Disruption on cards

Print edition : July 22, 2016

Traders on the floor of the New York Stock Exchange (NYSE) soon after the U.K. referendum result was announced. The Dow Jones industrial average quickly fell nearly 500 points on the news, with markets around the globe plunging. Photo: SPENCER PLATT/AFP

British one-pound sterling coins in an arranged photograph in Guildford, U.K., on June 13. Photo: Jason Alden/Bloomberg

Britain’s exit from the E.U. could disrupt world trade and jeopardise the process of pulling the global economy out of recession.

Britain has voted to leave the European Union (E.U.). The managers of global capitalism now have their hands full addressing the fallout of Brexit even as their efforts to manage the aftershocks of the crisis of 2008 remain unsuccessful. It does not help that Brexit immediately affects the E.U., where the legacy of the earlier crisis has been the worst. In fact, the churning within the E.U. is partly the result of the persisting crisis in parts of the region. And it is there that the next crisis is likely to unfold first.

But as recent history has repeatedly made clear, in a globally integrated world no crisis remains confined to one region. If Britain’s departure from the E.U. worsens the crisis in Europe, it will also, to different degrees, affect the rest of the world, including the so-called “emerging markets” such as India. That could worsen the depressed conditions confronting the current world economy. So, preventing Brexit from precipitating another crisis that could convert the Great Recession into a Great Depression is the task before these managers. The problem is, they know neither what Brexit will do nor what needs to be done, whatever adverse effect it may have. Moreover, governments across the globe are weighed down by “stimulus fatigue”, or the burden of stimulating a recovery while remaining committed to a neoliberal fiscal and monetary policy framework. They are ill-prepared to deal with one more potential obstacle to that recovery.

There are, of course, reasons to hope that the Brexit vote, if not reversed as even many “Leave” campaigners hope it will be, will not be as harmful as the initial collapse of global markets and the pound suggested. According to some experts, since the United Kingdom accounts for just 3.9 per cent of the global GDP, the exit of this small island economy from the E.U. club of 28 could do little damage to the rest of the integrated world economy. The problem is what happens after exit to the remaining 27 and their neighbours. The erstwhile 28 E.U. members plus Iceland, Norway and Switzerland account for around a quarter of global output.

There is adequate reason to believe that Brexit’s real economy effects in the U.K. will be significant. A recent paper by Nicholas Crafts of the University of Warwick (“The Growth Effects of EU Membership for the UK: A Review of the Evidence”, Department of Economics Working Paper Series No. 280, March 2016) estimates that the effects of enhanced trade that flowed from E.U. membership resulted in an annual gain (relative to being a part of the European Free Trade Agreement) of 10 per cent of GDP, which was much higher than the “membership cost” of 1.5 per cent, in the form of a net budgetary contribution and the net costs of common regulation.

Estimates of these kinds are controversial. But, as Crafts notes, growth in real GDP per person in the U.K. has been quite creditable since 1973 when it joined the E.U. Thus, during the period between 1973 and 1995, real GDP per person rose as fast in the U.K. as it did in Germany (West), almost as fast as in the United States and faster than in France. Moreover, during the 1995-2007 period, real GDP per head grew in the U.K. at a pace faster than it did in France, Germany and the U.S. In the 2007-14 period, which coincides with the post-crisis years, growth stagnated in the U.K., was negative in France, less than 1 percentage point in Germany and half a percentage point in the U.S. E.U. membership has not harmed the U.K. and possibly benefited it substantially so that a flagging economy began to show a degree of dynamism. An exit will directly harm the U.K.

A part of whatever loss is suffered could possibly be recouped after new arrangements are put in place. But that will take time as an agreement will have to be struck with the 27 remaining members of the E.U., with the many countries with whom E.U. had special trade deals that applied to the U.K. as a member as well, and to the remaining members of the World Trade Organisation (WTO), since the U.K. as a separate country has not made essential commitments with respect to its trade in goods and services. New benefits, if any, will be slow in coming and are uncertain, especially with respect to trade with the E.U., since it was the U.K. that chose to leave. But even the U.S. government is not happy with the referendum decision and President Barack Obama has won many enemies in the U.K. with his statement that Britain would be “at the back of the queue” among those seeking a trade deal with the U.S.

The problem is that the U.K.’s decision will badly damage a crisis-ridden Europe as well. To start with, the best performing nation within the “Remaining 27” (R27, for short), Germany, will possibly find an important market in the U.K. shrinking as well as less easy to access. In fact, faced with its own problems flowing from its “new nationalism”, the U.K. may seek to turn protectionist. On the other hand, as banks and firms from the U.K. are forced to close some or all of their operations in R27, business could be disrupted in these countries with as yet unforeseen consequences. Those adversely affected would look to greater policy space to address their own problems. Pressure from Germany and a few others to remain open to trade with the rest of the world would meet with opposition from those not benefiting from such trade or even from trade within the E.U. The result could be a desire for “independence” that the Right in Europe would definitely exploit. And the German Chancellor’s softer and accommodative position on the refugee issue may not help. Brexit could prove infectious.

Finally, if all is not well in terms of growth in Europe and the U.K., which together constitute a quarter of the world market, the real economy in the U.S. and the better performing economies in Asia, Latin America and Africa would be adversely affected as well. Any slowdown in world trade will affect all economies. The dollar is likely to strengthen as investors in Europe flee to safer dollar-denominated assets, reducing the competitiveness of American exports. Similar effects, even if on a smaller scale, would bedevil Japan, which has been fighting a long recession. And emerging markets, including China and India, which had earlier shown some signs of being “decoupled” from the world system, have already been hit by the persisting crisis in Europe and the absence of recovery elsewhere. The fallout of Brexit can only damage them further.

These consequences of Brexit raise the important question: Why did 52 per cent of those voters who turned up to vote in the U.K. referendum (72 per cent of those eligible) choose “Leave”? From the points of view of finance and industry, the U.K. seemed to have the best deal within the E.U. For example, while it did have to open its borders to workers choosing to move from other members of the union, it was protected by exception from having to meet common labour standards that most members had accepted. Membership also gave firms located in London, which has been the growth pole in the U.K., access to a “passport” to undertake business in the rest of the common market. Industrial firms located in the U.K. had full access to the single common market. Some other sections benefited too. For example, British universities starved of public funding could attract a large number of fee-paying students and their faculty had access to much-needed research funding from the common E.U. budget for that purpose.

The problem clearly was that much of the middle class and almost all of labour did not really benefit from the arrangement. The inflation-adjusted earnings of many of them have stagnated and jobs, for the young in particular, are more difficult to come by. Official figures on the average weekly earnings of employees show that real earnings fell after the financial crisis until mid 2014. While earnings have risen since, they have not yet regained pre-crisis levels. In other words, workers were severely hit by the 2008-09 crisis precipitated by the speculative activities of finance, but were not bailed out, while banks and financial firms were. Since the activities of the banks have increased hugely under globalisation, the anger of workers at their worsened status was directed at corporate-driven globalisation and the common European “market”. This made them fodder for cynical right-wing propaganda that the jobs and resources that migrants “stole” explained their condition. So, while migration and even the refugee inflow were not a major problem for the U.K., it was a useful instrument for many of the politicians involved. Those campaigning for Brexit used it to the hilt. Prime Minister David Cameron told E.U. leaders that the Remain-backers would not have lost the vote and that Brexit could have been avoided if E.U. leaders had given him a freer hand to control migration.

This blame game and the associated debate is unlikely to go away, but will wane as the effects of Brexit on the U.K., the E.U. and the world unravel and demand the attention of world leaders. The immediate effect is, of course, deep uncertainty. Will Brexit actually occur and if so, what will be the nature of the U.K.’s relationship with the E.U.? Will Scotland and Northern Ireland, which voted to remain in the E.U., stay in the U.K.? Will industry in the U.K., whether British or foreign-owned, remain competitive after Brexit? Will London lose its pre-eminent position as a global financial centre once financial firms located there have lost their passports to trade in the E.U. market and settle those trades? How far will the effects in the E.U. impact the rest of the global economy, including the U.S. and the more successful emerging markets such as China and India? How will this change the correlation of economic power in the world economy?

It was uncertainty of this kind that was responsible for the collapse of the pound and of equity markets worldwide in the immediate aftermath of the Brexit vote. Decline in stock prices as investors shifted out of equity to safer assets wiped out $2 trillion in stock value across markets on June 24. While the collapse of equity markets was attributed in part to algorithmic trading, human intervention to redress machine overreaction did not make much of a difference. At the end of the next trading day (June 27), the loss in stock value was placed at $3 trillion. According to Financial Times, the S&P Global Broad Market index (the BMI) had fallen by close to 6.9 per cent, which was the worst two-day decline since the financial crisis in 2008 and the 12th worst on record.

Obviously this collapse was not confined to the U.K. and Europe, but affected the U.S., other developed countries and the emerging markets as well. The benchmark index for U.S. stocks, the S&P 500, experienced its third worst two-day fall on record, losing 5.4 per cent or close to $1 trillion. Developed country equity markets as a group lost $2.8 trillion in value and emerging markets lost $179 billion over those two days. The much lower figure for equity markets partly reflects their much smaller market capitalisation.

Market volatility

It is indeed true that stock markets tend to be much more volatile when shocks like the Brexit vote generate extreme uncertainty. But the extreme volatility they are experiencing does point to the fact that financial markets would be an important focus of the Brexit fallout and act as important transmission mechanisms in the spread of the crisis to markets and countries outside of the U.K. and the E.U. Not surprisingly, bank stocks took severe and much stronger hits during the post-Brexit collapse.

This financial uncertainty will be strengthened by the fact that London and New York are the leading financial centres of the world. In fact, a set of rankings compiled by the Z/Yen group in September 2015 suggested that London had overtaken New York as the world’s most competitive financial centre.

Rankings aside, London’s attraction lies in the access that firms located there have to the European Economic Area (EEA) under the “passporting” option that allows firms established in one EEA state to undertake business in another. This can be done by setting up a branch in another state, by exercising the “branch passport” option, or by offering cross-border advisory and other services by exercising the “services passport” option.

The strength that “passporting” and light-touch regulation gave London made it an important hub for financial transactions within the E.U. According to Reuters, more than three-quarters of the business conducted in capital markets across the E.U. happens in Britain. As a result, about 417,000 people are employed by banks in Britain and there are an estimated 1.8 million others offering related financial and professional services. Leveraging those strengths and exploiting other factors (for example, working hours in London overlap with those in Hong Kong, Singapore and Tokyo), the city has been offering financial services to clients across a highly globalised world. Brexit not only puts under threat thousands of jobs in the city, with direct implications for economic activity, but will also disrupt a leading hub of global finance. What that disruption would mean is another source of uncertainty.

For “emerging markets” that have been drawn into this globalised financial whirl and are the locations for substantial sums of legacy investments in financial assets, uncertainty could precipitate capital flight. Even before Brexit, capital had been flowing out of these economies because of the uncertainty over U.S. interest rate policy, for example. Increased outflow after Brexit could precipitate financial, currency and real economy crises, as they have repeatedly done in developing countries since the early 1980s.

This danger is aggravated by the likelihood of a protectionist response in the developed economies to any further deterioration of an already bad economic situation. It must be noted that both the 2008 financial crisis and Brexit have been outcomes of developments within the developed countries, though they have had or will have repercussions elsewhere.

One consequence of these developments and the inequalising responses to them is disillusionment within the developed economies with finance, globalisation and the elite nexus of business and politicians that sustains the framework that precipitates periodic crises.

This has given space to politicians like Marine Le Pen in France and Donald Trump in the U.S. who are avowedly protectionist and whose aim is to win the support of the majority disillusioned with globalisation and its consequences.

It hardly bears repeating that these leaders are by no means against the corporate interests that have determined the direction that global integration or even integration within Europe has taken. The fact that globalisation is corporate-driven has meant that restructuring the E.U. and the global order (to make them more inclusive) and negotiating a coordinated effort to pull economies out of recession has proved impossible.

So, if the crisis intensifies, protectionism or retreating from excessive integration with the rest of the world may be the only way to go. Whatever the long-term implications of this, it could, in the short run, disrupt world trade and trigger beggar-thy-neighbour responses wherein one country attempts to fix its economic problems by means that tend to worsen those problems of other countries. Combined with all the other effects that the Brexit vote may have on a world still steeped in recession, the task of preventing the Great Recession from turning into a 21st century version of the Great Depression may well prove difficult.

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