Why the Brexit risk is now higher, not lower

When the Brexit vote first happened, I indicated that I didn’t see the huge risk to the UK that others did. In fact, I thought the initial tail risks were elsewhere, like the Italian banking system. The economic risks for the UK were always overstated because of monetary, fiscal and currency offsets. But now that a hard Brexit comes closer, the risks have increased, not decreased, as Mark Carney, the Bank of England Governor contends. Some thoughts below

First, here’s what Mark Carney is saying:

In the run up to the referendum, we felt it was the largest risk because there were things that could have happened which had financial stability implications. Actions were taken to mitigate that, but having got through the day after, the scale of the immediate risks has gone down.

Fair enough. The immediate financial stability implications of Brexit have faded and now the question is mostly geopolitical and economic. But if you look at Carney’s May statement, its clear that financial stability risks aren’t the only risks he originally outlined. Here’s how he put it in a speech a week after the Brexit vote:

All this uncertainty has contributed to a form of economic post-traumatic stress disorder amongst households and businesses, as well as in financial markets – that is, a heightened sensitivity to downside tail risks, a growing caution about the future, and an aversion to assets or irreversible decisions that may be exposed to future ‘disaster risk’.

There may be an affect heuristic at work. Put simply, long after the original trigger becomes remote, perceptions endure. They become embedded in economic narratives and their salience persistently affects risk perceptions and economic behaviour.

This point is not trivial. Research has shown that people who have experienced low returns throughout their lives, like the ‘Depression Babies’ of the 1930s, report lower willingness to take financial risk, are less likely to participate in the stock market, invest a lower fraction of their assets in equities, and are more pessimistic about future returns.

Today, uncertainty has meant an inchoate sense of economic insecurity for many people despite generalised economic prosperity. Across the advanced economies, employment appears less secure, wages more subdued, and inequality more pronounced. And its precautionary effects can mean spending is deferred because there is often a real option value to waiting. Firms delay investment decisions. Investors seek safe returns. Households put off buying durables. The common thread is that any economic decision that requires finance, has a sunk cost, or an uncertain payoff, is affected

The gist of these comments is that it is the uncertainty of Brexit that causes households and businesses to decrease consumption and investment. And it is the same thinking among City economists that led many to predict recession in the aftermath of the Brexit vote. The reality of course is that uncertainty did not cause people to spend less and the British economy has gone from strength to strength.

Moreover, if you looked at Sterling pre-Brexit, it was at a seven-year high on a trade-weighted basis just a month prior, comparable to Sterling’s overvaluation before it got booted out of the ERM in 1992. Princeton University professor and former IMF official Ashoka Mody says this is an important consideration regarding the UK’s gaping current account deficit:

The post-Brexit referendum movements in asset prices tell a consistent story. Whether over the months since the referendum, or in the days after the Conservative Party conference, property price expectations and the pound fell in tandem, suggesting that the pound’s carry trade bubble from 2012-2015 was unwinding. Stock prices, in contrast, rose and remained above pre-referendum levels. The implication is that some part of the lost competitiveness was being regained.

But what happens if and when the UK actually files Article 50 to exit the EU? That’s when the rubber hits the road. The likelihood of the UK carving out a special status with the EU looks remote. And so the UK will have to see through a hard Brexit and all the pitfalls that could entail. There won’t be any uncertainty then. If consumers actually do stop buying and business investment sinks, it is then that we should see that response. All of the financial stability concerns could indeed come roaring back too. And that’s when policy offsets might prove inadequate. So from where I sit, the risk from Brexit now is actually higher, not lower.

P.S. – This is a bit different than what I was saying three months ago. Look at what I said on CBC Business News back in October. The negative impact never came to pass in the immediate aftermath of Brexit. But by October, it was clear, the negative impacts were rising. Now, they’re even more pronounced.