Scott Sumner  

Brexit is not about Britain

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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.


Comments and Sharing






COMMENTS (32 to date)
Philo writes:

Scott, you really do think for yourself, rather than just following the crowd--for example, the crowd of economists. (That means you are a genius or--somewhat more likely--a crank.) All the more surprising, then, that, in some of your epistemological posts, you advise *us*, your readers, to *follow the crowd*!

Philo writes:

P.S.: the crowd thinks you're a crank, but I, thinking for myself, vote for *genius*. (But then, *I* am a crank, so what's my vote worth?)

robert writes:

If low interest rates are due low expected growth rates due to money lost having been invested in negative NPV projects, regulatory overhang, or being needed to support an aging population, how would monetary policy have a positive impact?

If low interest rates are due to tightening money supply due to the velocity of money slowing due to more stringent underwriting as well as increases in capital requirements, e.g. Basel III requirements, how would monetary policy have a positive impact?

Couldn't targeting NGDP have a negative impact on RGDP by distorting the pricing mechanisms in the speculative markets, e.g. chasing yields?

As far as young voters, do you feel that younger voters are better or less informed on the underlying issues as older voters? Are younger voters more cynical and less influenced by propaganda than older voters?

As far as nationalism, it seems to me that the trade-off was one of accountability & corruption versus free trade & movement. Politicians are lawyers, and lawyers are hired to represent their clients interests. Lawyers may feel that they have a responsibility to protect the greater good, enrich themselves, or signal their own virtue. At the point that the lawyers no longer represent their clients interests, their clients have the right and responsibility to fire them and hire someone who will fulfill their fiduciary duty. I think today was representative of that.

Lastly, I really enjoy your blog, and I learn a lot from reading it.

Scott Sumner writes:

Philo, Thanks, but the crowd is the markets, not the experts.

There's a reason why the French and German markets are down three times as much as the UK market---the markets get it.

Robert, You asked:

"If low interest rates are due low expected growth rates due to money lost having been invested in negative NPV projects, regulatory overhang, or being needed to support an aging population, how would monetary policy have a positive impact?"

Monetary policy cannot paper over real problems like malinvestment, but it can prevent a fall in NGDP, which would needlessly damage the economy.

You said:

"Couldn't targeting NGDP have a negative impact on RGDP by distorting the pricing mechanisms in the speculative markets, e.g. chasing yields?"

I believe that asset markets are efficient, so I don't worry about that.

The young are probably more comfortable with the increasingly cosmopolitan nature of British society.

TravisV writes:

Prof. Sumner,

Do you agree with me that the Bank of England deserves most of the blame for this negative news?

John T Kennedy writes:

" 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."


So you're saying radical ISLM is a big part of the problem?

Michael Rulle writes:

As far as Brexit in and of itself, I think it is a good thing. I wish we had also Francexit and as circular as it sounds Germanexit (I view this as an escape from Germany in an odd way). For all the reasons one opposed the Euro in the first place, come into play now. What is good is that countries can now package fiscal and monetary policies together were this to lead to a run on the Euro experiment.

Now there are infinite ways this can all go wrong. Maybe it is all just an irrational populist anti-foreigner vote for its own sake. Or hyper right wing groups will emerge all over Europe with new flags and guns a blazing. But I do not think so. I think it is just a vote against the unaccountable sclerotic bureaucracy in Brussels.The UK will do fine on its own and can create its sclerocracy if it so chooses.

But back to today. GB wants to go it alone and we have a monetary shock. Somewhere Scot wrote that as long as the Central banks do not act like its 2007 there should be no problem. As Scot has also said it's all about NGDP expectations, which are psychological anyway----"not concrete steps". Scot remains the Zen economist with his sound of one hand clapping prescriptions.

Yes, I get it that NGDP futures contracts will provide signals from the market as to whether the CBs are on the right course. What I have never gotten, other than perhaps the Fed buying and selling those contracts, what is it that Central banks can actually do to reinforce its NGDP targeting objectives as there are "no concrete steps" because "it is all psychological anyway".

There is more to your idea than this, I assume, but you never say what it might be. At least not to my understanding. I would love a hint.

Scott Sumner writes:

Travis, No, I blame the voters.

John, I would, but that's politically incorrect.

Michael, Those are not my views. I suggest you look at some of my older posts. Over at MoneyIllusion I have series called a short course in monetary economics.

Woodrow McClure writes:

I was thinking the exact same thing in regards to Brexit being similar to Britain's exit from the gold standard.

As of my writing 1:36 PM EST. The FTSE 100 is down about a few bps more than the S&P 500, and europe is still near double digit or above.

You argued that is was only partly a monetary shock for the UK, but I think it might be more of the correction than you are giving is credit for.

I found your argument very insightful.

BC writes:

"In contrast, negative real shocks are inflationary."

Good one sentence explanation. Just to clarify, do you define a real shock to be a shift in AS and a monetary shock to be a shift in AD?

Philo writes:

Brexit will be a lot easier than would be the exit of any of the countries in the Euro monetary union. Reconstituting national currencies that now no longer exist would be challenging.

Michael Rulle writes:

I will---thanks

I was merely quoting a comment you made to "Harold" on another site.

TravisV writes:

Prof. Sumner,

If you don't blame the Bank of England, please see this recent post by James Alexander:

https://thefaintofheart.wordpress.com/2016/06/10/where-were-99-of-uk-economists-in-august-2015

Britmouse writes:

Scott, I think the point about the FTSE 100 is misleading.

The FTSE 100 is dominated by companies which have mainly non-UK revenue, so the effect of Brexit on many will reflect the change in global prospects, but is also partly an *upward* revaluation with the fall in the pound. (e.g. BP is up)

The FTSE 250 is considered a better barometer of domestic prospects and is down 7% today.

Matthew Moore writes:

"When the older voters die off, will Britain rejoin the EU, or will the young get more nationalistic as they age?"

Depends entirely on relative performance in the meantime. My money is on the UK strongly outgrowing the EU for as long as the Euro exists - and any re-entry would require adoption of the Euro

Ted Murphy writes:

Always enjoy your interpretations. However, the dismal performance of the betting markets on Brexit (off by more than the polling) does not make the case for basing policy on an NGDP futures market more persuasive.

Sina Motamedi writes:

Scott,

I agree that Brexit is not a real shock, but why should Brexit cause a monetary shock? How/why does it change money demand?

[Broken URL fixed--Econlib Ed.]

ThaomasH writes:

Scott,

I DO wish you could be just a bit more accommodating with readers who do not already understand/agree with you. A negative "monetary" shock that arises without the monetary authorities "doing" anything will just confuse people.

Rather than trying to make the rhetorical point that Brexit was a "monetary" shock, just say that to prevent whatever kind of shock it was from leading to a fall in real output, monetary authorities need to announce that NGDP growth will not fall (indeed that it will return to its pre-crisis trend) and start pumping out the QE and watching the inflation rate exceed their former ceilings to persuade folks that they mean what they say.

Yes it would be nice if we had an NGDP futures market and yes it would be nice if people stopped obsessing about short term interest rates on government liabilities when there are so many other things that a central bank can buy, but neither of those is necessary. Let's get the policy right and argue about what to call it later.

Tom Davies writes:

+1 to Sina's question (and Thomas's point about confusion).

I understand why the evidence leads you to call this a 'monetary shock', but I don't understand the mechanism by which Brexit creates a monetary shock.

Lorenzo from Oz writes:

John T Kennedy: "So you're saying radical ISLM is a big part of the problem?"

GOLD! You winz the internetz for today :)

Lorenzo from Oz writes:

Excellent post: a fine example of what a good analytical framing plus paying attention to the data can do.

Weir writes:

Scott used the line about a stab in the back, which is appropriate since fascism was a youth movement too.

Do teenagers have a special insight into economics? Or are they even more obsessed with fitting in, and with status competition, and with their attractiveness, than people who actually work for a living?

Youth unemployment in Spain is fifty percent. But would teenagers in Spain vote to leave the EU? Or would the Twitter mobs and Facebook bullies keep the herd in line?

Social media and David Cameron were made for each other. His insult about "swivel-eyed loons" isn't an argument, except on Facebook. Because humans are social animals. Of course we care about other people's approval. But what are the economic arguments for the EU's anti-vaping laws? The EU's banana curve regulations? Their restrictions on trade with everyone outside the EU?

The EU in real life blocks innovation. The EU in real life is about the centralization of decisionmaking, instead of competition, instead of voting with your feet. It "harmonizes" bad laws so that governments never have to face up to the consequences of their destructive policies. And young people, it turns out, love Big Brother, so they'll vote for all this anyway.

Patrick Gillett writes:

GBPEUR also fell 7%, so from an external pov, the UK market fell more than the Northern European markets

Khodge writes:

Financial types create (futures) markets, not economists. Apparently the financial types, who are notoriously aggressive when creating new financial tools, are not interested in NGDP futures. That such a market has not (apparently) been created suggests that you are overstating the case for economics being stuck in the Stone Age.

Ted Sanders writes:

Scott, interesting idea, but one that may not be borne out by the data.

I've been looking through a bunch of single-country ETFs and although Spain was hit harder, the United Kingdom was hit more than most.

Google finance link comparing some comparable single-country ETFs

I'm not sure where you got the 4% from, but it may be an apple to the oranges that you're comparing. Is it measured in dollars or pounds? And is it a broad market index, or concentrated in the top 100 companies?

Anyway, I think your general point still stands that this is an issue for Europe and the entire world, not just the UK.

Alistair writes:

It seems obvious that the young will grow up and agree with their elders. There's a very long trend of people become Eurosceptic as they age.

After all, the older 'leave' voters today were younger 'in' voters several decades back.

And the EU isn't going to become more attractive as an institution from here on in..

Bill D Wall writes:

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Rajat writes:

Thanks Scott, great post. But on this:

"Brexit's most powerful effect is to make the eurozone crisis worse, by increasing doubts as to whether the eurozone will stay together."

Do you think it's that? Or is it that all markets are pricing in a tightening of global monetary conditions but the markets in those countries whose central banks are not expected to respond appropriately (eg Greece, Japan) lose most? I think you suggested something like this in your other post.

A writes:

@Ted Sanders, are you looking at foreign indices ETFs priced in dollars? That isn't a good proxy for relative impact because you are including currency swings. For example, a currency might lose 10% to the dollar, and but their ETF components might gain 11% in local currency, so that it's a wash to the U.S. ETF holder. But the corporate valuations include the effects of U.S. dollar strength.

Britmouse's critique is more relevant. Per Marketwatch: "The midcap FTSE 250 index MCX, -7.19% has U.K. revenue exposure of 52% compared with around 28% for the larger-cap FTSE 100, according to FactSet data. The midcap gauge was shoved down nearly 7%."

James Alexander writes:

A
Except that similarly domestic-focused Euro bourses were down 12%, local currency.

athEIst writes:

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Frank T. Manheim writes:

Owing to historical factors no nation can beat the U.S. in out-of-the-box innovation - where that is not interdicted by regulations.

But I would like to get evidence about how the EU blocks innovation. Sweden is No 2 in the world in environmental performance according to the Yale-Columbia EPI index and has reached 50% renewable energy use - compared to our 10%. Meanwhile Swedish Electrolux bought out the remaining major US appliance manufacturing from GE; IKEA makes Sweden the largest furniture manufacturer and home furnishings marketer; Sweden was the worlds 2nd truckmaker last I checked; and it beats our brains out in export import balance. There is more mobility to move from low to higher income, and Swedes have 10 times lower murder rate than we have, and half our health care cost.

So just how is the EU blocking innovation in Sweden?

One of the most important features of the EU is that it has benefited the poor nations as well as the rich nations. The EU has terrific problems but unlike the U.S. it has no legislative paralysis and works to resolve them.

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