. Maybe the same will be true for Trump voters.
Update: I also recommend David Beckworth’s excellent post on Brexit.