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by Christopher Thronbert, PhD
When the UK voted to leave the European Union on Thursday, it set off an explosion of media coverage even as equity markets around the globe, including in the United States, dived in the aftermath. Bond markets rallied and the $US spiked up sharply. The market has settled down a bit in the last two days—but judging by the initial reactions you’d think the Brexit was the single worst piece of financial market news since the failure of Lehman Brothers in 2008.
Except for it’s not. Not even close. While this is a serious change for the EU, it has none of the conditions that could cause a major recession in the UK, much less cause the kind of sharp global slowdown that seems to be indicated by the financial markets. This sort of disconnect between the economic reality and the financial reaction seems to be intensifying over time—with the Brexit perhaps being one of the worst episodes to date. Why it’s happening and whether it will it continue to get worse are questions that investors and market regulators need to start asking.
But let’s talk about why the Brexit is functionally a non-story. When a country votes to leave the EU a special provision of the charter rules is enacted and the country in question has 2 years to negotiate the specifics of the new relationship. In other words, while there is a change coming, it won’t happen for at least 2 years—if at all, since the UK may decide to change their minds through another referendum before then.
The other thing to remember is that just because the UK may leave the EU, that doesn’t mean it will lose access to EU markets as many observers seem to be suggesting. Rather, access will become slightly more limited. How much more depends on the negotiations that will take place in coming months.
One ongoing theory is that France and Germany will need to ‘punish’ the UK with harsh new terms of access in order to dissuade other EU nations from following in their path. But there is a functional limit to how far they might push that strategy. The UK and the EU, like many nations, are part of the World Trade Organization (WTO). This broader global set of trade rules specifically states that single countries cannot be singled out for trade sanctions without just cause.
Given all this, it seems the worst case scenario for the UK is that they would simply have to deal with the same set of rules the United States or China deals with when exporting goods and services to Europe—which aren’t all that bad judging by the healthy amount of trade already moving back and forth. And the UK has a big advantage given its physical proximity to the EU, and the fact that its institutions are already accustomed to working within the EU rule systems.
It’s more likely the UK and EU will end up with something even more open. The extensive movement of people between the two entities over the last couple of decades of integration have created economic linkages that benefit both sides of the negotiating table. It seems likely that many of the benefits of EU membership will be provided to the UK anyways.
This isn’t to say all will be fine in the UK. Their exporters will be hurt to some degree by the loss of open access—although at the moment they are being helped by the sharp drop of the Pound. But they will have time to adjust to the new rules. London’s enormous financial center might also be constrained at some level—but there is no place in Europe that is capable of ‘filling in’ at this time.
In short, this doesn’t seem like a recession-causing episode, but rather one that will slow growth modestly in the UK for the next decade. Ultimately, this is significant and unfortunate. But it is nowhere near sufficient to explain the massive equity sell offs seen in U.S. stock exchanges. After all, a modest slowdown in UK growth is functionally irrelevant for the U.S. economy.
What’s going on? It’s a vicious circle of ‘miserabalism’ and financial market volatility. The press, pundits, and politicians have always been guilty at some level of using exaggeration to drive their messages home. But in the increasingly competitive world of capturing the public’s attention the hyperbole has become more and more extreme. The Brexit was no exception. Its opponents claimed many things, including saying that the UK would be pushed into a depression if the Brexit passed. These predictions were offset by equally ridiculous claims from the yes on Brexit side.
Despite the fact that such claims were untrue, the financial markets responded sharply, as if they were.
Remember that a trader—particularly one in this era of high speed hijinks—cares little about reality. They only care about what they think other traders think about what other traders think. When the vote came through, traders started selling largely because they thought someone else might do the same. In other words, in game theory fashion, even if every trader knew these claims were ridiculous, you might still see the markets dive.
But the pundits, press, and politicians immediately take the declines in equity prices as the very justification that proves their hyperbole right. Sadly, by the time we get a few more quarters of UK GDP growth in, and that ends up disproving the hyperbole, the story will be relegated to the back page—with the headlines focused on some other looming crisis that is about to ruin the global economy.
Don’t get me wrong – there is an alarming aspect to what happened last week. But it’s less about the specifics of the UK leaving the EU, and more about the fact that they chose to leave despite the reality that, on net, the UK was modestly better off in the EU system. What is alarming is that in this era of unprecedented access to information and education, the public seems less able to distinguish miserabilism from real analysis. And this, in the end, explains some of the xenophobia and nationalism that has been popping up in so many places, including the U.S. presidential campaign. No wonder Donald Trump was so happy the Brexit happened.
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