We expected it was going to be close.
We just didn't expect it to be close and in favor of Brexit. This is likely to be one of those events in which most will remember exactly where they were upon hearing the news. As we've argued before, this won't be an unmitigated disaster for the United Kingdom, but from an economist's perspective, it's likely to be more negative than positive. The impact on the rest of the European Union (EU) and therefore the global economy may well be even bigger.
The market's immediate response to Brexit
Relative to the U.S. dollar, the British pound depreciated double-digit percentage points early this morning, and it may have further to fall. The euro has also weakened, while the Japanese yen has appreciated significantly. European bank equities are down significantly, particularly U.K. bank stocks. Meanwhile, yields on Japanese government bonds, German bunds, and U.S. Treasuries have dropped, pushing the prices of those relatively safe-haven sovereign debut issues higher. It's worth considering that stop orders have been forbidden today, and so far trading volumes are thin, exaggerating market moves. Today will be difficult, but it will take a little while to see what market moves will be sustainable.
The governor of the Bank of Japan (BoJ), Haruhiko Kuroda, was the first central banker to make an official statement about standing ready with swap lines to ensure market liquidity in the United Kingdom. The remaining G7 policymakers followed shortly thereafter. The Bank of England (BoE) will be pumping significant liquidity into the system today, but we think central bank liquidity measures will represent the extent of policy reactions for now. There have been many similarities drawn between a potential Brexit and the failure of Lehman Brothers in 2008. Lehman's bankruptcy filing took the markets by surprise, whereas we are all suffering from Brexhaustion, discussing Brexit to death. Banks in particular have had detailed contingency plans in place for weeks. There will be a lot of volatility, but this is not a complete surprise and, thus, not repeat of Lehman-like scenario.
With a 72% turnout and about a million more voters in favor of Leave over Remain, this was a solid win for the Leave campaign.1 Prime Minister Cameron resigned hours after the vote was called and said he hoped to have a new prime minister in place by September. This means a new politician will be forced to renegotiate the United Kingdom's relationship with its trading partners. The conservatives are essentially paralyzed, while there is no effective opposition in the country. It seems likely the United Kingdom will wait to invoke Article 50, which initiates the process of leaving the EU, until after a new prime minister is in place. This would also give the British government time to work out what exactly its goals are before the two-year term to negotiate the country's new trade relationships (a time horizon dictated by Article 50) begins. Leaving could take many different forms, following models established by Norway, Turkey, and Switzerland, or jettisoning all of these and just subscribing to World Trade Organization (WTO) rules. Given the focus of the Leave campaign on migration, it seems likely Britain will choose to leave the single market and restrict the ability of EU citizens to work in the United Kingdom. This means that the Norway model—while the least bad of all the Brexit models—is likely off the table.
Today's market movements will be huge, but the medium- to long-term impact of Brexit on the United Kingdom and particularly the EU are likely to be much bigger. The real question now is how badly the EU may react toward the United Kingdom as a result of this decision. If the markets continue to suffer, the United Kingdom might be granted leniency as it will be in the EU's best interests not to have an unstable neighbor thrown into the grips of financial crisis. However, if the market reaction becomes more muted, the EU is likely to make an example out of the United Kingdom to deter other member countries from making similar moves.
Within minutes of the victory for the Leave campaign being called, populist Dutch politician Geert Wilders demanded the Netherlands have a referendum on its EU membership as well. In France, shortly thereafter, Marine Le Pen (the leader of the National Front) called for a French EU referendum. Sinn Fein in Ireland has already demanded an Irish unification vote following the Brexit result. There have been suggestions of another Scottish referendum on leaving the United Kingdom, although it is unclear whether this will go ahead (and even more unclear that it could succeed). Brexit poses not only an existential threat to United Kingdom, but to the rest of the EU as well. If other European countries choose to leave the EU—and according to a recent Ipsos poll, nearly half of French and Italians said they would vote to leave given the option—then the contagion to the global economy will be significantly amplified.
In terms of policy responses, Brexit could be a game changer for central bank thinking. We have long expected the BoJ to be the first to implement helicopter money (a permanent transfer from a central bank to households), but we now think the BoE may be the first. If the United Kingdom does employ helicopter money, other central banks will follow. The BoJ was undoubtedly already going to ease monetary policy further this year even if the Remain camp had won. Brexit will only make Governor Kuroda's intervention more extreme. The same goes for the European Central Bank (ECB)—further expansion of quantitative easing, rates cut further into negative territory, and equity purchases all seemed likely before, but now they seem a foregone conclusion.
We had expected the U.S. Federal Reserve to hike rates in December 2016, but it may well have to wait until next year. In the face of aggressive, persistent easing from the BoE, BoJ, and ECB, the U.S. dollar will likely strengthen. The United States will continue importing deflationary pressures, and inflation will remain elusive. A key question is whether Brexit could push the United States into recession. We think it is unlikely the U.S. consumer—which is driving this recovery—will be thrown off by Brexit in the short term. However, if there is contagion to the rest of Europe, then a U.S. recession becomes more likely.
The United Kingdom has woken up today a deeply divided society. In the face of political instability and economic uncertainty, the British leadership must also figure out how to reunite the country to avoid adding social unrest to the list of challenges Britain faces. This is a tall order. Even worse, the Leave campaign pushed a lot of untruths over the past few months. Let's hope that the Leavers knew exactly what they were voting for and that we don't end up with a United Kingdom in which Remainers and Leavers both end up disappointed.
1 “EU Referendum Results,” BBC News, 6/24/16.