Global risks of Brexit dwarf the likely direct impact

Lawrence Summers
Voters will decide on Thursday whether or not the UK will withdraw from the European Union. At one level it is a fundamental political choice. Does the UK want to face the world alone as a limited scale island nation or to remain an influential part of the European Union — the world’s largest economy? Does it want to stand apart from Europe or try to shape it at this complex hour in global affairs? These are not questions that an American should presume to answer.

But Thursday’s choices will have immediate financial and economic consequences. And they can be assessed by outside economists. My judgments are I believe widely, though not universally, shared by both progressive and conservative global financial and economic analysts.

Put simply, Brexit could well be the worst self-inflicted policy wound by a G7 country since the formation of the G7 40 years ago. It is a risk no prudent policymaker would take. And the risk is not confined to the UK. In the current context, Brexit would unsettle the global economy and possibly tip it into recession. Four points are crucial.

First, unlike almost all other economic policy choices, Brexit is irreversible. François Mitterrand’s lurch towards socialism, Ronald Reagan’s excessive tax cuts and Japan’s encouragement of bubbles were all egregious errors but all were reversed, albeit not before substantial damage had been done. Divorce can be reversed by remarriage if regretted. There is no reversing Brexit if it proves unwise. Indeed, given the EU’s very strong incentive to discourage further dissolution, it is far from clear that there would even be concerted efforts to minimise its cost.

Second, markets are likely to suffer extraordinary volatility in the wake of Brexit. A Black Friday could follow referendum Thursday. It is likely that foreign investors in British stocks would lose 15 per cent off the bat, adding together market declines and currency losses. This is a judgment supported by the gyrations in markets induced by relatively small fluctuations in the perceived chance of Brexit and by the very high prices commanded by out of the money options. The truth is that even with all the regulatory changes that have been put in place we do not know for sure how the financial system will respond. A return of systemic risk as large losses lead to cascading liquidations cannot be ruled out. At a time when central banks have far less ammunition than they did in 2008, the consequences could be grave.

Third, Brexit will undermine confidence and increase uncertainty. No one knows what the new structure will be or how soon it will emerge. Quite likely, Brexit would lead to changes not only in Britain’s relationship with Europe but within Europe itself. While businesses wait to see what happens, they will hold off on new investment. Some will decide that it is much safer to base European operations outside the UK. Others will simply avoid hiring until matters are clear. There exist contingency plans to move hundreds of thousands of financial sector and other workers out of Britain. If matters play out slowly, they may be acted on. Given adverse markets, huge uncertainty, the likely absence of either expansionary fiscal policy (because of government policy commitments) or incrementally expansionary monetary policy (because of lack of room to cut rates), I believe Brexit would likely be followed by a recession in the UK.

Fourth, Brexit would quite likely have large contagion effects. So irrational and dangerous an act in a traditional bastion of mature democracy would prompt a global reassessment of the likelihood of dangerous populist policy. The result could be large and destabilising asset price declines and capital flows towards assets such as gold and the Swiss franc. A vicious cycle of falling asset prices, reduced confidence and further declines could ensue. I am reminded of the Smoot-Hawley tariff and the Depression. No direct calculation of its impact can explain more than a tiny part of the Depression. But it may have been a psychological tipping point. Brexit, too, could have global effects that dwarf its direct impacts.

None of this certain. But prudence dictates the avoidance of needless risk. Remain is the only rational economic choice.

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