Silver Linings of the Brexit

Economists warn of a sudden recession due to the uncertainty of Britain’s exit from the European Union and the lack of a strong plan for the future with minimal further disruption of the global markets. Over the past 2 weeks, the British pound has dropped to record 31 year lows against the American dollar, and the Bank of England recently stated that it would likely combat the financial turmoil through quantitative easing and rate cuts. Current economic predictions of households delaying consumption and corporations postponing investment would further lower the demand for labor and increase unemployment. However, despite the potential signs of further economic turmoil, there are silver linings that are becoming more apparent, such as emerging markets and the role of uncertainty.

Immediately after the U.K’s vote, emerging markets were fairly calm, and local stocks out-performed stocks in the mature markets. A part of this trend can be attributed to the possibility of U.S. interest rates remaining lower for longer, and the asymmetry of political risk in emerging and developed markets. A lesson starting to become more apparent is that investors underestimate political risk to their detriment, which can benefit the emerging markets. A large problem with developed markets is that investors hold widely held, untested assumptions to be true, causing economic havoc when those assumptions fall through. An example from the 2009 global financial crisis was the assumption that there couldn’t be a housing-market downturn nation-wide in the U.S., or that the Eurozone’s government bonds were risk-free. Emerging market investors are used to accounting for political instability, such as institutions failing or the lack of judicial independence. Investors are typically rewarded for taking the risk, more so if the institutional problems are resolved.

There are opposing views on the role that uncertainty plays on investments and the economy. Ben Bernanke’s graduate paper in in 1975 argued that when businesses face uncertainty, they tend to delay investment spending and hiring. However, there is recent evidence that for highly competitive environments, uncertainty increases investment and output. This is because businesses in competitive industries or economies can’t afford to wait for more information or risks to decrease, as the wait would give rivals investment and hiring opportunities. Overall, Britain’s economy is fairly competitive and has a somewhat flexible labor market. There are a large number of industry’s that are competitive and not dominated, such as computer science, and studies have found that they are likely to continue their investment and hiring to maximize future opportunities.