Brexit: What I got wrong, and what is still uncertain
By Scott Sumner
Immediately after the Brexit vote, I used the knee jerk reactions of various markets to try to estimate the impact. After 14 weeks, it looks like one key market reaction was wrong. Here’s the FTSE250, a stock index with a somewhat more domestic focus than the FTSE100:
It looks like the knee jerk reaction was wrong, on this occasion. Why might markets have gotten it wrong? Let’s start by looking at the most recent data out of the UK:
Recent data have reinforced optimism that the domestic economy is weathering the aftermath of the vote. The construction industry unexpectedly grew in September, while a manufacturing gauge jumped to its highest level in more than two years. A Citigroup Inc. index tracking economic surprises in Britain is near a three-year high.
After four years of underperformance, U.K. shares have become the highlight of Europe, when looked at in local currency terms. The FTSE 100 has surged 14 percent in 2016, while the regional Stoxx Europe 600 Index is still down 5.4 percent.
“It’s more than just a sterling weakness story,” Higgins said. “Economic data has actually been strong. There is a bit of a catching up here.”
opponents proponents of Brexit have a right to claim that the “Remains” got it wrong, predicting that uncertainty would cause a recession in the UK. It still might, but that seems increasingly unlikely. If I were a Brexit fan who didn’t believe in the EMH, I’d claim that the stock market initially fell because investors believed all the dire warnings coming from elite prognosticators, and then rallied when it found out those warnings were false.
The forex markets are one place where the knee jerk reaction does seem correct, in retrospect. The British pound fell sharply after the vote, and has not recovered at all. It seems likely that the forex markets still expect slower long run growth in the UK, even as the economy has held up in the short run. And here’s one area where the Brexiteers may have gotten it wrong—they promised that Britain would sign free trade agreements with the EU, and that option seems increasingly unlikely.
As far as my other predictions, it’s too soon to say. I thought Brexit would be a near-perfect test of the “uncertainty theory” of business cycles, and still believe that strongly. It created a massive amount of uncertainty, and most of the experts who believe in the uncertainty theory also predicted that Brexit would cause a recession. This should be a very good test.
Of course the usual caveats about monetary offset must be kept in mind. Fortunately the BoE seemed to react to the shock in such a way as to keep NGDP growth reasonably stable (although we won’t know for sure until more data comes in). I predicted only a small (0.5%) rise in unemployment, and thought the bigger impact would be on RGDP. I’m sticking with that prediction for now. If forced to revise my views, I’d probably move even further away from the conventional wisdom on the importance of uncertainty, as the early data suggests that uncertainty might be even less important than estimated by skeptics like me.
To summarize, Brexit is a really important natural experiment, which the entire profession should watch closely. The impact of Brexit on the real economy will take years to determine, as it will not actually occur until at least 2019. The impact of Brexit uncertainty will be clear much sooner–probably within another 4 to 8 months. By then we will know whether “uncertainty theories” of the business cycle can be safely tossed into the trash bin, or can live for another day. After all, it’s very unlikely that we’ll ever again see such a big uncertainty shock from the supply side. (Of course AD uncertainty is an entirely different story, and shocks like 2008 will continue to occur.)
PS. William Hague’s proposed negotiating strategy seems sensible to me, but I don’t know if the EU would accept it.
PPS. Nick Rowe has an interesting take on Brexit.