Reflections on the Referendum

7 MINS READJun 26, 2016 | 23:08 GMT
Reflections on the Referendum

Editor's note: The following analysis was written by ETM Analytics, an economic and financial advisory firm with offices in the United States and South Africa. While not a Stratfor analysis, it complements our views by providing a macroeconomic perspective of the Brexit referendum. We hope this joint effort amplifies our readers' understanding of the outcome of this historic vote.

The United Kingdom's decision to leave the European Union has raised more questions than answers. The results of the referendum have ushered in greater political uncertainty, a heightened sense of financial market risk and deep division in British society. But with so many scenarios in play, there is still much that we don't know. When will the British government actually invoke Article 50 of the Lisbon treaty and begin its formal departure? What will the new government look like now that Prime Minister David Cameron has resigned? When will the Parliament ratify the referendum results? What does the future hold for Scotland, which is already considering a second vote to remain in the European Union? How will Britain's new macroeconomic, business, trade and immigration policies take shape? And, perhaps most important, what is the fate of the bloc itself?

Before the referendum took place, ETM Analytics argued that leaving the European Union would be unlikely to make Britain's economy structurally worse off but that it could induce sufficient panic in financial markets to hasten an inevitable cyclical downturn. The British economy is fragile whether it leaves the European Union or not, but in our view Brexit gives it more opportunity for constructive reform and greater flexibility to deal with future regional financial and economic instability and contagion. We also argued, however, that leaving would not cure all of Britain's ills. These arguments still hold. So rather than repeat our previous predictions, we thought we might use this space for reflections on the past few days that may, we hope, begin to clarify the future.

Vicious Circles

The Brexit takes place against a precarious global macro backdrop. The global financial and monetary system is fragile, and, as we have noted, this fragility is a direct result of a flawed architecture. So we see the Brexit as a consequence of economic and financial dysfunction, not a cause of it.

The system's poor design has predisposed major economic systems to financial and economic crises. The crises, in turn, have inspired quick-fix solutions, not a fundamental redesigning of the system itself. Fiscal deficit spending and quantitative easing, for example, treat the symptoms but not the disease of economic distress. If anything, the quick fixes have made systemic dysfunction even worse, and state fiscal, monetary and regulatory control remains permanently elevated accordingly. The result is stagnation, rising wealth inequality and state power concentration that is voraciously breeding potent political discontent.

Political discontent has now manifested in ways that transcend well-worn political dividing lines, creating greater general uncertainty than normal — something fragile systems don't cope well with. The political volatility brewed in this financial and economic cauldron unmercifully loops back as a catalyst for even more system instability. This is where we are with Brexit, and we expect to see many more instances of the political volatility feedback loop exposing financial and economic weakness, not just in Britain but in major economies across the globe in the years ahead.

Breaking this vicious cycle by building a dynamic wealth-creation system is difficult but critical for countries in the throes of economic stagnation. In a sense, Brexit is a bet that Britain can do this more effectively and more quickly outside the strictures of the European Union bloc than in them. There's good reason to believe this. Our research shows that smaller nation-states have been highly capable of reforming their political, legal and financial systems constructively since the 2008-2009 global recession in ways that incubate rather than inhibit growth and diffuse rather than ferment political volatility.

Disentanglement from Brussels may buy the kind of flexibility Britain needs to tackle this challenging task better. Still, Britain is not a small nation-state but a large, complex and old one with deep international financial and economic roots. So Brexit success, while achievable, will have to be hard fought and hard won.

Europe Weakens

The immediate market reaction to the Brexit — what some call the "naked" reaction — was jarring. But, tellingly, continental European stock markets, and particularly banks, not only suffered terribly but performed worse than their British counterparts, even after adjusting for currency moves. Southern European sovereign bonds also sold off aggressively.

The implied early message in the markets is that Europe may be a bigger loser from the Brexit than the United Kingdom. This idea is certainly plausible even if one assumed the Brexit did not heighten the risk of an EU break-up. Brexit leaves an already fragile union more budget-constrained, less sure of drawing on British support for ailing periphery members, and open to being out-competed by a potentially more nimble and dynamic Britain.

Layer over this the particularly precarious state of the Continent's undercapitalized banks and the now heightened risk of further EU fragmentation and one can see why Brussels' nose is so out of joint. Investors are now applying a greater political risk discount across Europe in expectation of escalating vicious circles all over the region. We argued that the Brexit could be a catalyst for recession and financial panic in Britain, but it may be even more so in Europe.

Political Realignment

The British political landscape stands to be radically reshaped. Just a little more than a year ago, Britain's Conservatives were basking in the glory of their Parliamentary majority. Now the prime minister has resigned, and there is precious little clarity on what comes next, let alone whether the Conservatives retain such strong support. If a new government can't muster parliamentary confidence — which is no short order — elections probably aren't too far off. The referendum has effectively re-marked political territories and may eventually alter British party politics beyond recognition.

The reconfiguration of the political balance of power certainly leaves a problem of policy uncertainty that won't be solved quickly and will probably leave a sour taste in the mouths of financial markets. But we know from referendum day poll data that the British electorate is predominantly liberal, open and tolerant and wants to be internationally connected as Britain has been for centuries. We expect this is roughly where the British political pendulum will eventually swing again, and that should bode well for reform efforts. Though it may deviate periodically, Britain tends to revert to open financial flows, free trade, and strong global connectivity of human capital and technology flow.

But this "resting place" will have to deal with core grievances of the economically marginalized. The redistribution of wealth — a temptation for opportunistic politicians — would have a short shelf life. Not only is Britain in a fiscal cul-de-sac, but the referendum results make clear that this constituency is tired of the indignity and social immobility wrought by perpetual state largesse. Constituencies that are heavily subsidized by EU money voted overwhelmingly to leave the union. Reformers will have to grasp that most of those who voted to remain did so because to them the European Union represents openness and economic connectivity, while many who voted to leave want less regulation, jobs not handouts, and bringing sobriety to what they see as a rogue banking and financial sector.

This confluence of political forces can and should, under astute leadership, result in politically popular liberalization reforms, which could put Britain ahead of its developed market peers in growth and dynamism. The Brexit does not guarantee this outcome, but it gives the country some options. 

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