Brexit isn't the most serious threat to the EU -- the euro is
One surprising thing about Britain's vote to leave the EU is that the British economy has been doing better than a lot of European countries. Unemployment in the United Kingdom has fallen to 5 percent, its lowest level in a decade. In contrast, the average unemployment rate among countries that (unlike Britain) have joined the EU's common currency, the euro, is still above 10 percent.
And many economists argue that's not a coincidence -- that poor policies by the European Central Bank have systematically weakened growth in countries that have adopted the euro.
A new paper from economist David Beckworth makes the case that the economic woes of eurozone countries like Spain and Greece can ultimately be traced back to the euro itself. He argues that other problems in those countries, like their problems with high debt, were made worse by the ECB's tight-money policies.
This argument has huge implications. It suggests that without reforms, eurozone countries could continue suffering from slow growth and abnormally severe recessions for decades to come. That, in turn, will fuel public resentment against the EU and increase the danger that other countries will follow the UK's lead.
The stock markets that have been hardest hit by Brexit are in places like Italy, Spain and Greece, the epicenter of the on and off again eurozone crisis. This suggests that investors fear a contagion effect. Indeed with the sharp rally today, the FTSE100 is actually above it's pre-Brexit level, and even the more meaningful FTSE250 (which focuses on British domestic stocks), is only down about 7%, not much different from France and Germany).
I'm pretty skeptical of anyone's predictions as to how all of this will play out, including my own. Just to give you a sense of how hard this is to predict, consider the following hypothesis. Suppose Britain is able to successfully negotiate a Norway/Switzerland style agreement with the EU, and is also able to avoid the recession that almost everyone is now predicting. What then?
One effect would be to discredit the "experts" (like me) who warned that the UK should not exit the EU. And what implications might long-suffering citizens from Greece and Portugal draw from Britain's successful Brexit?
And here's something else to think about. If Greece noticed that the UK did well with its Brexit, and that led to a "Grexit", the results might be far worse. The Greek banking system might collapse for reasons explained in Timothy Lee's post, and the contagion effect could also hit the banking systems of the other PIGS.
In other words, while real factors are the dominant influence on long run growth, over business cycle frequencies it is monetary factors that dominate. The one issue Britain does not have to deal with is exiting the euro. And that's the most difficult problem of all.
Just to be clear, it's by no means certain that Britain will be able to negotiate a Norway/Switzerland type solution. The two sides are still far apart on immigration, and the EU is in no mood to hand out favors to the Brits. But in the end, serious countries do tend to muddle through, and come up with some sort of agreement. If that tempts some of the eurozone members to also try exiting, we may get a clear test of my view that monetary shocks tend to be more disruptive than real shocks, at least in the short run.
PS. I hope EU negotiators don't read this post and vow to make the UK suffer. If so, I apologize to Boris.
PPS. The mainstream media still hasn't quite figured out that Brexit is a problem because it tightens monetary conditions. But they are getting closer, worrying that Brexit leads to "tighter financial conditions."