Free exchange

The consensus crumbles

The economists who foresaw the backlash against globalisation

AFTER the second world war, the leaders of the Western world tried to build institutions to prevent the horrors of the preceding decades from recurring. They sought to foster both prosperity and interdependence, to “make war not only unthinkable but materially impossible”.

Their work has borne fruit. There has been no armed conflict in western Europe since.

Expanded global trade has raised incomes around the world. Yet, as the Brexit vote demonstrates, globalisation now seems to be receding. Most economists have been blindsided by the backlash. A few saw it coming. It is worth studying their reasoning, in order to work out whether a retrenchment is inevitable or might be avoided.

Even economists realise that free trade can be a hard sell politically. The political economy of trade is treacherous: its benefits, though substantial, are diffuse, but its costs are often concentrated, giving those affected a strong incentive to push for protectionism. Since 1776, when Adam Smith published “The Wealth of Nations”, those pressing for global openness have won more battles than they have lost. Yet opposition to globalisation seldom disappears, and often regroups. And a position once considered near-heretical, that globalisation itself seems to create forces that erode political support for integration, is gaining currency.

Dani Rodrik of Harvard University is the author of the best-known such critique. In the late 1990s he pointed out that deeper economic integration required harmonisation of laws and regulations across countries. Differences in rules on employment contracts or product-safety requirements, for instance, act as barriers to trade. Indeed, trade agreements like the Trans-Pacific Partnership focus more on “non-tariff barriers” than they do on tariff reduction. But the consequences often run counter to popular preferences: the French might find themselves barred from supporting a French-language film industry, for example.

Deeper integration, Mr Rodrik reckoned, will therefore lead either to an erosion of democracy, as national leaders disregard the will of the public, or will cause the dissolution of the nation state, as authority moves to supranational bodies elected to create harmonised rules for everyone to follow. These trade-offs create a “trilemma”, in Mr Rodrik’s view: societies cannot be globally integrated, completely sovereign and democratic—they can opt for only two of the three. In the late 1990s Mr Rodrik speculated that the sovereignty of nation states would be the item societies chose to discard. Yet it now seems that economic integration may be more vulnerable.

Alberto Alesina of Harvard University and Enrico Spolaore of Tufts University presented a different but related view of the trade-offs entailed by global economic integration in “The Size of Nations”, published in 2003. They note that there are advantages to being a large country.

Bigger countries can muster more resources for national defence, for instance. They also have large internal markets. But bigness also carries costs. The larger and more heterogeneous a country, the more difficult it is for the government to satisfy its citizens’ political preferences.

There is less variation in political views in Scotland, to take one example, than across Britain as a whole. When policy is made by the British parliament (rather than in Edinburgh, Belfast and so on) the average Briton is slightly less satisfied with the result.

Global integration, Messrs Alesina and Spolaore argue, reduces the economic cost of breaking up big countries, since the smaller entities that result will not be cut off from bigger markets.

Meanwhile the benefits of separatism, in terms of being able to cater better to the preferences of voters, are less diminished. So the global reduction in barriers to trade since the second world war, the pair contend, at least partly explains the simultaneous growth in the number of countries, even if national fractures often involve, or lead to, political instability and violence.

And then there is the question of how the benefits of globalisation are shared out. Joseph Stiglitz, a Nobel prizewinner, has warned that rent-seeking companies’ influence over trade rules harms workers and erodes support for trade liberalisation. Raghuram Rajan, the head of India’s central bank, has argued that clumsy government efforts to compensate workers hurt by globalisation contributed to the global financial crisis, by facilitating excessive household borrowing, among other things.

David Autor, David Dorn and Gordon Hanson have documented how the costs of America’s growing trade with China has fallen disproportionately on certain cities. And so on.

Open and shut
Branko Milanovic of the City University of New York believes such costs perpetuate a cycle of globalisation. He argues that periods of global integration and technological progress generate rising inequality, which inevitably triggers two countervailing forces, one beneficial and one harmful. On the one hand, governments tend to respond to rising inequality by increasing redistribution and investing in education; on the other, inequality leads to political upheaval and war. The first great era of globalisation, which ended in 1914, gave way to a long period of declining inequality, in which harmful countervailing forces played a bigger role than beneficial ones. History might repeat itself, he warns.

Such warnings do not amount to arguments against globalisation. As many of the economists in question are quick to note, the benefits of openness are massive. It is increasingly clear, however, that supporters of economic integration underestimated the risks both that big slices of society would feel left behind and that nationalism would continue to provide an alluring alternative. Either error alone might have undercut support for globalisation—and the six decades of relative peace and prosperity it has brought. In combination, they threaten to reverse it.

Wall Street's Best Minds

What is Brexit’s Impact on Global Economy?

A Pimco analyst assesses the economic fallout over the coming three to five years.

By Joachim Fels                

Many of those who voted “Leave” on Thursday reportedly already regret it, either because they didn’t really expect to prevail and merely wanted to register a protest vote, or because of the sharp sell-off in financial markets and the mushrooming forecasts of recession, or be it because, judged by the initial reactions in Scotland and Northern Ireland (which both voted “Remain”), Brexit could well turn the United Kingdom into the Kingdom of England and Wales – quite the opposite of making Britain great again.

Now the big question: What is the likely economic fallout from the Brexit vote on the rest of the world over both the cyclical (six-to-12-month) and the secular (three-to-five-year) horizons?
As we see it, the impact on global growth and inflation on the cyclical horizon is likely to be relatively small – and almost certainly not large enough to push the global economy into recession. Even if the UK fell into a recession, which is a distinct possibility, the direct knock-on effect on global GDP through lower UK import demand would be minimal as the UK accounts for only 3.6% of global imports of merchandize goods and 4.1% of global imports of commercial services.
In addition to the direct trade effect, business investment around the globe is likely to be dampened somewhat due to the heightened uncertainty about the global implications of Brexit and the tightening of financial conditions. If in doubt, companies will delay investment projects to assess how Brexit could affect them.
The trade and investment effects combined could lower the trajectory for global growth slightly in the next couple of quarters but not by enough to cause a recession. For the eurozone, which would obviously be most affected by Brexit after the UK, Nicola Mai estimates a negative impact on GDP of around 0.3%. The effect on the U.S. and other regions would likely be smaller.
However, we are closely watching three related swing factors that could lead to a larger negative impact on the global economy over the next six to 12 months: the dollar, China and central bank action. First, a significant further strengthening of the dollar in response to global risk aversion would be a problem not only for U.S. growth prospects but also for all the dollar debtors in emerging markets, and could also push commodity prices lower – we all watched that movie last year. Second, China might react yet again to dollar strength by allowing a more rapid depreciation of its currency against the greenback, which could intensify global growth and deflation concerns.
Third, an important reason why we expect the short-term hit to global confidence and growth from Brexit to be limited is that we anticipate further action by virtually all major central banks to limit the potential damage. We expect the Bank of England to cut its official interest rate from 0.5% to zero relatively soon and, if more is needed, to restart quantitative easing.
Our European team already put a 50:50 chance on additional European Central Bank easing before Brexit, and the probability has certainly not decreased with the vote. Our Tokyo team expects more Bank of Japan easing at the next policy meeting on 29 July and sees a high probability of currency intervention to weaken the yen in the near future. And in the U.S., a July hike is now completely off the table, September is not impossible but a low probability because the dust from Brexit may not have settled yet and the U.S. presidential race will be in full swing, and even a December hike looks increasingly questionable at this stage.
Finally, what about the longer-term implications of the Brexit vote? Does a British vote to withdraw from the EU inform us about the willingness of electorates in other countries, including the U.S., to be lured by populist promises? True, there is the chance (or hope) that a bad experience in Britain with Brexit might make voters elsewhere think twice.
However, as I see it, the vote in the UK is part of a wider, more global, backlash against the establishment, rising inequality and globalization. Even if populist, separatist and nationalist parties don’t come to power, the Brexit shock is likely to intensify the pressure on current and future mainstream governments to address inequality, become more protectionist and limit migration.  

What could this mean for the longer-term global economic outlook? Most importantly, investors will have to factor in a higher chance of a stagflationary outcome over the next three to five years: even lower growth or near-stagnation coupled with a significant rise in inflation.
This would likely come to pass if current or future governments turn more protectionist by erecting barriers to trade and migration, and take up or intensify the battle against inequality by redistributing income (through taxation and regulation) from capital to labor.
This could lower potential growth even further and would likely lead to higher wage and inflation pressures.
If this scenario came to pass, both risk assets and nominal bonds would fare badly – remember the 1970s?
However, in contrast to the ‘70s, investors now have an instrument at their disposal that didn’t exist back then: inflation-linked securities, which would benefit both from lower real interest rates resulting from lower economic growth and from rising inflation.

Fels is a Pimco managing director and global economic advisor based in the firm’s Newport Beach, Calif. office.

Strengthening Currencies Bedevil Central Banks

Upward pressure on Japanese yen, Swiss franc and U.S. dollar complicates efforts by policy makers to spur growth

By Chelsey Dulaney and Corrie Driebusch

Britain’s vote to leave the European Union has set off a fresh round of currency pressures in the world’s largest economies, further complicating efforts by central banks to spur growth.

The pound hit a three-decade low on Monday, and both Standard & Poor’s and Fitch Ratings cut their ratings on the U.K., saying that last week’s vote raises risks to the country’s economy.

Meanwhile, the Japanese yen, Swiss franc and U.S. dollar posted further gains, as market turmoil resumed after the weekend and sent investors in search of havens. Government bonds also benefited from the flight from risk, with the yield on the 10-year British bond falling below 1% for the first time, as the rout in U.S. and European stocks deepened.

The currency moves, in particular, pose risks for businesses and in turn for economies that have posted lackluster performance.

The resurgent yen and franc are putting renewed pressure on companies in Japan and Switzerland. Meanwhile, U.S. companies that had benefited from a weakening dollar this year face a bout of currency-related stress as the second-quarter earnings season looms.

Stronger currencies tend to make a country’s exporters less competitive as the effective price of their goods goes up. They also tamp down inflation as import prices fall, frustrating outcomes for central banks in Japan, Europe and the U.S. that are trying to calibrate policies to boost growth and inflation.

The moves could tempt central banks to intervene or modify policies to limit the upward pressure.

“Policy makers are unlikely to sit idly by while their strengthening currency derails any economic progress that they’ve made,” said Omer Esiner, chief market analyst at international-payments firm Commonwealth Foreign Exchange. “Central banks would be justified in stepping in.”

The problem is currencies can’t all weaken at once. The Swiss have been trying to push the franc down against the euro. The European Central Bank has nodded to the benefits of a weaker currency as it lowers interest rates into negative territory and expands its bond-buying programs. Japan has tried to weaken the yen against the dollar. And Federal Reserve officials have cited the stronger dollar as an impediment to growth.

All are showing little success, and investors have raised concerns that central-bank tools for influencing currency values are losing their effectiveness.

That situation is most evident in Japan, where the yen has appreciated sharply this year even as the Bank of Japan 8301 5.71 % adopted negative interest rates. The yen had already strengthened by more than 10% against the U.S. dollar in 2016 before the U.K. voted Thursday to leave the EU, known as Brexit. Since late Thursday, the dollar weakened below ¥100 for the first time since late 2013. The yen is up 18% for the year. Late Monday in New York, the dollar bought ¥101.99, from ¥102.20 Friday.

“What the Bank of Japan has to decide is whether they think intervention is helpful,” said Daragh Maher, head of U.S. foreign-exchange strategy at HSBC Holdings HSBC 2.59 % PLC.

“They want to be reasonably confident that intervention will be more helpful than not. They haven’t reached that point.”

The yen’s gains have put pressure on Japanese stocks, as investors worry that the country’s export-dependent companies will become less competitive. The Nikkei Stock Average fell 7.9% Friday after the British result was announced. It rose 2.4% Monday, but is down 20% this year.

Technology exporters such as Canon Inc. CAJ 1.68 % have already warned that the yen’s surge could eat into earnings. Canon, the maker of digital cameras and office printers, said each one-yen appreciation against the dollar reduces its annual operating profit by the equivalent of about $38 million.

The potential threat to already weak Japanese exports is adding pressure on the Bank of Japan to step in to control the yen’s rise. Athanasios Vamvakidis, Bank of America Merrill Lynch’s head of G-10 currency strategy in Europe, expects the central bank to introduce new easing at its next policy meeting, which is scheduled for late July.

“Given the substantial risks that the Bank of Japan will not be able to meet its inflation target, you want a currency that’s somewhat undervalued,” said Mr. Vamvakidis. “Further strength in the yen would be a big problem.”

The Swiss National Bank SNBN 1.10 % is having similar trouble controlling the rise in the franc. It said Friday that it had intervened in currency markets, the most overt early reaction by the world’s monetary authorities to the British vote. The franc weakened against both the euro and dollar over the past two sessions but remains up for the year.

“In terms of redirecting the market from migrating to the Swiss franc, I think it will have a marginal effect at best,” said Peter Rosenstreich, chief market strategist at Swissquote Bank.

Meanwhile, the dollar’s strength is posing a renewed threat to U.S. companies’ profits as the second quarter draws to a close. The WSJ Dollar Index, which measures the greenback against 16 other currencies, had fallen 5.6% this year before the U.K. decision. Over the past two days, the dollar index has rebounded 2.7%.

Analysts had expected U.S. corporations in the S&P 500 to post slight earnings growth in 2016 after a 6.6% contraction in the first quarter and an expected decline in the second quarter, which ends this week, according to FactSet. But the dollar’s surge in the wake of the referendum is causing investors to re-evaluate those assumptions.

“If we were expecting earnings growth slightly positive for the year, Brexit is enough to move the dial down to flat or negative for earnings growth,” said Nathan Thooft, head of asset allocation at John Hancock Asset Management.

The market turmoil and strength of the dollar are expected to keep the Federal Reserve’s interest-raising efforts on hold. The Fed doesn’t target currency levels, but officials have repeatedly cited the dollar’s strength as a drag on growth. Markets expect little chance of a rate increase this year and in fact are pricing in small odds of a rate cut. Higher rates would make the dollar more attractive to investors.

One group of potential beneficiaries of the recent moves in currency markets are British exporters.

With sterling slumping—trading at $1.3225 late in New York on Monday—British goods will become significantly cheaper to overseas consumers. That has helped support the shares of big U.K. companies despite the market tumult. The U.K.’s FTSE 100 Index, which includes many British exporters, has fallen 5.6% over the past two sessions, compared with the 11% decline for the broader Stoxx Europe 600 index.

Yet shares of U.K. real-estate companies, banks and airlines have been battered, as investors worry that a Brexit would dent investment and spending in the U.K.

“A weaker currency should by and large help British exporters. It should help raise inflation, which has consistently run below the Bank of England’s target,” said Mr. Esiner of Commonwealth Foreign Exchange. “But it does cause investors to pause and rethink investments in the U.K.”

Many analysts said the potential slowdown in the U.K. economy could prompt the Bank of England to ramp up stimulus in the coming months.


Who draws the party line?

Xi Jinping sends his spin doctors spinning

THE nondescript glazed-brick building at 5 West Chang’an Avenue, near Tiananmen Square, gives no hint of what happens inside. No brass plaque proclaims its purpose. In an office around the corner, a dog-eared card says the reception of the Propaganda Department of the Central Committee of the Communist Party will be open on Tuesdays, Thursdays and Fridays between 8am and 12pm. The staff deals only with party officials; armed guards politely shoo other visitors away.

In English, the Propaganda Department calls itself the Publicity Department (it adopted this translation in the 1990s, realising how bad the literal one sounded). It is both secretive and vast.

It is now at the centre of attempts by Xi Jinping, China’s president, to increase his control over the party, media and universities. It is also at the heart of factional infighting involving Mr Xi, his anti-corruption chief and allies of his two predecessors as president.

The Publicity Department sounds like the home of spin doctors, spokesmen and censors, and the scope of such activity is indeed vast. With the help of various government agencies, the department supervises 3,300-odd television stations, almost 2,000 newspapers and nearly 10,000 periodicals. The chief editors of these outfits meet regularly at the Publicity Department to receive their instructions. It spends around $10 billion a year trying to get the Chinese government’s opinions into foreign media outlets. According to researchers at Harvard University, propagandists help churn out 488m pro-government tweets a year.

But this public role is only the half of it. Another crucial function is to steer the government machinery. The country is too large to be governed through a bureaucratic chain of command alone. So the department also sends out signals from on high: Mr Xi’s speeches, and directives given by leaders during their visits to provinces or factories. Such messages tell lower-level officials what the high command is thinking and what is required of them.

The Publicity Department is the chief signals office. It decides which speeches to print and how much to push a new campaign. To this end it has authority over various government bodies (such as the Ministry of Culture and the Chinese Academy of Social Sciences), runs party-only newspapers (not for public consumption) and influences thousands of training schools for party officials. Every province, county and state-owned enterprise also has its own propagandists.

The department has been at the centre of battles between hardliners and reformers since the 1980s, when the then propaganda chief, Deng Liqun, was at loggerheads with Deng Xiaoping. It is not so much a group of spin doctors as a spin National Health Service.

The department is at the centre of things again because Mr Xi puts so much emphasis on the work it does. He has launched a string of ideological campaigns aimed at making party members better Marxists and more honest officials. He has insisted that universities pay more attention to teaching Marxism and less to other wicked foreign influences. In February he made a widely publicised visit to China’s three main media organisations, People’s Daily (a newspaper), Xinhua (a news agency) and China Central Television, in which he stressed that all media must “love the party, protect the party and serve the party”. This was interpreted as a swipe at the propaganda department’s bosses since it implied that the media should be paying more attention to Mr Xi, who regards himself as the party’s “core”.

Minitrue’s blues
So even as they emphasise its work, Mr Xi and his allies have been criticising the department. On June 8th, after a two-month investigation, the Central Commission for Discipline Inspection (CCDI), the party body responsible for fighting graft and enforcing loyalty, launched a stinging attack.

In a posting on the CCDI’s website, the leader of the investigation said the department “lacked depth in its research into developing contemporary Chinese Marxism”. He said “news propaganda” (a revealing phrase) was “not targeted and effective enough”; he claimed the department was “not forceful enough in co-ordinating ideological and political work at universities” and had failed online “to implement the principle of the party managing the media”. It is unusual for such an attack to be made public. It is unheard of for a party body to attack the reputation of the Publicity Department, the party’s own reputation-maker and breaker.

The CCDI’s charge sheet strengthened earlier hints that Mr Xi is unhappy with the department’s promotion of his policies. Less clear is which of its shortcomings he is upset about. It could be its failure to beat the drum for economic reform (Mr Xi made a big speech on the subject in January; it did not appear in People’s Daily for four months). Possibly it gave too much encouragement to a mini personality-cult of “Uncle Xi”, violating long-standing party orders against such fawning. 

Or possibly the Publicity Department has been caught up in factional infighting. The two propaganda chiefs are Liu Qibao, the head of the Publicity Department, and his (unrelated) supervisor, Liu Yunshan, a member of the Politburo Standing Committee, the Politburo’s inner circle, who was Liu Qibao’s predecessor. Both are former high-fliers in the Communist Youth League, which has long been a stepping stone to membership of the party elite.

“Princelings” such as Mr Xi, who have been helped to power by their blood ties to party veterans and their service in the provinces, often resent the cliquish influence of those who emerged through the league’s bureaucracy. They include Mr Xi’s predecessor as president, Hu Jintao, and many of those who rose through the ranks with him and remain in positions of influence. Liu Yunshan has the added disadvantage of being part of “Jiang’s gang”, the group of senior officials close to Jiang Zemin, Mr Hu’s predecessor, which is seen as another rival faction to Mr Xi.

Leaguers are falling foul of the anti-graft campaign to an extent that can hardly be coincidental. In late May and early June, the CCDI and the country’s chief prosecutors placed under investigation or indicted three allies of Vice-President Li Yuanchao, who was once one of the league’s most senior figures. Just before that, a court in the northern port city of Tianjin charged Ling Jihua with bribery, after a year-long investigation by the CCDI. Mr Ling had been a senior member of the league, and had served as chief aide to Mr Hu when he was president.

The Publicity Department is fighting its corner. Earlier this year it targeted Ren Zhiqiang, an outspoken property magnate and ally of the CCDI’s boss, Wang Qishan (who was his tutor in high school). Mr Ren had criticised efforts to tighten control of the media. By denouncing him, the Publicity Department could claim to be carrying out Mr Xi’s policies while simultaneously attacking a friend of Mr Wang, whose commission’s report was so damning.

Like media organisations everywhere, the Publicity Department is struggling to keep pace with changing consumer demands. Unlike most such organisations, it is also having to keep pace with the changing political requirements of its boss, Mr Xi. As an institution, these have made it more important than it was. But its current leaders might prefer a quieter life.

We Didn't Panic. We Just Sold Everything

by: Shareholders Unite
- Stocks were fully valued, so upside was limited.

- Brexit in and of itself won't lead to a market crash, let alone an immediate one.

- However, there are so many cracks and fissures in the world economy that the risks have increased significantly, and cash is king in this environment.

Two weeks ago we expressed our concern about the complacency that the upcoming Brexit vote engendered in the markets. These markets even rallied when the vote approached, apparently discounting an expected win for the Remain camp.
Well, how did that work out? Now, after the vote, many people here (and elsewhere) urge us to remain calm, which is solid advice. One should always try to remain calm in the markets, but that doesn't exclude big decisions, as long as they're taken rationally.
Here is one big decision: we sold everything on Friday. That's what we did in our little example portfolio (which, if you must, you can follow here). Except for two solar stocks and InvenSense, it was actually doing fine, with a few considerable wins.
However, with the Brexit vote, we decided to liquidate everything. At first sight, that might sound a hasty and emotional decision, but hear us out, it isn't.
Basically we see an environment for stocks in which the returns are capped and the risks have significantly increased. While individual stocks might still do well (and we might buy back a few stocks, or buy other ones), we think this environment warrants a much larger cash position.
Here are our reasons.
  • Brexit increases the chance of a recession
  • The world economy is fragile
  • US stocks are expensive
  • The biggest risk is political Brexit contagion
Brexit increases the chance of a recession
There are quite a few ways in which Brexit increases the chances of a recession:
It's unchartered territory, which is engendering uncertainty. Markets don't like uncertainty and neither do those that take investment decisions. It's unclear how the UK's trade relations with the EU will be affected (but affected they will be).
Politically, since immigration played such a big part for the Leave camp, immigration into the UK has to be lowered. But this goes against the four freedoms underpinning the single market, so the UK can't be a part of that.
The Norway solution, in which Norway is part of the single market while not being an EU member is therefore not open to the UK, so they're out of the single market.
This will affect trade, and issues of market access play a pretty prominent role in cross-border investment decisions. The uncertainty alone about how these issues will be solved is enough to have a material effect on investment. And the uncertainty will remain for a good while, years.
Here is The Economist:
With 72% of investors citing access to the European single market as important to the UK's attractiveness, the referendum has the potential to change perceptions of the UK dramatically, posing a major risk to FDI. Our survey indicates that 31% of investors will either freeze or reduce investment until the outcome is known.
Car exports are likely to suffer, according to the BBC:
Britain must strike a trade deal with Europe as soon as possible to protect the country's multi-billion pound car industry and avoid high tariffs. David Bailey, professor of industry at Aston University, warned of a "big uncertainty" for the sector following the UK's vote to leave the EU. Without a deal, he fears a return to the days when the industry faced a 10% tariff on exports. The UK exports 77.3% of its car output, 57.5% of which goes to Europe. "What we don't want in two years' time is to go back to [World Trade Organisation] rules which involve 10% tariffs on car exports," he said.

Then there is the impact of UK's trade relations with the rest of the world. At present they don't even have the required number of specialists to negotiate, as this was an EU policy area.
According to the above quoted Economist article, tax revenues will take a much larger hit than the 8 billion pounds which EU membership is supposed to save.
There are myriads of other implications that are not immediately obvious. What to think of funding for British tech start-ups. It turns out that a significant part for that comes from the EIF, the European Investment Fund.
Brexit is also likely to affect the position of the City of London, at least for trading the euro-denominated assets. Some of that is likely to move to the continent.
The one saving grace is the decline of the pound, which provides at least some compensation for the risks in the UK. The UK runs a very large trade deficit, it is therefore dependent on foreign capital to finance that.
Some of that foreign capital will not arrive because of the uncertainty and the questions about the conditions of future access to the single market. This can only mean the pound has further to fall, although a British recession will cut into the trade deficit by reducing imports (and a rising currency will do the same).
Fragile world economy
The most immediate recession risks are in the UK, but the rest of the world can catch some contagion as well. This is what happens when a shock to the system hits a world economy where fault lines are already plentiful. Here are just the main ones:
  • Much of the eurozone was just emerging from the longest slump in modern times, but the recovery can hardly be called vigorous and economic conditions (unemployment, debt levels) are mostly far worse than before the crisis. If growth is snuffed out again, this could have dire consequences.

  • Italian public debt has ratcheted up through the denominator effect (low or negative nominal GDP growth increasing debt/GDP ratios), they lost a quarter of their industry, GDP is still way below pre-crisis levels and youth unemployment is dramatically high. On top of that, Italian banks sit on the highest levels of bad loans.

  • Many emerging markets have huge amounts of dollar debt outstanding (see figure below), any rise in the dollar is hurting them and a sufficient rise can set off a chain reaction.

  • Japan has thrown everything and the kitchen sink to get out of deflation and get the yen lower, but Brexit shaves 8% off the Nikkei and the yen tumbles to 100 to the dollar. They need 4-5% nominal GDP growth to stabilize the public debt/GDP ratio. With 100 yen to the dollar, they can forget about that.
Here is how Morgan Stanley assessed the situation:
While the size of the economic impact depends on the political steps taken from here, our economists estimate that it could knock 1.5pp off UK GDP over the next 18 months. This impact is not limited to the UK. After considering the impacts to trade, confidence and investment, they see a potential cost of 0.8pp to euro area GDP. For the global economy, there could be a cumulative hit of ~0.5pp from our baseline between now and the end of 2017. This weakening of the global environment would likely weigh on the Fed's thinking. Our US economists no longer expect the Federal Reserve to raise rates this year, keeping G4 yields lower for longer."
Politics is already in disarray. We have a leadership contest in the ruling Conservative party that will last until October. Brexit campaign leaders seem to have been unprepared for their campaign to actually win, given their silence in the days following the outcome. Do they actually have a plan? It doesn't seem so, here is former Tory Chairman Liam Fox:
I think that it doesn't make any sense to trigger Article 50 without having a period of reflection first, for the Cabinet to determine exactly what it is that we're going to be seeking and in what timescale. And then you have to also consider what is happening with the French elections and the German elections next year and the implications that this might have for them. So a period of calm, a period of reflection, to let it all sink in and to work through what the actual technicalities are.
Funny enough, nobody can really force the UK to trigger invoking Article 50 and there might yet be ways to avoid this (for instance if a general election was called which could function as a sort of second referendum on Brexit).
If the Brexit camp can converge on a plan to keep access to the single market (for instance, through membership of the EEA), things could stabilize. But we're not there yet, British politics is in disarray and has to sort itself out first. That can take quite some time.
The future of the EU
Here is where the biggest fall-out can happen. While Britain wasn't a member of the euro, the impact could be greatest in the eurozone.
The large cracks in the eurozone have been papered over by a mild upturn in the business cycle after the longest slump in history. This has been driven by the ECB, lower energy cost, and a lower euro.
But this recovery is weak, and the cracks and fissures brought about by the euro are still very much present. What's more, the long slump brought about mostly by the deflationary bias of the euro itself, has left many countries in a terrible shape.
Usually a recovery restores metrics like unemployment and debt levels to before the recession, but in many eurozone countries this hasn't happened at all. Economically the likes of Italy, Portugal, Greece, Spain, and even Finland and France are very ill prepared to handle another downturn while they haven't really recovered from the previous one.
But it's the politics of this where the greatest danger lies. Populations in many of the eurozone countries are adrift. While many wrongly blame the EU, they are right to blame the most ambitious part of it, the euro.
Stocks were fully valued, even under better circumstances we saw limited upside. We're not saying that Brexit will crash the markets, but what we are saying is that Brexit could be the trigger that cracks some of the fissures festering in the world economy, of which there are quite a few. We think cash is king under these circumstances.

Brexit and the Future of Europe

George Soros


NEW YORK – Britain, I believe, had the best of all possible deals with the European Union, being a member of the common market without belonging to the euro and having secured a number of other opt-outs from EU rules. And yet that was not enough to stop the United Kingdom’s electorate from voting to leave. Why?

The answer could be seen in opinion polls in the months leading up to the “Brexit” referendum. The European migration crisis and the Brexit debate fed on each other. The “Leave” campaign exploited the deteriorating refugee situation – symbolized by frightening images of thousands of asylum-seekers concentrating in Calais, desperate to enter Britain by any means necessary – to stoke fear of “uncontrolled” immigration from other EU member states. And the European authorities delayed important decisions on refugee policy in order to avoid a negative effect on the British referendum vote, thereby perpetuating scenes of chaos like the one in Calais.
German Chancellor Angela Merkel’s decision to open her country’s doors wide to refugees was an inspiring gesture, but it was not properly thought out, because it ignored the pull factor. A sudden influx of asylum-seekers disrupted people in their everyday lives across the EU.
The lack of adequate controls, moreover, created panic, affecting everyone: the local population, the authorities in charge of public safety, and the refugees themselves. It has also paved the way for the rapid rise of xenophobic anti-European parties – such as the UK Independence Party, which spearheaded the Leave campaign – as national governments and European institutions seem incapable of handling the crisis.
Now the catastrophic scenario that many feared has materialized, making the disintegration of the EU practically irreversible. Britain eventually may or may not be relatively better off than other countries by leaving the EU, but its economy and people stand to suffer significantly in the short to medium term. The pound plunged to its lowest level in more than three decades immediately after the vote, and financial markets worldwide are likely to remain in turmoil as the long, complicated process of political and economic divorce from the EU is negotiated. The consequences for the real economy will be comparable only to the financial crisis of 2007-2008.
That process is sure to be fraught with further uncertainty and political risk, because what is at stake was never only some real or imaginary advantage for Britain, but the very survival of the European project. Brexit will open the floodgates for other anti-European forces within the Union. Indeed, no sooner was the referendum’s outcome announced than France’s National Front issued a call for “Frexit,” while Dutch populist Geert Wilders promoted “Nexit.”
Moreover, the UK itself may not survive. Scotland, which voted overwhelmingly to remain in the EU, can be expected to make another attempt to gain its independence, and some officials in Northern Ireland, where voters also backed Remain, have already called for unification with the Republic of Ireland.
The EU’s response to Brexit could well prove to be another pitfall. European leaders, eager to deter other member states from following suit, may be in no mood to offer the UK terms – particularly concerning access to Europe’s single market – that would soften the pain of leaving. With the EU accounting for half of British trade turnover, the impact on exporters could be devastating (despite a more competitive exchange rate). And, with financial institutions relocating their operations and staff to eurozone hubs in the coming years, the City of London (and London’s housing market) will not be spared the pain.
But the implications for Europe could be far worse. Tensions among member states have reached a breaking point, not only over refugees, but also as a result of exceptional strains between creditor and debtor countries within the eurozone. At the same time, weakened leaders in France and Germany are now squarely focused on domestic problems. In Italy, a 10% fall in the stock market following the Brexit vote clearly signals the country’s vulnerability to a full-blown banking crisis – which could well bring the populist Five Star Movement, which has just won the mayoralty in Rome, to power as early as next year.
None of this bodes well for a serious program of eurozone reform, which would have to include a genuine banking union, a limited fiscal union, and much stronger mechanisms of democratic accountability. And time is not on Europe’s side, as external pressures from the likes of Turkey and Russia – both of which are exploiting the discord to their advantage – compound Europe’s internal political strife.
That is where we are today. All of Europe, including Britain, would suffer from the loss of the common market and the loss of common values that the EU was designed to protect. Yet the EU truly has broken down and ceased to satisfy its citizens’ needs and aspirations. It is heading for a disorderly disintegration that will leave Europe worse off than where it would have been had the EU not been brought into existence.
But we must not give up. Admittedly, the EU is a flawed construction. After Brexit, all of us who believe in the values and principles that the EU was designed to uphold must band together to save it by thoroughly reconstructing it. I am convinced that as the consequences of Brexit unfold in the weeks and months ahead, more and more people will join us.